Keynesians on Treasury Default: Depends Who’s in the White House

Progressive-leftist commentators Paul Krugman and Matt Yglesias are aghast at Donald Trump’s (now retracted) musings that he might give a haircut to Treasury securities in the event of a fiscal crunch.

In this piece, Yglesias says Trump “just threatened to cause an unprecedented global financial crisis” because his policy would take away the world’s safe asset (i.e. Treasury securities). For his part, Krugman wrote that the “Trump solution would, among other things, deprive the world economy of its most crucial safe asset, U.S. debt, at a time when safe assets are already in short supply.” Krugman went on to point out that “when Mr. Trump talks nonsense, he’s usually just offering a bombastic version of a position that’s widespread in his party. In fact, it’s remarkable how many ridiculous Trumpisms were previously espoused by Mitt Romney in 2012…

This is an ironic statement for Krugman, since back in 2012 both he and Matt Yglesias argued that even if investors around the world suddenly feared a Treasury default, it would help the U.S. economy. In other words, even though Trump himself quickly walked back his suggestion of renegotiated Treasury debt (instead suggesting the Fed could just print our way out of a cash crunch), he could’ve gone to the barricades by quoting from Nobel laureate Paul Krugman himself.

Specifically, back in 2012 lots of right-wingers were horrified at the string of trillion-dollar-plus budget deficits that the Obama Administration was running. (See Table 1.1.) They were warning that worldwide investors might start to worry about a default, demanding higher interest rates which would make the debt that much harder to finance and hence cause a vicious self-fulfilling prophecy. (This is what had just happened to Greece, for example.)

Now at the time, Krugman and Yglesias thought these fears were nonsense. Not only were attacks from what they dubbed “invisible bond vigilantes” NOT going to come, but even if they did, it would help the U.S. economy.

I know it’s hard to believe that Krugman and Yglesias argued this, but they did. For example, here’s Krugman from December 2012:

“Now, the big fear now is that we’ll have a quite different type of vigilante attack, in which fear of default leads to a general flight from our nation’s assets, sort of like this:

[Krugman then has a diagram showing wealth flowing out of short- and long-term domestic bonds, and into foreign assets.–RPM]

How does this play out? Well, if you’re Greece, the exchange rate is fixed – or actually nonexistent, because you don’t have your own currency. So what happens is that both short-term and long-term interest rates rise.

But that can’t happen in the United States, where the Fed retains control over the money supply and of short-term interest rates. So what would happen instead would be a plunge in the exchange rate. And this would actually have an expansionary effect on the U.S. economy.

The point is that the analogy with Greece is just completely wrong; the difference in our monetary positions means that even if the bond vigilantes did attack, they would probably help, not hurt, our economy in the short run.”

There were plenty of other Krugman posts where he reiterated this theme; see here and here, for two examples.

Matt Yglesias was also crystal-clear back in 2012. Like Krugman, he didn’t merely say that there would not be an attack from the bond market on Treasury debt. No, Yglesias went further and argued that even if such an attack occurred, it would help the U.S. economy. Here he explains:

The interest rate spike story just seems incoherent. Suppose investors do start dumping treasury bonds and interest rates rise. Where does the money go?

Well it could go into private domestic investments, which would boost the economy. Or it go into foreign financial assets, which would reduce the value of the dollar and boost the economy by bolstering exporting and import-competing firms. Higher interest rates have historically caused recessions because the Federal Reserve was deliberately using high interest rates as a tool for inducing recessions because they thought higher unemployment would quash worker demands for higher wages and keep inflation under control. An exogenous reduction in the global investment community’s inclination to hold treasury bonds could reduce American doctors’ ability to take that trip to Paris they’ve been dreaming of this spring, but couldn’t induce a recession.

So isn’t that convenient? Back in 2012, in the face of Obama’s string of trillion-dollar deficits, Krugman and Yglesias said that the Federal Reserve controlled short-term interest rates, meaning that an investor desire to unload Treasuries would simply weaken the dollar and hence boost exports. Thus Aggregate Demand would be boosted and some of the unemployed could go back to work.

But now in 2016, when Donald Trump makes some off-the-cuff remarks that might lead investors to worry about a Treasury default, neither Krugman nor Yglesias mentions a word about the beneficial effects of a weaker currency. Now, their focus is on the Treasury’s role as the global “safe asset,” and how Trump’s remarks demonstrate his utter recklessness as he threatens the global financial system.

In closing, let me tie up one remaining loose end: Yes, it’s true that Krugman and Yglesias in 2012 were talking about investor fears of a default, while today they are analyzing a default itself. But obviously, if investor fears of a default are a good thing (as Krugman and Yglesias argued back in 2012), then Trump actually causing a default would also bring about those good effects (since investors would fear the default that Trump was about to implement). So at the very least, Krugman and Yglesias today would have to argue that the benefits of a default scare were swamped by the harms of an actual default.

But that’s being too generous. The specific reasons Krugman and Yglesias give today for the harm of a default–namely that it deprives the world of its “safe asset”–would have been true back in 2012 if bond investors suddenly began dumping Treasuries because they feared a default. In that scenario as well, the world would’ve lost its “safe asset.” And yet, neither Krugman nor Yglesias even used that term back then. Instead they kept scratching their heads, trying to even come up with a hypothetical model in which an attack from the “invisible bond vigilantes” would hurt Americans.

One almost gets the sense that they are partially motivated by political considerations, you know?

P.S. In case you’ve never encountered such an idea, check out Murray Rothbard’s argument in favor of debt repudiation on libertarian ethical grounds.