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Trump tax plan brings helpful discussion of “vigilante” bond theory

The Financial Times‘s Alphaville blog notes discussion of a “bond vigilante” effect has returned with the announcement of Trump’s deficit-increasing tax plan. The idea is that anticipations of increased bond supply will force interest rates on US Treasury securities upward–a “crowding out” effect colorfully attributed to bond traders called “vigilantes.” There is currently little evidence of such an effect in market data. Alphaville links to a previous article from the Bloomberg news service website, which gives more credence to the bond-vigilante theory.

Alphaville interviews a bond market analyst, who notes that

Inflation is the thing that drives investor aversion to fixed income markets, rather than government borrowing.
Historically, people used to talk about bond vigilantes in terms of deficits or significant increases in the debt-to-GDP ratio. But there’s no great evidence that the level of government borrowing has been a very significant driver of either the level of government yields, or the term premium, or the shape of the yield curve.

The articles do not make reference to the fact that the US issues debt denominated only in its own “sovereign currency”–a point clarified in the world of economics by modern money theory (MMT), a descendant of “chartalist” monetary theory, whose adherents included Keynes as well as Knapp and Innes.

Also, the articles note that forward securities markets remain more pessimistic about growth and optimistic about inflation suppression than the Fed’s projections. In other words, market expectations are for interest rates to be lower than the Fed’s own projections, because growth and inflation will be slightly lower than the Fed currently thinks, forcing it to slow its planned policy tightening. The FT‘s Alphaville also features an interesting historical discussion of reigning “real” short-term interest rate expectations. It makes a case that the Fed’s expectations have declined to roughly match the markets’ view that the “real” FFR will average around 1 percent over the full business cycle.

All of this discussion involves expectations about what the Fed will choose to do about interest rates on Treasury debt, reflecting a view that short-term rates are set by policy–not the interaction of supply and demand–and that longer-term rates are influenced additionally by inflationary expectations, and not the trajectory of anticipated deficits.

This analysis is consistent with a post-Keynesian or MMT view, rather than one that includes “portfolio crowding out,” in which the federal government competes with private borrowers for a given supply of loanable funds, driving yields upward. An example of this second view can be found for example in this New York Times news analysis, which makes reference to crowding-out as if it will almost certainly happen. That article refers to a Urban-Brookings Tax Policy Center study.

Overall, markets seem to be moving after the tax plan announcement in accord with both MMT and post-Keynesian endogenous money theories. It is a shame the Times piece and many others in the media do not take the occasion to mention alternative views about money and interest rate determination.

Of course, Alphaville’s insightful critique of interest rate fears does not mean that the Trump tax plan–with its big “supply-side” cuts–is a good one. But that topic is for another day.

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