Bond Bubbles and Modern Monetary Theory: Extra Monday DeLong Smackdown by Noah Smith

So I believe that Noah Smith has changed my mind about something…

I was thinking out loud to him about the key conundrum of Modern Monetary Theory…

Modern Monetary Theory, or perhaps we had better call it old Abba Lernerian fiscal theory, holds that the government’s fiscal-balance condition is not independent of the economy’s macroeconomic price-stability condition. Anything that pushes the government out of fiscal balance and requires raising taxes to avoid default will also produce higher inflation and so require macroeconomic austerity. And part of such austerity is, yes, raising taxes.

Why? Suppose people start to fear that the government will not raise enough in taxes to pay off its debts. They will then try to dump government liabilities for real goods and services. That will, the MMTers say, push aggregate demand about potential output and generate inflation.

I was saying to Noah that this seemed to me to rely very heavily on the efficient market hypothesis.

What if investors mistakenly thought that the debt was sustainable? Then there would be no dumping of bonds and no inflation. And suppose that one day, suddenly, expectations shifted discontinuously, so that the government was required to pay much higher interest payments in order to rollover the debt? And what if amortizing those high interest payments required raising taxes too far, and pushed the economy over onto the unsustainable part of the Laffer curve?

It thus seemed to me, I said, that MMT required the EMH. Deviations from the EMH, I said, allowed the possibility of a government debt-crisis baking itself into the cake without any advance warning via inflation.

And Noah looked at me and said: this is what the people who say we are in a bond bubble–the people you find incomprehensible–mean.

I said: They should not call it a bubble. That should be reserved for situations in which asset holders know that they are paying more than fundamental value.

He said: So? You are objecting to the word “bubble”. But, still, that is what they mean.

And I thought: Hmmm…

Noah is right…

I can no longer say that those who fear a bond bubble are incoherent.

I can (and will) say that their use of the word “bubble” in “bond bubble” is misleading: The people holding bonds are not doing because they expect the capital gains from selling them to a bigger fool. They are, rather, holding them because they have overestimated fundamental values.

And I can and will say that their fears are misplaced: There is no chance of an upward jump in interest rates large enough to require enough of a tax increase to push the economy over the top of the Laffer curve and into unsustainability, whether politicalor economic sustainability. Remember: the government can force the banking sector to hold as many bonds as it needs it to hold. Remember: the government can tax the interest on those bonds at whatever rate it needs to tax.

But score one for Noah Smith, with a very well-executed DeLong smackdown…