The Bond WarWhy Paul Krugman and Niall Ferguson are hammering each

other about T-Bill interest rates.

By Daniel GrossPosted Thursday, June 4, 2009, at 4:25 PM ET

Paul KrugmanIt's fair to say that 10-year and 30-year Treasury bonds are not subjects that enthrall the American public

the way, say, Kate Gosselin does. In the last six months, however, the state of those bonds has become the subject of

feverish argument in the economic elite. The interest rate of the 10-year Treasury bond has spiked from 2.07 percent in

December 2008, when the world was falling apart, to a recent high of 3.715 percent on June 1—a 79 percent increase. The

30-year bond has risen from 2.5 percent last December to about 4.5 percent today. Now factions led by economist Paul

Krugman and historian Niall Ferguson are feuding bitterly about the import of these charts. In late April, Krugman and

Ferguson squared off at a New York Review of Books/PEN panel, and they've continued with an op-ed war in the Financial

Times and New York Times (Ferguson here and Krugman here).

In a nutshell, Ferguson and his allies believe that the rising bond yields prove that markets are worried about the inflation

that will inevitably result from the fiscal policies of the Obama administration and the Fed. Given the large deficits and

rising concerns about the viability of Social Security and Medicare, Ferguson writes, "It is hardly surprising, then, that the

bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every U.S.

undergraduate) could such a tidal wave of debt issuance exert 'no upward pressure on interest rates.' " Ferguson's fears

have been echoed by the planet's leading inflation-phobe German Chancellor Angela Merkel and by influential Stanford

economistJohn Taylor. Turn on CNBC, and you're likely to hear talk aboutbond-market vigilantes, the mass of traders who

sell bonds and push interest rates up in order to warn governments not to spend freely.

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Dan Gross talked sense on the last bond bubble, gendered the world of stocks and bonds, and pooh-poohed the prognostications of America's

irreversible decline. Jack Shaferdefended Paul Krugman from the righteous onslaught of Andrew Sullivan. Gross also gloried in the history of

the government as lender of last resort.

Krugman and his fellow travelers couldn't disagree more. Far from being a sign of failure and impending disaster, they say,

the rising bond yields actually signal success and impending improvement. Government bonds were so low last December

because the world's investors were totally freaked out about risk. They sold everything—U.S. stocks, emerging market

government bonds, corporate bonds in Europe, Indian stocks—and parked their cash in the safest, most liquid investment

around: U.S. government bonds. In the months since then, as the stimulus and bailouts have helped stabilize the

economy, investors have started to relax. The indicators of market stress have improved. And so investors this spring

began to sell the low-yielding bonds and start buying stocks and other assets again. Check out these six-month charts of

the main stock market indices in Brazil and India. Clear-headed as always, Martin Wolf of theFinancial Times notes: "The

jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now

they are rushing out again. Welcome to the giddy world of financial markets." This line of argument makes sense,
especially when you look at a very long-term chart of the 30-year bonds, which shows just how much of an aberration the

December 2008 lows were. Does that chart look like a market that is worrying about the prospect of long-term inflation

and high-interest rates in the future?

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In evaluating the relative claims of the pessimists and the optimists, you also have to evaluate the messengers. And in this

instance, the Fergusonians lack credibility. H.L. Mencken tagged the Puritans as people possessed of the "haunting fear

that someone, somewhere, may be happy." Ferguson represents a strain of intellectual Toryism bedeviled by the haunting

fear that someone, somewhere may be getting social insurance. (Fellow sufferers include Clive Crook, Andrew Sullivan,

and George Will.) Their solution to the problem of large deficits always seems to be to cut entitlements and never to raise

taxes.

As for the bond vigilantes, have you noticed that they seem to surface only when a Democrat is in the White House?

Stanford's John Taylor didn't write many articles about the inflationary aspects of rapidly expanding deficits when the Bush

administration and Congress were turning surpluses into huge deficits, massively increasing government spending, and

creating a new Medicare prescription drug entitlement. He was working in the Bush Treasury Department. As

Krugman notes, "But it's hard to escape the sense that the current inflation fear-mongering is partly political, coming

largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the

government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration

into abandoning those rescue efforts."

What's more, the theory of bond vigilantes rests on the notion that the stock and bond markets function as a sort of daily

tracking poll, rendering a thumbs up or thumbs down on the efficacy of President Obama's economic plans. If you watch

CNBC, though, the market seems capable of showing only its disapproval. All the yahoos who shrieked about the "Obama

bear market" when stocks struggled in the first quarter of 2009 haven't turned around and declared an "Obama bull

market" even though the S&P 500 has rallied 37 percent since March.

Both the Fergusonians and the Krugmanites (of whom I count myself one) err in reading too much into short-term

fluctuations in bond prices. There's so much more at work. Randall Forsyth of Barron's explains a technical reason for the

short-term spike in 10-year and 30-year rates. Banks and financial institutions that own mortgages hedge their exposure

to refinancing by buying and selling Treasury bonds. When mortgage rates start to rise, as they've done in recent weeks,

institutions do the opposite and sell. "While mortgage investors previously had bought noncallable Treasuries to offset the

risk of their mortgages, mortgage investors have unwound that hedge, selling their Treasuries," Forsyth writes.

Finally, the notion that the market is telling us something—anything—ultimately rests on the erroneous assumption that

financial markets represent the collective wisdom of rational actors processing information efficiently. There are plenty of

cool-minded forward-thinking investors in the markets. But there are also a lot of lunatics, fools, sharks, widows and

orphans, government actors with ulterior motives, algorithmic traders, greedy speculators, and whack jobs. The markets

resemble the Star Wars bar scene more than they do the economics faculty lounge at Princeton.
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One former denizen of that lounge, Federal Reserve Chairman Ben Bernanke, seemed to split the difference yesterday.

"However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen," he told

Congress. "These increases appear to reflect concerns about large federal deficits but also other causes, including greater

optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of

mortgage holdings."