First ask why the risk premium rose.
A number of bloggers including Paul Krugman, Tyler Cowen and Nick Rowe have recently weighed in on the question of whether a higher risk premium would be expansionary. Before criticizing this analysis, let me emphasize that I do understand the concept of ceteris paribus. However I think it’s very dangerous to engage in this sort of speculation, because higher risk premia almost never happen, ceteris paribus. They happen for a reason, or multiple reasons. And any conclusions drawn from the certeris paribus case are often (mistakenly) applied to a real world increase in the risk premium, which is triggered by some sort of actual shock.
Let’s start by trying to understand why so many commenters found Krugman’s argument (that a higher risk premium on government debt can be expansionary) to be a bit too clever, a bit too counterintuitive. My hunch is that it was because their instincts tell them this is unlikely to happen, mostly because they don’t ever recall seeing anything like an expansionary rise in a risk premium, whereas they have often seen something closer to the opposite. (Closer, but not exactly the opposite, as rising risk premia are often associated with countries without their own currency, or with debts in foreign currency.)
And in fact we should not be surprised that we don’t see expansionary increases in the risk premium. The growth rate of NGDP is far and away the biggest determinant of the budget deficit. A major expansion in NGDP would sharply reduce the budget deficit, and also reduce the ratio of debt to GDP. So it’s almost impossible to imagine a rational expectations solution where you get an expansionary rise in the risk premium. Not because there is anything wrong with Krugman’s ceteris paribus reasoning, but rather because it’s almost impossible to imagine a shock that would be expected to promote both a higher risk premium and a faster recovery.
Another way of putting this point is that any assumed shock that boosts both the risk premium and the recovery, is unlikely to do so in a world of rational expectations. Now of course one could argue that the ratex assumption is wrong, but once we do so we are out of the world of science and into the world of pure conjecture. In that case proponents of the expansionary risk premium increase can no longer refer to scientific models in support of their assertions. Without ratex EVERYTHING changes, and virtually anything is possible. I could argue that the bond vigilante news frightens consumers, and the MPC falls sharply. Literally ANYTHING is possible, once you dump the ratex solution. As the old mapmakers used to indicate; “Here be monsters.”
What sort of actual shock would be most likely to cause a rise in the risk premium on US government debt? I have trouble visualizing any plausible scenario that would do this (in that sense I agree with Krugman, who is also skeptical.) But I’ll do my best. Here’s the sort of triple whammy that might do the trick:
1. Congress engages in a massive fiscal stimulus project, with no credible plan for the long run deficit problem.
2. The Fed views the plan as highly irresponsible, and sharply tightens policy—driving NGDP lower.
3. The Fed warns Congress that they will not bail out a failed fiscal policy with inflation, and that Congress will have to clean up its own mess.
That sort of shock might create a higher risk premium on Treasury debt. And that sort of shock would not be expansionary, just the opposite. But of course those arguing that a higher risk premium is expansionary are going to object that my conjecture violates ceteris paribus. True, but nothing ever happens to prices or risk premia, ceteris paribus. So the ceteris paribus case is not very interesting.
HT: Saturos, Mike Moffatt