Arnold Kling on the Bond Bubble

Arnold debates the marekt:

Markets: With so much unemployment and excess capacity, we cannot possibly have inflation.
Kling: Do you not remember the 1970’s? Furthermore, you may be over-estimating the excess capacity. An excess capacity to sell houses and trade securitized debt may not help absorb demand in other sectors.
Markets: The Fed has no plan to raise interest rates. Therefore, interest rates cannot rise.
Kling: The Fed merely determines the composition of government debt. The amount of government debt is determined by fiscal policy, which the Fed does not control. At some point, the huge supply of government debt has to matter. If the public loses its appetite for government bonds, then the only way the Fed can absorb the supply is to print gobs and gobs of money. Prices will rise, and bond-holders will suffer a partial default in terms of purchasing power. Even if the Fed is relatively passive, I think that the high-inflation scenario is plausible.
Markets: I can hold bonds for now. If inflation threatens to come back, I will see it in plenty of time to get out.
Kling: That is how bubbles work. Everyone thinks that they have more protection from the bubble than they really have. Personally, in spite of the inflation bets in my portfolio, my big worry is that I do not have protection from the political risk and financial chaos that could come from a sovereign debt crisis.

Posted by on November 2nd, 2009 at 10:28 am


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