About Those "Bond Vigilantes"

Adam Tooze has a post discussing the bond vigilante theory:

The phrase “bond vigilante” is normally attributed to Ed Yardeni a Wall Street economist who coined it in the 1980s to describe the role of bond markets in disciplining governments.

“Bond Investors Are The Economy’s Bond Vigilantes”, Yardeni once declared. “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.” As Yardeni later spelled out: “By vigilantes, I mean investors who watch over policies to determine whether they are good or bad for bond investors … If the government enacts policies that seem likely to reignite inflation”, Yardeni elaborated, “the vigilantes can step in to restore law and order to the markets and the economy.”

This is an example of reasoning from a price change. If bond traders fear that government policies are likely to lead to higher inflation, this may result in higher interest rates (via the Fisher effect). But higher interest rates due to the Fisher effect are not a contractionary policy. In order to prevent inflation from occurring, the government must stop engaging in inflationary policies. Bond vigilantes won’t solve the problem.

Tooze discusses the 1994 bear market for bonds, an example often cited by proponents of the bond vigilante theory:

Furthermore, 1994 was not a spontaneous bond market attack. It too was triggered by the Fed.

In the summer of 1993 Alan Greenspan had become worried about the acceleration of inflation. Even though the Clinton administration in August 1993 had forced through the fiscal consolidation plan that would return the US Federal government to surplus, Greenspan wanted to add further dampening pressure. He was convinced that allowing for inflation expectations real interests rates had fallen to zero.

Tooze is appropriately skeptical of the bond vigilante theory but is also reasoning from a price change. Tooze assumes the rate increase was caused by the Fed, presumably a contractionary monetary policy by the Fed. I see no evidence for this claim.

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