Should we be worried about "bond vigilantes"? What does the scary term even mean? Back in May of 2009, The Wall Street Journal issued an editorial explaining "bond vigilantes" and why they should be feared. Bond vigilantes are those investors who "demanded higher Treasury bond yields from the late 1970s through the 1990s whenever inflation fears popped up." In other words, they are investors concerned about the deficit. When the market fears the U.S. deficit is getting too large, U.S. bond prices rise, reflecting the sense of risk. Bond vigilantes "vanished earlier this decade amid the credit mania," explained The Wall Street Journal, "but they appear to be returning with a vengeance now that Congress and the Federal Reserve have flooded the world with dollars to beat the recession."

Not so fast, say Paul Krugman and a number of others: overblown fears about bond vigilantes are leading to austerity, which actually does have a chance of hurting the economy. In fact, looking at the latest prices on U.S. bonds, it seems that investors are more worried about austerity than profligacy in government spending.

  • The WSJ's Pro-Vigilante Argument "They have cause to be worried, given Washington's astonishing bet on fiscal and monetary reflation," wrote the editors a little over a year ago:
The Obama Administration's epic spending spree means the Treasury will have to float trillions of dollars in new debt in the next two or three years alone. ... No wonder the Chinese and other dollar asset holders are nervous. They wonder--as do we--whether the unspoken Beltway strategy is to pay off this debt by inflating away its value. ... It's not going too far to say we are watching a showdown between Fed Chairman Ben Bernanke and bond investors, otherwise known as the financial markets. When in doubt, bet on the markets.
  • The Strange and Dangerous Cult of Austerity  Even at the beginning of 2010, many were predicting an increase in bond rates, writes economist and New York Times columnist Paul Krugman. That didn't happen. Not only did the U.S. not go the way of Greece, with "investors ... pull[ing] the plug on spendthrift governments, driving up their borrowing costs," but "the argument has become even stranger recently, as it has become clear that investors aren't worried about deficits; they're worried about stagnation and deflation." How can we tell? They have been "driving interest rates on the debt of major economies lower, not higher. On Thursday, the rate on 10-year U.S. bonds was only 2.58 percent."
  • Investors Aren't Worried About What We Thought They Were, agrees Floyd Norris in news analysis for the Times. Though governments are busy wringing their hands over deficits, "the financial markets seem to be much more concerned by the possibility of renewed recession and a general deflation that could send asset values and prices down." Here's how he breaks it down:
Market reaction is the opposite of what happened in the late 1970s and early 1980s. Then "bond vigilantes" were reluctant to invest in United States Treasury securities because they feared runaway inflation. ... Now, far from showing a reluctance to finance the American government, investors are seeking safety and evidently believe American government debt is the safest possible investment ... Perhaps investors are nervous because they fear governments will swing too far toward austerity.
  • But Will Governments Get the Message? "Can 'the minds of the policy elite' be deprogrammed? Let's hope so," says economics professor Mark Thoma, looking at Krugman's argument.
  • You're All Wrong: Actually, There's a Bond Bubble! This is the argument of Boston University's Laurence Kotlikoff, among others. Krugman summarizes this idea as "investors aren't really concerned about economic weakness; they're just getting carried away." The Pragmatic Capitalist is similarly unpersuaded: "let us remember that a bubble (as it pertains to markets) is an irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse. These characteristics are not currently attributable to the U.S government bond market."