The Fed Can Control Long-Term Interest Rates

The Washington Post had another piece pushing deficit scare stories. This time it tells readers that Greece's problems could spillover to the U.S. According to the piece, fears of a Greek default could lead investors to become more worried about a U.S. default, pushing up interest rates on U.S. government bonds.

There are two logical problems with the assertions in the piece. If investors flee U.S. bonds because they fear default, where are they going to put their money? If the U.S. actually did default, then almost any other asset will also take a huge hit. For example, holding U.S. stock or bonds would be really really stupid if you thought that the U.S. government was going to default on its debt.

This would in turn imply a general flight from dollar denominated assets, which in turn would lead to a plunge in the value of the dollar. A plunging dollar would in turn lead to soaring exports and a would cause the economy to boom rather than crash, as the article claims.

The other logical problem is that, contrary to the assertion of the article, the Fed actually can control long-term interest rates. It can in principle buy as many Treasury bonds as it wants. Ordinarily it would be reluctant to buy a huge amount of long-term bonds because of fears of inflation, however in the context of a sharp downturn and high unemployment, inflation is not a serious concern.

--Dean Baker

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