I analyze macroeconomic issues from a fundamental perspective, and I analyze market behavior from a technical perspective. Original macroeconomic analysis can be found here and both macro analysis and commentary can be found on my Caps blog. If you like or appreciate my analysis, please add yourself to my Following List

Friday, August 20, 2010

Do Deficits Matter, Debt and Deleveraging, Resource Constraints, In/De/Hyper/Stag/etc./flation, Part I

This post is a follow-up to my last post The Matter of Deficits, Sovereign Default, and Modern Monetary Theory found at MTaA or on my Caps blog. Also in the process of writing this post, the length kept increasing that I decided to break it up into a series. This will be Part I.

The purpose of my last post was very specific: To get an answer to the question 'What is the default risk on US Sovereign Debt?'. To be very specific, I was referring to technical / nominal default only.

Another way to pose the question would be this way: 'What should the Credit Default Swap (CDS) rate be on US Sovereign Debt?'

You have to understand exactly what I was asking. In my last post, I was *not* asking 'What is the credit worthiness of United States Government (USG) debt?'. That is a separate issue to whether a sovereign currency issuer can default on their own debt.

The answer I come up with to the question: 'Is there a monetary reason for the USG to ever technically default on its debt?' is NO

Even though this is not the most important question (credit-worthiness and the 'value' of USG debt and the Federal Reserve Note [FRN, a.k.a. the US Dollar] are the far more important questions), it is still a very important question and a very important point to make. Because there is the perception today that the USG can technically be forced to into a position to default on it's debt. And per my last post, the conclusion that I came to and painstakingly demonstrated is that this is an incorrect operating assumption.

But now that we have settled that point (which is important because we can now adequately separate credit risk from default risk) we can get to the more important questions.

From my last post I wrote this definition:

The United States Government (which I will just abbreviate as USG from now on) is sovereign issuer of its own currency. The Fed (as an arm of the government) can expand its account instantaneously, what we refer to as 'money printing' (although all of us are aware that this is an electronic transaction and not a physical one. They are not actually running the printing presses when they do this. But the metaphor is apt). Since the Federal Reserve is the monopoly issuer of the Federal Reserve Note (FRN from now on), which is of course the current incarnation of the US Dollar, and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs in existence.

What this means is that the US Government is never revenue constrained.

This last sentence is not technically clear enough and will be the entire crux of this series of posts. Here is the way I should have written it:

From the standpoint of servicing it debt (not considering the value of the currency), the US Government is never revenue constrained

As I will discuss in-depth in this series of posts, there is a very big difference between technical default (which as I argued in the last post has no monetary basis for occurrence for a sovereign currency issuer) and effective default.

The point of this series will be to answer (or at least explore) the ideas of deficits, credit worthiness, and scenarios where the USG can effectively default.

In my last post, in order to properly answer the question 'What is the default risk on US Sovereign Debt?' we had to first understand more fully the fiat monetary system we currently have. We needed to understand the role of the US Treasury and the Federal Reserve in the current system, and it helped to understand the historical reason for them coming into existence. Please, if you have not done so already, read my last post (MTaA or on my Caps blog) since I will be drawing heavily upon and continuing this line of thought.


Okay, let the fun begin :). In order to explore these ideas I will start out with two examples which will be necessarily basic and contrived, in order to get across key ideas clearly. But I will add more realistic complexity later on, so please bear with me and (hopefully) enjoy the ride :)


Lets say in the entire world there are only two countries: Joeyland and Bobtenstein. They are sovereign entities. Moreover Joe is the leader/ruler/owner/dictator/what-have-you of Joeyland and Bob is the same for Bobtenstein. This makes Joe and Bob the only two sovereign entities in the world. And lets further say that the population of each country is identical with, I don't know, 1 million people each.

As sovereign rulers both Joe and Bob are responsible with coming up with and administering monetary systems. Bob comes up with a gold standard and calls his currency the 'shiner' and Joe comes up with a fiat money system and calls his currency the 'joeybuck'.

Further: Bobtenstein does not sit on any gold deposits. Everything was mined out of the ground and is in Bob's possession. As such there is a fixed amount of gold in Bobtenstein which the population is already aware of. Also Joeyland starts out with a fiat money system. This is different than the United States which started out on gold standard and transitioned to a fiat money standard. This was a scenario that I explored in-depth in my last post. So as such, Joey does not have a Central Bank or a Treasury (which as I demonstrated previously have no real use in a completely fiat system). Bob on the other hand only has a Treasury. There is no Central Bank of Bobtenstein (we will address this one in a bit).

So here we go. We have two countries, two rulers, two currencies. How do things work? Or more importantly, how do things get 'started'?

Lets start with Bobtenstein

Bobtenstein is a beautiful, but large country. There are isolated villages each living near various natural resources: lakes, grasslands, forests, mineral deposits, etc. They are happy, keep mostly to themselves, and are just living off the land. Bob, who is a nice guy and wants to do right by his people (we will call him a benevolent dictator), thinks that natural resources near one village could benefit the inhabitants of another village, and so he wants encourage the sharing of natural resources. Essentially he wants to Bobtenstein engage in commerce. Now, like I said, he is a nice guy and wants people to be happy. And he thinks the best way for this to occur is for people to determine for themselves what things are worth. Not to divvy up all of the natural resources (some of which are significantly more labor intensive to extract than others) and spread them out equally.

So Bob calls up his Treasury (after all he needs a building to warehouse the gold), tells them the plan, and takes half the gold (the 'shiners') in the Treasury and goes to every villager and gives them an equal share of the shiners. He explains his idea, says that every shiner is exactly the same. In order to get things started, he sets the price of a good based on the amount of labor it took to produce. But he then further explains that these prices are not set permanently, because he knows that eventually supply and demand will determine the actual prices and that they will change over time based on harvests, good fishing years, lumber quality, etc.

Bob is a happy guy, his people are happy. Bob has no army. He just wants things to be pleasant. But Bob is a busy guy checking up on the villages, and doesn't have time plant, fish, chop wood, etc. But he has the other half of his country's gold in his treasury. So what Bob does is spend just enough out of the Treasury that it takes himself to live on and what it costs to employ the keepers at the Treasury. But realizing that this action would create an imbalance, Bob implements a tax. The tax is shared among everybody, so that each person pays a small percentage of the amount of gold they hold and when totaled equals that which Bob spends in a year. This way his budget is balanced. His Treasury takes in what goes out so that it always contains half of the gold in existence. And the gold in circulation is always constant.

Commerce develops. People become more connected. Villages become more connected. People start to specialize in their crafts/labors. Bob likes what his country is becoming. Everybody is happy.

Now lets go to Joeyland.

Joe and Bob, despite being separate sovereign rulers, are good friends. Joeyland is very similar to Bobtenstein in that it has isolated villages and diverse natural resources. Bob tells Joe what he has been doing in Bobtenstein, says that it is great! He is happy, his people are happy, life just seems richer with everybody interacting.

Joe likes what he is hearing. But he thinks Bob's gold as a currency idea is dumb. First Joe doesn't have any gold anyways (that is the only real difference between Bobtenstein and Joeyland) and second he thinks gold is dumb. It is shiny and it is heavy. He finds it unwieldy. Third, he hates the name 'shiner', he thinks it is idiotic. But Joe does want Joeyland to benefit from the same style of commerce that Bobtenstein does. Joe is also a very nice guy and he wants his people to be happy. So in lieu of gold, Joey implements his 'joeybuck' idea.

Joe goes around to all the villages explaining his idea, just like Bob did. But instead of handing out gold, Joe hands out pieces of paper with his face on it. He says that this is legal tender for trading purposes. He gives everybody an equal share of the joeybucks. And basically does the same thing as Bob. He prints up a bunch of them, gives half to the population and keeps the rest for himself (and he doesn't need a Treasury, they are just stacks of paper).

He also implements a tax, just like Bob did and for the same reasons. Joe is very happy to see that commerce does ensue in Joeyland just like it did in Bobtenstein. People are happy, they like the joeybucks (Joe is a handsome guy so it is a nice picture which the ladies definitely appreciate), they like the trade, they like the interconnectedness. Joe is happy.


So I apologize for the cartoon-ish story, but I wanted to set up something simple first to illustrate some ideas to come.

If you recall from this post (The Gold Blog and scroll down to just before comment #1) I put together criteria for defining money and the characteristics it should exhibit, which are: 1) Money must be valued equivalently by all parties in the exchange, 2) have enduring value, 3) be regulated, 4) be liquid and 5) be fungible. I went through a similarly cartoonish (but ultimately useful) example of the failure of trying to use Snickers bars as money. If you haven't read that post before, I would encourage you to do so now. I wrote it over a year ago but I think many of the concepts are still useful. You will also notice, if you read the entire post, that I talk about debt servicing burdens and default risks of the US Government. I make some observations in this gold post that I have proven incorrect in my last post. My own view and understanding of this topic is constantly evolving. I have no problem admitting when I am incorrect in an assumption and I am willing to put my thoughts down as an object lesson so that you can see where I either make good points or learn from my own past mistakes. My hope is that my reasoning is useful, even if it takes me awhile to come to the right conclusions :)

The first observation to be made is that both systems behaved effectively identically. In this case the gold standard was operationally equivalent to the fiat money standard. Why? Precisely because the money supply was fixed in both cases. This being the case, because Bobtenstein and Joeyland have materially similar natural resources and the same population, the pricing structures of those natural resources will also be materially similar. The gold standard was neither better nor worse than fiat money in this case.

But here is another subtle point. The populace of Bobtenstein knew already that there was no more gold. That the amount of gold that Bob had was all there is. Therefore they knew a priori that Bob couldn't make more and that each shiner was always going to be worth the same. The populace of Joeyland did not have that luxury. They were being handed a piece of paper which might or might not be fixed in scarcity and told to exchange it for goods, as opposed to the Bobstensteinians who did know that their shiny yellow rocks were fixed in scarcity. But since Joe personally vouched for the fixed supply of Joeybucks, and everybody trusts Joe, and Joe has never given them a reason to think otherwise, they do trust the joeybucks. And everybody is happy.

What I am trying to (hopefully successfully) get at is the idea of trust in a currency. Trust is *not* just applicable to fiat money, but the gold standard as well. I mean why didn't the Bobstensteinians trade yellow rocks before? What was the reason to trust it? It is because Bob set up the framework within which gold could act as a currency. And once it became accepted as such, the idea is self-perpetuating, because the Bobstensteinians knew that the gold in circulation was a fixed quantity. Once the trust in the shiner was started, there was never any reason to 'untrust' it. This is not quite true for the Joeylanders. There is an initial ramp up in trust required for the joeybuck, just like there was for the shiner. But there must be renewed trust with each transaction since the only reason for the fixed quantity of joeybucks is based on Joe's word. As long as the trust between the currency holder and the sovereign currency issuer remains intact, the currency will always be viable. Trust is the key.

There is another salient point to make here. Recall this statement from my last post:

The only reason why we (as citizens of the US) have money is because the government spent it into existence ..... !!!?!??!??!!!!! Is this true, does this even make any sense? The answer is yes.

Lets apply this statement to the example of Joeyland and Bobtenstein.

Neither the Joeylanders nor the Bobstensteinians had a currency before Joe and Bob introduced it. So, by definition, when Joe and Bob invented their currencies, and they are the sovereign entities, they had all the money and the population had no money.

But we need to think a little more philosophically here. Let's say I am the only person in the world, the last man on Earth so to speak, and I have a billion dollars, just stacks of $1 dollar bills sitting around, do I actually have money? It is true that it looks like money and has George Washington's face on it. But is it 'money'? .... The answer is no. Because for money have have any meaning, for it to exist there must be two or more parties that a) have goods to exchange for it (otherwise they are just passing the same papers back and forth) and b) all parties must be willing to accept that the money as a store of value (otherwise why trade real goods for it). So as the last man on Earth, even with a billion pieces of green paper, I don't have money. Or said another way, money is the potential of a currency to enact commerce. If there are no other parties, or the other parties don't have money and goods, then commerce is not possible (I am referring to the trade of goods for legal tender, not bartering which can obviously happen without money).

So in exactly the same manner, since the populations of Joeyland and Bobtenstein has no money, and Joe and Bob were the only ones that did have money (and for the purposes of this example Joe and Bob cannot trade with eachother, e.g. the SHN/JBK is not a recognized symbol :) ) money for all practical purposes doesn't exist.

It comes into existence the moment that both Joe and Bob spend it into existence. In the example above, they simply give half to the populace. They simply spent without getting anything in return (like a donation is a charitable action, but it is still technically spending). But the point is that the money was effectively 'spent into existence'

Further, now that the money is in existence, then the second observation from the previous post can be made: This makes the statement that private sector savings is public sector debt crystal clear. It is an accounting identity. The population has (is saving) half of both Joe's and Bob's original amount. It is savings for the private sector and identically debt for the public sector (in this case Joe and Bob).


...Okay! This is very good!

We now have operational concepts for money, savings, currency trust, as well as a set of (albeit simple) examples against which we can exercise and verify some of the concepts from my last post.

Now, let's make things more interesting .... :)


This post is already long enough, so I will save the more realistic additions for the next post in the series. Unfortunately both Bobtenstein and Joeyland will be subject to 'monetary innovation' and 'creative accounting', and our happy land will not be so happy soon :(

Using the example countries defined in this post, the next post will cover these topics: revenue constraints, deficit spending, structural debt, private/private debt, public/private debt, bonds, taxation, etc.

I think this will end up proving a rather useful exercise. Stay tuned!
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