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Wednesday, August 18, 2010

The Matter of Deficits, Sovereign Default, and Modern Monetary Theory

Okay, fair warning. This is going to be one of my "thinking (and probably unfortunately rambling) out loud" posts. But I really do hope you read it because I am looking for feedback in this post. Because some of the conclusions I come to are ..... disturbing.

Let me also preempt the reading of this post and any subsequent discussions that I am not advocating for *anything* in this post. I am simply exploring what the world would look like if I were looking through Modern Monetary Theory's eyes.

The reason for this post:

I am very concerned about sovereign debt risks and the possibility of sovereign defaults. From a traditionalist standpoint, the US is running massive budget deficits, and issuing bonds at an alarming rate to try to keep the stimulus going but also just to simply keep the government running. Tax revenues are falling. This also seems incredibly unhealthy and unsustainable.

So from this point of view, the default risk of United States sovereign debt is certainly not zero. There are arguments regarding the size of the risk (based 90% debt-to-GDP, 100% debt-to-GDP, etc.). There are a whole host of ways to look at sovereign risk in historical terms.

Now there is another point of view, the Modern Monetary Theory view, regarding the sovereign default risk of the US

.... and it is 0. Not 0.0001%, not 0.00000000000000001%, but precisely and identically zero.


I have been doing a lot of reading, thinking and pondering on this topic. I want to take you all along for my thought experiment ride. And I want to solicit feedback regarding the validity of my analysis. Again, I am not looking for ideas on whether the current framework is 'good or bad' (even though inevitably some of my own thoughts on the matter are likely to show through). I am trying to simply understand it. Understanding is, after all, the key to risk evaluation.


So the idea goes like this

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.


Because notice in our definition of the FRN the Fed does not have to look at tax receipts or the size of the national deficit or the success of bond auctions with China and Japan as buyers. It quite literally says 'I have a million/billion/trillion/etc. FRNs in my account today' and can subsequently fund the government with whatever it needs instantaneously.

Now I expect a lot of people are yelling at me right now and saying "it's not that simple!". Which is technically true. But the reason, which I will show in a second, is because of a hold-over from earlier monetary times. There is literally nothing that would stop funding of the USG in this manner in practical terms. But even the the term 'funding' requires clarification in the MMT framework which I will get to in a minute.

First, let me address the "it's not that simple!" criticism with a simple question:

What is a US Government Bond?

From here: A bond is a debt investment in which an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company. A government bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. The first ever government bond was issued by the English government in 1693 to raise money to fund a war against France. It was in the form of a tontine.

This definition makes sense. It is what we are all used to. And let me illustrate why: The British Pound Sterling, or the US Dollar (not FRN, remember the Federal Reserve is a recent invention historically speaking) used to be convertible currencies. That is you could 'convert' the currency for a specified amount of gold or silver. In the past, governments were most definitely revenue constrained. There was a fixed amount of gold and silver in the world (new mining supply adds to the above ground supply historically by 0.25-1.5%, very small and largely insignificant).

So in this case, how does a government run a deficit?

You bet, it issued debt in the form of bonds. Creditor nations (ones that ran budget surpluses, based on collecting more taxes than they spent) could loan gold and silver, or their own currency (and since it was convertible was equivalent to loaning gold and silver), to debtor nations to fund projects. In the quote above, it was to fund a war.

The government bond market was basically invented as a way to get around the gold standard. Now, I am not trying to cast judgement, I am simply reviewing history to see what makes sense. Quite often a government felt an activity was so important that it felt like it needed more money than they had immediately (which generally boils down to two categories: wars or stimulus). Since the gold standard is by definition fixed, it requires all budgets to be balanced. You cannot spend more money than you have. Unless you have a alchemist in the back room turning lead into gold (which coincidently, alchemy was a *government* funded endeavor in the Middle Ages). The reason is simple. Again, I am not casting judgement, just making an observation. Politicians and Bureaucrats are not accountants and economists. They don't want constraints. Balancing a budget is hard. Fiscal planning is hard. Large expenses in the short term mean cutting elsewhere to balance. Politicians like to promise, and they are quite bad (historically speaking) at taking away.

So this is where the very rich history of sovereign defaults originates. When a government takes out debt and spends it on unproductive endeavors (war being most egregious form of an unproductive endeavor) or even endeavors that are simply less productive than the rate of borrowing (i.e. the debt incurred does not increase GDP and/or tax revenues to cover the servicing cost), then the deficit becomes structural. Historically the accumulation of too much structural debt is the primary reason for sovereign defaults under previous monetary systems.

... okay, so the point of that was to show why Government Bonds came into existence in the first place. Again. I am not labeling them as 'good' or 'bad'. I am simply trying to recognize where they came from and how they fit into today's world.

Now lets fast forward to 1971. (I am skipping over a lot of important details, such as The Federal Reserve Act of 1913, the Bretton Woods Agreement, etc. Because I am focusing on sovereign debt in this post and trying to answer questions regarding default risk)

Nixon closes the gold convertibility window. This means that the FRN (not the US Dollar anymore) is 100% fiat for the first time. The reason? To pay for the Vietnam War. Now I am sure a lot of economic historians will argue with me regarding its usefulness in removing the world from the shackles of gold or other ideological statements. My point in making this statement is that the conversion in 1971 was based almost completely on practicality. The US Treasury could not honor gold and silver commitments, we were engaged in an escalating war, the traditional route of USG bond offerings were getting progressively worse (interest rates), so it was time to change the rules of the game.

And the point of this post is to realize just how much they changed. And I have been thinking about this for a long time. I have written many posts regarding macroeconomics and the US Dollar, making many of these same observations that I have made in this post. But this point is, until you follow this train of thought all they way through, you will miss a very important, blindingly simple but absolutely alien idea which I will get to later.

So, as a testament to the haphazardness of the implementation of the 100% fiat currency experiment, I will pose simply one question:

What happened to all the USG bonds?

Recall what I said at the beginning of this post:

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 way 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 Note (FRN from now on), which is of course the US Dollar, is monopoly issuer of the currency and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs. What this means is that the US Government is never revenue constrained.

In 1971, we got rid of the gold standard and made our currency 100% fiat. In a 100% fiat system, the currency issuer is never revenue constrained. So in this system, government bonds are irrelevant.

Practically speaking it was something that the government did not want to deal with in war time. I mean countries all around the world held USG bonds. So what would have happened? Do we covert bonds to currency at prevailing rates (like I said, there is no limit to the amount of FRNs the Fed can produce, so it could have converted all the obligations with one stroke of the pen, this was before proliferation of computers :))? What happens to unpaid but implied future interest? Do we negotiate for foreign currency holdings? How should it have been handled? As you can see, it would have been an accounting nightmare. So what did they do instead? They punted.

They left a pre-fiat concept (from above: the government bond was invented as a way to get around the gold standard) in place in a newly 'minted' (sarcasm intended) fiat world, because it was too complicated to figure out how to sort it out, and go to this new currency regime, and fight a war all at the same time. Again, I am simply trying to look at this historically, not ideologically. Because what we have now is a mess, and it doesn't make sense. And I am trying to understand why it doesn't make sense.

So now I am going to fast forward to today. Again, I am going to skip over concepts like The Great Moderation (which is a huge debate, but I am not going there at the moment), and The Credit Bubble. Because I am trying to get at Sovereign Default Risk and the place of Treasury Bonds in our current monetary system.

What happens with a USG Treasury Bond today? What is it's function? purpose?

Remember again what I said at the beginning: In a 100% fiat currency system, the sovereign issuer is *never* revenue constrained. So in our new monetary system, we don't actually need to sell bonds to raise revenue. Japan nor China is our banker in this case. In China's case, they buy US Treasuries to manage the yuan exchange rate: Steve Saville: Getting Some Things Straight Regarding China

So what gives? The Fed-Treasury "dynamic duo" is one of the keys to how our modern financial system "works"... right? Let's see what's going on under the hood (from http://pragcap.com/when-will-the-bond-auctions-begin-to-fail):

So what happens when we auction bonds? Well, the NY Fed has accounts all over the country. The Treasury keeps very close tabs on excess reserves so as to avoid overdraft at the Fed. So the Treasury hops on the phone with the Fed and they target some level of bond issuance necessary to soak up these reserves. Why do they do this? Because excess reserves drive down the overnight lending rate so if the Fed is going to maintain the Fed Funds target rate they drain the excess reserves. Some people view this as auctioning off bonds that “fund” our spending, but in reality (because private sector net savings is public sector deficit – TO THE PENNY) it is just a monetary tool that helps the Fed hit their almighty and supposedly omnipotent target rate.

So now I need to back up for just a minute and address the The Federal Reserve Act. The idea of founding the Federal Reserve back in 1913 was to address the "booms and busts" that occurred under the gold standard. The idea being that the Federal Reserve could manage the money supply, expand and contract it somewhat around the gold standard to even out the boom/bust cycle [rant alert! I need to interject in my own thought because even though this whole idea sounds nice, neat and smart in theory, the fact of the matter is that booms and bust did *NOT* happen because of the gold standard, but because of deficit spending / bond issuance by not adhering to a gold standard. The boom/bust cycle is primarily driven by excess government indebtedness, which eventually migrates to the private sector leverage, which begets speculation. The formation of the Federal Reserve is simply the 'fix' to a misdiagnosed problem. end rant]. So they had a very specific function and mandate under a gold standard (and we can argue endlessly whether this is good or not), but they have no true mandate under a 100% fiat standard. I will finish this train of thought up in a minute.

I now have to return to the statement in bold near the top of the post: until you follow this train of thought all they way through, you will miss a very important, blindingly simple but absolutely alien idea which I will get to later.

So what is this alien idea? It is expressed here which I will sum up (http://pragcap.com/the-concept-of-vertical-and-horizontal-money-creation)

When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of non-government net financial assets.

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.

The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case.

Reserve accounting uses the standard accounting identities, but the meaning of “liability” is not “debt.” The husband-wife analogy for Central Bank-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system.

Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Treasury’s. That is, when a Treasury is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating Central Bank and Treasury as “government”).

When the Treasury’s are sold or redeemed, the reserves that were “stored” at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.

Therefore, the key to understanding Modern Monetary Theory is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase non-government net financial assets, and taxation withdraws net financial assets from non-government. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the Central Bank to hit its target rate.

Basically it means this: 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. Like I said, in 1971, the implementation of this system was ad hoc, basic questions about about the treatment of USG bonds were left unanswered, the role of the Fed (which is irrelevant in this system) was left in place to keep the hold-over "funding" mechanisms intact (even though as I have demonstrated above, they are not necessary. The Fed buys Treasuries to manage rates, not fund the government).

Again, I have touched on this idea in the past in my large gold and dollar posts, but never has it been so clearly and simply stated. I mean, it sounds so ridiculous when stated that way. But the government spent 100% fiat money into existence which is why we have money. This makes the statement that private sector savings is public sector debt crystal clear. It is an accounting identity.

.... okay.

So let's answer this question first, before I go on:

Can the US Government default on its debt? The answer I come up with is: No.

There is no monetary reason at all for this to ever occur. Congress may do so out of spite, everybody at the Fed may get food poisoning and not be there to buy US Treasuries during an auction. But there is no monetary reason for the US to default on its debt.

.... I have thought long and hard about this, and this is my conclusion. So before I go on, the question I have of the group is: Does this make sense?

Moreover, any country that is the sovereign issuer of their own currency has no monetary reason to ever default. This would be notably Great Britain and Japan (more on this at a later time).

However, any of the Eurozone countries could default, since they cannot issue their own currencies. The ECB controls the currency and Eurozone members cannot create as much money as they wanted to service their debt. This means Greece, Italy, Germany, etc. all non-zero sovereign default risks.

DO NOT MISINTERPRET WHAT I AM WRITING! I am *NOT* saying that this situation is 'good' or 'bad'. I am first just trying to recognize 'what is' so that I can confirm my analysis and move on from there

..... If this is leaving you a little queasy feeling, you are not alone.

Because then it really further fractures the concept of money.

Fair warning, I will probably digress a little here, but I think it will be useful.

If the USG is not revenue constrained then there are three items in existence that had reason to exist in a gold standard but have no reason to exist in a 100% fiat money system: Federal Taxes, The US Treasury and the Federal Reserve.

Federal Taxes: If the USG is not revenue constrained, then taxes serve no true economic purpose. The tax code is complicated, antiquated, and wastes so much time and energy. So if the Federal government does not need tax revenues to operate, which by my observations above then it doesn't, then it is simply an unnecessary and costly (in terms of wasted productivity) hold-over from our earlier monetary system.

The US Treasury: It's main job was to hold the nations gold and silver, and to issue and manage debt offerings. None of these are applicable in the current system.

The Federal Reserve: It was invented to add flexibility that the gold standard didn't offer. Now it has a made up / ad hoc mandate of "targeting a stable inflation rate". The market can and should determine what the price of money is (which is what interest rates are) based on supply and demand.

.... These may sound extreme. But my point is stating these observations is that WE ARE LYING TO OURSELVES!. At the government level, we keep talking about funding, taxing, spending as if we were on an earlier monetary system. But as I observe, these are ad hoc holdovers based on a quick transition to a 100% fiat monetary system. The are confusing holdovers that should be eliminated.

But here is the crux of the matter: Governments always want a free lunch.

Look at the history I laid out. The bond market was invented as a way to get around the gold standard (free lunch with the risk of sovereign default), the Federal Reserve was invented as a way to get around the gold standard and the bond market (free lunch with the risk of sovereign default and bigger speculative bubbles), and the 100% fiat currency system is just the next evolution of the free lunch mentality.

At least I posit that it was when it was implemented.

The problem is that any government has never been a good steward of the peoples money. Yes, yes, I know this is a loaded statement, but I am sure good debates will ensue. But my point is that in a 100% fiat money system, the monetary supply is so much more susceptible to manipulation and politicization. We need to think very carefully if this makes sense for us or for the world.

The gold standard or the 100% fiat money standard is neither good nor bad in and of themselves. They are simply systems. How easily those systems are 'gamed' / subverted is the more pressing question here.

There is a whole other line of though regarding 'do deficits matter', 'deflation', 'hyperinflation', the current recession, stimulus spending, etc which speaks to 'good' or 'bad' and I will not address them here (however you can be sure I will in another post :) )

However.... I can foresee a 'good' outcome out of all of this (the ideological side of binve is shining through :). And that is if a government does spend money into existence, and the citizens either spend or save depending on where we are in the business cycle, and if there is no Federal Reserve then interest rates will reflect the actual demand for money. This would be a remarkably self-regulating system. Then when the government decides it wants to go to war, etc. interest rates will eventually reflect the citizens reaction to this. And interest rates are not important for bond auctions, but rather the cost of borrowing for the citizens (while the USG is not revenue constrained the citizens definitely are). And so while governments can spend like crazy, the health of balance sheets in the private sector is always the measure of a nations economic health (which is why we call this current recession a household balance sheet recession). Productivity doesn't come from the government, it always comes from the private sector. This is precisely the problem with centrally planned economies. But I am veering off topic and that is a discussion for another post.

I think this *could* be a step in the right direction towards more transparent Free Market Capitalism (assuming the Fed is abolished). Now I am not 100% no-government. They serve some very useful purposes such as the maintenance of environmental laws (at least the laws that are not written by corporate lobbyists. But we have crony-capitalism now, not free markets) and the funding of pure science endeavors that may not have immediate practical value but have far reaching beneficial human impacts. However, governments are very bad at economics and monetary policy and they should stop messing with both.

In a 100% fiat system, everything regarding the confidence of your system is reflected in your currency. And without the gamesmanship of 'selling bonds' when it no longer necessary, then a global economy could be more fruitful, productive, balanced and fair based on honest market driven exchange rates.


So.... what do you think? Am I full of BS? Am I fundamentally not understanding the monetary system at play here? Do you agree / disagree?

Please discuss!!
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