Archive for March, 2011

The “Big Idea”: Insolvency is impossible, debasement is possible

March 31, 2011 2 comments

Matt Yglesias is tackling the “Big Idea“.  Once you realize that U.S. insolvency isn’t possible, a bunch of assumptions about the behavior of governments and the private sector need to go away too.

One of the biggest implications: The meaning of the yield curve is vastly simplified. Since default is impossible, default risk is zero.  The yield curve is more transparent in meaning.

Over to Warren:

“Let me add that the govt. has full and direct control over the term structure of govt rates, but has elected not to act in that regard, instead only setting the fed funds rate, which means the rest of the term structure is determined by anticipated future fed funds settings (plus or minus a few technicals of supply and demand of the institutional structure)

So, for example, if ‘the market’ thinks QE causes inflation, it can’t change the fed funds rate, but it can change longer term rates as market participants make the (incorrect) assumption that the coming inflation will cause the Fed to hike rates.”

Matt Yglesias channels Warren Mosler:

One thing I’d say about the potential implications of a government shutdown on the bond market is that I think it’s probably a mistake to see Treasury interest rates as primarily driven by default risk. If the government of El Salvador or Illinois borrows dollars, it might in the future run out of dollars and not repay its loan. But there’s no reason the government of the United States should ever run out of dollars. It makes the dollars.

An increase in Treasury borrowing costs could be driven by hope or by fear. In the “hope” scenario, if investors increase their view of the growth outlook they’ll become more willing to invest funds in things other than bonds and thus bond interest rates will have to go up. There’s also a fear scenario, which would probably be about the value of the dollar. If you lend the US government some dollars, you’re definitely going to get back the number of dollars that the US government promised you. But right now a dollar buys you about 0.70 euros and maybe five years from now it’ll only buy you 0.65 euros, in which case lending euros to the Dutch government might look like a better bet than lending dollars to the USA. That would drive interest rates up, but it still wouldn’t be default risk.

We can directly observe the cause of the “fear” – it is called inflation.  In a free floating currency regime, we cannot control the value of the currency relative to other currencies.  However, that isn’t the mandate of the Fed, or the worry of most citizens.  The Fed’s mandate is price stability, and people fear inflation.   We have tools and policies that can impact inflation.

Determining the exact rate of inflation is very hard.  But we have good ballpark estimates, and every reasonable observer agrees that inflation is under 4% in the U.S.

Still, it is far more difficult to determine the willingness of the bond market to fund perpetual deficits.  It turns out we don’t have to determine this willingness.  Note this should help to reduce business community uncertainty – the first step to confronting a fear is to identify it.

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Honeywell CEO: I am terrified of vampires

March 31, 2011 Comments off

I hate to even give a title like this to the blog post, but it is true.  The CEO of Honeywell – who is probably a really smart guy and a MBA – is terrified of something that doesn’t exist.

From Bloomberg:

“It’s impossible, because what’s happening is we have the baby boomer generation retiring,” Cote said in an interview that will air on Bloomberg Television’s “Conversations With Judy Woodruff” this weekend. “And there’s not enough people paying into the system. We will literally crush the system.”

Once we understand that insolvency is impossible, then we can move on to real debates over inflation and employment.

But until then, we have to deal with putting the kids to bed while they are terrified of monsters under the bed.  Anyone who has ever raised a kid knows that while the monsters are not real, those fears are 100% real. A kid afraid of  monsters will cry and shake from fear – they are terrified.

The statement by David Cote is earnest and heartfelt, and he truly believes he is doing the best for his company and country by pointing out “We will literally crush the system.”

Believing in the impossible does not make it true, but it does make us poorer.

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Solvency and Value, Insolvency and Debasement

March 29, 2011 32 comments

One of the stranger things about the world is that there are some ideas that are true even if we don’t believe them.  For example, no amount of work will make Pi a natural number.  If we believe Pi is a natural number, Pi is still not a natural number.  Fervent belief doesn’t change the nature of Pi.

The eternal solvency of fiat currency issuing governments is one of these things that cannot be impacted by human effort.  No matter who does what, a government issuing a currency can always pay its bills denominated in that currency.  A government issuing a fiat currency cannot be insolvent.

Jamie Galbraith lays the smackdown on insolvency:

If this is what you have in mind, then please explain: what is the “reasonable market value of assets held” by the government of the United States? Go ahead, if you want, and add up all the land, buildings, aircraft carriers and submarines. And then, don’t forget to add the capacity to produce, without limit, pieces of paper of a legal – and therefore market – value of “one dollar” each.

Can this value, which is unlimited, ever be less than the finite value of public debts? No, it cannot.

Conclusion: A government that issues its own currency and owes its debt in that currency cannot be insolvent.

Governments in control of their money cannot be insolvent.  Insolvency is the inability to pay off one’s debts as they fall due.  That’s how Wikipedia defines insolvency.

But the impossibility of insolvency does not mean the fiat currency will have value. A government might be fully solvent even with a worthless currency.  On the other hand, Solvency and currency value do not imply each other.

This distinction between insolvency and debasement is at the heart of MMT.  MMT makes a huge distinction between the process of debasement and the act of insolvency – and this distinction has massive practical implications on how governments should act.

First, it turns out solvency and currency value are confused, even by very smart people. Paul Krugman doesn’t understand this distinction.  It seems that Interfluidity is close to getting it, but he still doesn’t quite get it, because he puts a solvency constraint on governments issuing fiat currencies.  Read point SRW’s points #5-6 carefully, and then #8, and tell me he understands MMT.  Note SRW is a genius.  If SRW isn’t getting it, it isn’t his fault, its ours!

Scott Fullwiler laid out PK over at Naked Capitalism, while Pavlina Tcherneva implored him to understand over at new economic perspectives. Warren is also engaging him.

Central Banks have 2 official jobs – control the price level and get people working.  Inflation and employment are typically the only mandates of modern central banks.  But Central Banks don’t live in a vacuum – they exist in the real world alongside financial markets and the Treasury. Financial markets have concerns besides inflation and employment – heh.

What governs our interpretation of bond yields is the idea of Solvency.  Bonds trade on the perceived solvency of the issuing body.

Here is typical Bond Vigilante thinking: “Modern governments issue bonds that roughly match the amount of deficit spending of that government. Because they issue bonds, this must mean they need to borrow the money.  Anyone that needs to borrow has a risk of becoming insolvent. Therefore, governments should not issue too much debt lest they become insolvent.”

Bond Vigilantes are the ones in the market enforcing the solvency constraint on governments through bond markets. But the solvency constraint doesn’t apply to governments, so they cannot be enforcing solvency even if they believe they are.

Paul K channels every economist’s inner Bond Vigilante right here:

“I disagree. A 6 percent deficit would, under normal conditions, be very expansionary; but it could be offset with tight monetary policy, so that it need not be inflationary. But if the U.S. government has lost access to the bond market, the Fed can’t pursue a tight-money policy — on the contrary, it has to increase the monetary base fast enough to finance the revenue hole. And so a deficit that would be manageable with capital-market access becomes disastrous without.”

This is just a way of saying that a debt that is affordable at 4% interest may not be affordable at 20% interest, because of the solvency constraint. So using the tool of the printing press is a defacto admission of insolvency, therefore bypassing the bond market must trigger currency debasement. But these two ideas – the interest on the government debt and the debasement of a currency – cannot be linked through solvency, because governments issuing debt in their own currency cannot become insolvent.  Therefore, losing access to the bond markets isn’t the cause of currency debasement, because the link of insolvency is impossible.

It does’t matter what the interest rate is on government debt, the government cannot become insolvent. It could be 1000000%.   There is no point where the yields on bonds cause a run that results in the government not being able to issue more money.

Now, by this point, you must be thinking – why in the hell is he concerned with this difference?  Any interest rate of 100000% would be debasing the currency like Zimbabwe on steriods!  Why is the Traders Crucible going nuts over how many Angels are dancing about the difference between insolvency and debasement?

Well, we can directly observe the debasement of a currency  in an economy through the inflation rate. We can directly observe the process of debasement and loss of value of the currency through inflation.  We cannot directly observe the risk of insolvency – it must be inferred from bond price action.

Solvency cannot be and is never an issue, so the yield of a government bond in its own currency is divorced from solvency. There isn’t a link because the government cannot be insolvent.   This idea about government bond yields and government solvency is true even when most people don’t believe it is true. For example, it is true right now, today.  There is no link between the debasement of a currency and the bond market, because the link mechanism of insolvency is impossible.

Still, every government on the planet runs their budget with some fear of becoming insolvent. But we cannot directly observe the risk of insolvency.  So the resulting process is one of guesswork, misstatements, boneheaded plans, wild specualtion, and dumbassery, because there is no way to observe the risk of insolvency directly even though it is one of the ideas that govern our spending.

In other words, by removing the fear of insolvency, we can more directly observe the risk of debasement.

Too much spending can debase a currency through inflation.  Taking away a variable from the concerns of the government – that concern of solvency – makes the economic management process much easier. We cannot directly observe the willingness of the bond market to fund debt over the next 20 years.

These fears of insolvency are among the most serious concerns of the Fed, the Secretary of the Treasury, the President, and most intelligent observers of the Treasury bonds markets. Paul Krugman has this exact fear.

Keep in mind that Krugman is the most prominent person who has vocally questioned the existence of the Bond Vigilante.  He has many columns about how these people don’t seem to exist anywhere but in the imagination of the bond market. He has done great work for years on the bond market. Yet, here he is using the threat of the BV as a reason MMT doesn’t make sense.

But we don’t need to rely on the bond market to “give us signals” about the potential loss of access to their club to determine if we need to lower spending, or raise spending. We can just witness inflation and unemployment and make decisions on these two variables, instead of the three variables of unemployment, inflation, and insolvency.

This is a much simpler task, and is perhaps the core strength of the MMT paradigm.

Now, I am going to ask an important question: Is it the responsibility of the government to provide a low risk, long term store of wealth?  Something other than solvency must be governing the value of the currency and government bond yields today.  If something is impossible, it is impossible no matter what people do or believe. And the U.S. government cannot be insolvent.  So government bond yields right now are being governed by something other than the risk of insolvency.  I’ll say real yields are the price of an option on inflation, but that’s just wild speculation.

All we have to know is that governments cannot become insolvent if they issue debt in a currency they control.  They can issue currency, and that currency can change in value dramatically.  But we can directly observe the currency change in value through inflation or deflation.  Monitoring inflation is a far simpler task to manage than the 11 dimensional chess of inferring bond market sentiment.

We’re getting very close to the tipping point for MMT.  See Rodger?  A few decades of hard work could be followed by a payoff!

MMT goes big time

March 27, 2011 2 comments

Modern Monetary Theory keeps getting more and more attention – now from one of the true giants, Paul Krugman. Note that PK doesn’t get it yet.  The first step to understanding is engaging.

Jessie is backing down..

Interfluidity is on the case.

Rodger – what do you think now?

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Why didn’t I think of this

March 27, 2011 Comments off


H/T Credit Writedowns, and Political Irony

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Keynes – Ricardo Smackdown: Where is the U.K. Growth?

March 24, 2011 1 comment


If Ricardian-Osbornism is the correct theory, the confident expectation of £70bn worth of cuts over the next four years should already be having a stimulative effect on the economy. We should be starting to enjoy the benefits of what economists of a Ricardian persuasion call “expansionary fiscal contraction”. People should be starting to spend the money they know they will no longer need to set aside to pay higher taxes. In short, the recovery should already have started to speed up.”


To put this in perspective, 70 billion pounds is the equivalent of $784 Billion in cuts for the U.S over 5 years.  You could call it the anti-stimulus.  Note that the world isn’t collapsing right now – there is not a massive, ongoing worldwide panic that might be causing the U.K. economy to be in a recession.  The major issue facing the economic growth right now is uncertainty about the future of the U.K. economy.

The U.K. does not have a budget problem according to the common way of looking at the budget: Government debt is 54% of GDP. Of course according to MMT, this low budget is the problem, but we’re looking at it from the Ricardian perspective.   According to their perspective, the debt could be cut more, but is not anywhere near a crisis stage.

Real world economies and markets are forward looking.  You don’t buy food every day, you buy food for a few days or weeks in anticipation of your need.  When you need to go to the store, you don’t go buy a car because you already bought a car so you can go to the store.

Where is the frackin’ explosive growth in the U.K?  They do not have a budget problem.  They have their own currency. They are cutting government spending faster than anyone – their reduction in spending relative to prior levels is higher than any of the G-7 countries.  They have ridiculously low rates in the U.K. relative to their inflation – which should be massively stimulating the economy, but isn’t.

It’s like a case study of why neo-classical economics doesn’t work.   Nearly ideal conditions for growth according to Chicago School boys are resulting in inflation and low growth.

More genius from Skidelsky:

“Printing money is not the same thing as spending money, and it is the spending, not the printing, of money that will have an impact on the economy.”

I could spend all of my time just responding to what he writes.



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Banks will be even more insolvent as housing prices drop another 20%

March 22, 2011 2 comments

Some of the first posts I had on Traders Crucible were about housing prices.  I think housing prices are going to drop at least another 20% as I outline in my Strategic Ideas page.  The supply of homes underwater right now, the foreclosures that are being postponed by the banks, and the level of wages to prices are all huge factors in this prediction.

It turns out that Gary Schilling also thinks housing prices are going to go down by another 20%.  Glad to see even more reasons why housing is likely to go down more.

The impact on the banks will be tremendous.  Even at current housing prices, they are zombies – what will happen when the incentive to walk away gets both wider- as in impacting more people –  and deeper – meaning that specific individuals are more underwater on their mortgages?

Then, as the method for walking away becomes widespread knowledge, what will happen then?  This banking crisis is nowhere near over…

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