Home > Main > Solvency and Value, Insolvency and Debasement

Solvency and Value, Insolvency and Debasement

March 29, 2011

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!

  1. Tom Hickey
    March 29, 2011 at 12:12 pm


  2. TC
    March 29, 2011 at 12:29 pm

    Thanks Tom. It isn’t perfect, it repeats and jumps from idea to idea.

    But every person reading this will understand one of the core concepts of MMT. My role in the MMT world isn’t Randall Wray’s role, although I think I do come up with some cool ideas like the links between government spending and corporate profits, and my uncirculated currency model.

    My role is making sure people get it.

  3. March 29, 2011 at 12:49 pm

    Great article,

    The key point is that the policy variables that need to be targeted are unemployment and inflation. The tools in the chest are government spending, government taxation, interest rates and regulation

    The system simply needs to be designed to use the tools to hit the targets. Everything else is then merely a statistical outcome.

    • TC
      March 29, 2011 at 12:54 pm

      Exactly. Just agreeing on the variables is vastly important. Realizing that technical solvency is not variable worthy of concern makes the task easier. We can then have a vigorous debate about inflation without the bogeyman of insolvency.

  4. Rajiv
    March 29, 2011 at 3:30 pm


    You say

    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.

    I think Heteconomist may in fact have it right in 24 Hour Modern Money People

    My first thought on reading Krugman’s discussion of MMT was that he was attempting to position his own arguments against austerity as “moderate”. Whatever the motive, he may well have done the “modern monetary theory people” (I prefer 24 Hour Modern Money People) a favor. By posting an easy-to-counter straw-man characterization, he has basically given MMT proponents an open invitation to articulate their position on a high-profile site. The commentary on the original post was so lopsided in favor of MMT – they are 24 Hour People, after all, and their posting activity frenetic – that he apparently saw fit to add the follow-up post clarifying his position. It was another easy-to-counter straw-man characterization and open invitation. The crazy thought occurs that maybe he is actually trying to give the 24 Hour Modern Money People a boost. It wouldn’t completely surprise given his real concern at the moment is austerity – a policy matter on which he is in agreement with MMT in the neoclassical short run – and not primarily theoretical debate.

    In fact as a direct result of this, Pavlina R. Tcherneva’s article Modern Monetary Theory and Mr. Paul Krugman: a way forward is being widely read across the blogosphere. It is unlikely that there would have been this expansion of readership without PK’s articles.

    • TC
      March 29, 2011 at 3:37 pm

      I wouldn’t put it past him. He is a smart guy. His comments in the past have been hit and miss on MMT. I really don’t think he gets it.

      Anyway, I take the point. All publicity is good publicity.

  5. March 29, 2011 at 6:02 pm

    Good post!

    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.



    • TC
      March 29, 2011 at 6:35 pm

      Thanks Warren!

      I think once the “solvency-bond yields” mental link is broken, people are able to take your statements at face value. Lots of MMT sounds like insanity if you believe governments need to fund their deficits through borrowing.

      And we have set the long end of the curve before during WWII:


      so letting the curve be set by the market is clearly a choice of the current government. I didn’t want to get into what sets the curve, because the issue de jour is really about basic (mis)understandings of MMT.

  6. James
    March 29, 2011 at 7:42 pm

    Great article. MMT is approaching critical mass, thanks to the very persevering, capable, intellectually honest, and dedicated people it has inspired.

  7. Obsvr-1
    March 30, 2011 at 6:59 pm

    Great article, hammers home the fact that US gov’t can not be insolvent. This is what our leaders need to say every night before they go to bed –
    “We can NOT be insolvent, We can NOT be bankrupt, We are NOT broke.” And a little admonishment – “We must be fiscally responsible” (counter the dribble of “deficits don’t matter” implying indiscriminate and/or wasteful spending as good), “We must defend the value of the dollar; We must manage a neutral inflation/deflation economy”.

    As you stated: 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.

    To simplify the system, get out of the game and close down the US Bond market. Once this is done, then it will be overwhelming obvious that the FED is superfluous, so further simplification can be accomplished by Ending the FED.

    • TC
      March 31, 2011 at 4:23 pm

      I like having the bond market around. I think it is nice of the government to provide a notional value insured asset.

      I think it would be nice if the government offered puttable bonds as well.

      • Obsvr-1
        March 31, 2011 at 6:25 pm

        I believe all of the manipulation, complexity and banker/PD graft (rent) far outweigh any positive for having a US Bond market. Just issue US Dollars, not debt based, and use taxation to extract from the private sector. Use a combination of responsible fiscal policy and a inflation/deflation neutral tax policy (preferably with built in stabilizers, e.g. consumption tax + capital gains tax).

        Let the private sector and state/muni provide the investment choices for the private sector investors.

  8. Peter D
    March 31, 2011 at 11:24 pm

    I am not sure I got the point you tried to make, except for the fact that functional finance allows us to concentrate on employment and inflation (which is true!). Because as you yourself seem to acknowledge, most people talk of insolvency but actually mean currency debasement. And it even seems that insolvency is even considered the less severe problem than currency debasement/hyperinflation, so, removing the “lesser” risk is kind of not really helpful.
    Again, maybe I am missing the deeper point, but I don’t think the MMTers should get too hung up on people talking about insolvency when it is clear they mean something else. We should really drive the point home that MMT, in addition to describing the operational realities, in indeed also a theory of what could be achieved with fiat currency and functional finance (Scott Fullwiler’s general case), so that the fears of inflation etc can be allayed (to the extent that functional finance and adequate financial regulations are implemented).

    • TC
      April 1, 2011 at 4:43 pm

      Most people fear insolvency far more than currency debasement. But in any case, they confuse the two and equate them, and they are not the same thing. They have different mechanisms and require different policy responses.

      If you look at the rhetoric that people use in the wider culture, they use the words “the U.S. is going broke.” They also say that “The U.S. Dollar is going to be worthless”, but this is much less common.

      The point of this article was to get people to understand there is a distinction between going broke and a debased currency, and because of their differences, they require different policy responses.

      I’ll disagree about what we should be focus for the MMT community. We need more than one angle of attack, and the functional finance path is a solid path. I think being deliberately provocative works well in the modern culture, and the insolvency angle is provocative. We’re starting to get enough traction that we can hammer the insolvency angle to our advantage. But the functional finance path needs to be talked about as well.

      Not only that, by saying “We cannot go broke, but our currency could be worthless – here is how and why it is possible” we are both provocative and concede a serious point. It makes people listen to us. Really, we just need more people to listen for a bit, because once they do, about 80% of the people concede that it is in fact operationally correct.

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