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

March 31, 2011

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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  1. October 3, 2011 at 8:43 pm

    This definitely makes perfect sense to anyone

  1. April 1, 2011 at 4:49 pm
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