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Saturday, December 05, 2009


the tail risk to the united states in the GFC

first i should apologize -- regular blogging has taken a detour of late as other responsibilities intrude. i remain active on twitter, but haven't secured the time i'd like (and need) for more reflective discourse. i hope to change that.

about a month ago, edward harrison and marshall auerback, posting at harrison's excellent credit writedowns blog, posted a series of entries regarding aspects of modern monetary theory. MMT, sometimes labeled with the more archaic term chartalism, is an education unto itself -- but one worth earning. it has begun to make academic inroads, though it perhaps unfortunately has little immediate prospect of policy implementation. (then again, neither did keynes' ideas in 1930.) more importantly, MMT offers a lens through which one can focus on current important issues regarding systemic debt and currency.

harrison initially posted on the example of japan, riffing on an article by ambrose evans-pritchard, deriding the example of fiscal and monetary reflation without a measure of asset holding company liquidation and aggressive systemic reform as a macro reflationary failure which failed to boost incomes and spending.

auerback disagreed, arguing instead that japan's adherence to its export model suppressed domestic incomes and left it vulnerable to the global financial crisis (GFC).

The Japanese should have gone for domestic demand-led growth instead of export-led growth. When export growth reversed, the economy went into depression. Even Richard Koo, who has often spoken of a balance sheet recession and has the right approach on Japan, never imagined that such a thing would happen. But it’s easy enough to resolve; simply support domestic incomes with the right tax cuts to sustain domestic demand at desired levels to sustain output and employment.

One can always sustain domestic demand by altering the fiscal balance. In truth, it is as simple as debiting and crediting accounts on the Bank of Japan’s master yen account spread sheet.

auerback here importantly introduces MMT conceptions of government accounts.

[T]he notion that the country is in a ‘debt trap dynamic’ as Ambrose Evans-Pritchard suggests is ludicrous. Debt is serviced by data entries by the BOJ - debits and credits to securities accounts and transactions accounts at the BOJ. The BOJ can spend/credit accounts at will. It’s just data entry. Spending is not constrained by revenues (this is fiat currency, not a gold standard). In a worst case, ‘over-spending’ causes inflation. But, that happens to be what they are trying to accomplish. Getting some inflation would be considered a success. Moreover, it can easily be reversed by tightening fiscal policy if it comes to that.

harrison subsequently noted the true nature of sovereign default when a government issues its own currency, using the case of russia's surprise 1998 default which sparked the LTCM crisis.

Russia’s was not an involuntary default by a country which issues debt in its own fiat currency. Russia was a perfect example of a voluntary default due to huge foreign currency debt and foreign exchange reserve losses (see Wikipedia for a pretty accurate and thorough account on the events of the 1998 Russian financial crisis).

Russia defaulted voluntarily, an event which the geniuses at Long-Term Capital Management failed to model correctly. Moreover, the immediate stress on Russia was not the rouble-denominated debt but the mountain of foreign currency obligations via an unrealistic currency peg which were draining reserves. Similar events unfolded in Argentina a few years later as their currency board crumbled and the Peso was devalued by three-quarters.

Again, the point is that a government can always make good on its own fiat currency obligations if it chooses to do so. The real question is why a country might voluntarily default on its own currency debt or involuntarily on foreign currency debt. The answer usually has to do with taxes. In Argentina and Russia, the government was unable to prove that its taxation policies were benefitting its citizens, creating rampant tax evasion, especially in the monied classes. Capital flight took form as many dodged taxes. Capital flight eventually turns into currency revulsion which creates the pre-conditions for depression, as Latvia, Estonia and Lithuania learned most recently.

The relationship these examples from the Baltics, Argentina and Russia have with Japan and the United States is taxes. When taxes seem unfair or excessive, the citizens evade taxes and eventually revolt; you end up with a situation like Russia circa 1998, Argentina circa 2002 or Zimbabwe circa 2007.

there is an extraordindary amount of discourse in the american public square currently about the prospect of a government debt default. for the moment, it is entirely spurious -- the US is nowhere near any such threshold, and much of the talk is driven either by plain ignorance or by opportunist electioneering in advance of 2010 and 2012. harrison and auerback here instead outline something closer to the reality of government finance.

much of the long history of sovereign debt default as illustrated by rogoff and reinhart is, from my view, misunderstood. the gold standard is a much stricter mistress, and governments adhering to it really could be put in a position of necessary default out of an inability to redeem debt and currency in specie. that is not, however, the monetary system we now operate under.

more recently, countries or currency unions got into similar trouble by borrowing heavily in contracts denominated in or (often through the operation of foreign banks) funded by currencies that they could not print. this was the case in mexico in 1994, argentina in 2001 and is currently the case in the baltics. the potential for such societies to devalue their currency, effecting a "soft default" either to create the ability to repay government debt or ease the ability of the private sector to do so, is high. the united states in both its private and public sectors borrows in its own currency.

as the issuer of the currency in which its debt is denominated, there is no way for the united states government to default on its debt which is not elective. it simply cannot be compelled to default; it has to decide to out of fear of the consequences of servicing the debt. one of the tenets of MMT is that in a fiat currency system there is no material difference between government debt issuance and government currency issuance -- both are promissory notes, one interest-bearing, one not, both backed by the full faith and credit of the government. MMT economist bill mitchell regularly highlights the use of government debt as a useless archaism of the gold standard. governments would do as well to simply spend without issuing debt, with the limitation on spending being not any illusory fiction of debt service cost but the capacity of the economy to absorb such spending in complement with private sector spending without pressuring prices higher.

it seems that elective default could never happen, but clearly they do and there are reasons to elect to do so.

russia, as auerback and harrison discuss while referencing wikipedia, did so out of a desire to maintain foreign exchange holdings dwindling away under an artificially high exchange rate peg which brought ruble holders to the central bank to obtain forex. by 1997 russia had borrowed extensively from foreign vendors in ruble-denominated contracts paying very high interest rates. following the asian financial crisis, commodity demand declines reduced russian forex inflows, precipitating a decline in forex balances, a measure of capital flight and rising interest rates on ruble loans. rate increases choked off economic activity and tax receipts collapsed, aggravating russian government deficits. the IMF orchestrated a july 24 forex loan to fund maturing government bonds, but the peg was maintained and forex continued to bleed away. soon after a run on the ruble began as foreign vendors and asset holders began to realize that the ruble would eventually have to be radically devalued. on august 13 russian markets in stocks, bonds and the ruble collapsed as these foreign participants fled. on august 17 the government simultaneously revalued the official ruble exchange rate to a dirty float and rescheduled both private and public ruble debt -- though it is something of a mystery to this day why public debt was rescheduled. by september the ruble had fallen to about a third of its peg level, and inflation in 1998 exceeded 80% with food items having doubled and import prices quadrupled.

this is a similar story to that which occurred in iceland in 2008, and which the baltic states are currently attempting to forestall. can it happen in the united states?

the US clearly has some of the precursory conditions. a large and durable current account deficit has left it, opposite of japan, with a titanic systemic dependence on borrowed foreign deposits in the form of wholesale funding. there are vast foreign investments in american capital markets assets (though rather less in fixed assets). and the united states does in fact have an artificially-strong fixed or dirty float exchange rate with many of its creditors -- though such are pegged from the other side.

the first phase of the GFC saw export-model current-account-surplus countries take the brunt of economic ramifications of the collapse of trade. germany, japan, china and east asian states are loaded now with massive excess capacity built to fill american, british, spanish and eastern european demand. they continue to struggle with the deflationary consequences of simply not having domestic demand anything like their capacity to supply.

but one can envision a second phase wherein those afflicted systematically withdraw the funding they have been providing to the erstwhile repositories of excess demand. this in fact is being called by socgen economist glenn maguire in the form of large chinese current account deficits going forward; andy xie has said something similar. moreover, rumors of japanese sales of treasury bonds to fund domestic programs have been in the markets recently. should capital flight begin in the united states as it did in russia in 1998 -- and as it did in september 2008 following the collapse of lehman brothers, as evidenced by the titanic run on money markets which ensued and was then stemmed by frantic treasury and federal reserve action -- it is not inconceivable. john hempton has previously compared the position of the united states to that of korea in 1997.

there are some countries -- notably ireland, greece and spain -- which are (at least for now) in a currency union which does not allow them to devalue their currency unilaterally. this is often cited, not least by me, as a weakness -- particularly where the political system does not allow for the kind of fiscal effort which could offset a deflationary collapse through government support of aggregate incomes. but it swings both ways. the euro has also protected these countries from the anticipation of currency collapse which felled russia in 1998 and iceland in 2008. the united states may print the world's reserve currency, but it is a currency and at the whim of its creditors and asset-holders.

on some consideration, there is little doubt in my mind that the fundamental assertions of MMT are valid. there is no need for governments to issue debt instruments which are effectively interchangeable with currency, nor to maintain a balance sheet in the traditional sense. in conditions such as exist now -- with capacity utilization at historic lows, resource gluts, unemployment at generational highs -- there is no traditional inflationary impediment to printing as much spending as may be necessary to offset much-needed (as steve keen illustrates -- see figure 15) private sector saving and deleveraging on a national accounts basis to prevent a deflationary spike of real interest rates and concomitant downward spiral as the financial sector deactivates endogenous money and builds excess reserves, hopefully instead pulling the economy toward something like stability in unemployment if not full employment as it delevers.

moreover, MMT suggests that -- even should a run on the dollar materialize as foreign asset holders dump all things american in anticipation of step-change currency devaluation as a result of either peg-breaking in foreign capitals or radical policy changes in washington -- there is no mechanical barrier to prevent the central bank from buying every single asset dumped, soaking up every last dollar rejected through titanic forex operations. nor need any of the above operations -- sure in the current configuration to balloon the central bank balance sheet stunningly -- result in any loan growth, as the unbelievable reserves which would be created in the banking system can as easily be neutralized by first reinstituting and then raising the erstwhile concept of reserve requirements.

but the central bank cannot subsequently force terms of trade on foreign exporters -- and there's the rub. the dollar in the aftermath of a capital flight would not be very useful in securing traded goods, such as oil. dr. keen:

I think the Chartalists have half a point – a sovereign government with a compliant Central Bank can issue as much fiat money as it wants regardless of its budget position. But that tells us nothing about countries in the EU, for example – which are sovereign but don’t have a national Central Bank; while they acknowledge the international ramifications (currency devaluation), I don’t believe they give them sufficient weight; and I feel that their perception of how the macroeconomy would respond to this injection is somewhat superficial.

in the aftermath, prices might rise fiercely in spite of the further collapse of the FIRE economy as a result not of a wage-price spiral but of old-fashioned domestic scarcity.

though of varying opinion at different points in the education of the last ten years, i have for some time now expected a very serious deflationary resolution to overtake the monster private sector debt bubble, now bust. that remains the near-term prognosis -- particularly during periods when the dollar carry establishment is unwound by changes in risk appetite, driving the dollar north and economic activity south. the primary risk to the american economy remains the lack of political will to engage in the formidable long-term government fiscal deficit spending that would allow the private sector to deleverage over time out of income without engaging a deflationary paradox of thrift.

but i am also gradually coming to the view that americans should take advantage of any such episodes of panic to move cash into low-leverage real goods and commodities as a form of insurance against tail risk.

this is not a call to buy houses, land, equities or hybrid debt -- any asset that was financialized during the boom and whose valuation remains highly dependent on the ability to finance it with debt and/or capital structure is likely to get crushed (particularly in real terms) in coming years. i increasingly expect housing and equities to decline on the order of 80%+ real peak-to-trough. and episodic deflation -- resulting from risk aversion, flagging government stimulus, liquidity withdrawal or any combination thereof -- is indeed likely to make cash the best performer of all.

nor is it a call to the most deflation-proof instrument, government debt. while treasuries may outperform handily in deflationary periods, what they will not suffer well in real terms are the tail risks discussed above.

nor it is a call to run headlong into gold. i agree broadly with the reformed broker, and dubai friday as well as this friday's action confirmed his view. gold is for the time being a risk-on trade, its value being inflated by dollar weakness and speculative fervor in what is really a quite small commodity market. as can be seen when it is denominated in other currencies, gold is not uniquely a dollar story; however, the dollar is a huge part of the story -- and a strong deleveraging dollar rally could as easily as not take a third or more out of the gold price.

but it is a call to opportunistically diversify a significant portion of investable assets out of dollars as insurance against the possibility of a run on the dollar. such an event may never occur, but the anticipation of the tail risk will likely keep the hedge from being a big loser for the duration of the GFC.

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Good to see you back, and with a most provocative post. I need to reread this, but so far I agree with the general thrust of the argument--that the US will choose to default rather than be forced to. While people complain about the budget deficit, what they overlook is that currently we have the best of it--the government gets to spend far more money than it extracts from us in taxes. (This looks to be a structural problem--check out the CBO estimates for revenue and spending in November. All of the TARP and GSE bailouts are little more than a rounding error in the Y-O-Y comparisons.) Sure, it means the currency is doomed as a store of value, but they could extract my wealth through taxes--a move which I as a middle-class citizen would be unable to resist. I think I can partially avoid the confiscation of my wealth (such as it is) through devaluation. Odysseus had a choice between Scylla and Charybdis, and so do we. Watch out for that whirlpool. . .

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it's less that i think the US will choose to default, bwdik, than that they would have to choose and cannot be compelled. i don't expect they will.

but there is a tail risk, it seems to me, that a run could arise.

the run on the shadow banks in september 2008 morphed into a run on money markets -- essentially a run on the private sector banking system of the united states which is so very dependent on deposits borrowed from overseason. it was stopped by backstopping the banks with government funding guarantees.

the question is what might happen if that run returned -- or if it became a run on the government. the government can soak up all the rejected debt and dollars with a monster balance sheet expansion, then raise reserve requirements for the banks to prevent an expansion of lending on those new reserves. but the US would effectively be cut off in terms of trade -- this is the iceland outcome, more or less, and the result is inflation in spite of negative loan growth simply because imported goods and commodities get scarce.

this is a nuclear meltdown scenario, and it isn't likely in my view. cutting off iceland is one thing. even cutting off britain. but for asian and european mercantile powers to forswear the primary market of global exports will take a horrific disaster.

this is the only near-term inflationary scenario i have. in this scenario, through, holding commodities and precious metals makes sense -- and having some around as a hedge against apocalypse isn't silly, particularly in light of the socgen call for a china collapse and yuan devaluation.

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Nice work summarizing crucial topics, gm. I've been intending to address MMT and current outlook, also (there is never enough time, is there?). As you highlight, the currency factor is a key unknown, and I hadn't thought to consider the US as a pegged currency though as you say it is in a reverse sense, and that may matter. These are the big questions. I've done a little looking at currency data and money supply correlations, just need to find time to finish, FWIW... Oh, and thanks for the positive link in your other post!

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You're right, GM, I should have said that the US would need to choose default (under the current circumstances). To me, the present situation is analogous to a system in which a state change is thermodynamically preferred but has been unable to proceed due to the lack of a precipitating event. We cannot say what the event will be, but when it occurs the state change will be very fast.

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