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Tuesday, December 29, 2009


moving toward a new basel consensus

via alea -- patience wheatcroft in the wall street journal on the reform of the basel rules.

The backlash was inevitable, and what is now being advocated is the full Taliban approach, with exposure kept to the minimum. Much more stringent capital requirements will be imposed, with strict limitations on what will qualify as Tier One capital. The capital requirements for counterparty risks arising from derivatives and securities financing will be strengthened. Liquidity minimum standards will be introduced.

Leverage will be much more strictly limited and, in a move that could have wide-ranging consequences, there will be a requirement to use the good times to build up capital buffers for when the (inevitable) bad times come.

The U.K.'s prime minister, Gordon Brown, may have regularly proclaimed that he had done away with boom and bust, but the foolishness of his rodomontade is now painfully clear and regulators will want to be prepared for the turning of the economic cycle.

That will mean that, as the committee foreshadowed in the autumn, pay outs to staff and investors will be firmly sublimated in favor of shoring up the business.

However unjust the bankers and their investors might feel this to be, the taxpayers who have been forced to provide so much to prop up otherwise bankrupt financial institutions are unlikely to be sympathetic, even though many of their pension funds have in the past been beneficiaries of dividends from bank shares. Now the call is for caution.

There is still time for the banks to continue their current fling since the Basel recommendations are only aimed for implementation at the end of 2012, and then with some element of phasing. But a new, much tougher, regime is on its way.

much of what has been going on since march last has been the desperate effort of governments to not only keep western banking afloat but to construct a temporary paradigm in which banks can accrue capital at the expense of savers, borrowers and investors in order to aid in the necessary recapitalizing of large insolvent banking institutions before the absence of once-expected cash flows renders the (hopefully) temporary suspension of prudential accounting moot. perhaps the easiest of these steps to appreciate is the use of liquidity in the reflation of asset prices -- both of equities so as to allow titanic dilutive floats of common equity, and of securitizations and lower-quality debt instruments so as to prevent large writedowns on asset books as well as provide massively profitable opportunities in trading. (junk debt, it should be noted, is completing its best year ever by a wide margin.)

such helpful extensions of the government balance sheet will surely if quietly continue. for example, perhaps the most notable development of the holiday season was the quiet removal of treasury bailout caps on fannie mae and freddie mac.

The government's decision to provide unlimited support to Fannie Mae and Freddie Mac probably presages more aggressive action to prop up the U.S. housing market.

The government may put a mortgage-modification effort, called the Home Affordable Modification Program, or HAMP, into overdrive in coming years, pushing for reductions in the principal outstanding on home loans overseen by Fannie and Freddie, Bose George, an analyst at Keefe, Bruyette & Woods, wrote in a note to investors Monday. ...

KBW's George initially found the extra support "perplexing," he said, because Fannie and Freddie are unlikely to need more than $200 billion of government money each.

During the depths of the recession in March 2009, the Government Accountability Office estimated that the bailouts of the two companies would cost taxpayers $389 billion, the analyst noted. Since then, house prices have stabilized and have begun to creep up in some areas.

Instead, unlimited taxpayer support will give the government "more flexibility in potentially taking more aggressive action to support the housing market," George wrote.

HAMP has so far had little effect on foreclosures. So the government may push for an enhanced version of the program that includes reductions in the principal outstanding on mortgages, the analyst said.

Principal reductions are controversial because they leave banks and other major mortgage lenders with bigger losses and lessened capital. The industry prefers modifications that lower interest payments in other ways, such as extending the maturity of home loans.

Aggressive reductions in principal on mortgages overseen by Fannie and Freddie could leave the companies with significant losses and cut further into their waning capital bases. But Treasury can pump more money into the institutions to make up for that, George said.

debt forgiveness is in the end just another avenue for debt reduction, and an overdue one at that. i don't imagine it will have much salutary effect on home prices, which are in the process of returning to historical discounted cash flow relations to incomes and rents -- indeed acquiescing to principal writedowns is an implicit acknowledgment that house prices cannot be returned to anything like their former level. to the extent that mortgagor might be subsequently be free to relocate without creating a credit event, it may even increase housing supply and pressure prices further.

this should impair bank balance sheets mightily, as in most cases banks have (much like fannie and freddie) avoided marking real estate loan portfolios to loss expectations which will be realized in debt forgiveness. but this can be seen as the other side of the bailout coin -- the massive 2009 government aid in recapitalization and the continuing use of the fed, treasury, FDIC and GSEs to lighten the blow by transferring debt and debt guarantees to the government balance sheet is groundwork preparing banks for the losses to come. it seems the major banks will be nursed through this transition and slowly recapitalized on the other side to comport with more pragmatic and robust post-basel-2 standards. at least, that would seem to be the plan.

but will it hold? that's the real question, and it depends very much on whether the assessment of the federal reserve, treasury and administration about the nature and depth of the problems afflicting the capital markets -- particularly of cash flows and the leverage applied to them -- are accurate. if the impairment of the banks is being underestimated (and indeed even if it isn't) the tail risk of precipitating a currency event with a debt issuance shock looms -- one that, while not constituting an event of default, may nevertheless impair american access to internationally traded commodities.

the public remarks of government officials very likely do not betray the fullness of their comprehension of the issues, given the nature of what j.k. galbraith famously called "incantation". but neither is it likely that ben bernanke grasps how inefficacious monetary policy is and will remain for so long as net loan demand is negative and banks are deleveraging, building investment portfolios or even retiring wholesale funding rather than making new loans.

i suspect the fed hopes to have kickstarted in early 2009 with very easy monetary policy a self-sustaining if mild and fragile growth cycle akin to those sparked by his predecessor, increasing incomes and thereby creating the cash flows needed to sustain asset prices and retire debt out of earnings without a massive series of deflationary writedowns. such an invention would allow both the fed and treasury to, perhaps gently and incrementally, withdraw their monetary and fiscal support without relapse.

but i fear that's probably wrong. instead, i think they are misreading a strong inventory correction which followed a near-full-stop in late 2008, one which is probably closer to its end than beginning, as growth in real retail sales is yet to be observed. indeed the most recent retail figures from the fed show flat-to-slightly-down year-over-year through november -- and this in spite of the augmentation of a series of fiscal stimuli (including the quasi-fiscal stimulus of permanent fed asset purchases) and a significant weakening of the dollar from the crisis peak, in comparison to a post-crash economy of late 2008 which had already been in recession for a year.

and here again we return to the linchpin of the entire construction -- fiscal stimulus. the household balance sheet is profoundly damaged; any foray into debt forgiveness would indicate that the government understands and accepts that. loan growth to the consumer sector is highly unlikely for some time to come. corporate cash flows depend much on household spending, and so the reduced flows that result from the move to balance sheet repair necessitate a corporate deleveraging in kind. and the banks, for their part, are eager to deleverage themselves and willing to buy riskless government debt for the purpose to retracting from risk and avoiding capital charges. into this paradox of thrift only government spending can prevent a fall in incomes, therefore deposits, therefore leverage, therefore asset prices, therefore again incomes and so forth.

without any further action, the impact of the ARRA fiscal stimulus package will be waning in all future quarters as it continues to disburse but with reduced intensity. as has been repeated ad nauseum, this will mean a diminishing impact on GDP growth reverting to a drag on GDP growth in 2h2010. so too between now and the end of the first quarter will planned fed asset purchases trail off to zero. if my presumptions above are correct, this will mean a return to the deflationary dynamics of the paradox of thrift as 2010 progresses -- which means negative GDP growth, deepening negative change in real sales, decreased employment and lower asset prices (in the case of the most leveraged assets, much lower) in a double-dip that should definitively end any semantic argument about whether or not the current economic process constitutes a depression. and that would shatter the outlook and plan of the fed to marshal the financial system back to health, incurring huge further losses in the banks and GSEs alike.

in the event, as i don't see the political will for further fiscal stimulus, i don't expect the adoption of anything like more stringent capital rules for the banks would be welcome anytime soon -- perhaps its just as well that implementation isn't until 2012, and i imagine it might be delayed more still.

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Monday, December 14, 2009


the hazards of wealth concentration

nathan's economic edge links to max keiser's interview with steve keen, which begins at 12:40.

i want to focus on one point brought up immediately after the start, where keen comments on the effect on velocity of the concentration of wealth.

If you have an economy with a certain stock of money turning over at a particular speed that's the level of output it can support. and if you then have a transfer of wealth from those who have to spend it very rapidly, like workers who turn their money over basically 26 times a year, and it goes into the hands of the bill gates' of the world ... then they spend far more slowly than that, turning over their accounts once every ten years, you actually slow down the rate at which money is turning over and [lower] the level of output it can actually support.

this is perhaps relevant to the postulation of the origin of the crisis forwarded by historian james livingston.

Look first at the new trends of the 1920s. This was the first decade in which the new consumer durables--autos, radios, refrigerators, etc.--became the driving force of economic growth as such. This was the first decade in which a measurable decline of net investment coincided with spectacular increases in nonfarm labor productivity and industrial output (roughly 60% for both). This was the first decade in which a relative decline of trade unions gave capital the leverage it needed to enlarge its share of revenue and national income at the expense of labor.

These three trends were the key ingredients in a recipe for disaster. At the very moment that higher private-sector wages and thus increased consumer expenditures became the only available means to enforce the new pattern of economic growth, income shares shifted decisively away from wages, toward profits. At the very moment that net investment became unnecessary to enforce increased productivity and output, income shares shifted decisively away from wages, toward profits. ...

So the "underlying cause" of the Great Depression was a distribution of income that, on the one hand, choked off growth in consumer durables--the industries that were the new sources of economic growth as such--and that, on the other hand, produced the tidal wave of surplus capital which produced the stock market bubble of the late-1920s. By the same token, recovery from this economic disaster registered, and caused, a momentous structural change by making demand for consumer durables the leading edge of growth.

keen is offering that wealth concentration slowed the natural velocity of money by diminishing the savings available to consumers and concentrating it into pools of low-turnover investment capital. this trend of declining multiplicity was observable, as noted in the statistics kept by the federal reserve bank of saint louis. the diminishment of economic turnover (and real wages) was masked by the rising indebtedness and the associated growth of the FIRE economy -- until that debt boom collapsed, once debt service cost began to test the limits of output to support it. this is of a kind with livingston's view that the reduction in wages diminished real economic activity while supporting a capital markets bubble vulnerable to perturbation.

UPDATE: mark thoma offers bruce bartlett:

I have never understood how I am worse off if the top 1% of households increase their share of national wealth or income as long as the absolute level of wealth and income of the other 99% is unchanged.

read my blog, mr bartlett, and you would understand! increasing inequality of income distribution slows the velocity of money, increasing the need of counteractive debt/endogenous money creation and giving impetus to credit booms and their inevitable terminating crises.

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interesting to watch the pained realization in this country as we begin to conclude that the celebrated increase in living standards over the decades was mostly a charade. the items so celebrated as increasing the quality of life for the masses were little more than borrowed items loaned at usurious rates.

I suppose that observation is self evident to many folks but it seems to me that we are at a crossroads. we can endure either continued subjugation to the hamster wheel of debt, forgo those items that have become so dear to us, or appeal to the government to "correct" the problem. I suspect we'll get the latter whether we like it or not.

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I totally agree with the article. Seems like economies are like bicycles...inherently unstable, but still make forward progress. On one side is capitalism and its quest for efficiency and the resultant concentration of wealth. On the other side is the power of workers and labor. Extreme capitalism is subject to the same failure mechanism as is only a matter of whether the bicycle crashed to the left or the right.

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I totally agree with this article!

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We don't always agree, but I keep coming back to your blog, and now I know why. This post is an education for me, and the best commentary I've read here.

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Interesting article as for me. It would be great to read more concerning this theme. Thnx for posting this material.
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in honor of your penchant for typing in all lower case i will post my comment in all lower case as well! funny thing is i do this for email all the time and it drives my friends nuts...

anyway, great article on the evils of wealth concentration. my personal favorite whipping boy is that all this "increased value of living" that everyone keeps talking about it just a bunch of cell phone toting, dvr'ing bunch of people looking for ways to occupy their time. so much for great advancement!

as an aside i have recently started a blog and am wondering if there is anyway that I could get added to your blogroll? any help would be greatly appreciated.

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This is a great article!
So very true. If wealth was distributed to workers it would grow the economy. Where would the medical industry be if it's money were not drained away by the insurance companies?

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Tuesday, December 08, 2009


greece downgrade

just a placeholder for edward hugh's take on greece. it's taking its time, but southern europe is slowly but inevitably slipping into deep depression and (unlike the united states) government insolvency behind an inability to devalue currencies to finance monstrous government debts that only inclusion in the euro made possible to borrow.

We might be forgiven for getting the impression that to date rather than acting as a stimulus to deep economic reform, Euro membership has rather acted to reward those countries who would get into more and more debt, with ever less sustainable economic models, by supplying them with funding at far cheaper rates of interest than the markets would otherwise make available. It is this particular clockhand that Europe’s leaders would now dearly like to turn backwards, and this is why I have little doubt that it is in Greece that a stand will now be taken. If not, then that longest of long runs may arrive rather sooner than some of us, at least, are comfortable with.

i'd wager that with sustained economic pressure over the course of coming quarters and years the end result will be greece, italy, ireland, portugal and spain all (the PIIGS, in the parlance) leaving or being ejected from the currency union -- with fairly incredible turmoil in global capital markets as a likely adjunct.

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All the cracks of Greek society and economy, all the dirty secrets that the Left has tried to suppress have come sharply into the light of day.

Since the fall of the Regime of the Colonels, Greek politics have been dominated by the Left and their centralist allies. The present president, Karolos Papoulias, of the Panhellenic Socialist Movement, was reelected to his second five year term in 2005. His prime minister, Kostas Karamanlis, a progressive party, aka Left Lite) took power in 2004. Konstantinos Simitis, also of the Panhellenic Socialist Movement, presided over Greece from 1996 to 2004.

In 13 years of Leftist policies, they have ruined the Greek economy and brought the country to the brink of ruin. Underneath all of this is a seething core of nationalism now garnering growing support which may take power by the ballot or other means.

Pushed by the EU, over the years Greece opened its borders and allowed hundreds of thousands of Muslims to flood the country as a cheap labour source. The Left would happily impoverish their own people in favor of allowing cheap, foreign and often socially hostile laborers into their midst. Sound familiar, you Westerners?

The top 2% of Greece watched their fortunes skyrocket. The remainder of Greece, a nation dependent on tourism, watched their fortunes plummet.

The 2007 fires destroyed hundreds of thousands of acres, dozens of villages and took hundreds of lives. The whole of this tragedy, which found the leftist government absolutely unprepared, would have been much worse if not for massive aid brought by other countries.

Then came the Bank Panic of 2008. Greece suffered from further cuts in tourism and a collapse of international trade and transport. The came the cut off of cheap Euros flowing in from the Western Europeans.

University educated students who face a 20%+ unemployment rate, took to the streets in late 2008, a revolt that has continued to this very day. Their mass unrest and destruction of property and businesses has driven the Greek economy from its knees to its back, stopping tourism and costing billions of Euros in damage. Bombings throughout Greece have become an almost daily occurrence.

If this has not brought the Right to open revolt, it was thought the Islamic mini-Jihad now exploding in Athens would.

The Greeks experienced for 400 years the Islamic Yoke and they have not forgotten. In 2006, under EU pressure the Socialists gave permission to build the first mosque in Athens since Greece threw off the Islamic yoke less than 200 years ago. The people flatly stated they did not want another Kosovo on their lands. They've seen to what ends the West will go to in service to their Saudi masters. They've seen Obama's infamous bow in London.

This Saudi sponsored project prompted mass demonstrations and the government backed off. On the spot of the proposed Saudi mosque, now stands a newly built Orthodox chapel.

Now we have riots by imported Islamic aliens and their anarchist and leftist allies. But, the Greek Right is not toothless like its counterparts in the West. Muslim prayer centers have been burned. Anarchists have been attacked in the streets. Orthodox nationalists have never had so much reason to be angry as they do now.

Soon the UK, America and other PC enablers of Islamic tyranny will get to see first hand life under Islamic reign as they helped enforce on places like Kosovo. People of the West, if we allow this to continue, we are no better than accomplices to the crimes of the traitors.

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Monday, December 07, 2009


signs of a correction to the reflation trade


S&P 500 options to protect against declines in stocks over the next year cost 22 percent more than one-month contracts, the highest since 1999, data compiled by London-based Barclays Plc and Bloomberg show. ... The last time the average gap between one-year insurance and 30-day contracts was higher was five months before the S&P 500 began a 49 percent plunge in March 2000 during the collapse of the Internet bubble.

those last five months were a doozy, though. further, as noted by adam warner on twitter:

Options has called 30 of the last 2 $VIX explosions, will post later on it.

a yet better indication might be the commitments of traders data. jason goepfert:

Speculators continue to like the Nasdaq 100. Really, really like it.

The chart below shows commercial hedger positions in Nasdaq 100 futures, but by definition, large and small speculators are taking the other side of the trade. The bottom like is that "smart money" hedgers are net short to one of the most extreme degrees in the history of this data (going back to 2000).

The other three weeks highlighted on the chart are 12/01/04, 12/05/05 and 10/15/07.

daily NYSE reported short interest also shows a massive spike in specialist short sales on friday (december 4). these often mark short-term tops.

i think the VIX contango really only gains a lot of meaning with context like this.

the third aspect to watch closely will be the dollar, which is probably funding a significant global carry trade.

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The Albert Edwards leading indicator dip metric looks to have been a fakeout as the ECRI WLI made a new high today.

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Saturday, December 05, 2009


dividend trend comparison

this is a post too good to lose track of -- hbl at thought offerings is tracking earnings and dividends in comparison to the great depression.

Earnings have dropped more rapidly than during the Great Depression (dramatically so if you count reported rather than operating earnings), but they appear to have begun a recovery much sooner than occurred back then. Trailing 12-month dividends are still falling slightly faster than during the Great Depression, which is particularly remarkable given how much more severe deflation was then compared to now. These trends underscore that contrary to some claims, this is no crisis of confidence!

Since dividend changes tend to lag earnings changes, rising earnings could mean dividends will level out and start increasing soon (and in fact the quarterly fall in dividends from Q2 to Q3 was small). However, if earnings are being over-reported thanks to factors such as relaxed accounting rules or optimistic loan loss assumptions, dividends should ultimately reveal the truth about underlying cash flows.

And while we should all hope that this recovery can be sustained, there is a significant probability (details of which I hope to discuss in a separate post) that this is a temporary upturn in a longer term depression. A renewed fall in GDP, persistent unemployment, and intensifying deflationary pressures would not be good news for any fledgling recovery in earnings and dividends.

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ECRI is now long-term bearish .

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one interesting part about ECRI's comment is what even 9% unemployment implies, rb -- real GDP growth of 4.5% for 2010. that's the implied forecast. i don't see any real chance of that, business cycles be damned.

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Obama the centrist is getting gamed

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thanks for the article

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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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