currency war

by

Why Modern Monetary Theory is Wrong About Government Debt

I’ve taken some criticism — particularly from advocates of modern monetary theory and sectoral balances and all that — for using total debt rather than just private debt in my work.

The modern monetary theory line (in one sentence, and also in video form) is that government debt levels are nothing to worry about, because governments are the issuer of the currency, and can always print more.

This evokes the words of Alan Greenspan:

The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.

Of course, the point I am trying to make in worrying about total debt levels is not the danger of mass default (although certainly default cascades a la Lehman are a concern in any interconnective financial system), but that large debt loads can lead to painful spells of deleveraging and economic depression as has occurred in Japan for most of the last twenty years:

Japan-Debt-Hoisington-27

Of course, before the crisis in America (as was the case in Japan at the beginning of their crisis) government debt was not really a great contributor to the total debt level, meaning that the total debt graph looks far more similar to the private debt line than the public debt line, which means that when I talk about the dangers of growing total debt I am talking much more about private debt than public debt:

010212_2140_TheDebtwatc1

But what Japan empirically illustrates is the fact that all debt matters. Japan’s private debt levels have reset to below the pre-crisis norm, yet the economy remains depressed while public debt continues to climb (both in absolute terms, and as a percentage of GDP). If excessive private debt was the sole factor in Japan’s depression, Japan would have recovered long ago. What we have seen in Japan has been the transfer of the debt load from the private sector to the public, with only a relative small level of net deleveraging.

And high and growing public sector deficits often lead to contractionary tax hikes and spending cuts. This happened time and again during Japan’s lost decades. Peter Tasker of the Financial Times writes:

When Japan’s bubble economy imploded in the early 1990s, public finances were in surplus and government debt was a mere 20 per cent of gross domestic product. Twenty years on, the government is running a yawning deficit and gross public debt has swollen to a sumo-sized 200 per cent of GDP.

How did it get from there to here? Not by lavish public spending, as is sometimes assumed. Japan’s experiment with Keynesian-style public works programmes ended in 1997. True, they had failed to trigger durable economic recovery. But the alternative hypothesis – that fiscal and monetary virtue would be enough – proved woefully mistaken. Economic growth had been positive in the first half of the “lost decade”, but after the government raised consumption tax in 1998 any momentum vanished. Today Japan’s nominal GDP is lower than in 1992.

The real cause of fiscal deterioration was the damage done to tax revenues by this protracted slump. Central government outlays as a percentage of GDP are no higher now than in the early 1980s, but the tax take has fallen by 5 per cent of GDP since 1989, the year that consumption taxes were introduced.

A rise in debt relative to income has historically tended to lead to contractionary deleveraging irrespective of whether the debt is public or private.

The notion at the heart of modern monetary theory that governments that control their own currency do not have to engage in contractionary deleveraging remains largely ignored. Just because nations can (in a worst case scenario) always print money to pay their debt, doesn’t mean that they will always print money to pay their debt. They will often choose to adopt an austerity program (as is often mandated by the IMF), or default outright instead (as happened in Russia in the 1990s).

And what governments cannot guarantee is that the money they print will have value. This is determined by market participants. In the real economy people in general and creditors (and Germans) in particular are very afraid of inflation and increases in the money supply. History is littered with currency collapses, where citizens have lost confidence in the currency (although in truth most hyperinflations have occurred after some great shock to the real economy like a war or famine, and not solely as a result of excessive money printing).

And there has always been a significant danger of currency, trade and political retaliations by creditors and creditor nations, as a result of the perception of “money printing”. Many, many wars have been fought over national debts, and over currencies and their devaluation. One only has to look at China’s frustrated rhetoric regarding America’s various monetary expansions, the fact that many Eurasian creditor nations are moving away from the dollar as a reserve currency, as well as the growth of American-Chinese trade measures and retaliations, to see how policy of a far lesser order than the sort of thing advocated in modern monetary theory can exacerbate frictions in the global currency system (although nothing bad has come to pass yet).

Governments controlling their own currencies are likely to continue to defy the prescriptions of the modern monetary theorists for years to come. And that means that expansionary increases in government debt relative to the underlying economy will continue to be a prelude to contractionary deleveraging, just as is the case with the private sector. All debt matters.

by

Why I Still Fear Inflation

Paul Krugman wonders why others worry about inflation when he sees no evidence of inflationary trends:

Joe Wiesenthal makes the well-known point that aside from certain euro area countries, yields on sovereign debt have plunged since 2007; investors are rushing to buy sovereign debt, not fleeing it. I was a bit surprised by his description of this insight as being non-”mainstream”; I guess it depends on your definition of mainstream. But surely the notion that what we have is largely a process of private-sector deleveraging, with government deficits the consequence of this process, and interest rates low because we have an excess of desired saving, is pretty widespread (and backed by a lot of empirical evidence).

And there’s also a lot of discussion, which I’m ambivalent about, concerning the supposed shortage of safe assets; this is coming from bank research departments as well as academics, it’s a frequent topic on FT Alphaville, and so on. So Joe didn’t seem to me to be saying anything radical.

But those comments! It’s not just that the commenters disagree; they seem to regard Joe as some kind of space alien (or, for those who had the misfortune to see me on Squawk Box, a unicorn); they consider it just crazy and laughable to suggest that we aren’t facing an immense crisis of public deficits with Zimbabwe-style inflation just around the corner.

Krugman, of course, thinks it crazy and laughable that in the face of years of decreasing interest rates that anyone would believe that inflation could still be a menace. In fact, Krugman has made the point multiple times that more inflation would be a good thing, by decreasing the value of debt and thus allowing the private sector to deleverage a little quicker.

I remain convinced — even having watched Peter Schiff and Gonzalo Lira make incorrect inflationary projections — that there is exists the potential of significant inflationary problems in the medium and long term. Indeed, I believe elevated inflation is one of three roads out of where we are right now — the deleveraging trap.

In my worldview, this depression — although a multi-dimensional thing — has one cause above all others: too much total debt. Debt-as-a-percentage of GDP has grown significantly faster than productivity:

The deleveraging trap begins with the boom years: credit is created above and beyond the economy’s productive capacity. Incomes rise and prices rise above the rate of underlying productivity. And as the total debt level increases, more and more income that was once used for investment and consumption goes toward paying down debt and interest. This means that inflated asset prices become less and less sustainable, making the economy more and more susceptible to a downturn — wherein asset prices deflate, and the value of debt (relative to income) increases further. Under a non-interventionist regime, once the downturn occurs, this would result in credit freeze, mass default and liquidation, as occurred in 1907.

However, under an interventionist regime — like the modern Federal Reserve, or the Bank of Japan — the central bank steps in to lower rates and print money to support asset prices and bail out failed companies. This prevents the credit freeze, mass default, drastic deflation and liquidation. Unfortunately, it also sustains the debt load — following 2008, total debt remains over 350% of GDP. The easy money leads to a short cycle of expansion and growth, but the continued existence of the debt load means that consumers and businesses will still have to set aside a large part of their incomes to pay down debt. This means that any expansion will be short lived, and once the easy money begins to dry up, asset prices will again begin to deflate. The downward pressure on prices, spending and investment from the excessive debt load is huge, and requires sustained and significant central bank intervention to support asset prices and credit availability. The economy is put on life-support. Debt-as-a percentage of GDP may gradually fall (although in the Japanese example, this has not been the case) but progress is slow, and the debt load remains unsustainable.

A fundamental mistake is identifying the problem as one of aggregate demand, and not debt. Lowered aggregate demand is a symptom of the deleveraging trap caused by excessive debt and unsustainable asset prices. The Fed — and advocates of greater Fed interventionism to support aggregate demand, like Krugman — are mostly advocating the treatment of symptoms, not causes. And the treatment in this case may make the underlying causes worse — quantitative easing and low-interest rates are debt-additive policies; while supporting assets prices and GDP, they encourage the addition of debt. 

There are three routes out of the deleveraging trap; liquidation (destroying the debt via mass default), debt forgiveness (destroying the debt via systematically cancelling it), and inflating the debt away. Liquidation in a managed economy with a central bank is politically impossible. Debt forgiveness is politically difficult, although perhaps the most realistic effective bet. And inflating the debt away at a moderate rate of inflation would seem to be a slow and laborious process — the widely-advocated suggestion of a 4% inflation target would only eat slowly (if at all) into the 350%+ total debt-as-a-percentage-of-GDP load.

All three exit routes seem blocked. So the reality that we are staring at — and have been staring at for the last four years — has been remaining in the deleveraging trap.

So why in a deflationary environment like the deleveraging trap would I fear high inflation? Surely this is an absurd and unfounded fear?

Well,  Japan shows that nations can remain stuck in a deleveraging trap for a long, long time — although Japan has had to take to increasingly authoritarian measures such as mandating the purchase of treasury debt to keep rates low and so to keep the debt rolling. But eventually nations stuck in a deleveraging trap will have to take one of the routes out. While central banks refuse to consider the possibility of a debt jubilee, and refuse to consider the possibility of allowing markets to liquidate, the only route out remains inflation. 

Yet the big inflation that would be required to eject the United States from the deleveraging trap makes creditors — the sovereign states from which the US imports huge quantities of resources, energy, components, and finished goods — increasingly jittery.

According to Xinhua:

The U.S. has long been facing the same problem: living beyond its means. At present, the country has debts as high as 55 trillion U.S. dollars, including more than 14 trillion U.S. dollars of treasury bonds.

And last October:

Economists agree that as the United States’ largest foreign creditor, China should contemplate ways to pull itself out of the “dollar trap,” as the U.S. economy is faltering with its debt piling up and its currency on the brink to depreciate.

China must make fuller use of the non-financial assets in its foreign reserves, as well as speed up the diversification of investing channels to resist a possible long-term weakening of the dollar, said Xia Bing, director of the Finance Research Institutes of the Development Research Center under the State Council.

Zheng Xinli, permanent vice chairman of China Center for International Economic Exchanges, has suggested that Chinese companies boost overseas investment as a way to absorb trade surpluses and fend off the dollar risk.

And it’s not like America’s Eurasian creditors are doing nothing about this. As I wrote earlier this month:

If the exporter nations feel as if they are getting screwed, they are only more likely to escalate via the only real means they have — trade war. And having a monopoly on various resources including rare earth minerals (as well as various components and types of finished goods) gives them considerable leverage.

More and more Asian nations — led by China and Russia — have ditched the dollar for bilateral trade (out of fear of dollar instability). Tension rises between the United States and Asia over Syria and Iran. The Asian nations throw more and more abrasive rhetoric around — including war rhetoric.

And on the other hand, both Obama and Romney — as well as Hillary Clinton — seem dead-set on ramping up the tense rhetoric. Romney seems extremely keen to brand China a currency manipulator.

The Fed is caught between a rock and a hard place. If they inflate, they risk the danger of initiating a damaging and deleterious trade war with creditors who do not want to take an inflationary haircut. If they don’t inflate, they remain stuck in a deleveraging trap resulting in weak fundamentals, and large increases in government debt, also rattling creditors. 

The likeliest route from here remains that the Fed will continue to baffle the Krugmanites by pursuing relatively restrained inflationism (i.e. Operation Twist, restrained QE, no NGDP targeting, no debt jubilee, etc) to keep the economy ticking along while minimising creditor irritation. The problem with this is that the economy remains caught in the deleveraging trap. And while the economy is depressed tax revenues remain depressed, meaning that deficits will grow, further irritating creditors (who unlike bond-flipping hedge funds must eat the very low yields instead of passing off treasuries to a greater fool for a profit) who may pursue trade war and currency war strategies and gradually (or suddenly) desert US treasuries and dollars.

Geopolitical tension would spike commodity prices. And as more dollars end up back in the United States (there are currently $5+ trillion floating around Asia), there will be more inflation still. The reduced global demand for dollar-denominated assets would put pressure on the Fed to print to buy more treasuries.

Amusingly, this kind of scenario was predicted in 2003 by Krugman himself!:

The crisis won’t come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.

But at a certain point we’ll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government’s access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

This is not a Zimbabwe-style scenario, but it is a potentially unpleasant one involving a sharp depreciation of the dollar, and a significant change in the shape of the American economy (and geopolitical reality). It includes the risk of costly geopolitical escalation, including proxy war or war.

However, American primary and secondary industries would look significantly more competitive, and significant inflation — while penalising savers — would cut down the debt. Such a crisis would be painful and scary, but — so long as there is no escalation — largely beneficial.

by

The Real Fiscal Cliff

It’s that time of year again — time to kick the can.

No prizes for guessing what investors expect Congress to do:

And 2013 seems likely to give way to can-kicking in 2014, and 2015 and 2016 and 2017 and on — the GAO estimates that by 2080 the US public could hold 8 times as much government debt as the US generates GDP. Just as Japan has never truly dealt with its debt complex — and instead chose the path of cycles of deflation, an endless liquidity trap, a soaring debt-to-GDP ratio, and mandating financial institutions into buying treasuries — so America will continue to kick the can as long as rates and nominal inflation can be kept low, and goods and energy (the real underlying economy) kept flowing. Which — going by the Japanese example — could be a very long time.

Yet America is not Japan. The key difference? The balance of trade, and the flow of goods and services. While Japan’s debt is overwhelmingly domestically held, and while Japan has long been a net-exporter, the USA imports more goods and services than any nation in history:

And more and more US debt and currency is in the hands of the nations that export the goods and services on which America’s economy functions. Here’s the total debt held by foreigners:

And here’s the dollar reserves of various Asian exporter nations:

So when the can is kicked, the Asians — and especially the Chinese — feel they are getting screwed.

As Xinhua noted the last time America faced the fiscal cliff:

The U.S. has long been facing the same problem: living beyond its means. At present, the country has debts as high as 55 trillion U.S. dollars, including more than 14 trillion U.S. dollars of treasury bonds.

And last October:

Economists agree that as the United States’ largest foreign creditor, China should contemplate ways to pull itself out of the “dollar trap,” as the U.S. economy is faltering with its debt piling up and its currency on the brink to depreciate.

China must make fuller use of the non-financial assets in its foreign reserves, as well as speed up the diversification of investing channels to resist a possible long-term weakening of the dollar, said Xia Bing, director of the Finance Research Institutes of the Development Research Center under the State Council.

Zheng Xinli, permanent vice chairman of China Center for International Economic Exchanges, has suggested that Chinese companies boost overseas investment as a way to absorb trade surpluses and fend off the dollar risk.

Now to some degree the Asians knew the bargain they were getting into in buying US treasuries. They were never buying a claim on the US economy, or on the US gold reserves. They were buying a claim on reproducible Federal Reserve notes, and since 1971 the bargain has been that this is a purely fiat currency. Ultimately, if they do not feel like the US will be solvent in the long run, they should not have started lending to it. But now they are the largest real creditor, they have no choice but to keep on buying and keep on stabilising, simply because a functional US economy and a solvent US treasury is about the only way they will see any return at all.

Yet if they don’t exert leverage on the US, then the US seems unlikely to do much at all. Without a little turmoil, legislators have very little incentive to act. If the exporter nations feel as if they are getting screwed, they are only more likely to escalate via the only real means they have — trade war. And having a monopoly on various resources including rare earth minerals (as well as various components and types of finished goods) gives them considerable leverage.

More and more Asian nations — led by China and Russia — have ditched the dollar for bilateral trade (out of fear of dollar instability). Tension rises between the United States and Asia over Syria and Iran. The Asian nations throw more and more abrasive rhetoric around — including war rhetoric.

And on the other hand, both Obama and Romney — as well as Hillary Clinton — seem dead-set on ramping up the tense rhetoric. Romney seems extremely keen to brand China a currency manipulator.

In truth, both sides have a mutual interest in sitting down and engaging in a frank discussion, and then coming out with a serious long-term plan of co-operation on trade and fiscal issues where both sides accept compromises — perhaps Asia could agree to reinvest some of its dollar hoard in the United States to create American jobs and rebuild American infrastructure in exchange for a long-term American deficit-reduction and technology-sharing agreement?

But such co-operation would require real trust and respect — and I just don’t see it. China’s leaders deeply resent the West for the opium war years, and the humiliation that came with the end of the Chinese empire — and they see America as profligate, and culturally degenerate. And America’s leaders see China as an unstable anti-democratic dictatorship, not a prospective partner.

So the future, I think, will more likely involve both sides jumping off the cliff into the uncertain seas of trade war, currency war, default-by-debasement, tariffs, proxy war and regional and global political and economic instability.

by

Putin is Back

Yeah.

Let’s just remind ourselves what we’re dealing with here.

Here’s what Putin observed last August:

America are living beyond their means and shifting a part of the weight of their problems to the world economy. They are living like parasites off the global economy and their monopoly of the dollar. If [in America] there is a systemic malfunction, this will affect everyone. Countries like Russia and China hold a significant part of their reserves in American securities. There should be other reserve currencies.

It should be no surprise to anybody, then, that the last Russian government — as well as their autocratic ASEAN friends in China, Pakistan, Iran and so on — began taking proactive measures to extricate itself from the dollar system.

I expect the new government to accelerate such measures.