Credibility comes with understanding

I received a document today from one of the largest international investment banks in the world. One of its major offices is not far from where I am typing this right now in New York City. The document is a subscribers-only publication and so I cannot make it accessible here. But this blog discusses some of the contents of the document which might help readers who keep worrying about whether anyone important out there believes in the stuff that I write about. There is a constant undercurrent in the comments and private E-mails I receive that says that the treasurer, the central bank, the mainstream journalists and a host of other seemingly important people do not share my views on how the fiat monetary system operates. The issue then is one of credibility.

At the outset, in deciding what is credible you have to recognise that: (a) I am not a politician or appointed by a politician (central banker) so I have no reason to dissemble; (b) I am not paid by anyone who has a reason to promote any particular ideology – I am an independent academic operating in the true traditions of professorial enquiry; (c) I have spent my career researching and understanding these matters and have the highest academic qualifications in my discipline – noting that the treasurer and his predecessor have no formal qualifications in economics; and (d) I hang out with large financial market players who have made fortunes trading on their understandings of how these systems function.

But apart from providing the personal CV, perhaps the following discussion will help readers see things in better perpective – that is, it is not billy blog against the World!

While not disclosing the source of the document, here are some selective quotes with some of my own commentary.

First, the document notes that there is likely to be a huge demand for government debt instruments (bonds) coming from domestic sources due to the “necessary” increase in savings. Here is what is said:

The combined operations of Central banks and governments can control the term structure of rates, unconstrained by targets and ratios. Domestic investors in bonds are likely to replace the significant non-resident owners, as private sector savings necessarily increase. In this regard, the recent wave of deficit hysteria appears to miss the point that currency issuing governments are not financially constrained in the same way as households.

All you modern monetary theorists will then be able to tell everyone where the growth in private sector saving is coming from! Correct, the budget deficits. When the government sector goes into deficit the non-government sector necessarily goes into surplus as a matter of national accounting. This is not theory but fact. The accounting record of non-government saving is the accounting record $-for-$ of government deficits. Government deficits finance non-government saving.

The deficits add reserves to the private banking system just as budget surpluses destroy reserves. The private sector then can hold this wealth in various different financial assets. Overnight bank reserves typically earn nothing or below the rates available in the interbank market. So there is an incentive for banks to find other interest-bearing assets which will allow them to earn higher returns. Come in spinner! They find government bonds very attractive in this situation especially if there is uncertainty about the movements in other classes of financial assets (private bonds, bills – debt).

So as the private saving rises in line with the rising deficits, there is a growing “pool” of funds available to purchase government bonds. This should also reinforce the point that – the funds to purchase the debt comes from the deficit spending! Deficits finance private saving which in turn provides the funds to buy the debt instruments.

Of-course, they can decide to spend (liquidate) the reserves which will further stimulate economic growth and reduce unemployment and lead, via the automatic stabilisers, to lower deficits. All good unless you prefer less private spending and higher public net spending. In that case, we return to the discussion of yesterday’s blog – The budget deficits will increase taxation! – and the government would then increase taxes to ensure the private sector had less purchasing power.

Second, the document notes that banks now have a strong incentive to use their growing reserves to purchase government debt. The growth in reserves comes from the deficit spending. Net government spending provides the funds that are used to buy the debt.

The global regulatory response to the financial crisis will require a significant increase in liquidity buffers. Although this is a burden on both the earnings potential for banks and the outlook for economic growth in general, it is likely to be a strong positive for government bond markets. The potential for bank purchases of bonds is enormous given the requirement from regulators that liquidity buffers return to higher, more conservative levels.

This should help dispel any fears that you have about crowding out and the private markets “punishing” the government for their high debt levels. The deficits add the reserves which are then available to buy the debt. So there is not a scenario operating where there is a finite pool of cash out there which the government then depletes by offering debt and thus squeezes the funds available for private investement. The system simply does not work that way. Any private investor who is credit worthy can access loans. Loans create deposits and the requisite reserves to back the loans are added later (by borrowing etc).

Further, there is now an increased incentive to hold risk-free government debt to satisfy the regulator’s demands for increased “liquidity buffers”. All good.

Third, the document addresses the question of rising yields which is another part of the crowding-out scaremongering. The paper notes that solvency is never a question for a country which issues bonds in its own currency. Repeat: solvency is never a risk. Governments may voluntarily default on their debt for political reasons which would escape my understanding of rational behaviour. But there is no financial risk involved.

Markets have become gripped by deficit hysteria, the concept that there will not be enough buyers for the increased bond supply. The probability of Sovereign downgrade has apparently increased, according to the CDS market and the actions of the ratings agencies but …. [IDENTITY OF ORGANISATION SUPPRESSED] … believes this risk is overstated, especially for those countries which issue bonds in their own freely floating currencies … there is no empirical evidence to suggest that yields will have to go higher in a more macro-sense because of higher bond supply. Indeed, … long-dated yields are set to remain low for the foreseeable future and that the extremely low levels experienced at the beginning of 2009 could be revisited. Japan provides empirical evidence for the precedent of lower yields, and a higher deficit.

… The fear that yields will have to be higher because increased bond supply should be ‘priced to go’ is not consistent with the historical parallels that can be drawn with Japan.

Whenever a neo-liberal starts banging on about deficits and debt ask them to explain Japan. The smarter ones (and we are starting from very low IQ levels!) will point out that Japan was special because it had huge domestic capacity (high private saving ratio) to keep funding the yen-denominated debt. Therefore, this doesn’t apply to other countries such as Australia and the US.

Well, in a pure technical sense, it would not matter if the bond auction failed overall. I would not be concerned if no-one wanted to buy the debt. The net spending will still occur (it is not dependent on any revenue) and the reserve adds will necessarily follow and private saving will be funded. What the non-government sector wants to do with the net financial assets that are created by the deficits is its own business.

But moreover, the current dynamics are moving to increase the pool of domestic bond purchasers because the recession is reducing imports (reducing the supply of foreign savings) as the deficits expand domestic saving. The document also notes this point:

High domestic ownership of JGBs is often cited as an argument against the comparison but this fails to recognise how government bond markets are likely to become dominated by increased local demand. From a longer-term macro-economic perspective the narrowing of current account deficits, for example, will naturally result in a recycling of non-resident bond ownership into the domestic investor bases.

Fourth, the document then moves onto to discuss bond yields in more detail. The point is clear – the government (consolidated central bank and treasury) control short-term interest rates which in turn significantly influence the longer yields (long maturities). Further, the government doesn’t even have to tap into the long-term investment market at all. They have the power to “keep yields low for as long” as is necessary. Just like Japan did.

Debt monetisation is not something markets should worry about. Central banks are mostly independent and have established considerable credibility over longer term inflation expectations, so that at no time in the recent crisis have market-based inflation expectations become unhinged. Better articulation of the ‘exit strategy’ for QE (quantitative easing) will help but so will greater appreciation of how much influence Central Banks and government have over the entire term structure. Short-dated yields are driven by expectations for future levels of administrative rates, set by Central banks, (eg Fed funds and Base rates) but so too are long rates controlled by the combined actions of government and Central bank. The governments don’t have to issue long maturity bonds and working together with the Central bank can keep yields low for as long as necessary.

Fifth, to reinforce the reality that the central bank and the treasury are in fact one unit which I call the “consolidated government sector” the document says:

The fact Central banks and government work handin-hand appears to be under-estimated. Maybe this is because market participants take the ‘independent’ status of Central banks too literally or the result of applying the economics of previous cycles to the modern economy … This is because both Sovereigns issue in their own freely floating currencies and so are not subject to the same constraints as the Eurozone countries. The impact on the direction of yields is likely to be the same, however, with yield curves tending to flatten in a bullish fashion, reflecting the reality that rates are not going up anywhere, anytime soon, because the combined actions and interests of governments and Central banks will make sure they don’t.

Once again, we reject the notion that the amorphous financial moguls will drive rates to oblivion.

I intend considering some of the issues in more detail in tomorrow’s blog – especially to provide some more insights into why Japan is the model that blows neo-liberalism out of the water – but for now I provide one further quote from the document I received today.

It relates to a point that is crucial – what sort of monetary system are we operating in! Readers of this blog will realise that I talk about this a lot. Surely, but you can never understate the importance of understanding this as a precursor to understanding how the system works and what options are available to the sovereign government in a modern monetary system.

The document says:

Governments and Central banks have considerable authority over the shape of the term structure for rates. This is nothing new but worthy of further reflection at a time when deficit hysteria and fears of debt monetisation have been dominating the headlines. These fears emanate from historical experience under a different regime, when the Gold Standard existed. The freedom enjoyed by governments and Central banks which operate in fiat currency systems means that solvency risk is insignificant, they will always be able to pay coupons and redeem their bonds. Fiat currency is money that is decreed by government to be legal tender, nonconvertible and freely floating (eg USD, GBP, AUD). Non-fiat issuing entities are households, businesses and governments that fix the exchange rate of their currency to another one; for governments think of Argentina and the Eurozone.

So when a Sovereign issues its own currency, in a floating exchange rate regime (fiat currency), it is not the same as if it was issuing in a convertible currency in a fixed exchange rate regime, as in the period prior to 1971, when the Gold Standard existed. For further enlightenment on this there is the work of Professor Bill Mitchell, who has recently done much to present the case for the modern monetary economy, one where governments are not subject to spending constraints in the same way as households. A better understanding of how the system works will help to counter fears over growing deficits and monetisation.

How about that? This is a document released by one of the largest international suppliers of investment banking and financial services in the world. The writer clearly understands the way the monetary system works and is providing that advice to the clients of this organisation. Sound advice indeed.

So rest easily billy blog readers and spread the news to family and friends. The public deficits are financing their saving and giving them options to purchase all sort of financial assets including government bonds which are 100 per cent safe! The only risk-free asset there is. The issue of debt is also helping their superannuation funds stabliise the losses in recent months.

Today (Sunday) is very wet in New York. I am travelling upstate this afternoon to a major United Nations Development Program event which will occupy me until Tuesday. I am giving a workshop tomorrow discussing my work on employment guarantees in developing countries (I will talk more about this in blogs as I can – currently under contract). On Tuesday I am on a panel which will discuss the macroeconomic considerations surrounding fiscal options available to developing countries. All the usual sorts of things I talk about here. I am sure to have a blog about all of this in the coming days.

Tomorrow, Japan or fiscal rules. Something like that.

Political hypocrasy of the highest order

The Australian Government is apparently been considering offering a job to the former treasurer:

  • He who helped engineer the largest redistribution of income in our history from workers to profits;
  • He who ran destructive budget surpluses which squeezed the household sector so badly that their household saving went negative;
  • He who oversaw the stockpiling of record levels of household debt which now is backed by considerably lower wealth thanks to the increasingly volatile nature of the assets that were purchased with the debt;
  • He who drove the introduction of Work Choices;
  • He who failed was categorically rejected as the future Prime Minister by the electorate;
  • etc to ad nauseum

So then we read that the Deputy Prime Minister told ABC TV Sunday morning – Insiders program – that the former (failed) politican should be appropriately recognised. This was the interchange (edited for brevity):

BARRIE CASSIDY: … Have you managed to identify a government job for Peter Costello?

JULIA GILLARD: … The Prime Minister in Parliament made some generous remarks about Peter Costello’s contribution to the nation. I too, and Barrie I think you’ve been there when I’ve made some of these remarks, have recognised the contribution of the former treasurer to the nation and the value of the time he spent in politics.

He’s devoted many years of his life to public service and that deserves a round of appreciation and applause. I’ll be making that clear to him personally in Israel and I’m sure in Israel he’s going to be amongst friends who will want to celebrate with him a political track record of achievement that he should be reflecting on for the rest of his life as something that he did that was very good.

BARRIE CASSIDY: Now that’s very generous, but politics has turned nasty in Australia. Do you think the Labor Party rank and file would join you with that sort of sentiment?

JULIA GILLARD: I think the Labor Party rank and file, I think the Liberal Party rank and file get an opportunity to see up close the way politicians work and the kind of life it is. I make no complaints about the life Barrie, I chose it, but it does put stress and strains on individuals. It puts stress and strains on families.

And I think for someone like Peter Costello even a Labor Party supporter who went out year after year to campaign against Mr Costello and his policies would recognise that he’s a man who’s contributed many years of his life to public service. That would have come at some cost to his family life, to his personal life. There would have been many nights when he was in Canberra that he would have preferred to have been in his home in Melbourne with his wife and children.

Excuse me while I go outside for a little while and get some fresh air!

Ahh, and that means New York City – off for a 10 km run around Central Park.

This Post Has 3 Comments

  1. Dear Bill,
    At least there’s some schadenfreude to be had from Costello’s poor timing of his announcement to leave politics and Turnball’s current catastrophe.

    I don’t want to exacerbate your breathing difficulties, but I want to report something I read in the Australian on the weekend (I’ve finally banned that newspaper from the house). A guy from the Centre for Independent Studies claimed that governments could not create new economic activity, and could only redistribute products of the private sector. This strikes me as not only patently false but absurd. But then that seems to be the norm these days.

  2. Bill

    Much of the hysteria seems to be about inflation expectations, what would your inflation expectations be ? are you more still more concerned about deflation, rather than worrying about exiting from a ZIRP policy.

    am i right in thinking these automatic stabilisers are in evidence. So weak or contracting economic growth equals low interest rate policy to stimulate demand. Improved economic health further down the road equals raising of interest rates. In either case what happens to real interest rates, what are they influenced by…and is there not a big spread there ?

    a lot seems to be predicated on returning to levels of world growth we’ve seen previously, several years of anaemic performance or a japan scenario and does that mean the current policy response needs to continue as a stabiliser ? I wonder what world growth is going to look like over the next few years especially if we continue to see a changing trend in the import/export balance of the major economies. Much of the govt. intervention/stabilisers seemed to be talked of as temporary/exceptional measures…..i wonder if that role will not be as temporary as many of the bulls imagine. Again, is japan any kind of indicator ?

    Also, i’m inferring that the writers of the report you’ve quoted don’t appear to be too keen on the eurozone. What’s your take ?

  3. dear Tricky

    Good comment. I haven’t got any inflation risk built into my forecasts at the moment. Price pressures may come from the energy sector but this has nothing much to do with deficits – oil prices are cartel driven and reflect their market power. When economic times are strong they use that power to push energy prices up.

    It might be that interest rates will rise as growth resumes. But that has nothing to do with the deficits choking finite savings (via debt issuance). It will merely reflect the discretionary decision by the central bank to hike rates to control spending. Bad policy but the rates are controlled completely by the central bank.

    In terms of world growth forecasts, the latest from the World Bank are grim. It will take a long time to sort the mess out. But it seems that the massive fiscal interventions are putting a floor into the spending systems and prevent a major collapse.

    In terms of the Eurozone – well any sensible analyst who understood the voluntary nature of the constraints they are operating in would just reject it outright. Hopefully, the Germans will kill it with their neo-liberal stupidity.

    best wishes

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