Tuesday, 29 January 2013


UK 10-year gilt yield 2008-13 showing QE:

Why is there an evident spike starting autumn 2010 and continuing until early 2011 when there was no QE?

(larger version here).

For comparison, US 10-year Treasury yield:

(larger version here)

Correlation, wouldn't you say? (thanks to @wonkmonk_ for spotting this)

Well, the US was doing QE at that time. Could the UK's spike be due to the US's QE program? That suggests markets were arbitraging away differences between US Treasury and UK gilts yields. In which case one or the other effectively has no control whatsoever of monetary policy. Hmmm.

GBP/USD historical rates 2008-13:

(larger version here)

Steady, really. So this could be arbitrage. But we don't know the direction - are USTs driving gilts or the other way round?

Brent crude 2008-13:

Historical Data Chart

WTI crude 2008-13

(larger versions here and here)

If you remove the downwards trend on both US and UK charts (which we know is caused by monetary policy) there is reasonable correlation with this, too, particularly WTI.

Could the yield spikes have more to do with the oil price than QE? Oil price rises in a fragile economy are bad news.....

Monday, 28 January 2013

Misunderstanding QE

Yesterday I had a long conversation with someone with serious monetarist leanings, who tried hard to convince me that QE raises long bond yields. His argument was that government bond yields have nothing to do with central bank policy rates and can therefore be separately influenced via asset purchases. So Bernanke cuts the federal funds rate to near-zero, causing real interest rates on cash deposits and near-cash instruments to fall below zero, while using QE to induce expectations of higher inflation and thereby force up bond yields:

And to support his argument, he produced this chart:

(click here for larger version)

Now, this does indeed appear to show QE causing bond yields to rise, not fall. And I admit this did make wonder briefly whether what we have all been told about QE - that it works by depressing real interest rates along the yield curve, thus encouraging diversification into riskier assets - was actually correct. But I didn't wonder about this for more about than 5 minutes. You see this chart is not quite what it seems. Seeking Alpha (whose chart it is) has been somewhat selective in their choice of start and finish dates. Here's a more extended version of the same chart:

10 Year Treasury Rate Chart

(click here for larger version)

I haven't fitted a trend line to this, but I think it is obvious. There is a clear downwards trend from 2008 to 2013. The peaks that Seeking Alpha attribute to QE don't change the trend. So QE does not cause permanent increases in bond yields.

It does appear to cause temporary ones, though. My monetarist friend stated that raising inflation expectations was the whole point of QE, and therefore rising bond yields would be a sign that it was working. But this doesn't seem to fit with the evidence. Higher inflation expectations would arise because of the expansion of the monetary base caused by the creation of new money to fund asset purchases. When asset purchases stop, as they did in March 2010 and June 2011, the chart shows that bond yields drop down to the trend line. But QE wasn't unwound, and the purchased assets didn't expire - on the contrary, the Fed has a policy of replacing any purchased assets that mature. So the expansion of the monetary base remained the same after the end of asset purchases. It didn't get any bigger, but it didn't reduce significantly either:

(source: St. Louis Fed - click here for larger version)

Therefore one would expect bond yields to remain elevated after the end of QE. But they didn't. They fell - fast. In fact they fell back to the underlying trend, which was significantly lower and falling. Over the period during which there have been three rounds of QE, 10-year gilt yields have dropped from over 4% in 2008 to 1.88%. Since US core inflation is around 2%, that is actually a negative real rate. The index-linked yield confirms this;

(click here for larger version)

So if the point of QE is to raise inflation expectations and thereby change the path of future nominal interest rates, it has been a spectacular failure.

But that isn't the point of QE. It is an unconventional tool used when interest rates themselves cannot be cut any further because of the zero lower bound, and it is intended to depress (not raise) real interest rates along the yield curve. From Michael Woodford's Jackson Hole paper, 2012:
The declared intention of the programs has been to lower the market yields (and hence to raise the prices) of longer-term bonds (not necessarily limited to the particular types purchased by the Fed), with a view to easing the terms on which credit is available to both households and firms in the US. Their effectiveness in this regard is a matter of considerable debate.
The rising price of Treasuries is supposed to nudge investors towards riskier investments, depressing the yields on those too and therefore cutting corporate borrowing costs.  And falling yields not only on US Treasuries but on other bonds as well suggest that QE could be doing exactly what was intended. But Woodford points out that there might be numerous other reasons for this effect, including one particularly significant one (my emphasis):
But this should not necessarily be attributed solely to the Fed’s purchases of longer-term securities over this period; the period is one in which a continuing series of bad news has progressively increased the likelihood that market participants are likely to attach to the possibility of a protracted period of feeble economic growth and low inflation (or even deflation), and of course the FOMC has progressively extended farther into the future the length of the period for which it anticipates keeping its funds rate target in a band just above zero. Hence it is plausible to suppose that expectations regarding the length of time that short-term interest rates are likely to remain low have generally increased since the fall of 2008 (when it was not yet even obvious that the zero lower bound would be reached).
In other words the principal influence on bond yields is not inflation expectations but the anticipated path of short-term interest rates as indicated by Fed statements and behaviour. Longer-term bond yields are on the floor because the Fed is indicating that short-term interest rates will remain near zero for the foreseeable future. Unbounded QE supports this policy stance and therefore helps to keep bond yields low: to the extent that it raises inflation expectations, the effect is weak and short-lived.

This is rather in contrast to my monetarist friend's view of the same paper. He claimed that Woodford was arguing for increased QE in order to raise the future path of nominal interest rates. This is frankly baffling. Why on earth would the Fed do QE to raise the future path of nominal interest rates at the same time as signalling that those same interest rates would remain on the floor for the foreseeable future? Surely QE is intended to support the monetary policy stance, not contradict it?

But then, as I noted at the start of this post, my monetarist friend doesn't think short-term interest rates and bond yields are related. Unfortunately that is not what Woodford says, and Woodford's evidence is considerable. And the relationship Woodford identifies between short-term interest rates and government bond yields makes logical sense, too. At the shorter end, government bonds and interest-bearing cash deposits are substitutes. At present interest rates on cash deposits are effectively zero, and the Fed is indicating that those rates will remain at or near zero for several years to come. Expectations of interest rates above zero are therefore moving out to the long end, pushing down bond yields along the curve.

Really what Woodford is saying that the main channel through which the central bank influences market rates is signalling ("expectations"), and that policy tools such as QE support this channel rather than being alternatives to it. Communication is everything - which explains the emphasis that Mark Carney placed on it at Davos.

In fact Woodford's paper does not argue for unbounded QE to raise expectations of future interest rates at all. What Woodford DOES argue for is unbounded QE as a policy tool to support a central bank NGDP target. This is because of his concern that inflation targeting actually contradicts the aims of low interest rate policy: it is not credible simultaneously to indicate that interest rates will remain low indefinitely AND commit to an inflation target. Confused signals like this undermine monetary policy and render it ineffective. However, it seems to me that the Fed is being somewhat flexible in the interpretation of its inflation target anyway: it appears to have shifted the emphasis to reaching full employment.

So QE should be used to support the stated monetary policy stance. But even then Woodford is lukewarm about it (my emphasis):
"A more logical policy would rely on a combination of commitment to a clear target criterion to guide future decisions about interest-rate policy with immediate policy actions that should stimulate spending immediately without relying too much on expectational channels. Neither a program of expanding the supply of bank reserves nor a program of expanding the central bank’s holdings of longer-term Treasury securities is a good example of the latter kind of policy..."
And he concludes the paper with a strong call for an increased role for fiscal policy in coordination with central bank monetary policy, and commends the UK's Funding for Lending (FLS) scheme as a step in the right direction:
"The most obvious source of a boost to current aggregate demand that would not depend solely on expectational channels is fiscal stimulus — whether through an increase in government purchases, tax incentives for current expenditure such as an investment tax credit, or subsidies for lending like the FLS...."
For some reason, with all the hoo-hah there was at the time about Woodford's support for NGDP targeting, this "heresy" was completely overlooked. Woodford is hardly a monetary hawk.

Because the UK's financial sector is severely damaged and the direction of regulatory change is unsupportive, I am not convinced that the FLS scheme will be all that effective: I suspect it will further inflate an already overblown housing market rather than improving business finance, which is what is really needed. But Woodford is right that it is the first serious example of coordinated monetary and fiscal policy, and right to indicate - as many others have - that fiscal policy is the key to ending the current stagnation.

Monetary policy has not completely run out of steam yet, and we certainly haven't seen the last of QE. But if you want a bazooka, look to the fiscal side.

UPDATE. Since most of the comments so far have homed in on the temporary yield hikes rather than the long-term trend, I thought I would add my views on those hikes. Temporary hikes that don't affect the long-term trend would normally be regarded as "noise", but in this case they do seem to be aligned with QE on/off. However, they are clearly mispricing, since they don't affect the long-term trend. There is no way they can be regarded as indicating that QE is INTENDED to raise yields. It is an anomalous effect. Whether the cause is carry capture strategies due to raised inflation expectations, as Izabella Kaminska suggests, or Michael Sankowski's idea that traders are bringing forward purchases to benefit from guaranteed sale and high prices, the raised yields can only be a temporary phenomenon and are bound to unwind over time. Neither QE1 nor QE2 was really long enough for the mispricing to unwind.

Sunday, 27 January 2013

The sandwich generation

On Wednesday last week I cancelled all my teaching so I could look after my mother. Following a fall last August when she broke her hip, my mother is now disabled and my father is her full-time carer. But he had a hospital appointment that day, so I stepped in.

This doesn't sound too serious, does it? Except that my father will be 80 in April and has health problems of his own. And the rest of my family are hundreds of miles away. I have no doubt that as he gets older and she gets frailer, there will be more calls on my time. Just as when my children were young I had to organise my work around their needs, so it seems likely that eventually I will have to organise my paid work around the needs of my parents. And perhaps it will become impossible for me to do what I currently do. After all, singing teaching - particularly in schools - isn't something that can be easily combined with caring for frail elderly people.

But I am not free to become a full-time carer for elderly parents. I have a mortgage, and bills to pay. And I have dependent children. My son is 18 and my daughter 15, and both are still at school. I expect that both of them will remain in education for several years to come. And even if they are away from home while they are at college or university, the state of youth employment at the moment is such that they are likely to remain financially dependent on me for at least another 10 years.

I am one of the "sandwich generation". I am caught between the extended dependence of my children and the increasing dependence of my parents.

There are many, many people like me. When I used the phrase "the sandwich generation" recently in a conversation with office staff at one of my schools - staff who like me were middle-aged women with teenage children and elderly parents - every one of them instantly knew what I meant. The "squeezed middle" is not well-off families suffering cuts in their child benefit. No, it is people like us. Women - mainly - who must keep on working to support their children, while at the same time taking on the care of elderly relatives. And in some cases, these women also care for grandchildren so that their children can work.

It is fair to say that not all women of my generation somehow have to keep working while taking on increasing care responsibilities. There are many women whose husbands earn sufficient to enable them to give up work to care for elderly parents and/or grandchildren. But they too are part of the sandwich generation. After all, he must work to support his wife - and therefore, indirectly, the frail relatives she is caring for - and his dependent children. And she can no longer work because of the needs of frail relatives. Neither is "free". There may of course be couples in which the balance is the other way round - she is working and he is caring. I do not mean to be sexist. But in this generation, old stereotypes abound and most caring responsibilities fall on women.

The trend towards later parenthood combined with young people delaying entry to the (paid) workforce means that many middle-aged people will still have adult children living at home as they approach their own retirement. And the days are gone when adult children could be expected to bring in an income to support the household. Many of them are working for nothing, doing unpaid internships or voluntary work to build up their CVs. Many more have stayed in education, doing more and more courses of study and building up qualifications in the hope of improving their prospects of employment. And many more are working for very low wages, doing casual and part-time work, or are unemployed. Youth unemployment would be a national disgrace were it not for the fact that other countries are even worse. In fact youth unemployment is a global problem. Even emerging markets are not immune. The fact is that the world seems unable to create sufficient work to enable young people to achieve financial independence and set up their own households much before the age of 30.  And even when they achieve this, many of these young people are already saddled with high levels of debt from their student years. I wonder sometimes what the future holds for our children, when we make life so very hard for them right from the start.

The exception to this is of course those young people who choose to have children while very young themselves and rely on State support for themselves and their children. One could say that these young people have simply replaced dependence on their parents with dependence on the State. And the sandwich generation still pay for them. After all, the sandwich generation are working and paying taxes, which are used to support these young people. It is all the same, really.

At the opposite end of the scale, elderly people are living much longer. But not necessarily more healthily. Many elderly people now can expect to have years of ill-health and increasing disability before they die. And  the State provides little assistance with personal care. Unless those people have some form of independent means enabling them to pay for professional care, the responsibility for their day-to-day care inevitably falls on those closest to them - their spouses, and when their spouses themselves become too frail, their children.

We hear much rhetoric about the "baby boomers", how asset-rich they are and how their aquisition of wealth has made houses unaffordable for young people. And we hear many stories about young people angry about their lack of financial independence and despairing about the sheer impossibility of buying a house at current prices. To many people it seems "fair" that older people should have to support younger ones. But that burden doesn't fall on the "baby boomers". It falls on the parents of those young people, sandwiched in between the prosperous "baby boomers" and the disgruntled youth, who are paying mortgages and trying to save for their own retirements while supporting both their children and their elderly parents. But no-one talks about them. The "sandwich generation", it seems, is invisible.

Monday, 21 January 2013

The End of Britain?

There is a very scary bulletin from the investors' magazine MoneyWeek doing the rounds. It is entitled "The End of Britain", and forecasts an imminent disastrous financial collapse.

I've checked with the editor of MoneyWeek, and yes it is genuinely their production. The reason why it looks different from the rest of their output is because it was written by their marketing department. And that of course gives the clue as to what this is all about. Whether or not they genuinely believe there will be a disastrous collapse is not the point, though to be fair MoneyWeek is generally fairly pessimistic about the UK and has been forecasting a property market collapse for several years now. No, this is all a marketing ploy. They want to scare you into buying a subscription to their magazine.

I could just say "Don't do it", but actually as this bulletin is seriously scary I think it would be more useful if I took it apart and debunked it. So here goes.

The first thing that the bulletin does is establish credibility by listing all the events that MoneyWeek has correctly forecasted in the last few years. So they claim credit for forecasting the 2008 oil price spike - which actually is a much under-rated phenomenon which is not often discussed. And the reason it is not discussed is because of the financial crisis and the fall of Lehman, which happened the same year. Did MoneyWeek forecast that? No, they did not. They claim that they warned people to "stay away from the big banks". But Lehman wasn't a big bank. Nor was Northern Rock, or Bradford & Bingley, or even HBOS. Nor were the Icelandic banks. Nor were the hundreds and hundreds of US lenders that went bust. MoneyWeek DID NOT forecast the financial crisis.

Then they claim that five years ago they forecast the slide in the pound, and that it has now suffered a "long decline". Let's check this, shall we? Here's the GBP/USD exchange rate chart for the last 10 years:

Click to enlarge even more

click here for larger version

Five years ago is January 2008 - by which time the pound was already falling from its 2007 high. Doesn't take a genius to forecast something that is already happening. Admittedly the pound did then fall off a cliff because of the base rate cut later in 2008, but it then climbed back up a bit and has held at around the same level ever since."Long term decline"? Doesn't look like it to me. And what about that dramatic drop? Oh wait, they didn't forecast the fall of Lehman and the subsequent deep recession, did they - you know, the deepest recession since the 1930s? So obviously they couldn't forecast the exceptional measures taken by the Bank of England to support the economy, including deliberately weakening the pound - of which Mervyn King is still rather proud.

Then they also say that three years ago they told everybody to SELL EUROPE. So that''s January 2010. When exactly did the Eurozone crisis start? The BBC has helpfully provided a timeline here. Here's an extract:


Slovakia joins the euro.
Estonia, Denmark, Latvia and Lithuania join the Exchange Rate Mechanism to bring their currencies and monetary policy into line with the euro in preparation for joining.
In April, the EU orders France, Spain, the Irish Republic and Greece to reduce their budget deficits - the difference between their spending and tax receipts.
In October, amid much anger towards the previous government over corruption and spending, George Papandreou's Socialists win an emphatic snap general election victory in Greece.
In November, concerns about some EU member states' debts start to grow following the Dubai sovereign debt crisis.
In December, Greece admits that its debts have reached 300bn euros -the highest in modern history.
Greece is burdened with debt amounting to 113% of GDP - nearly double the eurozone limit of 60%. Ratings agencies start to downgrade Greek bank and government debt.


In January, an EU report condemns "severe irregularities" in Greek accounting procedures. Greece's budget deficit in 2009 is revised upwards to 12.7%, from 3.7%, and more than four times the maximum allowed by EU rules.

Well, well. It seems that here too MoneyWeek "forecast" something that was already happening. It didn't take much imagination to realise that the Greek crisis was going to affect the countries tied to it by a single currency. And "Europe" is a rather wide defnition, don't you think? Here are the yields on 10 year German bunds over the period 2007-2012 (just to remind you, falling yields=rising prices and vice versa):
I hope MoneyWeek have a disclaimer on their investment advice, because they could have some very angry investors who took their advice to "Sell Europe". Germany is part of Europe.....
Anyway, that's enough of debunking MoneyWeek's claim to be clairvoyant. Now let's look at what exactly they are forecasting this time and whether it is reasonable.
1. The Debt Tsunami
The first claim they make is that Britain is about to be overwhelmed by a "tidal wave" of debt. And they produce some very scary charts indeed to show how the UK's national debt has risen since 1900. Now those charts come from a reputable source and are indeed correct. However, they show the NOMINAL amount of debt - which means they take no account of inflation. It's amazing what happens to your debt figures when you remove the effects of inflation:
Here's the chart from MoneyWeek showing UK nominal debt in £:
Now here's the same chart adjusted for inflation:
Doesn't look quite so scary now, does it? Though there is still a spike in the last few years. But I haven't finished yet. Most people would agree that the general standard of living in the UK is considerably higher now than it was in 1900, or indeed in 1950, or even 1970. That's because our national production has risen - considerably, actually. Which means we are wealthier than we were before. So if we look at our debt in relation to GDP, this happens:
We would have to suffer an absolutely catastrophic drop in GDP for our debt to be anything like the sort of burden on the economy that it was in the 1920s and 30s and after World War II.
Ok, so MoneyWeek's use of debt statistics here is distinctly dodgy. Their next chart is actually correct and reasonable. Britain does indeed have a large private debt burden and has the third highest total debt level in the world. MoneyWeek doesn't mention that nearly half of that comes from the financial sector, in which the UK is the world leader and whose business is intermediating debt to create credit. That does rather distort the figures, really. 
And Money Week then go on to add in future liabilities as if they all have to be paid today. Sigh. No, my children don't need to receive their pensions yet. Nor do I, actually. So there is no reason to show those liabilities as falling due now. That is not to say we don't have a FUTURE problem with unfunded liabilities. But MoneyWeek is forecasting imminent collapse. I really can't see how the UK can collapse in 2013 due to liabilities that don't fall due for another 20, 30, even 50 years. 
Oh, and they compare the UK to Eurozone countries. They aren't comparable. We really aren't going to end up like Greece, for reasons that I explain here.
So that debt tidal wave looks like it could be surfable. On to the next scary subject. 
2. The Overblown Welfare State
And another dodgy chart. In fact the same thing again, but for govt spending instead of debt. Here we go:
UK govt nominal net spending in £
Adjusted for inflation:
And related to the increase in national production (GDP):
Where exactly is this unaffordable growth in the welfare state? Yes, public spending has indeed grown in nominal terms, and much of that can be laid at the door of more generous health and welfare spending. But we have got richer too, and the thing about being richer is that you can afford things that poorer people can't afford. As MoneyWeek's readers should know very well. 
So is their claim that "Britain is broke" really true? Here's what they say:
If the UK had been a business or an individual, we’d have been declared bankrupt by now. We’d have been forced to sell our business premises or our home and would have been housed in a run-down flat long ago.
Er, no we wouldn't. You see, although we have a lot of debt and we spend a lot of money, we EARN a lot too. Our charts versus GDP look pretty good, really. I'd say we were definitely a going concern.

3. The great collapse

They take about 15,000 words to do it, but in a nutshell MoneyWeek forecast that rising interest rates will cause failure of the banking system, collapse of the bond and property markets and hyperinflation.

Firstly, let me say that MoneyWeek are correct to make the point that the UK's borrowing costs are historically low, and debt would be more of a burden if they were higher. No doubt their investors would like rates to be higher, which might be why they are forecasting that they will rise - talking things up often does work. At the moment there are no signs whatsoever of interest rates getting off the floor, so this looks very much like wishful thinking to me.

But then they lose the plot and start comparing the UK to Greece again. Greece had falsified its debt position and deliberately misled investors as to the true state of its public finances. Is it any wonder there was a buyer's strike? And what on earth is the reason for supposing that the UK would suffer the same fate?

And it gets worse. Further down they compare the UK to Argentina. This is frankly silly: a large part of Argentina's problem was its attempt to hold a currency peg to the US dollar at the expense of its economy. The only time the UK ever came close to trashing its economy in the same way was 1988-92 when it was pegging its currency to the Deutschmark at too high a rate, which forced the economy into recession. The UK was eventually forced out of the ERM and now has an absolute horror of pegged or managed exchange rates. Sterling is fully floating and likely to remain so. No way are we going to suffer Argentina's fate.

The property market crash they forecast I think is possible. I don't think the housing market corrected sufficiently in 2007-9 and it still has further to fall to reach a sustainable price level. In the short term this would indeed hurt people who were over-mortgaged and financially overstretched. And it would annoy the people (mostly middle-aged and elderly) who bought their properties when prices were much lower and were expecting to profit from house price appreciation. Tough, frankly. But we have had housing market crashes before and recovered. Why should this be any different?

The bank failure that they forecast simply isn't believable. The run on Northern Rock was caused by the inept handling of what was originally a liquidity crisis by both the Treasury and the Bank of England. There are measures in place now to ensure that banks really can obtain emergency liquidity - the Bank of England now has a proper discount window facility like the Fed, which it did not have in 2007. And banks actually DO have more money: they are being required to have more capital and more liquid assets to protect them from bank runs. But more importantly, it is absolute nonsense to say that the UK won't have enough money to bail out its banks. This isn't the Eurozone. The UK has a central bank and issues its own currency. It can NEVER run out of its own money. As I've said numerous times now, the risk for currency issuers is not insolvency, but inflation. Which brings me to the next scary story.

4. The inflation monster

There are two parts to this: firstly that we would see a return to the inflation of the 1970s, and secondly that the public debt level would so erode confidence in the currency that there would be Weimar-style hyperinflation. These two are not remotely related, which demonstrates how very muddled this paper is. I shall take each in turn.

The background to the economic problems of the 1970s was the breakup of the Bretton Woods managed exchange rate system, the Yom Kippur war leading to the oil price shock of 1973, and a property market collapse leading to the Secondary Banking Crisis of 1973. But underlying it all was inept fiscal and monetary management of the economy. Inflation had in fact been rising steadily since the devaluation of the pound in 1967, and the wrong measures were used to contain it. We are, frankly, MUCH better at managing inflation now. Yes, we have had slightly higher inflation than we would really like in the last few years. But in no way has inflation been allowed to run "out of control", and there is absolutely no reason to assume that that would change. I debunked the 1970s inflation monster myth here.

The idea that the UK's debt level would cause Weimar-style hyperinflation is also rubbish. The roots of Weimar's hyperinflation lay in the First World War and its aftermath, particularly the imposition of war reparations which far exceeded the ability of a war-damaged economy to pay them, as Keynes noted, and which had to be paid in foreign currency (gold). As far as I can see, the UK has not recently lost a world war and there are no claims for punitive reparations that I know of. Nor does the UK have particularly high levels of debt denominated in foreign currencies - unlike Hungary, for example. Most of its debt is in sterling. And as I've already noted, sterling debts can always be serviced - perhaps at the price of slightly higher inflation, but not hyperinflation. Whoever wrote this should have done some basic research into the causes of hyperinflation - here, for example.

And finally we get to what this is really all about:

5. GUBMINT COULD STEAL YOUR MONEY! Subscribe to our magazine to find out how to protect your wealth.....

Oddly enough, this is actually the strongest part of this bulletin. They really did do their homework on the occasions in the past when governments have fleeced their own citizens. And I have to admit that it is certainly not beyond the bounds of possibility that UK savers could indeed suffer savings confiscation in a variety of ways. Indeed they already are, through negative real interest rates. Am I bothered? Probably not. I lose much less sleep over the prospect of savers losing their savings than I do over the prospect of ordinary people losing their jobs and their homes. 

I think it is very sad indeed that a respected investment magazine like MoneyWeek is so desperate for business that it is resorting to despicable scaremongering. This bulletin is poorly researched, badly written and presents completely the wrong image. I'm not about to advise anyone what to do with their money, but I can certainly think of much better things to do with mine than subscribe to this rag. This marketing ploy by MoneyWeek is a very, very bad mistake.

Saturday, 19 January 2013

Central banks, safe assets and that independence question

This is version 2 of this post, since I got it massively wrong the first time round. Thanks to cig for correcting me (see comments). 

Simon Wren-Lewis weighed in on the safe assets discussion last week - his post is here and I strongly recommend a read even though it is definitely wonkish (I had to read it twice). Simon's discussion of collateral effects on interest rates adds a dimension that has so far been missing from the debate and helps to explain why long-term, as well as short-term, debt is needed by the financial system - a point that Pozsar misses. Long-term government debt can be used as collateral in the creation of shorter-term private sector "safe assets", which reduces the need for short-term government debt as collateral.

Simon suggests that government depositing cash from excess government borrowing at the central bank, as I suggested, would not be tenable. He doesn't explain why, so I thought I would have a go.

When you consider the central bank and treasury as a consolidated entity, the cash balances at the central bank and the borrowing net out and are eliminated. Neither the excess borrowing nor the uninvested cash show up on the consolidated balance sheet. So it can't be a consolidated balance sheet risk problem. However, as I've noted before, just because something is eliminated in accounting terms doesn't mean it disappears in reality. Unconsolidated, the government has debt, and the central bank has cash.

The fact that the government's excess cash is lodged safely at the central bank means that default risk is zero. Central banks can create money ex nihilo, so there is absolutely no possibility that the money could not be returned. From the point of view of the government's creditors - or depositors, as I would prefer to call them - this makes the debt completely risk-free, and therefore should mean that the interest rate on that debt is very nearly zero. But from the point of view of the central bank, it has serious implications for the conduct of monetary policy.

Intuitively it seems reasonable to suppose that the Treasury depositing excess cash at the central bank would cause a huge increase in the monetary base. But I've done a bit of research into the makeup of the monetary base, and it seems that central deposits are excluded from the monetary base calculation. In which case, in theory the Treasury could deposit as much cash as it wished and there would be no effect on reserves at all. However.....that's not quite right. I looked up exactly how the US Federal Government conducts an auction and receives payment. The NY Fed produces an extremely helpful document explaining how it works.

When the Fed auctions bills or bonds, payment is nearly always made via commercial banks which have reserve accounts at the Fed. The only exception to this would be an individual who wrote a cheque directly to the Treasury, in which case that cheque would be credited directly to the Treasury's account at the Fed and there would be no impact on reserves. All other payments go through reserve accounts: the reserve accounts are drained by the amount of the debt purchased, and the Treasury's deposit account is credited. Therefore Treasury debt issuance drains reserves. Debt issuance on the scale required to meet the financial system's need for safe assets would drain reserves by a very considerable amount. In effect it would be a huge monetary tightening. It would undo the effects of all the QE the Fed has conducted.

There are a few things the Fed could do to undo the contractionary effect on the monetary reserve of all that debt issuance:

1) Cut interest rates. Er, no - at the moment it can't. Or not very much, anyway. I don't wish to get into the negative rates argument again, but the zero bound is binding in an economy that still uses cash and I am personally unconvinced that negative rates would necessarily be expansionary.

2) Buy up the debt the Treasury has just issued. That would completely defeat the purpose of issuing it, which is to provide safe assets to the financial system.

3) Buy private sector risky assets. This could tie in nicely with Simon's idea that the government could build up a portfolio of risky assets, but I doubt if he meant it to be the central bank that bought them. It would mean the central bank conducting quasi-fiscal operations (taking stakes in public enterprises) and accepting credit risk. And it is questionable whether the central bank has the expertise to manage such a portfolio.

I don't pretend to be an expert on central bank operations, so there may well be other options too. All of these are things that the Fed could do by itself. But they are the tools that it uses to conduct monetary policy, not to sterilize the effect of Treasury actions. It would seem more appropriate for the actions to correct the reserve drain to be taken by the Treasury. As far as I can see there are two options for the Government:

1) Allow the Treasury deposit to be redistributed to commercial bank reserve accounts. This would ensure that debt sales didn't affect the reserve level, which in a world where debt issuance has nothing to do with financing government spending and everything to do with preventing the financial system from seizing up just might be a good thing. There seems little point in simply exchanging one type of safe asset for another, which would be the effect of that reserve drain. I'm not entirely sure how this would be done, but it seems likely that the settlement accounting would have to be reversed, leaving the balance on the Treasury account at zero and the in/out entries as memorandum items. As reserves never leave the banking system, this action would sterilize the impact of the debt issuance without placing the debt itself at risk.

(UPDATE - It seems the Bank of Canada already has such a facility. From its explanatory notes on the composition of the Bank of Canada's balance sheet (my emphasis):

3. Government of Canada deposits. The government keeps deposits at the Bank of
Canada, against which it writes all its cheques. The government also maintains
deposit accounts with direct clearers. The maintenance of these government accounts
with the Bank of Canada and the direct clearers gives the Bank of Canada an additional instrument of monetary control, called government deposit transfers.)

2) Spend the money. Back to Simon's idea of buying up risky assets, I guess. At least this would be done by the Government rather than the central bank, which at least preserves the fiction of central bank independence for a little longer.

From a safe asset perspective, I am unconvinced by Simon's suggestion that the Government should build up stocks of risky private sector assets - although from an economic point of view it has considerable merits. Yes, the fact that the central bank can always monetize debt, and government can always tax, would mitigate the balance sheet risks arising from such a strategy. But they would not be zero. Government would pay higher borrowing costs, I think. And if the risk asset portfolio suffered losses, there would be a risk of knock-on impact to the value of government debt due to resurrected default fears - exactly what we DON'T want for safe assets. As BIS said, the whole point of a safe asset is that there should be no possibility of it becoming unsafe.

Miles Kimball has suggested that government investment might be separated from government itself through the creation of a sovereign wealth fund, which could be managed by private sector investment experts. This would eliminate the "government is rubbish at picking winners" problem that is always raised whenever anyone suggests government should invest in private sector enterprises, and it would hopefully mitigate the real risk of rent-seeking and capture by special interests. But government would still be the ultimate guarantor for such a fund's debt, so it would still rest on the credibility of the government/central bank nexus. Investors may prefer explicit backing for government debt from the central bank via excess cash balances. In which case the best option is option 1 - redistribute the balance on the Treasury account. 

The other issue with all this debt issuance is that the balance sheet of the central bank would become very dependent on the Treasury. The structure would be similar to a parent-subsidiary structure where the parent loads the subsidiary's balance sheet with debt. Would the Treasury expect the central bank to pay interest on this debt - since it would be paying interest itself? If so, that would be a permanent small reserve drain - a tiny, continual monetary tightening. This might not be significant, though when policy is generally expansionary it seems a bit silly. But more importantly, the central bank would no longer be in any way independent, and monetary and fiscal policy would become inseparable.

However, due to QE we are already a very long way down this road: central bank independence is already being challenged, and coordination of monetary and fiscal policy is being recommended by some rather significant players, notably the NY Fed, which is visibly uncomfortable with the USA's political paralysis and the pressure that it is under to deliver more than monetary policy reasonably can by itself in a liquidity trap. The end of central bank independence is being promoted by central banks themselves.

The stability of any economy and the safety of its liabilities depend on the economic management team working effectively to achieve desired outcomes and deal effectively with problems. The independence of the central bank and separation of monetary and fiscal policy worked well in the past, but the crisis of 2008 and subsequent recession fundamentally changed the economic landscape. The conduct of monetary and fiscal policy in Western economies is no longer the same, and therefore the roles of monetary and fiscal authorities must change. As monetary and fiscal policy become ever more blurred, cooperation not separation becomes the name of the game. Central bank independence needs to be consigned to history.

Related links:

Safe assets and government debt - mainly macro
When governments become banks - Coppola Comment
Government debt isn't what you think it is - Coppola Comment
Era of independent central banks is over - Stephen King, HSBC
Helicopter Money - McCulley & Pozsar
Institutional Cash Pools and the Triffin Dilemma of the US banking system - Pozsar (IMF)
Why the US needs its own sovereign wealth fund - Quartz
The Treasury auction process: objectives, structure and recent adaptations - NY Fed (2005)

So what's the catch?

Oh brilliant. I produce a post trying to explain in non-mathematical terms the equivalence of government  debt and interest-bearing money in a fiat money regime. And I immediately get hammered for - variously - writing about the "money tree", playing accounting tricks instead of doing real economics, and inventing a scenario where no-one ever has to pay taxes and governments just print endless amounts of money. How on earth my critics managed to deduce that lot from my post I don't know, but I will at least address the last of these, which is the only serious point. I was awfully tempted to ask my "economics" critic to define "real economics".....

Anyway. let me explain. No, I did not, and do not, suggest that governments can just print money ad infinitum to meet their spending obligations. And no, I did not, and do not, suggest that no-one needs to pay taxes. On the contrary.

Taxes are ESSENTIAL in a fiat currency regime. The value of the currency - and of the associated debt (since interest-bearing government debt is simply a stream of future private sector money claims) - depends on the government's ability to tax its population. If it can't then fiat currency is worthless - and by extension, so is debt. Which is why every recorded example of hyperinflation (when fiat currency becomes worthless) is associated with severely dysfunctional government, social chaos and - often - regime change, usually following a severe POLITICAL shock such as losing a war. A dysfunctional government can't tax its population: a traumatised and angry population can't be taxed. Hyperinflation is primarily a political phenomenon.

Those of you who were hoping that my endorsement of money issuance as a means of meeting government spending commitments meant that I was coming round to the idea of higher spending commitments unsupported by additional production and/or taxation are going to be disappointed, I'm afraid. I haven't converted to your cause. I stand exactly where I did before - increased government spending must support, or be supported by, increased production in the real economy, OR it must be supported by higher taxes - which must be subject to democratic approval. If it is supported neither by increased production nor higher taxes, then it will be unsustainable however it is funded.

The same fiscal discipline needs to be applied whether governments choose to meet their spending commitments by creating money or issuing debt. THERE IS NO DIFFERENCE. Money printing is NOT an opportunity to do things that you couldn't do if you had to borrow the money. The horror we have of money printing arises from those few times in history when governments have met spending commitments by printing money without the necessary fiscal discipline, and the result has been inflation. Someone asked me whether Zimbabwe's behaviour undermined my argument that governments can meet their spending commitments through money issuance without it being inflationary. But my argument was that RESPONSIBLE governments can meet their spending commitments through money issuance, just as RESPONSIBLE governments can meet their spending commitments through debt issuance. Zimbabwe had an irresponsible, inept and malicious government that was hell-bent on trashing the only significant industry - agriculture - to further its political ends. It couldn't raise money through debt issuance, because no-one in their right minds would lend to it, so it printed the money instead. How this undermines my argument is a mystery to me.

So money printing is not a free lunch. There is a catch, which is that it has to be supported by production and taxation. Just like debt.

What is really depressing is that the post wasn't even about money issuance. It was about the role of debt in a fiat money regime, and the importance of government acting as a savings bank for its citizens. Somehow that got lost in all the money printing hysteria.

I hope this is all nicely clear now.

Related post: Government debt isn't what you think it is

Friday, 18 January 2013

Government debt isn't what you think it is

Government debt is not debt in any meaningful sense of the word.

Well, actually that's not quite true. Let me clarify. The debt of genuinely sovereign governments that issue their own currencies, have properly functioning central banks and full control of monetary policy is not debt in any meaningful sense of the word.

This all stems from the nature of our fiat money system. In a fiat money system, governments create money. More accurately, money is created by private banks as agents of the state, backed and supported by the central bank which is part of government. The "independence" of central banks is pure fiction. Central banks may operate independently of political control - if politicians allow them to - but they are part of the government machine just as much as government treasury departments are.

Most central banks - with the notable exception of the Federal Reserves - were originally created to fund governments, but their role has changed over the centuries and we have now reached the interesting position where central banks are not allowed to fund governments directly, though they can and do fund them indirectly via the banking system. But there is no reason under a fiat money system why a sovereign government could not simply instruct its central bank to issue money to meet spending commitments, rather than issuing debt. When governments do this it is known as monetization, or "printing money" - although these days not much printing would be involved. It is NOT the same as QE, which exchanges various forms of government debt for money.

Monetization has historically been associated with hyperinflation, and it is fair to say that the fear of inflation is the principal reason why governments don't simply issue money to meet spending commitments. But leaving aside voluntary (and sometimes legal) constraints on monetization, sovereign governments that issue their own currencies do not need to borrow to meet spending commitments.

So if government could in theory meet its spending commitments entirely through money issuance, why do we need government debt at all? Many people would argue that we don't. But I disagree. You see, debt serves a useful purpose which money does not adequately meet because of its primary function as a medium of exchange.

In the past, when governments did not have control of their own currencies because they were tied to gold, governments had to borrow to fund their spending, because they could not simply issue money. And those countries that today don't have control of their own currencies also have to borrow. So for Eurozone countries - including the mighty Germany - debt is indeed debt. They cannot issue their own currencies, and therefore they have to borrow to meet spending commitments. But for everyone else, debt is not debt, it is savings. The trouble is that we have not yet really understood the nature of our fiat money system. We are still trying to treat it like a gold standard. Thus we insist that governments must borrow to meet spending commitments. And if they borrow what we consider "too much", we start to worry about over-commitment and the debt burden on future generations and the cost of interest service and what on earth the markets will think and will people stop buying our debt and oh my goodness we had better cut back and get this deficit under control. This panic spiral is completely unnecessary and in my view stems from a fundamental misunderstanding of the role of government debt in a fiat money system.

Debt provides a safe store of value for the citizens of the country. It is similar to insured deposits at banks. Like deposits, debt is interest-bearing. And at the moment, debt benefits from a 100% guarantee from government, whereas the insurance on deposits is capped. It is also highly liquid, and therefore the funds are rather more accessible than they are in many time deposit accounts. Debt is also fully transferrable: you can give your son gilts for his 21st birthday, but you can't give him a deposit account. Well, actually, you can if you are a UK resident. You could open a National Savings account in his name, deposit funds in it and give him a National Savings certificate of deposit representing those funds. You would have done EXACTLY the same as buying him gilts to the same value. Effectively, gilts are certificates of deposit. When you buy government securities, you are depositing your money in a 100% government-insured interest-bearing deposit account. Governments really are banks.

But what about the interest on debt? Well, it used to be that government securities were interest-bearing whereas money was not, and this reflected the slightly higher risk of debt. This is because unlike money, debt is time-limited: when it matures it has to be redeemed or refinanced, and there is always the risk that government won't be able to find the money to do that. Or at least that's what people think. They are wrong, of course: sovereign currency-issuing governments can ALWAYS find the money to refinance their debts, because they can issue it. There is effectively zero duration risk on the debt of sovereign currency-issuing governments.

But now that banks pay interest on government-insured deposit accounts, and central banks pay interest on excess reserves, most money is interest-bearing. And interest rates on government debt for highly-regarded currency-issuing sovereigns are at an all-time low. As I've noted before, the liquid nature of government debt means that any real difference between the interest rates on deposits and the yields on debt is arbitraged away. Therefore the interest cost of money and debt are pretty much the same. Governments are free to choose which to issue depending on the saving versus spending needs of the economy.

At present, when the preference is for saving over spending and this has caused a nasty drop in aggregate demand, arguably the preference should be for issuing money rather than debt, since money is the medium of exchange in the real economy and we wish to encourage spending - though of course as money is also an interest-bearing safe asset, adding money may just encourage people to stash it away if their preference is to save. But when the problem is too much spending and government wishes to encourage saving, government may choose to issue more debt and less money, which reduces the money stock in the real economy while maintaining liquidity in the financial system (since interest-bearing money and government debt are near-substitutes). It's a balance. Note that this dynamic balancing of monetary and fiscal instruments requires cooperation of central bank and treasury. It is not possible for them genuinely to be independent of each other for this to work, though if the central bank is responsible for inflation targeting it would probably be sensible for it to be in the driving seat. Perhaps it is time to recognise that the central bank needs to have the right to TELL the Treasury to issue debt!

Note also that I am still not talking about QE. No asset purchases are involved. The money is what Friedman called "helicopter money" - money issued by the central bank and spent directly into the economy. And on the Treasury side, debt should similarly be issued primarily to residents, not to foreigners. This is because of the nature of interest on debt.

Most people who call for government to stop issuing debt  - whether because they want government to meet spending commitments through money issuance, or simply want a severe fiscal contraction to "get the deficit under control" - do so because they believe that the interest payments are a deadweight cost. They are wrong. When government debt is held by residents, interest paid is not a cost. It is a tax credit - and if government wanted to, it could recover that by imposition of offsetting taxes.

So ideally, a sovereign currency-issuing government meets its spending commitments by issuing both money, which is used as the medium of exchange in the real economy, AND sufficient interest-bearing debt of various tenors to enable its citizens to save safely in something other than the medium of exchange. It pays interest on that debt from tax receipts, and it taxes away any interest tax credits that it doesn't want certain people (say high earners) to receive. So far, so good. It's a lovely closed system, and provided government is responsible it should not be inflationary. Where it all goes wrong is when foreigners get involved. Because that's when safe government debt becomes risky, and maintaining it, a cost.

Foreign holders of government debt have no direct stay in the way governments manage their economies. They have no vote. So for them the fact that they have no control means risk. The citizens of the country could elect a government that repudiates overseas holdings of its debt or manages the economy so ineptly that the value of the debt is eroded. Therefore foreign debt holders use indirect means of influencing the way governments manage their economies. They demand fiscal austerity measures to hold down government spending for fear of default, and rejection of monetization for fear of inflation. And they threaten to sell their holdings if governments don't comply. For governments who do not issue their currencies, this is a real problem - as we are seeing in the Eurozone. If they can't raise enough from tax income to meet their spending commitments, a buyer's strike can cause them to go bust. But this can't happen to a sovereign currency-issuing government, because it can always print money to pay its debts or buy them back. The threat is empty - but we all still listen to it. How often to we hear people saying that the UK must get its debt under control or it will end up like Greece? No it won't . The UK has a central bank and its own currency. Greece doesn't. That is why Greece really can go bust and the UK can't. That's not to say that the UK can't have serious economic problems, and I am certainly not advocating fiscal profligacy. But for currency issuers the risk is inflation, not insolvency.

In addition to dilution of fiscal and monetary control, foreign holdings of debt cause another problem. Interest paid to foreign debt-holders is a real cost - it leaves the domestic economy. Yes, it comes back eventually in the form of export purchases, but that can take years. In the meantime, it is not available for productive investment in the issuing country. And because it is paid from tax receipts, it is a fiscal transfer from domestic taxpayers to foreign residents. The more government debt is held by foreigners, the less real control it has of fiscal and monetary policy and the greater the real cost to taxpayers.

So why do currency-issuing governments issue debt to foreigners at all? The simple answer is: trade. Overseas residents need foreign currency in order to purchase exports, but just like domestic residents, they prefer to hold their foreign currency savings as something other than the medium of exchange - and indeed if they don't there can be problems with liquidity in international trade finance. So there does need to be some "leakage" of government debt to overseas residents. Problems arise when the holdings of government debt by overseas residents overwhelm the ability of the national economy to support them, and the interests of overseas residents trump those of national citizens. To my mind this is a dangerous imbalance which can lead to all manner of dysfunctional economic policies and eventually to nationalism, balkanisation and political unrest. We do not know what level of overseas holdings of government debt creates this imbalance, but it is notable that Japan, which has the highest debt/GDP level in the world yet is widely regarded as a "safe haven" for investment, has very low foreign holdings of its debt. The vast majority is owned by its own citizens.

This brings me neatly back to that safe asset proposal that I've been talking about recently. Since the failure of private sector "safe" assets in 2008 and the subsequent failure of Eurozone "safe" sovereign debt, the financial system has relied on the debt of sovereign currency-issuing governments for collateral and safe investments. But there is a serious shortage of safe government debt. I've argued already that it is unreasonable to expect one or two countries to provide sufficient safe assets for the entire global financial system. The unequal burden of producing sufficient safe assets for the entire system would eventually overwhelm them. But why should governments provide safe assets for this system at all?

Keeping the global financial system going is essential for the smooth operation of international trade. There is much the global financial system does that is self-serving and, to quote Adair Turner, "socially useless". But not everything is, and to the extent that safe collateral and liquidity are needed to support trade finance and capital flows, it would be reasonable for governments to provide these as a last resort. I don't think it should be a first resort, though. The quest for absolute safety is doomed to fail and is a distraction from the real purpose of investment, which is to finance the productive development of the real economy. The financial sector should try a lot harder to produce assets that, while not completely safe, are acceptable as collateral with a reasonable haircut. And governments and regulators should rethink regulatory rules that increase demands for sovereign debt by global banks and investors. But above all, investors need to come out of their bunkers and start accepting risk. Until they do, the world will be stuck in a deflationary slump.

Related links:

Liquidity trap heralds fundamental change - Coppola Comment
When governments become banks - Coppola Comment
Safe assets and Triffin's dilemma - Coppola Comment
The illusion of safety - Coppola Comment
All Your Dorks Are Belong To This - Pragmatic Capitalism
In fact for the wonkish among you I recommend a read of the entire "dork debate" posts. Waldman's post contains links to most of them:
A confederacy of dorks - Interfluidity

I'm also adding a link to a subsequent post in which I address concerns that I did not discuss taxation in this post and so (according to some) gave the impression that governments can simply issue unlimited money  without consequences. They can't. And as debt is simply a future money claim, that means they can't issue unlimited debt either.

So what is the catch?  - Coppola Comment

I haven't finished with this subject by any means. There will be further posts on external borrowing constraints and the role of currency, the equivalence of monetary and fiscal policy, and supranational safe assets. That's all I've thought of so far but there will no doubt be others.

Wednesday, 16 January 2013

Safe assets and Triffin's dilemma

"Providing reserves and exchanges for the whole world is too much for one country and one currency to bear."

Henry H. Fowler

U.S. Secretary of the Treasury

There has been quite a bit of puzzlement in some quarters as to why I savaged BIS over the whole idea of a limitless supply of government-produced safe assets purely to meet the needs of the financial system. Firstly, let me make it clear that I do not believe that any asset is ever really "safe". Nor do I believe that global investors have any right whatsoever to expect national governments to provide them with what amounts to unconditional backing for their deposits. The first duty of national governments is to their people, not to the needs of a global financial elite. And it is quite wrong of global financial elites to pressure governments into issuing debt that they do not need purely in order to provide them with liquidity. Nor should global financial elites impose austerity measures that are not warranted by the economic situation, purely to reassure themselves that the assets they rely on for liquidity cannot ever become unsafe.

So that is my political stance, if you like. But this post is concerned with the particular effect on the US of producing global safe assets in much the same way as it has hitherto produced the world's reserve currency.

Firstly, a reminder of the global safe assets scheme. The BIS paper envisaged that certain governments - notably the US - would provide enough debt assets to meet the needs of the financial system, making up the current (considerable) shortfall. This debt issuance would be considerably more than actually required to meet government spending obligations, and it would mostly be of short tenor (Pozsar). This would leave the US government with surplus funds. However, because investors would expect the effect of actually spending that money to fuel inflation, which would reduce the value of the debt, the BIS authors effectively recommended that the government should not actually spend the funds raised from debt issuance. On the contrary, to ensure that the government could meet its interest and refinancing obligations at all times, the BIS authors expected the government to run primary surpluses - in other words keep public spending commitments below tax income. In addition to the surplus funds from debt issuance, therefore, there would also be surplus funds from the excess of tax income over public spending. These funds would presumably be placed on deposit at the central bank.

I pointed out in the post that from a national macroeconomic position this makes no sense whatsoever, and would lead to progressive indebtedness and impoverishment of the supplying country's private sector. This is where people lost the thread, and I assume that was because I did not explain the economic effects of such excessive debt issuance in an austere fiscal environment. So let me explain here using the sectoral balances equation that I looked at in my last post.

The basic sectoral balance equation is this:

Private sector (savings - investment) = Government (spending - tax income) + External (net exports - imports)

In algebra:              (S - I) = (G - T) + (X - M)

The first thing to note is that if government debt is bought by foreign investors, those investors must have currency with which to buy it. So the government must also issue more currency than the country itself needs, and the excess must find its way to overseas residents. This would have to be done by running a substantial trade deficit. Therefore in the equation, (X - M) must be significantly negative.

The excess US dollars that find their way into the pockets of overseas exporters are exchanged for US government Treasuries through financial sector intermediation, and are repatriated to the US. This creates a surplus in the capital account equal (more-or-less) to the trade deficit. At this point we simply have potentially inflationary expansion of the US government's balance sheet. But our investors don't like inflation, and the US government doesn't want investors to lose confidence in US Treasuries. So the BIS authors assume that the US government holds down government spending and keeps taxes high in order to generate a primary surplus (T > G). Therefore (G - T) is also negative. To keep it simple I will allow the uninvested proceeds from debt issuance simply to disappear from the equation (because this equation assumes that G includes all money received from debt issuance, which in this scenario is not true).

We now have two negative terms on the right-hand side of the equation. Therefore (S - I) must also be negative. To show the effect of this on the US private sector, I'm now going to use the enhanced version of this equation developed by Monetary Realism. The enhanced version of this equation looks like this:

S = I + (S - I) = I + (G - T) + (X - M)

where I is private sector direct investment and (S - I) = dNFA, the change in private sector holdings of net financial assets. Note that according to the first equation, those net financial assets are government liabilities (debt and cash) and foreign liabilities (debt and cash). Now we already know that the three terms (S - I), (G - T) and (X - M) are negative. So the combined effect of the large trade deficit and the primary surplus is that the private sector's holdings of net financial assets have fallen. In other words, household and corporate financial savings have been raided.

That's bad enough. But look also at the effect on I, which is direct investment by the private sector in the domestic economy. I is reduced by the combined total of the primary surplus and the trade deficit. So not only have domestic savings been raided, domestic direct investment has also been clobbered. Money has been drained from the domestic private sector. It has been divided between a ridiculous government surplus and cash backing for future claims of nervous global investors.

Of course, the private sector can maintain investment if it cuts consumption spending, since savings are the excess of disposable income (after taxes) over consumption spending. This would force imports to reduce, but since our investors would like that (because most of them assume that a large trade deficit is a Bad Thing even though it's necessary in order for them to have currency to buy their safe assets) it would also be likely to increase the value of both the currency and the debt.  But notice how contractionary all this is. What it amounts to is permanent austerity for the domestic population. Progressive impoverishment, simply to preserve the perceived safety - and therefore the value - of government debt (and by extension the currency). Either starve the domestic economy of investment, or starve its people. Or both.

It could be argued that the over-production of both debt and currency to meet global needs is pretty much what the US is doing already. But there are two very important differences. The US not only runs a large trade deficit, it also runs a fiscal deficit: the currency repatriated through the sale of government debt to overseas residents is used to meet government spending commitments in excess of tax income. So although (X - M) is negative, this is offset by the fiscal deficit (G > T). Yes, I and/or C aren't as large as they would be if the US was running a trade surplus. But they aren't disastrous - as they would be if the US tried to run a primary surplus while maintaining debt issuance.

Over-production of government financial assets by dominant world nation (s) to meet the needs of the financial system is nothing new. It has been going on for centuries. Yes, in the past it has mainly been currency that was in demand: the financial system's need for government debt as a safe asset is a new phenomenon and arises from the fundamental change in the nature of money that I've discussed previously. But the problem is an old one. It is known as Triffin's dilemma, and it was the proximate cause of the failure of Bretton Woods.

As the IMF explains, the US had been running balance of payments deficits throughout the 1950s, which flooded the world with dollars. The world became dependent on a plentiful supply of dollars for liquidity and reserves. But the buildup of reserves exchangeable for gold by central banks threatened to drain the US's gold reserves. The economist Robert Triffin outlined the problem as follows:

  • If the US stopped running trade deficits, the world would suffer a crippling shortage of liquidity which could push it into a deflationary spiral, leading to instability
  • If the US continued to run trade deficits, confidence in the dollar would decline, leading to its rejection as the world reserve currency and breakup of the Bretton Woods system, leading to instability.
In other words, the US had to run a trade deficit in order to maintain dollar liquidity, but it had to run a trade surplus in order to maintain dollar confidence. Clearly it couldn't do both. What actually happened was the second of these. Bretton Woods collapsed in 1971 when Nixon suspended the convertibility of the dollar to gold, preferring that to the loss of the US's entire gold reserves. The dollar has not been rejected as world reserve currency, mainly I suspect because there really isn't an alternative. But eventually there will be, and then the US dollar will fall from its pedestal and the US will be left with the burden of an extraordinarily large trade deficit. I do not look forward to that day with any pleasure.

Proposals for over-production of US government debt suffer from the same problem with knobs on: the US must run both trade AND FISCAL deficits in order to maintain excess debt production without impoverishing its population, but it must run at least a fiscal surplus and ideally a trade surplus as well in order to maintain confidence in the debt. This is not a sustainable solution to the global safe assets problem.

There can be no solution to Triffin's dilemma that relies on nation states. The only possible solution would be a supra-national body providing both reserve currency and safe assets to the world financial system. The present proposals for safe assets production do not go far enough.

Related links:

Coppola Comment       When governments become banks
                                    The illusion of safety
                                    Modern gods and human sacrifice
                                    Consumption booms and austerity
                                    Liquidity trap heralds fundamental change
BIS working paper       Global safe assets
IMF working paper      Institutional cash pools and the Triffin Dilemma
Investopedia                 How the Triffin Dilemma affects currencies
IMF                             System in Crisis: The Dollar Glut