Currency Revulsion

I have said it a few times but it bears repeating: If you march down to the government with your paper IOU with $100 printed on it to demand your money, the government will simply hand you another paper IOU with the exact same amount printed on it. As the British ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].” All US government obligations are substantially identical promises to repay a specific amount of the currency unit of account backed by nothing but taxing authority.

So, Treasury bonds don’t ‘fund’ anything. If the Treasury were allowed to run overdrafts at the central bank, the US government could stop issuing bonds altogether and credit bank accounts with keystrokes. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.

But what about currency revulsion, you ask? What if government deficit spends out of control?

Well, that’s the confidence trick of fiat currency. If confidence in the currency erodes, tax evasion will rise, citizens will begin surreptitiously using other media of exchange to transact and inflation and currency depreciation will spiral out of control. Notice, however, I mention currency depreciation and inflation instead of national solvency.

Clearly the US government cannot involuntarily default on a currency obligation it can manufacture in infinite quantities. The same is true in Japan or Australia. Ask yourself why Italy and why not Japan when thinking about highly indebted nations under attack in the sovereign debt crisis. Japan is sovereign in its currency. Bond market participants know this. That is also why US yields are under 3% and Spanish yields are not. That is why Ireland could default but the UK will not.

Obviously, I am not talking about willingness to pay, “the Ecuador question” which plagues the US, but rather ability to pay.

Here’s how I think about it:

  1. Monetarily sovereign government obligations are promises to repay a specific amount of the currency unit of account (say British pounds) backed by nothing but taxing authority meaning (the British) government can manufacture these IOUs in infinite quantities.
  2. The concern is that government will spend out of control. Therefore, we create ways to limit its manufacture of IOUs. For example, the US government has no overdraft facility at the Federal Reserve and must issue bonds to match deficit spending ‘money printing’ .
  3. If the ‘independent’ CB does not stand at the ready to allow the government to manufacture these IOUs without ‘funding’, the sovereign is subject to default risk.
  4. Without default risk, the yield curve is based on expected future policy rates plus a risk premium. Long-term interest rates are a series of future short-term rates. For example, we know from the expiration of QE2 in the US that the central bank’s supply and demand of Treasuries were not central to yields because yields went lower instead of higher after the central bank stopped QE2 and reduced its demand. Another example: if bond market actors believe that nominal interest rates will be very low for an ‘extended period’ because the Fed tells them so, rates will respond accordingly.
  5. Currency revulsion that results from financial repression for a monetarily sovereign government expresses itself as currency depreciation first, and not via interest rates until inflation from money printing and currency depreciation force policy rates higher.
  6. With default risk, the yield curve also reflects an anticipated loss of principle and/or interest.

In the euro zone, the governments are not monetarily sovereign (like states in the US) and have only an implicit backstop from the ECB (akin to Fannie and Freddie). So, rightfully people are tacking a default premium onto the term structure. Germany has almost zero default risk. France has slightly more. Spain and Italy have even more. Greece has nearly 100% default risk. That means there is enough doubt about whether the ‘independent’ ECB stands at the ready to backstop the French sovereign to cause French spreads to German Bunds to increase.

Notice that the macro debt fundamentals of France are worse than Spain’s (higher debt to GDP and deficits since the euro began and higher present debt to GDP and same large budget deficit). Yet spreads are much lower. That tells me that France has a perceived backstop that Spain does not. If the ECB credibly committed to ‘monetising’ deficits as the Fed has done, yields would immediately fall to reflect the diminished default risk. The ECB has not done so because this backstop would create currency revulsion and weaken the euro.

For the euro nations, default is a risk that must be reflected in yields as it is for any currency user, implicit or partial ECB backstop or not. For monetarily sovereign nations, with their negative real yields aka financial repression, it is the currency where revulsion shows itself, not yields. But if deflation takes hold the currency appreciates as real yields climb. That has trapped Japan in a deflationary episode. If you want to avoid that trap, you will be forced to manufacture CPI inflation; and that means you need currency depreciation before deflation takes hold. QE has not done the trick. With the sovereign debt crisis on, the US dollar acts as a relative safe haven. This is the dilemma for the Fed, now boxed in politically during the onset of another downturn


  1. David Lazarus says

    This ignores the fact that US assets were overvalued. Having them revert to a more sustainable value is hardly deflationary. Japans stock and property values were clearly in a bubble. While they were deflationary to asset holders the same outlook faces many countries. Japan bailed out its banks so realistic property values were not imposed on them or the public. They have been in a slow sticky fall for two decades. That has happened in Spain and Ireland where property prices have fallen to a level where banks have made big losses but still above a sustainable level. The Spanish property market has already been in a slump for 4 years and clearly has a considerable way to fall. We are still a long way from currency revulsion. I do think that the first sign that currency revulsion is underway is serious social disorder.

    1. fresno dan says

      Thats a very good point – is a house returning to 3X income deflationary or is the market “working”? Of course, I wonder about markets that let prices “inflate” so much to begin with.

      I always wonder why people think inflation is a panacea – do people who pay their increased health insurance premiums going to have more demand and go shopping? I wonder how many people got wage increases, or some other increase of income, that actually covers the increase in health insurance premiums (and DONT get me started about deductables)…

      1. Dave Holden says

        I think inflationistas subscribe to a similar mode of thinking as Krugman on stimulus. It’s what I call “never enough” thinking and what they’d call “not enough”. I think their view is that with enough price inflation wage inflation well inexorably follow. So far that doesn’t seem to be happening in the UK where we pretty much have stagflation. But maybe we just don’t have “enough” inflation.

      2. David Lazarus says

        The reversion to mean is not deflationary. Hence we can have falling house prices with rising inflation. At the moment we have 5% inflation in the UK and that is with stagnant property prices which suspect are 40% over valued still. So if the Bank of England stick with their zero interest rate policy and property prices are static then to get that value back to a sustainable level we would need more than 8 years of 5% inflation and static prices to get them back to a level that is realistic in real terms. Though my thought is that there is no way that with that policy will peoples income be able to grow so the debt burden on households will climb, as stagnant wages and incomes falling in real terms because of inflation will mean that eventually that even those static prices will be unsustainable because real wages will have fallen 40% so would still be prime for a fall again in absolute terms.

        The Anglos saxon to debt and inflation is bizarre. We avoid debt except when it is mortgage, and we abhor inflation except when it is house prices.

  2. mdot says

    “5. Currency revulsion that results from financial repression for a monetarily sovereign government expresses itself as currency depreciation first, and not via interest rates until inflation from money printing and currency depreciation force policy rates higher.”

    Can anybody clarify this point? My being unclear about this point may be related to my reading comprehension or economic ignorance or both, but is this making the point that in the event of currency revulsion, inflation first appears followed by higher rates?

    Is there a differentiation between “currency depreciation” and “inflation”? Is currency depreciation the result of currency revulsion which is itself the psychological result of printing money?

    Also, what qualifies as “financial repression”?

    My apologies if this is all elementary or trivial.

    1. Dave Holden says

      @mdot – I’m probably suffering from the same problem because I was about to ask the same question.

      Another question I have is what are the dynamics of currency revulsion? We’ve seen that interest rates can change very quickly – certainly faster than the Eurocracy can respond. Is their a similar dynamic with currency revulsion or is this a more gradual thing?

      1. Edward Harrison says

        We seem to be in a competitive currency depreciation scenario where everyone wants a weaker currency: the US, Switzerland, China, you name it. I doubt that currency revulsion will cause an unprecedented flight out of a currency in the near-term.

    2. David Lazarus says

      The current zero interest rate policy would in my mind count as financial repression. It is one that will have reverberate badly in years to come. For savers and pensioners it is a substantial tax on their incomes. It is causing wealth destruction on a massive scale as pensioners eat into their capital as interest rates are insufficient to live on. It is harming the pension industry as it hits pension savings, and returns. Without decent returns people will not save for a pension. For governments they ignore this, because it will be another administration that has to pick up the pieces. It is a way of central banks supporting bank asset values with underpriced interest rates. If interest rates were at even the historical low of 2% which it had been in the past then many would have struggled to pay their mortgages. Here in the UK there are many who are only coping because of 0.5% interest rates. As these increase they will probably default. So these people are just holding on to bail out the banks.

      1. Dave Holden says

        As another aside re interest rates and inflation this one has me running in circles to some extent.

        see the section “Charles Plosser and the 50% contraction of the Fed’s balance sheet” where he seems to be pointing out that *raising* interest rates risks causing inflation unless the Fed rapidly reduces its balance sheet. Well isn’t inflation what they’re trying to do?

        1. David Lazarus says

          I saw that and wonder why would it need to be so expensive to reverse the policy. As you raise rates the economy will slow and so the any inflation will be stomped on by the raising rates. To cut the money supply by reversing QE will only make things worse if done at the same time. These are separate policies as far as I can see and could be used independently.

      2. fresno dan says

        Again, very good points.
        What frustrates me is that I don’t see anything, other that theory about interest policy, that tries to put some numbers to it.
        How much interest income is lost (and to what income quintiles?) – and not just seniors and small savers, but pensions.

        And what is the logic of people keeping their mortgage for a house that is priced 2 or 3 times the historical norm with metrics like price to income? (oh, yeah, by the banks, for the banks….)

        1. David Lazarus says

          The UK pension sector are already reporting a fall in pension contributions. This will is like extend and pretend on an individual basis where people are simply not saving enough for retirement. Households are diverting pension saving to cover fixed costs like day to day expenses and for mortgages. This is going to create substantial problems for governments in that people will retire without sufficient income and so be dependant on state pensions. Though government policy has not helped resolve this problem. For the last thirty years governments of all colours have raided pension funds. They also allowed the financial sector to skim from pension pots. So in less than 30 years, we as a nation have gone to having the biggest surpluses, to having the biggest shortfall in pensions in the EU.

          Pension contributions need to rise substantially and retirement age needs to increase by as much as ten years. Both will be unpopular but demographics mean that this fact has to be faced soon.

          Also low interest rates decimate pensions as the annuities, which are generally funded by long dated government bonds, will be generate an insufficient income for the pensioner. Raising rates back to long term levels would solve that problem

    3. Edward Harrison says

      Point 5 is a corollary of point 4. Without default risk, the yield curve is based on expected future policy rates plus a risk premium.

      That means that when people shun US assets, the adjustment mechanism is the currency not interest rates as under the gold standard. This is because the dollar is a floating exchange rate nonconvertible currency and there is no need to defend a currency peg or staunch the outflow of gold by jacking up rates.

      A lot of people have a gold standard view of the world that tells them rates must go higher when in fact the adjustment is via exchange rates.

      1. David Lazarus says

        I do not see the US facing the prospect of currency revulsion for quite some time. That is something that will happen to other currencies first. I see the talk about such prospects as a way to talk up the gold price from gold bugs.

        In the interim a falling dollar will mean inflation of goods and services, which first increase the trade deficit but then lower it as goods are priced out of the market. If interest rates are increased to maintain the exchange rate that might lower inflation as it reduces the cost of import inflation but will hit the rest of the economy. Though there will be beneficiaries from a return to normal interest rates. The big losers will be the banks as home loans will again come under pressure.

  3. Dave Holden says

    As an aside I’ve just started reading David Graeber’s book on the history of Debt

    It gives a very different take on the history of money than the one I’m used to.

  4. McKillop says

    The book of Genesis claims that creation began with “Fiat lux”: the new masters of the universe create their “fiat bux”.
    (Or should we speak of “Diktat dough” – with its naughts and crosses?)
    Sorry to inflict my puns upon you, but in my recently started attempts to understand money et C., I need to award my ego with some sort of prize. And so take the risk that you will chuckle.

    1. Patrick Donnelly says

      Genesis is an eye witness account of the events that caused Egypt to remove all the gods and revere just the Sun, Aten, rather than Saturn as it had disappeared and the sun had reappeared. EU Mythology as science!

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