Bond vigilantes and the currency relief valve
The last post by Randall Wray is an interesting one because it points out how the world has changed since the end of the gold standard and why the sovereign debt crisis is centered in the euro zone.
While I have an Austrian bias overall, for me, MMT is the best way to think about nonconvertible floating exchange rate systems as distinct from fixed exchange rate, currency board, pegged and convertible systems. The difference is policy space and what I would call the bond vigilante relief valve.
In the old gold convertible system, the central bank had to jack up rates to prevent an outflow of gold. Interest rates were the release valve. But in those old days, only by adjusting the gold peg i.e. depreciating the currency, could countries under attack get away with low rates once the vigilantes were on to them. That’s what happened during the Great Depression. Once the conversion was broken, the currency depreciated and depression lessened immediately.
Today the release valve is always the currency because there is no gold tether. So the currency gives way, not interest rates. And to the degree that interest rates would increase, the central bank can print. The currency revulsion question then is always currency depreciation, inflation and even hyperinflation (when and under what preconditions) not interest rate spikes.
Sovereigns with significant foreign currency liabilities face the same issues as sovereigns under the gold standard – as we saw in Iceland in 2008. In the Russia and Argentina defaults last decade, those countries had foreign currency liabilities and a currency peg. This was the problem. It’s different for nonconvertible floating exchange rate currencies issued by a sovereign with no foreign currency obligations.
Where the bond vigilante story is usually flawed is in thinking that the bond vigilantes have power. Shorting government bonds when the central bank is politically aligned with the Treasury is a sure-fire way to lose lots of money. The consolidated government’s balance sheet consists of IOU liabilities that it can manufacture in infinite quantities. Why would anyone think they can win that game? It’s like my writing IOUs for blog points. Maybe I write more than I can ever cover for. But I create the points. I can always create more. if I write too many, their value depreciates.
The Europeans are currency users with a central bank that is not politically aligned. This is a very different institutional arrangement to the US. The Fed can ‘financially repress’ all it wants. They control rates. Long-term, the result will be currency depreciation relative to other central banks not repressing. But if everyone is engaged in financial repression i.e forcing negative real interest rates across the curve – and I think they all will be – then clearly it’s only hard currency that wins: gold, land, etc. After an initial bond vigilante run, Bill Gross has got religion on this.
From an investing standpoint you have to get this one right. The bond vigilante paradigm has been false in Japan for well over a decade and it is false in the US now as well. If you had seen rates in Japan at 2% and shorted them saying they would go up, you would have lost your shirt. Conversely, if one uses the currency sovereignty paradigm, the short-JGBs trade is one that one would have avoided.
What cautious investors should do is underweight repressed assets and overweight next best alternatives in similar assets classes or in different currencies – corporate over government bonds, Canadian over US, etc. Indonesia, for example is an opportunity.
One last note: Bill Gross had a good piece in the FT about what I have dubbed ‘permanent zero’. He called it the ugly side of ultra-cheap money. I think he’s onto something that worries me as well. It’s the same sort of thing we saw in Japan and it means, critically, that when the economy hits recession, the yield curve flattens even more – and banks get savaged by this just as the asset side of their balance sheet is falling apart. They are then forced to sell good assets to delever and that causes a negative spiral. For the US, the next recession will be like this – and it will be nasty for risk assets as a result.