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

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