The can down the road...

[doodle]

It is looking more and more likely that a comprehensive solution to our longer term fiscal challenges will not emerge this month. Obama's press conference today didn't sound too upbeat on the debt issue. In fact, it is looking more and more likely that very little will be accomplished except a temporary couple billion dollar extension to get us a few more months down the road. The debt ratings agencys have said that if a plan is lacking, they would "probably" downgrade out debt in short order.

Is the media and other talking heads (el-arian, gross, faber, rogers etc.) overplaying this issue like another Y2K......or is there a crisis looming? What is your take?

[MediumTex]

The can they are kicking is beginning to look more like a 55 gallon drum filled with sand.

[Jan Van]

Comprehensive solution??? You didn't really expect a comprehensive solution did you? Wouldn't that take long term vision and some other leadership skills?

[doodle]

So back to my favorite issue....why are the rates on treasuries so low again? We have established that the Japanese rates were driven down by domestic savers fleeing to the perception of stability in govt debt.

Our debt on the other hand, partly because it is so large and partly because Americans are bad at saving, is financed in large part by international individuals and entities. This is turn makes it much more upwardly biased if we start looking like Greece pretty soon.

From my vantage point it looks like we are going to have a lot of bandaid measures until a crisis and overwhelming political pressure force these "leaders" to do something.

Can anyone paint a scenario where the fiscal and budgetary issues of our government cause people to flee en masse into the debt promises they are selling when about half of congress is pushing around the word "default"?

In Sweden's crisis in the early 90's this is how the politicians behaved to stem off disaster...

“The only thing that held back an avalanche was the hope that the system was holding,”? said Leif Pagrotzky, a senior member of the opposition at the time. “In public we stuck together 100 percent, but we fought behind the scenes.”?

[kka]

So back to my favorite issue....why are the rates on treasuries so low again? We have established that the Japanese rates were driven down by domestic savers fleeing to the perception of stability in govt debt.

Our debt on the other hand, partly because it is so large and partly because Americans are bad at saving, is financed in large part by international individuals and entities. This is turn makes it much more upwardly biased if we start looking like Greece pretty soon.

2/3rds of the US debt is held domestically.
http://www.ritholtz.com/blog/2011/01/is ... e-us-debt/

Greece doesn't have their own currency and is much more comparable to a state within the US than a government who is a monopoly supplier of currency in a floating exchange rate fiat money system.
http://pragcap.com/resources/understand ... ary-system

My take is that rates are low because inflation and expected inflation is low.  Most of the world is in a balance sheet recession, and the deleveraging of private individuals and companies overwhelms any inflationary efforts of central banks.

[Gumby]

Our debt on the other hand, partly because it is so large and partly because Americans are bad at saving, is financed in large part by international individuals and entities. This is turn makes it much more upwardly biased if we start looking like Greece pretty soon.

It's important to understand why the Euro system is in crisis. Deficit fearmongers keep claiming that the U.S. could become "the next Greece". But that isn't just unlikely — it's impossible. Greece doesn't control its currency. So it can run into financing problems, like a U.S. state or a company. Could the U.S. have some completely different kind of problem? Sure. But it will not have a Greece problem. Not now, not ever.

The problem at hand is whether or not the Treasury can make its coupon payments on August 4th (when the first coupon payments are due). I have a hard time believing that the Treasury can't figure out a loophole (or turn on a printing press) to make its payments on that day.

[doodle]

Do we really have "control" of our currency? The government certainly does on the supply side...but do we have control of the demand side? There is a limit to how much intervention the Fed can do do keep the demand strong. If QE2 really ended, the largest buyer has just left the auction.

How do we have control over the demand for our currency and debt?

[moda0306]

doodle,

Taxation controls the demand side.  Taxation is essentially destroying money by forcing people in the U.S. to empty their checking accounts for thousands every year.

Without taxation the whole "game" wouldn't work.  You need a legitimate force telling people they'll go to jail if they don't pay taxes... if you have that, even confetti can be currency (as long as they control production of said confetti).

[doodle]

Right, but taxation doesn't control demand for our debt...especially in an international market. I know that the government will be able to control citizens demand for US dollars but the price and demand for our debt will ultimately have to be set by the market.

[Gumby]

Right, but taxation doesn't control demand for our debt...especially in an international market. I know that the government will be able to control citizens demand for US dollars but the price and demand for our debt will ultimately have to be set by the market.

So, what do you suppose bond holders look for when they purchase and sell Treasuries? Do they care about government spending? No, apparently not — spending has skyrocketed. Do they care about tax rates? Nope. Tax rates are at historic lows.

Treasury holders only care about one thing: that their bonds have virtually Zero Credit Risk. So, the demand for our debt is mainly priced on the value of a guaranteed payment by the full faith and credit of the US government. That's all there is to it.

If the government is unable to fulfill that promise, then the market will react.

[moda0306]

Gumby,

I'd add that they also want the bond to sustain real value, and not lose out to inflation, so one could argue that our bonds will become unattractive when they lag inflation, even if there is zero credit risk.

But at the same time, when inflation is being driven by commodities, 1) it's always going to be difficult for bondholders (and even stockholders at times) to beat inflation the way they used to, and 2) to invest in the commodities themselves is extremely risky, so foreign bond-holders will "take what they can get" at that point, IMO.

[Gumby]

I'd add that they also want the bond to sustain real value, and not lose out to inflation, so one could argue that our bonds will become unattractive when they lag inflation, even if there is zero credit risk.

Yes, and they should lose value in that situation. Treasuries are simply zero credit risk instruments — with various durations — that react to changes in interest rates. The longer the duration, the stronger the reaction. That's exactly what they do. That's why people buy and sell them.

Sometimes it helps to look at what the fixed-income polar opposite of a Long Term Treasury might be. Here's a fixed-income instrument that has no interest rate risk, but has credit risk:

iShares Launches Floating Rate Fixed Income ETF

[moda0306]

Gumby,

It really begs the question that if these are so unique in the marketplace and currently so saught after, is the world, and the US, better off for having a mostly fiat currency with central banks simply holding a lot of gold to give them clout.

I'm not arguing for crony capitalist monetary policy of bailing out banks, etc, but simply acknowledging that maybe "the market" (aka, free individuals and their banks) WANTS there to be a fiat system, and let us as wise investors worry about inflation, not inflation + default.... just as "the market" wants a military and system of courts to encourage honest commerce.

I mean look at Greece... they had the monetary equivalent of a gold-standard (can't print Euro's), but still managed to get themselves into a real pickle.  So did Ireland, and was also a poster-child for conservative economic policy to boot... now look at them.  It seems to me poor vs good economic/fiscal management does a lot more for an economy than simply handcuffing your currency to gold or something else.  The bad spending and moral crises developed by government would probably happen anyway, and then you're beholden to (often foreign) bondholders on top of it by a currency you can't devalue to bring your economy back around.

I'm curious... what did the fed actually do before we broke the gold standard (so between 1913 and 193x)??  How did banking work at that time?

[Gumby]

It seems to me poor vs good economic/fiscal management does a lot more for an economy than simply handcuffing your currency to gold or something else.

It always makes me cringe, but I think there is validity to that statement. Perhaps a gold standard is like a governor on a car — limiting a country's speed to avoid a speeding accident. We are certainly able to travel faster without a gold standard, but I'll be the first to admit that I have no idea how slippery the road is up ahead.

The bad spending and moral crises developed by government would probably happen anyway, and then you're beholden to (often foreign) bondholders on top of it by a currency you can't devalue to bring your economy back around.

Yes, I agree that we have more flexibility (at least for now) without the gold standard.

I'm curious... what did the fed actually do before we broke the gold standard (so between 1913 and 193x)??  How did banking work at that time?

It's a fantastic question. Deficits mattered a whole lot more when we were on the gold standard. Isn't that why people were encouraged to buy war bonds and such? You certainly don't see those posters anymore.

[Gumby]

I found this short run down:

1776-1873: Primitive banking. This period was characterized by "Free Banking" (many private instruments became worthless), volatility, disorder, little cumulative inflation in the modern sense.

1873-1913: Sound Money and a "Golden Era" (especially if you had money). There was a structural decline in most prices during this period which has led to some controversy amongst monetary scholars, as some think prices were pulled down by industrialization and massive increases in productivity — which would not actually be "deflation" OR problems with the gold supply and the lack of a bimetallic standard creating monetary contraction and true "deflation".

1913-1933: Boom to Bust. The imbalances created by WWI and the 1920s bubble created, with the assistance of the new FED, a collapse the world economy: inflation to deflation.

1933-1946: Depression and War. Most of the nations of the world abandon the gold standard in order to reflate collapsed economies, fulfill obligations and fund military activities and purchases.

1946-1971: Bretton Woods System. Countries fixed their exchange rates relative to the U.S. dollar. The U.S. promised to fix the price of gold at $35 per ounce. Fairly stable prices in the US — a period of relatively sound money and prosperity — especially for average Americans.

1971-2011: The Federal Reserve Note. The dollar becomes an "IOU Nothing" and is basically reduced to an irredeemable symbolic "ticket" with no par value ("Fiat Money"). Its purchasing power declined at an accelerated rate after 1971 and its value in the future could be anything.

Source: Inflation and Delusion

According to Wikipedia, the Federal Reserve Act of 1913 was conceived when, "Americans became persuaded that the country needed some sort of banking and currency reform that would, when threatened by financial panics, provide a ready reserve of liquid assets, and furthermore allow for currency and credit to expand and contract seasonally within the U.S. economy."

After perusing the eras above, it does makes sense that "average" Amercians do better under the gold standard, since their purchasing power would not erode as much over time.

[moda0306]

Thanks... certainly breaks it down in somewhat biased and simplified terms, but it doesn't really describe what the fed actually did.  Did it set interest rates?  Was this the dawn of fractional reserve banking (what would cause a run on banks)?  If so, how does the gold-holding requirement reconcile with fractional reserve banking?  Did the gold-holding requirement mimick today's reserve requirement, where a bank only had to have xx% of gold on hand of the total deposits?

[Gumby]

Thanks... certainly breaks it down in somewhat biased and simplified terms, but it doesn't really describe what the fed actually did.  Did it set interest rates?  Was this the dawn of fractional reserve banking (what would cause a run on banks)?  If so, how does the gold-holding requirement reconcile with fractional reserve banking?  Did the gold-holding requirement mimick today's reserve requirement, where a bank only had to have xx% of gold on hand of the total deposits?

It takes a long time to download (lots of neat photos) but here's the entire history of how the system began:

http://www.bos.frb.org/about/pubs/begin.pdf

But, even that doesn't seem to explain what the Fed specifically did.

EDIT: Found a real gem (opinion) in the New York Times free archive from 1914:

"Fiatism Run Mad"

From what I'm reading, Vanderlip was still toying with the idea of only a partial to no backing of gold (40% or 50% or 0%) in 1914.

[moda0306]

To me I always question "what" is eroding Americans' purchasing power... if it's "fed-financed" defecit spending to fund middle-class tax-cuts or stimulus spending, I think it's safe to say that the middle class is the main beneficiary of the inflation.

If it's reducing reserve requirements and making cheap loans to financial institutions, then you and I have to wait for the trickle-down.

I tend to think a fiat currency can be operated in a much-more middle-class-friendly way than ours currently is.... where dollars are put in Americans' pockets (or not taken out), not simply issued to banks with the hopes of credit trickling down at higher rates to financially uneducated and debt-ridden middle-class Americans.

That might see even more inflation and/or instability, but at least it would be because people have cold-hard cash... and then they could even use that to pay down debt (as many would, and should).

Regarding your link (and many others)... there's so much political weight that's carried by people regarding economics that it's tough to get a balanced explanation of the fed and gold standard in years' past all the way up until today.

[Gumby]

Regarding your link (and many others)... there's so much political weight that's carried by people regarding economics that it's tough to get a balanced explanation of the fed and gold standard in years' past all the way up until today.

Agreed.

[Gumby]

To get the topic back on track. If we can agree that Treasuries are seen as an instrument of Zero Credit Risk — mostly due to fiatism and the might of the military — then the biggest threat to Treasuries over the next few weeks is the tarnishing of that perception.

Doodle, I agree that there is a fear that a misstep in this ongoing political theater could spook the markets. As of this moment, that hasn't happened yet. I can't say it won't happen, but I'm only trying to explain why Treasuries aren't (and shouldn't be) at 12% or 20% right now.

[moda0306]

Regarding your link (and many others)... there's so much political weight that's carried by people regarding economics that it's tough to get a balanced explanation of the fed and gold standard in years' past all the way up until today.

Agreed.

That's what I come here for... plus there's not one solid drumbeat here.  VERY diverse opinions, often backed by reasonable logic, facts, observations, historical contexts, etc.  It's like a melting pot of opinions discussed in a balanced fashion, where often only chaos exists (internet message boards), and though only one of us can be right (more likely none of us are ), we're all smarter for having each other to bounce these ideas off of... also, despite these diverse opinions, there seems to be a self-challenging nature to all of us.  We usually are 90% confident in our opinions (read: guesses) about how economics works, so we balance our rhetoric to those odds.  This creates an entirely different atmosphere than boards where people are 100% sure of their opinions, 20% informed, and 150% motivated to out-insult others, not out-think them.

The phrase, "The more you learn, the less you know" is about as accurate as any I've heard.

[Gumby]

btw, today was the last day of QE2!

[Jan Van]

Greece doesn't have their own currency and is much more comparable to a state within the US than a government who is a monopoly supplier of currency in a floating exchange rate fiat money system.
http://pragcap.com/resources/understand ... ary-system

Interesting article. Will have to re-read that a couple of times. Can somebody explain to me how Modern Monetary Theory and the Debt Ceiling relate? Meaning, isn't the Debt Ceiling "unnecessary"? In the sense that we could keep spending, but of course ...

We can just spend to our hearts content, right? Absolutely not. The bogey here is inflation which is constantly moving up and down with the amount of money in the system based on my tax rate, spending, borrowing, etc. Thus, government cannot just spend and spend and spend or the extra dollars in the system will chase too few goods and drive up prices. It’s important to understand that government cannot just spend recklessly. This is important so I’ll say it again. This does not give the government the ability to spend and spend and spend. If they spend too much and tax too little they can create mal-investment and inflation. Likewise, if the government taxes too much and spends too little they create a government surplus and private sector deficit (by accounting identity). This can result in deflation and/or excess private sector debt levels.

In other words, all the Debt Ceiling does is keep the government from creating "mal-investment and inflation", but it really hasn't got anything to do with matching expenditures to taxes?

[moda0306]

jmourik,

The debt represents previously run defecits... I think what matters more in terms of inflation is current defecits (which, of course, will push you up against higher debt...so I understand the tie-in).

To a modern-monetarist, the debt ceiling is probably an utterly stupid mistake, as it has no tie to inflation, but simply puts a cap on nominal overall debt, which they insist is really quite irrelevant.

The idea of debt being nothing more than a monetary policy tool, not a means of funding government, is difficult to absorb and seems a bit much, but I have to say it makes sense on some levels.

[Gumby]

I'm not arguing for crony capitalist monetary policy of bailing out banks, etc, but simply acknowledging that maybe "the market" (aka, free individuals and their banks) WANTS there to be a fiat system, and let us as wise investors worry about inflation, not inflation + default.... just as "the market" wants a military and system of courts to encourage honest commerce.

I mean look at Greece... they had the monetary equivalent of a gold-standard (can't print Euro's), but still managed to get themselves into a real pickle.  So did Ireland, and was also a poster-child for conservative economic policy to boot... now look at them.  It seems to me poor vs good economic/fiscal management does a lot more for an economy than simply handcuffing your currency to gold or something else.  The bad spending and moral crises developed by government would probably happen anyway, and then you're beholden to (often foreign) bondholders on top of it by a currency you can't devalue to bring your economy back around.

I recently re-read some conversations I had with a modern-monetarist. When I asked him if the gold standard was preferable to fiat, he replied:

If you accept government as a given, fiat is better than gold.

In an anarchy gold would be better.

Why do you suppose that is?