Debt Crisis

More On the Oil Price Developments

The consensus view on the recent plunge in oil prices is that it is a net positive. The logic involved is that the falling price represents a transfer of wealth from oil producers to oil consumers, and as there are far more of the latter, the boost to consumer spending will outweigh any difficulty faced by oil producers.

This logic would be sound if it was simply a case of increasing production satisfying consistent demand. The following chart suggests that is not the case:


While supply has risen over the last 5 plus years, the extent to which it has risen has been exaggerated a bit in relation to the explanations for the oil plunge. The supply rise has been relatively consistent, and even with the recent boom in US shale oil, the additions to the global supply from that boom have not been so dramatic as to send the global supply kiting through the roof. The main issue has been the lack of demand for oil at the levels that prevailed for most of the last 5 years, between $70-110/barrel. In the face of the recent flattening of demand (which OPEC expects to further decline in 2015), combined with the unchanged supply situation, a price drop is to be expected.

The next issue to resolve is the reason for the declining demand. As Irving Fisher wrote in his 1913 article The Monetary Side of the Cost of Living Problem, analysis of the supply and demand conditions relating to the good itself is only half of the picture. The monetary condition is equally as important for determining the whole story. From that standpoint, we turn to the Fed. The following is a chart displaying the year over year change in the Fed balance sheet compared with the price of oil.


The heavy pre 2010 year over year changes in the Fed balance sheet reflect the magnitude of the original Quantitative Easing program. The subsequent iterations of QE had less of an impact on the growth of balance sheet in relative terms, each time ‘only’ increasing the Fed Balance sheet roughly 40% year over year. This has been accompanied by price action in oil which has basically oscillated in a $40 range. I’ve mentioned multiple times that for QE to achieve the goal of constant price increases, each increase of the balance sheet has to be larger than the last, in relative terms. Since the original QE increased the balance sheet by 100%, subsequent increases of the balance sheet have to be in excess of 100%. Failure to do this will result in downward pressure on prices as the relative flow that is responsible for boosting prices starts to deteriorate. As I wrote in ‘Underpants Gnome Economics’:

Not only does active tightening place downward pressure on prices, but inaction by the Fed also leads to lower prices. Once prices have been pushed higher via accommodative policy, their continued rise depends on continued demand, which can only express itself when there are increased dollars in circulation. A relatively stable money supply does not suffice, and compared to an expanding supply, this stance is actually tighter, even though the absolute level of money in circulation may be very high. This is especially true in the face of an increased supply of goods and services.

Despite engaging in unprecedented easing of monetary policy in absolute terms, the fact that the Fed has been relatively tight (especially with the tapering of QE3 beginning in September 2013) means that deflationary pressures are certain to reassert themselves.

A few have been speculating in recent weeks that oil may be the first place in which this deflationary pressure appears. I joined them the other day in examining the implications of an oil collapse. Since then, the line of reasoning I presented (that the oil decline might reveal a layer of bad debt and pose a threat to the financial system) has been buttressed by a number of news articles with gloomy implications. From Bloomberg this morning:

In a stunning analysis this week, Goldman Sachs found almost $1 trillion in investments in future oil projects at risk. They looked at 400 of the world’s largest new oil and gas fields — excluding U.S. shale — and found projects representing $930 billion of future investment that are no longer profitable with Brent crude at $70.


The Goldman tally takes the long view of project finance as it plays out over the next decade or more. But the initial impact of low prices may be swift. Next year alone, oil and gas companies will make final investment decisions on 800 projects worth $500 billion, said Lars Eirik Nicolaisen, a partner at Oslo-based Rystad Energy. If the price of oil averages $70 in 2015, he wrote in an email, $150 billion will be pulled from oil and gas exploration around the world.

An oil price of $65 dollars a barrel next year would trigger the biggest drop in project finance in decades, according to a Sanford C. Bernstein analysis last week.

Unprofitability at a lower price means a reduction in outlays for future production. This means a decline in employment and utilization of capital, as this BBC article mentions:

“It’s almost impossible to make money at these oil prices”, Mr Allan, who is a director of Premier Oil in addition to chairing Brindex, told the BBC. “It’s a huge crisis.”

“This has happened before, and the industry adapts, but the adaptation is one of slashing people, slashing projects and reducing costs wherever possible, and that’s painful for our staff, painful for companies and painful for the country.

“It’s close to collapse. In terms of new investments – there will be none, everyone is retreating, people are being laid off at most companies this week and in the coming weeks. Budgets for 2015 are being cut by everyone.”

Mr Allan said many of the job cuts across the industry would not have been publicly announced. Oil workers are often employed as contractors, which are easier for employers to cut.

His remarks echo comments made by the veteran oil man and government adviser Sir Ian Wood, who last week predicted a wave of job losses in the North Sea over the next 18 months.

The US-based oil giant ConocoPhillips is cutting 230 out of 1,650 jobs in the UK.

This month it announced a 20% reduction in its worldwide capital expenditure budget, in response to falling oil prices.

Other big oil firms are expected to make similar cuts to their drilling and exploration budgets. Research from the investment bank Goldman Sachs predicted that they would need to cut capital expenditure by 30% to restore their profitability at current prices.

Service providers to the industry have also been hit. Texas-based oilfield services company Schlumberger cut back its UK-based fleet of geological survey ships in December, taking an $800m loss and cutting an unspecified number of jobs.

On Wednesday Aberdeen-based Wood Group announced a pay freeze for staff, and cut rates for its contractors.

Apache, one of the North Sea’s biggest producers, has followed suit and will impose a 10 percent reduction on its contractors’ wages from January 1st.

Capital Expenditure reduction. Employment reduction. Wage freezes/reductions. All of these have knock on effects in the shape of reductions in spending in other areas, not to mention the pressure that bad loans puts on the financial sector. The oil decline is a classic debt deflation in the making, which is a totally different prospect to the positive ‘it’s like a tax cut’ interpretation which is the consensus view at the moment.

Despite the potential bleak situation, the solution is to actually embrace the oil declines, because the falling price is the cure. The real problem was the proliferation of credit and debt issuance which roughly tripled the oil price rise from the 2009 depths to its stasis in the $70-110 range, enabling an expansion of investment, capital formation, and an increase in production costs. These unsustainable developments have now been revealed, as the inability for the economy as a whole to sustain high oil prices has led to a drop in demand, and thus the price. The drop in price now renders a lot of the credit undertaken in the past dubious in nature. Inevitable credit contraction and liquidation will follow, perhaps culminating in a reduction in oil supply. However, the end result is a situation in which stability returns. Costs of production will fall along with the price, to a point where investment projects can be undertaken profitably again, leading to the resumption of hiring and production. This is how markets work to correct imbalances.

Unfortunately, central bankers do not like the way markets work, so they will attempt to intervene. As it stands now, the Federal Reserve seems unperturbed by the move in oil prices, based on Janet Yellen’s press conference yesterday. If and when the issues I’ve mentioned rear their heads, the interpretation of any troubling situation will be that it is the low price which is the problem. The erroneous view that price moves cause changes in economic fortunes, rather than merely being effects of those changes, will lead the FOMC to resume easing, in ever greater amounts, to bail out anyone who may have been harmed by the pitfalls of a contraction of bad debt. The end result of this intervention will likely be a propping up of prices at elevated levels, the exact phenomenon which enabled an unsustainable edifice of oil development funded by leveraged financial institutions to be constructed in the first place. Let’s not get too far ahead of ourselves though, these developments are a few steps down the road, but it’s a road we’ve travelled on multiple times in the last 15 years. It’s hard not to be concerned.

The Debt Ceiling, Government Shutdown and Optics

In contemplating human transactions, the law of optics is reversed; we see the most indistinctly the objects which are close around us; we view them through the discoloured medium of our own prejudices and passions; the more familiar we are with them, the less truly do we estimate their real colours and dimensions.

– Richard Whately

We are currently in the midst of another government shutdown, which, in conjunction with the fast approaching debt limit, present plenty of discussion topics in early fall. With respect to the shutdown, the media has been in full blown crisis mode with its coverage, complete with pundits lamenting over the good old days. Like when President Reagan and Tip O’Neill were chums and bipartisanship was the way of the world. Except, of course, during the eight government shut downs that occurred during the Reagan administration. Of course one can point to the fact that they were different then, but every shutdown is different. Even prior to the Reagan shutdowns, President Carter went through several shutdowns, including five separate shutdowns revolving around abortion. This discrepancy between the actual goings on and the narrative highlights the issue of optics. The combined debt ceiling and government shutdown saga has allowed for the construction of the idea that the entire US economy is on the verge of collapse – all thanks to the Republicans. The following points help to shape the optics supporting that idea:

‘The Move to Shut Down the Government is Unprecedented in its Irresponsibility’

The narrative with respect to this shutdown, largely speaking, is that the Republicans in the House – the Tea Party in particular are being a bunch of children who are throwing a temper tantrum because they don’t like the legislation being passed. In fact the view is that it’s more pernicious than that, with opposition pundits and members of Congress accusing the Republicans of being terrorists holding the nation hostage with bombs strapped to their chests. This implication of the Republicans engaging in untoward or egregious tactics is out of order. A body of congress inducing a shutdown as part of negotiations isn’t unprecedented, as I wrote before it’s happened plenty of times over the last 40 years. Chris Matthews, speaking last Sunday attempted to differentiate this shut down from prior ones, stating:

Let me tell you this. They were issues of a day or two. They were issues of funding. Now, what I said before is, you can argue over numbers, and then you can — if it’s seven or nine, make it eight. But when you say we’re going to get rid of the number one program that you put into law and put in the history books, and your party’s been fighting for, for half a century, you can’t say, “Give me that.” That’s a non-negotiable stand. That’s the problem.

Matthews is wrong to make a distinction. This shutdown is also an issue of funding, specifically for Obamacare. The fact that it is the ‘number one program’ isn’t relevant. Consider the reason for the November 1981 and December 1982 shutdowns, as described in the Washington Post link from above. First 1981:

Reagan promised to veto any spending bill that didn’t include at least half of his proposed $8.4 billion in domestic budget cuts. The Senate passed a bill that met his specifications, but the House insisted on both greater defense cuts than Reagan wanted and pay raises for itself and for senior-level federal civil servants. Eventually, the House and Senate agreed to and passed a package that fell $2 billion short of the cuts Reagan wanted, so Reagan vetoed it and shut down the government.

And 1982:

House and Senate negotiators want to fund $5.4 billion and $1.2 billion, respectively, in public works spending to create jobs, but the Reagan administration threatened to veto any spending bill that included jobs money. The House also opposed funding the MX missile program, a major defense priority of Reagan’s.

As President Reagan in 1981, President Obama was not going to sign any spending bill that did not include 100% funding for Obamacare. Just as then, the House bill differed from the Presidents’ wishes, although unlike then the Senate and House did not come to an agreement. Again in 1982, the President was not going to sign any bill that included things he didn’t want, particularly funding for a major program which was an administration priority.

Interesting is the framing here – Reagan is the one who did the shutting in 1981, because he did not accept what Congress had put on his desk. This time around, the Republicans are seen as the ones doing the shutting – even though the Republican House has put forth spending bills. If blame was applied consistently, it would be the Senate and the President who are responsible for the shutdown, but that isn’t what the optics are.

The reason is a matter of scope. As Matthews suggests, Obamacare is a massive program, one that has been fought for across multiple generations. The weapons initiative that caused one of Reagan’s shutdowns seems fairly run of the mill in comparison. This difference in size doesn’t necessarily mean there is a difference in a legislative resistance to funding it. Let alone a ‘problem,’ or some sort of nefarious plot by Republicans to inflict evil on helpless people. It’s probably right that such a huge bill receives such strong scrutiny. The suggestion that such scrutiny is somehow underhanded in anyway, in light of the aforementioned historical discrepancies in apportioning blame, is just pandering to ideology and politics more than anything else.

Similarly, the debt ceiling has become such an important issue now as compared with years in the past because of scope. Rightly or wrongly, the current United States economic model depends on a continuing expansion of debt to operate. That fact means that anything standing in the way of continual expansion of debt is problematic. This reliance on ever increasing debt is something I’ve written about before in more detail, so I won’t expand too much here. Its relevance here is that it has become the underlying base of the framing of the debt ceiling debate, although it hasn’t been explicitly discussed. What has been discussed across the board is what a failure to raise the debt ceiling means.

‘The Failure to Increase the Debt Ceiling is A Default on the Debt Obligations of the United States’

The word ‘default’ has been used pretty recklessly during this saga, with everyone from the President, lawmakers, to TV pundits talking about how the failure to raise the debt ceiling would essentially be tantamount to default. This is wrong. The debt limit caps the amount of debt the US government can accrue. A failure to raise the debt limit merely means the total debt remains steady at that limit. A default, in the realm of repayment of that existing debt is simply a failure to make interest payments according to schedule and the principal at the end of the loan agreement. According to the Treasury, the interest expense for Fiscal Year 2013 came in at just under $416 billion. With revenues in excess of $2.5 trillion, there is no concern over the ability to pay the interest on the debt. When it comes to principal payments that come due, the debt ceiling does not prevent the Treasury from continually rolling over those debts that do come due since their rolling over would not increase the total amount of debt in existence. Thus there would be no default, in the manner in which many are describing, such that the rating, let alone legitimacy of US Treasuries would be called into question.

‘The Failure to Increase the Debt Ceiling is a failure to ‘pay our bills”

The link between increasing the debt limit and payments of bills is an interesting one, the implications of which have not been discussed in any real way thus far. From this CNN article:

If lawmakers don’t raise the limit on federal borrowing soon, they will put the nation at risk of defaulting on some of its legal obligations.

…which include interest on the debt, Social Security payments, and payments to federal contractors.

There is a difference between interest payments, and the other payments such as Social Security and payments to contractors. With respect to ‘paying bills,’ paying the interest is the only thing that credibly falls under that banner. That interest is on debts already incurred. Social Security payments, payments to contractors, and virtually all other spending are payments that have been promised. Failing to raise the debt ceiling would mean failure to meet some of the promised payments made, and while that would be problematic in one sense, there would be no ‘default’ in a technical sense, meaning the concomitant issues of broad based collapse in the Treasury market is unlikely.

Why the Debt Ceiling Exists in the First Place and the Consequences of Continually Raising It

From this report about the history of the debt limit, the reason it exists is the following:

The debt limit also provides Congress with the strings to control the federal purse, allowing Congress to assert its constitutional prerogatives to control spending. The debt limit also imposes a form of fiscal accountability, which compels Congress and the President to take visible action to allow further federal borrowing when the federal government spends more than it collects in revenues. In the words of one author, the debt limit “expresses a national devotion to the idea of thrift and to economical management of the fiscal affairs of the government.”

There are two interesting points to make here. The first is that the real consequence of a failure to increase the debt limit is the almost instant balancing of the budget. Without the ability to take on more debt, the Federal Government would be limited to spending what it collected in taxes, and will be forced to cut proposed spending massively. In truth, there would be other revenue boosting measures available, such as selling assets, but these pale in comparison to being able to increase the level of debt. The need to increase debt arises from the fact that proposed spending is not covered by the revenue brought in. This implies that the spending that the government wants to do is not necessarily backed by the willingness of the people to fund it. Congress, representing that will of the people (in theory), is only afforded a certain level of debt up to which it can accrue to cover this difference between what it wants to spend and what it can raise in revenues.

This brings us to the optical nature of the debt ceiling itself. The existence of a debt ceiling, according to the paper, conveys a sense of accountability and economical management of the governments’ finances. Constantly raising the debt ceiling every time it is reached is to merely render the idea of fiscal accountability and economical management of finances an illusion. Furthermore, the insistence that all hell would break loose if the debt ceiling isn’t increased means that it will never be increased. The same song was sung in the 2011 edition of the debt ceiling crisis. If it was true then and it is true now, it will be true the next time the debt ceiling is reached (assuming an agreement is made to avert the current situation).

Simply stated, if a constantly increasing debt is what is needed to avert crisis as is asserted, then crisis is inevitable. This is because the condition for ‘survival’, a constantly increasing debt, cannot persist indefinitely. This will be news to some of a certain persuasion, but there are limits to the amount one can borrow, regardless of whether or not you are the greatest economic power the world has ever seen. Should that time come, Federal Reserve and their ability to create money to buy all of the debt isn’t a solution either. That simply introduces the certainty of a currency crisis into the equation.

On the Optics of ‘Voluntary’ vs ‘Involuntary’ Crises

As written above, the fact that the US economy is so structurally dependent on constant increases in debt means any failure to increase debt becomes a blow to that particular structure. Thus should the debt ceiling not be raised, it is pretty clear that there will be an immediate downturn in the economy. This ‘voluntary’ crisis, brought about by not increasing the debt and thus denying promised payments, would not play well with the public. With respect to the ideas of more libertarian, free market oriented people, this would deal a very serious blow to their ideas. Recall that the narrative is that the Tea Party – essentially a group most Americans describe as libertarians and free market proponents – are behind the current shut down and debt ceiling impasse. Any downturn in the fortunes of the economy would fall squarely on their shoulders, at least optically speaking.

Before continuing, I must stress that the current economic structure of constant increases in debt to support spending and consumption is not an economic model that can last in the long term. I’ve expanded upon why a few times, as I’ve mentioned above. A dismantling of that economic structure would not be a bad thing if long term, sustained economic growth is the desired goal. The issue is how the transition from a debt-dependent-boom-bust economy to a longer term savings and production based economy would be viewed by the general public. Because this transition almost certainly involves some sort of crisis, as the debt dependent paradigm implodes, the way the next economy is shaped will depend on how the crisis is perceived. Yet more optics.

Should the crisis come about in ‘voluntary’ form based on the failure to increase the debt limit or something similar, the existence of crisis and potential hardship in the short term will supersede any of the longer term benefits in the view of most people. I believe that there will be a severe negative reaction towards Republicans, especially Tea Partiers, and anyone who has sympathy with the views of free market economics. It will be the fault of the ‘free market ideology’ that landed the country in crisis yet again, and surely subsequent elections will usher in politicians and movements in a direction opposite to free markets.

The ‘involuntary’ crisis happens if the debt ceiling is raised, and is continued to be raised, skirmishes notwithstanding. As I described above, the probability that the US can constantly increase its debt for the rest of time is zero. At some point, it will no longer be able to borrow, and enlisting the Federal Reserve to take over, explicitly monetizing the debt, would represent the last straw. In that event, there would be no conclusion to draw other than the continued proliferation of debt resulted in crisis. From there, a hard look would have to be taken at the policies and ideology that induced taking on so much debt. While that process leaves plenty of room for error, it is much more likely that the general public begins to lean towards a more free market solution than in the voluntary case.


For the record, I do believe that there will be an agreement to raise the debt ceiling. I believe this for the simple fact that the Republicans, while adorning the label of ‘the free market party’ are in reality far, far from deserving such a label. Political expedience and adhering to the line of least resistance will impel them to agree to raise the debt ceiling. With respect to Obamacare, for the sake of optics it is probably better that a deal is agreed there as well, with full funding for Obamacare. If the bill is fully funded and it collapses under its own weight, the problem will be there for all to see. In meddling with it however, a very easy argument is afforded the Democrats should it then falter – namely that it would have worked unencumbered, therefore government must move to increase its role in health insurance.

It is all a matter of optics.

More on the Trillion Dollar Coin Idea

I was watching Bloomberg this morning, and the trillion dollar coin came up again. Joe Weisenthal and Josh Barro were both on discussing the merits of their case in the following clip:

If you’re unaware of the situation, Ryan Avent at The Economist sums it up briefly:

America’s government is full of oddities, and here’s one: it is possible for the government to pass spending and tax bills which lead to an illegal amount of accumulated debt. The government’s borrowing results from all the tax and spending choices made by past and present elected officials and leads to annual deficits that add to a strock of public debt. Once the tax and spending choices are made, the resulting debt load is a fait accompli, a residual. Yet said elected officials have also seen fit to pass a law declaring that debt must fall below a specific limit. From time to time, then, Congress has to pass a law raising the limit—essentially, declaring its past choices legal—or face dire fiscal consequences. If the limit is reached and not raised government outlays must be cut immediately and dramatically or the government must default on some of its debt-interest payments.

The idea to get around the debt limit is the minting of a trillion dollar coin, which would allow the US government to write checks against that coin, instead of borrowing money. This idea has received quite a bit of discussion, and Barro has written again defending the proposal and tackling most of the rebuttals, which gives me a nice platform to discuss the issues with the idea. (more…)

Thoughts About the Fiscal Cliff, Debt and Deficits in General

After much fanfare, the US congress passed a bill averting the so called Fiscal Cliff. If there is one lesson to take away from this ordeal is that when push comes to shove, policymakers will always always always kick the can down the road. The Fiscal Cliff itself is the result of debt ceiling negotiations in the summer of 2011, and the deal reached this week simply means that the arguments over taxes and spending will begin afresh in two months as the debt ceiling negotiations ensue. Rather than go over the details in the specific deal itself, I’d like to discuss the bigger picture and what it means going forward. (more…)

My Take on Bonds and ‘The Bond Bubble’

The other day I was directed via Twitter to this piece from Cullen Roche at Pragmatic Capitalism. Written in 2010, it was an attempt to debunk the view that there was a bubble brewing in bonds. In his tweet, he suggested that his piece was still relevant today in 2012. In fairness, not much has really changed since 2010, so if his post was merited then it is now. I’ll comment on those merits below while opining on more general thoughts about bonds and the monetary system in the process.

Roche begins by defining for the reader what a market ‘bubble’ is. He states that (emphasis his):

…a bubble (as it pertains to markets) is an irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse. The keys here are extreme disequilibrium and systemic collapse. In order to have a bubble both aspects must occur.

I don’t see much wrong there, and it is important that a working definition of a bubble is given. Roche then continues, describing the basic rationale of your typical bond bubble advocate, namely that the idea that the fiscal burdens that the U.S. government will undertake are unsustainable. That, along with the idea that this will lead to a collapse in the U.S. bond market, is labeled a ‘myth.’ To explain why he feels this way, Roche constructs his argument by stating what the bond market is and how it works. To quote at length (emphasis his):

This brings us to a key question. What exactly is the U.S. government bond market? In a country with monetary sovereignty in a floating exchange rate system (USA & Japan, for instance) the bond market is really nothing more than a mechanism through which the central bank controls the money supply. It doesn’t actually fund anything as it does in Europe or under a gold standard. This is best understood by studying the bond auction data in the USA. Despite constant shrieking of a potential lack of buyers in government bonds over the years we continue to see incredibly high demand for US debt. The auctions are always oversubscribed. They never fail. Why is this? Why do the buyers keep coming back for more? The simple answer is because the government puts the buyers there. The auctions are designed not to fail. How is this you ask?

The government bond market is merely a monetary tool that the central bank utilizes to control the cost (or supply) of money by controlling the level of reserves in the system. So, when the government auctions bonds they are merely targeting reserves in the system. This action is mandated by Congress as an accounting tool and so is seen as a source of funding, however, in reality the Central Bank is merely draining reserves that the Treasury already spent into existence – reserves that were deposited at various banks (read this process in greater detail here). Therefore, it’s incorrect to argue that there won’t be buyers of U.S. bonds – with the banks earning 0.25% on their reserves and the government offering anything above that (depending on duration) the trade is a no-brainer for the banks who hold these reserves. The government is basically offering them free money and the Central Bank keeps control of the money supply in exchange (at least in theory). What is not occurring is some sort of funding mechanism. The Treasury could care less if the auctions are 2X, 3X or 4X oversubscribed. They don’t get extra money when this occurs. They don’t get a gold coin that can then be spent. So long as they meet the 1:1 bid to cover the auction is a huge success because they drained their targeted reserves and convinced Congress that we aren’t going bankrupt.

Most of the issue I have with the MMT perspective revolves around their obsession with the minutiae of monetary mechanics, which they then use as a base to make economic assertions as though economic laws have suddenly changed. When you disagree with their derived economic implications (note: not the mechanics themselves), they smugly accuse you of not understanding how the ‘modern economy’ works. As if fiat money is a modern construct. I’ll have to revisit this general issue in a more dedicated post, but for now let’s deal with the bond market.

What Roche is correct about is the fact that the United States does not necessarily need to ‘fund’ any spending it does. It does not necessarily need to collect taxes or raise foreign debt in order to spend, thanks to the fact that it has the power to issue unlimited amounts of currency. It can never run out of money because it can always print it. In an example of my aforementioned reservations with MMTers, they will focus on my use of the word ‘print’ in the last sentence, explaining that functionally what happens is that the Federal Reserve debits and credits the accounts of various actors in accordance with designated spending patterns of the government. This is true, but the fact that the Federal Reserve does not literally print bills on paper and distribute them does not change the fact that ‘money’ that did not exist before is now extant in bank accounts. The obsession with making sure we know it has been a digital process versus a paper printing exercise is baffling to me, because with respect to the economic impact there is no functional difference.

What the MMTers seem to miss, with respect to the quality of government bonds, is that the existence of sovereignty over money supply only removes default risk in the explicit, traditional sense. It does not remove the risk that the bond will be defaulted on implicitly, by paying the creditor with newly created currency (or digitized bank account credits for MMT political correctness) which by definition is of lesser value than what was lent.

In other words, when a country without monetary sovereignty (like Greece) runs into problems owing to overextensions of debt issuance, it will be forced into default because creditors will no longer lend and existing debt burdens are too difficult to service. In contrast, a country with monetary sovereignty (like the United States) that gets into difficulty owing to overextensions of debt issuance can simply call on its central bank to buy debt issues. So again, Roche is correct to point out that there will be no auction failure because there will always be enough Federal Reserve driven demand available. This isn’t the complete story, but it suffices for this piece.

So What’s the Problem?

The problem emanates from the fact that a greater portion of US Treasury debt issuance is bought via money created by the Federal Reserve. In other words, the deficit spending done by the US government is being enabled by Federal Reserve policy. Once again, the minutia concerning the exact mechanics of this process is largely irrelevant to the ultimate economic consequences. Unquestionably, the net result is the injection of newly created money into the economy by the Fed through the vehicle of Treasury securities.

The government rationale for embarking on this increased deficit spending is the existence of a depressed economy that needs support. The natural inclination of the private sector has been to draw down its debt levels and to reduce consumption spending, as the price level is such that spending has stalled and the debt required for financing that spending has also stalled. Hence, the government steps in to support spending at this elevated price level.

In the interest of this flawed response to the problem the high price and debt levels have posed, the government will need to continually increase the amount of debt and money supply to prop up asset prices, just like the housing bubble needed an increased amount of marginal debt to perpetuate at higher housing prices. Any slowdown in government largesse will be met with declines in asset prices, ultimately leading to another breakdown in the economy. The relatively neutral action by Federal Reserve following QE1 and QE2 illustrate this point. Both periods led to stock declines nearing recognized bear market levels, and serious threat of economic decline. Long story short, the Federal Reserve and Federal Government are going to have to maintain loose policy in perpetuity. They are not the proverbial training wheels; they are actually the big wheels themselves.


In light of that, where will all the requisite debt come from? As discussed before, technically the US doesn’t need foreign money to issue debt. Roche points out that in 2010, when the piece was written, the largest foreign creditors to the US were backing off. He writes:

Over the years the classic hyperinflationist or defaultista argument has been that China will stop buying our debt or that Japan will stop buying our debt. But the problem with this argument is that China is not our banker. Japan is not our banker. What do we care if they buy our bonds?

In recent months Chinese net holdings of U.S. debt declined…But U.S. treasury yields continue to plunge. The demand for this paper is enormous even though the largest holder of these bonds appears to be getting scared off.

Although China has increased their overall exposure to US debt since Roche wrote this piece, it has been much less than the Federal Reserve. Just 3 months after Roche wrote, the Federal Reserve became the largest single holder of US debt. Since that time, it has increased its holdings by 85%, compared to a 30% increase for China. According to the WSJ, the Federal Reserve bought 61% of Treasury issuance last year.

This increasing reliance on the Federal Reserve to be the ultimate buyer of US Treasury issuance underlies the crux of the bond bubble argument. Returning to the definition of a bubble as given by Roche:

…a bubble (as it pertains to markets) is an irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse.

The ‘irrational psychological market environment’ is another way of saying that the item in question is continually bid higher, far past any rational understanding of the fundamentals. It’s what enabled tech stocks to be bid up to over $1 billion in market capitalization despite having revenues of $600,000, advertising costs of $12 million, while selling its merchandise at a loss. With respect to Treasury debt, the irrationality is the continued bidding up of treasury bonds despite the fact that yields are inadequate compensation for the inflation that exists currently, and the inflation that will exist owing to continued debt issuance.

This view makes the assumption that the Federal Government will continue to issue debt to prop up the system, and that the Federal Reserve will continue to increase its balance sheet to accommodate that debt. These are solid assumptions in my view, based on the pledges by Ben Bernanke, and the actions taken in 2008. The Federal Government and Federal Reserve have shown they have no interest in allowing a collapse in the price level, and will engage in the spending and debt issuance necessary to continue forestalling that collapse.

The increased money that flows into the economy via deficit spending and the Federal Reserve provides the impetus for the increase in the prices of food, energy, stocks, commodities, healthcare, education, etc. I find it bizarre that so many argue against that point, only to turn around and advocate increased ‘demand boosting’ efforts. All that ‘demand’ is doing is bidding up the prices of goods and services. The problem with this is that income levels do not rise with the increase in prices, meaning that at some stage, the consumer will not be able to keep spending at the higher price level. This can be seen by noting that average real wages have been in constant decline since the ‘recovery’ began in 2009. The consequence of this is that when private spending inevitably stops, the government and Federal Reserve must act again to stabilize the price level, issuing more debt and creating more currency.

Even if one chooses to take the stance that there is no inflation, that individual would be deluded to think that the Fed and government are not going to push until there is. Even the current CPI defined inflation of 2.3% renders 10 year Treasury debt negative in real terms, as it traded at a rate of 1.69% earlier today. In other words, any buyer of 10 year debt today with the intention of holding to maturity is voluntarily losing money. That fits any definition of ‘irrationality’ if you ask me. Of course, that does not preclude Treasury debt from yielding lower from here, it just renders such a trade even more irrational than one placed today.

Irrationality alone doesn’t make a bubble. The resulting ‘extreme disequilibrium’ portion of the bubble definition fits the aforementioned increasing disconnects between incomes and prices that the Federal Reserve-enabled deficit spending gives rise to. Yet, given this disconnect, the Federal Reserve and government are going to have to keep the pedal to the metal so to speak. As stated above, Washington is now ‘the big wheels’ on the bicycle as opposed to the training wheels. Any let up, any creep higher in interest rates will serve to destroy the debt driven consumer spending model, which means asset prices go lower, which means the banks and the economy collapse. Said another way, the need and impetus for the simultaneous existence of ever lower interest rates (to drive debt expansion) and increased inflation (to prevent prices from ever falling again) is exactly what gives the bond market bubbly characteristics, if not make it a bubble already. Those simultaneous conditions exactly represent an irrational environment (low yields+high inflation) that results in extreme disequilibrium (prices running away from incomes).

Talking about systemic collapse, the final piece of the prototypical bubble, Roche writes:

Some market participants have gone so far as to compare the U.S. bond market to the Nasdaq bubble. This is simply not a fair comparison. The Nasdaq declined 90% from peak to trough. If you buy a 10 year government bond and hold it to maturity you will receive your principle back in full in addition to the coupon payments. If inflation jumps from the currently low levels to 5% you will be sacrificing 2.5% per year in real terms. Certainly not a winning pick, but nowhere near what the apocalyptic results of the Nasdaq bubble were.

Should inflation print 5% in the CPI, the Federal Reserve would be under massive pressure to raise rates. As I’ve argued throughout this piece, the slightest tightening measures would invite unwanted collapse, thus it is my contention that the Federal Reserve will continue its policy of low rates. However, anything short of an aggressive tightening will only increase the incentive for currency holders to trade their dollars for hard assets, further driving prices up. This is essentially what happened in the 70’s, until Volcker jacked the Fed Funds rate to 20%. The Federal Reserve will not willingly do that today, given such a rate would absolutely obliterate an economy that was far, far more levered than it was in the early 80s.

Returning to Roches’ 5% inflation hypothetical – the 10 year was roughly 2.6% when Roche wrote, meaning that a purchase then meant an instant loss of 2.4% in real terms. If the Fed refused to raise interest rates at that point, over time inflation would further increase, meaning that in subsequent years that 2.4% loss in real terms would grow even larger. If the Fed did raise rates (such that the 10 year yields 5%, a figure closer to historical norms and one that would cancel out inflation in this example), it would represent a capital loss of 48% (a 10 year bond with a face of 1000 yielding 2.6% would need to be priced at 520 to return the same coupon at 5%). A purchase at today’s level of 1.69% would result in a 66% loss of capital should the Fed hike to 5%. That qualifies as apocalyptic given that 5% is a historical norm, let alone a higher rate that may be necessary should inflation get out of hand. As mentioned above, a stubborn refusal to raise rates in the face of 5% inflation would merely stoke inflation earlier, risking hyperinflation if it continues to play itself out.

Note – THIS IS NOT A CALL FOR IMMINENT HYPERINFLATION. This is merely the illustration of the predicament the Federal Reserve and government find themselves in. For hyperinflation to occur would require the loss of confidence in the currency. That is a psychological matter that is nearly impossible to predict with accuracy. Thus the people who have made such predictions with specific dates have made themselves to look foolish. Equally foolish, however, are those who deny hyperinflation is even possible at all. A more reasoned assessment is to note, as the ‘hyperinflationistas’ have done, that the ingredients are undoubtedly in place. What isn’t is the catalyst, but the continued intention for yields to remain low while rising inflation is needed makes that catalyst more and more likely. Which is why the description of an:

irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse.

Is most certainly applicable to the bond market at this time.