Modern Monetary Theory (MMT)

Simply put, MMT is the idea that for a country that issues government debt in its own currency budget deficits don’t matter.   The government can simply print more money if it wants to spend more than it collects in taxes.

Although the theory has been around for a while (the first Google result I got was a critical opinion piece from almost a decade ago), it’s been revived recently by “progressive” Democrats arguing for dramatically increasing social welfare spending.  For them, the answer to the question “What about the Federal deficit?,”  is “MMT,” the government can always issue more debt/print more money.

MMT reminds me a bit of Modern Portfolio Theory (MPT), which was crafted in the 1970s and “proved” that the wild gyrations going on in world stock markets in the late 1960s and the first half of the 1970s were impossible.

 

Four issues come to mind:

–20th century economic history–the UK, Greece, Italy, Korea, Thailand, Malaysia, lots of Latin America…   demonstrates that really bad things happen once government debt gets to the level where investors begin to suspect they won’t be repaid in full.

This has already happened three times in the US: during the Carter administration, when Washington was forced to issue Treasury bonds denominated in foreign currency; during the government debt crisis of 1987, which caused a bond market collapse that triggered, in turn, the Black Monday stock market swoon a few months later; and during the Great Bond Massacre of 1993-94.

In other words, as with MPT, the briefest glance outside through an ivory tower window would show the theory doesn’t describe reality very well

–the traditional case for gold–and, lately, for cryptocurrencies–is to hedge against the government tendency to repay debt in inflation-debased currency.  In other words, every investor’s checklist includes guarding against print-more-money governments

–excessive spending today is conventionally (and correctly, in my view) seen as leaving today’s banquet check to be picked up by one’s children or grandchildren.  In the contemporary cautionary tale of Japan, the tab in question has included massive loss of national wealth, a sharp drop in living standards and economic stagnation for a third of a century.  No wonder Japanese Millennials have a hard time dealing with their elders.

Why would the US be different?  Why are Millennial legislators, of all people, advocating this strategy?

–conventional wisdom is that the first indication that a government is losing its creditworthiness is that foreigners stop buying.  This is arguably not a big deal, since foreigners come and go; locals typically make up the heart of the market.  During the US bond market crisis of 1987, however, the biggest domestic bond market participants staged the buyers strike.  Something very similar happened in 1993-94.  I don’t see any reason to believe that the culture of the “bond vigilante” has disappeared.  So, in my opinion, the negative reaction to a policy of constant deficit spending in the US is likely to be severe and to come very quickly.

S&P downgrade of US sovereign debt: investment implications

what S&P said

After the stock market close in New York last Friday, Standard and Poors’ Ratings Direct issued a research report in which it downgraded the long-term credit rating of the United States from AAA to AA+, with a negative outlook.

According to S&P, “negative outlook” means that there’s at least one chance in three that it will downgrade the US further within the next two years.

Short-term paper remains unaffected, with a A-1+ rating.

its reasoning

Two main factors:

–the rising public debt, and

–the fact that “elected officials remain wary of tackling the structural issues” in a way that AAA countries are expected to do (which I read as meaning that S&P regards government in Washington as a bunch of wannabe ballplayers wearing big-league uniforms and demanding big-league perks but who can’t hit the ball out of the infield ).

Apparently, the performance of all parties to the debt ceiling debacle was enough to make S&P revise down the opinion it formed in April.

who doesn’t know this already?

I think it would be hard to find any professional fixed income investor who isn’t aware the US has a debt problem.  In fact, over my thirty+ years watching the stock market, conventional wisdom (and actual experience) has always been that the rating agency opinions are lagging indicators of financial health.  To my mind, one of the crazier aspects of the sub-prime mortgage bubble is that professionals actually claimed they relied on the ratings, rather than doing analysis themselves–kind of like depending on last year’s calendar to tell you the day of the week.

As Casey Stengel would have commented, ” You could Google it.”   In round numbers, Washington has $2.5 trillion in annual income but spends $4 trillion.  Outstanding federal debt is already over $14.3 trillion, or about six years’ worth of gross income.  And that doesn’t count $40+ trillion in the present value of retirement and medical care promises Washington has made but hasn’t set aside the money for.

investment implications

short-term

There may be a day or two–if that–of negative reaction in both stocks and bonds to having the S&P shoe finally drop.  Otherwise, in the short term, I think there are no negative consequences.

Two other ratings agencies, Moodys and Fitch, have already reaffirmed their AAA rating of US sovereign debt.  So it’s unlikely that any large investor has a contract that will force it to sell Treasuries.

Besides, where else is there the same combination of liquidity and relative safety that still exists in Treasuries  …Japan?   …Italy?    I don’t think so.

In addition, as I mentioned above, this is scarcely a surprise.

longer-term

This is much harder to handicap.

On the one hand, the downgrade will doubtless cause China to increase its efforts to create a substitute for the dollar as the global reserve currency.  As Xinhua, the Chinese news agency puts it, “The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.”  In the same article, Xinhua also calls for international supervision of the issuance of dollar obligations, and the establishment of a substitute world reserve currency.

On the other,  Americans’ opinion of Congress is at an all-time (meaning since the Seventies) low, with 82% rating legislators unfavorably.  The New York Times, a Democratic bastion, just ran an op-ed piece arguing the country would be better off with Richard Nixon as president than Barack Obama.

It’s at least possible that the embarrassment of a national credit downgrade after 70 years of AAA will sharpen political debate and influence the next national election–coming in November 2012.  The groundswell appears to me to be already taking form.  If so, the public outcry may well influence, in a favorable way, the recommendations of the congressional committee being established to make budget-balancing recommendations as part of the debt ceiling deal.

Who knows.

I also think this event brings us closer–both in time and value–to a buying opportunity in world markets.  Today will be an interesting day to watch closely.

S&P revises its outlook for T-bonds from stable to negative

The S&P announcement

Yesterday the rating agency issued a new “unsolicited” opinion (meaning it wasn’t hired by the US to do so) on US government debt.  While retaining its current AAA rating for Treasuries, S&P has revised down its outlook for the country’s long-terms obligations from stable to negative.

What does this mean?

“Negative” means S&P thinks there’s at least a one in three chance of a credit downgrade within the next two years.

S&P’s reasoning?

The factors S&P considers most important are:

–deterioration of the US fiscal position over the past decade

–damage done by the financial crisis and ensuing recession

–inability of Washington to agree over the past two years on a plan to address these issues

–the “significant risk” that nothing will be done before the election in November 2012.

Although S&P (like everyone else) regards unfunded entitlement programs Social Security and Medicare/Medicaid as the main sources of budgetary woes, it points out that the country may also have to cough up another $685 billion to recapitalize Fannie Mae and Freddie Mac.  S&P observes, as well, that much of the US sovereign debt is concentrated in the hands of a small number of foreign governments, raising the possibility that one or more might change their minds.

be careful what you wish for

It wasn’t that long ago that Congress was lambasting the rating agencies for not being proactive enough in downgrading the exotic credit instruments spewed out by Wall Street.  Their collapse weakened the national finances and made the deficit a “today” issue rather than one that could be safely be put off.

I wonder how Washington likes proactivity now?

And the S&P raters whose integrity was questioned by Congress wouldn’t be human if they didn’t take a kind of satisfaction in calling attention to the fact that the UK–and even France (?!?)–are further along the path to fiscal responsibility than the US.

what happens next?

A lot depends.  I don’t think there’s much anyone can say for sure.

For one thing, not everyone agrees that the S&P analysis is correct.  For example, a comment popped into my inbox at about 6pm on Monday from Jim Paulsen, the chief economist for Wells Capital, arguing that the deficit is primarily cyclical.

It seems to me, though, that the S&P announcement puts additional pressure on elected officials to cooperate with one another.  That pressure would increase if, say, Moodys, were to follow the S&P lead and say something similar.  The debate on raising the federal debt ceiling will give an almost immediate indication of whether the Democrats and Republicans can work together.

No matter what, my guess is that the S&P announcement will turn out to be a significant turning point for US government finances.  Despite the dollar being the world’s reserve currency, I think the days of Washington just willy-nilly issuing news bonds are coming to an end–sort of like maxing out an almost infinite credit line.

Also, if past form holds true (and I think it will), domestic borrowers–not foreigners–would be the first to desert the Treasury market in large numbers.  This means that worry about Treasuries will express itself initially, and primarily, through higher interest rates, not a weaker currency.  Only if the situation becomes really ugly will the dollar come under significant pressure.

From an overall economic perspective, I find the “hidden” loss of wealth through currency depreciation to have worse negative effects than adjustment through higher interest rates and a slower economy.  From a stock market point of view, however, it’s much easier to devise a money-making strategy in a weak currency environment than in a high interest rate one.

Stay tuned.



Issuing 100-year bonds? … the Treasury says “No, thanks.”

the suggestion

Once every three months, the Treasury Borrowing Advisory Committee, whose members come from among the designated primary Treasury bond dealers, makes a presentation to the government on the state of that market.  In the most recent meeting, earlier this week, the TBAC suggested that the Treasury is missing an opportunity to sell to a potentially large segment of bond buyers–$2.4 trillion worth–by sticking with the plain-vanilla bonds it issues now.  Although the TBAC cited callable and variable-rate securities as possible new flavors, its main suggestion was that government issue longer maturity bonds.  It thinks there would be many willing buyers of even 100-year Treasuries.

The TBAC argument in favor of long-duration bonds is economic.  Its main conclusions:

–insurance companies, due to the long duration nature of the risks they underwrite, need a constant supply of high-quality bonds to use as an offset.

–new capital adequacy rules for banks will increase demand from this sector as well.

Three other points were unspoken:

–even private companies have been able to issue very long duration bonds over the past year

–interest rates are at emergency-low levels, so circumstances are very favorable for sellers, and

–the current US issuance strategy, which emphasizes bonds with maturities of three years or less, minimizes the current interest expense of the country’s debt burden, but exposes the government to considerable refinancing risk, as the following data taken from the TBAC powerpoint presentation illustrate:

outstanding Treasury bond maturities

3 years or less       40%
5-7 years                40%
10-15 years            12%
20+ years                8%.

the response

During a subsequent press conference, a Treasury spokesperson said a 100-year bond makes no sense for the US government.  I don’t think this is an economic conclusion.  It’s a political one.

No, I don’t think the Treasury is concerned with potential repercussions from the losses it might be saddling buyers of a 100-year bond with, as interest rates begin to rise.  After all, it continues to sell savings bonds to the (shrinking number of) Americans unwise enough to purchase them.

Instead, I think the Treasury has two main motives in taking the immense refinancing risk its current maturity profile entails:

–with the government paying 1% interest or less on 40% of the outstanding debt, the current outlay to finance the borrowings is much less than it would be with a more prudent maturity schedule ( a 1% increase would add about $140 billion to the budget deficit), and

–in the current, highly partisan political climate, the administration would surely be accused of acquiescing to, or institutionalizing, the current size of government debt by extending maturities.

I guess it makes some sense to argue that the constant need to refinance exerts pressure on Washington to rein in spending.  There’s no evidence I can see in Congressional behavior that would suggest this theory is right, however.  In fact, it seems to me more like the lower interest expense reduces any sense of urgency to rein in deficit spending.

 

 

S&P downgrades Japan: a cautionary tale?

the S&P downgrade

Last week Standard & Poors downgraded the sovereign debt of Japan, reducing its rating on the Tokyo government’s bonds by one notch, to AA- from AA.  In doing so, S&P cited:

–high government debt ratios

–persistent deflation

–an aging population and shrinking workforce

–social security expenses at almost a third of the government budget, and rising

–the lack of a coherent plan to address the growing debt problem, and

–the global recession, which has worsened the situation.

With the possible exception of the last point, none of this is exactly news.  S&P could have cited all the other factors five years–or even ten years–ago.

What’s going on?

Two things, in my opinion:

1.  The Liberal Democratic Party, the dominant force in Japanese politics for the past fifty years, was tossed out of office in a landslide victory for the opposition Democratic Party of Japan in August 2009.  This happened once before, in the late 1980s, when the Socialist Party, from which the DPJ springs, did the same thing.  On both occasions, the transfer of power was followed by heavy-duty partisan infighting within the winning party, stunning ministerial ineptitude and legislative paralysis.  The past eighteen months have demonstrated that chances of another charismatic leader like Prime Minister Koizumi of the LDP emerging from the current fray are pretty remote.

2.  There’s a business cycle pattern to changes in the credit agencies’ ratings.  While the globe is expanding, the agencies’ ratings lag the economic reality.  They end up being too bullish for way too long.  In contrast, after having been castigated by the regulatory authorities and the markets for this behavior, the agencies become excessively cautious.  They downgrade aggressively and actively search for high-profile instances to do so, in order to tout their new-found conservatism.  Once the economic cycle turns up, of course, the rating agencies have tended to quickly forget this prudence and resume their former generosity to client bond issues.

no market reaction, but lots of expert commentary

Since the ratings downgrade contains no new insights into Japan’s malaise, the reaction from financial markets has been ho-hum.  But pundits have seized on this chance to air their views.  Internal commentators have been beating the drum again for economic reform.  External ones have reiterated their stance that Japan today is a look into the future for the US if we don’t mend our ways.

my thoughts, too

Since everyone else is doing it, I thought I’d also give my views about Japan (yet again), based on my twenty-five years of experience in the Japanese equity market.  Here goes:

1.  Reform just isn’t going to happen.  For decades, Japan has followed a policy of preserving the status quo, even at the cost of no economic growth.  The result has been that creative destruction, where a new generation of firms rises from the ashes of the old, isn’t allowed to happen.  Weak and inefficient entrants in an industry aren’t compelled either to change their ways or fail.  They receive explicit and implicit social protection instead.  So they drag down the strong.

2.  Perversely, the economic stagnation and mild deflation that result from this policy help perpetuate the system.  Lack of economic growth keeps interest rates low. Domestic investors have few viable investment alternatives, so they continue to put their savings into government bonds.    Therefore, Tokyo can fund continuing deficits easily and at low cost.  In a funny sense, the worst thing that could happen to Japan over the next several years would be for the economy to spontaneously (it would take a miracle, though) begin to grow.  Alternatives to government bonds would arise for investors.  And interest rates would likely go up, raising Tokyo’s financing costs.  Voilà, government debt crisis.

3.  There is a point of similarity, I think, between the Japanese situation and the American that is something to worry about.

It’s not in the industrial base, which is much more dynamic and much less hide-bound in the US than in Japan.

It’s not in the politics, either, though both the Capitol and Nagatacho are to my mind similarly dysfunctional.  But the Japanese electorate has put up with legislative failure for over twenty years.  I think, however, as Americans work out that Washington is not meeting its needs, change will come swiftly and dramatically.  We’ve already seen some of this twice within a little more than two years.

One of the most striking aspects of Japan to me as an investor is the strongly held belief in that country of its cultural and economic superiority over everyone else.  The fact of this belief isn’t so surprising.  Every major power seems to think more or less the same thing about itself.  Certainly, the US does, too. But in Japan, sort of like in France, its intensity stands out.  Neither seems to me to have a sense of perspective/humor about itself. (I’ve been told, for example, by a Japanese CEO in a face-to-face interview that he didn’t want foreigners like me holding stock in his company.  Why?  …we’re subhuman, that’s why.  Actually, he told my translator, who skipped over that part–both unaware that a “subhuman” might actually understand a little Japanese.)

If you think it’s a priori impossible for a foreigner to have anything to teach you, you can be blind to the objective situation–meaning that a sense of national pride that’s out of control will act as a barrier to beneficial change.

Although the US may have prominent individuals who believe as intensely as the Japanese/French that anything domestic is superior to anything foreign, I think most of us have a little more common sense.  Again, however, only time will tell.