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.

The mess in Greece–any silver linings?

the mess

When Greece was admitted into the EU about a decade ago, there were suspicions that the country had fudged its economic numbers a bit to meet the minimum criteria for entry. But the EU chose to look the other way.  In the middle of the decade, more evidence of cheating was uncovered, but again the EU chose to look the other way.

the discovery

Last year, after a change of government, the new administration confirmed that Greece had indeed been cooking the books in its reports to the EU , to its citizens and to the outside world, in a major way for years.

With a lag of some months, these revelations have sparked the currency and bond crisis, akin to the Asian developing market worries of 1997, that we are in now.

positives?

We all know the negatives.  Are there any positives to be taken from the situation?  I think so.  Specifically,

1.  Better now than a year ago, when the whole world was falling apart.

2.  It appears that the EU is finally going to address the Greece issue instead of papering it over.  Germany, ever the economic policeman of Europe, seems unwilling to move down a slippery slope of denial and compromise. And even if it were, world government bond markets will no longer allow that to happen.  It’s unclear what the ultimate outcome for Greece will be—the two polar cases are its leaving the EU and and an IMF-led policy overhaul—but some thing definitive will happen.

3.  The Greece situation probably puts an end for a long while to the idea that the euro can replace the dollar as the world’s reserve currency, or even serve as a viable second team substitute.  This probably buys some time for the US to get its own fiscal house in order, but I think that’s a mixed blessing.

The implication for China, which is already offloading dollars through acquisitions and foreign aid as fast as it can, of the unsuitability of the euro as a home for its foreign currency reserves is to push harder to advance the renminbi as a medium for inernational trade.

3.  Germany vs. Greece can easily be seen as the pattern for the way a possible confrontation years down the road between China and the US might develop.   As such, it may serve as a salutary warning to the US.  I would particularly note that the Greek crisis came out of nowhere but quickly developed a savage intensity.  Scary.  And hopefully motivation to avoid the Greek outcome through sensible economic policy at any cost.

(On the other hand, given the strange (to me) way Washington operates, politicians could easily regard the real failing of Greece to be ruling out devaluation as an option by entering the EU.  This would imply that Congress and the sitting administration should set the inflationary ball rolling sooner rather than later.  Not good.  Also not a silver lining, and therefore a topic for another day.

Government debt trap: how a country’s finances can go bad

The debt trap

Long-time observers of the Japanese economy are beginning to worry publicly that the country is slowly falling into a government debt trap.  The last time I recall this sort of talk was in the late Eighties, when commentators worried that pre-Euro Italy was in the same bad shape.

What is a government debt trap?  The general idea is that the government debt situation spirals out of control as the cost of servicing government borrowings rises dramatically, through some combination of high interest rates and the volume of government debt outstanding.

Caveats

The easiest way to explain the phenomenon is to give an illustration.  I’m going to keep it very simple.  Governments have become very crafty at keeping items like the cost of a war, or of senior citizen benefits, or explicit or implicit guarantees for failing “government-sponsored” enterprises.  But I’m going to ignore that.

I’m also not going to have the country in my illustration grow over the years.  Naturally, if GDP–and therefore tax receipts–grow, but government expenditures remain flat (fat chance!), then the situation I’m about to describe may gradually improve.  If, on the other hand, government expenditures grow at the same rate as tax receipts, the situation becomes worse.

Also, in theory at least, governments run deficits in downturns and surpluses in upturns, so that over a business cycle they are breakeven.  I’m going to ignore this reality as well. (This is kind of scary.  It’s like I’m turning into an academic!  I hope it wears off soon after this post.)  Take the “years” I’m talking about as being an average of what happens over a business cycle.  Bear with me through the initial part.  I’ll inject a dose of realism at the end.

Here goes–

Illustrations

Let’s make the following assumptions about a country:

CASE  1

annual GDP         100

tax receipts             30

govt expenditures        35

govt debt        0

interest rate on govt debt       5%.

This situation is relative benign.  The government runs a primary deficit (tax receipts minus government expenditures, before debt service) of 5.  Interest expense on that debt is .25, so the overall deficit is 5.25.  Interest expense makes little difference to the overall deficit.  The deficit is also structural, not cyclical; that is to say, it won’t go away as the business cycle develops.

Let’s look at something more interesting.

CASE 2a

Everything is the same as in case 1, except that government debt is now 100.(this might arguably be the UK or US in a few years).

The primary deficit remains 5, but now we also owe bondholders another 5 in interest expense.  So the government has to borrow 10 to cover expenses.

In year 2, we have the primary deficit of 5, but government debt is now 110, so interest expense is 5.5.

If this same situation persists through year 10, then government debt is over 200 and interest expense alone is 10.

At this point, in order to get the budget into primary balance, the government would have to cut expenditures by about 15%.  To get into overall balance, expenditures would have to go down by 40%. What are the chances of that happening?

CASE 2b

The same as case 1, except interest rates are 10% and outstanding government debt is 150.  (This is, more or less, the Italy of the late 1980s.)

In year 1, the primary deficit is 5 and interest expense is 15, so the government has to borrow 20 to cover expenses.

In year 2, the primary deficit is 5, interest expense is 17 and total debt rises to 216.

If we follow this progression out to year 5, debt rises to 270 and interest expense is 24.

In year 7, interest expense exceeds tax receipts!!!

Who’s going to lend to this country, even in year 1?  Well, there are the people who lent to Nakheel in Dubai, but they’ve got enough trouble as it is.  And, PT Barnum’s beliefs to the contrary, would there be enough of them in any event?

CASE 2c

The same as case 1, except debt is 200 and interest rates are 1.5%.  (This is more or less today’s Japan)

In year 1, the primary deficit is 5 and interest expense is 3.  Total government debt rises to 208.

In year 5, the primary deficit is 5, interest expense is 3.6 and total debt is just under 250.

In year 10, the primary deficit is 5, interest expense is 4.2 and total debt is just under 300.

In this case, the overall government debt is gigantic, equalling 10 years’ tax receipts.  How will the government ever be able to pay this money back? Note, however ,that the government can achieve overall budget balance relatively easily, by cutting expenditures/raising taxes by a little over 10%.  The biggest danger is that bondholders decide not to roll over existing debt at current interest rates.  If interest rates–and therefore interest expense– go up, or if the government is unable to pay current maturities from the proceeds of new debt sales, big trouble arises very quickly.

(A little) realism injection

1.  If we can figure out, at least in general directional terms, the possibility of severe future trouble in just a few minutes, so too can any potential government bond investor.  So the government in question begins to have difficulty in rolling over existing debt long before the year 10 situations emerge.

2.  Legislators, or their aides, understand the developing problems as well.  But their desire to bring government largesse to their constituents–and thus assure their reelection–typically overwhelms and desire to cut expenditures or raise taxes.  In the “benign” case, they stick their collective heads in the sand.  In the worse case, they deliberately foster inflationary policies, on the thought that this lowers the real value of what the government needs to pay back.  This throws gasoline on the fire.

3.  Off balance sheet liabilities make the debt situation worse.

4.  All the bond issuance by itself is inflationary, as is the currency weakness that ensues as foreigners sell their holdings an repatriate the money, or simply hedge the local currency exposure they have.

5.  It makes a difference whether the government is bought by locals or foreigners.  In the first case, the current generation is borrowing from its sons and daughters, saddling them with debt that finances current consumption.  Foreign buyers can come and go much more quickly, so the need to finance a portion of the government’s debt externally usually makes the situation more volatile.  One exception:  my observation (and, remember, I’m a stock guy) is that in past debt crises in the US, domestic investors have been much quicker to withhold their funds than foreigners.

6.  Case 2b is the more “normal” development path of debt running wild.  Case 2c, Japan, is unusual in that Japanese savers continue to commit money to the bond market despite very low nominal interest rates.  Observers have attributed this to a self-reinforcing circle of economic weakness, as follows:

a.  Government policy expresses the social desire to preserve a traditional way of life.  So Tokyo’s actions tend to preserve the status quo.  In particular, highly inefficient, money-losing companies are not allowed to fail or to be bought by more competent management.  This action damages the prospects for healthier firms and results in low economic growth and possible deflation.

b.  To stimulate growth, the government engages in (basically worthless) public works projects, which require public borrowing.  Because the economy flirts with deflation, nominal yields are low.

c.  Citizens recognize the situation and save heavily, rather than consume, in order to have funds for retirement.  Since most publicly-traded companies have poor profit prospects, the equity market is seen as too risky.  Bank deposit rates are effectively zero.  This leaves government bonds, even with a 1.5% coupon, the best alternative.

The big risk to Japan, therefore, is that one day domestic savers find another vehicle for their savings and want their money back.  This is unlike the “normal” case, where rising nominal interest rates are typically the country’s undoing.