debasing the currency

what debasing is

“Debasing” is goldbug-speak. In past centuries, when gold was actually used as money everywhere, when countries minted gold coins and kept reserves of the yellow metal as symbols of their ability to repay borrowings, governments in trouble would sometimes dilute their gold by blending in inexpensive base metals. So they would repay creditors substantially less than they’d borrowed. That’s debasing.

The modern equivalent of physical debasement is running a highly stimulative money policy, the idea being to create lots of inflation, which would allow a government to repay borrowings in inflation-debased currency.

A report from Goldman Sachs strategists came out this week suggesting that this process is at work in Washington right now, as a consequence, intended or not, of pandemic-fighting fiscal and monetary stimulus. Its conclusion: buy gold.

relevance for us as investors

I haven’t seen the report itself. I’ve only seen coverage in the financial press. (I’m not a Goldman client. For what it’s worth, I think the firm does top-notch factual research but struggles to find interesting investment conclusions from what it unearths. For you and me, Merrill Edge is the best I’ve found.)

I wrote about the gold issue in May. Except for China and India, where gold is still money, I don’t think holding gold achieves much of anything. The fact that a major brokerage house, typically a stronghold of Republican political sentiment, is willing to suggest–and seek publicity for–this idea, with its implied criticism of Trump’s dumpster-fire handling of the economy, is the most interesting aspect of its publication.

I think inflation is the least of our worries. Last year the federal government took in $3.5 trillion in taxes. Pre-pandemic, Washington was thought to be on course to spend about $1 trillion more than in 2020, due in large part to Trump’s failure to offset tax cuts with removal of special interest tax breaks for politically connected swamp creatures. The actual deficit will more likely be around $8 trillion. This would mean a total federal debt of, say, $28 trillion, or about 135% of GDP. That would place us up there with Italy among the most indebted nations in the world.

Yes, debt this high creates worries about devaluation as a way of not paying creditors back in full. Historically, however, such high levels of government debt are also associated with much slower GDP growth and emigration of the best and the brightest to make a life where economic opportunities are greater.

From a purely financial point of view, Trump’s threats to renege on government debt held by foreigners (basically making us look like Argentina) and his use of the banking system to attack political enemies are also giving new impetus to the search for alternatives to the dollar as the go-to currency for international trade and as a store of value.

I could go on about the other ways Trump continues to severely damage the US, while failing to provide any support for the left-behind rural citizens who support him. But I think the key question for the rest of the world is whether the US electing a white racist incompetent was a disastrous mistake or whether he really represents what the country stands for. If the latter proves true in November, the currency and securities markets reaction will likely be strongly negative.

what might cause a dollar swoon

government saving/spending–in theory

In theory, governments spend more than they take in to ease the pain and speed recovery during bad economic times. They spend less than they take in during booms to moderate growth and repay borrowings made during recession.

what really happens

In practice, this occurs less than one might hope. Even so, the Trump administration is one for the books. Despite coming into office after seven growth years in a row, Trump endorsed an immediate new dose of government stimulus–a bill that cut personal income tax for his ultra-wealthy backers and reduced the corporate tax rate from nosebleed levels to around the world average. While the latter was necessary to prevent US companies from reincorporating elsewhere, elimination of pork barrel tax breaks for favored industries that would have balanced the books was conspicuously absent.

The country suddenly sprouted a $1 trillion budget deficit at a time when that’s the last thing we needed.

Then came the coronavirus, Trump’s deer-in-the-headlights response and his continual exhortations to his followers to ignore healthcare protocols belatedly put in place have produced a worst-in-the-world outcome for the US. Huge economic damage and tens of thousands of unnecessary deaths. Vintage Trump. National income (and tax revenue to federal and state governments) is way down. And Washington has spent $2 trillion+ on fiscal stimulus, with doubtless more to come.

To make up a number, let’s say we end 2020 with $27 trillion in government debt (we cracked above $26 billion yesterday). That would be about 125% of GDP, up where a dubious credit like Italy has typically been. It would take 7.7 years worth of government cash flow to repay our federal debt completely. These are ugly numbers, especially in the 11th year of economic expansion.

At some point, potential buyers of government bonds will begin to question whether/when/how they’ll get their money, or their clients’ money, back. In academic theory, foreigners work this out faster than locals. In my experience with US financial markets, Wall Street is the first to head for the door. The result of buyers’ worry would be that the Treasury would need to offer higher interest rates to issue all the debt it will want. To the degree that the government has been borrowing short-term (to minimize its interest outlay) the deficit problem quickly becomes worse. Three solutions: raise taxes, cut services, find some way of not repaying borrowings.

not repaying

Historically, the path of least resistance for governments is to attempt the last of these. The standard route is to create inflation by running an excessively loose monetary policy. Gold bugs like to call this “debasing the currency.” The idea is that if prices are rising by, say, 5% annually and the stock of outstanding debt has been borrowed at 2%, holders will experience a 3% annual loss in the purchasing power of their bond principal.

The beauty of this solution in politicians’ eyes is the ability it gives them to blame someone else for what they are doing.

The downside is that international banks and professional investors will recognize this ploy and sell their holdings, creating a potentially large local currency decline.

The issue with the devaluation solution in today’s world is that sovereign debtors have been trying for at least the past decade to create local inflation–without success.

This would leave either tax increases or default as options. The slightest inkling of either would trigger large-scale flight from the country/currency, I think. Again, Wall Street would likely be the first. Holders of local currency would assume third-world-style capital controls would soon be put in place to stop this movement, adding to their flight impulse.

The most likely signal for capital flight to shift into high gear, in my view, would be Trump’s reelection.

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.

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.