Blog Post: Can a country default on its debts? Can the US?

[Higgenbotham]

Here's a reference on the gold coinage used during the time leading up to the South Sea Bubble. Since there was little debasement of the coinage in 1717, Britain was effectively on a stable money system from 1698 on, as well as from 1717 on as the article states.

In 1698, with the decision to fix the official value of the guinea at 21s 6d (lowered to 21s in 1717 – the rate at which it remained for the rest of the century), England's currency system was effectively, though not yet explicitly, converted to a gold standard.

http://www.pierre-marteau.com/wiki/inde ... tain:Money

[JLak]

As a percentage of debt/GDP (even though the latter is falling), the US is still far below where Japan is.

"..The United States, with its $65.9 trillion fiscal gap..."
http://research.stlouisfed.org/publicat ... likoff.pdf

The part about derivatives has been one of my reasons for thinking that this bubble cannot be reflated further because the derivatives came from the private market, dwarf what the government is capable of spending, and the derivatives are now basically eating a hole in the financial system that cannot be cured until the debt is liquidated. ... What I think the foreign holders of treasuries would like to see is for the value of their treasuries to be maintained for a few years until they get their act together enough to be ready to jettison the dollar standard

1. We had one crash in 2002 and the credit bubble found a way to expand beyond what anyone had thought possible, partly out of greed, but mostly fear I think. Banks must keep up with inflation of credit because they have to pay interest somewhere near inflation or lose deposits, which is the surest path to banking Armageddon.
2. The market for dollars is supply/demand like anything else. If all the foreign holders are selling, the supply increases and demand decreases. What does that do to price?
3. If we're using historical arguments and we say that US bonds are worthless, then what does that do to the value of the dollar. Surely the dollar and the t-bill are the most closely correlated assets in any financial market throughout the history of both.

Not to mention that the monetary base has already doubled

and when the bad assets get bought or the banks are forced to lend, the banks will start to release reserves. Do you expect them to hold onto $800B in reserves forever?

[Higgenbotham]

1. We had one crash in 2002 and the credit bubble found a way to expand beyond what anyone had thought possible, partly out of greed, but mostly fear I think. Banks must keep up with inflation of credit because they have to pay interest somewhere near inflation or lose deposits, which is the surest path to banking Armageddon.
2. The market for dollars is supply/demand like anything else. If all the foreign holders are selling, the supply increases and demand decreases. What does that do to price?
3. If we're using historical arguments and we say that US bonds are worthless, then what does that do to the value of the dollar. Surely the dollar and the t-bill are the most closely correlated assets in any financial market throughout the history of both.

Not to mention that the monetary base has already doubled

1. The 2002 crash was able to find a bottom at 1% short term rates. This time, that didn't happen as short term rates have now gone to zero. Once short term rates go to zero then we are in what the Fed theorists call a "liquidity trap" and there have been various ideas proposed as to how to deal with that. Bernanke is working off of those ideas and the first thing he did was to use the Fed's balance sheet to reliquefy the banks. That didn't work either, at least not yet, so now the government is involved.
2. That's true if they sell. They can sell. Today Central Bank reserves are US Treasuries (basically). Russia went partially to Euros but that backfired on them. The whole free trade idea as I understand it has been for the Asians to accumulate reserves and issue yuan, yen, etc., off of that to keep the export game going.
3. The US dollar and t-bill are pretty much interchangeable, but US bonds are a different thing. Just off the top of my head, if there was a flight out of bonds today, it is my guess the dollar would get stronger as money flowed into the short end of the curve. That is actually what has been happening for the past week or two. The Bloomberg article on duration says essentially the same thing.

The monetary base consists of currency and bank reserves. Reserves have been pushed into the banking system and they aren't going anywhere because the banks aren't confident in lending. From what I read, the problem is that their assets are declining and they need to hold onto the money. About the time the monetary base exploded, you may have heard some of the politicians (I clearly remember Bush) scolding the banks for not lending. But that's what happens in a liquidity trap. In order to create inflation, money has to move and debt default has to stop, but that isn't happening (so far).

[JLak]

2. That's true if they sell. They can sell. Today Central Bank reserves are US Treasuries (basically). Russia went partially to Euros but that backfired on them. The whole free trade idea as I understand it has been for the Asians to accumulate reserves and issue yuan, yen, etc., off of that to keep the export game going.
3. The US dollar and t-bill are pretty much interchangeable, but US bonds are a different thing. Just off the top of my head, if there was a flight out of bonds today, it is my guess the dollar would get stronger as money flowed into the short end of the curve. That is actually what has been happening for the past week or two. The Bloomberg article on duration says essentially the same thing.

Okay so my question, and it really is a sincere question this time as I don't have any experience with international monetary policy, is:
What would happen to the value of a foreign currency if they found that the value of their bank reserves held significantly less buying power than before?

It seems to me that would trigger massive bank failure and deflation in those currencies. On the other hand, if the Treasuries in reserve form an implicit exchange rate for the monetary base they cover, then the rest of the world simply inflates along with the declining value of Treasuries.

Seriously, if you or anyone else out there has any historical examples or policy information, please let us know because I think that this is one area where technical information has been severely lacking.

[Higgenbotham]

2. That's true if they sell. They can sell. Today Central Bank reserves are US Treasuries (basically). Russia went partially to Euros but that backfired on them. The whole free trade idea as I understand it has been for the Asians to accumulate reserves and issue yuan, yen, etc., off of that to keep the export game going.
3. The US dollar and t-bill are pretty much interchangeable, but US bonds are a different thing. Just off the top of my head, if there was a flight out of bonds today, it is my guess the dollar would get stronger as money flowed into the short end of the curve. That is actually what has been happening for the past week or two. The Bloomberg article on duration says essentially the same thing.

Okay so my question, and it really is a sincere question this time as I don't have any experience with international monetary policy, is:
What would happen to the value of a foreign currency if they found that the value of their bank reserves held significantly less buying power than before?

It seems to me that would trigger massive bank failure and deflation in those currencies. On the other hand, if the Treasuries in reserve form an implicit exchange rate for the monetary base they cover, then the rest of the world simply inflates along with the declining value of Treasuries.

Seriously, if you or anyone else out there has any historical examples or policy information, please let us know because I think that this is one area where technical information has been severely lacking.

I don't know. I thought about it for awhile and can't really come up with a good answer. It seems like there are too many confounding factors. If a Central Bank was on a gold standard and removed half their gold, then in theory the value of the currency unit would go from X per ounce to 2X per ounce. But I don't think the answer is that simple in the real world.

Also, on that last post I made, I checked the charts and the dollar has been rising for 6 weeks while the 30 year bond has been falling for 6 weeks, not a week or two as I stated in the post.

[wtf]

Bloomberg
Treasury Real Yield at 16-Month High on Inflation Bet
By Dakin Campbell
Feb. 2 (Bloomberg) -- For the first time since 2007, Treasury investors are betting that inflation will accelerate.

The yield on 10-year notes exceeds the consumer price index by 2.72 percentage points, the most since December 2006. The gap between two- and 10-year rates widened at the fastest pace in a year last month as traders demanded more compensation for longer-term debt. Treasury Inflation Protected Securities that signaled falling prices as recently as Nov. 20 show they will increase in the U.S. this year.

Deflation was the growing concern for investors in 2008 as government bond yields fell to historic lows in December, the Reuters/Jefferies CRB Index of commodities tumbled 53 percent since July and home prices plunged 18 percent amid a deepening recession. Now, the bond market is saying Federal Reserve interest rates at zero percent, President Barack Obama’s $819 billion planned stimulus package and $8.5 trillion of U.S. initiatives to revive credit markets will reignite inflation.

“When the Fed gets finished here they will have an inflation nightmare on their hands,” said Mark MacQueen, who helps oversee $7 billion as co-founder of Sage Advisor Services Ltd. in Austin, Texas. “There is a lot of downside in conservative government bonds.”

MacQueen is selling 30-year Treasuries, which are more sensitive to inflation expectations than shorter-maturity debt.

http://jessescrossroadscafe.blogspot.co ... curve.html

[Higgenbotham]

What would happen to the value of a foreign currency if they found that the value of their bank reserves held significantly less buying power than before?

It seems to me that would trigger massive bank failure and deflation in those currencies. On the other hand, if the Treasuries in reserve form an implicit exchange rate for the monetary base they cover, then the rest of the world simply inflates along with the declining value of Treasuries.

Seriously, if you or anyone else out there has any historical examples or policy information, please let us know because I think that this is one area where technical information has been severely lacking.

A related question is what happens if the collateral that the Fed has taken in from the banks in exchange for treasury debt become worthless, and the Fed doesn't get their treasury debt back? Effectively, the Fed would only have $400 billion in treasury debt and $800 billion in Federal Reserve Notes outstanding. I don't know what the market would do with a situation like that. Perhaps, there would be a preference for checks written on T-bill money market accounts, but would some kind of market spring up for such a thing where there would be a premium on those checks over Federal Reserve Notes? Could it? Then what happens to T-bill interest rates? Do they go strongly negative? And how do redemptions of T-bills into C of I's affect this? I don't have the answers, but that could be one of our Fourth Turning crisis events right there.

[StilesBC]

Gold Standards can be inflated as well. It's happened many times. The government simply recalls the coins and dilutes the gold or silver with copper or something else.

I believe the British used tally sticks prior to the gold standard. I can't remember the sources, but it lasted 6 centuries (longer than any other currency in the history of civilization). Which goes to show that anything can be used as currency.

[Higgenbotham]

Bloomberg
Treasury Real Yield at 16-Month High on Inflation Bet
By Dakin Campbell
Feb. 2 (Bloomberg) -- For the first time since 2007, Treasury investors are betting that inflation will accelerate.

The yield on 10-year notes exceeds the consumer price index by 2.72 percentage points, the most since December 2006. The gap between two- and 10-year rates widened at the fastest pace in a year last month as traders demanded more compensation for longer-term debt. Treasury Inflation Protected Securities that signaled falling prices as recently as Nov. 20 show they will increase in the U.S. this year.

On the first two sentences (second paragraph) everything needed to evaluate this has been has been posted various places here and on the main website. It doesn't necessarily mean inflation. Some clues would be CDS rates and terms, note and bond rates, and the 30, 90, 180, and 360 day T-bill rates to see if they are lifting off the near zero level.

On the third sentence (second paragraph), 5 year TIPS are yielding 1.5% while 5 year notes are yielding 1.9%, so the conventional interpetation of this data is that investors are betting that the CPI will average more than 0.4% over the next 5 years. That could vary from year to year so it doesn't explicitly predict anything for this year or next. There aren't any shorter durations for TIPS so that's the best comparison that can be made. But here's the really interesting thing about this. TIP rates actually went negative last March 2008 so, according to the conventional interpretation, at that time investors were betting on a large increase in inflation! That's right, check it out, the stories on that are still out there. To give another chess analogy (maybe I have this one wrong too), he who grabs the queen knight's pawn sleeps in the streets.

[JLak]

Gold Standards can be inflated as well. It's happened many times. The government simply recalls the coins and dilutes the gold or silver with copper or something else.
I believe the British used tally sticks prior to the gold standard. I can't remember the sources, but it lasted 6 centuries (longer than any other currency in the history of civilization). Which goes to show that anything can be used as currency.

I've been trying to consider what might come next, what is the purest form of currency. I believe that eventually currency will become purely mathematical. You might say that the current form of fiat is pure math, but it's a very simple system dominated by human decisions and rather arbitrary at that. A purely mathematical form would rely on a fundamental scarcity that can be exchanged absolutely in the form of data without the need for a bank to back it up. This is my definition of financial utopia. I guess this counts as nihilism, so it may be more accurate to consider me as a late Gen-Xer instead of an early Millennial.