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Bond vigilantes and the currency relief valve

The last post by Randall Wray is an interesting one because it points out how the world has changed since the end of the gold standard and why the sovereign debt crisis is centered in the euro zone.

While I have an Austrian bias overall, for me, MMT is the best way to think about nonconvertible floating exchange rate systems as distinct from fixed exchange rate, currency board, pegged and convertible systems. The difference is policy space and what I would call the bond vigilante relief valve.

In the old gold convertible system, the central bank had to jack up rates to prevent an outflow of gold. Interest rates were the release valve. But in those old days, only by adjusting the gold peg i.e. depreciating the currency, could countries under attack get away with low rates once the vigilantes were on to them. That’s what happened during the Great Depression. Once the conversion was broken, the currency depreciated and depression lessened immediately.

Today the release valve is always the currency because there is no gold tether. So the currency gives way, not interest rates. And to the degree that interest rates would increase, the central bank can print. The currency revulsion question then is always currency depreciation, inflation and even hyperinflation (when and under what preconditions) not interest rate spikes.

Sovereigns with significant foreign currency liabilities face the same issues as sovereigns under the gold standard – as we saw in Iceland in 2008. In the Russia and Argentina defaults last decade, those countries had foreign currency liabilities and a currency peg. This was the problem. It’s different for nonconvertible floating exchange rate currencies issued by a sovereign with no foreign currency obligations.

Where the bond vigilante story is usually flawed is in thinking that the bond vigilantes have power. Shorting government bonds when the central bank is politically aligned with the Treasury is a sure-fire way to lose lots of money. The consolidated government’s balance sheet consists of IOU liabilities that it can manufacture in infinite quantities. Why would anyone think they can win that game? It’s like my writing Yves IOUs for blog points. Maybe I write more than I can ever cover her for. But I create the points. I can always create more. if I write too many, their value depreciates.

Bond Market Vigilantes

The Europeans are currency users with a central bank that is not politically aligned. This is a very different institutional arrangement to the US. The Fed can ‘financially repress’ all it wants. They control rates. Long-term, the result will be currency depreciation relative to other central banks not repressing. But if everyone is engaged in financial repression i.e forcing negative real interest rates across the curve – and I think they all will be – then clearly it’s only hard currency that wins: gold, land, etc. After an initial bond vigilante run, Bill Gross has got religion on this.

Paul Krugman gets it too. I didn’t always think this was the case. But now Krugman is way out in front on this one as Randy attests in his post.

From an investing standpoint you have to get this one right. The bond vigilante paradigm has been false in Japan for well over a decade and it is false in the US now as well. If you had seen rates in Japan at 2% and shorted them saying they would go up, you would have lost your shirt. Conversely, if one uses the currency sovereignty paradigm, the short-JGBs trade is one that one would have avoided.

What cautious investors should do is underweight repressed assets and overweight next best alternatives in similar assets classes or in different currencies – corporate over government bonds, Canadian over US, etc. Indonesia, for example is an opportunity.

One last note: Bill Gross had a good piece in the FT about what I have dubbed ‘permanent zero’. He called it the ugly side of ultra-cheap money. I think he’s onto something that worries me as well. It’s the same sort of thing we saw in Japan and it means, critically, that when the economy hits recession, the yield curve flattens even more – and banks get savaged by this just as the asset side of their balance sheet is falling apart. They are then forced to sell good assets to delever and that causes a negative spiral. For the US, the next recession will be like this – and it will be nasty for risk assets as a result.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

10 Comments

  1. Scott Fullwiler says:

    Great piece, Ed!  Incidentally, if interest rates don’t spike, then one of the main sources of hyperinflation–”printing money” to cover debt service rising without bound with spiking rates–goes away.  Same thing if the govt hasn’t borrowed in a foreign currency, as even a depreciating currency doesn’t bring the traditional spiral of “printing money” to service foreign denominated debt rising exponentially.  That’s not to say there can’t be inflation, even hyperinflation, but two of the historically important sources aren’t there for a currency issuer under flexible exchange rates (which necessarily means no foreign denominated debt, at least to an economically significant degree).

    • Thanks, Scott. Your comments about interest rates make a lot of sense to me and one reason you have to discount the hyperinflation talk. With central banks manufacturing reserves in large quantities since the credit crisis began, you would think people would understand that this is not the gold standard and that there is no transmission mechanism from ‘money printing’ to private sector credit growth.

      The key is that with fiscal austerity the norm, deflation is the flation that will have bite. That’s what people should realise.

  2. Dave Holden says:

    If currency depreciates doesn’t this risk causing inflation and then won’t interest rates be increased?

    • Dave, you’re in the UK. So you know better than most that a depreciated British pound has indeed caused inflation but has not caused the Bank of England to even think of raising rates. They can go on like this for some time. That is what financial repression is all about.

    • Dave, you’re in the UK. So you know better than most that a depreciated British pound has indeed caused inflation but has not caused the Bank of England to even think of raising rates. They can go on like this for some time. That is what financial repression is all about.

      • Anonymous says:

        Joseph Stiglitz also mentioned recently that long term zero rates kill job creation as it beats down the cost of labour so investment is in the form of capital intensive investment so that job creation is minimal. The problem is that as financial repression does its damage it weakens households so that come the next recession more and more have lower incomes. 

      • Dave Holden says:

        True enough. That said it was becoming more and more politically untenable, given the BOE remit which is solely an inflation target. “Fortunately” for the BOE the elephant in the room – private sector deleveraging – is now coming back to the fore, so it looks like we’re going to get an inflationary hiatus. However, with interest rates as low as they can go, and the only outlet valve policy makers are willing to consider being those most likely to lead to continued currency devaluation, one wonders how long that will last.

        • Anonymous says:

          There are two issues, inflation of day to day items and deflation of assets. It is the fear of the later that is stopping the BOE actually raising interest rates to counter inflation. While there are statistical effects that will lower inflation shortly, mainly the fact that the increase in VAT will fall out of the statistics. So lowering headline inflation, so we can expect more QE to stop the slump in asset prices. 

          • Dave Holden says:

            Interesting idea that BOE will use QE as a mechanism to prevent a slide in asset prices, more evidence of asymmetrical policy making right there. On inflation, yes I agree that VAT falling out will help lower headline inflation, however to me it seems that the main cause of the inflation we’ve seen in the UK are two fold, currency devaluation combined with the spike in commodities provoked by QE2 (US version). Yes Krugman and MMTers blab on about it “just being an asset swap..” in fact it pushed folks into risk assets including commodities.

          • Dave says:

            Interesting idea that BOE will use QE as a mechanism to prevent a slide in asset prices, more evidence of asymmetrical policy making right there. On inflation, yes I agree that VAT falling out will help lower headline inflation, however to me it seems that the main cause of the inflation we’ve seen in the UK are two fold, currency devaluation combined with the spike in commodities provoked by QE2 (US version). Yes Krugman and MMTers blab on about it “just being an asset swap..” in fact it pushed folks into risk assets including commodities.