Credit Writedowns

I see that Paul Krugman has shifted his rhetoric in a recent post on British government economic policy. Let me explain how in this post so that I can make a point as to how bond market vigilantes actually work.

The reality of course, is that euro zone governments do have to worry about losing market favour. They cannot rely on the central bank as a debt buyer of last resort the way the Japanese, the British or the Americans can. If, for whatever reason, sovereign debt buyers become skittish about euro zone sovereign obligations, the impact is immediate and yields rise. In a worst case scenario, you get a crisis and default as we did in Greece. So the impetus to keep sovereign debt levels manageable is clear. This makes the euro zone different from other currency areas that have currency sovereignty and flexible nonconvertible currencies.

I was on the Daily Ticker with Lauren Lyster talking about Japan yesterday. My view is that there is no material negative change in Japan’s sovereign debt outlook nor will there be in the medium term because of Abenomics. The video is at the bottom of this post. Before you watch it let me say a little bit about why I take this view on Japan and speak more generally about government debt and deficits. Mike Konczal wrote a post that is getting a lot of buzz on high deficits and Reinhart and Rogoff that will be a good jumping off point for discussion.

This is a good interview with Kyle Bass because it cuts to the heart of the matter. If you are a partisan in the Bass debate on Japan, you can see him as being either correct or incorrect. Now, I have covered this before and I have stressed that he is looking to make an asymmetric bet on outlier events to hedge his market-long portfolio. He is not taking a flyer via outsized risk exposure to short JGB trades. And Bass does make this clear in his commentary. Nonetheless, his macro view of the way interest-rate targeting central banks operate in a fiat currency system is completely wrong.

Long-term interest rates are a series of future short-term rates. That necessarily means that an interest-rate targetting central bank exerts the dominant influence not just on the short end in its currency area, but across the yield curve. Nevertheless, a lot of people act like this isn’t true. The bond vigilante paradigm, for example, is a clear violation of this principal. Ben Bernanke sets the record straight.

For domestic investors, the safe haven asset class are government liabilities if the government has substantially all liabilities in the currency it creates. For foreign investors, like domestic investors, you want to protect against default risk by investing in a currency area’s risk-free asset class but you also want to mitigate currency risk. That’s what safe haven risk is all about. The other stuff is irrelevant.

The financial crisis has reduced the ranks of countries with pristine macro fundamentals. Thus, the availability of safe assets has declined precipitously. Investors in a bind where they have funds to invest but a limited number of options, both in terms of yield and in terms of asset quality. The result has been a schizophrenic risk-on risk-off kind of investing environment. I expect this behavior to continue.

The key to Spain’s turning the corner as 2013 begins is the housing market. This takes on increasing importance given the reprieve in crisis interest rates. House prices are still falling and the economy is contracting despite the improvement, making a return to crisis possible.

The French housing market transaction volume declined by 25% last year, according to Century21. The fall in the French housing market is just beginning. And given the macro problems in France and the previous run up in house prices, the housing sector will take on increasing importance in France as a credit decelerator as France struggles with the sovereign debt crisis.

Until just recently, Germany was more indebted than Spain. The country was the first, along with France, to breach the Maastricht Treaty’s 3% hurdle for annual deficits in 2005, prompting a change in the rules. And Germany has also been in violation the Maastricht Treaty’s stability and growth pact provision on government debt to GDP. In sum, the German government’s macro financials [...]

Here’s a very good video on MMT with Stephanie Kelton, the chair of the Economics department at the University of Missouri at Kansas City talking to Lauren Lyster of RT’s Capital Account. As you know, despite my Austrian bias and my remaining allegiance to what Marshall Auerback calls “deficit terrorism”, I think MMT’s descriptive framework is compelling in many regards. [...]

Note: this daily will not have links as I am still on holiday. But, I will begin to post more in the coming week and resume a normal posting schedule next week. Yesterday, Moody’s Investors Service finally downgraded the sovereign credit ratings for France from AAA. This was a long time coming because France’s sovereign fundamentals are no better than [...]