I was on RT’s Capital Account on Friday night talking to Lauren Lyster about QE and the conversation moved more into the realm of fiat currency and government’s coercive taxing power. This is particularly relevant given arguments within Republican circles about returning the US to the gold standard.
Last July I wrote a post about fiat money called “Government tax coercion versus fiat money liberty“. The gist here was that there is a basic mismatch in terms of government limits on the asset and liabilities sides of its balance sheet. On the one hand, government has the right to force everyone to transact and pay tax only in money it creates, the penalty being prison. That gives government coercive power over the asset side of its balance sheet. Yet, on the other hand, there is almost no constraint on government’s ability to deficit spend and create private sector net financial assets. Likewise, there is almost no constraint on the central bank’s dictating private sector interest rates by creating base money and swapping that money for financial assets in the private sector.
My point at the time was that this is a recipe for cronyism. The question is what to do about it. The standard solution has been to tie government’s hands on the liabilities side. Different currency areas use different regimes. Some emerging markets have used a currency board or a currency peg to tie their currency to a more stable currency in the hopes this would act as a limitation. Other countries use a currency peg. The US has forbidden the central government from having an overdraft facility at the central bank and has mandated it issue debt securities, just one specific type of government liability, to cover deficits. The US also has a debt ceiling as an artificial constraint to tie government’s hands.
None of these artificial constraints work magic. Argentina collapsed despite its currency board as a balance of payments problem built up. China has a US dollar peg and it has had the reverse problem of current account surpluses leading to massive reserve accumulation and an unbalanced economy ridden with resource misallocation. In the US, private sector credit growth has consistently outpaced nominal GDP growth, leading to ever-rising private sector debt levels. And now with private debt growth limited by the inability to lower the fed funds rate, deficit spending has soared without any increase in interest rates – just the opposite of what believers in bond vigilantism would tell you.
The notion that market discipline will cause governments to be brought to heel is laughable. All evidence shows the opposite, that there are no short- or medium-term consequences meted out by bond markets. It always cruises along for easy sailing for long periods and then ends violently in crisis. And then the question is whether to relax the self-imposed government liability creation restraints.
The euro area has eliminated the ability of national central banks to control reserve creation, while forcing deficits to be below 3% of GDP. I have called this a modern day gold standard. “I like to think of the Euro as gold and the Euro countries as having implicitly retained their national currencies with a fixed rate to the Euro”. And what do we see? As in the 1920s, the ‘standard’ didn’t prevent crisis. You could even argue that the standard induced complacency as people deluded themselves that market discipline actually worked. And when crisis hit, the standard has actually made things worse, both now and in the 1930s. In the depression, the countries that dropped the peg quickest, recovered.
In the end, there are only two ways to get out of a private sector debt crisis, which this is. You have to either reduce the debt levels or increase the income or GDP levels. You can also do both. Deficit spending attacks the denominator of the debt to income or debt to GDP metric by trying to increase net financial assets in the private sector enough to increase incomes and jump start the economy. Default and debt forgiveness attack the numerator by reducing debt loads but they simultaneously add a deflationary impulse to the economy because someone’s debt is someone else’s income. QE is an attempt to do both by reducing interest costs and inflating asset prices as a result. This boosts income and lowers the increase in debt. The unintended consequences in terms of resource misallocation, speculative investing and foregone interest savings are large.
No government is going to stand idle in the face of crisis. They will employ all of these tactics. But vested interests and ideology will sway policy toward one policy response over another. My view is that the deflationary route will be much more difficult to hoe politically and socially. And so eventually every nation with a large private sector debt burden and substantially all government liabilities in a currency it could create will throw off the self-imposed fiscal and monetary constraints. The only question then is how they finesse the ideological, political and legal hurdles in doing so.
As an investor, I would count on reflation as the policy trend then. The caveat here is that significant deflationary relapses will punctuate the trend violently enough to wipe out anyone fully committed to a reflationary-sided speculative position. Just ask John Paulson. This is classic secular bear market stuff. The upturns in bear markets are still long. And the updraft is even more powerful than in bull markets. Think 1933-1937 or 1974-1980. It’s just that, in a secular bear market, when the reflationary trend hits a political or ideological speed bump, the downdraft is much more severe.