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Friday, April 12, 2024



Courtesy of The Pragmatic Capitalist 

High angle view of a globe on a heap of Indian banknotes and Euro banknotes Vertical

This idea that the United States is the next Greece persists.  We saw it several times this week from various analysts and the regular pundits who continue to trot out this argument despite having been terribly wrong about their hyperinflation and/or default thesis over the last few years.  I think it’s very important that investors understand that the United States cannot default on its obligations in the same way that Greece, a US state or a household can.  Why is it important to understand this?  Because markets are psychologically driven.  Regular readers know I am not the most optimistic prognosticator.  Anyone who has read this site over the last few years knows that I have and continue to believe we are mired in a balance sheet recession.  My outlook is not rosey, but it is not dire either.  I do not believe doom is on the horizon and I most certainly do not believe the United States, as the sovereign supplier of a non-convertible floating exchange rate currency, will default on its obligations.

At the center of this argument is the actual workings of our monetary system. So, how does the United States actually fund itself?  Unlike a household, the United States does not require revenue or debt to fund itself.  The United States government simply credits bank accounts.  They walk into a room and input numbers into computers – literally.  This might sound counter-intuitive to the rest of us who fund our spending through debt issuance or revenue streams, but the same is not true for the Federal Government. This was best explained last week in an interview on BNN by Marshall Auerback, a portfolio strategist with RAB Capital:

“Governments spend by crediting bank accounts.  The causation is that you spend money first.  What happens afterwards is bonds are issued as a reserve drain.  They don’t actually fund anything.  This is one of the great myths that is perpetuated by most of the economics profession.  So the idea that we have “unfunded liabilities” is ludicrous.  If we declare a war, for example, in Iraq or Afghanistan, we don’t go to our bond holders.  We don’t go to China to give them a line-item veto for what we can and can’t spend.  We just spend the money. The implicit assumption here is that somehow we have some external constraint.  The only time you have an external constraint in regards to debt is when you operate a currency peg or when you cede fiscal sovereignty to another entity as in the case in the European Monetary Union or you have foreign denominated debt in which case you need to have sufficient funds on hand in order to repay that debt.  But it’s a non-issue for a country like Canada or the US which is a sovereign nation issuing a fiat currency – a non-convertible currency. It’s a nonsensical concept.  The whole idea of ponzi schemes make no sense when you have no external constraint.  Now, clearly, when I make this point I am not trying to suggest that spending can go on to an unlimited degree.  There is a constraint.  The constraint is called inflation.   But we’ve got high levels of unemployment and we’ve got very very significant output gaps so I don’t think that’s  a risk we need to worry about right now.   But clearly when I’ve made this point in the past people tend to characterize it as ‘well you don’t think deficits matter’.  That’s not what I am saying at all.”

This is such an excellent paragraph that I would urge you to read it several times.  But for sake of this discussion I would like you to focus on the bold comments.  Marshall notes that we do not ask China to approve our spending.  This should hit you like a ton of bricks if you are convinced that China actually funds our spending.

When you spend money you either have savings or perhaps you have credit.  Maybe a credit card company has approved a certain amount of spending up to a limit.  Maybe your banker has approved a loan up to a certain limit.  But the important fact here is that you obtain the funds first.  The bank or credit card company approves the loanfirst.  You don’t spend money and then borrow.  That would be nonsensical.  The Federal government, on the other hand, does no such thing. The US government doesn’t have a red phone that is used to call China before it spends money.    In essence, they just spend the money and essentially say “you’re going to take this and enjoy it China”.  That should strike you as incredibly odd and raise questions about everything the media, professors and the punditry force down your throats on a daily basis about being indebted up to our necks to foreigners.  It is all hogwash.

So now you must be wondering why the bond market exists if it doesn’t fund anything.  I explained this a few weeks ago:

“The government bond market is merely a monetary tool that the central bank utilizes to control the cost (or supply) of money by controlling the level of reserves in the system. So, when the government auctions bonds they are merely targeting reserves in the system. This action is mandated by Congress as an accounting tool and so is seen as a source of funding, however, in reality the Central Bank is merely draining reserves that the Treasury already spent into existence – reserves that were deposited at various banks (read this process in greater detail here). Therefore, it’s incorrect to argue that there won’t be buyers of U.S. bonds – with the banks earning 0.25% on their reserves and the government offering anything above that (depending on duration) the trade is a no-brainer for the banks who hold these reserves. The government is basically offering them free money and the Central Bank keeps control of the money supply in exchange (at least in theory). What is not occurring is some sort of funding mechanism. The Fed could care less if the auctions are 2X, 3X or 4X oversubscribed. They don’t get extra money when this occurs. They don’t get a gold coin that can then be spent. So long as they meet the 1:1 bid to cover the auction is a huge success because they drained their targeted reserves and convinced Congress that we aren’t going bankrupt.”

The government bond market isn’t this great funding tool.  It is merely a monetary tool that is use to control interest rates.  This is important because it helps you to recognize the sequence of events here.  We are spending first andthen issuing bonds.  The bonds are issued to control the level of reserves in the system which subsequently helps the central bank control interest rates (and and in theory, the amount of money in the system).  This should show you again, that something is substantially different here from the way a household, US state or country in the EMU funds itself.

I know I haven’t had the most uplifting macro outlook over the last few years.  But I try my best to be a realist about the current environment.  The USA is mired in a painful balance sheet recession that is the result of excessive levels of private sector debt.   The de-leveraging of that bubble in debt will be difficult, however, it will not destroy this country.  Unfortunately, the US government has done little to alleviate the pressures on the private sector.  They have bailed out the losers at every step of the way and propped up industries and sectors that should have been allowed to collapse.  Meanwhile, Main Street has suffered. Despite their many mistakes it’s important that we recognize the US government is not at risk of becoming insolvent.  It’s not wrong to be frustrated with the state of the economy and the ineptitude of government, however, the fear mongering over total collapse and doom is not only unfounded, but potentially very destructive to future policy, sentiment and most importantly your investment portfolio. 

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