In the first part of this series, we saw how the process of “debt monetization” - sometimes called QE - can reach a critical inflection point in which confidence in the currency is eroded. This loss of confidence can provide the “spark” which can lead to an inflationary spiral. Historically, a key element in this loss of confidence usually involves the central bank purchasing government securities at a rate of interest that is below the actual and expected rate of inflation (i.e. negative real interest rates).
In this essay, we shall see how and why this occurs.
What Triggers The Loss of Confidence In A Currency?
One of the key things that many observers have not understood about inflationary episodes in Weimar Germany and elsewhere is what triggered the initial loss of confidence in the currency.
For example, simplistic proponents of the Quantity Theory of Money (QTM) and its variants such as Monetarism sustain that inflation and the associated loss of confidence in a currency is simply a matter of the expansion of the quantity of money. This is clearly a false doctrine and its falsity is clearly demonstrated by the case of 1920 Germany and the case of the U.S. today. History has proven in these examples and in many others that stagnant prices or deflation can occur even in the face of rapid monetary expansion.
Contrary to popular belief, the loss of confidence in a currency is not something that can be determined a priori in any quantitative manner or by reference to any fixed rule. The confidence the people have in the purchasing power of a currency is largely a subjective phenomenon. This can occur with or without large rates of expansion of the monetary base. It is very much a psychological phenomenon.
What is the psychological inflection point? Many historical examples can be found. But a common element to be found in virtually all cases in which there has been severe erosion in public confidence in a currency is this: Central bank purchases of government securities – particularly long-term securities – at rates of interest that are substantially below the actual and expected rate of inflation (i.e. real interest rates).
What Determines The Value of A Currency?
Contrary to popular belief, the value of a currency is not determined by the quantity of currency in circulation.
The quantity of currency in circulation is but one of myriad factors that influence the value of a currency.
As can be seen in the Weimar example and the example of the U.S. today “debt monetization” by a central bank that leads to an increase in the monetary base will not in and of itself trigger a crisis of confidence in a currency or associated inflation.
As long as the assets purchased by the central bank are perceived to have a market value that equals or exceeds the amount of currency outstanding, then no substantial loss of confidence in the currency of that nation need occur.
In particular, if the assets purchased by the central bank are debt securities backed by full faith and credit of the government and those securities pay a positive real rate of interest (i.e. they have positive net present value) then no loss of confidence in the currency or associated inflation need occur.
Inflation is largely a function of the perceived value of a currency.
Many people have been taught to believe that “paper” currency has no value. This is utter nonsense.
Issuance of currency is not gratuitous. The images of “money printing” and “helicopter drops” are fundamentally misleading. The issuance of currency is a double-entry transaction, and as such, an evaluation of this transaction must respect the principles of double-entry accounting.
Currency issued is a liability of the central bank; currency represents a claim on the assets of the central bank.
An analogy is a bond certificate. A bond certificate is a piece of paper. But that piece of paper is valuable because it grants its holder a claim on valuable assets held by the company that issues the bond. Thus, the value of the bond does not reside in the substance that it is made of; it resides in the value of the assets that the bond gives the holder a claim on.
By the same token, since currency is a claim on the assets of the central bank, the perceived value of a currency is critically affected by the perceived value of the assets held by the central bank.
For this reason, if new issues of currency are adequately backed by valuable assets held by the central bank, no loss of confidence in the currency or associated inflation need result.
What Causes Confidence In A Currency To Erode?
In Weimar Germany, one of the landmarks in reaching the critical inflection point in the loss in confidence in the currency was when the German central bank started purchasing government securities – particularly long term government securities – at rates of interest that were significantly below actual and expected rates of inflation (i.e. negative interest rates).
Ignorant ravings by ideologues notwithstanding, government bonds are a valuable asset to its holders. They are backed by the full faith and credit of a sovereign government, which in turn is backed by the power of the sovereign government to tax and its power of eminent domain (including the power to confiscate land, gold and other assets).
In order to understand why increased quantities of money through debt monetization is not necessarily inflationary it can be helpful to analyze the analogous situation of a company that issues bonds. Just because a company issues bonds and increases the quantity of the company’s bonds in circulation does not mean that the outstanding bonds issued by the company will lose value. The bond issuance is a double-entry transaction. In exchange for issuing bonds, the company receives cash. If the company invests that cash in assets that produce sufficient cash flow to enable payment of principal and interest, then the value of the previously outstanding bonds will not be affected. Indeed, under many circumstances, the value of previously outstanding bonds can actually increase with new issues that increase the quantity of bonds in circulation.
The exact same dynamic works with the issuance of currency. There is no necessary or simple relation between the quantity of currency outstanding and its value. Indeed, the value of currency can rise while the quantity of the currency expands. The value of a currency depends on myriad factors completely separate from the quantity of that currency in circulation. Therein lies much of the fallacy of QTM and its offshoots such as monetarism. Fundamentally, what is important about the value of a currency is not its quantity but the value of the assets that back the currency.
Government bonds (TLT), when backed by the taxing power of the issuing government and when they are attached to a positive real rate of interest, are an extremely valuable asset. Indeed, given the sovereign power of the state to tax, spend and issue currency, this asset is no less valuable than a security or a currency backed by gold or any other “hard” asset. Indeed, the power of the sovereign to tax is a claim on all hard assets.
In the case of Weimar Germany, as in the case of other nations, a key inflection point came when the German central bank started to purchase government securities - long-term government securities in particular - at negative interest rates. When a central bank does this, it is engaging in a clear and transparent case of “debasement” of the national currency.
Contrary to popular belief, “debasement” does not occur when a central bank increases the quantity of currency in circulation. It occurs only when the assets purchased with the newly issued currency are not worth the face value of the currency issued in present value terms.
Government bonds purchased at nominal rates of interest that are below the rate of inflation have negative present value. When this occurs, the value of a currency issued by the central bank is backed by assets whose discounted present real value is worth considerably less than the face value of the currency issued. In other words, when the central bank issues currency in exchange for bonds that are worth less in real present value terms than the price paid for them, the value of the currency issued will tend to decline in value more or less proportionately – or perhaps even more in the expectation further purchases of this nature will be made in the future.
At some point, some members of the public come to understand that the currency that they are hoarding is being “debased” in this manner and they start to “disgorge” it. Indeed, noticing that interest rates are negative, many will attempt to borrow funds at relatively low interest rates with the expectation that they will be able to pay the debts off in the distant future with the “debased” currency. As detailed before, all of this causes an increase in aggregate demand, which fuels the initial inflationary surge.
2.0% 10Y Bond: A Line In the Sand
I believe that Fed officials have read and understand the history of inflation in other nations and in other eras. To the extent that I am correct, the Fed will not in to any substantial degree purchase 10Y Treasury securities that yield less than 2.0%. The reason is simple. 2.0% is a lower-bound limit for what the public believes to be a credibly sustainable rate of inflation. The public does not believe that the Fed will allow or will be able to sustain inflation below 2.0% in the long term. The TIPS market (TIP), public surveys (U. of Michigan) and the price of gold (GLD) clearly support this assumption. In fact, the pricing of these assets signal rising inflationary expectations. Indeed, with CPI currently accelerating and running a 3.8% annual clip, inflationary expectations are clearly on the rise.
Thus, purchasing 10Y Treasury bonds that yield 2.0% would constitute a grave danger for the value of the USD (UUP) and the prospects for inflation. It is one thing to allow panicked Europeans to purchase U.S. Treasury bonds at negative interest rates given their fears of a collapse of the euro. Such precautionary purchases of bonds poses no inflationary threat. It is quite another matter for the Fed to issue new money and purchase Treasury bonds yielding a rate of interest that is lower than the current and expected rate of future inflation. Such purchases would constitute a clear case of debasement and could set off a very rapid loss of confidence in the U.S. dollar.
The reason is clear. If the Fed purchases 10Y Treasury bonds yielding 2.0% and future inflation is 3%, the new currency issued is “debased” by approximately 10%. Assuming that investors demand a 0% real return on their investment, the present value of new currency issued in exchange for 10Y Treasury bonds yielding 2.0% is roughly 10% below the face value of the currency issued. If investors require a real return of 1.0%, the debasement is closer to 20%.
Small levels of “debasement” can be tolerated through the issue of short-term debt at negative real interest rates. For example a 1Y Treasury note purchased by the Fed at 0.2% yield implies a debasement of about 2.8% assuming inflation of 3.0%. That is roughly in line with actual and/or expected rates of inflation. Thus, issuance of short-term debt at modestly negative real interest rates does not pose a major threat.
However, when a central bank purchases Treasury notes further along the curve at negative interest rates, the debasement effect is much greater. For example, if the Fed were to purchase 10Y Treasury bonds yielding 1.0% and inflation were expected to be 3%, the debasement of the currency approaches 20%. Such a level of debasement would likely trigger the sort of de-hoarding and the sort of inflationary spiral described earlier.
The Fed has to be very careful not to become too complacent in its QE policy. In particular, the Fed cannot hope to contain an inflationary surge and an associated large rise in long-term interest rates if it begins to purchase 10Y Treasury bonds yielding significantly below 2.0%. The reason is that current holders of long-term Treasury bonds (^TNX,^TYX, IEF, TLT) (possibly even foreign central banks) will “put” back those bonds into the market, forcing the Fed to make more purchases. At some point, the issuance of currency to purchase bonds becomes so copious, the Fed’s balance sheet expansion becomes so large, and the erosion in the perceived value of the currency becomes so great, that long-term interest rates on private debt surge in the expectation of future inflation. At the same time, the pace of spending surges as the public “disgorges” hoarded currency. At this point, the inflationary spiral becomes virtually uncontainable.
I don’t expect that the U.S. will repeat the experience of Weimer Germany in the 1920s or of Argentina or Brazil in the 1970s. And I believe this precisely because I do not think that the U.S. Fed will go so far as to purchase long-duration assets at highly negative real yields – i.e. highly negative NPVs.
In this regard, I believe that 2.0% is a line in the sand. Bond purchases at yields below those levels could place the U.S. in a Weimar-type scenario.
Indeed, for the reasons cited in this article, I would not expect the Fed to purchase any substantial amount of 10Y Treasury bonds (IEF) at yields of less than 3.0%. For reasons I shall describe in one of my next articles 10Y yields below 3.0% would do absolutely nothing to lower the cost of credit in the private economy or stimulate economic activity.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short TLT and long TBT and SBND