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Since the S&P rating agency downgraded the U.S. sovereign debt in August 2011, it has sparked a firestorm among politicians, economists and investors alike. Warren Buffet has issued a challenge to the Republican Party to try to cut the deficit while doomsayers have said that the U.S. is the next Greece. In this continuing series on Soft Currency Economics, I would like to examine the facts and fiction behind sovereign debt default and the true meaning of the S&P downgrade.

When a sovereign nation's money supply is determined by the amount of hard assets that country holds, like gold or silver, the country's currency is called a hard currency. The country has to hold a certain amount of gold or silver and be ready to convert its currency into gold or silver upon request. Therefore the country cannot issue more currency than its gold and silver holdings. Europe is similar. Not because the Euro is backed by gold, but because the issuance of Euros is controlled by the ECB ("European Central Bank") and not the individual country's central banks. Therefore, countries like Greece, Italy, Spain, etc. can only spend beyond their tax collection by issuing bonds. They first issue those bonds and then get to spend the proceeds from the bond sales.

On the other hand, a soft currency or fiat money is not backed by any tangible asset and therefore, the money supply of a soft currency is solely determined by the financial and economic policies of that government. A soft currency gets it value solely from its ability to extinguish tax liabilities of that country. There is no inherent limit on federal expenses and therefore on federal spending. The U.S. Dollar is a soft currency and its issuance is controlled purely by policy and not the level of any gold or silver deposits we own.

When the U.S. government decides to spend fiat money, it adds to its banking reserve system and when it taxes or borrows (issues Treasury securities) it drains reserves from its banking system. These reserve operations are done solely to maintain the target Federal Funds rate. If the US government increased its banking reserves but failed to issue new securities, the interest rates would fall to zero. Let us take an example to better understand this concept.

One may argue that you can always sell your U.S. Dollars for other currencies or commodities, like Gold, Silver, Oil, Grains, Stocks, and so on. True, but at the end of that trading chain, somebody will be left holding the U.S. Dollars and they will need a place to park those U.S. Dollars to earn some return. If there were not enough Treasury bonds around, supply and demand dynamics would drive the investors to bid up the price of the Treasuries till the yield on them fell close to zero. Therefore, it is important to understand that in the case of a soft currency like the U.S. Dollar, the bonds are issued after the spending and solely as a means to prevent interest rates from falling to zero.

Now that we understand the mechanics of federal spending and the issuance of government securities, one can see that the spending is done before the issuance of securities and that spending is not curtailed by the government's ability to place its bonds. This leads to the next logical conclusion, which is that the government of a fiat currency (e.g. U.S., U.K. and Japan) can retire its domestic debt without financial constraint. That is a fact for all soft currencies.

What about the level of interest rates on sovereign debt? Level of interest rates on sovereign debt compete with the expected rate of return on other assets denominated in that country's currency. Therefore, the interest rate on the 30-year U.S. government bond is a statement on the expectation of risk adjusted return on other assets like stocks, which in turn is an expectation of long-term economic growth. Case in point is Japan, where the debt/GDP ratio at 228% is much higher than the US, yet the 30-year interest rates are below 2%. The Japanese GDP growth over the last 10 years has been close to 0. If a sovereign country's fiat debt was providing too high of a yield compared to other assets, investors would simply switch out of other assets into the debt, until the yield would equal the expected risk adjusted returns of other asset classes.

This brings me to the next commonly posed question: What would happen if China went to the U.S. central bank and wanted to cash in its $1 trillion worth of bonds? In the simplest terms, the U.S. central bank would print $1 trillion of paper bills and hand them to the Chinese and retire the treasury bonds. Then the Chinese would be stuck with a whole lot of paper, which they could try to sell for other goods and services, thus passing that paper to someone else. In the absence of Treasury bonds, the person stuck with all that paper would earn zero interest rate on that paper.

So what exactly is the S&P downgrade of the US debt outlook really saying? It is really a statement on the expected economic growth rate of the US economy and also a statement on the competitiveness of the US Dollar. While it is true that a sovereign government with fiat currency can print as much as it wants, it can have a detrimental effect on the value of its currency. Case in point again is the fall in the value of all fiat currencies against commodities. Therefore, the S&P downgrade is more a downgrade of the long-term economic picture of the U.S. economy and the value of the U.S. Dollar.

Source: Facts And Fiction Of Sovereign Debt Default