A PUZZLE SOLVED!

Way back in July Paul Krugman asked why Italian and Japanese bond yields were diverging despite similar debt and demographic issues. He didn’t have a firm answer (his words, not mine):

“A question (to which I don’t have the full answer): why are the interest rates on Italian and Japanese debt so different? As of right now, 10-year Japanese bonds are yielding 1.09%; 10-year Italian bonds 5.76%.

…I actually don’t have a firm view. But it seems to be an important puzzle to resolve.”

In today’s NY Times op-ed he appears to have resolved this great puzzle:

“What has happened, it turns out, is that by going on the euro, Spain and Italy in effect reduced themselves to the status of third-world countries that have to borrow in someone else’s currency, with all the loss of flexibility that implies. In particular, since euro-area countries can’t print money even in an emergency, they’re subject to funding disruptions in a way that nations that kept their own currencies aren’t — and the result is what you see right now. America, which borrows in dollars, doesn’t have that problem.

The other thing you need to know is that in the face of the current crisis, austerity has been a failure everywhere it has been tried: no country with significant debts has managed to slash its way back into the good graces of the financial markets. For example, Ireland is the good boy of Europe, having responded to its debt problems with savage austerity that has driven its unemployment rate to 14 percent. Yet the interest rate on Irish bonds is still above 8 percent — worse than Italy.”

It’s great to see that we’re making progress in understanding all of this. And while Dr. Krugman’s article does an excellent job dispelling many of the myths regarding the Euro currency, we could have all saved a lot of time, energy and pain if we’d just listened to the Post-Keynesian economists like Wynne Godley and Warren Mosler who have been saying this for years.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. Yep, yep, I noticed the same thing. A very fair assessment. I’ve been closely following Krugman, nothing else to see here.

    Well done MMT.

    • Yeah, no, I dunno. I’ve lost a lot of respect for Krugman since I expect much more from him. And he’s not delivered. But THIS? It’s painful to watch unfold. I’m not sure what else to say.

    • One of the most important principles of good leadership is giving credit where credit is due.

      This principle acknowledges individuals and encourages the flow of our collective wisdom instead of a few untested ideas.

      It appears to be increasingly rare commodity in todays world of intellectual theft.

    • A suggestion that I think connects to recognition of MMT…

      Start a Google search with the 3-letter only key: MMT

    • As someone said: maybe he is not a Mensch.

      I have been pestering him on his blog: where is MMT’s credit?

    • Cullen- I don’t pretend to understand….ok..let me be honest. I don’t understand every inter workings of economics. I know I don’t know alot. So I keep on keeping on reading more and more here and there etc.

      Via Ritholtz site I was put in contact with Paul Brodsky..who I reached out to and like you was extremely kind to visit with me.

      Ok..His latest missive raises many issues I think the highly educated on the other side have with MMT. Answer these and I think you have a game changer. I can’t. I’m not there yet in my understanding. I’m much further along then I was a year ago but…I defer to you. Like a student to a his Mentor. I’m sure you have heard about his latest missive. http://www.qbamco.com. Some of his points I can tackle but others I would benefit from you wisdom. It get’s good on page 8 and on. Appreciate if you could help me. I could send you the questions he raises directly that I’m having a tough time grasping.

      Thanks Cullen

      • As usual, I am experiencing technical difficulties. The site requires a login. Do you have the actual link to the document you are referring to? Or is this one of their newsletters?

  2. For those that follow Kyle Bass, he is adamant that Japanese bond yields will rise significantly in the coming years to the point I’m pretty sure I read that he took a mortgage out on his home in yen, not dollars, in anticipation of this event.

    Seems like Mr. Market is a little slow in realizing how dangerous this sovereign debt crisis is. A couple months ago it was all Greece Greece Greece in the news. Now Italy gets all the attention. If Bass is right, in the near future we’re going to be talking about rising yields in Japan, France, and then the US. Scary stuff.

    • “A couple months ago it was all Greece Greece Greece in the news. Now Italy gets all the attention. If Bass is right, in the near future we’re going to be talking about rising yields in Japan, France, and then the US. Scary stuff.”

      The question seems to me to be, “what mechanism will cause yields on sovereign bonds of the various countries to rise?”

      http://pragcap.com/i-want-to-come-back-as-the-federal-reserve-you-can-intimidate-everybody

      • I can’t predict when yields will rise in the US, Japan, and the UK. Yields can stay near zero for longer than most people think (for example Japan). The only thing that can force the Fed to raise rates is a persistent and uncontrolled rise in inflation. We aren’t going to get such inflation until Labor regains pricing power, either through a large reduction in unemployment, or new, pro-union legislation. We could get a huge rise in energy prices due to global shortage, and this could be the spark that ignites new pro-union legislation.

        • Mr. Bass is a smart man, no doubt, but he operates under a flawed monetary understanding. He thinks, for a number of misinformed reasons, that Japan, the U.S., etc. will not be able to meet their “debt” obligations in the future. This is incorrect. Any country that is the monopoly issuer of its own non-convertible, free-floating currency will always be able to meet its obligations. In fact, all such countries could unilaterally retire all their current “debts” by swapping their bonds at par for bond-denominated currency without it having any inflationary effect. As Cullen is wont to say: it’s identical to shifting your savings balance to your checking balance. It will not impact your propensity to spend, and it does not alter the net assets you have, therefore it is not inflationary.

          • “bond-denominated currency”

            Could you explain this a little more.

            I understand the, “Any country that is the monopoly issuer of its own non-convertible, free-floating currency will always be able to meet its obligations.”

            So the next step “In fact, all such countries could unilaterally retire all their current “debts”” has always seemed logical.

            But I’ve never figured out how it would work.

            • When I started learning MMT, I stumbled on this one as well. It really helped to simply visualize it as an bookkeeping entry in accounting– Let’s say you have $10,000 in government bonds (“national debt” to the mainstream) in your possession. To you this is an asset- and the govt’s liability. If the treasury were to call in your bonds and give you a check for 10 grand, what would you have? A $10,000 asset- same as before; but now the “liability” no longer exists, i.e., no “national debt”. this is not inflationary because your bonds are essentially liquid anyway since you can very easily swap them for cash. If you needed to spend that money, you would already be doing so; you are holding bonds as a form of savings. The asset swap would only be inflationary if by having cash instead of bonds you had a burning urge to go on a shopping spree now (though in fact, it’s the INCREASED DEMAND from the spending that is an inflationary pressure and not the cash itself). Does this help? Did I get it right?

              • Beethoven, I can’t guarantee its right but it certainly is logical and fills in a gap. Thanks!

                One more thing if you don’t mind…

                So on the govt side they just reduced the “debt”. So if they did a lot of this, well, sounds like a solution. Can’t be that easy. What am I missing?

                • Work– You’re not missing anything. It’s really that easy. There are plenty of difficult problems around, but the U.S. “national debt” is not one of them.

                  Suppose the entire national debt were to be monetized. As described by Beethoven, there would be a lot of people and institutions holding cash and looking for alternative places to save (since U.S. government bonds were no longer available). So there would be a greater demand for the alternative saving mechanisms, and the prices of these alternative assets would rise due to the increased demand.

                  Thus, for example, during the recent “quantitative easing” (QE2), the Fed monetized $600 of “national debt”. What happened to the $600 billion of cash that replaced the former bonds? Much was left in bank reserves, earning 1/4% interest from the Fed. Perhaps some was invested in commodity funds, driving up the prices of oil and other commodities.

                  Since government bonds are risk free (since they are issued by the currency issuer, who can never run out of currency to issue (barring political nonsense such as the debt ceiling)), if there were no national debt, there would be more risk in saving. Institutions saving to pay out pensions, for example, would be forced into riskier saving alternatives…

                • Thanks for that, it helps.

                  Let me ask about a different example. Congress approve a job bill for $500 billion.

                  Now I understand that theoretically they don’t need to fund it from someplace – they could simply create cash out of thin air. But in practice they do. (Assume that’s a law??)

                  So they issue Treasury bills of some kind for $500 billion and then they get $500 billion of cash for that. They spend that cash on jobs programs (hopefully productively).

                  Now as I understand it (which could be wrong) the “normal” process would be that they have this expense for the jobs spending and someday they’ll have to pay back those Treasuries that funded it. So they tax people $500 billion. They now have the cash to redeem/payback the bonds. And they have tax revenue to offset the jobs program expense. Everythings in balance.

                  So if they want to get rid of the debt earlier, where do they get the cash without creating more debt?

                  I guess I get the big theory but what would be the accounting for cash created out of thin air?

                  • “So if they want to get rid of the debt earlier, where do they get the cash without creating more debt?”

                    From an accounting perspective, the national debt is an accumulation of yearly budget deficits. Similarly, to pay down the national debt, we would need to run consistent budget surpluses. Like for the next 200 years…via tax increases or spending decreases, or a combination of the two. You know, run a government “profit” at the sole expense of the private sector. Once the national debt is paid off, taxes can be collected in hula hoops or 8-track cartridges…also know as a massive private sector garage sale. And pets don’t count. I call. ;)

                  • Thanks gee russel I’ll take a look at that.

                    Wilma, What you’re describing is how it works now and I think I generally get that. What I’m after is when I’m explaining to someone about MMT I say “Here’s how it works…” and I describe something like my example. (And I recognize that if we don’t collect the taxes right away there is a deficit and as long is there is low inflation, that debt is okay).

                    But then I try to contrast how it works to how it would work under MMT when you wouldn’t have to issue debt. No deficit; just spend. How do I expain how that works? How would it be accounted for?

                    From an accounting perspective, the national debt is an accumulation of yearly budget deficits. Similarly, to pay down the national debt, we would need to run consistent budget surpluses. Like for the next 200 years…via tax increases or spending decreases, or a combination of the two. You know, run a government “profit” at the sole expense of the private sector. Once the national debt is paid off, taxes can be collected in hula hoops or 8-track cartridges…also know as a massive private sector garage sale.

                    • Thanks for that. It was helpful although the “current procedures” puts my simple explanation to shame. On the other hand, when I think about explaining the alternative I can see the glaze halfway through the word “war..rants”.

                      Look forward to the “wonky” balance sheet treatement to see if there is a way to boil this down. (While I read the other 22 blogs.)

                    • “Look forward to the “wonky” balance sheet treatement to see if there is a way to boil this down. (While I read the other 22 blogs.)”

                      Same here. And I too need to read the other 22 since I’ve only really focused on this site until recently. Be forewarned though, MMT is a vortex…you can check-in but you can never leave. You’ll find yourself spending entire weekends on this stuff, like I’m doing now.

                      Also, since you seem to be interested in accounting identities, you may find the following helpful (as I did):

                      http://neweconomicperspectives.blogspot.com/2010/11/yes-government-bonds-add-to-private.html

  3. I feel your pain Cullen for sure. But the real geniuses rarely get the glory…it just seems to be the way this world works more often than not.

    But really it doesn’t matter….b/c more than anything what matters is the information and (hopefully) policies that will be built from that info. This is a HUGE STEP for MMT principles getting to the President…I don’t know if you caught his latest faux pas regarding the Fed buying “unlimited” Treasuries at Der Spiegel or not…but here’s the link and quote too for you below:

    Obama, at any rate, felt that they would have little value. Instead, he confronted the Germans in Cannes with a suggestion so radical that it alarmed both Merkel and Schäuble. To save the common currency, Obama proposed that the Europeans follow the example of the American Federal Reserve, which buys up almost unlimited amounts of US treasury bonds when necessary.

    http://www.spiegel.de/international/europe/0,1518,796280-3,00.html

    Really we should all flood Paul’s blog with praise and celebration and support for realizing AND POSTING this info to the world, b/c it really is a milestone. People respond much better to positive encouragement and I’ve always been a believer that if a man will criticize another’s faults he should also just as equally praise his successes but that’s just me.

    Thanks again for everything…you are definitely a large monkey that contributes greatly to the “100th monkey” whoever that may be. Good deeds never go unseen. ;)

    Cheers mate and thanks again!

  4. I may be giving Paul more credit than is due, but I wonder whether he really has got it (after all stupid he ain’t) and he’s just releasing it in Baby Steps to get his readership to follow the evolution of thought.

    Paul does understand the politics of the situation. It’s far too big a leap the announce that he’s got it, we should abolish the Central bank tomorrow, let the market set the interest rate off zero, and the Treasury will top up private bank accounts as required to offset excess private financial savings here and abroad.

    • No I don’t think PK actually gets the details…

      “In particular, since euro-area countries can’t print money even in an emergency, they’re subject to funding disruptions in a way that nations that kept their own currencies aren’t”

      The usage of the words “can’t print money” and “disruptions” would make me guess he still means they would still be fiscally constrained just less so if they had their own currencies.

  5. Now can you please go to the Germans and explain to them why what they are proposing for Europe by way of fiscal austerity is not the same process that they went through when they absorbed the East German bloc.I’m sure they think it is the same and that what they did other countries in Europe should also be able to do. Nonsense of course,but they don’t seem to know it.

  6. Disprove Krugman position by simply listing (a very long list) of countries that had massive debts and their own currencies which eventually failed.

    Japan looks ok much as the jumper half way to earth looks ok.

    Reminds me of the Tyler Cowen comfort (before the crisis) with the great moderation… he seems to have quietly faded that thesis but not reverted, as he ought, to the Austrian position for which a textbook exposition is being played out page 1 in financial press day by day.

  7. Funny thing – why just to compare Italy to Japan? First, we need to include Germany, on Italy side, as it also borrows in foreign currency. And has similar population problems (as almost all Europe does). Secondly, we would need to include UK, on Japan side, as it borrows in it’s own currency. And all mentioned currencies are not world reserve.
    So, picture becomes a little more complicated. Besides the ability to print, some other things need to be considered – structure of budget, saving rates, growth estimates, current account balance among others.
    In the end, if Italy tomorrow converts all its debt to lira-denominated, I strongly doubt its yield will be close to current levels, not even mentioning Japan’s…..

    • Italy and Japan are demographically similar, with birth rates of near 1 child per woman. They do make a good comparison in a lot of ways.

      • Right, but what about some other quite important factors? Or do you really think that birth rate and absence/presence of own currency for borrowing purposes are the two main factors explaining major developments in countries’ economics?
        I mentioned some factors, which i think are more important than birth rate in determining bond spreads. They are different for Italy and Japan, and, I believe two countries are bad comparison.

        • All those things and many others do matter but you can’t even begin to interpret those factors until you first set a context of repayment(currency user) or inflation(currency issuer) risk.

          • Partially agree. And that’s why I mentioned Germany and UK in my post. One is currency issuer, the other is currency user. And yet, look at their bonds’ spreads! Clearly, this factor is very important, but the other factors are important too, likely even more. And birth rate is close to the end of the list.
            And my point remains that the main reason for Italy and Japan to have such difference in bonds’ spreads is not currency issuer/user dilemma.

            • Here’s the way I compare them. German bonds are like the most senior tranche in a CDO and Greek bonds the most junior. They’re both exposed to the same euro risk but Germany is running the show and German bonds will be the very last to go bust if it unravels.

              Comparing German bonds to the UK is like comparing that AAA rated senior CDO tranche to say, a treasury bond. They both (for a time) carried the same risk rating but one had a repayment risk and the other didn’t. That worked… until it didn’t.

              • Interesting comparison. But do not forget – in CDO you usually have cash flows going to senior tranches by definition. It is not the case in euro union.
                Here is my comparison – let’s imagine tomorrow each country in euro union is reverting back to their own currencies, and converts all sovereign bonds denominated in euro. Then adjustments in exchange rate happen. We will soon see that germany paper goes up, probably not in terms of yield, but certainly in terms of FX. France bonds will likely deteriorate somewhat both in terms of yield and FX, and Italy and Spain will deteriorate significantly. Greece will probably go to 20-30% of old euro par….
                What i think is that the market is starting to price in this possibility…..

  8. Ouch, harsh! TPC, you’re really not going to get that Nobel now; I heard you were on the list because of your endorsement of the Swedish banking model, but those cool Swedes don’t like one of their own being taken out to the wood shed … oh, well, you and Al Gore will have to talk about something else now …

    BTW I’m not sure whether the puzzled is really solved either. One would have expected the Yen to depreciate, but I guess the market expectation is that deflation will dominate vs. EUR and USD, or the corollary, that EUR and USD will have much higher inflation (perhaps hyperinflation ;-> ).

  9. Even before ‘getting’ MMT, I sensed a problem with PK (especially after reading New Yorker piece), although tending to sympathize with his politics.

    I think it relates in his case to the age-old insularity of the Academe.

    Additional factors fostering its resistance to new/original thinking: nonfunctional status inequality (as opposed to ‘collegiality’); ethnocentrism; larger context of ideological conflict heightened by ‘Cold War’ tensions; reaction to 60′s excesses; most recently, increasingly pervasive influence of money and sources of funding.

  10. On the July article the 14th commenter was an MMTer who solved the mystery. On this latest article I scanned about 30 comments and not one MMTer to be found. Meanwhile Krugman most certainly doesn’t get it…. “America, which borrows in dollars, doesn’t have that problem.”

    Had he said “America, which prints dollars to spend….” than maybe he’d be seeing the MMT light.

  11. I still feel like I haven’t seen, by MMT’ers (which I consider myself, though definitely not the smartest of this buch), or Paul Krugman, a good explanation of what happened during the 1970′s when we had worsening unemployment AND rising interest rates, inflation, and stagnant nominal growth.

    I’m not talking Weimar or Zimbabwe here…. great explanations have been put forth… but I feel like the big, glaring hole in Keynesianism and MMT alike is the stagflation of the 1970′s into the early 1980′s.

    A

    • “…explanation of what happened during the 1970′s when we had worsening unemployment AND rising interest rates, inflation, and stagnant nominal growth”

      OPEC?

      • I (having no good reason to justify to someone why they should listen to me) would probably agree with Rharaz; at least part of the problem was cost push inflation.

        MMT doesn’t ‘do-away’ with the fact that resources are scarce or the effects of a dwindling supply of a resource a nation/economy (/world) relies upon very heavily.

      • OPEC and peak oil USA edition. Plus economy was more dependent on oil in the 70s than now.

    • The inflation data for that period follows the energy shocks pretty closely. 1973-1974 OPEC embargo (first oil shock) and some of the political choices made in response. The the second oil shock of 1979-1981 (Iranian Islamic revolution followed by Iran – Iraq war).

      1974 peak month December 12.34% (11.03% for year)
      1980 peak month March 14.76% (13.58% for year)

    • The stagflation of the 1970′s was in part (a lot) caused by the oil shocks but there were other important factors…

      1) During the late 60′s and very early 70′s the government was overspending relative to taxes to finance Vietnam. Industrial utilization was around 90% – meaning were likely over 100%. This set the stage for some demand-push inflation and rising wages. People sometimes like to point out inflation was rising even before the oil shocks and this is why.

      2) Strong unions. Unions were able to put up a fight over wages when the oil shocks happened which helped create the spiraling rise in prices. When an economy experiences a supply shock, its ability to produce declines. That means there is a real income contraction as well. As a society we didn’t do to well in deciding who was going to take the hit and unions presented enough strength to make it a real battle.

      3) Far more bad policy response than good. In the face of a supply constraint you have limited short term options – conservation and substitution. We did poorly (at first) at either. Most policy response was around demand destruction; hence rising interest rates and rising unemployment. Eventually the US relaxed restrictions on natural gas and we had a significant substitute… and we eventually destroyed demand sufficiently with the 1981 recession and 20% interest rates.

  12. Krugman is still talking about “printing money”, which shows he doesn’t get it. That’s exactly what Milton Friedman would say, and he wasn’t an MMTer.

  13. So we had, simultaneously, high inflation, high unemployment (even before the ’81 recession), and high interest rates, and chose to raise the rates even more to actually create a recession and break inflations back. What ensued afterwards was decades of prosperity.

    MMT’ers argue, though, that fears of inflation are overblown and unemployment is the bigger problem. What would they have argued in the ’70′s?? The same thing, methinks, because as long as there’s not full employment they seem to be in favor of expanding the money supply, not creating a recession to bleed inflation out of the economy.

    Today, we’re seeing high unemployment and negative real interest rates, just like the 1970′s, though actual inflation and rates are relatively low. Why was breaking the back of inflation so important back then, but today breaking the back of unemployment so much more important.

    So I guess my questions are the following:

    1) If we truly can “control” short-term rates, how did they get so high even before 1981? What would MMT have suggested to do with interest rates?

    2) How are they so sure we’ll go the route of Japan if the 1970′s are possible with a supply shock?

    3) If inflation can be bad with high unemployment simply as a result of a supply shock, then why do we act like they are mutually exclusive?

    4) If we can have high inflation AND high unemployment at the same time, how do we choose which one to battle?

    5) What would an MMT’er have said to do with monetary policy during the 70′s? Do they favor Volcker’s actions to literally create a recession?