Myth Busting


There appears to be great confusion over the recent rally in US Treasuries.  While US politicians play political chicken and bounce around a potential default, bonds just refuse to sell-off.  And America’s economists are confused.

A comparison that has been going around in recent days is between Japan and Italy.  And Japan is in many ways analogous to the USA in this environment.  The overarching similarity is an autonomous monetary system.  But this appears to slip past the brightest economists.

Paul Krugman takes a crack at why Japan’s bond market remains oblivious to its issues:

“What is true is that the Bank of Japan is keeping rates at zero, while the European Central Bank seems determined to raise rates. Is that enough to explain the difference? Or is it something about the absence of a proper lender-of-last-resort function?

Or, finally, do Japanese politics — for all their disappointments — just look more mature than those of Italy?

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

Scott Sumner later added his own thoughts to the subject.  And this morning James Kwak is asking the same question about US Treasuries.

But there’s something far simpler occurring here that consistently causes a huge amount of misconception in the markets and economic circles where the “best” thinkers dominate the agenda with their defunct gold standard paradigm.  Edward Harrison at Credit Writedowns provides the answer to our headline question:

“But when I see Italy and Japan, I think currency sovereignty: the ability, not the willingness of government to hand you another paper IOU with the exact same amount printed on it” when you present it with an obligation in the currency of account.

Japan has currency and inflation risk and all the other risks I outlined but it has an infinite ability to hand you government-created IOUs. Italy does not and can be bankrupted as a result. It’s as simple as that.”

Ding ding ding!  Someone give Edward a gold star.  There’s no such thing as Japan “running out” of Yen.  Just like the USA can’t run out of US Dollars.  So bond markets essentially focus on one facet of the market – the inflation risk.  As we all know, Japan is still battling very low inflation.  And the USA can’t seem to get much traction going on the inflation front either.   So why aren’t treasuries cratering?  Because there’s no such thing as an autonomous currency issuer “running out” of the currency that they have an endless supply of.   As Edward said, “It’s as simple as that.”

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