Twenty Years Ago - An Italian Epiphany Circumstances in the early 1990’s led me to an understanding of the actual functioning of a currency. Back then, it was the government of Italy, rather than the United States, which was in crisis. Professor Rudi Dornbusch, an influential academic economist at MIT, insisted that Italy was on the verge of default because their debt-to-GDP ratio exceeded 110% and the lira interest rate was higher than the Italian growth rate. Things were so bad that Italian Government Securities denominated in lira yielded about 2% more than the cost of borrowing the lira from the banks. The perceived risk of owning Italian government bonds was so high that you could buy Italian government securities at about 14%, and borrow the lira to pay for them from the banks at only about 12% for the full term of the securities. This was a free lunch of 2%, raw meat for any bond desk like mine, apart from just one thing; the perceived risk of default by the Italian government. There was easy money to be made, but only if you knew for sure that the Italian government wouldn’t default. The “Free Lunch” possibility totally preoccupied me. The reward for turning this into a risk free spread was immense. So I started brainstorming the issue with my partners. We knew no nation had ever defaulted on its own currency when it was not legally convertible into gold or anything else. There was a time when nations issued securities that were convertible into gold. That era, however, ended for good in 1971 when President Nixon took us off the gold standard internationally (the same year I got my BA from U-Conn) and we entered the era of floating exchange rates and non-convertible currencies. While some people still think that the America dollar is backed by the gold in Fort Knox, which is not the case. If you take a $ 10 bill to the Treasury Department and demand gold for it, they won’t give it to you because they simply are not legally allowed to do so, even if they wanted to. They will give you two $ 5 bills or ten $ 1 bills, but forget about getting any gold. Historically, government defaults came only with the likes of gold standards, fixed exchange rates, external currency debt, and indexed domestic debt. But why was that? The answer generally given was “because they can always print the money.” Fair enough, but there were no defaults (lots of inflation but no defaults) and no one ever did “print the money, ” so I needed a better reason before committing millions of our investors funds. A few days later when talking to our research analyst, Tom Shulke, it came to me. I said, “Tom, if we buy securities from the Fed or Treasury, functionally there is no difference. We send the funds to the same place (the Federal Reserve) and we own the same thing, a Treasury security, which is nothing more than account at the Fed that pays interest.” So functionally it has to all be the same. Yet presumably the Treasury sells securities to fund expenditures, while when the Fed sells securities, it’s a “reserve drain” to “offset operating factors” and manage the fed funds rate. Yet they have to be functionally the same - it’s all just a glorified reserve drain! Many of my colleagues in the world of hedge fund management were intrigued by the profit potential that might exist in the 2% free lunch that the Government of Italy was offering us. Maurice Samuels, then a portfolio manager at Harvard Management, immediately got on board, and set up meetings for us in Rome with officials of the Italian government to discuss these issues. Maurice and I were soon on a plane to Rome. Shortly after landing, we were meeting with Professor Luigi Spaventa, a senior official of the Italian Government’s Treasury Department. (I recall telling Maurice to duck as we entered the room. He looked up and started to laugh. The opening was maybe twenty feet high. “That’s so you could enter this room in Roman times carrying a spear,” he replied.) Professor Spaventa was sitting behind an elegant desk. He was wearing a three-piece suit, and smoking one of those curled pipes. The image of the great English economist John Maynard Keynes, whose work was at the center of much economic policy discussion for so many years, came to mind. Professor Spaventa was Italian, but he spoke English with a British accent, furthering the Keynesian imagery. After we exchanged greetings, I opened with a question that got right to the core of the reason for our trip. “Professor Spaventa, this is a rhetorical question, but why is Italy issuing Treasury securities? Is it to get lira to spend, or is it to prevent the lira interbank rate falling to zero from your target rate of 12%?” I could tell that Professor Spaventa was at first puzzled by the questions. He was probably expecting us to question when we would get our withholding tax back. The Italian Treasury Department was way behind on making their payments. They had only two people assigned to the task of remitting the withheld funds to foreign holders of Italian bonds, and one of these two was a woman on maternity leave. Professor Spaventa took a minute to collect his thoughts. When he answered my question, he revealed an understanding of monetary operations we had rarely seen from Treasury officials in any country. “No,” he replied. “The interbank rate would only fall to 1⁄2%, NOT 0%, as we pay 1⁄2% interest on reserves.” His insightful response was everything we had hoped for. Here was a Finance Minister who actually understood monetary operations and reserve accounting! (Note also that only recently has the U.S. Fed been allowed to pay interest on reserves as a tool for hitting their interest rate target). I said nothing, giving him more time to consider the question. A few seconds later he jumped up out of his seat proclaiming “Yes! And the International Monetary Fund is making us act pro cyclical!” My question had led to the realization that the IMF was making the Italian Government tighten policy due to a default risk that did not exist. Our meeting, originally planned to last for only twenty minutes, went on for two hours. The good Professor began inviting his associates in nearby offices to join us to hear the good news, and instantly the cappuccino was flowing like water. The dark cloud of default had been lifted. This was time for celebration! A week later, an announcement came out of the Italian Ministry of Finance regarding all Italian government bonds - “No extraordinary measures will be taken. All payments will be made on time.” We and our clients were later told we were the largest holders of Italian lira denominated bonds outside of Italy, and managed a pretty good few years with that position. Italy did not default, nor was there ever any solvency risk. Insolvency is never an issue with non-convertible currency and floating exchange rates. We knew that, and now the Italian Government also understood this and was unlikely to “do something stupid,” such as proclaiming a default when there was no actual financial reason to do so. Over the next few years, our funds and happy clients made well over $ 100 million in profits on these transactions, and we may have saved the Italian Government as well. The awareness of how currencies function operationally inspired this book and hopefully will soon save the world from itself. As I continued to consider the ramifications of government solvency not being an issue, the ongoing debate over the U.S. budget deficit was raging. It was the early 1990’s, and the recession had driven the deficit up to 5% of GDP (deficits are traditionally thought of as a percent of GDP when comparing one nation with another, and one year to another, to adjust for the different sized economies). Gloom and doom were everywhere. News anchor David Brinkley suggested that the nation needed to declare bankruptcy and get it over with. Ross Perot’s popularity was on the rise with his fiscal responsibility theme. Perot actually became one of the most successful 3rd party candidates in history by promising to balance the budget. (His rising popularity was cut short only when he claimed the Viet Cong were stalking his daughter’s wedding in Texas.) With my new understanding, I was keenly aware of the risks to the welfare of our nation. I knew that the larger federal deficits was what was fixing the broken economy, but I watched helplessly as our mainstream leaders and the entire media clamored for fiscal responsibility (lower deficits) and were prolonging the agony. It was then that I began conceiving the academic paper that would become Soft Currency Economics. I discussed it with my previous boss, Ned Janotta, at William Blair. He suggested I talk to Donald Rumsfeld (his college roommate, close friend and business associate), who personally knew many of the country’s leading economists, about getting it published. Shortly after, I got together with “Rummy” for an hour during his only opening that week. We met in the steam room of the Chicago Racquet Club and discussed fiscal and monetary policy. He sent me to Art Laffer who took on the project in 1994 and assigned Mark McNary to co-author, research and edit. Soft Currency Economics, which follows was published in 1996. Warren Mosler, Soft Currency Economics II (Modern Monetary Theory) amazon/Soft-Currency-Economics-II-MMT-ebook/dp/B009XDGZLI/ref=tmm_kin_swatch_0?_encoding=UTF8&sr=8-1&qid=1420950157
Posted on: Sun, 11 Jan 2015 04:24:27 +0000
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