When is Government-Issued Debt Safe? If You Think This is Only True When Debt is Below Some Threshold You May be Dead Wrong

This story began in earnest back in the early 1990’s when Italian government bonds denominated in lira yielded about 2% more than the cost of borrowing the lira from the banks. One could buy Italian securities at about 14%, and borrow the lira to pay for them at about 12% for the term of the securities. This was a free lunch of 2% apart from one thing- the perceived risk of default by the Italian government. Professor Rudi Dornbusch, an influential academic economist, was insisting Italy was on the verge of default because of their debt to GDP ratio exceeded 110% and the lira interest rate was higher than the Italian growth rate. This situation caught my attention as there was easy money to be made if one knew for sure the Italian government wouldn’t default.

So I started brainstorming the issue with my partners. We knew no nation had ever defaulted in its own currency with a floating exchange rate policy, and defaults only came with gold standards, fixed exchange rates, external currency debt, and indexed domestic debt. But why? The answer given was ‘because they can always print the money.’ Fair enough, but no one ever did ‘print the money,’ so there must be a better reason.

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 Fed) and we own the same thing, 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. Obviously in fact they are the same- it’s all just a glorified reserve drain!’

Not long after that Maurice Samuels, then a portfolio manager at Harvard Management, set up meetings in Rome with officials of the Italian government to discuss these issues. The pivotal meeting was with Professor Luigi Spaventa at the Italian Treasury. I opened with ‘Professor Spaventa, this is a rhetorical question, but why is Italy issuing Treasury securities? To get lira to spend or, rather, because if you don’t issue securities, the lira interbank will fall to 0 when your target rate is 12%?” Professor Spaventa at first looked puzzled, not prepared for that kind of question, then took a minute to think about it, and replied, “no, the interbank rate would only fall to ½% as we pay ½% interest on reserves.” Perfect answer for us- here was a Finance Minister who actually understood monetary operations and reserve accounting! A few seconds later he jumped up out of his seat proclaiming “Yes! And they (the IMF) are making us act pro cyclical! A 20-minute meeting went on for two hours as he called in his associates, and made cappuccino for us before we had to run to the next meeting. A week later an announcement came out of the Italian Ministry of Finance- ‘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 denominate bonds outside of Italy, and managed a pretty good few years out of that position. Italy did not default, nor was there any solvency risk.  Insolvency is never an issue with non convertible currency and floating exchange rates.

Author: Warren Mosler