I discussed this topic in greater length in Section 3.5 of my book Breakeven Inflation Analysis. The conclusion was not entirely satisfactory: we do not have enough data to do a proper historical analysis of breakeven inflation accuracy. The exception might be the United Kingdom, which started issuing inflation-linked bonds in the early 1980s. However, the bizarre structure of (old) U.K. linkers meant that it would take a lot of work to examine the returns for historical bonds. The Bank of England does publish historical real/nominal/inflation yield curves, but I would be a lot happier if I could compare “physical” bond yields to the fitted curve.
Wednesday, January 19, 2022
(Note: This article was delayed because of technical difficulties. I finally found a work around.)
Although hand-wringing about Quantitative Easing and the “transitory-ness” of inflation is catching most people’s attentions, there is an interesting theoretical concern that is about to get quite pressing. That is: what is up with r* (which is the modernised version of the “natural rate of interest,” although the word “natural” was finally dropped from the jargon). Although post-Keynesians generally argue that r* does not exist — so this is a non-issue — neoclassicals cannot easily embrace that position.
Friday, January 14, 2022
Wednesday, January 12, 2022
Tuesday, January 11, 2022
Thursday, January 6, 2022
The minutes for the December 14-15 Federal Open Market Committee (FOMC) meeting were released, and the apparent hawkishness has at least temporarily caused a tizzy in frothy risk markets. From my perspective, there was not a lot of surprises in there, but I do not put a whole lot of value on micro-Fed watching. No matter what they thought they will do in December 2021, what they will do in June 2022 depends upon the data released between now and then. This article has some probably obvious comments on the outlook, as well as some theoretical rants about the underlying framework.
Tuesday, January 4, 2022
Some Areas of Applicability
I see certain areas of applicability that I will first outline.
- As a way of asserting political sovereignty, and as a possible prelude to separation from the common currency. I will return to this at the end.
- As a gimmick to boost the local economy. From my perspective, this largely applies to municipalities.
- Launch a crypto-currency to fleece suckers. This can be justified on the basis that everyone else is doing it.
Putting aside the previous disclaimers, I do not see much room for parallel currencies at the Canadian provincial level. Although I will use some MMT terminology, the logic is quite conventional. This discussion expands on the one in Section 8.6 of my book Understanding Government Finance.
The Canadian Federal Government is a currency sovereign, and the Canadian dollar has been floating for almost the entire post-1950 period (there was a short peg period within that interval). The Canadian tax system is effective, and the decks are stacked against any alternative currency. (Cross-border trade with the United States is large, and so many businesses have U.S. dollar operations. However, the volatility of the Canadian dollar means that firms operate on a largely hedged basis — tales of bankruptcies due to currency mismatches are extremely sparse. Households have ready access to U.S. dollar-denominated bank accounts, but mortgage borrowing in anything other than Canadian dollars is largely shunned. The only case I was aware of was an ex-colleague with a yen-denominated mortgage — as a speculative short — and from what I recall, he took a bath on the transaction.)
Provinces and municipalities are currency users, and they have almost the same financial constraints as private actors. They issue bonds which are rated by the rating agencies, and the spreads of the bonds generally tend to follow the ratings as well as “technicals.”
- Smaller provinces (or those with small debt outstanding) can only have small, illiquid issues. These are not attractive for trading, and so tend to have a wider spread than the rating might imply.
- Referenda for Quebec independence tends to widen spreads far in excess of what the rating might imply.
- Like corporate bonds, rating changes tend to lag events. One could back out a “market-implied rating,” and that rating might imply an upgrade/downgrade before the rating agencies react.
However, unlike the American state and local bond market or corporate bonds, Canadian sub-sovereigns do not really default in the modern era — for reasons to be discussed below. This means that the spread movements are generally not very dramatic — away from Quebec referenda. This is similar to other quasi-sovereign markets, like supra-nationals and products like German pfandbriefe.
This all leads to a fairly conventional framework for finance: the provinces and municipalities have to abide by the “rules of the game” (which are specific to their peers) to keep access to the bond market. That is, they face a financial constraint.
The Rules of the Game
The main rule that provinces and Canadian municipalities have to adhere to is that their debt levels need to be sustainable in the long term. This sounds exactly like the neoclassical financial constraint. The difference between the Canadian provinces and American states is that they are largely free of arbitrary technical rules about borrowing (e.g., balanced budget rules) and they generally do not worry about liquidity risk — short-term loss of access to financing in a crisis. Although I cannot state that provinces are default risk free, it is a reasonable working assumption is that they are too big too fail: if they do not do something that greatly angers the Federal government, the Federal Government and/or the Bank of Canada will backstop any short-term financing crisis. And being a currency sovereign, the Federal Government is an extremely credible backstop.
Admittedly, this was not always the case. In Quebec, the nationalist politicians of the 1960s were extremely unhappy with the provincial bond traders down Highway 401 in Toronto. The desire to get greater autonomy versus that group helped push the province to create la Caisse de dépôt et placement du Québec (“the Caisse” — my old employer). This entity mainly manages public service pensions as well as the base state pension plan of Quebecers (Quebec opted out of the Canada Pension plan), and has a big balance sheet that acts to stabilise the market in Quebec bonds.
In any event, so long as the provinces do not do crazy things, the Feds have their back. However, the taxpayers of the province (or future taxpayers) will need to service debt. So even if the provincial government does not have to worry too much about bond market vigilantes, they still need to worry about voters not being happy about future tax hikes.
Results at the Provincial Level
The Canadian federal financing system has been stable in the post-World War II era. The Canadian welfare state is largely implemented at the provincial level, with the Federal government acting as an agent to transfer financial resources. Quebec — one of the more heavily indebted provinces — has a debt/GDP ratio of around 50%, which dwarfs the ratios of American states (typically 10% of GDP). The expenditures/revenue are similarly large. From my experience, the income tax take of Quebec is roughly equal to that of the Feds, although that might differ at very high/low ends of the income spectrum.
Implementation of the welfare state also allows for regional political economy divergences. Alberta is at the other end of the spectrum from Quebec. Courtesy of a plucky attachment to free market capitalism — and large hydrocarbon resources — Alberta has low provincial taxes and a somewhat more barebones welfare state, and historically extremely low debt levels. (They also have the provincial equivalent of a “sovereign wealth fund.”) Attempting to force more centralised programmes would only spur separation movements — not only in Quebec, but even in Western Canada. (I no longer live out west, but my guess is that the support for Western separatism is at a historical low, but that also reflects the low profile of the Federal government in recent decades.)
Only a few Canadian municipalities are large enough to issue bonds, and even for the ones that did, the issue sizes were small. As such, I personally paid little attention to them (but other team members did monitor them). However, I believe I picked up enough by osmosis to offer the following remarks.
The first thing to note is that Canadian municipalities largely exist at the whim of provincial governments. This is different than the usual experience in the United States. As an example, the Quebec government ruffled a lot of feathers by fusing most of the municipalities in the greater Montreal area into a few large units. Voters were enraged, and many of the municipalities split off from the larger cities. Very simply, if the provincial government can arbitrarily put your municipality out of existence overnight, the provinces have the power to oversee municipal finance.
The philosophy for Canadian municipal taxes is straightforward: decide how much revenue they want, and then back out the property tax rate based on the aggregate assessed property values. The municipalities very slowly move the assessed values, and employ the sneaky trick of keeping them below market. If your assessed property value is well below market, you tend not to challenge the assessment.
This means that Canadian municipal finances would be less strained by a hypothetical drop in house prices than was the case in the United States in the aftermath of the Financial Crisis. The municipalities with problems are the ones that are getting an influx of revenue from new developments.
Since World War II (roughly when the Canadian government became a currency sovereign), there have been no provincial defaults. Based on a vaguely-remembered conversation with a ratings agency analyst, there was one municipal default. I believe it happened in the 1950s, and there was some kind of hanky-panky by the municipal government.
Bond markets that do not experience defaults tend to trade on a spread basis. It is very hard for “bond vigilantes” to get steam, since “mean reversion believers” will eventually step in.
Things were more exciting before World War II. (Since Canadian Confederation was only in 1867, there is not a whole lot of pre-World World II history to work with.) Canadian federal politicians mindlessly held to the Gold Standard, and so bailouts of sub-sovereigns were not automatic.
I am unsure how many municipalities went under, but there was one provincial default — Alberta. I never tracked down an economic analysis of the default, but read political analyses. Alberta was dirt poor at the time (oil riches were in the future), and they elected a Social Credit government.
Social Credit was a heretical monetary doctrine — which cynics might compare to some other heterodox activists in the modern era — that had a policy recommendation in favour of “social credit” payments: an early universal basic income proposal.
This horrified the not particularly bright or innovative gold standard believers in Ottawa, and so tensions were high. Since Alberta was hit hard by the global collapse in grains prices during the Depression, they ended up in default, helped by Ottawa throwing them under the bus.
The Achilles Heel of the System
The main risk to the Canadian governmental financial system comes from the provinces. Although there is implicit “too big to fail” backing from the Federal government, there is no explicit guarantee. As such, the provinces have big balance sheets, and things could go horribly wrong.
The conventional worry would be a “rogue province” going nuts, and making unsustainable fiscal promises. Canadian voters are volatile, and frankly, some provincial politicians are real pieces of work. The conventional response is to worry about bond market vigilantes, and the pressure from the financial media would sooner or later make the provincial government back down. In practice, the Canadian establishment is fiscally conservative, and so the “crisis” would largely be a media affair, and what the bond market participants might do is largely hypothetical.
The other risk is that the Federal government follows a hard line “sound finance” policy, and makes it unclear that it is unhappy with provincial debt levels. This would eliminate the implicit backing. That said, the Canadian bank oligopoly is heavily invested in provincial bonds as part of their liquidity management. The bank economists that dominate financial media are normally sound finance types, but their principles might shift if their employers’ continued operations are put at risk.
Provincial Parallel Currencies
I can now return to the original discussion that spawned this article: does issuing a provincial parallel currency make sense? Given the history of provincial experimentation leading to the development of the Canadian welfare state, having greater financial flexibility might appear attractive.
However, for provinces that intend to remain part of Confederation, their government accounting is firmly in Canadian dollars. Issuing a scrip is just another financial instrument, and how much does it cost? The problem I see with a scrip is that the cost of administering it is going to be larger than the cost of issuing a 30-year bond. The potential float is small, and the main reason people might hold it is if the scrip can be used to pay provincial tax (or similar) obligations. Realistically, they would only do so if the scrip traded at a discount to their par value in Canadian dollars. This discount would end up embedded in the cost of issuance.
The use cases seem to be minor.
- Issue a crypto-currency to take advantage of current market conditions.
- As a gimmick, which might be more useful if interest rates rise a lot.
- A desperation move in a financing crisis.
- Preparation for sovereignty.
The problem with issuing a scrip is that it does not fit the “rules of the game” of Confederation: money is the domain of the Federal government. This would naturally raise the ire of both the politicians and the Bank of Canada. This puts the implicit backstop of provincial debt at risk. If such an act raised the risk premia on provincial debt, the added debt service costs could easily overwhelm whatever financial benefit the scrip issuance provides.
If a province wanted to leave Confederation, they might want to issue a parallel currency in preparation. (I believe Warren Mosler offered a suggestion for a structure at the last Quebec referendum.)
In the case of Quebec, there are very good political reasons not to do so. Since the 1960s, support for Quebec “sovereignty” waxed and waned. At various points, it polled above 50%. The problem is that the support level was extremely dependent upon the wording. For example, using “independence” instead of “sovereignty” dropped the polling results, typically below the 50% level. Although this might seem unusual to outsiders, “sovereignty” in Quebec is in practice vaguely defined. In fact, “sovereignty association” — which looks like a self-contradiction — was the preferred phrasing.
Adding specifics were also damaging — particularly the loss of Canadian passports and the Canadian dollar. Ask the question whether they would be willing to give up using the Canadian dollar and their passports, polling dropped by 10-15% — well below the 50% threshold.
As a result, issuing a parallel currency is not politically attractive for sovereigntists.