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Sunday, November 18, 2018

How Can A Floating Currency Sovereign Default?

I have been toying with an idea of writing a book with the title "How Can a Floating Currency Sovereign Default?" As a follower of Modern Monetary Theory (MMT), this is a bit of a joke, since the text of the book would just be: "They can't." The book can then be submitted to the World's Shortest Book Competition.

Thinking about this has led to me to the realisation that the usual way of discussing sovereign default is inherently defective. (This criticism extends to my earlier book Understanding Government Finance, unfortunately.) The usual technique is to describe the mechanisms for default, look at some models, and argue why a default is unlikely. This then runs into a hurricane of whataboutery - what about the external constraint, Russia, Iceland, etc.

Part I: The Easy Part

I think we need to follow a different tack, and I expect to turn that into a somewhat longer book.
  1. We first assume that a theoretical country is immune to default.
  2. We examine the theoretical properties of this country.
  3. We can then compare real world countries to this ideal default-free country. The unproven argument is that what MMT refers to as "floating currency sovereigns" match the description.
That's basically the first part of the book. It would no longer qualify for the "World's Shortest Book," but it would be pretty short. The most interesting part would be the discussion of the steps needed to make sure a real world country qualifies as being default risk free. (For a number of countries, I have seen legal arguments that default is already impossible. I lack the legal training to judge those arguments; I will instead have to look at financial/economic institutions.) 

For readers interesting in MMT, the first part of the book may be the most interesting; if I know what I am doing (which remains to be determined...), I will keep that first part as easily understood as possible.

Part II: Whataboutery...

Part II of the book would be where I would get bogged down in details, dealing with the "What about X?" issues. Although I am not aiming to make this an academic tome, it should be more advanced than my first few books (such as Understanding Government Finance), and have more literature references. I expect that 90% or more of the references will show up in the second half.

In my view, the "what about" questions are broadly misleading. The reason why is straightforward: there are many possible mechanisms for a country to miss payments on its debt. The issue is whether they matter for economic/financial analysis.

I will put forth first a non-controversial example. Let us fix a country X. Imagine then that the government of X disappears as a result of being wiped out by an attack by aliens from Pluto (Yuggoth in their language), who are still mad about being downgraded from planet status. It is clear that surviving bond holders will not be seeing any scheduled coupon or principal payments from that government. (I will put aside the question of legal default; it is unclear whether anyone would have legal standing to have default declared.)

Although my example is deliberately over-the-top, any examination of history shows that extreme risks to the status quo always exist. The question is whether we can expect any analysis of the economy to offer any insight to the risk? It seems straightforward that examination of economic time series of country X does not give us any insight to the probability that the country will be obliterated by the advanced technology of the Plutonians. 

If we want to get closer to the concerns of those who are worried about the default risk of floating currency sovereigns, we will rapidly see that almost all the non-geopolitical risk revolves around politics. Even if the government cannot be forced to default, it can choose to do so. The implication is that we are judging political risks, not economic/financial risks. (This was my argument in Understanding Government Finance.)

Discussing all the "what about" scenarios requires plowing through the usual suspects, and demonstrating how the risks discussed are political. To take a particular example beloved of Post-Keynesian critics of MMT: the so-called external constraint. We will need to run through the mechanisms that allegedly imply the need for default, and show that any default is still the result of a political decision by the government, and not in the hands of those darned foreigners.

In order to keep the scope of the book manageable, I will confine my attention to floating currency sovereigns. This makes life much easier, as it basically excludes looking at historical default episodes. If I wanted to write a book on sovereign default, then 90% of the book would be a discussion of various fixed exchange rate systems, and the woes of developing countries. Although I have some familiarity with those cases, I would be on territory that I am much less familiar with, and writing would be much more difficult.

Final Remarks

The final formatting of the paperback edition of Breakeven Inflation Analysis has been completed, and its publication will be after I have seen the printed proof. I will start running excerpts once the paperback edition is ready. By implication, I am ready to start work on my next book. I am currently debating whether to do a book on business cycles (more specifically, the causes of recessions), or on floating currency sovereign default. The beauty of floating currency sovereign default is that even with the sections on whataboutery, the book would be compact and easy to write. By doing it first, it gives me time to do more research and writing on recessions.

I will keep doing initial drafts in parallel, and then pin down which book to pursue first some time early in 2019.

(c) Brian Romanchuk 2018


  1. Hi
    Just to say that I’ve dipped into Michael Pettis’ Volatility Machine’ tho before getting a stronger sense of what MMT offers to guard oneself against the knee jerks & the what-ifs that lead discussions about finance, create confusions between commodities, money, net worth, trade balances, political victimisation across borders etc etc.

    In Pettis’ book volatility is about economies that don’t float, and your last blog about MMT reminded me of this. I found Pettis’ examples useful so for me please do get bogged down a little in examples that illustrate some of the general finance/accounting principles involved.

    Today’s blog includes the political and I don’t think the Pettis book did. This question really does raise the spectre of Death Star US and I can understand that some people need to get to understand the financial/accounting before they can understand how money sovereignty works.

    Observing how my small country New Zealand can respond politically to believed in threats from outside sees NZ being situated economically at the bottom of the pecking order of most other foreign predators. All it takes is for commentators to mention the reserve currency status of the US$ and the fact of NZ running a trade deficit for this instantly to get a Pavlov tremble. So discussing not only a trade deficit but also the running of a carefree gov deficit in addition creates loads of bowing & scraping to presumed risks like a catechism gets worshipers automatically chanting their learned economist replies.

    Actually it’s the private banks that have borrowed big abroad & gov propping them up with government sanctioned mortgage lending seems to be NZ’s political curse though not understood properly in its financial/economic dimension.

    So, I look forward to you giving this all an airing ASAP :)


  2. The risks posed by banks is probably the biggest weakness in the “it’s all political” argument. In a sense, it is, since politics led to bad regulation. It’s entirely possible that governments made bad decisions where the path of least resistance is to default, and one such decision would be to stupdly bail out the banking system.

  3. "How Can a Floating Currency Sovereign Default?"

    What does "floating currency" have to do with "sovereign default"? The two terms apply to entirely different economic events.

    "floating currency" applies to a relationship between different currencies. Each currency is judged for trade value against other currencies. This judgement depends not only upon real product exchanges but also upon the perceived future value of each currency for it's 'gift certificate' potential. (This explains why Japan and China (as saving nations) are willing to hold such large quantities of U.S. debt.)

    On the other hand, "sovereign default" refers to a government (who issues currency) actually defaulting on it's debt. I would agree with you that this would always be a political decision, no matter what the citizenship of debt holders might be.

    Your proposed title is a teaser, for sure. Might be a clever segue into a revealing discussion.

    1. I think 'floating currency sovereign' means the currency is not 'pegged' or promised by the issuer to exchange for a certain amount of another currency or commodity. If it was pegged and the peg was abandoned, that by itself would constitute a form of 'default' and I think Brian was trying to rule that form of default out.

    2. I had a reply, but it got eaten. Oops.

      A “non-floating currency soveriegn” is not an obvious definition, but one thing to disqualify countries is borrowing in a foreign currency - even if the currency value floats.


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