Warren Mosler - Soft Currency Economics II (MMT - Modern Monetary Theory Book 1)

Circumstances in the early 1990s led me to an understanding ofthe actual functioning of a currency. Back then, it was the government ofItaly, rather than the United States, which was in crisis. Professor RudiDornbusch, an influential academic economist at MIT, insisted that Italy was onthe verge of default because their debt-to-GDP ratio exceeded 110% and the lirainterest rate was higher than the Italian growth rate.

Things were so bad that Italian Government Securities denominatedin lira yielded about 2% more than the cost of borrowing the lira from thebanks. The perceived risk of owning Italian government bonds was so high thatyou could buy Italian government securities at about 14%, and borrow the lirato pay for them from the banks at only about 12% for the full term of thesecurities. 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 Italiangovernment. There was easy money to be made, but only if you knew for sure thatthe Italian government wouldnt default.

The Free Lunch possibility totally preoccupied me. The rewardfor turning this into a risk free spread was immense. So I startedbrainstorming the issue with my partners. We knew no nation had ever defaultedon its own currency when it was not legally convertible into gold or anythingelse. There was a time when nations issued securities that were convertibleinto gold. That era, however, ended for good in 1971 when President Nixon tookus off the gold standard internationally (the same year I got my BA fromU-Conn) and we entered the era of floating exchange rates and non-convertiblecurrencies.

While some people still think that the America dollar is backed bythe gold in Fort Knox, which is not the case. If you take a $10 bill to theTreasury Department and demand gold for it, they wont give it to you becausethey simply are not legally allowed to do so, even if they wanted to. They willgive you two $5 bills or ten $1 bills, but forget about getting any gold.

Historically, government defaults came only with the likes of goldstandards, fixed exchange rates, external currency debt, and indexed domesticdebt. But why was that? The answer generally given was because they can alwaysprint the money. Fair enough, but there were no defaults (lots of inflationbut no defaults) and no one ever did print the money, so I needed a betterreason 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 (theFederal Reserve) and we own the same thing, a Treasury security, which isnothing more than account at the Fed that pays interest.

So functionally it has to all be the same. Yet presumably theTreasury sells securities to fund expenditures, while when the Fed sells securities,its a reserve drain to offset operating factors and manage the fed fundsrate. Yet they have to be functionally the same - its all just a glorifiedreserve drain! Many of my colleagues in the world of hedge fund management wereintrigued by the profit potential that might exist in the 2% free lunch thatthe Government of Italy was offering us. Maurice Samuels, then a portfoliomanager at Harvard Management, immediately got on board, and set up meetingsfor us in Rome with officials of the Italian government to discuss theseissues.

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 ItalianGovernments Treasury Department. (I recall telling Maurice to duck as weentered the room. He looked up and started to laugh. The opening was maybetwenty feet high. Thats so you could enter this room in Roman times carryinga 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. Theimage of the great English economist John Maynard Keynes, whose work was at thecenter 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.