Friday, May 15, 2009

You can't get a little bit "fiat"

As you likely know, the administration is proposing to lend $100bn to the IMF, as part of that organization’s increase in resources following the G20 summit. Peter Orszag, head of OMB, argued that there was zero probability of this money being lost, so $100bn should be “scored” for budget purposes as $0bn – which is how this kind of transaction has been handled in the past. As the IMF likes to say, it is “the lender of last resort, but the first to be repaid.”

After considerable back and forth, the scoring issue was referred to the CBO. The CBO has reportedly decided there is a 5 percent probability of default by the IMF. This is an extraordinarily important statement. Most informed people just assume that the risk of IMF default is zero, because that would essentially constitute a complete breakdown of the global economy and payments system. But nothing is zero probability, particularly in a world of massive financial panics, incipient protectionism, and improvised global governance
. Baseline Scenario

Another day, another example of monetary confusion.

To what do I refer? I'm (once again) noticing the apparently widespread view that "credit risk" only occurs in the event of default- a view that seems to me a "residual monetary image" from the days of fixed exchange rates to specie.

When money was defined as a fixed amount of Gold or Silver, "credit risk" could be conflated with the risk of default- either you got your specie (or equivalent) or you didn't.

However, we haven't had such a link to specie for decades. The value of fiat money fluctuates, which is both the blessing and curse of that policy. The risk of, say, a default by the US Treasury, which was a concern of France before the link to Gold was severed, is now almost nil because the only obligation is to pay US$s, which the Fed can print.

In other words, the risk of default inherent in a fixed specie exchange system has been replaced- at least for countries that can issue debt in their own currency- by the risk of devaluation.

There isn't, as the old saying goes, any free lunch. To borrow a concept from physics, risk, like matter and energy (combined), is never created nor destroyed, it just changes form.

It seems to me this residual monetary image- the view that money, specifically the US$, is a thing unto itself and not merely a share of output divided by the stock thereof- is the last bit of foundation holding the house of cards together.

Human conception is a curious thing. I can remember quite a few instances when I was sure I knew something only to later find out I did not. I didn't, for various reasons, take in all the consequences. I thought, to use another old adage, one could get a little bit pregnant- an adage that has lost some of its punch with the availability of abortions.

One also can't get a little bit fiat. Either there is a fixed exchange to specie or there isn't. The most pressing risk in funding the IMF is not whether they will be repaid in US$s, on which I agree with the CBO's assessment, but what those US$s will buy when repaid.