There was commentary earlier this week (September 26, 2022) from an investment banker entitled ‘MMT takes a pounding’. I won’t link to it because I don’t want to send traffic to their site. But it is the narrative that the financial market commentators who desire to politicise public debate and use it to attack their pet hates. Modern Monetary Theory (MMT) apparently is a pet hate of this character and like many with similar biases he has been champing at the bit for some semblance of ‘evidence’ that MMT analysis is flawed. This week’s events in Britain have given them more succour. Except when you understand what has actually happened the events demonstrate key MMT propositions.
The banker I referred to in the Introduction wrote:
The global signals from the UK’s mini-budget matter. Modern monetary theory has been taken into a corner by the bond markets and beaten up. Advanced economy bond yields are not supposed to soar the way UK gilt yields rose.
So you get the drift.
MMT apparently says that fiscal positions do not matter – whereas the latest British kerfuffle indicates they do.
Well, first, MMT says that fiscal positions definitely matter and the conduct of fiscal policy is crucial to how the economy operates.
What MMT also says is that bond markets, without any offsetting government action, can run riot and create high risk private investment situations that force institutions to sell of government bonds (gilts in the British context), sometimes as ‘fire sales’, which because of the intrinsic inverse relationship between bond prices and yields, will drive the yields up quickly.
If there is deep financial instability threatened in any segment of the financial markets, which endanger solvency of some bank or pension fund, then it is clear that the panic can instigate large and rapid shifts in yields, given the way secondary bond markets work.
The fact that in history we have observed instances like this doesn’t say anything about the validity or veracity of MMT.
Second, MMT emphasises that while fiscal positions do matter, the way that the government chooses to act in relation to accompanying institutions they have created influences non-government sector outcomes.
So if a government sets in place a ‘rule’ that says it can only spend more than the taxation revenue it collects if it issues matching debt to the non-government sector and organises the debt issuing process as an auction where the investors get to determine the yields the government must pay on those issued liabilities then we can easily see yields behave like they did this week in the UK.
Conversely, if the government abandoned the debt-issuing institutions, MMT tells us that it could keep spending currency into existence and the bond markets could try ‘beating up’ whoever or whatever they chose but it would have no consequences for the spending plans.
Further, under the debt-issuance rule, a central bank (part of government) also has the capacity to ‘squeeze’ investment plans of non-government financial market players if they so choose.
This is what happened in Britain this week.
The shenanigans that we observed in now way invalidates MMT – rather it supports the key propositions regarding the capacity of the government sector vis-a-vis the non-government sector.
What actually happened?
First, we need to understand so-called Liability Driven Investments (LDI), which are financial market ‘instruments’ (products) that apply to defined pension schemes where the pension or superannuation fund has promised to pay x benefits at some point in time to the beneficiaries, and must ensure they have the appropriate asset coverage (with commensurate returns) to match the liabilities when they come due.
LDIs have grown like dramatically in recent years.
The Pension Protection Fund in the UK, which is a statutory corporation created in 2004 to protect defined benefit schemes, publishes its – PPF7800 Index – each month, which provides information of the “latest funding positions for all eligible defined benefit schemes” in the UK.
The first graph shows the aggregate assets and liabilities for UK defined benefit pension funds from March 2006 (first data collection by PPF) to August 2022 (most recent data).
The standout is the high degree of fluctuation between the two aggregates, particularly on the liability side.
The solvency of a defined-benefit pension fund (D-FPF) relies on assets growing through favourable investment returns and/or increasing its contribution base so that its ‘funding position’, its ability to meet its liabilities improves
Clearly, if the liabilities are growing then the assets have to grow and be of appropriate maturity.
In the case of the British D-FPFs, the funding ratio (the difference between the total assets and liabilities), which is shown in the next graph, has been highly volatile and often negative.
This has mostly been driven by the volatility of the liabilities.
The purpose of a LDI instrument is to both enhace the funding ratio while reducing the risk attached to the asset base that drives this ratio.
The aim is to reduce the volatility of the liabilities by investing some of the assets in low risk financial assets, which help the pension fund minimise the liability risk, and, investing the other assets in higher risk, growth assets.
I won’t go into the detail here – it is tedious and is not needed to get the point.
But the low risk tranche of the assets are invested in such a way that they fluctuate with the fluctuating liabilities while the second tranche is designed to deliver asset growth through returns that exceed the growth of the liabilities.
In the case of the first tranche, the asset investments will be designed to rise and fall with the same key factors that cause the liabilities to rise and fall – interest rate changes, inflation, etc.
Which means if the liabilities suddenly increase, the assets will also increase in value.
If a pension fund finds itself in deficit then, then the LDI strategy will be to push assets into higher return (risk) categories to push the growth in assets ahead of the liability growth.
So what happened in the UK this week
First, the bond markets in Britain turned political, which is a story in itself – how the financial top-end-of-town now see the Tories as flagrant in fiscal policy, the beneficiaries of the recent ‘mini-budget’ being the top-end-of-town.
That is a curious development.
But bond markets regularly express political views by selling government debt off.
So what! Nothing extraordinary there.
Second, the extraordinary bit this week has been the behaviour of the pension funds.
They found their funding ratio turning ugly and had to quickly shore up their assets to ensure they could meet their on-going liabilities.
So they entered into ‘swap’ arrangements, which are regularly deployed under the LDI strategies to manage liability risks.
A swap is just a contract where two parties agree to exchange payments into the future.
For example, an interest rate swap could involve a pension fund going to a bank and accepting a fixed rate of interest on a loan in return for an agreement to pay the bank a interest rate that is market adjusted.
Clearly, if the interest rate rises, the swap value works in the bank’s favour and vice-versa.
The important additional point to understand is that unlike using bond investments to manage liability risk under an LDI, swaps are more specific and do not require the pension fund to allocate a substantial amount of assets to buying bonds to cover the risk.
So the pension fund can get the desired liquidity now, through a swap, without tying up its assets, which can be invested to pursue returns in other investments.
There are complexities in these arrangements that I won’t go into here.
That liquidity can be used to pursue higher risk returns but the strategy can backfire if interest rates start rising and turn against the pension fund.
Most of these contracts have ‘mark to market’ conditions, which result in so-called ‘margin calls’, which are simply interim payments that the ‘losing’ party has to pay to the ‘gaining’ party.
So if the pension funds start requiring immediate cash to cover their loss positions in their swap contracts, then they have to sell any liquid assets they have on their books to get cash or go broke.
That means they are forced into a fire sale of their government bond holdings, which in the broader market increases supply and drives down the price and pushes up the yields.
The spike in yields has nothing much to do with the fiscal position of government.
Further, as the bond market investors seek to sell off bonds – the lemming rush – the pension funds face further ‘margin calls’ because their assets are losing value and the funding ratio deteriorates.
The pension funds then call their LDI managers – some of the big investment banks like Blackrock etc – to sell of assets, including government bond holdings so that they can meet their obligations under the LDI contracts.
The sequence then reinforced itself – fire sale, prices fall, more margin calls, more fire sales, yields keep rising.
And so on.
One of the related problems is that pension funds are managed according to the greed principle rather than to exclusively ensure liabilities can be met.
The latter goal is relatively simple – just invest in risk-free assets that deliver a known principle at a known maturity.
So if you need $30 billion in 20 years time, the easiest way to guarantee you will have it is to buy a 20-year bond that has a face value of $30 billion.
Then whatever happens to bond prices in the secondary market is irrelevant – the pension fund just cashes in the bond in 20-years and gets the required cash.
But pension fund managers get greedy (probably because they devise salary packages that benefit from higher returns) and so they use these interest-rate swap arrangements that allow them to use the fund’ cash to pursue returns in more risky assets – like shares.
The financial market players who devise all these tricky and dangerous derivative products then prey on the greed of the pension fund managers to flog them products that seemingly will deliver massive returns.
The problem then, which was really exposed this week, is that greed leads to chaos, when the ‘models’ fail and the markets go feral.
If left to its ‘market’ resolution, some pension funds would have gone broke this week because they would not have been able to generate sufficient cash to cover their liabilities.
Enter the government
What the Bank of England did was to use its massive capacity as the currency issuer to short-circuit this bedlam.
Only the government can do that.
The Bank of England entered the long-term bond market and bought up big using its currency capacity.
The Bank issued two statements yesterday (September 28, 2022):
In its first announcement, the Bank said that:
Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability. This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy.
In line with its financial stability objective, the Bank of England stands ready to restore market functioning and reduce any risks from contagion to credit conditions for UK households and businesses.
To achieve this, the Bank will carry out temporary purchases of long-dated UK government bonds from 28 September. The purpose of these purchases will be to restore orderly market conditions. The purchases will be carried out on whatever scale is necessary to effect this outcome. The operation will be fully indemnified by HM Treasury.
The second statement just outlined the operational details.
The upshot is that bond prices rose and yields fell sharply again – back to where they were last week (see the next graph which shows the UK 30-year gilt yield (TMBMKGB-30Y).
The Bank of England also wanted to moderate problems arising in the mortgage markets, where banks also fund positions using interest-rate swaps, and also faced major funding issues.
I might delve into that issue another day.
So not a case of the bond markets “beating up” MMT, but rather a case of the currency issing capacity of the government to control yields if it so chooses, a core MMT proposition.
The Bank of England’s bond purchases also caught the short selling vultures who, knowing the pension funds were in trouble and needed to liquidate quickly, were speculating that bond prices would fall even further and their short selling positions would generate profits.
Their speculative hope is that the on-going panic and liquidation of bond holdings of the pension funds to get cash drives the spot price of the bonds in the secondary market down so that they could meet their short sale contracts by buying a price below the initial price agreed in the contract.
The Bank of England squeezed those speculators and forced them to quickly cover their exposures which further drove up bond prices and drove down yields.
There are all sorts of characters out there who seek out the flimiest reason to denigrate MMT.
They usually posit a fictional version of MMT and compare it to the real world saying ‘see MMT is ridiculous’.
That is going on at present.
I think these characters are deeply insecure.
The last week in Britain does not invalidate MMT.
That is enough for today!
(c) Copyright 2022 William Mitchell. All Rights Reserved.