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Hi David- been a long time, seems nothing has changed!

(See my 2002 letter to you below)

You downgraded Japan below Botswana, their debt/GDP went to over 150% with annual deficits over 8%, and all with a zero or near zero interest rate policy for over a decade, cds traded up, and 10 year JGB’s were continually issued in any size they wanted at the lowest rates in the world.

This is no accident. It’s inherent in monetary operations with non convertible currency and floating exchange rates. Your analysis is applicable only to fixed exchange rate regimes regarding defaulting on their conversion clauses.

Do the world a favor, reverse your position, and explain the reason for your current and prior errors, thanks!

All the best,

Warren

AN OPEN LETTER TO THE RATINGS AGENCIES

Flawed Logic Destabilizing the World Financial System

Repeated downgrades of Japan by the ratings agencies due to flawed logic have been destabilizing both Japan and the financial world in general. Their monumental error can be traced to a lack of understanding the operational realities of a Government that issues its own currency. For the Government of Japan, payment in yen, its currency of issue, is a simple matter of crediting a member bank account at the BOJ (Bank of Japan). There is no inherent operational constraint for this process. Simply stated, Government checks (payable in yen) will not bounce. The BOJ has the ABILITY to clear any MOF check for ANY size, simply by adding a credit balance to the member bank account in question. Yes, the BOJ could be UNWILLING to clear ANY check, but that is an entirely different matter than being UNABLE to credit an account. Operationally, concepts of the BOJ not having ‘sufficient funds’ to credit member accounts are functionally inapplicable.

As a point of logic, the concept of ABILITY to pay being inherently revenue constrained is not applicable to the issuer of a currency. Any such constraints are necessarily self-imposed (including various ‘no overdraft’ legislation in some countries for the Treasury at the Central Bank). The issuer can always make payment of its currency by crediting the appropriate account or by issuing actual paper currency if demanded by the counter party.

An extreme example is Russia in August 1998. The ruble was convertible into $US at the Russian Central Bank at the rate of 6.45 rubles per $US. The Russian government, desirous of maintaining this fixed exchange rate policy, was limited in its WILLINGNESS to pay by its holdings of $US reserves, since even at very high interest rates holders of rubles desired to exchange them for $US at the Russian Central Bank. Facing declining $US reserves, and unable to obtain additional reserves in international markets, convertibility was suspended around mid August, and the Russian Central Bank has no choice but to allow the ruble to float.

All throughout this process, the Russian Government had the ABILITY to pay in rubles. However, due to its choice of fixing the exchange rate at level above ‘market levels’ it was not, in mid August, WILLING to make payments in rubles. In fact, even after floating the ruble, when payment could have been made without losing reserves, the Russian Government, which included the Treasury and Central Bank, continued to be UNWILLING to make payments in rubles when due, both domestically and internationally. It defaulted on ruble payment BY CHOICE, as it always possessed the ABILITY to pay simply by crediting the appropriate accounts with rubles at the Central Bank.

Why Russia made this choice is the subject of much debate. However, there is no debate over the fact that Russia had the ABILITY to meet its notional ruble obligations but was UNWILLING to pay and instead CHOSE to default.

Note that even Turkey, with lira debt in quadrillions, interest rates in the neighborhood of 100%, annual currency depreciation in the neighborhood of 50%, little ‘faith’ in government, and only inflation keeping the debt to gdp ratio from rising, has never missed a lira payment and never had a lira ‘funding crisis.’ Turkey has had problems with its $US debt, but not with its ability to spend lira. Government spending of lira is limited only by the desire to purchase what happens to be offered for sale. It is not and cannot be ‘revenue constrained.’ Operationally, Turkey has the same unlimited ABILITY to pay in its own currency as does Japan, the US, or any other issuer of its own currency.

The Turkish example, and many others, makes it quite obvious that ABILITY to pay in local currency is, in practice as well as in theory, unlimited. ‘Deteriorating debt ratios’ and the like do not inhibit a sovereign’s ABILITY to pay in its currency of issue.

So why have the ratings agencies implied that default risk for holders of Japan’s yen denominated debt has increased to the point of deserving a downgrade? Do they understand that ABILITY to pay is beyond question, and therefore are basing their downgrade on the premise that Japan may at some point be UNWILLING to pay? If so, they have never mentioned that in their country reports.

A few years back, due to political disputes, the US Congress decided to default on US Government debt. The only reason the US Government did not default was because Treasury Secretary Robert Rubin was able to make payment from an account balance undisclosed to Congress. The US Government clearly showed an UNWILLINGNESS to pay that Japan has NEVER shown or even hinted at. Furthermore, again unlike Japan, the US continues this behavior just about every time the self imposed US ‘debt ceiling’ is about to be breached. And yet the ratings agencies have never even considered downgrading the US on WILLINGNESS to pay.

Therefore, one can only conclude 1) Japan has been downgraded on ABILITY to pay, and 2) The logic of the ratings agencies is flawed. In a world where currently there are serious ‘real’ financial problems to address, the ratings agencies have introduced a ‘contrived’ financial problem of substantial magnitude, as many regulations regarding the holdings of securities specify ratings assigned by the leading ratings agencies. Governments have chosen to rely on the ratings agencies for credit analysis, and downgrades often compel banks, insurance companies, pension plans, and other publicly regulated institutions to liquidate the securities in question.

Japan’s yen denominated debt qualifies for a AAA rating. ABILITY to pay is beyond question. WILLINGNESS to pay has never been questioned, even by the agencies engaged in recent downgrades. The destabilizing downgrades are the result of flawed logic.

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Karim writes:

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This will allow them to raise rates simply by paying interest on reserves and not require them to first ‘unwind’ their portfolio as was the case in Japan.

Press Release

May 20 — The Federal Reserve Board on Wednesday announced the approval of final amendments to Regulation D (Reserve Requirements of Depository Institutions) to liberalize the types of transfers consumers can make from savings deposits and to make it easier for community banks that use correspondent banks to receive interest on excess balances held at Federal Reserve Banks.

The amendments would also ensure that correspondents that are not eligible to receive interest on their own balances at Reserve Banks pass back to their respondents any interest earned on required reserve balances held on behalf of those respondents. The Board is also making other clarifying changes to Regulation D and Regulation I (Issue and Cancellation of Federal Reserve Bank Capital Stock).

The Board has revised Regulation D’s restrictions on the types and number of transfers and withdrawals that may be made from savings deposits. The final amendments increase from three to six the permissible monthly number of transfers or withdrawals from savings deposits by check, debit card, or similar order payable to third parties. Technological advancements have eliminated any rational basis for the distinction between transfers by these means and other types of pre-authorized or automatic transfers subject to the six-per-month limitation.

The Board also approved final amendments to Regulation D to authorize the establishment of excess balance accounts at Federal Reserve Banks. Excess balance accounts are limited-purpose accounts for maintaining excess balances of one or more institutions that are eligible to earn interest on their Federal Reserve balances. Each participant in an excess balance account will designate an institution to act as agent (which may be the participant’s current pass-through correspondent) for purposes of managing the account. The Board is authorizing excess balance accounts to alleviate pressures on correspondent-respondent business relationships in the current unusual financial market environment, which has led some respondents to prefer holding their excess balances in an account at the Federal Reserve, rather than selling them through a correspondent in the federal funds market. A correspondent could hold its respondents’ excess balances in its own account at the Federal Reserve Bank; however, doing so may adversely affect the correspondent’s regulatory leverage ratio. As market conditions evolve, the Board will evaluate the continuing need for excess balance accounts.

In October 2008, the Board adopted an interim final rule amending Regulation D that directed Federal Reserve Banks to pay interest on balances held by eligible institutions in accounts at Reserve Banks. The final rule revises those provisions as they apply to balances of respondents maintained by “ineligible” pass-through correspondents–that is, entities such as nondepository institutions that serve as correspondents but are not eligible to receive interest on the balances they maintain on their own behalf at the Federal Reserve. Specifically, the final rule provides that only required reserve balances maintained in an ineligible correspondent’s account on behalf of its respondents will receive interest. Ineligible correspondents will be required to pass back that interest to their respondents. Both required reserve and excess balances in the account of an eligible pass-through correspondent will continue to receive interest and those correspondents are permitted, but not required, to pass back that interest to their respondents.

The final amendments to Regulations D and I will become effective 30 days after publication in the Federal Register. Excess balance accounts will be available for the reserve maintenance period beginning July 2, 2009.

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Give California the $15 billion and give all the other states the same per capita amount.

This way it’s fair and equitable and helps spur a general economic recovery.

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