There is a lively discussion over at Warren Mosler’s modestly named blog Center Of the Universe, revolving around Mosler’s plan for Greece. We’ve heard this story before, but this particular plan is a bit more tricky to dissect, so let’s get some background information on arbitrage first.
There is always a paradigm tension between arguing that asset prices are set by supply and demand versus arbitrage. Of course in actual markets, prices are set by auction — so supply and demand seems to win. However in certain circumstances you can argue that there will always be a demand if the price is below a certain threshold, and there will always be supply if the price is above a certain threshold, so even though actual prices will be set by supply and demand, these will arrange themselves so that the equilibrium price can be determined by arbitrage.
For example, if the central bank allows unlimited borrowing at one rate, then we can argue, abstracting from risk, that bond yields will not rise above that rate, etc. As soon as the supply of bonds increases, the central bank ensures that the demand for bonds increases to match. Suppose on the other hand that the central bank allowed unlimited borrowing at 4%, but each time a private sector actor bought a bond, the central bank would offer to sell another bond at auction? What can you say about the equilibrium price? Each time demand increases, supply increases by the exact same amount. Furthermore, let’s suppose that the central bank did not lend unconstrained, but only against a limited quantity of collateral and only to a small group of borrowers.
Now can you argue that bond yields would not fall below 4%? No, you cannot. The only thing you can argue is that those eligible to borrow would most likely earn an arbitrage profit up until they were no longer eligible. Rather than being fixed at 4%, the actual price would be indeterminate based on just the information provided. As we are talking about Greece, the odds that the bonds would trade at the risk-free rate are slim.
And that’s what’s going on in Mosler’s proposal. He argues that by making bonds eligible for payment of taxes, that they would become risk-free instruments. But for everyone paying taxes with a bond, the government will sell another bond. Here supply increases with demand, bond for bond, so that you cannot argue that arbitrage will set the price.
As a result, there will be a select group in the economy — primarily banks — that will earn arbitrage profits as a result of this proposal, which is why it’s a signature Mosler proposal. The guy should patent progressive sounding policies that pick the pockets of the middle class and supply banks with economic rents. Those suckers whose taxes are withheld and who do not have cheap access to credit will have to pay their taxes, whereas those who do have access to cheap credit will buy bonds from the government at a haircut, and then supply those bonds in lieu of their tax obligations, up until they are no longer eligible to borrow. Effectively the government will impose radically regressive taxes on the Greek population in the event of default.
Now certainly those holding Greek debt would prefer to have this benefit than to not have it. Everyone prefers a government transfer, and no one likes to pay taxes. However, exempting bond holders from payment of Greek taxes doesn’t actually help Greece in any material sense, and it does not ensure that yields on Greek debt will be materially lower. The only thing it ensures that there will be real transfers from the non-bank population to the banks; from those without access to cheap credit to those with this access.
The way to actually solve Greece’s problem is, of course default and exit from the Euro. The opposite of giving bondholders an additional transfer. Greece is already transferring far too many resources to them.
UPDATE: fixed “rise below/rise above” typo pointed out by SRW.