Tuesday, February 10, 2009

Sovereigns cannot default

John Campbell was my teacher many lifetimes ago. I recommend his presentation (pdf) on treasury bond risk. He correctly points out that a sovereign, floating a fiat currency, with liabilities denominated in its own currency, cannot default. The sovereign has swapped default risk for inflation risk, and inflation is not default. Sovereign debt has no credit risk, it just has inflation risk, which is why those "triple A" ratings for US Treasuries are as meaningful as triple A ratings were for subprime mortgages. Ratings agencies are no better than they were.

The upshot is that nominal sovereign debt is a good bet against deflation, but a bad bet for stagflation. I'm guessing Campbell recommends TIPs. He was in the late 90s (and it was a bad call then).


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