Britain was put on negative credit watch by Standard and Poor’s for downward re-rating from its current AAA this week. The United States, Japan and several other countries are running record deficits, yet their bond yields are still close to all-time lows. That brings up an awkward question: what happens if the global investment community, public and private sector, sours on government bonds as an asset class?
There’s good reason for rational investors to do so. Britain’s debt is forecast by Standard and Poor’s to exceed 100% of Gross Domestic Product by 2013, Japan’s debt may exceed a lofty 200% of GDP by 2011 and nobody believes the official forecast that US government debt will remain as low as 80% of GDP by the end of the current budget horizon in 2019. Yet in all three countries, interest rates on government debt are barely above the immediate rate of inflation, let alone the rate of inflation that is likely to arrive in the next 12-18 months as monetary “stimulus” works its magic. Face it, if governments were companies, you wouldn’t touch their stock with a ten-foot pole.
Monetary authorities like Ben Bernanke who claim loftily that they will withdraw monetary easing well in time before inflation really gets a grip should be disbelieved. So should fiscal panjandrums like Treasury Secretary Tim Geithner or Chancellor of the Exchequer Alistair Darling, when they claim that the current orgy of public spending is only temporary. Cutting spending is far more difficult than increasing it, and will be done only with the greatest reluctance. As for Japanese prime minister Taro Aso, he has an election to face within the next four months, and deeply unscrupulous LDP party barons behind him, who believe that the only way to win the support of the Japanese rural voter is to run a superhighway through his back garden.
As White House Chief of Staff Rahm Emanuel said just after the US election “You never want a serious crisis to go to waste.” Since the majority of today’s politicians, it appears, have no greater joy in life than spending somebody else’s money, it is not surprising that they have exploited an atmosphere of panic during the onset of the recession to force through gigantic public spending programs that are now coming into effect, almost all of which bear no relationship whatever to economic recovery.
Most government debt markets (including some but probably not all of those in euros) are thus likely to suffer an oversupply crisis over the next year or so. Funding requirements of the order of 10% of GDP have not been common in the past, except during major wars when the private sector more or less shuts down except for war production and the government takes emergency powers to commandeer resources. A situation in which governments in several of the world’s largest economies are tapping their bond markets simultaneously at this level has not occurred since World War II, and was impossible before that, when the world was on a Gold Standard.
So far, there has been no major crunch, because monetary authorities have funded the deficits – in Britain’s case providing about 65% of their finance, at least for a few months. It is clear however that far from being able to withdraw their excessive monetary accommodation as the economy stabilizes, central banks will have to continue financing budget deficits, because only by that means will the money be raised. That will in turn cause inflation, which will cause the market to re-price nominal interest rates upwards and long-term government bond prices correspondingly downwards.
Even the most hawkish of the Fed governors, the Philadelphia Fed’s Charles Plosser, talked last week only of an inflation problem that might lead to 4% inflation by 2012. He is far too low, and far too late. The recent upsurge in oil and gold prices, back above $60 and close to $1,000 respectively, indicates that inflationary forces have already taken a grip on the global economy.
Government statistical departments have considerable latitude to fudge reported inflation figures for a few months, rounding everything down and giving themselves the benefit of the doubt, and the media and other authority figures will give them all the help they can, but by the end of 2009 it will be obvious to even the doziest Middle Eastern central banker that inflation in the US and Britain, at least, is running at over 5%, and is well on the way to 15-20%. Government bond rates of 3% or 4% will at that point become unsustainable, however hard the Fed and the Bank of England buy the bonds.
When we examine the potential government bond market position at that point it is likely to be a grim one. Yields will still be close to zero in real terms, yet inflation will be accelerating while most major governments will still be demanding fantastic amounts of money from the market. In that situation, rational investors will go on a “buyers’ strike.” They will already have more than they want of this supposedly risk-free paper, yet they will be asked to buy still more of it, when they are becoming increasingly sure that it will give them a negligible real yield over the long term, and a money loss through price decline in the short term.
The theory that the People’s Bank of China, the Bank of Japan and the various Middle Eastern central banks will buy more of this rubbish in order to protect their existing holdings will at some stage become false, and that refutation will probably happen suddenly. Prices will collapse, and further long-term funding will become impossible. Bonds of OECD governments will have ceased to be a risk-free asset.
Much of economic history has occurred without government bonds being regarded as the ultimate safety investment; there is no reason why we cannot have an economic system without this postulate. England before 1694 accrued substantial savings without a sound public debt market, the United States had no government debt for substantial portions of the nineteenth century and a number of Islamic and emerging market economies operate today without government debt markets. However, as these examples will indicate, sound government debt markets increase economic efficiency, by providing a “risk-free” haven for capital balances. Thus a collapse in government debt markets will have adverse economic consequences in two ways: there will be direct disruption from government defaults and enforced service cutbacks, and there will be a step backward in economic efficiency, causing a long-term reduction in output potential.
Nevertheless, even without US, British or Japanese government debt, risk-averse investors, whether or not central banks, will have second-best alternatives available. There will be a few governments, such as those of Germany, Korea and Brazil, whose economic prospects remain reasonable and which will not have blown through their borrowing capacity. On the other hand, banks will be poor investments, since their now illiquid and risky holdings of government paper will only add to the immense pile of rubbish already on their balance sheets.
Those stable industrial companies in the United States and Europe which have not over-extended themselves will have shares and maybe bonds (if in non-inflating currencies) outstanding that may appear good value. Shares of Proctor and Gamble, Coca-Cola, Nintendo and Cadbury, companies that are not overleveraged and that sell either basic goods or cheap entertainment, will be the true “blue-chip” investments for the safety-conscious investor. It is after all irrational in a capitalist system to assume that wealth-producing businesses are less solid investments than wealth-absorbing governments.
Above all, there will be commodities. Traditionally, central banks held their reserves in gold rather than other countries’ government bonds. For the major central bank pools of money such as Japan, China, Taiwan and the Middle East, we are likely to go back to that. They will diversify a bit from gold, possibly to silver, but also to non-traditional commodity stores of value such as grain, copper, other metals and especially oil.
This change in central bank investment policy will have two effects. First, it will cause an enormous bull market in gold, whose annual production is worth only about $100 billion at current prices, a pittance in relation to the weight of money heading its way. A gold price of $5,000 per ounce is well within reach. Second, these commodity purchases carried out for investment will increase reported inflation, especially in items such as oil and food, which to Ben Bernanke may be “non-core” but to the rest of us are essential for survival.
That’s why the argument beloved of central bankers, that inflation is impossible while there are is an “output gap” between actual and potential output, is so erroneous. Anyone who experienced the 1970s, or those under 40 who were paying attention in economic history class, will already know that idea to be bunkum. Twice in 1974 and 1979-82 the United States experienced substantial inflation and recession simultaneously, and Britain in 1975 experienced inflation of 25% in the middle of a deep downturn.
Policymakers WANT to believe that deflation is the main threat, because it justifies zero interest rates, and they WANT to believe that they can borrow 10% of GDP without adverse consequences, because it justifies them in spending public money, which is always fun. However in reality both beliefs are wrong and the global economy is about to demonstrate this the hard way. A rush to commodities will intensify an already problematic surge in inflation, while severe bond market indigestion will reduce economic well-being for much of the next decade.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)