The warning by Standard and Poor’s that there was now a 50% chance that it would downgrade U.S. Federal debt from its traditional AAA-rated status has concentrated a lot of minds, in Washington and elsewhere. At one level it has forced commentators and investors to recognize that without the United States and the European countries caught up in the eurozone mess, there are not a lot of risk-free credits left – the average pension fund cannot reasonably satisfy its long-term liabilities by buying debt issued by the Isle of Man, for example. This in turn raises an even more alarming but interesting possibility – what would a world look like in which enough government defaults and bad behavior had taken place so that there was no longer a market for government obligations among low-risk investors. As I shall argue, such an outcome could allow the free market system to work much better than it currently does.
Government bonds were the first instruments to develop truly liquid markets in the dawn of modern capitalism. Private companies were mostly very small, and even when large, like the Bank of England, the South Sea Company and the East India Company, were highly dependent on government for their welfare. Except in moments of high speculation such the 1720 South Sea Bubble and the 1825 boom in South American bonds (some of them for countries that did not exist) the majority of individual investment until the very end of the 19th Century was in government bonds, with foreign government and railroad bonds being favored by risk seeking investors to increase their yield. The railroads themselves and their predecessors the canals were financed primarily with bonds not stock, generally with some kind of government concession or land grant as underlying security until the railroad/canal was built and began yielding steady revenues.
Nineteenth century British investors depended upon the famous Consols (created in a conversion operation in 1751) to provide them with a rock solid 3% or, after the 1888 conversion, 2½% yield. U.S. investors in the nineteenth century bought Federal government bonds (in the period during and after the Civil War) state government bonds and of course railroad bonds. Only after the 1880s stock market boom in Britain and the 1897-1902 “trust” consolidation boom in the United States did non-professional investors buy significant quantities of corporate stock. In Britain indeed, with a further surge in government bonds from the two World Wars, the “cult of the equity” flourished only from the late 1950s.
Yet this brings to light an interesting counterfactual speculation. Suppose that Britain had not been forced to fight a 20-year war from 1793 to 1815, which gave it public debt of 250% of GDP. Would the London financial intermediaries in that case, balked of easy risk-free money in government bonds and the global bond issuance business which their bond market expertise gave them, have turned to the stock financing needs of the early Industrial Revolution? Notoriously, Britain lost her early industrial lead because her companies remained too small in scale.
For example Sir Henry Bessemer invented the eponymous steel-making process in the 1850s, announcing it in Cheltenham in 1856 (quick home-town plug there!). However he lacked the capital to produce steel on a large scale, and even later in life was still producing it through a private partnership with an ironmaster W. J. Galloway. It was Andrew Carnegie across the Atlantic who from 1870 developed steel-making on a much larger scale behind a tariff wall, making the British steelmakers globally uncompetitive. Can our counterfactual dare to suppose that without the immense government debt from 1815, the London capital markets would have developed sufficiently to have allowed Bessemer (by all means with Galloway as venture capitalist and plant manager) to raise public equity on such a scale as to beat Carnegie at his own game?
The above historical fantasy thus suggests that well-developed government bond markets may not have been universally economically benign. It also suggests that they may not have been inevitable. If Britain’s Financial Revolution had coincided with its Industrial Revolution, instead of preceding it by more than a century, then the beloved Consols might never have appeared. Britain would have been thwarted by lack of money in its 20-year struggle against Bonapartist France — but then Napoleon himself might never have emerged from obscurity. After all, without Britain’s possession of active financial markets and the resource superiority to which they led, France, which naturally had a larger population and more resources than Britain, would have suffered no economically and psychologically draining defeats in the War of the Spanish Succession (1702-13), the War of the Austrian Succession (1742-48), the Seven Years War (1756-63) and the (expensive and damaging for France) War of American Independence. With financial solvency and a decent 100-year track record, the benign Louis XVI and his dazzling, cultured wife Marie-Antoinette might have enjoyed a prosperous reign of fifty years or more, with low taxes and free-market development led by Jean-Baptiste Say and later Frederic Bastiat, during which the French economy would have developed its own Révolution Industrielle…
A U.S. ratings downgrade would not produce the end of government bond markets, far from it. The universe of bonds available to safety-seeking investors would be limited, as half the eighteen AAA-rated sovereign credits outside the United States are involved in the EU financial crisis and others are far too small for their bonds to be truly investible. Nevertheless, Norway, Switzerland, Singapore and Canada between them provide a reasonable refuge for all but the largest investors.
However, the potential downgrading of the U.S. credit rating is itself a signal that default is no longer unthinkable. Japan, too, has debt above 200% of GDP and must have at least a substantial possibility of default. As we have seen in Europe, the dividing line between a poor credit risk that is accepted by the markets and one that is forced into default is very fine indeed, often depending merely on the whims of a few large bond traders on a particular day. Thus it is by no means inconceivable that the next decade could see a succession of sovereign defaults, calling into question the credibility of most large government bond programs and leaving only a few Norway/Singapore/Switzerland minnows untainted by the possibility of investor losses.
In such a situation, government bonds would no longer be a major asset class. Issues of government bonds would be difficult, and would be bought only by risk-tolerant investors. The total volume of new government bonds issued would be small, as would the volume of outstanding bonds that were not tainted in some way by past defaults and the risk of future ones.
Such a world may be unimaginable to us today, but it is not economically impossible or irrational. Corporate bonds are issued on the assumption that the activity financed by the bond will produce enough revenues in the future to pay interest and principal. By definition, there can be no such assurance for a government bond, which rests only on the ability of its issuer to squeeze yet more loot out of the country’s unfortunate taxpayers. At some point, the potential yield from taxation reaches a level at which further looting becomes impossible, either because of universal evasion or because marginal tax rates have reached the level at which the Laffer Curve bends downwards. Rapid economic growth since World War II has prevented many Western countries from reaching that point, but growth itself is dependent on a moderate level of taxation and a restrained level of government meddling, both of which appear in some danger.
It is not therefore difficult to imagine that with government deficits swelled by the foolish 2009 “stimulus” mania we may be arriving at a point where governments are no longer able to issue debt based on vague promises of repayment, but must instead live off their annual taxation income. The great government finance revolution brought about by the Bank of England and Sir Robert Walpole would thus have been reversed.
There would be considerable advantages to such an economic system. Governments would no longer be able to engage in deficit spending, but would be forced to live within their means. In times of recession, either government would be subject to fierce cutbacks, or bills would go unpaid. In consequence, the government would no longer be a particularly attractive customer
for businesses, which would instead be compelled to redirect their product offerings towards the private sector. Many rather unproductive government consultants and contractors would go bust.
In the capital markets, investors seeking a fixed and totally safe return would no longer look towards governments, but to the most stable and profitable private companies, like Procter and Gamble or Coca-Cola. There would still be a AAA-rated bond market, and the prospect of absolute security would reduce the yields on its scarce paper far below those on lesser rated credits, so that it would become immensely advantageous for business to arrange themselves to maximize their credit quality. Many projects that are today carried out by governments would be forced into the private sector, although there would be no reason why the Pennsylvania Turnpike, for example, could not raise finance entirely without government support, based on its potential toll receipts. Meanwhile capital would not disappear, but would be forced into providing finance for the productive private sector, thus creating jobs and reducing unemployment.
In such a world, economic activities that have become bloated by excessive regulation, such as infrastructure provision (in the United States), healthcare and education, would no longer be funded by the government, because the government would not be able to raise the money. Consequently, governments would be forced to repeal the morass of regulations that has raised the costs of those activities to such levels. When the proposed tunnel under the Hudson River costs in real inflation-adjusted dollars fifteen times as much as the near-identical Holland Tunnel, opened in 1927, it should be clear that government-mandated regulation and featherbedding have added intolerable levels of unnecessary overhead. In a world without government bonds, that overhead would be forcibly removed.
A world without government bonds would be a world with far fewer cost-inflating regulations; economic activities would have to be viable in their own right. It would have more private sector jobs, as capital markets for both debt and equity would be focused on private companies. Governments would necessarily be smaller, because they would be unable to finance growth with debt, so would immediately have to impose unpopular taxes as they took on new activities. In summary, with fewer Napoleons and more Henry Bessemers, the world would be a considerably more attractive place.
From the point of view of a French patriot, the Financial Revolution of the late seventeenth century and the greater financial freedom which it gave the British government in particular may be thought a thoroughly undesirable innovation. When looked at objectively, one is forced to share that French patriot’s viewpoint, and to rejoice that current developments may possibly produce the unexpected death of that economically destructive creature, the government bond market.
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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.)