Bloom of Doom IV: Safe Assets and Sore Surprises
Many still think sovereign debt is safe (although I’d like to know how many “elder statesmen” still invest in these “assets” themselves today). This is astonishing at the best of times: would you give credit to a boy who still lived at home at the age of 200+ with no income of his own? Oh, of course, I see, you hope his Mum and Dad Taxpayer will foot the bill. So if he goes to the “Royal Casino” and buys chips, looses big time, then even scraps his old, but perfectly serviceable car to get a new one, you still give him more credit and more, and more?
(See more statistical material in our References section!)
Noooooo, you, the sane investor wouldn’t do that? Or would you? Oh, I see, he uses a bit of blackmail to get most of his money and you are just afraid of the ruffian?
Maybe some will hate me now, others may have an uncanny feeling of some semblances that they yet want to take time off to digest. But the time has come to be graphical and not mince words over this catastrophe-in-the-making. While Big Brother can still tax you, even bleed you white when taxes should be reduced during times of recession (between the falling value of money and rising taxes there is always a tendency to reach the 100% threshold of your income, wouldn’t politicians every so often “re-adjust” their tax policies or provide loopholes that then make you buy a house on credit if that’s made tax-deductible – feels a bit like on a leash, doesn’t it, not like a dog that’s allowed to frolic?).
So the third thing states do to get more money (apart from those taxes that weren’t even enough at 100% and outright “printing it” – but the latter is a bit more complicated to explain, not all do it themselves) is to sell “sovereign bonds”. The problem, as in fact with all bonds, is that you buy them (anyone in his right mind, of course) for only two good reasons:
- because at the time you think this to be the best (partial) investment you could think of and
- because you are sure you’ll get your money back plus regular interest payments (zero bonds are a bit different).
Now, two things can happen: while the bond still “runs” its course, i.e. is not yet redeemable, you might have a new feeling some other investment might be better for you or you become afraid, your debtor might not pay you back or not the full amount or not at the pre-agreed point in time.
If (almost) everyone had the first feeling, then (almost) everyone would like to swap their investment for the better one. This can typically happen when everyone buys into e.g. the next stock market bubble. This would by and large eventually depress the price of bonds until it had a level (or reciprocally the bond a higher interest rate) where it would again look favourable compared to other investment alternatives.
In the second case you would try to get rid of the bond as fast as possible, i.e. as long as someone who wasn’t so risk-averse as you or just had stronger faith in the debtor (or was oblivious) would still buy.
Both reasons for selling in the end amount to the same effect: the price for the bond in the market place falls to such a level where it became attractive for other buyers. If a bond was for one hundred dollars “nominal value” and carried 3% interest and it now fell to a market price of only 50 dollars then, if the debtor still paid interest as agreed at the time of the bond’s emission, then for a new buyer buying at 50 dollars that effectively would mean 6% interest. Very simple (actually the actual real interest rate in this example depends on the term to maturity, but we won’t go there in this post).
With sovereign debt there is a danger that not only (the reputation of) the currency itself will be harmed but all government debt. It kicks off a vicious circle whereby weaker bond prices mean higher interest rates and higher rates mean more debt service down the road (when the government wants to issue new bonds, as they always do, and more each time) which then gives buyers second thoughts as to how long “sovereign” states can keep rolling over their debt successfully in the future. If the debt is so disproportionately higher compared to the tax revenue or GDP (which itself already is overstated by various factors, one prominent one being state expenditure!) that no one can conceive of it ever being paid back, then investors begin to retreat. This can already be seen more or less drastically with Great Britain, Greece, Spain, Dubai, Portugal, Japan, China, Venezuela, Argentina, Pakistan, Ukraine, Iraq, Iceland, Latvia and … California (and I’ll add to this almost daily I presume). And then the blame games might begin which, if the last times are a guide, often end in outright war.
The moment this rot has set in, everyone tries to “quietly” sell their government bonds which sets off another hike in interest rates and so forth. But it gets worse: when this last point is reached, everyone knows there is but one alternative to outright sovereign default: the debasement of the currency. Either higher taxes or that.
So what does price inflation mean? Higher interest rates. Why higher interest rates? Because if you lend money at 3% for a year you expect to get 3% real interest.If prices on average rise by 3% per year, then you’d demand 6% interest. If you anticipate the state to debase the currency to get rid of debt, then you in advance demand higher interest rates (since you can’t change that later, i.e. after you bought the bond). If you demand higher rates then the next buyer anticipates that because the state now has a higher debt service burden, so more likely will he default. That drives up the risk premium a.k.a. interest rates. That drives up …
Well, I think we all got that by now (or does anyone reading this work in the government?).
Now, future reactions of potential government bond buyers hinge, I believe, on two aspects:
- Do they not yet see another asset that’s more worth their while buying (with house prices falling, all other assets depressed or volatile, and the, no sarcasm here, “flight to quality” they’re still desperately buying US bonds, look at at the Chinese)
- and do they still believe, the state will repay them?
We see two developments here: one is a slow education process where bond buyers become more and more aware that not just because someone has the title of POTUS or is an economics professor at Harvard or has a Nobel price need he be a guarantee for public debt. The guy is not personally liable and his bonus, forgive me, his pension does not, as is now discussed for bankers, depend on past performance.
You might also want to check out MoneyAndMarkets – Martin D. Weiss, Ph.D.: “Transcript: Nine Shocking New Predictions for 2010-2012“, 2010-03-01!
Are states then, hopefully, “too big to fail“? I’m sorry, he, who bails out every Tom, Dick and Harry, Fanny, Freddy and all the other in-laws (incest is said to make for frail constitutions), cannot bailout himself. Already bond investors are becoming nervous, people are buying gold as if there was no tomorrow, the dollar has depreciated terribly against the yellow metal etc. Chances are, you see the beginning of the above vicious circle.
So back to Mum and Dad Taxpayer, is it?