In my previous report, "There Is No Money," I surveyed Europe's sovereign debt markets. I argued that the outgoing Chief Secretary to the Treasury of Great Britain, Liam Byrne, hit the nail on the head when he placed a note on his desk for the incoming Chief Secretary to read: "There is no money." He did this as a joke, as he later explained to the media, but the joke was on the incoming government: there really is no money. But there are expenses — lots and lots of expenses. These expenses will increase. Tax revenues will not cover them
What is true for the government of Great Britain is also true of all national governments in the West. The European governments are all running unprecedented deficits for peacetime, some greater than others as a percentage of national production.
Investors are content to continue to buy IOUs from these governments, despite the fact that no modern national government is expected to pay off its debts, and no mainstream economist would recommend any such policy. It is universally assumed that government debt is forever. It is also universally assumed that economic growth is also forever. The fact that national government debts around the world are racing ahead of economic growth is assumed by investors, voters, and economists to be a temporary phenomenon. It isn't temporary. It is permanent.
Bond investors have the choice among national government bonds, state bonds, municipal bonds, and corporate bonds. They select national government bonds first of all. They seek predictable interest payments. It is widely assumed that no large national government will ever default on its debt. It is also widely assumed that no national government can ever pay off its debt or should pay off its debt.
Investors buy national government bonds because they expect to be able to get out of this purchase at any time. In other words, they expect liquidity. They believe that they individually will be able to sell the bond and gain a currency of predictable value at any time. They also know, of course, that if everybody tried to sell his government bonds at the same time, interest rates would skyrocket, the market value of the bonds would collapse, and nobody would get his money back. But they assume that this is no different from any other capital market. If anybody wants to be able to get out of a market, he assumes that he will be able to get out of it simply by calling his broker and telling the broker to sell the asset. He knows that not everybody can get out at the same time, but he also believes that not everybody will attempt to get out of the market at the same time. So, liquidity is a matter of selecting particular markets that are less likely to be subject to sell-offs at the same time.
The crisis that has overwhelmed the European capital markets since April 23, 2010, when the Greek government said it could not meet its obligations, has begun to raise questions in the minds of investors regarding the liquidity of certain European governments' sovereign debt. It is not that they believe that they will not be able to sell at any time. It is that they believe that they will not be able to sell for the same amount of money that they have invested in the bonds today. In other words, they think liquidity will decrease. They think interest rates may increase, which is the same as saying that they think the market value of their bonds may fall.
There is now a quest to buy the sovereign debt of nations that will retain the liquidity of their bond markets, but will not be subject to interest rate spikes, and will not be subject to mass inflation by the nation's central bank. The quest seems to arrive at the door of the United States Treasury. From around the world, investors are shifting resources in the direction of United States government bonds. They are doing this because they believe that this is the largest bond market in the world, and that there is the least likelihood of a collapse of liquidity. They believe that they will be able to sell their bonds at any time, and receive back dollars of constant purchasing power.
TOO BIG TO FAIL
The problem with this assumption is that the size of the United States debt market is large precisely because of the enormous increase of Federal debt. It is precisely the increase of the debt, now expanding by $1.5 trillion a year, that convinces investors that it is wise to buy U.S. Treasury debt. It is the very magnitude of the obligation that convinces them that there is liquidity in this market. The largest debtor in the world is presumed to be the most reliable debtor in the world. The largest amount of debt owed is presumed to be the safest place to purchase additional bonds. In other words, it is the very inability of the United States government to run a budget surplus that increases the demand for the debts of the United States government.
On the surface of things, the arrangement sounds insane. Why would anybody continue to lend money to the biggest debtor in the world, meaning the debtor who would be least likely to be able to repay his debts? The answer is liquidity. It is the very size of the debt that persuades individuals to buy more debt. Why should this be? Because, given the law of large numbers, they assume that this market is least likely to be subject to a run on the bank. It is least likely for debtors to cash in their bonds in a quest for greater income. It is least likely that they will be stiffed by the United States government, precisely because there are so many other debtors. They assume that there is safety in numbers. The sale of their debt on any given day is least likely to have any effect whatsoever on the market for United States bonds, precisely because this is the largest bond market in the world.
You can see where this is heading. Investors can also see where this is heading. It is heading towards default. The largest debtor in the world is unable to balance its budget. Of all the debtors on the face of the planet, this one is the most obvious debtor to default, unless he changes his ways. But what we see is that Congress is not changing its ways. If anything, it is spending more today than it has ever spent in peacetime American history. We are seeing an acceleration of the debt, which means we are seeing the expansion of this gigantic debt market.
Rather than increasing the likelihood of an individual being able to get his money out of this market, debt is increasing the likelihood that there will be, at some point, a kind of run on the bank. There will be some large creditor, such as the Peoples Bank of China, which will decide to unload its share of the debt of the United States government.
RUNNING UP THE TAB
The United States government is beginning to resemble a very rich drunk who has credit with every bar in town. He has always paid his bills on time in the past, and he consumes an enormous quantity of liquor each month. Every bartender in town is happy to see him come in the door, because he knows that the guy is going to drink more than his fair share of the available booze. Again, he always pays on time.
Over time, he begins to run up the tab in each tavern. At the end of the month, he always pays. This seems like a good deal. But, as time goes on, and his sobriety becomes less frequent, some bartender begins to worry that the guy's tab is growing at an alarming pace. He knows that other bartenders in the town have been serving the guy, and he begins to think that in the man's race between sobriety and insolvency, his tavern is going to wind up with a gigantic unpaid bill. So, he tells the drunk that it's time to pay up. The drunk insists that there is no problem, he is perfectly able to make the payment at the end of the month. But the bartender insists, so the guy writes a check to the bartender, and then continues drinking.
The bartender takes the check to the bank, and there is no problem: the check clears. But the bartender has a suspicion that if every bartender in town decided at the same time to demand payment from this decreasingly sober client, they would find themselves owners of unpayable IOUs. Nevertheless, the other bartenders continue to extend credit. After all, this man has been around for a long time. He has never defaulted in the past. He keeps drinking, and he keeps paying.
Then, one day, he falls down in a stupor, and a bartender has to take him home. When the bartender decides that it's time to get paid, the man insists that he will be able to pay real soon, but he cannot do it at the present time.
There is no question that at some point the drunk is going to default. Every bartender in town is making a good living by extending the guy credit, but every bar is at risk of default by this man. In fact, there is not a bartender in town who doesn't know that this guy is going to drink himself into poverty. Nevertheless, bartenders being what they are, nobody sends him away. Everyone thinks he is still good for the money. They keep letting him drink at their expense, until, one fine day, he is taken to the hospital, strapped into a bed, and is forced to go cold turkey. He hasn't a dime to his name. Everybody who extended credit finds that all they have for their forfeited liquor is a stack of IOUs.
If ever there was an out-of-control default with respect to fiscal policy, it is the United States government. The government simply cannot stop spending. It is unwilling to increase taxes, except on the rich, but then that threatens a political revolt. So, the government keeps borrowing, and it keeps spending.
THE OLYMPIAD OF DEBT
The race is on around the world, in what might be described as the Olympiad of debt. Governments around the world are spending at record rates, and the only reason that they can do this is that investors continue to extend credit to them.
The investors have long since given up any hope of repayment, but they still retain hope of liquidity and regular interest payments. They expect the governments to service the debt, yet they know for sure that it is impossible for the government to repay the debt. So, they look for salvation in economic growth. The trouble is, it is clear today that there is no possibility that economic growth is going to be able to overtake the gigantic debts of central governments. Traditional Keynesians and Chicago school economists do not raise the alarm, and investment advisers do not raise the alarm.
It is obvious to anybody who can look at a balance sheet that the governments are going to default. So, like the bartenders filling the glass of that drunk, everybody hopes that he will be paid off, despite the fact that everyone knows for certain that not everybody can be paid off at the same time.
The bartenders all hope that the drunk is going to remain productive enough in his hours of sobriety that he will be able to pay off his debts at the end of the month. Yet it is obvious, day by day, that the man is losing control. He is rarely sober, and it is unlikely that he is going to be able to borrow additional money from his relatives to continue to run up the tab in every tavern in town. So are the governments of the West.
We know what is going to happen, yet nobody seems to care. People are still lending the United States government trillions of dollars at an interest rate of about 4% for a 30-year bond. They are lending the government money at less than 2/10 of a percent for 90-day debt. The investors' faith in liquidity, which is faith in the magnitude of the government's debt, reinforces the spending patterns of Congress. Like the drunk who gains self-confidence because every bartender in town is still pouring drinks into his glass in exchange for a promise to pay at the end of the month, so is the Congress. It is borrowing money from investors and especially Asian central banks. The digital booze keeps flowing in from around the world.
The lunacy will end, but only when the major bartender, the Peoples Bank of China, decides to quit extending credit to the United States Treasury. When that day happens, interest rates are going to climb, the market value of the debt is going to fall, and there will be gnashing of teeth around the world. No central banker wants to be the first one to pull the plug, or even the second plug, but all of them are perfectly willing to pull the third plug, to make certain that they are not stiffed by the United States Treasury. Nobody wants to be first in line in the bank run, or even second in line, but everybody is going to try to be third in line.
What is true of the United States is true of every Western European government. They are all running up the tab, and they are drinking more heavily than ever. I suggest that you look into the future with the same clear vision that you would if you were advising a bartender about extending additional debt to members participating in the Olympiad of inebriation.
I suggest that to the extent that you have extended credit to the United States government, such as in the form of Social Security payments and Medicare payments, that you make plans to find other sources of income and subsidized medical care than the falling down drunk who has been staggering into the tavern over the last seven years.
The amazing thing is that this advice is regarded as radical. This is regarded as off-the-wall crazy by conventional financial advisers. They believe, as Congress believes, that there is no end to the floating of debt, that economic growth will overcome the debt, and that sobriety is one drink away. "We can quit borrowing at any time. We just don't want to."
June 7, 2010
Copyright © 2010 Gary North