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The phrase “his word is his bond” is not heard as much these days as it was in my youth, back when Eisenhower was President. The phrase relied on a concept of “bond” that meant reliability. This reliability was based on predictability.
The other use of the word refers to bondage. The person who is in bonds is tied up. That also relates to the ides of a bond. A person is restricted by whatever it was that he promised to do. He is therefore predictable. The essence of “bond” is predictability.
Today, governments issue bonds. They have been doing this in the West for three centuries. They have been defaulting on these bonds ever since, just as they have been doing on all other forms of debt since at least the fourth century B.C. The rate of defaults has escalated over the last two centuries.
In an academic paper on these defaults, we learn this. “Most fiscal crises of European antiquity, however, seem to have been resolved through currency debasement’ — namely, inflations or devaluations — rather than debt restructurings.”
This is a tip-off. The politicians have sought to preserve the illusion of trust — “their word is their bond” — only to cheat the debtors by inflating the currencies. They repay the debts with money of reduced value. They pay the amount of money they owe, but the money will not buy as much. As the prophet Isaiah told Judah in the mid-eighth century B.C., “Thy silver has become dross” (Isa. 1:22a). This deception has been going on for a long time.
Modern defaults began in the sixteenth century. They accelerated in the seventeenth. “France and Spain remained the leading defaulters, with a total of eight defaults and six defaults, respectively, between the sixteenth and the end of the eighteenth centuries.” Then the ball really got rolling. “Only in the nineteenth century, however, did debt crises, defaults, and debt restructurings — defined as changes in the originally envisaged debt service payments, either after a default or under the threat of default — explode in terms of both numbers and geographical incidence.”
The modern era has been the great era of defaulting governments. Government bonds have often been viewed as risk-free. This is an illusion. This illusion led northern European bankers after the formation of the euro in 1999 to lend to the PIIGS’s governments at low interest rates suitable for low-risk Germany. That idiocy has blown up in their faces. Now the bankers demand that German taxpayers bail out the PIIGS, and the European Central Bank inflate in order to lend money to PIIGS banks, which in turn buy more bonds from the PIIGS’s governments. So far, their demands have been met.
This leads me to a consideration of the economics of government bonds. It can be summarized in one sentence: “Politicians’ words are their bond, and they are liars.”
SIPHONING OFF PRODUCTIVE CAPITAL
Fact: every dollar that goes into government debt is not going into the private sector. This is a major problem today. The U.S. government is borrowing and wasting an additional $1.2 trillion a year in on-budget (admitted) debt. Meanwhile, it must roll over existing debt as it matures.
The single most important economic factor in strengthening the growth of the modern state has been the development of government bonds. Governments have been able to sustain their growth because they have promised investors to pay interest on money lent to the government.
The government guarantees the payment of a specific rate of interest over a specific period of time. Investors, looking for safety, and looking also for a steady stream of income that is not subject to the risks of the free market, hand over their money to the government on the basis of their trust that the government will not default in any way on its obligations.
As mentioned, a major way that governments default is accomplished through mass inflation, or even hyperinflation. When governments, meaning central banks, increase the money supply, this has an effect on prices. Prices will begin to rise. Investors realize that the money that they will get back over the period of the loan will be worth less than today. So, they demand that the government promise to pay a higher rate of interest.
Those investors who accepted the government’s promise when the rate of inflation was lower now suffer capital losses. They hold IOUs from the government to pay a particular rate of interest, and now the government is paying new investors a higher rate of interest. So, new investors are not going to buy bonds from the older investors at the old selling price, because those bonds pay a lower rate of interest than newer ones. They are going to demand that existing sellers of bonds take a lower price than the sellers paid when they bought the bonds from the government.
SKINNING THE RICH
The ability of the government to extract wealth from rich people through taxation has always been limited. Rich people know how to hide their money. They know how to get it out of the country, and they know how to get it into markets that are less easily taxed.
So, politicians learned half a millennium ago to get their hands on rich people’s money before rich people started hiding their money. They did this by promising to pay a rate of interest on the money. Government bonds are ways of extracting money in advance, especially from rich people, which politicians would have preferred to tax directly, but which they did not tax directly because they knew that rich people would hide the money.
The whole point of the bond market is to enable the government to expand its operations beyond what would be possible by collecting taxes today. Politicians are able to get more money to expand operations today, because they promise to repay lenders a specific rate of interest. But, of course, this does not promise that the government will not repay with debased money.
When the international gold standard operated, 1815 to 1914, governments found it very difficult to cheat lenders over the long run. The gold standard was the means by which buyers of government bonds protected their investment against the indirect and insidious default involved in monetary inflation. The gold standard put pressure on governments not to inflate, because if they did inflate, there would be a run on the government’s treasury. People would bring in the government’s inflated money, and they would demand payment in gold. So, the governments dared not inflate their currencies.
Once the international gold standard ended at the outbreak of World War I, government bonds became the great means of extracting wealth from the rich population. The governments could then inflate to pay off those bonds with deeply depreciated money. They all did this. There is no government that did not extract wealth from bond purchasers by means of monetary inflation after 1914.
The lenders keep turning their money over to governments to buy bonds, always hoping that the government will stabilize the money supply, and that they would be repaid with fair market value.
When Richard Nixon unilaterally took this country off the gold standard in August of 1971, this was an announcement that there would be another wave of expropriation of bond investors. That expropriation began in 1940, and it continued until 1982. At that point, the Federal Reserve made clear that it would not inflate much, and long-term interest rates began to decline. Along with that decline came a rise in the stock market. We can date this: August 16, 1982. From that point on, there was sufficient fiat money to keep the system going, but it was obvious that mass inflation was not going to come, and so long-term interest rates began to fall. That was the basis of the rising stock market until the year 2000.
People trust the government. Rich people trust the government. Rich people turn over their money in advance to government, on the promise of the government to repay that money at a fixed rate.
Today, bond interest rates are probably at the lowest that we are going to see. Long-term interest rates I believe are very close to the bottom. From this point on, the recovering economy will begin to push long-term interest rates back up. People who have bought long-term bonds will begin to suffer capital losses.
GOVERNMENT BONDS AS SPECULATIONS
The case for government bonds vs. corporate bonds is simple. Governments do not repay bond holders when rates fall. Corporations do.
When rates fall, bond prices rise. Corporations that are saddled with expensive bonds issue more bonds at a lower rate and pay off existing bond holders. “Heads, you lose.” But if rates rise, the bond holders are stuck with a declining asset. “Tails, you lose.” If a bond can be recalled (paid off early), it’s not a good long-term investment.
The same is true of mortgages. The debtor will re-finance.
Government bonds can be a temporary port in the storm. That is, they can be a speculation. But the idea that you can buy them and hold them to maturity is a myth. Eventually, governments default.
VOTE “NO” ON MUNICIPAL BONDS
With respect to general political principle, no one should ever vote for the issuing of new bonds. This is always an attempt by local politicians to increase the amount of money they have to spend, spend, spend on boondoggles and good old boy deals. There is no aspect of local government that is more corrupt than the issuing of bonds for general obligations or even specific obligations. This is the way that local politicians pay off their constituents who have real money, and who contribute to campaigns. One group of investors, meaning distant bond investors, are expropriated over the long term, while other constituents, meaning the local good old boy network, profits as a result of this expropriation.
The voters are then put on the hook to repay the bonds. The higher the bond indebtedness, the more that local taxpayers must repay the original investors. If inflation does not wipe out the obligation, then taxpayers are going to see taxes rise on their property, or see local sales taxes increased.
Because property taxes are the basis of county government, people cannot hide the taxable asset. The government knows who owns the property, and the government can extract payments from the voters until such time as there is a voter rebellion. Because voters pay very little attention to county government, they do not understand that the constant issuing of new bond indebtedness is the basis of their loss of liberty at the local level.
This is why any conservative political movement should have as its number-one goal, locally, the blocking of every bond authorization election. They must do whatever is necessary to alert voters to the costs of paying off those bonds, and the power of the voters to stop the expansion of local government and stop the expansion of rising property taxes by means of politics.
Local politics should focus on strangling local government expenditures. The best way to do this is to make certain that every bond authorization that comes before the voters is defeated. If the good old boys locally cannot raise money by means of bond sales, they will have to do it by direct taxation, and this creates political resistance.
The expert here is conservative activist Paul Dorr. He trains people in the techniques of defeating municipal bond elections. Let us hope that others adopt his techniques and sell their services.
Americans are so convinced that long-term debt is a good idea that they find it difficult to organize politically against bond issues locally. They vote for the bonds, because they think it is essentially free money. They are present-oriented, and they do not factor in the effects of increased bond indebtedness on local property values and local business.
This is the heart of the matter. The voters, who legally control the issuing of bonds, are present-oriented, which means that they discount sharply the costs of paying off the bonds in the future. On the other hand, investors in bonds are future-oriented, and they see the advantage of getting a future stream of income without any risk on their part, or so they think. They assume that the risk is minimal, because they assume there will be no mass inflation, and they assume that there will be no taxpayer revolt. They assume that the pension obligations of the cities and counties will not force either the bankruptcy of these jurisdictions or else force a default on the bonds. It is much less risky politically to default on bonds owned by distant investors than it is to raise taxes on local taxpayers.
There is going to come a day when the defaults begin, and people who have turned their money over to the government will rue the day they ever trusted the government. The politicians know that bond investors have short memories, and that they will come right back with their money to do it again. We have learned that repeatedly over the past 400 years. Investors in Latin American bonds have learned this every generation for over two centuries. Slow learners wind up big losers.
When governments resort to inflation to stimulate the economy, they ultimately undermine the hopes and dreams of bond investors. But there are not many bond investors, so governments really do not worry very much about undermining their dreams.
I hope this cycle can be broken. If the great default is great enough, maybe it will be.
April 21, 2012
Copyright © 2012 Gary North