From Vern Gowdie on the Gold Coast: Over the weekend Richard Holden, a professor of economics at the UNSW Australia Business School wrote an article inThe Weekend Australian titled ‘Economy like a car in need of a tune-up.’ Here’s the problem with that: the economy is not a machine that can be tinkered with successfully. It’s a complex organism where people make billions of decisions every day on investments, expenditure, saving and consumption. Machines are more or less predictable. Economies are not. As Bill Bonner asks: What machine has intelligent parts… each responding to its own information base, more or less independently? But this isn’t even the main problem with the article. According to Professor Holden, it’s misguided to think government finances should be managed the same as a household. His argument is that households have a finite life. Households need to live within their means to pay down debt over their lifetime. Governments, on the other hand, are perpetual, so there’s no need to focus on debt repayment. The debt baton can be passed from one generation to the next indefinitely. Professor Holden goes on to say business debt is also different to government debt, though I do agree with this insight: And notice that most businesses have a positive level of debt permanently. That’s precisely because good businesses have attractive investments to make, can borrow at lower rates than the expected return on those investments and expect to be around a long time. Business, in theory, borrows to make investments it believes will deliver a greater return than the cost of the borrowed money. The investment industry calls this ‘good debt’. On the other hand, ‘bad debt’ is money borrowed for things for which there is no return on investment. The majority of government debt falls into this category. Since the GFC, governments the world over have been issuing bonds (notes of promise) to raise capital to fill budget shortfalls and to fund their ‘stimulus’ schemes. The money borrowed to finance wanton government spending provides no productive return on capital. Further, it’s money on which interest must be paid. I was surprised to find myself partially agreeing with another thing Professor Holden said: Government doesn’t make stuff and it doesn’t create jobs or wealth. I say partially because government does create jobs — public sector jobs and plenty of them. Government sets up bureaucracies that levy taxes (duty, surcharge, excise etc.). They then collect and re-distribute these taxes. When the taxes collected don’t match the amount to be redistributed, governments borrow by issuing bonds of varying durations. The bond is a promise to pay back the amount of money that’s been borrowed together with interest on the borrowed money. If you follow Professor Holden’s logic, this process of promising to repay can be carried on into perpetuity. Really? Does the term ‘sovereign default’ come to mind? Since 1900, Argentina has defaulted six times, Greece twice, Russia three times and Germany once. The list of defaulting sovereigns is a long one. History shows there’s a tipping point at which even a nation’s finances can no longer afford the cost of debt...just like a household. The nation goes bankrupt...just like a household. The academic economists will say ‘yes, but it is different now. Modern economies are much more stable under the control of central bankers.’ As Minsky famously said, ‘Stability leads to instability.’ The abolition of the gold standard in 1971 gave central bankers the licence to print money, and they’ve taken full advantage of it in recent years. The fact central bankers have created relative ‘stability’ via the printing press doesn’t mean the system isn’t vulnerable to a wave of future defaults. A government bond, in theory, is the most secure investment an investor can make. The implication is the government guarantees your money (principle and interest). . The reality is a government bond is a promise — not a guarantee — to be paid. History tells us not all these promises have been kept. Our children and grandchildren deserve far better than to start their working life burdened by the costs of our collective indulgences and financial mismanagement. We, as a society, should live within our means. The problem is governments have over-promised and now cannot deliver. Tax collections are insufficient to meet outgoings. News that the Eurozone’s headline price index fell to -0.2% in December has been a call to action for the European Central Bank (ECB) to slay the deflationary dragon. The call to arms involves cranking up the printing presses to fund government bond purchases. Creating money ex nihilo to underwrite government budgets is a ridiculous proposition. It has somehow gained credibility thanks to academic economists and central bankers endorsing it. . Politicians love it because it absolves them of hard decisions. On 9 January 2015, the UK Telegraph said: The European Central Bank has drawn up a plan to buy up to €500bn of high-quality government debt as it mulls over how best to inject a fresh round of monetary stimulus into the ailing currency bloc. What is high-quality government debt? When the country has a low debt to GDP ratio? When the country has a AAA credit rating? When the government is in firm control of the printing presses? The following table is a list of major 10-year government bond offerings (in descending debt/GDP order):
Japan, with the highest debt to GDP ratio and only an ‘A’ credit rating has the lowest 10-year rate on offer, 0.28% PER ANNUM. In a true market, Japan’s rate should be closer to that of Greece and Russia. However, the Bank of Japan (BoJ) is in complete control of the money press. The BoJ owns the Japanese bond market at present and is setting its own price. So much for a free market. The prospect of a Greek exit from the warm embrace of the euro is reflected in the 10.14% rate. Without the ECB printing press underwriting the promise to pay, investors are a little nervous on the prospect of default. And rightly so. Whereas Italy (not far behind Greece in terms of debt to GDP ratio and credit rating) is paying a fraction of the price (interest rate) for its debt. Why? Because it’s backed by the ECB presses. Finally, look at Russia. By far the lowest debt to GDP ratio and a credit rating only a couple of notches below Italy and Spain, but the heightened risk of default has been priced into the 10-year bond yield. Note that Greece and Russia both have a history of default, so perhaps this is also priced into the equation. In a normal world (one where massive central bank intervention doesn’t distort market values), bond pricing was traditionally a function of the inflation outlook and an assessment on the capacity of the issuer to honour their promise. However, these days, bond rates appear to be determined by the level of central bank intervention to buy bonds to support government deficits. The more intervention, the lower the rates. Japan doesn’t have a snowball’s chance in hell of ever balancing its budget. It’s debt pile will grow into perpetuity...until it doesn’t. Surely Japan, even with wafer thin interest rates, cannot print money forever to bridge the gap between declining tax revenues and increasing expenditures. Eventually, the unintended consequences — massive currency depreciation, higher inflation, soaring energy costs — would ring the bell on this folly. The suggestion that government debt can be carried on into perpetuity is a reflection of how far the economics profession has drifted from reality. I may not be an economics professor, but I know that for households, businesses and governments ‘there’s no new way to go broke, it’s always too much debt’. Sovereign nations do default when debt burdens become too onerous or it’s politically opportune to give a two fingered salute to foreign financiers. When the era of living beyond our means meets economic reality, these ‘perpetual’ debt machines will grind to a halt. Sovereign debt defaults will mark the end of this era and hopefully the dawning of one where economic common sense prevails. Regards, Vern Gowdie+ |
