The short of the century – The bubble in government bonds is finally bursting

Government bonds

“The government can always pay.”

This is a statement that has no basis in fact. Any rational analysis will quickly expose it to be a fallacy. Economic theory, economic history, and plain good old horse sense can demonstrate effortlessly that this statement is an illusion. Yet, it is today a widely held and deeply cherished illusion in the world of finance (and, incidentally, the world of politics). In fact, it has become one of the defining myths of the modern fiat money era. It has for decades provided portfolio managers and bankers with an imaginary refuge from the turbulent world of capitalist “creative destruction”, a ‘safe haven’ where their nerves and capital could rest. The ‘free lunch’ might not have been a feast – only the ‘risk-free rate’ was to be had – but it was better than nothing and anyway a welcome break from capitalism and entrepreneurship. And by the way, if you leverage your government bond portfolio sufficiently with the help of central-bank-provided, zero-cost fiat money, the returns could still be quite handsome.

The fate of myths is that they sooner or later clash with reality. Then they are exposed as myths, which requires a painful giving-up of beloved certainties, a readjustment of paradigms and an abrupt change in behaviour. This is what we have been witnessing in European sovereign bond markets and will soon observe outside Europe as well. To believe that this process would stop with Greece or even Italy, as seemed to be the consensus in the summer of 2011, was naïve. That it would stop with France or even be contained within the European Monetary Union is the present hope of government bond investors and government-bond issuers, i.e. politicians. It is equally naïve and it received a meaningful dent last week in form of the worst auction result for German government debt (Bunds) ever.

When the irrational belief that the major governments – those of the U.S., Germany, U.K., France, Japan – can and will always pay, regardless of the size of their overall obligations, and that their bonds are therefore ‘risk-free’, is finally being questioned, we could witness a momentous change in market behaviour. That this moment will be reached at some point is beyond doubt. I would argue that this moment could be sooner than many think.

Before we look at present events more closely and risk a peek into the future, let us revisit some of the fundamental facts of government bond investing.

Some basic facts about lending to the state

Printed money

Photographer Graeme Weatherston.

Government bonds are not backed by productive capital and will not be repaid out of capitalist production, at least not directly. Those who lend to the state do so in the expectation that the state, after consuming what it has borrowed right away, will repay its creditors by either taxing the productive section of society (i.e. those who have not put their money into ‘safe’ government bonds but risked it in a competitive enterprise and managed to generate a return by providing something of value to the buying public) or by printing the money and thereby taxing the fiat-money users in society (i.e. everybody) via a declining purchasing power of the monetary unit. Government bonds channel savings back into consumption, and they shift scarce resources away from employment that is directed by markets (and thus ultimately consumers) and into employment that is directed by politics. The rising public debt levels of the modern fiat money era indicate substantial and growing waste of resources and misallocation of capital, and are harbingers of great social and economic upheaval.

That banks and portfolio managers lend so generously to the state is not surprising as the cost of error (over-lending and over-borrowing) is apparently easily socialized across the wider public, either via higher levels of taxation or faster paper money debasement. “The state can always pay.”

The game is now up. The accumulated debt load has become too big to be serviced or repaid in any stable manner out of taxation or fiat money creation. If these mechanisms are nevertheless still employed it must lead to chaos.

Fact is this: Around the world government spending, budget deficits and accumulated debt loads are unsustainable in light of real underlying economic strength and the true available pool of private savings. But the modern welfare state cannot shrink. Nobody in the political machinery has any idea how it should be done. The fiat money economy is not built for deleveraging and the welfare democracy not for downsizing.

If you needed any further evidence of this you got it in spades last week. In the U.S. the ‘super-committee’ failed to reach agreement on spending cuts, and in the UK the Prime Minister admitted that the government was failing in its effort to reduce the debt load and announced various subsidies for the housing market, tax-funded bribes for companies to hire unemployed teenagers, and New Deal-style infrastructure projects to ‘kick start’ the economy.

federal reserveThe confused and pointless “Occupy Wall Street” movement seems to have brought to the forefront of public discussion again the notion that all of this could be sorted by taxing the rich. That this is even debated shows how little the public appreciates the sheer mind-boggling extravagance of the modern welfare-warfare state: In 2011 the U.S. government will have spent at least $3,700 billion while taking in about $2,200 billion, thus running an eye-watering $1.5 trillion deficit. It collects less than $1 trillion in income tax. Thus, even if the government doubled its intake from income taxation instantly it could not close the budget gap. The situation is completely out of control, and to those who believe that this is no problem because the U.S. government can always print the money, I can only say: Be careful what you wish for.

Beyond repair

But back to Europe, which continues to get most attention at the moment: As I said, long-held and cherished myths are not abandoned easily. The investment community has for months demanded ever more urgently a policy ‘bazooka’ that would restore the old order. Of course, by this is meant again the established mechanisms for repaying the lenders to the state: tax somebody else or print money. If the taxes needed to repay Greek and Italian debt could not be had from Greeks and Italians, then the Germans should pay as part of ‘fiscal integration’ or communal bond issuance. Or, the bond investors get repaid out of printed money from the ECB. “Unlimited bond-buying” via the printing press was the other bazooka.

Such proposals are unoriginal and illustrate that the gravity of the situation is not fully appreciated. Germany and France simply lack the resources to bailout the others, or even their own banks. As to the ECB’s printing press, as I explained here, ‘unlimited’ bond buying cannot be limited to Italy, which in itself would pose an enormous challenge. The overall size of the operation would soon be such that concerns about inflation must rise, and once real interest rates begin to go up deficits will expand even faster, forcing the ECB to buy ever more bonds. A spiral of ever higher real rates, more central bank bond buying, and in turn rising inflation expectations and even higher real interest rates is the classic fiat money endgame.

(At this point I often get the following comment: But what about Japan? Have they not been conducting QE for many years without a rise in inflation? — No! The Bank of Japan’s balance sheet is roughly the same size today as it was ten years ago. By contrast, since 2008, the balance sheets of the Fed, the Bank of England and the ECB have roughly tripled in size. For numerous reasons, Japan is a gigantic accident waiting to happen but in terms of monetary sanity the Japanese are presently the least mad.)

Eurotower In Frankfurt

ECB, photograph by Florian K

The political class, the fiat money bureaucracy and their eager creditors in the financial community have collectively checkmated themselves. Dreams of the policy ‘bazooka’ and the helpless babbling about ‘lack of political leadership’ cannot mask that sinking feeling that a lot of the ‘risk-free assets’ that have been carelessly accumulated over recent decades now turn out to be toxic waste that could burn a sizable hole into investment portfolios. Hiking taxes or printing the money is not a sensible solution but that does not mean it won’t be tried – it most certainly will be, and with predictably disastrous results. But here is the funny bit: if these are the potential outcomes of the European debt crisis: defaults, fiscal integration, unlimited helicopter money  – why would anybody buy German Bunds? Did anybody really think that the ECB could print the entire European sovereign bond market to a sustainable 2 percent communal interest rate, or that in a fiscal union everybody converges on Germany’s 2 percent rate? Yet, for months and months now (until last week), the investment community has happily piled into German debt as the alleged ‘safe haven’. Why?

Mass psychosis

To explain this we have to resort to psychology. As I explained here, amateur psychology has no place in economic theory but it is often useful when trying to make sense of short-term market phenomena. Traders, bankers and investors simply didn’t want to give up the myth of the safe asset. Although the problems are essentially the same almost everywhere, the investment community did not want to believe that government bonds as such were a dodgy investment but only that certain government bonds were dodgy investments. Bizarrely, the realization of acute fiscal predicament in one state thus led to massive inflows into the bonds of other, only slightly less fiscally challenged states, which were then prematurely declared ‘safe havens’ precisely until their predicament was exposed as well. It almost appeared as one only had to wait for the tidal wave of fiscal concern to take one state after another out of the safe-haven basket into the basket of basket cases.

So why not get a step ahead of this train wreck in slow motion and go short Bunds, U.S. Treasuries and UK gilts now? The math on these seems straightforward. If the ECB, the Fed and the Bank of England do not engage in large-scale money-printing (and once again, they certainly should not but the Fed and BoE are already itching to do more) then the underlying disinflationary forces and the fiscal death trap that these nations are already caught up in should make their bonds excellent shorts: the endgame is default. At least this would be an honorable and not entirely unethical outcome. But more likely is the somewhat cowardly ‘solution’ of debt monetization. The many bank economists who are now clamoring for this approach do so against better judgment – one can only assume they do it out of desperation, which gives us some indication of the situation their banks are in.

The problem is way too big for some elegant inflating-away of the debt. As QE in the U.S. and the UK demonstrates, providing a fiat-money-funded backstop to the government does not mean debt-reduction but additional debt-accumulation. Once started, large-scale bond buying will have no endpoint but simply have to continue ad infinitum. This must at some point raise inflation concerns and thus lead to ever more of the remaining private-held government bonds getting dumped onto the central bank. To keep the government in business the central bank will then have to print more money faster and do so at times of rising inflation expectations. This is a recipe for disaster. The endgame is currency collapse and default.

While the math seems to be clear, the desire to believe in the infallibility and omnipotence of the state, which in our secular age has become the new deity, is powerful and may keep those government bonds bid for a while longer. Who knows? But when the ice breaks, this is surely one of the major trading opportunities in this unspeakable financial mess, maybe the short of the century. In this context, the events of last week were meaningful. Reality has finally caught up with German Bunds. The poor price action in Bund futures is indication that German government debt is losing its safe haven status. Fiscal concerns are now engulfing ‘the core’ of Europe. Again, investors desperately hold on to their belief that ‘safe havens’ exist somewhere out there, so they are stupidly piling into Gilts and Treasuries. Soon these will make an excellent short as well.

1 kilo gold bar

The essential self-defence asset (photo by Swiss Banker)

At this point, I should probably add a disclaimer: The purpose of this site is not to give investment advice but to provide a different and – I like to believe – superior explanation of the present crisis. I am expressing opinions here, and it remains the responsibility of the reader to see if he/she follows my rationale and what conclusions he or she draws for his/her own actions. We are in the endgame of our present – mankind’s latest – experiment with unlimited state paper money. This crisis will continue to unfold and many people will lose money. If we understand this crisis correctly, we may protect our wealth better. For this, I believe, holding substantial positions in physical gold (and probably a few other assets) is crucial. But there could occasionally be other opportunities to make money. This crisis has already exposed the fallacy that our fiat money system in combination with deposit insurance and hyper-regulation has made our banks safe. The next fallacy to get exposed is the belief in safe government bonds. The consequences for financial markets are enormous – and this can offer opportunities. But be careful. Markets are very volatile. Also, at some stage in the future, I expect government interference and a ban on naked shorts. But until that happens, we could be looking at the short of the century.

In the meantime the debasement of paper money continues.

 

 

 

 

 

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Last week in Europe - Some thoughts on the ongoing crisis
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Comments

  1. Eveready says

    This should be posted everywhere Detlev.
    I think Germany having a problem selling bonds is a psychological tipping point with investors. It really is hard to, in one’s mind, to justify that the US and Britain is the safe alternative to those spendthrift, profligate Germans!

  2. Steve Thompson says

    Not only do we need to be concerned about Europe’s unsustainable debt levels, the United States and their $15 trillion debt are rapidly approaching the point of no return. As shown in this article, it is becoming less and less likely that America will ever be able to balance its budget, particularly if interest rates should rise to historical norms:??

    http://viableopposition.blogspot.com/2011/11/united-states-debt-interest-scenarios.html

  3. Zog says

    Detlev, the logic of your argument for shorting government bonds is sound enough, but how do you find a counterparty that is likely to survive the debacle impied by the same logic?

    • says

      Hi Zog, good question. This is a highly speculative trade, so one should not commit too much capital to it. It is very different from the long gold position in my view. Apart from the risk that the market goes against you for a while longer (even if you are “ultimately” right) additional risks include the possibility that, just when the trade really begins to work, the government bans naked shorts in their debt (remember that naked shorts in certain bank stocks are already banned in various European countries – by simple administrative decision, completely arbitrarily) or that your broker goes under (remember MF Global, which seems to be a gigantic disaster and gives you a taste of what could be in store). How can you deal with these additional risks? — You cannot. So you have to scale your trade accordingly. You must be able to lose the money you put into that trade. But remember, this is not a trade to sit on and hold throughout the crisis. The loss of faith in government bonds is still an early phase of the crisis. This is ultimately followed by more aggressive money printing by the central banks – hey, somebody has to pay for those government checks! – and then loss of faith in paper money, or, in the absence of helicopter money, government default. At these later stages of the crisis you may want to be already out of the trade. Again: this is not a trade to put on, forget and hold throughout the crisis. This is my personal take on it.

  4. NICK GREENWOOD says

    All very interersting and many would agree, but you tell me HOW to short UK treasuries. I would love to short the 10yr bond rate – but there is no instrument by which to do so. If I’m wrong, I would be delighted to read it. Though not with a spreadbet please – I mean via a tradeable security of some kind so that I can do so in my SIPP.

    • says

      Nick, there are Long 10 year Gilt futures traded on Liffe in London. I can’t see why one should not be able to short those. Please speak to your broker about it. However, I don’t see why a spread-betting firm would not be a possible solution too. Whether this is a good trade for a SIPP I can’t say. Please see also my response to Zog.

  5. says

    The USA has a big, big debt problem. Have a look at http://www.usdebtclock.org

    The National debt has just gone through US$ 15 trn (100% of GDP)
    Look at the data at the bottom of the website referred to above.

    This shows that the unfunded liabilities (i.e. those which will have to be paid for from future taxation or future borrowing) of the US are about USD 116 trillion (!!!) or USD1mn per taxpayer.

    It is not all gloom and doom , assets per citizen are USD 250,419. Debt per citizen is USD 48,157. The problem is those unfunded liabilities of USD 116 trilion which are off-balance sheet and hence usually ignored.

    The “Supercommittee” could not even come with a mere USD 1.3trillion of cuts over 10 years .

    However, this does not mean US debt prices will fall immediately as the USA seems to benefit from global capital flows and a safe haven status which it to borrow at 2% for ten years. This represents a negative real return. Indeed if inflation takes off in the next ten years it could represent a very bad trade.

    However if you are going to short US government debt, the timing of the trade is critical. As Keynes observed, “the market can remain irrational longer than you can remain solvent”.

    • Paul says

      I have no doubt that shorting government debt could be highly profitable and it seems that other smart people such as Kyle Bass are recommending the same thing – especially Japanese debt.
      Agree with you Sanjiv about timing; hence shorting is not for me. I think I’ll stick with my ‘boring’land which gives me small yield, which I will convert to gold, and stress free life.

      • says

        That is a very sensible approach. As I said in my blog, I try to provide a kind of intellectual road map of where I think we are going. Everybody has to work out for themselves what to do and what suits them. Not everything is for everybody. However, I would not be too timid in buying gold. And please remember: owning land exposes you to the taxman. Just look at the situation in Greece. Just a thought.

        • Paul says

          Thanks for your reply Detlev,
          I farm the land and have a registered farm business which brings in a small income, plus I grow veg and rear livestock for our table. I am lucky enough not to rely upon the income as there is no real money in farming but I love developing the land and seeing it productive. I am hoping that the government would not be so stupid as to heavily tax the country’s food producers (though anything is possible)
          I take your point about not being too timid with regards to gold and I am researching the best ways to hold it and to avoid a paper trail.
          Thanks again for a great blog

  6. says

    Another brilliant article Detlev. I only wish I believed you were wrong.

    I listened for a while to the Governor of the Bank of England and his colleagues at the Treasury Select Committee today: Sir Mervyn was frank that they cannot predict the general pattern of events. The Eurozone crisis was “not in the fan chart” predicting growth…

    Eventually, reality will prevail, but what a historic, scandalous failure of public policy it seems we must live through.

    • Peter Manousakos says

      I agree with MP Baker. But I feel I need to return to this notion of the failed policies I wrote about below; as spectacularly insane as these policies are, individual entrepreneurs seem to always provide a counter balance of sorts. I agree with Dev and his readers; but the sly devil in me can’t help but be impressed that we have bought so much time. New industries have been born, entrepreneurs upsetting economic paradigms not as a result of these insane policies, but in spite of them. One can’t help but be impressed. Having said that…Bring back honest money! :)

  7. Patrick says

    FDR made the private ownership of gold illegal in the US during the events of the 1930′s, so anyone who’d bought it after the crash had no option but to either sell it to the Fed Govt at the price they set, or dig a hole to keep it in for an unknowable future period. As someone who is in the lower percentile income wise, though with some savings, I don’t see any strategy which would offer protection to the likes of me, and ‘me’ probably includes a very sizeable proportion of the population of the UK. Nevertheless, I intend putting your book, Detlev, on my Christmas list, because I like your clarity of thought and expression. I shall resist the temptation to sound off about the neccessity of stockpiling baked beans, cigarettes and shotguns….at least until the pud has been digested.

    Thanks for an excellent blog btw, which I only discovered a couple of weeks ago. I agree with your perception (hope I read you right) that we could be coming up to the fruition of yet another consequence of the Great War, as its 100th anniversary arrives.

    • Peter Manousakos says

      It’s a terrifying thought Patrick but unlikely in my opinion. The mechanisms of dissent in our society are too strong. Western governments has never been more terrified of its citizenry.

    • Christian says

      Patrick, bear in mind that FDR nationalised private gold holdings in order to back the US$; at the time the US was still on a gold standard. As all fiat money today is no longer backed by gold, governments would not need to nationalise/confiscate gold to prop up their currencies.
      Of course that doesn’t mean that politicians will not become so desperate for money that they will start confiscating (aka taxing) the wealth of the citizens. But in that case I would imagine they will not stop with gold, which very few people actually own.
      You will do yourself a favour by reading Detlev’s book, I finished it just last week and found it extremely valuable in content and form.

  8. Peter Manousakos says

    Dev, this is one of the most thought provoking pieces you have written so far. soemtimes your tone carries the sense of an apocalypse around the corner and it can be a little frustrating. In your defense, you do make compelling arguements that I agree with overall. But outcomes are impossible to predict. The argument you make is sound but the predictions of collapse seem to date back to Bretton Woods. You and I both want the same thing – the dissolution of the monopoly on our money by the state. However, I also believe that total collapse is likely not to happen any time soon so long as individuals see past the chaos and create order out of it. Will this be in the form of a new industrial model? A black market means of exchange? a technological innovation that will transform the entire economy? I don’t know. what I do know is this; it is a testament to the human condition that we have managed to buy so much time from monetary collapse. I think the time is right for me to read Human Action again. Mises would be both dismayed and impressed that this monetary saga has gone on for so long. Thank you. you contribute greatly to the doscourse for us laypeople/amateur economists ( who seem to be smarter than the economic engineers.

  9. says

    Mr. Schlichter,

    A comment and a question about your excellent post. You stated: “That banks and portfolio managers lend so generously to the state is not surprising as the cost of error (over-lending and over-borrowing) is apparently easily socialized across the wider public, either via higher levels of taxation or faster paper money debasement.” I would add to this a point stressed by Jesus Huerta de Soto in “Money, Bank Credit, and Economic Cycles” that politicians allow banks to violate the property rights of (demand) depositors by permitting fractional reserve banking. This allows the banks to profit by the flood of fiduciary media unbacked by real savings and in return, the banks provide the state with loans. The banking industry and the state are mutual enablers. When the system inevitably blows up, the banks have already booked their profits and they reap further benefits if they are bailed out, as this allows them to start the process anew. Although fiat currencies are inherently unstable, when they are used in conjunction with a fractional reserve banking system, what has occurred during the past 40 years was inevitable.

    My question regards Japan. Someone once characterized Japans fiscal situation as a bug in search of a windshield. I would be interested in your views as to why Japan has not imploded.

  10. Zach says

    Does this mean that I should cash out my 401k accounts — which are primarily invested in various mutual bond funds and buy gold and other physical investments? I have about $100K and I’m 40 years old, but when I retire will that $100K be worth very much?

  11. Myno says

    Bloomberg reports JPMorgan strategists recommending entering 2012 with an increased percentage of Mortgage Backed Securities in your portfolio. Ahh… is this a Hair of the Dog strategy, or what?

  12. Tickle Duster says

    WIKI:

    In 1933, U.S. President Franklin D. Roosevelt issued Executive Order 6102, which outlawed the private ownership of gold coins, gold bullion, and gold certificates by American citizens, forcing them to sell these to the Federal Reserve. As a result, the value of the gold held by the Federal Reserve increased from $4 billion to $12 billion between 1933 and 1937. This left the federal government with a large gold reserve and no place to store it. In 1936, the U.S. Treasury Department began construction of the United States Bullion Depository at Fort Knox, Kentucky, on land transferred from the military. The Gold Vault was completed in December 1936 for US $560,000, or $8.5 million in 2009 dollars. The site is located on what is now Bullion Boulevard at the intersection of Gold Vault Road.

    • says

      I think this act of confiscation of Gold at a fixed and below market price was combined with the ending of domestic convertibility of the US Dollar into Gold. This would then allow the printing presses to rip and the value of the US dollar to decline against gold and other assets. I think the price at which people were forced to sell all their gold in 1933 was USD 20.69 per ounce. By 1934 it was trading at USD 34.7.

      Nixon suspended the international convertibility of US dollars into Gold (at a rate of exchange of USD 35 per oz)in August 1971 aand the modern era of complete fiat money began.

  13. David Goldstone says

    Another excellent piece. As ever, I agree with the broad thrust of your analysis and indeed I am short on all of the bonds you describe and for the reasons you give.

    However, I think to some extent, distinctions need to be drawn between the various bonds/countries involved.

    (1) Pressure on the PIIGS is largely a solvency issue. These places are (ironically) in a similar position to nations under a gold standard in that they cannot inflate their debts because they do not have their own currency. This pressure will continue to grow as long as the Germans refuse to allow the ECB to inflate/buy PIIGS bonds/issue Eurozone bonds. On the other hand, if the Germans give in then we will see at least in the short term a fall in PIIGS yields (but a corresponding rise in Bund yields).

    (2) Pressure, when it comes, on Gilts and US Treasury bonds will be a result of inflationary concerns, rather than solvency issues. I know the U.S. is no longer AAA, but the reality is that it will not formally default on its bonds and nor will the UK. They will just inflate them away for as long as they can. I don’t see any immediate sign of selling pressure based on inflationary concerns. Eventually of course with current policies, inflation is inevitable and then the endgame could well be upon us. But it could be a while.

    (3) I’m not sure about the Bund. It is trickier to analyse. It has come under slight, but not very much, pressure. Since the Germans effectively control the Euro, I doubt there is much in the way of a solvency concern. But the Germans are in an unenviable position. Either Merkel gives in and agrees to ECB money printing, in which case there will be inflationary concerns for all euro demoninated bonds, which would hit the Bund hardest. Or she refuses, in which case there is the prospect of the Euro collapsing which would do great damage to German banks and would probably result in massive bailouts in Germany, leading to … inflationary concerns.

    One other possiblity which I think needs to be mentioned is the risk of a rapid and uncontrollable chain of defaults in Europe with spillovers elsewhere. This would be hugely deflationary in the short term with vast debts just disappearing into thin air. The proper reaction would be let it happen, but of course the far more likely panic reaction would be mass printing and bailouts on a scale never seen before. But in the short term, such a scenario could I suppose result in increased demand for US and UK bonds and even a downward push on gold. It would certainly be turbulent and call for nerves of steel.

    Anyway, we shall see. We certainly live in interesting times.

    David

  14. David Goldstone says

    Nick:

    I have asked my SIPP manager the same question but have yet to get an answer. In the meantime, the only practical way to short bonds is via spread firms, to which the usual caveats apply!!

  15. Paul says

    In my gold research I came across a very interesting seminar by Chris Martenson on the Goldmoney website, I would urge those interested to watch it.
    What I like about the presenter is that he has used his specialist field, science, to come to some stark conclusions about the problems we face.
    However, unlike Detlev whose field is obviously Austrian economics, Chris focuses on the economy, energy and resources in this seminar. A quick Wiki search, if true, shows that this man has some credibility being an ex Vice President of Pfizer.
    I find it very interesting that his premise is that we are at the onset of hitting real resource limits which are an anathema our economy’s need for constant growth.
    His ultimate conclusion in the Q and A is the same as Detlev’s: Buy gold and silver.
    I would be interested in others’ views on the matter.
    http://www.goldmoney.com/video/martenson-presentation.html

  16. David Roberts says

    Paul, the premise “that we are at the onset of hitting real resource limits” was shown by Julian Simon in his book: The Ultimate Resource, to be mistaken, both now and in the future.

    • Paul says

      Written in 1981 and revised in 1996. Not too up to date there. Mind you Malthus has been around a lot longer!!
      I think the resources (oil) are there but they are being found in decreasing quality and the energy returned for energy used in extraction is decreasing.
      The subject needs very close scrutiny because if we are reaching resource limits and the high price of oil is not due to speculation alone then there will be no way that our governments can hope to achieve the growth required to service our present debt let alone that of the future.
      Don’t want to spend too much time on this subject as the thread is really about bonds. Perhaps we can both read each others’ info and comment in a few weeks…

      • David Roberts says

        A more recent book on a similar theme is Matt Ridley’s The Rational Optimist.

        The relevance of Julian Simon to this thread is that he believed that the most likely threat to human progress came from government. Paper Money Collapse describes one way that governments have done this.

    • Eveready says

      Malthus’ ghost rises again! We have been told so many times that we are at “our resource limit” that you would think those who hold such positions would be embarassed by their terrible record of predictions alone. I remember in college in the late 70s being told how we all would be riding bicycles in the 80s. But this resource limit idea does play into the hands of central banks and welfare states. Prices are going up because of resource depletion (shortages). Don’t blame us! Blame God! Our printing has nothing to do with it. Keep your eyes off of us!

      • Paul says

        Interestingly the forewards of Chris Martenson’s book The Crash Course and Detlev Schlitcher’s book Papermoney Collapse have both been written by Addison Wiggin.

  17. anon says

    Could you comment on this piece from Tim Worstall in Forbes magazine?. At the end he talks of the ECB solving this crisis by printing money and “montising” the debt. I have only a layman’s reading of economics, mainly Austrian, but that would seem to:
    1-Steal from the general public by reducing the value of their money,savings etc as well as driving up the cost of living a leading to rising interest rates (I know central banks have kept interest rates down so far but that surely cannot last in the face of rapidly rising inflation)
    2-Put us on a slippery slope to hyperinflation. The banks may stay open and hand out you your cash but it is cash that will rapidly decline in value.
    Tim Worstall is normally a strong defender of free markets and my economics is not up to a critique of his reasoning. I would be grateful to hear your thoughts on the article.

    “Eurozone: At Last Somebody Does Something!
    By TIM WORSTALL
    My complaints over the past few weeks have become increasingly shrill: the economy of Europe is just about to go off the edge of a cliff and no one seems to be doing anything about it.

    Well, today, someone did do something: the assembled central banks of the world (really, the G-7 but that’s as makes no difference) announced that they would be offering all the liquidity the banking system could possibly ask for:

    The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.

    These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points. This pricing will be applied to all operations conducted from 5 December 2011. The authorization of these swap arrangements has been extended to 1 February 2013. In addition, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank will continue to offer three-month tenders until further notice.

    Please note that this doesn’t in fact end the problems. What it does mean is that we’re not going to have a disaster while the politicians fumble around for a few more weeks trying to find a way to force the ECB to do the only thing that will solve the problems. And that is, as I and many others better informed than I have been saying, start printing money and monetising the debts. Unfortunately, not only does the ECB not want to do this it;’s actually illegal under current law for it to do so.

    Which is, as I’m sure you understand, something of a problem.”

    • Eveready says

      I like how all the pro bail out the central bankers use the word “liquidity” instead of “money”. I mean how would it sound to the general public if Worstall said:
      Well, today, someone did do something: the assembled central banks of the world (really, the G-7 but that’s as makes no difference) announced that they would be offering all the MONEY [instead of liquidity] the banking system could possibly ask for:

  18. David Goldstone says

    Paul, suggest you take a look at Julian Simon’s work. One of his conclusions is that for all practical purposes natural resources are unlimited in a physical sense. . The limits are purely economic. So talk of running out of any particular resource is meaningless.

    • Paul says

      I have had a quick look on Wiki and I have to say that I am finding his arguments very tenuous and outdated. This is particularly so of the Simon – Elrlich wager 1980 – 1990, a wager he would now be losing if played up to present times

      I agree with this idea of running out being impossible, there will always be oil in the ground. The question is when does the ratio of energy used in extraction make the energy or mineral extracted very expensive.
      With two of you guys mentioning Simon’s work it’s making me feel as if it was a standard text book for the 1980s economic student! However, I will look at it in more detail.

      • Mr Ecks says

        The present price of metals is being affected by economic/political conditions, NOT any real shortage of metals or any problem extracting them.

        Your man Erlich should have zero credibilty anywhere. He is a loser having also proved to be a false prophet in the matter of the mass starvation of mankind back in the 70′s. “The Population Bomb” ring any bells?.

        One of the worse aspects of the economic troubles to come will be watching eco-freaks and leftist con-men trying to blame the free market for all the troubles brought about by the statist and socialist goverment policies that the same liars and con-men approve of.

        • Paul says

          He’s not my man. I had never heard of him before Simon’s name was mentioned and only know of him through this wager.I also have not said I believe that currently the price of anything is being caused by any shortage. I am considering the argument. It’s called being open minded.
          Have you watched the presentation or do you know so much already that you do not need to consider others’ views?

          • David Roberts says

            Paul, beware if you become one of those who are convinced by Julian Simons arguments, you will find yourself at odds with most of received opinion.

            I have watched the presentation you suggested and I see completely different outcomes from those indicated by Chris Martenson.

            A geometric progression to me indicates that some significant improvement to our world is imminent. A hackneyed example is the use of oak in British ship building, by the middle of the nineteenth century demand had outstripped supply, so what happens, iron starts to be used. Its not only plentiful but better. The crux is that for the human animal, necessity is the mother of invention.

  19. David Goldstone says

    Anon:
    Something tell me that Detlev will need no encouragement to write a piece on the G7′s latest foolery !

  20. Jamie says

    Detlev, I do enjoy reading your theories but I do have some worries that you are wrong. Forgive for me being negative but I hope you don’t mind some debate, and maybe you can convince me otherwise. I have 2 points to make/ask please:

    1) Are you aware of Wynne Godfrey’s work – presumably yes. He may not have been the first, but I believe he discussed the sectoral balance identity, where: PRIVATE SECTOR NET POSITION + GOVT SECTOR NET POSITION -CURRENT ACCOUNT = 0. Therefore, if the private sector wants to save, then either the govt needs to allow them to, by borrowing, or the country need to run a large trade surplus. Since the US and UK do not currently run trade surpluses, then their govts net debt will need to increase as the private sector’s net savings increase – this is an identity not a theory. So govt debt can be a GOOD thing, as it allows the private sector to save money, no (in practice by owning Treasuries presumably)?
    2) If you look at the UK’s govt debt as a % of GDP (IMF figures), the recent increase is just a blip and it is below the average of the past 180 years – hardly that high in other words?

    • Adriano says

      Hi Jamie,
      I would like to join the debate while waiting for Detlev’s reply. English is not my first language so forgive any mistake.
      As an engineer, who deals almost every day with mathematical models, I have always wondered how some macroeconomists could give us clues of the market economy by using primary school maths. When I discovered the Austrian School I realised I was not alone.

      1) I am not aware of W. Godfrey’s work at all so I just stick to your post.
      PRIVATE SECTOR NET POSITION + GOVT SECTOR NET POSITION -CURRENT ACCOUNT = 0

      Nothing to agree or disagree with it. Just an identity.
      First, just a couple of points to make clear:
      a)In this identity private investments are regarded as a transfer of money within the private sector and therefore as a spending. Nothing to argue about, but definitions need to be consistent.
      b) As you did not mention it at all, I am allowed also to assume that the central bank does not increase or decrease the quantity of money in circulation.

      May I ask you WHY???????

      There is a fallacy here that it is typical of all Keynesian like macroeconomics reasoning (to be honest I have to admit I got caught more than once :) ).
      Suppose we have a govt that does not borrow a penny and that we have no import/export or they are in perfect balance all the time.
      Therefore PRIVATE SECTOR NET POSITION=0. That’s perfectly right!

      Does that mean that NO ONE can save money? If you knew your govt is not issuing any bond would you go on squandering all your pay straight away!!! I don’t think so!!!
      If you even did, sure I wouldn’t! For sure we would have at list one person who saves money: me.
      Would such a saving behaviour violate the equation PRIVATE SECTOR NET POSITION=0?
      ABSOLUTELY NOT!!!

      Can you see where the fallacy is? It is immediately evident if we call things with their proper name: the PRIVATE SECTOR NET POSITION in the equation is an AGGREGATE PRIVATE SECTOR NET POSITION, that is the NET POSITION of the PRIVATE SECTOR as a WHOLE!
      Therefore if I increase my savings (I assumed constant the quantity of money) there must be one or more people who are spending (or “investing”) theirs. Ergo the AGGREGATE private savings is zero, and will always be zero if the quantity of money does not change.
      If govt steps in issuing bonds then, I agree, the AGGREGATE PRIVATE SECTOR NET POSITION will increase accordingly.
      Would that be a GOOD thing? I do not think so but I am running out of time for this post… just remember that we “masked” the private investments in the “spending” and also that the govt debt must (or should) be paid back sooner or later.

      2)

      I partially agree with you: it does not look that bad.
      Having said that, as per the AGGREGATE of point 1, consider “AVERAGE”.
      Govt debt has been above and below the average.
      Consider when it begun to rise sharply (that is govt running large deficit spending) in the past. Mind the date.
      Did something really bad happened those days that forced the government to accumulate large deficit spending?
      And what was the aftermaths when the debt had to be paid off? You can ask someone who now is at least in his/her 70.
      Are we facing same dramatic events? If not, do we have any reasonable justification to run such large deficit spending right now?

      • Jamie says

        Adriano,

        Thanks for your reply – I had assumed noone saw my comment so wasn’t expecting one!

        I don’t mean to get into a long-winded discussion with you but will make a couple of quick points, not necessarily trying to defeat your view but just to consider.

        1) I take your point that we could have aggregate private sector of 0, while within that aggregate there would be savers and borrowers. However, imagine a situation where we start off (not at time zero but from, say now) with a net private sector position of £1trillion pounds of borrowings. If the private sector in aggregate decides it wants to reduce its borrowings, how is it going to do that? The only realistic way is for the govt sector to increase its deficit (or reduce its surplus). So its impossible to have the often desired situation where the private sector is increasing its total savings, the govt is running a balanced budget, without having a massive current account surplus – every country cannot have a trade surplus!

        2) Agreed the average debt position can be skewed by things such as WW2! But I still think this point is worth consideration. Now that we have a fiat currency, our borrowing is not constrained as it was under other systems. The only borrowing constraint for non Eurozone countries is inflation – inflation is not really a worry at the moment. For Eurozone countries, of course, as currency users rather than issuers – well they really are in big trouble.

    • says

      Jamie, apologies for the slow response. I was traveling a lot and had quite a few speaking engagements. As to 1) This is simply an accounting identity and does not explain anything. Of course, we can make all sorts of wild assumptions, such as ‘what if the private sector wants to save in aggregate but there is no trade surplus’ but then we have to check if that is a reasonable combination of events. Let’s start with a high propensity to save (currently NOT the case in the UK!). In order to have what you call the ‘private sector net position’ in surplus, the domestic corporate sector must not take up these savings and invest them. Why? Okay, maybe they do not want to expand their balance sheets. Then the private savers would, if they still insist on saving, have to lower the returns they demand on their savings. Investing now gets cheaper. Still no takers. How likely is that? Remember that a lack of final demand is not a problem. The people who save do so for a purpose. They do not want to consume now so that they can consume more later. And nobody sees a business opportunity in providing the goods and services for later consumption – even though the capital that is needed for this is being provided at very low cost? But even if we maintain that this is the case within the domestic economy, would nobody outside the country see an opportunity in scooping up these cheap savings? This would then lead to a trade surplus which is indeed the automatic outcome of a high propensity to save domestically. The fact that the UK and the US do not run trade surpluses can be explained straightforwardly: they do NOT have a high domestic propensity to save.
      I think the key problem with the equation you present is this: The analysis does not take prices into consideration. Prices are the most important driver of economic phenomena. Prices co-ordinate action. Interest rates are crucial relative prices that coordinate the public’s propensity to save with the corporate sector’s propensity to invest. In a free market with hard money and non-distorted interest rates there is no reason to assume that unused savings would accumulate and that the government would have to run a deficit to bring things back into balance. And let us do a little reality-check here: Do we really think the government runs huge deficits to help the poor saver place his money? By the way, everything I said about the government consuming those savings and not building a productive capital stock with them would still apply, even under the most unrealistic assumption that these savings could not be used productively in the private sector.
      As to 2). Yes, historically, the British state seems to have acquired even bigger debt loads occasionally. Maybe it can get away with it again but I seriously doubt it. Of course, the final decision will be the markets’. We will find out. But please remember this. In the past, the huge debt load was the result of major wars. These wars were costly and destructive, but usually fairly short. (In contrast to the so-called War on Terror, which will be even costlier, equally destructive but literally without end.) After the war was over, the debt load was worked off. Today, however, the modern client state spends almost as much money in peacetime as the old state spent on wars. These expenditures of the modern welfare democracy are without a time limit and are set to rise forever on trend. Governments in modern mass democracies have so far proven incapable of reigning in spending and budget deficits. The outlook is very different. Remember also that Britain had to be bailed out by the IMF in the 1970s, when debt loads were much lower than during the Napoleonic Wars, and that Ireland and Greece went bust recently at debt levels also well below 200 percent. Bottom-line: When the market loses confidence in your ability to manage your debt it is game over. You are bust! Nobody knows at what level that is. Please also note that the private sector is now much more highly leveraged. If you take the public and the private sector together, debt-to-GDP in the UK is the highest in the world! Close to 500%!

      • Jamie says

        Many thanks for your response. I am sure you are a busy man so I don’t want to bore you all day with my thoughts. But if I may I will just respond one final time.

        Regarding the private sector saving, and those savings not being taken up by the corporate sector to invest. I meant that the “savings” are in fact the paying down of debt, i.e. deleveraging. This deleveraging does appear to be occurring in both the US and UK as far as I can tell according to private debt to GDP stats. Wouldn’t the paying down of debt occur mainly in the form of cash going to banks – if the banks then use that cash to increase their reserves (because they don’t want to lend at the moment) then the questions around why isn’t that cash being invested disappears, I think? And I would argue that a lack of final demand is the problem, and that is being caused by both the private sector and govt sector trying to deleverage at the same time.

        I should also clarify that I do believe in low govt spending and low taxes in the long run, but given the position we are in I wonder whether the we need a bit more govt spending in the short run.

        • Adriano says

          Hi Jamie,
          Do not fear to hurt me! This discussion is quite intriguing, stimulating and a good mental exercise. I can only thank you. Just, again, please forgive my English :) !

          In your reply you made what I reckon is a fundamental and turning point!
          I got confused at the beginning and had to make a little research. Have a look here:
          (http://articles.businessinsider.com/2011-02-03/markets/29993505_1_sector-budget-surplus-budget-deficit
          It is what your initial post is all about.

          The turning point you made is this:

          “However, imagine a situation where we start off (not at time zero but from, say now) with a net private sector position of £1trillion pounds of borrowings. If the private sector in aggregate decides it wants to reduce its borrowings, how is it going to do that? The only realistic way is for the govt sector to increase its deficit (or reduce its surplus)”

          Given the amount, I suppose that what you meant for “£1trillion pounds of borrowings” was actually £1trillion pounds of DEBT!
          If you did not mean DEBT but DEFICIT that would not make a big difference in what I am going to say.

          However, let’s suppose you actually meant debt.
          First, bear in mind that the famous identity is not about DEBT or WEALTH!
          It is a financial year balance! In the cited article it is written as:
          Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0
          Let me rewrite it once more as follow:
          PRIVATE BUDGET SURPLUS + GOVT BUDGET SURPLUS = TRADE SURPLUS
          The examples in the article are very clear about.
          Let us assume that at the time=NOW the private sector has £1trillion pounds of DEBT.
          Good starting point! Doesn’t everyone say that people are broken (mortgages, credit cards, etc.) and banks are broken as well for same reasons plus (surprise!!!) insolvent SOVEREIGN DEBT (…that’s interesting, isn’t it?).
          The PRIVATE SECTOR as a WHOLE is broken and therefore the economy is the verge of collapse. We are all scared of debt and of an imminent GFC mark II. We must pay the debt off!
          Can we??? No worries!!!
          Here come the economic “experts” that pull the supreme identity off the high hat and say:
          “Look, since we have no trade surplus at the moment, nor we can expect any in the foresee future, the only solution is the government to run a budget deficit.”
          Guess what are they saying next: “As the private sector pays off the debt, investments will recover as well as spending and this will kick-start the economy and, as a result, more people will be able to get a job”. Ah, I forgot… “this will also restore CONFIDENCE in the markets”!
          We’ll be fine mate!!! It is just matter of making the money go round!
          If someone (like me) dares to argue: “but… the govt is even more broken… and… and… it is already running a budget deficit by itself…”, they can say that it is maths, not their opinion – “it is a simple as that”.

          Why these experts never use the same mighty identity to picture us HOW the hell we got into this mess?
          If the private sector NOW has £1trillion pounds of DEBT it means that it has previously had DEFICITs, for example an average budget deficit of £100 million a year for the last ten years! Has the govt run same budget surplus during the last ten year? Give yourself the answer!
          But, with regard to this point, the music mysteriously change! Eh, no! The identity doesn’t apply anymore!
          “The govt was to run a budget deficit in order to maintain the minimum welfare without increasing taxes beyond the limit that would have harmed economic growth and, when necessary, also provide the necessary stimulus to the aggregate demand”
          But now let me play with the same toy as this is really an identity and not a theory:
          Given that BOTH the private sector AND the govt have had budget deficits during the last ten year (say £100 million each) where the hell is the money gone?
          Easy: we as a nation, during the last ten years, have run TRADE DEFICITs (£200 million a year in our example) and, by piling them up, we have issued a big IOU to other foreign economies.
          I say “we” even if I am not English because in my home country (Italy, the nightmare of the moment) the situation is even worse (by the way I have migrated to Australia).
          Then, if we got into debt due to prolonged trade deficits, can we honestly think to get rid of it by simply swapping debt among us? Shouldn’t we address the cause of the problem first? No way: economic “experts” tell us that running a govt deficit is the only way to achieve a private surplus because we are not having a trade surplus at the moment.
          But, did they first have a look at the trade balance? Are they sure it is not in SURPLUS? Let’s have a look:
          http://www.tradingeconomics.com/united-kingdom/balance-of-trade
          They are right! It is definitely not a SURPLUS! It’s still a DEFICIT!
          Might these “experts” be American and thus talking about their situation?
          http://www.tradingeconomics.com/united-states/balance-of-trade
          From bad to worse!!!
          I reckon that if you repeat the search for most of the western countries (except maybe the “bad” Germany) you will find similar situations.
          My God, we are still running a trade deficit!
          Well, is there any problem? The govt has simply to run a budget deficit that is the sum of the surplus fixed as target for the private sector – to allow it to pay the debt off – plus the ongoing trade deficit.
          What if in the meantime the trade deficit increases instead of reducing.
          Come on, more money! We have the Bank of England!
          IT IS AS SIMPLE AS THAT!!!
          If these spin doctors were med doctors they would not even think trying to stop the bleeding first. Their only concern would be pumping the blood from one part of the body to the other.
          You finish your post by saying: “every country cannot have a trade surplus!”
          And you are perfectly right!!! UK and USA have not for sure!
          What about China? http://www.tradingeconomics.com/china/balance-of-trade
          Germany? http://www.tradingeconomics.com/germany/balance-of-trade
          Some are in red, others are in black.

          Well, let’s imagine a United State of the World:
          WORLD PRIVATE BUDGET SURPLUS + WORLD GOVT BUDGET SURPLUS = 0
          (No alien allowed so TRADE SURPLUS=0)

          That’s the ultimate solution of debt! What European Union! Let’s create the World Union so we will not owe anything to anyone anymore! Or… maybe not. But, wait a minute… is not the world globalised (except maybe for North Korea)?
          So, nothing wrong if we rewrote our identity in this way:

          WORLD AGGREGATE PRIVATE BUDGET SURPLUS + WORLD AGGREGATE GOVT BUDGET SURPLUS = 0

          Nations that have a trade surplus compensate for those who have a trade deficit. Therefore if we sum up the debt of all world governments then the aggregate private sector should become to be very rich!!!
          So, why is the sovereign debt a problem? And why all media say the world economy is on the verge of another GFC? What the hell are the problems that we have?
          I do not know, but I know one thing for sure: we do have problems!

          But, make no mistake!
          It won’t be long before other “experts” pull out this kind of identity again to “demonstrate” that the problem is the failure of the market economy.
          They will say something like this:
          “Look, this is not a theory, it is just an identity. Governments, as an aggregate, have debt. Therefore the private sector as a whole is rich. But wealth is concentrated in just a few hands as the rich got richer while the majority of the population got poorer and poorer, therefore taking in excessive debt that now cannot pay off. As a consequence the AGGREGATE DEMAND is sluggish that in turn brings the industry to collapse causing rising unemployment. It is mandatory for governments to take COORDINATE action and find the way to redistribute the wealth in order to stop this vicious cycle before it is too late.”
          It is incredible how many theories can be worked out from an identity!!!

          In conclusion, thank you very much for you post Jamie! It gave me a lot to think about and, I do not know why, I now feel a bit richer (or less poor) than before.

          • Jamie says

            Adriano – sorry for my slow reply. I enjoyed your response!

            I do agree that we cannot go on increasing government spending and debt forever, and that, in better times, we should have been reducing govt interference in the economy so that we were in surplus. However, given the situation that we now find ourselves in, unpleasant as it is, I think govt debt does need to increase in the short term!

            Regarding whether there is a GFC – well I think the media is largely wrong. Europe is facing crisis as the individual countries within the Euro cannot print Euros so have no control over how to pay their debts, plus they have no currency or interest rate autonomy. But I think the rest of the world are in less trouble as we can print money to pay our debts, so the worst outcome would be inflation/weakening currency for the rest of us (depending on policy response of govts of course!).

  21. seha says

    Very well written article. Indeed, one can only laugh at solutions brought about by the Economist a,k.a. the unofficial cheerleader of international finance, that strong political leadership will dig us out of this hole!

  22. says

    National debt means how much money the U.S. Government has spent over the authorized budegt.A government budegt is no different than a family budegt.They know approximately how much money is coming in and try to stay withen the budegt authorized by congress .But the big spenders in gvt. can’t do it, so they get congress to raise the debt limit every so often and add more debt all the time.This is the National debt.Who do, We the People, owe the debt to?We owe it to the Federal Reserve banking system which has loaned our government the money they asked for.************************************************************

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