The short of the century

The bubble in government bonds is finally bursting

by DETLEV SCHLICHTER

“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

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.

The 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.)

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.

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.