When the Bond Buying Stops, Its Game Over

January 10, 2012 07:46

After 40 years of unending fiat money expansion, the world suffers from excess levels of debt. A lot of this debt will never be repaid. My expectation is that the market will increasingly question the ability and the willingness of most states – and that, crucially, includes the big states – to control their spending and to shed their addiction to debt financing.


By Detlev Schlichter Jan 9th, 2012 at Whiskey & Gunpowder


I would not touch bonds with a barge pole, especially government bonds. After 40 years of unending fiat money expansion, the world suffers from excess levels of debt. A lot of this debt will never be repaid. My expectation is that the market will increasingly question the ability and the willingness of most states – and that, crucially, includes the big states – to control their spending and to shed their addiction to debt financing.

What happens to high-spending credit-dependent states when the market loses confidence in them has been evident in cases such as Ireland, Portugal and Greece? Among the big financial calamities of 2011 were notably government bond markets. Perversely, some of the big winners of 2011 were also government bond markets.

Market participants have so successfully been conditioned to believe in state bonds as safe assets that when some sovereigns go into fiscal meltdown it only serves as reason to buy even more bonds of the sovereigns that are still standing, even though their fiscal outlook isn’t much better. While the fate of Greek and Italian bonds should have cast serious doubt over the long-term prospect for Bunds, Gilts and Treasuries, it only propelled them to new all-time highs. Strange world.

All policy efforts are now directed toward keeping the overextended credit edifice from correcting. After decades of fiat money fuelled credit growth, the financial system is in large parts an overbuilt house of cards. The system cannot cope with higher yields and wider risk premiums. Those would accelerate the pressure toward deleveraging and debt deflation and default. “When they stop buying bonds, the game is over.”

They still bought bonds in 2011

2011 was another strong year for gold. Despite a brutal beating in the last month of the year, the precious metal produced again double-digit returns for the year as a whole if measured in paper dollars: up 10 percent. I believe that gold will continue to do well, as it remains the essential self-defense asset.

Amazingly, Treasuries did almost as well as gold (+9.6%) and TIPS (inflation-protected Treasuries) did even better. German Bunds benefited from the disaster in other euro bond markets. They pretty much matched Treasuries in terms of total return (currency-adjusted they did less well as the euro declined slightly versus the dollar). This is entirely unjustified because the EMU debt and banking woes will put considerable additional strain on Germany’s public finances. UK Gilts did better than gold and Treasuries, despite rising inflation in the UK, weak growth and a public debt load that is only ever going up.

This cannot go on for long. Bonds are fixed rate investments with finite maturities. The price gains of 2011 have lowered the yields to maturity, in some cases markedly so, and thus diminished the chance of additional gain. Does that mean reversal is imminent? No. Maybe the notion, or better the myth, that the bonds of the United States, the United Kingdom and Germany are risk-free assets can somehow be maintained. Maybe yields can decline even further. Who knows? Personally, I doubt it.

In the case of the US, the fiscal situation seems beyond repair. The Congressional Budget Office publishes its own projections on the long-term fiscal outlook. These are based on some overly rosy economic assumptions and still make for rather grim reading – hundreds of billions of dollars in deficits every year forever. The true path for the U.S.’s public accounts will certainly be much worse. The U.S. has now acquired a habit of running budget deficits to the tune of 10 percent of GDP year after year (more than $1.5 trillion in 2011) and there seems to be no end in sight. There is presently no deflation in the U.S. Neither does the TIPS market expect any. Yet, investors seem happy to hold U.S. government paper at what are certainly negative real yields. Investors are practically paying the U.S. government for the privilege of funding its out-of-control spending.

I have long maintained that government bonds are a bad investment because the endgame for them will either be outright default or inflation. In both cases, as a bondholder, you lose. The outcomes are either default or default. The idea that these debt loads could be elegantly inflated away is nonsense. They are already too big for that. So either you face outright default or, if authorities try to inflate, hyperinflation and currency disaster, and then default. In either case, you will not be repaid with anything of real value.

“Let them eat bonds!”

But are default or inflation and then default really inevitable? What if the present scenario continues forever? This seems to be the new “hope”. It is not a pretty scenario in that it involves the ongoing confiscation of wealth from bondholders but it seems to be less drastic than default or hyperinflation. Could we not work off the excessive stock of debt by suppressing bond yields below (moderate) inflation rates for an extended period of time? Of course, we cannot rely on the self-sacrifice of the bondholder, although he appears rather willing of sacrifice at present. So the government will have to use all its might to force bond-investors into accepting zero or negative returns for an extended period of time. After all, the state is the territorial monopolist of coercion and compulsion. It makes the laws. And controls the banks.

In a state fiat money systems banks must ultimately cease to be private, capitalist enterprises. Many banks have already been fully or partially nationalized. The remaining private ones are under tight, and ever tighter, regulation by the state. Should it not be easy for the state to force banks to invest more in government bonds, even at low or negative real returns? Should it not be possible to redirect whatever saving and credit there is from the private to the public sector?

Such a strategy has been outlined – not advocated- by Russell Napier of CLSA. He calls it ‘repression’. It ultimately involves rather draconian market intervention in order to continuously force the diversion of capital from private use to public use at artificially low levels of compensation. At some stage it will require capital controls.

But let’s face it: most of what we have experienced over the past three years in terms of government intervention would have been simply unimaginable only five years ago. We should therefore not be surprised if market intervention becomes ever more heavy-handed and is used increasingly to favour the funding of the public sector.

That such a policy will be implemented, and ever more boldly, I have no doubt. In fact, I predicted it in my book. See chapter 10 of Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, in particular pages 226 -228. I called it ‘the nationalization of money and credit’. It is a phase in the crisis but it is not an endgame. Where I disagree with the above mentioned writers is the following: Repression, to the extent that it works, will not reduce government debt, and besides, it won’t work.

Consider the recent environment: Certain governments have been able to borrow directly from their central banks via quantitative easing and in the bond market at low or even negative real interest rates. Does that mean they have reduced the amount of outstanding debt? Are such hugely advantageous conditions used to cut back the debt load?

No. The opposite is the case. Access to cheap credit, whether that credit was provided by the printing press, obedient bond investors or hyper-regulated banks, has allowed states to run larger budget deficits and accumulate more debt. Remember, we are not talking here about the workout of a debt-situation resulting from a war, a natural disaster, or some other one-off event. We are talking about the modern welfare state with its ever-growing commitments and increasingly out-of-control spending. Only cutting off the state from cheap funding will ever constrain it, not giving it access to more resources more cheaply.

We do not live in Paul Krugman’s parallel universe of Keynesian fiscal stimulus, where every dollar spent by the government magically translates into 2 dollars of real GDP growth. Here, on planet Earth, the constant shift of resources from private markets to the state bureaucracy weakens the economy. Shrinking the private sector and growing the public sector kills economic growth. In the perverse logic of the modern welfare state. This then requires even more state spending in the next period. As the economy continues to struggle, public sector outlays will grow while tax receipts will shrink.

‘Repression’, to the extent that it succeeds in shifting resources from the private market to the state, makes the crisis worse. It must lead to more debt, more capital misallocation and a weaker economy. We will not save our economy by trampling on the remaining bits of functioning capitalism and by confiscating more resources from the private sector. ‘Repression’ is self-defeating.

Additionally, it won’t work. Private wealth-holders will not sit on their hands forever while their hard-earned savings are being confiscated by the state. If banks become mere tools to fund the state and thus provide zero or negative real returns to shareholders and depositors, shareholders and depositors will pull their money from the banks.

But there is no alternatives for the depositors, is there? Of course, there is: Gold.

As the enemies of gold in the establishment financial press never tire of reminding us, gold pays no interest and no dividend. Because of storage and insurance costs, it is a ‘negative carry asset’. But in an environment of ‘repression’, so are government bonds and bank deposits.

With zero or negative returns guaranteed on supposedly ‘safe’ government bonds and bank deposits, ever more investors, including small savers, will turn toward gold which has the additional advantage that its upside is practically unlimited – its price can double, triple or quadruple (all of which I expect) as long as paper money debasement continues (which I consider a near certainty).

Of course, a determined state will counter any evasion of controls with more controls. Maybe we will see taxes on gold investment or even restrictions on trading and owning gold. Via capital controls the country could be locked down. All of this is, of course, hugely destructive for the economy and ultimately self-defeating. I expect that we will see quite a bit of this stuff in coming years. Try and be prepared!

But this will not be part of the solution. It will make matters worse. And it means that the endgame is still either voluntary default or hyperinflation and default. ‘Repression’ or ‘nationalization of money and credit’ is a policy of desperation. It is not a solution. It won’t be the endgame.


Detlev Schlicter


Detlev S. Schlichter (Hampstead, UK) is a writer and Austrian School Economist. Schlichter has a degree in economics and spent nearly 20 years working in international finance, including stints at Merrill Lynch and JP Morgan. He served as a portfolio manager of fixed income portfolios at J.P. Morgan Investment Management and, in 1996, moved to London to work in the global bond team of the company there. In his career, Schlichter has overseen billions in assets for institutional clients around the globe.



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