Is a Bond Crisis Inevitable?

3 posts

Niccolo and Donkey
Is a Bond Crisis Inevitable?

The American Conservative

Patrick J. Buchanan

December 30, 2010

With Christmas shoppers out in force and the stock market surging to a two-year high, talk is spreading that the long-awaited recovery is at hand.


But gleaning the news from Europe and Asia as U.S. cities, states and the federal government sink into debt, it is difficult to believe a worldwide financial crisis that hammers governments, banks and bondholders alike can be long averted. Consider.

Fitch and Moody’s have just downgraded the debt of Ireland, Greece, Portugal and Hungary. In Budapest, the politicians talk of default. Spain has been warned its debt and banks could be downgraded.

The European Central Bank is buying up this paper to prevent panic selling by investors. There is talk of forcing bondholders to take a haircut. They would trade their suspect bonds for new euro bonds whose face value would be appreciably less.

In the Latin American debt crisis, the United States bailed out its banks holding the bad paper by giving them U.S.-backed bonds, while forcing them to take a loss on their Latin bonds. Courtesy of Uncle Sam, Latin America walked away from a huge slice of its debt.

The Japanese national debt is slated to pass 200 percent of gross domestic product this year, highest of any major economy on earth. Half of Japan’s spending is now financed by bonds. Tax revenues do not even cover 50 percent.

Nor is America out of the woods.

Financial analyst Meredith Whitney told “60 minutes” we can expect 50 to 100 cities and counties to default on their municipal bonds. Though derided as an alarmist, Whitney was among the few who warned that U.S. banks were in treacherous waters before 2008.

If anyone is an alarmist, it is The New York Times. In an editorial the day after Christmas, “The Looming Crisis in the States,” the Times writes, “Illinois, California and several other states are at increasing risk of being the first states to default since the 1930s.”

California and Illinois are to America what Germany and Spain are to the European Union — the first and fifth largest states.

Illinois, writes the Times, “is faced with $4 billion in overdue payments.” The state “has lacked the money to pay its bills. Some of its employees have been evicted from their offices for nonpayment of rent, social service groups have laid off hundreds of workers while waiting for checks, pharmacies have closed for lack of Medicaid payments.” Illinois is also still borrowing to finance half of its budget.

By Sept. 30, the U.S. government will have run three straight deficits of close to 10 percent of GDP. And Barack Obama and the GOP just passed $858 billion in new and extended tax cuts and fresh spending.

Yet many dismiss the threat of a series of defaults by European nations and U.S. states and cities leading to a financial crisis that could eclipse the one we have just passed through.

What is the basis of this confidence?

Germany dominates the European Central Bank and will not allow defaults by Ireland, Portugal, Greece or Spain. For that would imperil the One Europe project to which Germany has been dedicated since World War II. Berlin will do what is necessary to save the euro and prevent Europe’s monetary union from collapse.

What is wrong with this thesis is that it is not Germany alone that decides on defaults. The weaker countries in the euro zone, like Greece, may decide they will not endure the agonies of austerity any longer. Street politics may force regimes to abandon the regimens imposed upon them as a condition of their bailouts.

In America, it is the Fed that is the last line of defense and has shown a disposition to act in a financial crisis.

Since 2008, it has doubled the money supply and taken a trillion dollars in bad debt off the books of U.S. banks. Secretly, it has lent trillions to banks and businesses all over the world and is now buying U.S. bonds to inject more dollars into the economy.

But how does the Fed prevent a state like Illinois from failing to meet its debt obligations and defaulting? How does the Fed prevent a series of municipal bond defaults by cities and counties that lack the tax revenue to pay their bills and whose credit rating has reached a junk-bond status where they can no longer borrow?

Congress would have to vote the bailout money. But will a House that owns its majority to the Tea Party approve half a trillion dollars to bail out Democratic-run cities or Obama’s home state or Jerry Brown’s California?

This June, the stimulus money runs out, and as housing prices continue to fall across America, property tax revenue will fall.

The Feds are about to stop bailing out the states, and the states, on shortening rations, will stop bailing out counties, cities and towns.

We may be closer to the falls than we imagine.

I doubt there will be a 'bond crisis'. If anything, the bond market will cause the crisis rather than be the crisis. (Leaving aside municipal bonds, which are a special case).

US Corp bonds are now less risky than global corp debt, for the first time in history:

This is somewhat misleading, as QE2 has crowded out *all* capital investment in this country, rendering corporate debt somewhat moot. Essentially, we are in a liquidity trap, and the velocity of money has slowed to the point that further 'intervention' by the Fed will simply drive up cash holdings, not cause new investment of any sort -- it is *all* crowded out.

Under these circumstances, the old floor on risk, which used to be the Treasury rate (interest on a perfectly safe investment) -- has now been raised above that floor, so that 'the old safe' is no longer possible at any price, which is why everyone prefers cash rather than T-bills now. T-bills are essentially junk, and not the floor anymore -- cash and/or corporate bonds are. To the extent anyone can find business at all.

The effect of QE2 is entirely predictable in Neo-Classical economics -- which I don't believe but it is as good as anything right now, if only you do the calculation. What the calculation says is that no one will want the sovereign junk, and there will be (1) a bubble in commodities and (2) a flight to cash, blue chip stocks, and high grade bonds. All the signs so far indicate a simple increase in Liquidity Preference (upward ship of the LM curve in the IS-LM diagram), a classic liquidity trap, and a collapse of investment (S = I both drop), due to crowding out, high risk, few opportunities, and a general reversal of trends in global trade. None of which is remotely surprising under the circumstances. Net creditors (banks, etc.) are repairing their balance sheets and holding cash, which is exactly what finance says they *should* do.

The bond market is too big for any government on earth to control (not us, not China), and in the end it will break any currency or government that moves against it. Politically, the governments know this, and they are *very* hesitant to soak the bondholders and allow market discipline, which ought to happen, to happen in fact. The bond markets have the best of both worlds -- they can break anyone on the planet in a 'bond revolt', and they get white glove treatment if they don't.

What's not to like about owning the planet? Wealth always wins this game -- until the wealthy class gets put to death by the rising Caesar (see the Roman Equites, the kingmaker class in the Marius and Sulla struggles, and their fate when Augustus Caesar decided to end those once and for all).

As for sovereign and municipal debt, I suspect that what will happen is that the economies of all countries, and especially the US, will try to retain as much of the current system as possible by (1) privitising large areas formerly controlled by the central government (like the Fed vs. a Central Bank), and (2) making those private corps. the owners of most of the wealth -- collateralisation of the bad debts. The Fed will end up owning used car lots, unsold inventory, and lots of houses. That means those assets will be concentrated in the few hands that control the shares that control the Fed. We will see a similar process with other agencies.

The net result will be no crisis -- but a surprising transformation from a pseudo-capitalist hybrid economy (worldwide), to a form of slavery under a centralised regime. I don't think there will be one world empire, just fragments of technical control.

Bankruptcy of the sovereign governments doesn't mean a 'crisis'. It means a sale. The non-viable countries will be sold into debt slavery, which is to say they will be converted into Empire.
Funny, considering it's the government that can (indirectly) print money for themselves. The US is in a "liquidity trap" right now. Companies that can make money are just saving up money to hedge against future uncertainty. That is good for the prospect of sustainable recovery.

Money is being printed and added to the reserves of banks, and the banks aren't lending. This isn't unlike the situation in Wiemar Germany 1919-1921, right before the hyperinflation started. Prices were dropping, and the central bank just couldn't get more money to circulate through the system. When the money finally started to get around, it got around very, very quickly.

The fed hasn't printed enough money for a hyperinflationary episode, but enough for massive bouts of inflation which won't lead to increased employment, but plenty of economic dis-coordination. Stagflation. An impossibility in the Keynesian fantasyland, but it'll come. That's the best case scenario.