Sovereign risk and bond bubbles

The Fed has now joined in the fun of printing money and buying up its own government bonds, to try to reassure investors that all is well with the world. Monetarists assure us that this will create more deposits in banks, which in turn might be spent and start to lift the recessions. That would be good news indeed. If you hurl enough money at a problem, someday some of it might start to do something useful depite the broken banks and the falling property prices. The monetarists are right to say people and companies are short of money. It’s deposits they need more than bank loans, turnover businesses require more than working capital bank facilities.

My worry is that on both sides of the Atlantic the governments are trying this at the same time as running collosal government deficits, and issuing huge quantities of bonds to pay for them. Markets are being told that buying different government bonds is a “flight to quality” which can never be criticised. Those who think this have not read their history books.

History tells us that many countries have in the past defaulted on their public debts when the burden becomes too great. It’s not just the well known South American villains who have let the international money lenders down. Countries like Spain, Japan and Germany have also been serial offenders if you go back far enough. The UK and the US have not in the past cancelled obligations or refused to pay interest, but they have often inflated their way out of the full rigour of the repayments, paying the lenders back in depreciated dollars or pounds.

Even if this time round they do prevent a return of high inflation and meet all the repayments, it is still possible to lose money fron a “flight to quality” if you buy a long bond on too low a rate of interest. There can be bubbles in gilt edged securities, as well as in properties and private sector shares. One of the problems the Japanese encountered when trying money printing in the 1990s was deciding how quickly to withdraw the cash once it seemed to be working, to avoid triggering a great inflation. They also discovered that if you did not first mend the banks, it was difficult for anything else to work.

It is worrying how quickly the Obama administration has been bogged down by the Credit Crunch. They try initiative after initiative, just like the UK, allowing nothing to work through. At the base of all this trouble is the obstinate refusal of the authorities on both sides of the Ataltnic to take a tough approach to the broken banks and financial institutions where the public sector now has a significant investment. It is causing political pressures for the politicians, who seem incapable of finding the people to sort out these broken and badly run organisations. The financial sector living on public sector subsidy is living well beyond its means and failing to sort out its businesses quickly enough. The result will be more losses, more bad news for taxpayers, and more anger about the remuneration of the executives responsible.


  1. Waramess
    March 20, 2009

    Odly enough I was watching a video by Peter Schiff yesterday in which he ws predicting this would all end in a USA sovereign default.

    The Chinese aren’t voters, are they?

    This is of course the same fate that awaits the UK when this bunch of economic ignoramus’ have finished.

    For anyone interested the video can be seen on

    1. Stuart Fairney
      March 21, 2009

      Great video link, thanks for that.

      1. adam
        March 21, 2009

        Fox Freedomwatch is a superb new show for the Libertarian fringe. Austrian economists will enjoy it too.
        I can also recommend Charles Adams lectures on tax history over at Mises media section. I really enjoyed them

  2. Stuart Fairney
    March 20, 2009

    Exec bonuses are a side-show, nothing more, to distract attention from the serious, indeed critical issues you highlight.

    And when the national bank starts buyng up government bonds (at the government’s invitation, because of a lack of other buyers) does this not show that the markets consider a national default risk is at least possible?

  3. Andrew Lilico
    March 20, 2009

    The UK did, of course, effectively default in the 1932, unilaterally deciding that it would pay a coupon of 3.5p on its war debts instead of the 5p promised. This was effectively a default of 40% of the value of a large portion of the UK’s debt, and was one of the major economic events of the 1930s. A similar event had happened between 1887 and 1889 when consols were “converted” from 3% to 2.5%.

    Thus, the UK does have a history of default.

    1. Stuart Fairney
      March 20, 2009

      You could of course argue that Brown didn’t have the after effects of WW1 to contend with and his debts were self-created.

  4. Andrew Lilico
    March 20, 2009

    Apologies – I meant 30%, obviously….

  5. Simon D
    March 20, 2009

    I agree with your comments, especially about the UK banks. What we need to hear from the Government is details of the business plans for the banks that they own. These should include:

    1. Achievement of proper capitalisation and debt levels.
    2. Serious and urgent cost control measures, especially in relation to wages and bonuses.
    3. A plan to achieve sustainable remuneration policies.
    4. A plan to fatten up and sell off non-core businesses.
    5. A proposed solution to the casino banking operations.
    6. A plan to re-skill customer contact employees who meet the public on a daily basis in the high street branches.
    7. A solution to the problem of failure to lend to viable businesses.
    8. A solution to the problem of propensity to lend to individuals and businesses who now, because of the collapse of the property market, cannot service either the interest or the capital on their borrowings.
    6. A road map by which the Government will take us to the point where the banks can be sold back to the private sector at huge profit to the taxpayer.

    I think the public will have to wait a long time for this.

    The banks, as they were in June 2008, are now history. All we want to know from the Government is what the future holds. It would also help, given the way the Government trumpets its democratic credentials, to have a proper and sustained debate in the House of Commons on these issues lasting for two or three days.

  6. Johnny Norfolk
    March 20, 2009

    I wonder why the Germans are not doing it. They have learned the hard way about the value of money, labour have not. i see Obama as another Blair, it will all end in tears.

  7. Lola
    March 20, 2009

    The only way I can of ‘fixing’ the banks is to put the failed ones into administration. The bondholders and the shareholders lose pretty well everything. The bad business – which taking business from the good businesses – goes and the rump will be bought. The rump probably being the high street operations and other profitable divisions. At the same time the government – that is me and you and I’m up for it if your are Mr R – could underwrite all the depositors.

    Why not?

  8. Acorn
    March 20, 2009

    Which came first, the chicken or the egg? Or, in today parlance, M0 or M3 (or M4 in our case). Basically, does bank credit money appear before government money; or, the other way about. This latter argument has been occurring recently on some of the economic blog sites, one of the most readable comments is at the following, I recommend it to Redwoodians:-

    If you don’t know your M0 from your MZM, I recommend the following:-

    One big question is, how much stimulus is enough stimulus? The first article will tell you that even the mighty US can’t get close to covering all the US private sector debt. As the UK is following a similar stimulus model to the US, I must assume the UK government will have the same dilemma; with big banks and an economy one eighth the size of the US and a currency that no longer has “reserve status”.

    JR’s quote of “big banks with a medium sized country attached” is starting to sound Churchillian on reflection. As far as the UK is concerned, stimulus wise; “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
    Sir Winston Churchill, November 1942

    March 20, 2009

    I agree, it is SME’s that should have urgent government aid, not large badly run inefficient organisations

  10. Dan Tubb
    March 20, 2009

    Sadly a recession is unavoidable. No government plan or initiative can defy gravity, but the attempt to do so might push us into depression. This is exactly what happen in 1930’s America and more recently in Japan.

    Governments cannot create any wealth, they can only redistribute it. And government plans and initiatives take money from those that are good at creating wealth and give it to those that are good at destroying wealth.

    Let’s be honest and admit that the boom was the problem the bust is a necessary correction. In much the same way that going cold turkey is sadly necessary after abusing heroin. You can make yourself well by injecting more, but only for smaller and smaller time periods. Our economy got bloated on an inflated money supply and lead to excessive asset prices, triggering a debt bubble.

    The greatest disaster would be if the plans of the US and UK government actually worked, and we entered a new debt bubble. It would make the inevitable coming back to earth so much more painful than it already is.

    The recession must be allowed to play out, and the public sector must share in the proceeds of slump. Once the public sector crowding out has been removed can the private sector create the wealth we need to pay back generational levels of debt.

    1. Robert
      March 20, 2009

      Quite agree

  11. chris southern
    March 20, 2009

    Lets face it, the banks are being bailed out with other peoples money.
    Even if the money is paid back (somehow) the people still lose as the currencies are being debased, as such the people come out of this not only poorer, but facing higher (and more) taxes due to all of the wasted money during this crisis.

    The people have been robbed blind by the goverment as well as the Bankers. The people are the ones who shoulder the debt, the fines, the fees as well as the future taxes because of it.
    When will people realise that Kensyian economics, just like socialism, are good theories, but do not work on their own when put into practice.
    In the instance of Kensian economics, it should work alongside Austiran economics by reminding people that in the good times you NEED to put money aside for that rainy (reccesion) day.
    In the case of socialism, it should be the concience within goverment, reminding the more financialy prudent concervative minds that you need to think about how a decision will effect the people.
    Both schools of economics as well as both ideoligies within the two main parties are parts of the same coin, and coins just don’t work with only one side.

    1. chris southern
      March 20, 2009

      Just to add, for Kensyian economis to work alongside Austrian economics goverments should remember that bailing out failing business is not helping people out in the long run, it is distorting the market for the worse by propping up uncompetative and failing business.
      What it should do is (using the money set aside) fund the needed infrastructure projects as well as helping to kick starting new parts of the market.
      This way it does not disrupt the market, but helps to add to the markets future growth, be it by providing start up funds for new business, or by training, where needed.

      (i’m over being angry now, and hopefully i’m contributing a lot better!)

  12. Blank Xavier
    March 20, 2009

    JR wrote:
    > The monetarists are right to say people and companies are short of
    > money.

    No no no no no no – a thousand times NO.

    There is not a shortage of money. There is a shortage of WEALTH.

    I can have absolutely no money at all and be fabulously rich – if I own enough diamonds, or cars, or cows or pots and pans I am rich, rich, rich! if I have these things, there’s plenty of money out there. Tons of the stuff.

    Money has no intrinsic value. It’s paper. If you give someone bales and bales of money in an obsolete currency, you have given them absolutely no wealth at all (unless perhaps the notes they have are in demand in the currency collectors market).

    If you give someone bags of diamonds, they definitely get richer.

    Giving an *economy* more money does not make it richer. There has been no creation of *wealth*.

    All that actually happens is a *transfer* of wealth. Money represents wealth. The more money there is, the less it is worth in wealth terms. Create money and you dilute the value of money. The person being *given* the money is laughing – but everyone else is that bit poorer, in exact proportion. Their wealth has been transfered to the individual receiving the money.

    Basically, it’s tax. Everyone loses wealth, the Government takes that wealth and spends it.

    When your economy is going down the pan literally the last thing you need is more tax. It is poison to a sick man.

  13. Adrian Peirson
    March 20, 2009

    Until we start coining and printing our own currency instead of Borrowing it from Offshore Bankers we can never be sovereign nor Free.

    1. alan jutson
      March 21, 2009

      The problem is the Government are thinking of selling the Royal mint to the highest bidder.
      Yes I know not much of the family silver left, let alone gold.
      So we will have to buy our money from someone else !!!!!

  14. Not an Economist
    March 20, 2009

    Fulminating against fat cat bankers’s bonuses will gradually turn into a general argument against pay rates being set by the market. Granted the anti banker bonuses mob could be seen to be making a special case – i.e., these bonuses are in effect being paid by the taxpayer. But these criticisms are being made in a context that is very hostile to the free market and the arguments will become increasingly blurred in my view. This (implied) tendency toward wage/salary controls will be acclerated when price inflation starts to kick in over the next twelve months, sthg that will take a lot of very stupid people who are still looking out for deflation very much by surprise.

    Of-course we could console ourselves in the belief that Labour will lose the next general election – but thats not an open and shut case. Recent monetary pumping will prompt an inflationary spike in the economy that to many will look like genuine recovery, while it will in fact be no more real than the upturn after the monetary easing in the early 2000’s after the dot com crash and will ultimately lead to an even bigger downturn than the one we have just had later on down the road. Thats bad enough but in the short term any inflationary upturn in the fortunes of the economy could be just enough to convince voters that Gordon may in fact be deserving of another chance at the Premiership. Which is nice.


    Reply: As an advocate of free enterprise, I have always made clear that private sector companies should be free to pay whatever bonsues they think appropriate, where they face the discipline of the competitive market. Even loss making comapnies may wish to pay bonuses – on the basis that they think they will become proftiable, or because the shareholders are happy to do so for some other reason.
    What I find unacceptable is for highly paid bankers in institutions now wholly or largely owned by the taxpayer to be paid bonuses when their banks have lost so much money. It should be a condition of taxpayer support that they pay no more such bonuses, and get pay down to realistic levels until they can make a profit again and be sold back to private shareholders.

  15. mikestallard
    March 20, 2009

    My late Dad always said that once you have heard about something it is too late.
    In the gym today, three of us OAPs were discussing the shuffling of pieces of paper between various government departments. The pieces of paper happened to be government bonds and the departments happened to be the BoE and the Treasury.
    Shuffle shuffle.
    So? As said above, it doesn’t create wealth.
    But worse: it doesn’t fool anybody. Producing more and more pieces of paper will only make things worse.
    And out there, the financiers are light years ahead of us 3 OAPs. It is their livelihood.

    On Open Europe is the dismal saga of the Neil Kinnoch attempt to clean up the EU in 1999.
    The behaviour of the politicians was effective: shut the whole scandal down.
    That is what second rate, tired politicians do: cover up and hope nobody notices.
    And that is what will happen with the banks.

    David Cameron was totally right when he called for a drastic reduction in the State spending. But he isn’t tired or second rate.

  16. savonarola
    March 20, 2009

    Inflation is coming. Get prepared. Gilts are a value trap. US Treasuries are a value trap.

    1. Blank Xavier
      March 20, 2009

      If inflation is coming…the correct response is to borrow 🙂

      1. Stuart Fairney
        March 21, 2009

        Or to be heavily indebited already, which explains much when you think of it.

  17. TomTom
    March 21, 2009

    The Real Balance Effect is operating at present and why the Government is so stupidly making it worse is hard to fathom. Car sales are collapsing because they represent a very poor investment with negative return on capital invested; this at a time when Government has crippled bank shareholders by crashing their shares (Peston broadcasts) and cancelling dividends…this has a huge Wealth Effect on Savers and those on Fixed Incomes… repair their cratered capital they must save more to rebuild capital.

    As people consume capital they are frightened for the future, especially when they see the Government hell-bent on generating Inflation and food prices soaring. The Precautionary Balances must be increased, and Consumption decreased sharply with all discretionary spending cancelled.

    It is funny that the FTSE consists of Banks and Oils, yet the government has sprayed billions of pounds into banks with salaries, bonuses, ex-gratia payments, pensions all continuing….bondholders no doubt still getting their coupon….only Shareholders have been singled out for a haircut.

    So investors now no longer trust Fund Managers who let banks career off course and then voted through crackpot mergers leaving pensioners and savers feeling abused by Insiders pillaging Outsiders to keep their own network of mutual back-stratching afloat. Long-Term Savings in The City are dead and pointless as are Shareholder Rights – there is no point in any individual buying Voting Shares and better with Bonds and Prefs. if at all.

    The Real Balance Effect will not turn positive in an economy running a huge trade deficit, it is impossible to stimulate an economy dependent upon imports and lacking a capacity to provide significant proportions of its own food and finished goods. The Government is engaged on an exercise which, if it could succeed, would destroy the external sector as the country failed to fund its trade deficits on a sustained basis – yet it cannot exclude imports because it has no capacity to produce. Ultimately the Fortress Europe notion of a trading bloc will become the last refuge just as Imperial Preference was proposed by Beaverbrook in the 1930s.

  18. A. Sedgwick
    March 21, 2009

    In the great bank rescue the first mistake was not to let Northern Rock go into professional administration with deposits guaranteed by the taxpayer. More serious errors of judgment followed and many of us who warned of the spending and debt bubble have been asking the question – who will finance all this debt. QE is a false dawn and the only answer to reassure real gilt buyers is by slashing state spending. Bruiser McNulty was on Newsnight and as the Chairman of the Chambers of Commerce, David Frost, who was largely sidelined in the discussion, said the minister and the state employee trade union representative were living in cloud cuckoo land. We aint seen nothing yet.

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