June 16, 2016

End of the Government Credit Line, Part 1

It has been a long-standing conventional wisdom in global finance that treasury bonds are the safe low-risk "anchor" you should always keep in your portfolio. That is still predominantly true, but the Great Recession shook that conventional wisdom and weakened investors' confidence in debt issued by governments.

Since the depth of the recession in 2009-2010 things have not gotten much better. The Greek debt write-down in 2012, sold to investors as a structural necessity to permanently turn things around, only led to a net loss among investors and a continuation of the underlying, reckless fiscal policies that created the government debt problem in the first place.

During the recovery, which started in 2011, the world should have seen a reversal of government borrowing. Deficits should have gone away, or at least shrunk so drastically that countries with large debt and less-than-perfect credit could be upgraded again. That has not happened.

Instead of a return to stable government debt, we have seen debts continue to grow, both in Europe and the United States. 

The growth in government debt across the western world has been propelled by politicians who use deficits to continue financing welfare-state programs far beyond what taxpayers can afford. The use of deficits has been driven by a destructive combination of ignorance and fiscal greed, as if there is no upper limit to what governments can borrow.

Well, there is. And we are beginning to see the end of that credit line. It is not a pretty sight.

There are three components to the credit line end: the widespread practice of NIRP, or Negative Interest Rate Policy, by central banks; the slow-to-non-existent growth in the world's major economies; and the endless political commitment to the welfare state.

There will be three articles dealing with this topic. This the first one discusses NIRP and its relation to excess government borrowing. 

In practice, NIRP means that central banks no longer pay interest on deposits that financial institutions make overnight. Historically, this has not been the case. When banks have had more cash than they needed, so to speak, they have made a short-term deposit with the central bank to earn a little bit of interest on the excess cash. By changing that overnight deposit rate central banks have been able to exercise some influence over the supply of liquidity in the economy.

During the Great Recession the European Central Bank drastically changed its policy for overnight deposit interest rates. For the first time in the ECB's life the bank decided first to stop paying interest and then to actually punish banks for overnight deposits. In other words, a negative interest rate. 

The motive for the negative interest rate was to encourage banks to lend more to businesses and households. More loans to businesses would stimulate gross fixed capital formation - firms building factories, warehouses, offices etc - while more loans to households would stimulate purchases of durables such as homes, cars, appliances and furniture. 

The problem is that such loans can only be made if there are people out there who: a) have the right credit, and b) are able to pay the loan back. In the euro zone it was rare to find such clients, and the supply of good borrowers did not increase just because the ECB started punishing banks with excess liquidity on their hands. Since the macroeconomic reasoning behind negative interest rates was that they would stimulate real-sector growth, with the NIRP coming to an end once the economy was strong enough to continue growing without monetary stimulus. 

No such growth has materialized. On the contrary, it seems as though the entire western world is stuck in the low gears of growth. The United States has not seen a single year with three percent growth since before Obama was elected, averaging 2.03 percent per year since 2011. The European growth numbers are even worse, with EU GDP growing at a measly one percent for the same period. The euro zone is even worse, averaging only 0.64 percent per year. 

More on the growth records in the next installment of this article series. For now, one more point about NIPR. This monetary policy practice that started out as isolated cases of misguided monetary stimulus is now actively driving the treasury bond market into the ditch. To see why, let us first take a look at the current bond-market situation. As Wall Street Journal noted on April 8:
Negative interest rates have swept the globe, from Switzerland to Sweden to Japan. By one measure, they’re here in the U.S. too. The 2016 rally in government bond prices has taken U.S. real yields, which subtract inflation from the 10-year Treasury yield, below zero for the first time since 2012.
Look out below! Government bond yields around the globe are being driven to historic lows as investors worried about the slow pace of global growth, political risk and uncertainty over central bank stimulus policies snap up government paper in a bid to pare risk and snare decent yields where they can find it. 
NIRP has created a gigantic pool of idle cash in the global economy. Idle cash is an abomination in the financial industry, for the simple reason that it does not produce any new money. Where can they go with this cash? The real sector is mostly ruled out because of its slow-to-no growth mode that keeps investment opportunities few and far between.

Idle cash therefore finds its way into the stock market (explaining recent European stock rallies) and the treasury bond market. 

The problem is that the NIRP has disrupted the market-driven growth in liquidity that, in a free-market economy, secures a reasonable balance between supply and demand for liquidity. NIRP forces the supply of liquidity to continue to grow faster than the economy needs it (in fact, NIRP is almost the definition of that excess supply). Instead of allowing it to slush around in the global financial markets, investors take their excess cash to the stock and bond markets. 

Here is where the problems start for our welfare states. Initially, the NIRP-incentivized demand for treasury bonds is good for governments in desperate need of funding their deficits. However, that changes over time as welfare states continue to issue more and more debt. With more borrowing, welfare-state debt-to-GDP ratios climb higher and higher, raising new concerns about government ability to pay back their loans, or even pay their debtors the interest they deserve. 

But does this not mean that the NIRP is good for indebted governments? After all, it will send more and more cash their way, thus neutralizing the negative effects that originate in the rising debt-to-GDP ratio. Is this not good for debt-addicted welfare states? Does this not mean that governments whose spending promises exceed what their taxpayers can afford have now found the Holy Grail of perpetual cost-free funding?

No, and here is why. The cost of the entitlement programs in a standard European welfare state grow at 2.5-3 percent per year. That rate increases when workforce participation drops as a result of long-term unemployment, and when the combination of natural population growth and immigration increases labor supply faster than labor demand. Since labor demand is fundamentally driven by GDP, a labor supply growth in excess of GDP growth simply means an increasing share of the work force is left idling - and relying on the promises of the welfare state.

Austerity programs aim to reduce the growth rate in the cost of the welfare state, closer to the growth in GDP (which de facto is the tax base). The problem is that any measures to slow down the growth of the welfare state by means of austerity only postpone growth in entitlement programs - it does not eliminate that growth. As a result, when austerity programs end the cost increase of the welfare state returns to "normal".

The point here is that the welfare states whose costs increase faster than their tax bases gradually demand more and more deficits - and thereby more debt - to continue to fund their promises. In other words, Europe's welfare states will continue to demand more and more of the money that global investors want to invest. In order to secure that supply of investors' money, the welfare-state governments need central banks that maintain, and even intensify NIRP.

With NIRP thus being perpetuated, and proliferated, by the needs of Europe's and North America's welfare states, the overnight rates offered by central banks will continue to slowly slide further into negative territory. But even as the scare of punitive central-bank overnight deposit fines remains and intensifies, global investors will be increasingly reluctant to holding treasury bonds. The reason is the very growth in welfare-state debt: the larger the debt-to-GDP ratio, the higher is the default risk.

Investors started shying away from some European welfare states' treasuries already in the depth of the Great Recession. As those welfare states piled up debt faster than the speed of sanity, their credit ratings started tumbling just as fast. Investors demanded rapid increases in interest rates in order to touch those treasuries. The solution came from the ECB which started lending money to financial institutions at very low rates, combined with a buy-back guarantee for anyone holding euro-denominated treasury bonds.

Only with the combination of artificial monetary incentives from the central bank could the Europeans convince financial institutions to buy high-risk bonds. The problem is that when government debt continues to rise, and credit ratings tumble, not even the sharp-edged central-bank NIRP stick will motivate them to buy endless amounts of treasuries.

Our governments know this, so they have created another coercive measure to force investors to lend their money to welfare states. It is called "Basel III" and we will talk more about it in the third installment of this article series.

The combination of NIRP and continuous welfare-state borrowing has created a vicious downward spiral. Financial institutions are discouraged from parking their excess cash with central banks; since the real sector of the economy is not growing, it offers far too few investment opportunities for global investors; in order to make some money on their idle cash, investors put their money in their stock markets and in treasury bond markets.

Then, as debt keeps growing faster than GDP in those welfare states, there comes a point where not even NIRP works as an investor incentive to buy bonds. Eventually, NIRP reaches a point-of-absurdity when investors bail out, dump bad treasuries and take their money elsewhere.

How far away is that day?

Before we have an answer, let us review the other two factors that contribute to putting an end to government borrowing: GDP growth and the welfare state itself. More on those two in the second and third installments of this article series.

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