We’re in an interesting situation where most developed country governments are borrowing at a rapid rate, and their central banks are financing it. Public old age retirement and health plans are underfunded. Most major developed countries can’t grow rapidly, and there’s really nothing that can be done about it — competition from cheaper labor in developing countries is forcing developed country wages down. We can’t grow out of the debt.
We wait for the tipping point. When will investor sentiment change from believing debts will be paid in equivalent purchasing power, to believing that they will not get paid back in equivalent purchasing power terms?
Greece is past the tipping point. Other nations in Europe teeter. Is Japan nearing such a point? They rejoice to see the Yen weakening as the BOJ finances the government deficit. Be careful what you wish for, Japan — what is good in small, can become self-reinforcing if lenders lose confidence in the Japanese government.
Part of the trouble is with central banks repressing savers, deficits are considerably lower than they otherwise would be because short bond yields are low. If rates rose, deficits would begin to rise gradually but distinctly in proportion to the maturity structure of the country. That’s the tipping point. There are only two states with an unstable equilibrium between them — government debt is trusted, and government debt is not trusted.
Now there is no simple answer here — how will the government react?
Each situation has a different best investment. That’s a boon to governments, or disaster would have happened already. Doubt as to policy blunts the rush to panic. There may be worry but they don’t know what to do.
One more note: when one nation passes the tipping point, the question will be raised on other nations. Imagine a world where many developed nations default on their debts. There would be few certainties and silver and gold would likely become new currencies.
These are just some musings of mine; all sorts of kooky things could happen, but the pressure to use the five reactions listed above will be considerable globally. Prepare as best you can; this one isn’t easy.
You’re analysing government debt as if it was a midcap bond. It isn’t.
Investors who want an asset with the characteristic of sovereign bonds have no alternative. Everyone rushing into gold and creating mad volatility isn’t one, these guys are specifically not looking for volatility. There’s basically no alternative, so rates can stay permanently low.
If for some reason demand did nevertheless go down, rates are set by the central bank so cannot go up unless they decide to put them up. There can be a shortage of demand, in which case issuance can be used to make up for the shortfall.
The only residual risk is then inflation. That is not directly produced by issuance: inflation comes when people have more money to spend than can be supplied, not when people just sit on savings. So you get inflation only when you have full employment and the economy at full capacity, that is a boom, that is when it is easy to raise taxes, indeed the tax take naturally goes up if you don’t touch the tax system.
@ Cig -
You are correct. Perhaps more importantly (in terms of investment opportunity) is that these points are largely not acknowledged, even by the ‘experts’.
I’m not singling out the author of this blog in particular; for the only source (I read probably ~20-30 regularly) that correctly called the monster move in long-dated US Treasuries over the past two years was Hoisington (www[dot]hoisingtonmgt[dot]com).
Most analysts I’ve seen just caution readers to watch for inflation, without thinking through (much less describing) all of the drivers that must occur in order for inflation to materialize.
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