“I don’t have to outrun the bear; I just have to outrun you.”

That old joke about two guys seeing a bear from the distance, and one putting on some lovely running shoes from his backpack; the other one asks – what are you doing mate, you can’t outrun the bear just because of those fancy new shoes. That’s when the first guy replies as above.

This is somehow appropriate for the sovereign debt markets over the course of 2012. Many moons ago, I wrote an article – “Deaf frogs and the Pied Piper” (Asia Times Online, September 30, 2008) – that was mainly about the wrong lessons being absorbed by Asian policymakers as they saw the global financial crisis unfold, specifically taking active positions against the free market. In the event, Asian central bankers have continued to intervene in the bond markets in an attempt to keep their currencies “competitive” and in effect create a whole bunch of second-order effects in global debt markets.

Of course, in addition to the actions of Asian central banks, efforts by the Financial Times’ “Man of the Year” (I called him that first, back in January this year) European Central Bank president Mario Draghi in pumping out hundreds of billions of euros, and “Helicopter” Ben Bernanke, who as chairman of the Federal Reserve has gone from QE1 and QE2 to QE3 and now either QE3.5 or QE4.0 depending on who you believe, have resulted in a flood of liquidity that has lifted pretty much all boats in the sovereign debt market.

Even the ones with holes mind you; so quick has been the tide that even these horrible pieces of rotten wood have managed to stay afloat long enough to fool anyone into thinking they were actually viable boats.

This is of course where the financial media and Keynesians come into the picture – if one bothers to make any distinction between the two that is. The three notes below [1-3] show:
a. An article on the Bloomberg website that dismisses the effects of rating downgrades on sovereign debt markets this year;
b. An article in the Financial Times that does the same, in the more narrow context of France; and
c. An article by Paul Krugman about the US not having a debt crisis.

I could get snarky and ask whether Krugman is having an identity crisis between his roles as a polemicist or an economist, but that would be too churlish for this time of the year. Instead, let’s look at the basic aspects of the global bond markets; facts that are more or less undisputed:
1. Most of the top benchmarks now trade through their own inflation rates, ie investors have accepted negative real yields over the course of this year;
2. Most of the Group of Seven/Organization for Economic Cooperation and Development (OECD) is still saddled with excessive debts compared to the demographic and economic realities of today;
3. No country other than Ireland and Germany has initiated let alone succeeded in quelling yawning budget deficits over the course of 2012;
4. Many more countries are likely to be downgraded in the OECD than upgraded over the next five years based on current trends in fiscal deficits and any (extraneous or even expected) shock to interest payments;
5. Banks haven’t been fixed globally, and the cost to do so – much of it to be absorbed by governments rather than free markets – still numbers in the hundreds of billions in terms of new capital and write-offs of bad assets currently on the books;
6. There is the US fiscal cliff, which looks set to be resolved albeit with the type of compromise that may actually sink US credit ratings over the near term;
7. Japan’s newly elected LDP government is looking to sell more sovereign debt to the Bank of Japan, even as it forces private savers to join with the government in buying foreign debt in a bid to keep the yuan weaker; this will cause a significant credit downgrade in 2013-14;
8. Then there is the grandfather of all crises, the European sovereign debt crisis; wherein Greece avoided being ejected from the common currency zone in 2012 but faces the same pressures once again in 2013. Spain and Italy are likely to hit the wall once again too, and elections for a new German chancellor may change the direction of the debt crisis inexorably towards a breakup of the union

So if all these issues are likely to buffet the sovereign debt markets, why then are yields so phlegmatic? Quite simply because of the central banks: as they attempt to apply the lessons of classical economics, risks of a different type of crisis are building up. In a new paper by the Bank of International Settlements, Claudio Borio writes eloquently on the subject of macroeconomics in general and monetary (policy) economics in particular and how policy makers are absolutely failing to grasp the risks of their actions. He summarizes the essay thus:

Three themes run through the essay. Think medium term! The financial cycle is much longer than the traditional business cycle. Think monetary! Modelling the financial cycle correctly, rather than simply mimicking some of its features superficially, requires recognising fully the fundamental monetary nature of our economies: the financial system does not just allocate, but also generates, purchasing power, and has very much a life of its own. Think global! The global economy, with its financial, product and input markets, is highly integrated. Understanding economic developments and the challenges they pose calls for a top-down and holistic perspective – one in which financial cycles interact, at times proceeding in sync, at others proceeding at different speeds and in different phases across the globe. [4]

Reading through this carefully, it is clear that the author doesn’t expect currency monetary policy actions to produce anything other than a long-lasting adverse reaction in the underlying economies. Specifically, the article addresses the resurgent strain of Keynesian idiocy in terms of expansionary fiscal policy:

Consider fiscal policy next. The challenge here is to use the typically scarce fiscal space effectively, so as to avoid the risk of a sovereign crisis. A widespread view among macroeconomists is that expansionary fiscal policy through pump-priming (increases in expenditures and reductions in taxes) is comparatively more effective when the economy is weak. Economic agents are “finance-constrained”, unable to borrow as much as they would like in order to spend: their propensity to spend any additional income they receive is high (eg, Gali et al (2007), Roeger and in ‘t Veld (2009), Eggertsson and Krugman (2012)). In addition, with slack in the economy and interest rates possibly already constrained by the zero lower bound, there is no incentive to tighten monetary policy in response (eg, Eggertsson and Woodford (2003), Christiano et al (2011)).

This view, however, does not seem to take into account the specific features of a balance sheet recession. If agents are overindebted, they may naturally give priority to the repayment of debt and not spend the additional income: in the extreme, the marginal propensity to consume would be zero. Moreover, if the banking system is not working smoothly in the background, it can actually dampen the second-round effects of the fiscal multiplier: the funds need to go to those more willing to spend, but may not get there.

Importantly, the available empirical evidence that finds higher fiscal multipliers when the economy is weak does not condition on the type of recession (eg, IMF (2010)). And some preliminary new research that controls for such differences actually finds that fiscal policy is less effective than in normal recessions (see below). This is clearly an area that deserves further study.

The highlighted section has very much been the experience over the past few years of Keynesian idiocy. Today, the stock of excess cash in customer accounts across the US banking accounts is US$2 trillion [5], well over the threshold in 2007 due mainly to an increasing, marginal, propensity to save rather than consume. Monetary policy in the US has failed, in other words, because it has produced the exact opposite to expansionary fiscal policy (this can also be written in the opposite sense ie that fiscal expansionary policy has failed…).

It is thus important at this stage to step back and ask the question – what are the billions of dollars in US bank savings and those of Asian central banks doing now? Or more importantly, where are they invested now: and therein lies the answer to the question asked at the beginning of this article about credit quality.

This money in bank accounts (commercial in the US and central in Asia) is not available for classical risk investing: US banks aren’t lending, and Asian central banks don’t understand risk anyway. So the money is parked in government bonds around the world, in effect pushing down yields of the undeserving borrowers because there is, quite simply, nothing else to do with the money.

An observation of this type produces an equal and opposite corollary: what then? Where we are headed is a special branch of investment economics that classifies success as the equivalent of failure. No comprendo?

Well, all it means is that, at the first sign of success, ie economic growth arising from “animal spirits”, investors will have to comprehensively dump sovereign bonds; however, the dumping will push up yields and therefore destroy any nascent recovery. As an opposing force, any economic failure, viz a “dip” to recession, will increase the holdings of government bonds and effectively push yields even lower when credit quality is arguably at its worst.

These contrarian forces will work through the markets across currency, time and economic zones. Sometimes Japan will be down, and at other times it will be Germany. An alternative to such a volatile existence could be simply dump all government bonds from one’s portfolio, buy a heck of a lot of gold and wait on the sidelines for positive economic growth indicators.

And in passing, a joke about investor choices in sovereign debt markets expressed on a more human note; in this example I will simply state investors are the “old man” and governments their “wife”:

There was a man who had four children, all extremely good-looking, except for the youngest one, Craig. Craig was quite ugly! The man grew old, and just before he died he asked his wife, “Mary, I have only one question. Please tell me the truth. Am I Craig’s father?”
“Yes, my dear,” replied his wife. “I promise you, Craig is 100% yours.”
The husband smiled. “I can die a happy man. Goodbye, my love.” And he peacefully passed away.
Mary gave a big sigh and said, “Thank goodness he didn’t ask me about the other three.” 

Best regards for the holidays folks, and may you all have safe travels, happy tidings and a merry time with kith and kin.

1. Bloomberg on bond markets and rating agencies.
2. Financial Times on a Gallic ‘shrug’ against a downgrade.
3. Paul Krugman in the New York Times.
4. BIS working paper “The Financial Cycle and Macroeconomics: What have we learnt?”, Claudio Borio, December 2012.
5. See here.