Central Bankers Begin to see the paint and the outline of the corner
By: Stephen Johnston
Will Rogers once quipped, “If stupidity got us into this mess, then why can’t it get us out?” This seems like an apt description of the zero interest rate policies (ZIRP) being pursued by the world’s monetary authorities.
On the topic of ZIRP, needless to say we continue to live in historic financial times and in particular in the first synchronized, global, fiat money inflation effort. We have ZIRP and negative real interest rates in virtually every major market and with the recent US Fed decision to continue its quantitative easing (QE) policy the monetary base of the world’s reserve currency appears set to continue its rapid growth. This is an unsustainable trend if history is a guide. It has been written many times before in one form or another but it bears repeating - there is no way to create capital and the prosperity that flows from it other than through private savings and private production - simply printing money does not create capital.
Sadly this is a message to which our governments, under the sway of Keynesian ideology, are unwilling to listen. It is axiomatic that state spending requires that capital is first taken out of the hands of the profit making private sector activities via taxes, borrowing or inflation and then deployed in typically, loss-making public sector activities. Having said this, the current bout of excess money printing is simply a stealthy redistribution scheme that allows capital to be harvested from savers/pension funds and extracted by the financial sector.
Obviously, while I believe that eliminating ZIRP/QE is the right thing to do for the long-term health of the economy, the recent equity and bond market declines are but modest harbingers of the unintended short-term consequences that the US Fed’s prolonged ZIRP/QE program and its termination will wreak - rollover and convexity risk. These risks will loom large if and when the US Federal Reserve and its global proxies, in the form of the Bank of Japan, European Central Bank, and the Bank of England, stop their massive bond-buying sprees as rates normalize. I believe it is these issues that are making central bankers nervous as they start to see the outline of the corner into which they are painting themselves.
Sovereign borrowers have had virtually unfettered access to the credit markets over the last two decades. Those privileges are gradually being revoked as the ability to repay is being called into question. Without the ability to roll over obligations at current historically depressed interest rates, the truly precarious nature of sovereign finances will be revealed. Consider that while interest rates for many developed nations are at generational lows, sovereign debt loads as a percentage of GDP are at all-time highs.
What happens to western governments when their borrowing costs rise from 2% to something approaching the long-term historical average of 5%? In countries like Japan and the US, the answer is that the majority of the budget would be dedicated simply to paying interest. Perhaps this sounds alarmist and unlikely, but consider that, as of 2012, US federal government debt exceeds $15 trillion USD. In 2011, the US government paid $454 billion USD in interest (an implied rate of 2.9%). The Congressional Budget Office notes that federal government debt will rise to $20 trillion USD by 2015. If we assume that it carried a rate of 5% instead of 3%, interest payments would total $ 1 trillion USD or 45% of current tax revenues.
Clearly, state debt service as a percent of tax revenues is already at high levels for most developed nations, yet interest rates are at historic lows. As state finances enter distress, they are forced to finance themselves at shorter durations creating roll-over risk. The combination of interest servicing issues, and duration compression, leaves them heavily exposed to even modest increases in interest rates. When rates rise, state revenues will be rapidly consumed by just the interest on servicing their debt, let alone funding day-to-day commitments.
And therein lies the issue. Our commitments are entering a high growth phase in the face of deteriorating demographics and growing dependency ratios. The magnitude of our impending entitlement costs are largely being ignored despite some lip service coverage in the mainstream media. Layer on an absence of political support for a reduction in government spending and can some form of printing press inflationary default be far behind? It’s certainly difficult to see how any combination of tax increases, economic growth or marginal adjustments to entitlements is going to close western funding gaps.
To quote Jens Parssons from the book Dying of Money: Lessons of the Great German & American Inflations – “Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no-one pays.
That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and an ineffectiveness of all traditional remedies. Everyone pays and no-one benefits. That is the full cycle of every inflation” (emphasis mine).
The Austrian School of Economics has many useful insights on the economic consequences of state intervention in the economy and unbridled monetary expansion. Friedrich Hayek, a prominent Austrian economist, wrote The Road to Serfdom and The Fatal Conceit as a warning against the prevention of the free operation of the markets - privatizing gains and socializing losses is not capitalism and not good for the economy despite what politically connected ‘too big to fail’ banks would like us to believe. It has been central bank control over the cost of money (i.e. interest rates) and the moral hazard created with ‘too big to fail’ that led directly to the problems we now face. More of the same will not solve our problems - let interest rates normalize and insolvent financial institutions suffer the consequences.
The unvarnished truth is that we are living beyond our means and dishonestly passing the cost onto future generations - Herbert Hoover once prophetically said, “Blessed are the young for they shall inherit the national debt.