Quote of the Day: Government Bonds as Instruments for Financial Repression

Fact: every dollar that goes into government debt is not going into the private sector. This is a major problem today. The U.S. government is borrowing and wasting an additional $1.2 trillion a year in on-budget (admitted) debt. Meanwhile, it must roll over existing debt as it matures.

The single most important economic factor in strengthening the growth of the modern state has been the development of government bonds. Governments have been able to sustain their growth because they have promised investors to pay interest on money lent to the government.

The government guarantees the payment of a specific rate of interest over a specific period of time. Investors, looking for safety, and looking also for a steady stream of income that is not subject to the risks of the free market, hand over their money to the government on the basis of their trust that the government will not default in any way on its obligations.

As mentioned, a major way that governments default is accomplished through mass inflation, or even hyperinflation. When governments, meaning central banks, increase the money supply, this has an effect on prices. Prices will begin to rise. Investors realize that the money that they will get back over the period of the loan will be worth less than today. So, they demand that the government promise to pay a higher rate of interest.

Those investors who accepted the government's promise when the rate of inflation was lower now suffer capital losses. They hold IOUs from the government to pay a particular rate of interest, and now the government is paying new investors a higher rate of interest. So, new investors are not going to buy bonds from the older investors at the old selling price, because those bonds pay a lower rate of interest than newer ones. They are going to demand that existing sellers of bonds take a lower price than the sellers paid when they bought the bonds from the government.

The ability of the government to extract wealth from rich people through taxation has always been limited. Rich people know how to hide their money. They know how to get it out of the country, and they know how to get it into markets that are less easily taxed.

So, politicians learned half a millennium ago to get their hands on rich people's money before rich people started hiding their money. They did this by promising to pay a rate of interest on the money. Government bonds are ways of extracting money in advance, especially from rich people, which politicians would have preferred to tax directly, but which they did not tax directly because they knew that rich people would hide the money.

The whole point of the bond market is to enable the government to expand its operations beyond what would be possible by collecting taxes today. Politicians are able to get more money to expand operations today, because they promise to repay lenders a specific rate of interest. But, of course, this does not promise that the government will not repay with debased money.

That’s from Professor Gary North. Read the rest here

The Myth of ‘Safe Assets’

The IMF is concerned about the potential shortage of supply of “safe assets”

Writes the Wall Street Journal Blog

Worries about nations’ fiscal health could cut the world’s supply of “safe” government debt by 16% in the next four years, the International Monetary Fund said Wednesday.

The diminishing supply comes even as demand rises for safe assets such as high-quality corporate bonds and sovereign debt, which many banks and investors need amid market uncertainty and regulatory changes.

The shrinking pool of safe assets could create more worries about financial stability, the IMF said.

“Safe asset scarcity will increase the price of safety and compel investors to move down the safety scale as they scramble to obtain scarce assets,” the fund said in its Global Financial Stability Report. “It could also lead to more short-term spikes in volatility, and shortages of liquid, stable collateral that acts as the ‘lubricant’ or substitute of trust in financial transactions.”

The notion of ‘safe assets’, which rest on the assumption of ‘intrinsic value’, is really an illusion. It has been a myth repeatedly peddled, inculcated and propagandized for the public to accept the falsehood of the necessity of the welfare-warfare state. The power to tax does not guarantee economic and financial feasibility and consequently ‘security’.

Safety does not emerge out of government decree, as the recent crisis or as history shown whether applied to government bonds or to money.

Instead, valuations are subjectively determined by acting man or by individuals.

The great Professor Ludwig von Mises explained

Value is the importance that acting man attaches to ultimate ends. Only to ultimate ends is primary and original value assigned. Means are valued derivatively according to their serviceableness in contributing to the attainment of ultimate ends. Their valuation is derived from the valuation of the respective ends. They are important for man only as far as they make it possible for him to attain some ends.

Value is not intrinsic, it is not in things. It is within us; it is the way in which man reacts to the conditions of his environment.

Neither is value in words and doctrines. It is reflected in human conduct. It is not what a man or groups of men say about value that counts, but how they act. The oratory of moralists and the pompousness of party programs are significant as such. But they influence the course of human events only as far as they really determine the actions of men.

Put differently, to paraphrase a popular axiom, safe assets are in the eyes of the beholder.

Take for instance gold.

Gold was essentially an ignored asset at the start of the new millennium, however following 11 consecutive years of price increases, the public’s perception has substantially changed. Now gold has been incorporated as part of the safe asset list of the IMF.

Through history, gold’s perceived safety arises from the money attributes it possesses compared with, or relative to, fiat currencies.

As I previously wrote,

paper currencies are basically IOUs issued and stamped by governments as “legal tender” and backed by nothing but FAITH in the issuer. Because paper money is an IOU, it bears counterparty risks.

Where money as a medium of exchange requires these characteristics: durability, divisibility, scarcity, portability, uniformity and acceptability, unlimited issuance of paper money essentially diminishes the moneyness quality of paper currencies. As we cited earlier given the massive and full scale deployment of the printing press globally, such the raises the risk of a potential of disintegration of the present financial architecture.

However gold may not permanently be a refuge asset either. A serendipitous discovery of a process that enables gold to be produced abundantly would lead to a loss of the current attributes and thereby the subsequent loss of gold’s moneyness. And in the world of rapid advances in technology this is something we cannot discount.

To quote Dr. Frank Shostak

If the increase in the supply of gold were to persist, people would likely abandon gold as the medium of exchange and adopt another commodity.

Bottom line: Safety is matter of subjective individual valuations and definitely not decreed by politicians and or the bureaucracy.

Chart from Dr. Ed Yardeni

To the contrary, what government declares as “safe” are likely to be the riskiest assets. A good example is the ongoing crisis in the Eurozone where toxicity has surfaced out of supposed “safe” debt instruments.

It has been the nature of the state to abuse on their powers, by plundering their citizenry through arbitrary laws, or policies of financial repression (includes inflationism), that ultimately undermines the quality of government issued papers.

In short, self-destructive actions cannot be reckoned as ‘risk free’ which serves as a paradoxical, or must I add absurd, proposition.

$6 Trillion worth of Fake US bonds Seized by Italian Police

From Reuters

Italian police said on Friday they had seized about $6 trillion worth of fake U.S. Treasury bonds and other securities in Switzerland, and arrested eight Italians accused of international fraud and other financial crimes.

The operation, co-ordinated by prosecutors from the southern Italian city of Potenza, was carried out by Italian, Swiss and U.S. authorities after a year-long investigation, an Italian police source said.

It began as a investigation into mafia loan-sharking, but gradually expanded as prosecutors used telephone and computer intercepts to unearth evidence of illegal activity surrounding Treasury bonds.

The fake securities, worth more than a third of U.S. national debt, were seized in January from a Swiss trust company where they were held in three large trunks.

The U.S. Embassy in Rome thanked the Italian authorities and said the forgeries were "an attempt to defraud several Swiss banks". It said U.S. experts had helped to identify the bonds as fakes.

Eventually these alleged 'genuine' government or treasury bonds will be exposed for what they are. They will be defaulted upon either directly or indirectly through massive inflation. In addition, “risk free” by edict (Basel Accord) is a myth.

Burton Malkiel: Why Developed Economy Government Bondholders will Lose Money

At the Wall Street Journal, Professor Burton Malkiel, author of the classic finance book "A Random Walk Down Wall Street", argues that government bonds will generate negative for investors. He writes, (bold emphasis mine)

For years, investors have been urged to diversify their investments by including asset classes in their portfolios that may be relatively uncorrelated with the stock market. Over the 2000s, bonds have been an excellent diversifier by performing particularly well when the stock market declined and providing stability to an investor's overall returns. But bond yields today are unusually low.

Are we in an era now when many bondholders are likely to experience very unsatisfactory investment results? I think the answer is "yes" for many types of bonds—and that this will remain true for some time to come.

Many of the developed economies of the world are burdened with excessive debt. Governments around the world are having great difficulty reining in spending. The seemingly less painful policy response to these problems is very likely to keep interest rates on government debt artificially low as the real burdens of government debt are reduced—meaning the debt is inflated away.

Artificially low interest rates are a subtle form of debt restructuring and represent a kind of invisible taxation. Today, the 10-year U.S. Treasury bond yields 2%, which is below the current 3.5% headline (Consumer Price Index) rate of inflation. Even if inflation over the next decade averages 2%, which is the Federal Reserve's informal target, investors will find that they will have earned a zero real rate of return. If inflation accelerates, the rate of return will be negative.

We have seen this movie before. After World War II, the debt-to-GDP ratio in the United States peaked at 122% in 1946, even higher than today's ratio of about 100%. The policy response then was to keep interest rates pegged at the low wartime levels for several years and then to allow them to rise only gradually beginning in the 1950s. Moderate-to-high inflation did reduce the debt/GDP ratio to 33% in 1980, but this was achieved at the expense of the bondholder.

Ten-year Treasurys yielded 2.5% during the late 1940s. Bond investors suffered a double whammy during the 1950s and later. Not only were interest rates artificially low at the start of the period, but bondholders suffered capital losses when interest rates were allowed to rise. As a result, bondholders received nominal rates of return that were barely positive over the period and real returns (after inflation) that were significantly negative. We are likely to be entering a similar period today.

So what are investors—especially retirees who seek steady income—to do? I think there are two reasonable strategies that investors should consider. The first is to look for bonds with moderate credit risk where the spreads over U.S. Treasury yields are generous. The second is to consider substituting a portfolio of dividend-paying blue chip stocks for a high-quality bond portfolio.

Aside from a portfolio of blue chip stocks, Professor Malkiel recommends tax exempt bonds and foreign bonds.

I’d add that emerging market equities should also be part of one’s portfolio.

Read the rest here

Will Gold Backed Bonds Play a Role in the Euro Debt Crisis?

From the Guardian.co.uk

A solution to the eurozone crisis is staring European leaders in the face. Remarkably, they have failed to consider gold as the asset of last resort. Eurozone member nations and the European financial stability facility (EFSF), the bailout fund, could use gold to back new bond issues.

The security of gold-backed bonds would encourage investors. Indeed, central banks purchased 4.8m ounces of gold worth $8bn (£5bn) in the third quarter. The application of gold backing would allow stricken nations such as Greece, Portugal, Spain and Ireland to depart from the restrictive eurozone and the accompanying depressive austerity policies, if they wished. The bonds would give them time to devalue, adjust and grow again, and also isolate the crisis from other European nations.

As at the end of October, eurozone nation central banks owned 347m ounces of gold worth $604bn. This compares with 400.5m ounces, then worth only $110.5bn, in the first quarter of 2000. The gold reserves fell because European central banks subsequently sold gold at knockdown prices of $250 to $350 an ounce after the 11 September terror attacks. Since then the lemming instinct of European finance ministers and central banks has once again prevailed and their gold sales have dried up, despite recent record prices of $1,800-1,900 an ounce.

Fortunately for eurozone leaders and their advisers, there is still a lot of gold left in the kitty. The current market value of the eurozone's 347m ounces has surged to $604bn, or €447bn – more than the current capital of the EFSF…

Eurozone leaders have devised several complicated partial loss guarantee schemes to persuade China and other potential investors to invest in EFSF bonds. Hardly surprising that the response has been: "Thanks, but no thanks." On the other hand, if EFSF bond issues had the backing of gold plus interest, it would be surprising if European and international investors didn't snap them up. Depending on demand, gold backing could be 25% to 50% of the total value of an Italian bond, for example.

Gold backed bonds have worked before. Take some precedents. In 1981 and 1982, South Africa, which was then the world's largest gold producer, swapped nearly 5m ounces of gold collateral in return for foreign exchange. In the late 1970s and early 1980s, indebted nations such as Brazil, Uruguay and Portugal either swapped or sold their gold to raise funds. In 1973, France issued 'Giscard' bonds, indexed to the price of gold.

While I think bonds collateralized by gold could indeed be tapped, I don’t think this would work like a magical wand that could wish away the debt crisis, where crisis afflicted EU governments can just “depart from the restrictive Eurozone”, elude “depressive austerity policies”, or “to devalue”. That would be oversimplistic and naïve.

Growth of Social Transfers (From Faz community) [hat tip Prof. Antony Mueller]

The Eurozone has been blighted by insolvency issues, mostly emanating from an overextended welfare and heavily regulated state which has been compounded by a debt overdosed dysfunctional banking system.

EU’s gold holdings would signify only a fraction of EU’s debts.

The US and Japan has not been immune to the same crisis, except that the EU has been the first to feel the crunch from an unsustainable political economic system.

Growth of government debt (From Faz community)

Gold backed bonds does nothing to change this dynamic, except to possibly gain access to funding in the marketplace which may help the EU to mitigate current conditions as reform programs are undertaken.

Nevertheless, the good news is that the urgency to address the current dire situation from the fiat money based debt mess has been prompting mainstream media to reconsider gold as part of the possible solution. Such is the gradual transformation of gold from an ignored “barbaric metal” to eventually “money”.

Third Week for ECB’s QE: 6.7 billion Euros

Last week accounted for the third week where the European Central Bank’s (ECB) Quantitative Easing (QE) has been in action.

This from Reuters, (bold emphasis mine)

The ECB said on Monday it had more than halved its bond purchases to 6.7 billion euros last week. The central bank had bought a record 22 billion euros in the week to Aug. 12, when it intervened in the bond market after 19 weeks of inactivity.

Continued support from the central bank remains crucial to prop up investors' confidence in the short-term, analysts and traders said, amid uncertainties over a second bailout package for Greece.

Adding to markets' jitters, Italy is struggling to agree changes to a 45.5 billion euro austerity package the government hastily approved this month in return for the ECB's help and which is making its way through parliament.

"Italy needs to convince the market it can make it without help from the ECB," Cazzulani said.

This follows the previous two weeks of €22 billion and €14.3 billion of bond buying where ECB’s debt monetization facility has now reached €120.3 billion, according to Zero Hedge.

The above news account only exhibits that global financial markets have been artificially propped up by actions of major global central banks, in the hope that markets will be assuaged by the political tokenism applied by crisis affected governments in reforming their system.

The fact is that there hardly has been any meaningful free market reforms or reforms aimed to improve on the real economy. Resources are, in this process, merely being rechanneled or transferred from the welfare state to the banking system.

The underlying goal has been to preserve the banking system, which has over the years bankrolled the welfare state, through government bonds. And the welfare state-banking system relationship has been backed, regulated and implicitly guaranteed by the central banks.

Professor Gary North aptly writes,

Governments always announce and defend by monopolistic violence their legal sovereignty over money. They say that they will control the terms of exchange. All monetary standards are based on government promises and IOUs called government bonds. These contracts are always broken by governments.

Contracts are being broken consistently as governments’ inflate in order to uphold the current welfare based political system.

A system that depends on inflation is never sustainable.

NO Such Thing as Risk Free: S&P Downgrades US

The United States has lost its coveted top AAA credit rating.

Credit rating agency Standard & Poor's on Friday downgraded the nation's rating for the first time since the U.S. won the top ranking in 1917. The move came after Congress haggled over budget cuts and the nation's borrowing limit — and failed to cut enough government spending to satisfy S&P. The issue has contributed to convulsions in financial markets.

The drop in the rating by one notch to AA-plus was expected. The three main credit agencies, which also include Moody's Investor Service and Fitch, had warned during the budget fight that if Congress did not cut spending far enough, the country faced a downgrade. S&P said that it is making the move because the deficit reduction plan passed by Congress on Tuesday did not go far enough to stabilize the country's debt situation. Moody's said Friday it was keeping its AAA rating on the nation's debt, but that it might still lower it.

That’s from the Associated Press.

Governments have painted bonds to be sacramental, which the public has worshipped for all these years. Now that the tide has began to ebb, this illusion has been exposed.

As the great Frank Chodorov wrote

The use of the word investment in connection with a bond issued by the State is a treacherous euphemism. When you buy an industrial bond you lend your money to a corporation so that it can buy a machine with which to increase its output of things wanted by the market. The interest paid you is part of the increased production made possible by your loan. That is an investment. The State, however, does not put your money into production. The State spends it — that is all the State is capable of doing — and your savings disappear. The interest you get comes out of the tax fund, to which you contribute your share, and your share is increased by the cost of servicing your bond. In effect, you are paying yourself. Is that an investment?

Government bonds represent as key instruments of financial repression. They signify as redistribution mechanism of scarce and economically valuable resources from the taxpayers (productive sector of society) to the benefit of the politicians, bureaucrats and vested interest groups (unproductive sectors). Yet this arrangement has limits. Apparently we have reached it.

Now even the politically connected major credit rating agencies have obviously bowed to the forces of the marketplace. Risk-free cannot be attained by fiat or legislation (such as the Basel Accords on the banking system).

Risk-free is thus a myth.

The Myth Of Risk Free Government Bonds

Bruce Krastings at the Zero Hedge has an interesting story to tell.

It's essentially about the sordid fate of Hungary's bearer bonds of 1924.

"Fifty years later the $500 of principal and the $1,250 of accrued interest were worth $40.", says Mr. Krastings.

Read the rest here

Yet the global banking system have been designed to hold government bonds as risk free assets and core holdings on their balance sheets. This bias towards "risk-free" government bonds effectively translates to subsidies to governments.

As Cato's Mark Calabria explains,

``Under Basel, the amount of capital a bank is required to hold against an asset is a function of its risk category. For the highest risk assets, like corporate bonds, banks are required to hold 8%. Yet for those seen as the lowest risk, short term government bonds, banks aren’t required to hold any capital. So while you’d have to hold 8% capital against say, Ford bonds, you don’t have to hold any capital against Greek debt. Depending on the difference between the weights and the debt yields, such a system provides very strong incentives to load up on the highest yielding bonds of the least risky class. Fannie and Freddie debt required holding only 1.6% capital. Very small losses in either Greek or GSE debt would cause massive losses to the banks, due to their large holdings of both." (bold emphasis added)

So unless we see a change in the mandated treatment of government bonds, which implies that subsidies to governments will need to be slashed, we will only keep jumping from one crisis to another, as shown in the chart below from the World Bank, where the incidences of banking crisis has ballooned post-Bretton Woods US dollar-gold standard.

In short, crisis are products of the inflationary central banking based-fiat money standard.

As Ludwig von Mises reminds us, ``It is always an inflationist policy, not economic conditions, which bring about the monetary depreciation. The evil is philosophical in character."