The National Debt is Too…Small? – Fat Tail Daily
If one man’s debt is another man’s asset, what is too much debt? Too many assets!?
That’s not just wordplay. It’s designed to make you think carefully about the nature of our government debt.
Economists will tell you it’s too high. 20 years after our national debt hit zero, we’re in deep trouble again.
But what about the other side of the trade?
Someone owns all those government bonds. Which presumably means they quite like them. Even at historically low yields, the bonds still find willing buyers.
Warning about the national debt is perfectly valid. But what about all those people who want to buy government bonds? Can we really just leave them high and dry?
Imagine our national debt was paid off, again. What’d happen to the investors who want to buy government bonds? They’d have to find something else to buy. Something more risky. Is that really a good idea?
Let’s find out…
Government bonds are the foundation
of the financial system
There are many ways in which this is true. The obvious one is that government bonds are extremely low risk.
Having an extremely low risk place to keep your funds can be very important. Especially if you’re a bank CEO, pension fund manager, or an insurance company.
These companies downright need the government bond market, if only for its liquidity. Meaning the bonds can be sold very quickly without having to sell at distressed asset prices.
In a natural disaster, insurance companies can dump their government bonds to raise funds for payouts.
In a bank run, banks can sell government bonds to raise money to meet withdrawals.
A pension fund can rely on government bonds paying out to meet its redemptions.
Investors looking to ‘sit out’ a crash in the stock market can shift into the safety of government bonds.
And large companies can keep vast hordes of cash safely in the government bond market without worrying about counterparty risk.
In an economy with decent returns for holding government bonds, all these bondholders still make money on the lowest risk portion of their investments.
That keeps banking costs and insurance premiums down and discourages excessive risk-taking in financial markets.
But if there isn’t much national debt to invest in, demand for bonds would push yields down. Leaving bondholders with poor returns.
They’d have to earn their returns somewhere else. Meaning their customers — you.
Of course, the returns that government bonds pay must come from somewhere. And so, the government’s interest bill is really just a redistribution of wealth. From the taxpayer to the investor.
I’m sure you’d prefer to pay less tax and forgo the bond returns. Me too. But the point is that the net benefit of paying off the national debt will be less than most anti-debt campaigners would like to mention. We’d lose something too.
But there are even more important angles for investors, even if they don’t care about the national debt…
Finance’s theory of relativity
Financial markets function in relative terms — not absolute.
Whether 10% is a good return depends on countless other factors like inflation, what alternative assets with less risk are offering and what tax bracket you’re in.
Similarly, interest rates of 5% can be considered high or low depending on what everything else is up to.
In a world where everything is relative, you need a reference rate. A yardstick against which other things are measured.
The most important reference rate in finance is the government bond yield. It is like sea level for geographers. Everything else gets measured relative to that.
Why? Because government bonds are considered risk-free, at least in theory. Everything else has risk.
So, if you want to ask whether a risky investment is paying a worthwhile return, what you’re really asking is how much higher than government bonds the expected return is.
Without a meaningful government bond yield, the rest of the financial markets would be like a high school physics classroom without gravity. Chaos.
Collateral shortage
We’ve covered the importance of risk-free liquid assets and the value of a reference rate. But government bonds are also used as collateral.
Just as you can’t get a loan to buy a house without a mortgage attached to it, many financial transactions require posting government bonds as collateral.
Over at Strategic Intelligence Australia, Jim Rickards has been warning about a shortage of US dollars and treasuries.
It sounds absurd to most of us, given the size of the US national debt. But the point is that the financial system needs access to vast amounts of bonds. And a liquid pool to buy and sell them in.
America’s vast national debt is one reason why the US dollar dominates international exchange. Everyone can hold treasuries as an intermediate asset instead of leaving their money at the bank.
But lately, according to Jim Rickards, treasuries and US dollars have been hard to come by. That’s causing blockages in the financial plumbing.
To make this concept come alive, let me tell you a true story…
A Western university-educated central banker returned home to Indonesia to try and help her impoverished countrymen with good monetary policy.
She’d learned about things like the importance of independent central banks, the NAIRU – the non-accelerating inflation rate of unemployment, and quantitative easing.
But instead of setting interest rates from the comfort of her office, the central banker found herself with a more hands-on form of monetary policy. She’d drive into the mountains each week to distribute cash.
Why?
There was a shortage. The locals in the mountains didn’t have access to cash. So they couldn’t trade for the goods and services they needed.
They had the goods and were willing to provide the services. They just didn’t have the money to turn inefficient barter into a functioning economy. Central bankers had to bring them the money.
What’s going on in markets can be the same. It needs government bonds to function. Cutting supply can drastically undermine the economy as much as cutting off cash to a mountain valley.
Codswallop!
I’ve explained why government bonds are rather important. And that you need to have a lot of them to make financial markets and even the economy function well.
The point is that a lack of government debt can be a hindrance, at least theoretically. This is especially true of financialised economies like Australia’s.
You could even argue that larger, more developed economies need large government debts to satisfy the hunger for risk-free liquid assets.
Maybe large, liquid and stable government bond markets are what made financial markets possible in the first place. That’s certainly a plausible reading of history.
But is any of it true?
The biggest argument against all this is very straightforward. If we didn’t have the national debt, investors would need to find other ways to deploy their capital. And they’d do a dramatically better job than our politicians do with the money they borrow. Which, over time, would make us all dramatically better off.
Imagine if insurance companies and banks had to deploy capital to economic projects worth doing, instead of buying government bonds that finance the NDIS. GDP and investment in projects would soar.
But the real point of today’s story is to give a fair hearing to the tradeoff of paying off the national debt. After all, as the economist Thomas Sowell explained, ‘there are no solutions, only tradeoffs.’
