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Monday, June 24, 2019

Should Treasury Bond Investors Be Worried?

Debt market investors are getting nervous. They have good reasons to get nervous. But do they really understand just how nervous they should be?


The Wall Street Journal reports increasing unease on the sovereign-debt market:*
The collapse in bond yields since this spring has been stark, swift and global, upending expectations that the world's economy would be strong enough to support a return to normal monetary policy after years of easy money. The drop says investors expect a recession may be looming, and that central banks will have to step in with lower rates to try to forestall it. 
A recession on both sides of the Atlantic Ocean would bring about a sharp spike in borrowing, the prediction of which is now being worked into the sovereign debt market. However, the prediction is not just one of a recession, but also of a solidified, permanent need by governments to borrow money.

This last point is very important, and almost constantly under-appreciated by analysts and - especially - political leaders. However, even as this worry is rising, it remains under-appreciated even among savvy investors. 

The deficit problem, namely, is bigger and more long term in nature than the vast majority of investors realize.

It is widely recognized that the U.S. government has made deficits a permanent funding source, but not that states and local governments have done the same. Figure 1 reports, respectively, federal and state-local government deficits as percent of total government spending in the U.S. economy:

Figure 1
Source of raw data: Bureau of Economic Analysis

Even less recognized is the fact that the euro zone, taken as one economy, also runs a permanent deficit. Figure 2 illustrates it in current-price euros as an addition on top of total government revenue:

Figure 2
Source: Eurostat

Viewed as percent of total government spending in both economies, the total deficits come out as follows:

Figure 3
Sources: Eurostat (Euro zone total), Bureau of Economic Analysis (U.S. total)

Making deficits a permanent funding source is problematic for many reasons, one being that it forces central banks into a perennially accommodating policy mode. This in turn means low interest rates, but it also means abundant amounts of liquidity being pumped into the economy.

It is not wise to continue to pump excessive liquidity into any economy over time, and it is even less of a good idea when growth is slow. Both Europe and America are having problems with growth. The euro zone has not managed to exceed three percent in any business-cycle period since the beginning of consistent data for the area. The U.S. economy exceeded four percent in the Clinton growth period but has struggled since then to stay above two percent. Notably, that is a level the euro zone has not seen in 20 years:

Figure 4
SourcesEurostat (Euro zone/Euro-19), Bureau of Economic Analysis (USA)

When the supply of liquidity outruns what the economy can absorb for the purposes of market-evaluated investments in the private sector, the excess liquidity finds its way into other equity. Since excess liquidity comes with low interest rates so long as inflation is low, there will be abundant supply of cheap credit for investments outside of the real sector (where, again, growth is slow and profit opportunities limited). This leads to values in real estate and on the stock market inflating far above what real-sector activity would merit. 

In other words, the package with permanent deficits, lax monetary policy and slow GDP growth provides a forceful recipe for recurring speculative bubbles. The root cause, again, is the habit of American and European welfare states to use deficits as a permanent funding source for their spending. If they did not constantly exceed the capacity of their taxpayers, there would be a path to more systemic stability in both economies.

Such a path, however, can only open if government permanently reforms away its egalitarian welfare state. Since that won't happen any time soon, we should expect the macroeconomic landscape to continue to be wobbly, prone to speculative bubbles, riddled with deficits and stuck in slow growth.

This last item, slow GDP growth, plays a key role here, both as a generator of instability and a platform for a more stable economy. Slow growth generates instability by slowing down the growth in tax revenue; since government spending in a welfare state is independent of growth - even accelerates due to slow growth - a sluggish GDP necessarily leads to permanent deficits.

By contrast, strong GDP growth stabilizes the economy by expanding investment opportunities within the real sector. Contrary to conventional wisdom, this eases the speculative pressure on financial markets, though it does not go away entirely until government has eliminated its deficits.

Since GDP growth plays a key role in determining the balance of the government budget, the cause of slow growth emerges as essential to the long-term health of a modern industrialized economy. That cause is not what conventional wisdom suggests, such as "aging population" as discussed in the Wall Street Journal article. The population of Western countries has been aging for centuries, pushing life expectancy higher and higher as health care has advanced and the standard of living improved. 

Nor is the cause a "shrinking" working-age population. If that were a cause of slowdown in growth, neither India nor China would be anywhere close to the economic powerhouses they are today. 

The real cause of slow growth is in the weight and rigidity that the welfare state imposes on the economy. Entitlement programs discourage workforce participation and career advancement; taxes needed to pay for those entitlements, and regulations that come with any large government, shrink the economic landscape within which entrepreneurs and investors can work and thrive. Taxes, of course, also discourage workforce participation, especially at the higher levels of earnings. In the face of taxes and red tape, small-business owners choose to stay small instead of expanding, creating new jobs and making more money for people. 

Since the welfare state discourages economic growth, it is the original cause of its own deficits. Therefore, so long as the welfare state remains, and so long as the prime directive of government is to perpetuate said welfare state, current fiscal and social policies aimed at maintaining the welfare state will remain in place. As a direct result, budget deficits will also remain in place. They are, plainly, a structural inevitability in mature welfare states.

The worry that is currently engulfing the sovereign-debt market is well founded, but probably not driven by the right, profound insights into what really causes government deficits. Short term, this is good because it means that investors will not abandon that market - which they would likely do if they saw the real scope of deficits ahead of them. Long term, though, inadequate insight into the true nature of the deficit problem means that debt investors are in for unpleasant surprises, such as the ones we saw in several places in the Great Recession. 
*) Monday, June 24, print edition, pp. A1, A2 and B10.

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