Bond trading

Bond trading

Information trumps execution

Interviews with CEOs…

Interviews with CEOs…

…of top banks around the globe

Inside investment: Between two worlds

Market volatility is unsurprising. The actions of no longer really independent central banks are stoking the embers of a dying system. A final reckoning is coming.

Like medieval schoolmen, academics are now squabbling over the Excel spreadsheets that informed some of Reinhart and Rogoff’s magisterial study of debt, This Time is Different. Regardless of the interpretation of the data, history shows that it is normal for sovereign nations to spend more than their income, accumulate large debts and then default. It is a sort of economic lifecycle, and we are now doddering on the threshold of the old-age, non-payment phase.

The sovereign debt of Japan is 210% of GDP, that of the US about 100% , the same as Italy. France’s is 90% and the UK and Germany are at around 85%. In 1990, most of these countries had sovereign debt well under 100% of GDP, and the UK, Germany and France were under 50%. We have reached the point where neither repayment nor sustained increased borrowing are feasible.


Japan’s tax revenues are about 28% of GDP, for example; a 5% interest rate, as was the case in the 1980s, would result in interest expense of 40% of revenues, which would increase today’s budget deficit of 10% of GDP to greater than 20%. The same maths applied to the US would have interest expense amounting to 25% of tax revenues, also doubling the deficit.

The current agony of the central bankers is the death rattle of the dying system. We are, as the poet, Matthew Arnold wrote in Stanzas from the Grand Chartreuse: "Wandering between two worlds, one dead,/ The other powerless to be born..."

There are at least seven ways in which countries can deal with their debts: payment in full; defeasement; financial repression; voluntary modification of terms; cancellation; default; and repudiation.

Defeasement consists of putting sufficient money in trust to service fully a bond issue. Financial repression is using legal coercion to keep interest rates below the rate of inflation to reduce the real burden over time, as was successfully practised by the UK and the US in the two decades following the end of the Second World War.

Voluntary modification of terms occurs when creditors agree to extensions of maturity, or reductions in principal or interest rates, as supposedly occurred recently with some of Greece’s obligations. Cancellation results when a central bank purchases its government’s debts in exchange for currency it creates and then cancels the government’s obligation.

Default means, of course, that a country has failed to meet its debt obligations in part or full. Finally, when a government declares certain of its debts to be illegitimate, it repudiates them; repudiation commonly occurs with regime changes.

There are more exotic forms of non-payment, such as expulsion, as when Edward I of England (1290) and then Philip the Fair (1306) of France not only exiled their Jewish creditors, thus extinguishing their royal debts, but also gained resources by assigning to themselves the right to collect the debts owed by others to these lenders.

Philip immolated other lenders (the Knights Templar) at the stake (1307), including Grand Master Jacques de Molay. This eliminated his debts to the order while at the same time avoiding the hold-out problem.

The new abnormal

The desperate machinations of monetary officials to sustain the dying system are now seriously interfering with the functioning of the competitive marketplace. Recently, Stanley Druckenmiller, former manager of the Quantum Fund, said that investing "has become harder for me, because the importance of my skills is receding... Today, all these price signals [of a free market] are compromised... If the most important price in the most important economy in the world is being rigged, and everything else is priced off it, what am I supposed to read into other price movements?"

It is a difficult time for investors. We are in what Nouriel Roubini and Ian Bremmer recently labelled "the New Abnormal, a period in which every market assumption must be questioned and the wise investor is prepared to be surprised". They go on to say that the new abnormal will end with a crisis or emergency because policymakers will not take pre-emptive measures. In the meantime, "the reality is that credit and equity bubbles are likely to form in the next two years owing to ongoing loose US monetary policy".


When a crisis ends the new abnormal, policymakers will be forced to deal with debt in an accelerated manner. We are now in a period of de facto quasi-cancellation because governments, via the no longer really independent central banks, are buying their own debt and remitting the interest to their treasuries. This can easily be formalized as cancellation by an accounting change that would write off these debt holdings and their corresponding liabilities.

This would mean that the money created by central banks to purchase government securities will be unleashed permanently rather than temporarily into the system. This would increase the risk of inflation and so would have to be coupled with increased financial repression in the form of interest rate ceilings and currency controls to be effective. Cancellation combined with financial repression seems the most likely outcome of an eventual crisis.

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