Forever debt, forever war

China’s Defence Ministry has announced joint naval exercises in September with the Russian Navy. I’ve been banging on about the money wars all week. But let’s not forget that armed conflict is the more traditional type of conflict. And in a world where geopolitics matters again, armed conflict always looms in the background as “the continuation of politics by other means,” as Carl von Clausewitz once wrote.

Of course the Americans, the Japanese, and the Australians routinely conduct joint naval exercises. Just because China’s building a bunch of artificial islands in the South China Sea, planting a flag on them, and calling them “sovereign” doesn’t mean there’s anything unusual about America’s two biggest rivals teaming up for drills.

“This is a routine exercise between the two armed forces, aimed at strengthening the developing China-Russia strategic cooperative partnership,” Yang Yujun of China’s Defence Ministry told a news conference. “The exercise is not directed against third parties.” Of course it isn’t.

Perpetual bonds and forever war

Now, back to the money wars. Washington did not fire a shot overnight. The US Federal Reserve’s Open Market Committee declined to raise US interest rates. It meets again in late September, its last meeting before the US presidential election on 1 and 2 November. Given the Fed prefers to remain neutral in US politics (both parties kowtow to the banks that own the Fed anyway), let’s assume the Fed will remain above the fray for a few months. What next?

If you’re home and alone on Friday night at 9pm, be sure to tune in as the European Banking Authority releases its stress test results. The EBA assesses capital adequacy under certain “stressful” situations at Europe’s 51 most systemically important banks. That’s right Italy. I’m watching you. And you too Deutsche Bank, with your $35 trillion in nominal derivatives exposure.

Before then, though, there is always… always, Japan. On the fiscal front, the Japanese monetary generals are ready to send another 28 trillion yen over the line and into the markets to prop up asset prices and hold down bond yields. That’s around £200 billion, if you’re scoring at home. But such is the scale of Japan’s war on savers and deflation that it pales in comparison to the monetary assault that may follow.

Bank of Japan governor Haruhiko Kuroda may keep his word and do nothing. But if he does something, what will that something be? Well, he can lower the target inflation rate even further. It’s already negative 0.1%. But why stop there?

He can buy more government bonds. As I’ve reported before, though, the Bank of Japan already owns more than two thirds of the Japanese government bond market. Its Godzilla-like presence in the bond market has driven Japanese savers and investors overseas into US Treasuries, pushing bond yields down and prices up in America.

So, aside from purchasing ever more assets with ever greater quantities of money which didn’t exist before, what can the BoJ realistically do that it already hasn’t done? You may already know the answer. In fact, if you know the financial history of 18th century Britain, you definitely know the answer. But if you don’t, let me introduce you to perpetual bonds.

Borrowed money that’s never repaid

A perpetual bond is borrowed money that never has to be repaid. A government issues the bond at a fixed interest rate, payable via coupon in perpetuity, with the principal never to be repaid, unless the government chooses to redeem the bond. This may seem crazy. But keep in mind that Japan may join France and Spain, who’ve already taken advantage of ultra-low interest rates to sell bonds that mature in 50 years (2066). Ireland and Belgium have sold 100-year (or century bonds) in private placements (not auctions).

My point is: with official interest rates at record lows, governments are not shy about selling long-term debt now. The demand is voracious, as central bankers hoover up shorter maturities. And the cost is low. From a purely rational point of view, if you’re a government, why wouldn’t you borrow at these prices?

But wait! There’s more. You can do better. With a perpetual bond, you can borrow now at a low (perhaps even negative interest) rate, and never have to pay it back. Imagine, say, a central bank buying a negative-yielding perpetual bond issued directly by the government. The government would get paid to borrow and never have to pay the money back.

And the central bank? It could hold the bond in perpetuity on its balance sheet, thereby (in theory) avoiding the necessity of taking a loss on the bond should interest rates rise. Long-term bonds are especially sensitive to interest rate rises. It’s inflation. If your money is locked up for decades in a bond, and if there’s regular (or rampant) inflation, you’re sure to lose purchasing power once you get paid back in full.

If it all sounds too weird to be true, there’s precedent for it right here in the UK. In 1751, the British government issued what were called consolidated annuities. That was shortened to “consols.” They’re the forerunner of gilts.

A consol is a perpetual bond. The key difference between when they were first issued and now is that the original consols actually paid a coupon. That’s why it was an annuity. In a low-inflation environment (the Victorian Equilibrium, as David Fischer has dubbed it), it wasn’t a bad way to regularly generate income.

The key, obviously, was that the sovereign issuer was a good credit. You could trust the British Empire. At least, you could trust that you’d be repaid. There was gold in the vaults, and the sun never set, etc.

Today, you have highly indebted sovereign governments with huge long-term unfunded liabilities contemplating issuing perpetual bonds which would be bought directly by the central bank with money brought into existence from thin air. What could possibly go wrong with that? Economist Richard Koo says that confidence in these indebted countries and in their currencies will be destroyed.

My claim is even more direct: money as we know it will be destroyed. Its destruction will necessitate the introduction of a new kind of cash which you will have no choice but to use. It’s a scenario only Dr Strangelove or a central planner with the ego the size of Jupiter could love.

Category: Economics

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