Debt is Not The Problem – Economic Management Is.  

Blain’s Morning Porridge – 21st September 2024: Debt is Not The Problem – Economic Management Is.

“Parliamentary debate fosters compromise, Referendums fuel polarisation.

Many market participants fear the rising quantum of Government Debt spells crisis across the globe. Tush and Nonsense. Debt is not the problem – markets exist to price risk. The crisis lies in economic management, and Political Risk!

Yesterday I raised a question: is Rishi Sunak’s apparent abandonment of Net Zero plans a potential danger for the UK economy? (Read the papers this morning for multiple answers.) Later in the day I found myself in conversation with a US Chief Investment Officer concerned about the dollar and the rising quantum of US debt – he reckons the US debt load will trigger a massive “turning point”, likely to escalate into the biggest financial crisis in history! (Each successive financial crisis is bigger than the last – the power of compounding inflation!)

Essentially, they both boil down to the same issue – can nations under economic stress in markets maintain their Virtuous Sovereign Trinity of a stable currency and sustainable bond markets, held together by competent politics, to power themselves out of economic pickles?

The current “pickle” in the West is long-term: how to rejuvenate tired economies: repair and replace failing infrastructure and utilities, address inadequate social services (including health and education), ameliorate rising inequality and perceived injustice, provide defence and security, while managing the transition to cleaner, more reliable renewable energy sources, all the while fostering growth to maintain and raise living standards. These all require large scale investment and direction. Politicians and market pundits say we can’t fund it – we need to economise.

My contention is Debt is not the problem. The crisis is in economic management.

The conventional view of a “dangerously” high quantum of sovereign debt was framed by the eminent economists Carmen Reinhard and Kenneth Rogoff. They broadly asserted rising debt inevitably leads to weaker growth. At some stage – above say, 80% debt/GDP – government debt crowds out other financing and growth and slows the economy, thus austerity spending and limited government borrowing is a good thing.

Such logic makes sense to handbag economists thinking like housewives seeking to balance the family purse. It’s become an article of faith on the right and among many investors that governments should reduce debt levels.

Why can’t we finance these economic needs through the state? Markets are massively complex – but are well able to process risk and price debt. Simply assuming debt is bad is missing a massive opportunity for the reconstruction of economies. Markets set prices – and we have a massive functioning market that exists to price risk.

For all the talk of imminent debt catastrophe across the West, and the fastest pace of interest rates rises in history – there are no signs of real stress in bond markets. Strip out the noise, and yields have risen and prices fallen in response to central banks fighting inflation. Not because investors fear nations are going bust on too much debt. Where did that idea come from? Academics writing about debt? Tucker Carlson saying it?

Let’s go back to first principles in the bond market:

To understand how debt could finance growth, understand the bond market. Fixed Income bond investors only care about 2 things:

• Being paid interest.
• Receiving back principal.

We call that credit risk.

They watch inflation – demanding a higher yield on bonds during inflationary periods to keep their returns positive.

Smart government bond investors understand the basic rule of Sovereign debt: no country with its’ own sovereign currency will ever, ever go bust or default. (Yep, sovereign credit ratings are pointless.) A nation can issue debt and pay interest and principal by printing money.

The US has outstanding debt of $33 trillion ($27 bln of Treasures and $6 bln of inter-government debt), but could repay it all by simply printing money. There would be consequences from flooding the global economy with money: as Treasuries are held around the globe a rash of dollars would trigger massive inflation and a fall in the value of these unwanted dollars – a currency crash.

The only thing that would stop the US repaying its debt would be “government” deciding not to repay – which as we’re all aware is a heightened risk in these polarised political days – triggering massive consequences and confirming my belief “bad politics” is the biggest market danger. Political risk is the known-unknown in Sovereign Bond Markets. Both the UK and US are massively and obviously vulnerable to political shenanigans and chaos destabilising the monetary functioning of their economies.

Countries that default on their debt inevitably do so because they borrowed (unhedged) in another currency, and when the time comes to repay that debt, they have to buy back that currency on the open market or via central banks because some other country owns the keys to the printing press. That’s what breaks Argentina every three or four years.

The role of a nation’s debt management office is to balance a dynamic financial environment of rates, currency and inflation to ensure their bond market remains open and functioning. It’s not debt that’s the problem – it’s understanding the parameters of what debt might do to the currency, inflation and the economy that matters.

• For instance, during the QE era we learnt keeping interest rates too low generated massive hidden financial asset inflation which in turn financialised the behaviour of participants in the real economy, favouring corporates using profits to gamble in stocks and bonds rather than generating real returns from capital investment in plant and infrastructure.

The right level of rates is critical. The QE lesson was clear: A sustainable bond market setting the “risk-free-rate” (Treasuries or Gilts) sets a clear relative measure of investment returns, leading to informed investment decisions and growth.

• If the US treasury is 4% then a decent Aa rated corporate knows it can raise finance at a spread above that (say 100 basis points, 5%), and make all the necessary business calculations, and examines multiple investment options, before borrowing to build new productive capacity leading to economic growth and rising tax payments as every corporate and participant in the market knows the price of money and invests and spends accordingly.

Setting the right level of rates not only finances government, but stimulates growth in the public sector – Do not distort that rate, as the negative consequences are multiple.

Debt should not be a problem for a nation that maintains a Virtuous Sovereign Trinity of a stable currency, a sustainable bond market, and political competency. Both the US and UK should qualify – except for that last bit.. political competency. When you fear the consequences of a re-elected Trump, or Sunak’s short-term pursuit of votes running the risk of a second Trussterf*ck event, then you can see how politics is a ticking bomb.

The corollary of political incompetence is a functioning economy where the government is making sound long-term spending decisions, businesses making informed decisions on raising credit to invest and expand, which consumers can spend with confidence, expecting their incomes to keep rising to financing spending. Virtuous circle and a virtuous trinity...

Of course, there is always periodic instability.

Currencies are volatile. Could the mighty dollar be replaced and therefore a weakening dollar trigger a cascade of consequences leading to economic mayhem as described above? It’s a risk, but unlikely to happen without a political shove.

The dollar remains the global reserve currency off which every other asset – real or financial – is priced against. Critically that includes oil and energy which are the key components driving current inflation. The current wartime domestic currency payments by China and India for Russian fire-sale oil are not a harbinger of a non-dollar oil market developing, but a signal of a distressed seller forced to become a price taker. At the moment there is little chance of an alternative currency – yuan, or a Brics taler, replacing the dollar. It remains the value reserve, and therefore any surplus dollars will be invested into dollar securities… That said, the tides of history are remorseless..

Weaker economies have currencies which can demonstrate extreme volatility as inflation, rates and bad politics wreck an economy. The smaller and more volatile an economy – the more likely is crisis. You can add corruption to the “competent politics” part of the equation – a nation that fails to control and abate corruption is far more likely to suffer political volatility.

It’s OK for governments to borrow – the market will price demand vs supply and rates will rise when governments borrow too much. It’s also normal for governments to borrow more than they raise from tax – constantly rising the quantum of govt debt in line with inflation and growth, like maintaining a big mortgage. If the size of the government debt remains about constant to the size of the economy – not really a crisis. No one really worries much about Japan’s massive 300% debt to GDP load. The interest rate is so low it can pay that cost. (At the moment.)

Many on the right will argue it should not be the business of government to finance the economy. The biggest debate in any economy is always who pays – public goods vs private. Yet, put it to the test by privatising the economy, and you get market failure. The catastrophic failure of mass public utility privatisations in the UK demonstrates private ownership manages public utilities no better than under public ownership, and simply prioritises dividends to owners over public good. and public debt has not fallen – private ownership of public utilities has required massive subsidy.

Somewhere there is a happy mix of a public and private economy.

We panic when a country does something stupid. It becomes a potential crises when govt’s look daft – witness the Trussterf*ck exactly a year ago. When government makes foolish spending and taxation plans the market very quickly panics. All it took was a small, but significant rise in gilt yields on the back of crashing currency, to trigger margin calls on Gilt leverage to almost – very nearly – break the 330 year old Gilt market.

We also panic when a nation reaches 160 Debt/GDP in a currency it does not own – like Greece and Italy a decade ago. This is why I remain ambivalent on the Euro and ECB – members can’t avoid default by printing more Euros, they need a consensus among the ECB members to do so, and since German workers don’t want to be paying Italian pensions… you can see the problem. Euro sovereign bonds are more like a credit market.

Should we be panicking about Debt and the dollar?

The US bond market is the most liquid in the world. It works because everyone buys and sells goods and commodities in dollars, so have dollars to invest, which they do in Treasuries. That will not change – as long as it works. The US can continue to expand its debt quantum if that supports its on-going growth – which is well ahead of Europe and inflation.

But, if there was a shock, like war, or the US becoming more isolationist, or a real move towards other currencies to settle global trade, or even conceivably the introduction of digitally settled cross border digital currencies trades which reduces currency volatility and therefore the apparent importance of the dollar – effectively we forget the dollar at the base of each price – then that may change.

BUT – The danger is in politics. Trump and Sunak are symptoms of Chaotic Populism. There is increasing resentment as the working and middle classes are hollowed out by inequality, foreign products, and failing infrastructure. They act as an accelerant on political instability. There is a real danger it’s not external forces that ends US economic hegemony, but internal crisis that breaks the dollar and the mighty Treasury market.

Five Things To Read This Morning

BBerg               Fed May Hike More to Fight Sticky Inflation, Jamie Dimon Says

FT                     Sunak’s unwise retreat on climate policies

WSJ                  Don’t Buy The Fed’s Rate Projections

Guardian          One in Three Europeans now votes anti-establishment

Torygraph         The Remainers last economic argument against Brexit has crumbled

Out of time and back to the day job

Bill Blain

Strategist – Shard Capital