Public Debt and The So-Called Bond Vigilantes
This desire for security is crucial, too, in explaining the leverage which the government exercises upon the bond market when it comes to its own debt. Those who deny this leverage, who instead hold that it is exercised by the bond market over governments, often point to that species of financial life known as the bond vigilante. Originally uncovered by Ed Yardeni, a well-known investment research consultant, a bond vigilante is someone who roams the sovereign debt market on the lookout for governments that are pursuing macroeconomic policies to which investors are liable to object. Such policies include elevated budget deficits, escalating debt, and a loose monetary regime. Once such malefactors are identified, the bond vigilante will join forces with his or her fellows in the cause of market justice and aggressively bet against the debt securities of the country involved. With the costs of funding its debt increasing as a result, the country is forced to obey the bond vigilante. Depending on the problem at hand, the budget deficit will have to be slashed, or the money supply tightened, or both. Given that those who take part in this type of trading are described as vigilantes, the case is already stacked against their actually pursuing justice. It is a way of speaking very much in accord with the opinion of bond market critics who see traders there as having usurped the democratically granted authority of governments to oversee the economy. There was a slew of books and articles published in the 1990s stating this charge. The issue then went dormant in the early to late 2000s, until it reemerged amid the European sovereign debt crisis that began in 2010. Various politicians and intellectuals once again raised the cry that the bond market had displaced democracy in imposing austerity policies.
What the critics neglect to take into account is that the system of government under which we operate is meant to be a liberal, rather than a majori- tarian, democracy. In the latter, the ultimate decision-making authority in the community lies entirely with whomever 50 % + 1 of the population deems appropriate. Anything that constrains this authority, such as bond investors suddenly demanding a higher yield for government debt securities, will appear as an affront to democracy. The implicit assumption here, though, is that the money capital wielded by bond investors does not truly belong to them to direct as they please. That is, whenever the government’s necessities demand it, bond investors are enjoined to offer their funds to the community on amicable terms. This is tantamount to declaring that the will of the majority trumps private property rights. In a liberal democracy, by contrast, majority power is given its due in making social decisions, but it is not supposed to reign absolutely. It is checked and balanced by practices and institutions that defend regional interests. It is constrained by the requirement of putting proposed legislation before the review of a body less beholden to the public. It is framed by a judicial framework designed to protect a set of individual rights based on the rule of law. Included within that set is the right to private property.
True, liberal democracies limit that right when a compelling public interest demands it. Yet barring a war that threatens the nation’s security, it is hard to justify the expectation that investors ought to be ready to lend out their money at affordable rates to the government irrespective of the policies being pursued. Such an expectation, taken to its logical extent, would permit the state to compel individuals to purchase its bonds. That is what the Northern Italian republics of Venice, Florence, and Genoa did in the Renaissance when bond markets first emerged. But it is not what liberal democracies are supposed to do.
In respecting the property rights of bond investors, it is not as if liberal democracy is granting sustenance to a faction inherently at odds with the common good. In theory, the credit markets can serve as a check to the everlasting propensity of governments to misuse their power. Recall the tax consumer versus taxpayer analysis from the previous chapter. Given the combination of the uneven distribution of wealth in advanced economies, and the democratic principle that a minimum of 50 % + 1 decides for the community, the most successful politicians will be those that build a majority coalition of tax consumers on the backs of a minority of taxpayers. Democracy’s commitment to equality furthers this dynamic, giving moral force and urgency to this state-directed redistribution of wealth. After some time has passed and politicians have outdone each other in offering public goods to voters, the costs of the government’s programs threaten to turn the tax consumers into taxpayers. To forestall voter ire, especially among the electorally critical middle class, politicians find it very tempting to collect less in taxes from the public than is spent on their behalf. Consequently, the government runs persistent budget deficits and piles up a large public debt, thereby passing on the costs of present government benefits to future generations—who, conveniently for democratic politicians, do not have a vote. By lending to the government the difference between its outlays and receipts, the bond market offers politicians a very beguiling source of financing. Precisely by bringing the state within its ambit, however, the bond market can keep it from going too far with its expenditures. Bond traders can progressively raise the yield on the government’s bonds the more that the public debt rises. The government would then have an incentive to fix its finances before reaching the critical point where bond investors refuse to continue funding it or where the required yield escalates sharply—all thanks to bond investors’ application of their property rights. This check becomes even more vital, in light of how our liberal democracies have abandoned the monetary tie to gold. Absent this constraint, governments can more confidently go into debt knowing that the option exists to simply manufacture currency to pay back their bonds. If yields are increased concomitantly as monetary conditions are relaxed, the bond market can hinder this politically convenient tactic.
In practice, do the bond markets constrain governments in these ways? In light of what has transpired in the Eurozone since 2010, first in Greece, Ireland, Portugal, and then subsequently, in Spain and Italy, the answer would appear to be an obvious yes. In one way or another, accelerating bond yields have forced these countries to retrench their public sectors and raise taxes (though, it must be said, much greater emphasis has been laid on taxes). Yet the bond market’s invigilation of governments is more complicated than that. This becomes evident when we ask: how did several nations, developed ones no less, arrive at the stage where debt finance either became prohibitively expensive, or virtually unavailable, all around the same time? If the bond market were serving as an effective check, would not at least a few of these country’s politicians have been deterred from watching over a perilous buildup of public debt? Perhaps these instances can be brushed aside as a freakish sequence brought about by a perfect storm of unfavorable political and economic variables. Even then, there is a longer historical record that still needs to be explained away.
States renege on their debt more regularly than one might think. In his 1933 book, The Bond Market: An Autopsy, Max Winkler spoke of government defaults as, “an ancient tradition”. This goes back to Dionysus of Syracuse in the fourth century BC through to the Greek city-states of the same era. Then there was Rome in its both republican and autocratic phases as well as England between the fourteenth and sixteenth centuries. Spain defaulted on several occasions in the sixteenth and seventeenth centuries. So did every single Latin American country in the nineteenth century. That century also saw defaults in Germany, Austria, Portugal, and Spain again. Then, too, there was the wave of defaults after World War I among many of that conflict’s belligerents. A default, by the way, consists not just in the non-payment of a scheduled obligation. It also encompasses a temporary suspension of payment, a restructuring of the debt, or even the inflationary tack of paying the debt back in a deliberately cheapened currency. Using a more statistical approach than Winkler, Carmen M. Reinhart and Kenneth S. Rogoff count 318 defaults between 1800 and 2008, this among 66 countries accounting for 90 % of world GDP. That works out to a rate of about 1.5 defaults a year, although their occurrence tends to be temporally clustered. The nineteenth century featured a number of short-lived spikes in debt reneging. Defaults reached their highest levels during the interwar period. Subsequently, the rate declined toward the pre-World War I range, eventually plumbing all-time lows just before the recent financial crisis.
Parsing the data, Reinhart and Rogoff notice that not every country is equally subject to losing confidence from the financial markets. They distinguish two groups: the serial defaulters and the non-defaulters. The serial defaulters are made up of developing nations with a history of debt restructuring and high inflation. The non-defaulters, meanwhile, consist mostly of developed nations that have demonstrated a long and consistent record of meeting their credit obligations and achieving price stability. The first group manifests less of what Reinhart and Rogoff call debt tolerance. What this means is that the markets turn against the securities of the serial defaulters at significantly lower thresholds of public debt than is the case with the non-defaulters. In 2001, for example, when Argentina was felled by the markets, its public debt/GDP percentage stood at 50 %. Countries in the non-defaulter category generally have to be above 60 % before encountering serious obstacles in obtaining capital from the bond markets. When Sweden succumbed to a crisis in the early 1990s, its public debt/GDP ratio was in the 60-70 % range. Not too much later in the mid-1990s, Canada saw its bond yields escalate when its debt hit similar levels. More recently, non-defaulters have been able to go much beyond those levels before attracting the bond market’s scrutiny. Portugal saw its line in the sand drawn at around 80 %, and Italy even higher at 115 %. Japan’s ratio currently stands around 174 % and it is able to borrow from investors at some of the lowest interest rates in the world. The USA can do the same even though it recently breached the 100 % threshold. This difference in treatment accorded to countries based on their policy history suggests that the bond markets do hold governments to account. Lending the most credence to this is Reinhart and Rogoff’s observation that “graduation” from serial defaulter to non-defaulter takes a long period of fiscal and monetary probity for a nation to achieve.
The problem is that the bond market is like the citizen army of a medieval town that only goes into action when its walls are about to be breached by an opposing force. To be a truly effective check on states, bond traders should be taking preventative measures when the enemy of excess debt is still at a distance, well away from the town walls. Yet bond markets often do the exact opposite, feeding the enemy by eagerly investing in a spendthrift country’s bonds. Debt crises tend to be preceded by massive capital inflows from abroad. A good part of these monies find their way into the country’s bond and money markets. Afterwards, this inflow is suddenly reversed into an outflow. This is what happened in Mexico prior to its receiving a bailout from the USA and IMF in 1995. It also occurred in Argentina in the decade before its 2001 default. And it was the same in Portugal and Greece in the decade leading up to the Euro sovereign debt crisis. Such was the demand for Greek bonds, which the country effectively defaulted on when it negotiated a restructuring of its debt in 2012, that yields spreads versus German bunds fell from 11 % in 1998 to a mere 0.1 % to 0.3 % range between 2002 and 2007. What is telling in all these cases is that the countries involved were all viewed as candidates for graduation from the serial to the non-defaulter class. Bond investors are evidently enticed by the potential in these situations to reap huge rates of return. They can buy debt securities on the cheap issued by nations that later become recognized as solid credits. But anytime the chance of such gains exists, the human inclination toward overconfidence is apt to be triggered. In their excitement, investors bid up prices too high and, as Adam Smith discerned, returns do not end up matching the risks assumed.
Aside from this psychological weakness, there are deeper factors making the bond market a less than watchful sentinel. Chief among these is the desire for safety that animates the vast majority of human beings, a desire more firmly impressed on the dominant middle-class souls of liberal democracy exposed to the tremors of market economies. The thrust of this is that the bonds issued by an entity armed with a coercive authority to tax are usually going to elicit strong demand. Risk-averse investors are the natural allies of the tax-consuming class whose interests eventually predominate in democracies. The bond market will happily fund the tax consumers in return for a share of the taxpayer pie. It cannot be denied that fixed-income players have an interest in seeing that the government does not overreach. But the chase for a secure yield is apt to temper this concern. And this leaves the markets sufficiently emboldened to test the maximum point of a state’s debt tolerance. Indeed, so strong is this impulse that investors are apt to overlook the risks inherent even to the most secure instruments of sovereign debt. An illustration of this is the tendency to define the bonds of a few highly ranked governments, such as the USA and Germany, as zero-risk securities for the purposes of calculating the risk premium on other bonds. I have followed this common usage here in describing yield spreads. Strictly speaking, however, nothing in the investment world is perfectly safe. There is no refuge from which to completely escape the Heraclitean flux of advanced commercial societies. Only time, of course, will tell if those who have harkened to the relative sanctuary of German bunds and US Treasury securities since 2008 will end up harshly rediscovering that fact. The rapid ascent in both these countries’ debt/GDP ratios as their bonds have rallied is certainly ominous.
Also helping to sustain an inflated demand for government bonds is the web of aforementioned regulations. By these, I mean the rules mandating such institutions as banks, insurance companies, and pension funds to limit their portfolios to those debt securities officially designated as safe. History amply demonstrates the bond-rating agencies are disposed to give them the badge of safety right up until it becomes frightfully obvious that the state backing the debt is under major stress. Greek bonds were not downgraded to junk until April 2010 by S&P, by which time their yields were 6.5 % above German bunds. Capital requirements for banks—the guidelines for which are established internationally by the Basel Accords—permit them to set aside fewer reserves for government bonds. Needless to say, this rather conveniently serves the interests of the states making up the Basel regulations in assuring themselves a market for their debt. Even amid the recent turmoil in the Southern European bond market, European banks could buy their own nation’s bonds and
Fig. 4.5 G20 Advanced nations debt as % of GDP, 1880-2012. Source: IMF not have to set aside any capital. In 2015, the Basel Committee of Banking Supervisors announced that it would review this practice. But as I write these words, it was still being allowed. Nor should we overlook the investment banks who earn fees and commissions from marketing and trading sovereign debt. To protect their bottom line, the investment banks prefer to see governments continually issuing bonds. What all this amounts to is a financial version of the military-industrial complex, what one might call the government bond market complex.
Figure 4.5 graphically seals the case that the bond markets have not been up to the task of restraining governments in the post-Bretton Woods era. The chart below depicts the public debt/GDP ratios of the
G20 advanced nations from 1880 to 2012. In part, the chart reminds us how wars and their aftermath used to be the major source of pressure on government budgets. Indeed, the need to finance wars lies at the historical origins of the bond market in Renaissance Italy, seventeenth-century Holland, and eighteenth-century England. Back then, the tax-consuming class was smaller than it is in contemporary democracies. The tax consumers were made up of elites ambitious to attain prestige and gain in war. They were also driven by a cupidity that thought it normal business to secure international markets through force.
From the onset of World War I to the immediate years after World War II, the G20 advanced nations rarely maintained a debt ratio below 60 %. Before that, during the classical gold standard period, public indebtedness was low. That figure also trended lower after World War II, plumbing a low of 23 % in 1974. Not uncoincidentally, that was around the time that the last remnants of Bretton Woods were torn down. The consequent delinking of money to gold has completely unleashed democratic governments to indulge their propensity toward deficits and debt. Driven by a much larger cohort of tax consumers than ever before, more interested now in social welfare expenditures than in fighting wars, G20 debt ratios have steadily risen since 1974 toward interwar levels. And all of this made possible by the bond market. Should it continue being so amenable—and there is little reason to see why it will not—the weight of the public debt will continue its ascent, especially as Western governments are expected to face a rising tide of spending on entitlements to pensions and health care as the population ages. Sooner or later, therefore, the bond vigilantes will make their appearance to hold governments to account. One cannot be sure when exactly that will happen. But whenever it does, it will probably be too late.
-  James Macdonald, A Free Nation Deep in Debt, 73.
-  Max Winkler, Foreign Bonds'. An Autopsy (Washington: Beard Books, 1999).
-  Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different. Eight Centuries ofFinancial Folly (Princeton: Princeton University Press, 2009), 34-47.
-  Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different. Eight Centuries ofFinancial Folly, 21-33.
-  Adam Smith, The Wealth of Nations, I, x, b.
-  Emma Ross-Thomas and Andrew Davis, “Greece’s Debt Cut to Junk, First for EuroMember”, Bloomberg, (April 27, 2010), http://www.bloomberg.com/news/2010-04-27/greek-debt-cut-to-junk-at-s-p.html
-  Huw Jones, “Global Bank Watchdog to Review Rule on Zero Weighting of SovereignDebt”, Reuters, (January 23, 2015), http://www.reuters.com/article/2015/01/23/basel-sovereign-regulations-idUSL6N0V22ZO20150123
-  IMF, “Historical Debt Database”, http://www.imf.org/external/ns/cs.aspx?id=262. Fora description of the database, see S. Ali Abbas, Nazim Belhocine, Asmaa ElGanainy, andMark Horton, “A Historical Public Debt Database”, IMF Working Paper, no. WP/10/2045(2010), http://www.imf.org/external/pubs/ft/wp/2010/wp10245.pdf
-  See Laurence J.Kotlikoff and Scott Burns, The Clash of Generations: Saving Ourselves, OurKids, and Our Economy (Cambridge, MA: The MIT Press, 2012).