Some thoughts on government debt during deflation

A question of Keynes vs. Kondratieff

Until recently, the sovereign debt of nearly all governments would rally during panic episodes as stocks and commodities fell. This makes sense, as strong sovereign debt is cash for big boys, and investors are forced to reach further and further out for yield as short-rates are driven to zero or negative. However, starting with Greece, this pattern may change, as bonds are likely putting in a secular top in the 2008-2016 window. Their last bottom of course was the early 1980s, and their last top was 1946-47. The indebtedness and unabashed Keynesianism of all of the world’s governments seem to virtually guarantee higher interest rates in the coming years, even though US, German and Japanese bonds are still finding a bid during panics.

We have already seen the beginnings of this development in municipal bonds and the crappiest sovereign debt, but the market may slowly realize that it is all crap, beyond the short-term credit of the strongest governments.

Prechter makes the point in Conquer the Crash that higher rates on risky long-dated sovereign debt are part and parcel of deflation, an increased preference for the safest cash and cash alternatives. Steepening yield curves fit right into that trend. If the long bond sells off hard, this does not mean the end of the dollar, but the opposite. All else being equal, if T-bonds fell with stocks this year, it would just mean that the US government would finally feel the same pinch as everyone else.

Now for the tricky part. We have to keep in mind that interest rates are more than just a mechanical product of fiscal deficits, savings rates and politics. They are a kind of natural social phenomenon, a reflection of forces I can’t fully understand. They are not rational: why were short-term rates in the low single digits during the second world war when the US had just abandoned the gold standard, had a debt:GDP ratio of over 100% and inflation was running at 8-12%? Why were they still double-digit in the mid-1980s when the economy was good and inflation was 3-4%? (For some charts and discussion of the long-term rate cycle, see this post). The only answers that make any sense are that it was time for rates to bottom and then it was time for them to top.

We are certainly entering what *Kondratieff described as winter, when debts are called in and defaulted upon and cash is at a premium. This is associated with low interest rates, reflecting a low demand for credit, provided that the monetary unit retains value, which it tends to do since this unit is how debts are denominated and settled. And with deflation very much a reality, low rates can provide a high real yield so long as the credit is sound. With housing and wages falling by large percentages and every consumer good on sale, what is the real yield on a 10-year note priced at 3.6%?

There is no telling how long rates will stay low or how low they will go. See Japan, 1990-

Those are the market rates on the credit of a horribly indebted nation with terrible demographics that has been trying to spend its way out of recession for 20 years. Is there a better way to explain this than Kondratieff winter?

If social forces demand that governments start to shift towards frugality and default like the rest of society (and government is a reflection of social mood), this would be very supportive of the current fiat regimes. Think about it: what would happen to the Euro if Greece defaulted (which is what they should do)? Billions in euro-denominated balances would go “poof” and the remaining euros would be worth more.

What if younger generations of Americans, the ones who most enthusiastically support Ron Paul and even phonies like the new senator from Massachusetts, start to exert pressure for the rolling back of that $70+ trillion in retirement and health-care promises? Those are contracts that the government can’t honor, so by definition, it won’t. It will try to pretend otherwise, but it won’t. In effect, much of the debt will be repudiated.

There are huge caveats to the above, such as radical socialism or expanded warfare, but there are going to be real deflationary undertones to social mood that may effect policy and prolong the current paper regimes for longer than almost anyone suspects. Kondratieff winters are not short episodes, but generational, and if the last two turning points in the interest rate cycle are a guide, there could even be another ten years to the bottom.

That is hard to believe right now, but it is possible if social forces demand default. I can’t gauge the odds very well, but I have to consider this longer-term bull case for treasury bonds and a few strong currencies. Bottom line — history has not been kind to paper money and government bonds in times of crisis, but the nature of deflation may give them a longer life than we have assumed.

If you just can’t wait to short some sovereign debt, try Japan before America. They may be a generation ahead of the west in the rate cycle, and really, how much lower could they go?

*Kondratieff waves in the US (click image to expand):

welling@weeden, 1.23.09

One thing that strikes me in the above chart is how huge the latest wave is compared to the others. At 60 years and running, it is the longest, and prices, rates and stocks have gone up so much more than during any of the previous three. Just out of proportionality, it would be perfectly fitting if rates and prices fell for another 5-10 years.

Here’s a clearer view of the Aaa corporate bond rate from 1919 to 2010:

-

Also see Rothbard and then Mish on Kondratieff theory. As Rothbard makes clear, winter is not necessarily an awful time to be alive, judging from the strong economic growth of the 1830s-40s and 1880s-90s. This means that prolonged unemployment and war can’t be blamed merely on the credit cycle, but that fingers must be pointed at the socialists, Keynesians and fascists who’s actions directly brought about the nightmare of 1929-1945.

4 thoughts on “Some thoughts on government debt during deflation

  1. “why were short-term rates in the low single digits during the second world war when the US had just abandoned the gold standard, had a debt:GDP ratio of over 100% and inflation was running at 8-12%?”

    Consumption was capped by various administrative measures (coupons for gas, food, etc…). So the cash that was earned could not be spent, nor freely invested and ended up in Govt Bonds with negative real interest rate. Investing in war bonds was considered patriotic and consequently only a minority of investors (less patriotic maybe ?) grabbed the opportunities to get real assets such as utilities or militaro-industrial units at cheap prices. This was the time where Keynes built the vast wealth he left when he died. (At the time, he was a “pro bono” adviser to the war economic planning, and IMO was effectively paid with very profitable inside information, a bit like Paulson being paid by his enormous tax-free sale of Goldman Sachs shares)
    The other side of the coin was the Treasury Fed accord that allowed for monetization of Federal Govt Debt at low rates.

    In real terms, it was seriously deflationary (and even more so in Germany and Japan, where essentially all debts defaulted to zero, as the currencies were worth nothing at the end of the war), and really was what cleaned the bloated balance sheets of the GD. The New Deal, as today’s stimuluses, was not even the start of the solution, but still part of the problem.

    The lessons from this episode are two-fold :
    - the level of frugality necessary to “clean the rottenness” is higher than even the staunchest proponents of fiscal rectitude can imagine.
    - there are not many social mechanisms beyond war that can achieve such a downward change in people expectations. My hope is that perceived limitations on natural resources availability could do the trick (I think that such limitations are real, whether they are real or not is not the issue here, the important thing is that people are convinced !), but I am pessimistic overall.

  2. Interesting comments about the war era, but that interest rate trend was well-established before the war and continued afterwards until about ’49. Also, the fixed-rate period was only for a couple of years and when it was abandonded, rates fell! The rate trend was also reflected in corporate bonds – patriotically, those were no different than stocks, which had a very nice yield.

    I absolutely agree, the depression lasted until ’49-50, and the war only made things worse by destroying Japan and Europe and killing tens of millions. That’s not exactly good economic policy. I also suspect you are right that debt will just be wiped out, quite possibly though war. No telling how nasty things will get this decade.

  3. Fantastic post Mike.
    My here (Harry S. Dent JR) is using the seasons quite extensively in his speeches and interviews.
    If you are interested in hearing more about the seasons, you know where to turn to :-)

  4. Great article! All the talk of hyper-inflation just doesn’t match our current situation. I’m also looking for the yield curve in treasuries to contract. As others commented, a lot of debt needs to be defaulted.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Connecting to %s