Never at any other point in history have governments owed so much to so many. And with central banks complicit in their relentless money printing, more investors are making their voices heard by betting big on Bitcoin.
“When you owe the bank money, it’s your problem, when you owe all the banks money, suddenly it’s their problem,” a stone-faced Chen said to the lawyer taking his deposition.
Accused of unauthorized trading of hundreds of millions of dollars’ worth of oil contracts, Chen was CEO at the time for a prominent Chinese oil trading company which was believed to have had links to Beijing, and which had traded well beyond its allowed mandate.
But the banks had been complicit as well, extending copious amounts of credit to Chen, despite having suspicions that he neither had the authority to execute trades of such magnitudes, nor did the company have the assets to back up any losses.
Yet the banks lent anyway, believing that Beijing would intervene should anything go pear-shaped.
And pear-shaped they went.
After a series of disastrous trades, Chen’s firm was in the hole to the tune of US$800 million, but had assets no more than US$150 million at best.
And as the 2008 financial crisis hit, the oil trading firm he once headed was starting to buckle under the strain.
Ultimately the banks settled, agreeing to take cents in the dollar and allowing the firm to continue operating as a going concern, but their losses were in the hundreds of millions.
Money For Nothing
Fast forward to our present epoch and it’s governments from rich countries now who have had no choice but to spend as much as a fifth of their GDP to support households and businesses facing down the economic fallout of the coronavirus pandemic.
Cumulative debt levels now exceed GDP in many rich economies and on average, debt as a share of GDP has surpassed highs not seen since the end of the Second World War.
But there are more than a few economists who believe that governments can not only afford to take on more debt, but should be encouraged to do so.
According to Olivier Blanchard and other economists, advanced economies can afford to take on much more debt, given rock-bottom interest rates that are close to zero and plenty of unemployment.
Ironic somewhat that such views are being championed by a French economist when similar views led indirectly to the French Revolution.
In the early 18th century and in order to resurrect the economic fortunes of France, which had suffered successive bankruptcies from ruinous wars of conquest, Sir John Law, a one-time Scottish banker and convicted murderer wrote,
“I maintain that an absolute prince, who knows how to govern can extend his credit further and find needed funds at a lower interest rate than a prince who is limited in his authority.”
“In credit, supreme power must reside in only one person.”
The economic bubble inflated by the relentless printing of paper money and inflation of the world’s first stock market bubble, eventually led to the French Revolution and set France’s economic progress back by decades as the French shunned paper money.
Yet according to data from the International Monetary Fund, despite worsening economic conditions, sovereign interest payments in rich countries fell from over 3% of GDP before the pandemic, to about 2%, despite debt-to-GDP rations increasing by more than a fifth over the same period.
Beggar Thy Future
In this surreal world of ultra-low interest rates, where the issuance of fresh sovereign debt paying negative interest rates makes interest expenses even lower, what limits are there to government borrowing?
According to advocates of Modern Monetary Theory (“MMT”) there are none, at least not for countries that issue their own currency and have spare productive capacity.
Because central banks can simply print money to pay off maturing debt, the risk of inflation is not high so long as there is still substantial unemployment.
The idea that politicians can have money for nothing, more government spending without increasing taxes, has only increased MMT’s popularity.
But any “theory” that advocates a free lunch should be viewed with a healthy dose of skepticism.
To understand how MMT works, consider normal economic conditions with positive interest rates.
A central bank could decide to print money to buy government bonds, and the government could then spend that money by transferring it to citizens by way of stimulus checks.
As a practical matter however, there is only so much money that someone will keep as cash in their mattress.
Presumably, they would keep their excess money with a commercial bank and that bank will deposit that cash it has accumulated in its reserve account with the central bank.
Those reserves that commercial banks hold with central banks attract interest, which the central bank gets by buying government bonds, issued at a coupon rate and passing that on to the commercial banks.
But in today’s eclectic economy, the central bank can finance purchases of government bonds by issuing zero-interest reserves to commercial banks, which are willing to hold those reserves because they are highly liquid and presumed safe.
And while a government can avoid short term dislocations in money markets through central bank intervention, it is not free to borrow indiscriminately or indefinitely because ultimately investors decide whether or not such debt is safe.
It’s not enough for a government to ensure that it can afford to make its interest payments on its debt, it must also demonstrate that it can repay the principal.
Because even though a government can technically issue fresh debt to pay off maturing debt, investors will only buy that new debt if they are confident that the government can repay all its debt from prospective revenues.
But that was in the past.
Right now, central banks themselves are the biggest buyers of government debt.
By some estimates, the Bank of Japan holds as much as three quarters of the Japanese government’s debts.
And if that sounds like a Ponzi scheme, in many ways it is.
By printing money and buying up government debt, central banks can “magically” make money appear in government coffers and give investors the confidence that the sovereign debt they’re investing in has a backstop.
Of course if the government issuance of debt was to fund economic development that could eventually create new sources of revenue, that would be one thing.
But where the issuance of debt is to flood the economy with funny money so that households and businesses don’t go bankrupt without any real economic activity, then we’ve effectively entered the realm of economic fantasy.
In such circumstances, politicians are faced with Sophie’s choice — raise taxes and risk being voted out of office, or default on existing debt to create room for fresh issuances.
And most rich-country governments are not willing to do either.
The only option then is to allow for higher inflation, which would erode the stock of debt denominated in current dollars.
The Only Way is Up, Baby
And that’s why institutional investors are looking into Bitcoin.
As part of a complete and healthy asset portfolio, fixed income by way of bonds, in particular safe government bonds such as U.S. Treasuries, form a key component .
Many companies also keep a significant portion of their cash in the form of safe U.S. Treasuries, as opposed to simply depositing it in the bank.
But the real threat of inflation has meant that more than a handful are exploring other possibilities including Bitcoin.
Because Bitcoin has a deflationary creation schedule — the number of Bitcoins ever created is fixed and the amount paid out to miners halves roughly every four years — in a high inflation environment, Bitcoin could potentially become one of the best ways to keep and by extension, settle scores.
And more than a handful of high-profile investors and even listed-firms are betting on precisely that.
Billionaire hedge fund investors Paul Tudor Jones and Stanley Druckenmiller have both revealed their investment into Bitcoin, to hedge against inflation.
And firms such as business software maker MicroStrategy, as well as payment services provider Square have all allocated a portion of their assets to Bitcoin.
Recently, electric vehicle maker Tesla’s CEO Elon Musk publicly inquired about what the costs would be (presumably the slippage) for the firm to conduct several large Bitcoin transactions.
Yet are inflation expectations over exaggerated?
In the decade following the 2008 financial crisis, despite (at the time) unprecedented quantitative easing, inflation fell well below the U.S. Federal Reserve’s 2% target and has remained muted across much of the rich world.
And advocates of MMT suggest that because rich economies are nowhere near to full employment, the risk of inflation have been overblown.
Yet inflation could emerge not because of anything to do with employment, but because governments have reached the limits of the debt that they can repay.
Inflation and employment are often linked, but such a view harkens back to a more industrial era, where labor unions were common and the means of production, labor-centric.
Decades of automation and globalization have meant that manufacturing is now more decentralized and the costs of labor in most instances form a much less significant factor in the cost of production, with less of an effect on final prices.
The last time the world saw rampant inflation was in the 1970s, where oil shocks and labor unrest led to inflation as high as 10% in the rich world.
But the world has changed dramatically since then.
China is now the world’s de facto factory and other emerging economies are catching up by providing seemingly endless amounts of young and importantly cheap, skilled labor.
Automation is now a major component in production as well, meaning that except for the most labor intensive industries, linking employment to inflation is not as straightforward as it once was.
So the real source of inflation could come instead from an unlikely source, governments themselves.
Governments issuing fresh debt may be forced to increase the interest rates on their debt in order to get investors to bite, failing which central banks would need to print more money to otherwise keep government borrowing costs low.
Either strategy raises the prospect of inflation and debases the value of currencies, which is why more sophisticated investors are taking a bet on Bitcoin and other cryptocurrencies.
And given the divisive nature of politics in rich countries of late, the prospect of raising taxes and cutting back on spending is politically distasteful.
Absolute princes may be few and far between, these days, but the absolute spending by governments could still lead to inflation royal titles be damned.