James Carville, the legendary adviser to Bill Clinton, once quipped that if there was reincarnation, he wanted to come back as the bond market, as he could intimidate everybody.
This was in 1990, when bond markets actually still worked efficiently and governments had to be mindful of what fiscal policies they would adopt. Otherwise, the market would punish them with higher interest rates and quickly curtail politicians who thought they could thrive on ambitious spending.
Those days are long gone. When the financial crisis hit in 2007 and raging economic and financial fires had to be extinguished, the world set a historic precedent of quantitative easing and – by flooding the system with excessive liquidity – made the primary function of the bond market obsolete for the better part of a decade. Artificially low interest rates were an invitation for political leaders to fight the burst credit bubble with more government debt.
As a result, the US national debt has more than doubled in the past 10 years. It currently stands at an incredible $21.6 trillion. However, despite economic improvements during the first half of Donald Trump's presidency, Washington has not reined in that mountain of debt.
On the contrary, Trump’s spending will produce budget deficits of around $1 trillion annually for at least two to three years running. The national debt might even hit $25 trillion before he stands for re-election.
They say it ain’t over until the fat lady sings. She might just start to breathe in hard. At the time of this unprecedented deficit-spending cycle, the Federal Reserve is raising rates and has significantly forced up yields across the curve. In other words, the cost of carrying the debt is rising.
Federal Reserve chairman Jay Powell’s rigorous normalisation of the monetary system is bringing the bond market back to life. He has not only raised rates and will do so again, but he has also started to taper the $2.4 trillion Treasury position on the Fed’s balance sheet, albeit in small doses.
Once the market is re-empowered to play its regulating role, even one Donald Trump will have to concede to it. If he doesn’t, a massive depreciation of the dollar and possibly an ensuing destabilisation of the global financial system would likely be the consequence.
Europe is in a similar position. Politically, the Old Continent has been in clear trouble recently with regards to Brexit and immigration issues.
Worse still, the eurozone is edging closer to its next survival test after the crisis around Greece in 2012. Italy’s new populist government doesn’t seem to have any interest in complying with EU rules and laws, and is breaking away from the European framework on key issues such as migration and fiscal policy.
Reneging on previous cabinet commitments as to whether refugees will be admitted at Italy’s borders and using threats by questioning Italy’s membership in both EU and the currency union to enforce a spending pattern that is far from conducive to bringing stability back to the debt situation have quickly become common in European politics.
The most recent spat between Brussels and Rome about the -2.4% budget deficit shows an acceleration in brinkmanship. And, the fronts are continually hardening.
Italy, as the case in point, sports government debt of almost €2.35 trillion, which constitutes approaching 135% of GDP. It is the largest nominal debt on the Old Continent, higher than France’s and certainly higher than Germany’s, even though Italy’s economy represents only 75% and 50% of the other economies, respectively. With regards to the debt-to-GDP ratio, only Greece surpasses Italy at a 180% ratio, but Greece’s GDP is 1% of the EU total, whereas Italy’s is 10%.
It doesn’t end there. In order to keep the common currency in place despite current account and payment imbalances among eurozone members, the eurosystem relies on the so-called Target2 mechanism, which balances fund flows via the European Central Bank (ECB).
If, for example, a country is plagued by fund outflows – and in the case of Italy, the phenomenon of capital flight has accelerated – they have to be channelled back through the Target2 system in order to keep the eurozone together.
In the process, receivables and liabilities vis-à-vis the ECB (but, implicitly, the affected jurisdictions) are being built up on the balance sheets of the respective national central banks. And so, Germany’s positive Target2 balance of close to €1 trillion mostly reflects the same amount of liabilities on Europe’s periphery part. Italy’s negative Target2 balance means that Germany effectively lends Italians some €475bn.
These almost half a trillion euros are essentially unsecured liabilities implicitly underwritten by the Italian government that comes on top of the country’s sovereign debt. So, Rome’s outstanding debt is pushing an unmanageable €3 trillion.
Some pundits will tell you that Target2 imbalances won’t matter, as long as the eurozone remains as one, but that is rather a theoretical and naive way of looking at it.
The problem is that the eurosystem has entirely run out of control, and Italian politicians understand their power in negotiating with the creditor side. A Euro break-up now isn’t desirable on either side, as creditor and debtors would both suffer existential damage to their financial state.
Rather, Italy requires a reset – or the mother of all debt restructurings. To be sure, a massive haircut in periphery debt would come at the expense of the EU’s surplus champion, Germany.
A natural rebalancing of the accounts, ie sustainable trade surpluses in Italy and investments in the country, is illusory and not to be expected. Nor can politicians fall back on the tried-and-tested dilution of debt by way of inflation or currency depreciation, as the eurozone no longer allows for such options. Technically speaking, a write-down remains the only way forward. Politically, however, one wonders how the German taxpayer base will react to such prospect.
In summary, the Western societies’ mountains of debt will eventually crash down on us. When this will happen, no one can tell. US governments may manage to kick the proverbial can down the road for decades to come. We are past the point of return, however. The day of reckoning cannot be avoided.
Roland Hinterkoerner is a former banker and founder of Expertise Asia. expertise-asia.com