Mountains of Debt

We’ve caught ourselves going back to Niall Ferguson’s The Ascent of Money quite regularly since the book was recently published.  Since many of the lessons learned (or shall we say lessons which should have been learned) in this well-documented financial history of the world are just as important to investors today as they were centuries ago, we thought we’d dedicate a few posts to the excellent Harvard Historian.

After the creation of credit by banks, the birth of the bond market was the second great revolution in the ascent of money.

From a politician’s point of view, the bond market is powerful partly because it passes a daily judgment on the credibility of every government’s fiscal and monetary policies.  But its real power lies in its ability to punish a government with higher borrowing costs. Even an upward move of half a percentage point can hurt a government that is running a deficit, adding higher debt service to its already high expenditures. As in so many financial relationships, there is a feedback loop. The higher interest payments make the deficit even larger. The bond market raises its eyebrows even higher. The bonds sell off again. The interest rates go up again.  And so on. Sooner or later the government faces three stark alternatives. Does it default on a part of its debt, fulfilling the bond market’s worst fears? Or, to reassure the bond market, does it cut expenditures in some other area, upsetting voters or vested interests? Or does it try to reduce the deficit by raising taxes? The bond market began by facilitating government borrowing. In a crisis, however, it can end up dictating government policy. 

James Carville once observed that if there was reincarnation, he’d want to come back as the bond market, because “you can intimidate everyone.”  We’ll have more to say on this in the near future as dramatic increases in sovereign balance sheets are likely to test the world’s bond markets in coming years.