There is much to be terrified about in today’s global economy. The eurozone’s death dance, China’s slowdown and America’s inability to create jobs are enough to make the most upbeat investors gloomy. But even these problems pale in comparison with the biggest threat, one with implications so hideous that financiers are reluctant to talk about it even now. The truth is that the economies of rich countries, including the UK, are being kept alive by another and astonishingly under-reported bull market — in government debt. This is the bond bubble; and when it bursts, as it surely will, the result will be a recession far deeper than the crash from which we are trying to recover.
This danger is ignored for a very understandable reason: government bonds are so boring that most people pay them no attention. Yet they fulfil a vital role, crucial to Britain’s nascent economic recovery. Bonds are, in effect, the IOU notes issued by debt-hungry governments. America, unsurprisingly, is the biggest issuer. The bond market is the pipeline of debt, flowing into the British economy and setting the price at which banks lend to mortgage holders and small businesses, as well as the cost of borrowing for the large multinationals that employ so many Britons. Bonds have also become the drug to which the political establishment is now addicted.
These bonds have become dangerously cheap. A new record was set this week, when George Osborne’s Treasury was able to borrow at an astonishing 2.2 per cent a year over a ten-year period. The German government can do so at 1.8 per cent a year, and America at 2 per cent. Crucially, in many cases, the interest rate is less than the expected inflation rate. So the ‘real terms’ interest rate at which governments borrow is actually negative. Lending anyone money at zero interest is weird enough. But the bond bubble now means that UK and American governments can be loaned money — and, in effect, be paid for the privilege.
This is crazy. It shows that the bond markets are well and truly in major bubble territory, their valuations as absurd as the rocketing subprime properties of yore. And, just like last time, hardly anyone is sounding the alarm. The bond bubble means that banks can also borrow at very low rates — and pass it on, allowing us to carry on taking out cheap mortgages. Fatally, we have come to think of 3 per cent mortgages as the new normal. Companies, home-owners, storecard holders — everyone is being lulled into a false sense of security. No one is prepared for when the bond bubble bursts and interest rates shoot back to their norm.
So why has debt become so cheap? There are three reasons. The first is Alan Greenspan, former chairman of the US Federal Reserve, who tried to recover from the post-9/11 slowdown by lowering interest rates — a hubristic decision which imagined that cheap debt would generate permanent and real growth. These new, ultra-low American base rates soon spilt over to government bonds, fuelling the bubble.
The second is the rise of the services sector. As developed economies moved away from being reliant on expensive factories, they didn’t have to invest so much in new machines. More money was left over to invest in other things, such as bonds, which pushed down the cost of borrowing.
The third and most dramatic cause of the bond bubble is the savings glut in the emerging markets. Developing countries have been saving their pennies — and lending them to the debt-addicted countries. Thrift, which used to be a virtue of the West, has now gone east. The sums involved are staggering. In 1995, foreign exchange reserves held by the world’s central banks (mainly in emerging countries) stood at about $1.4 trillion. It is now $9.7 trillion, a third of it Chinese, and with an additional $4.7 trillion in sovereign wealth funds held by cash-rich countries like Norway and Qatar. In total, a $14.4 trillion piggy bank — a lump of cash so large that it is distorting the world economy.
All this money can’t be kept as bank notes under Chinese mattresses. It is usually invested, and western bonds are supposed to be the safest investment there is. So an avalanche of cash cascades from East to West. The sheer volume of this cash inflated the bond bubble, which means western governments can get away with lending at ridiculously low interest rates. For the finance minister, this means cash to fund huge deficits. For the consumer, this means a 3.2 per cent fixed rate mortgage. And for the debt addicts everywhere, this means as much cheap dope as they can lay their hands on.
As economic curses go, cheap debt may not seem to the cruellest. But the bond bubble is dangerous, because it encourages bad behaviour. It creates the impression that anyone can borrow anything — and get away with it. George Osborne argues that Britain’s AAA credit rating is crucial, and he’s right. But when Standard & Poor’s downgraded America’s to AA+, there was no punishment. Instead, there was so much demand for American bonds that the real-terms interest on the bonds went below zero. Barack Obama was ‘punished’ by investors saying they’d pay to borrow from his government.
The verdict of the Keynesians was instantaneous. The economist Paul Krugman was jubilant: ‘What the market is saying — almost shouting — is “we’re not worried about the deficit! We’re worried about the weak economy!”’ Certainly, if investors see no opportunities anywhere else in the economy, they will accept ultra-low rates on government debt. But the bond bubble distorts what the market is saying, sending out a false message. The market is by no means relaxed about the deficit. Asian economies may hate this, as much as America loves it. But the gargantuan pile of cash has to go somewhere and bonds are, for now, the least bad choice.
China spelled out its dilemma after America was downgraded. The Chinese state news agency, Xinhua, said the USA should cure its ‘addiction to debts’ — without seeming to notice the obvious implication that Beijing is the drug pusher. But for all China’s criticisms of America’s profligacy, it has no choice. America’s debt market is the only one big enough to absorb China’s savings pile. Such an appetite for bonds not only allows America and Britain to keep on borrowing, but actively encourages it.
Britain needs this debt, and badly. For all George Osborne’s talk of austerity, the Chancellor plans to borrow more over this parliament than Labour did in 13 years. Certainly, Labour’s published plan would have increased debt by 59 per cent, against the Tories’ 51 per cent. Osborne’s plan — to stop increasing debt in seven years — may not be much different from that of Alistair Darling. But it’s solid and more credible than many of the plans offered on the Continent. This keeps Britain inside the deceptive warmth of the bond bubble, with cheap debt for all. But with a deficit which remains among the worst in Europe (we have the most indebted households in the G7) Britain remains worryingly vulnerable.
The irony is that it was the debt bubble, in its earlier years, that helped cause the financial crisis from which we’re now trying to recover. As the cost of borrowing fell, starting in the early 1990s, everyone started to lose their heads. Nobody ever discusses this because it is easier to criticise greedy bankers; but much of the excessive leverage, the maxed-out credit cards, the house price bubble from Dallas to Dubai, the over-exuberance and the massive misallocation of capital into overvalued property can be laid at the door of the bond markets. And these bond markets were, of course, themselves hugely distorted by the rate-cutting central bankers Alan Greenspan and Sir Mervyn Kin
So the bond bubble not only helped cause the boom and subsequent crash. It then helped western governments deal with their hangover by serving another round of debt tequila. An economist from Mars, landing today, would find it extraordinary that most western countries are responding to the debt crisis by doubling their national debt. And if this pipeline of cheap debt dries up, what then?
Slowly, across Europe, we are beginning to find out. The debt bubble is bursting in some countries but not others. Italy, for example, is now having to offer 5.5 per cent interest on its IOU notes — a rise which is causing agony for its government and people. Greek bond markets have gone off the scale, with the market demanding more than 170 per cent to take on its three-year bond. Even the cash-rich Chinese fear that Greece is going bust. This panic over the dodgy European countries only serves to increase demand for bonds in Britain, lowering our debt costs further.
The thing about bubbles is that you never know when they will burst. But already there are signs of strain. The governor of China’s central bank recently declared that its reserves ‘exceed reasonable requirements’ — a nod to the fact that Brazil, China, Russia and India are facing pressure to spend the cash on development at home. As the emerging markets grow richer, they will spend far more on machinery and roads — and deposit less in their piggy banks. If the $14 trillion worldwide piggy bank starts to be emptied, the bond bubble will deflate, pushing up interest rates around the world. The populations of emerging countries are also getting older. This means they will dip into pension pots, thus also reducing the amount of money available to go into bond markets.
If debt starts to be priced at normal rates, the adjustment will be agonising — not least for Osborne’s government. How many Brits would be comfortable if their mortgage interest rates went back to 6 per cent, which was normal, even cheap, for so much of our recent history? Or 10 per cent? Trillions of pounds’ worth of pension and insurance money is invested in bonds, so when they crash it will destroy wealth on a massive scale. Stock markets will fall, in some cases severely, while the great property boom will give way to a crash — as the cost of mortgages climbs permanently higher.
After the last crash, the Queen visited the London School of Economics and asked a killer question: ‘Why did no one see it coming?’ The answer is the same reason that no one now talks about the bond bubble: mankind is hubristic. There is a huge willingness to believe that artificial prosperity, caused by excessively cheap credit, is actually real. The bubble may hang over Britain for many more months, perhaps even years. But it is madness to think it will last forever. Sooner or later, the party will be permanently and ignominiously shut down, the real hangover will begin. And this time, the only cure will be belt-tightening, sweat and hard work.
Allister Heath is editor of City AM and an associate editor of The Spectator.