A Thought-Experiment: Central Banks Purchase All Government Debt

October 3 2016

We are nearing a point of no return. The Japanese central bank, for instance, already owns over a third of all outstanding public debt. And Japan is no exception. In Europe, a similar tendency exists. Last week, the Bank of Japan decided to cap the interest rate on 10-year government bonds at no more than 0%. That implies that the Bank of Japan, every time interest rates rise above 0%, will continue buying Japanese government bonds. Until the central banks owns all outstanding government debt. And then what? What will happen when central banks own all public debt?

The “Bond Vigilantes”

The “bond vigilantes” are an idealization of bond investors. Whenever a government, or a company, takes on too much debt relative to its ability to generate income, bond investors would push up yields by selling bonds.

The market for government bonds changes in a large cinema with a too narrow emergency exit. Few buyers, many sellers. A clear signal to reckless governments.

This logic has many merits. Even as recent as 2011 these so-called “bond vigilantes” gave a clear warning signal to various European governments. Countries such as Ireland, Portugal, Greece and even Spain were at the receiving end. The interest rates on their debt skyrocketed. The interest rate on Spanish ten-year government bonds, for instance, exceeded the 6%. According to some academics, this is the percentage at which government debt becomes unbearable and at which the end of time dawns.

Until central bankers did something that central bankers up to recently simply were unable to do: buy all government debt necessary to keep interest rates low.

The Gold Standard

This, of course, was impossible under a gold standard. Under a gold standard, a central bank cannot buy unlimited amounts of government debt and other assets.

It seems that “bond vigilantes” are a dying breed. Beaten by central bankers, who had bottomless wallets to their disposal. The demand for government debt is due to the intervention of central bankers artificially high, or even unlimited. The appetite for bonds is theoretically limitless.

Practically, however, there were a lot of doubts. It was again the Japanese central bank, soon to be followed by the others, which began buying domestic government bonds in large quantities. Because the only statistic that according to central bankers’ logic would indicate failure, the consumer price index, wouldn’t budge, the Bank of Japan kept buying domestic government debt like hotcakes.

But where will this end?

It is inevitable that interest rates at a certain point will give way. Unless central banks continue purchasing bonds, even as every private investor is putting his or her bonds up for sale, until all government bonds are in hands of the “lender of last resort” (or perhaps in this case the “buyer of first resort”?).

What If the Central Bank Buys Up All Government Debt?

To answer this question, it might be smart to address another question first. Who owns the current government debt?

The generic answer is the financial sector: banks, pension funds and other financial institutions.

That means that buying up all that government debt will not directly lead to higher consumer prices.

In other words, it appears that the central bank would even get away with goggling up all that outstanding domestic public debt.

One big problem, however, are future bond issues. As long as governments keep on running deficits and old debt matures, government have to issue new bonds. But even that seems, in theory, a “surmountable” obstacle.

So if buying up all those government bonds, and thereby keeping the interest rate on government debt permanently low or at zero, has no direct consequences in terms of quickly rising consumer prices, then what does?

A Loss of Confidence in the Currency

The answer is a matter of confidence. Of course, consumer prices might start rising indirectly because the bond holders that sell government bonds to the central bank could spend their proceeds on products and services that are part of the consumer price index. But it is more likely that these proceeds remain in the financial sector and will be used to, for example, push stock prices or other bond prices to new highs.

The only possible answer to the question posed above is a loss of confidence in the respective currency, or a “crack-up boom” as the economist Ludwig von Mises once called it. It is the complete collapse of a currency because people no longer believe that the currency will maintain its value in the future. In other words, instead of a healthy demand for the currency in question, consumers shift their demand to other currencies and goods. This negative spiral leads to the complete destruction of the currency or if not at least to a radical reversal in monetary policy. From ultra-loose, to ultra-conservative.

Ironically, a loss of confidence in a currency goes hand in hand with higher inflation. When people try to get their hands on other currencies and goods faster and faster, this lower demand for money (cash balances) will result in an increasingly rapid loss of purchasing power of the currency. That is, inflation.

The central bank will no longer have a choice: continue until death or give up prematurely by normalizing monetary policy. It would mean the return of the “bond vigilantes.” Or as a colleague of mine says: market forces ALWAYS overwhelm anti-market logic. This time will be no exception.

Therefore, our conclusion should be that without a shift in monetary policy higher inflation is inevitable. Gold is well positioned.

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