Chris Johns: Era of free money could be coming to an end

Is the era of free and easy government borrowing drawing to a close? Governments everywhere have been able to spend vast sums of money in order to cushion the economic devastation caused by the pandemic, spending financed mostly by debt. Borrowing increased last year by about $20 trillion (€16.5 trillion), taking the key global debt to GDP ratio to a level last seen at the end of the second World War.

Irish government borrowing in 2020 was not as bad as feared nor, relative to the size of our economy, were we among the world’s biggest borrowers.

That’s mostly due to a better than expected economic outcome. At the end of last month, gross government debt stood at €226.4 billion compared to €204.2 billion at the end of 2019. Irish government debt expanded by about 10 per cent last year compared to a global average of 20 per cent.

While we might be grateful for our appearance towards the bottom of the league table of borrowers, whether we are talking about 10 per cent or 20 per cent increases, we are looking at big numbers. Remarkably, we, along with most other developed countries, were able to borrow at near zero cost.

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It's widely appreciated that the head-wrecking nature of government bond markets meant some borrowing was done at negative rates: bond markets paid us to borrow from them. When we come to roll over that debt, we will hand over less than we borrowed. About €20 trillion of the world's debt stock carries a negative interest rate. Strange times indeed.

Bond markets

Bond market news is usually confined to the nether regions of the business pages. Stock market gyrations attract more attention. One exception to this rule of thumb was during the financial crisis: readers of a certain vintage will remember the call “to burn the bondholders”, a plea to the government of the time not to take on the bonds of some of the failing banks and building societies.

The relatively invisible nature of bond markets is a bit of a puzzle. Government bond yields (interest rates) affect everything: stock market prices, mortgage rates, corporate investment decisions and house prices, to name but a few.

Estimates vary, but the global government bond market is up to twice the size of world equity markets. The total bond market, when we add in the borrowings of entities like companies, is as much as three times the size of the global equity market. Daily trading in bonds can be three times as much as that of equities.

Nevertheless, bonds, for reasons that most professional investors don’t really understand, rarely capture the popular imagination. Perhaps that’s why they are investment professionals rather than something else.

But, right now, bonds do deserve popular attention.

Bond markets are signalling trouble. For all of us. Their prices are falling, which means that yields and interest rates are rising. One traditional role of those yields and rates is to exert fiscal discipline on finance ministers: bonds tell governments when they are borrowing too much.

Does the fact that rates are rising signal that the days of free (literally) money are over? Is the job of supporting pandemic-afflicted economies about to become much more difficult? Or even impossible?

One of the many myths and misunderstandings about government debt is that it “one day has to be paid back”. It doesn’t and usually isn’t. Historically, it’s just rolled over.

Interest on debt

The key variable is the rate at which bonds, when they mature, are exchanged for new ones. We may have low rates now but when we roll over our existing debt we have no idea what we will be expected to pay at that time. A consequence of low rates is that government spending on debt interest is massively lower than forecast. That may or may nor last. If bond yields shoot up over the next few years so will debt interest costs. That’s why finance ministers are wary about borrowing, even if today’s yields are low.

Bond yields move around for all sorts of reasons. A big driver is inflation. And markets are starting to worry. All that extra borrowing counts as economic stimulus.

As we (hopefully) look to economic recovery as the pandemic ends, plenty of economists are warning that we are heading into an era of higher inflation. Those economists are taking their cue from bond markets, where yields are rising. This is particularly true in the US, where stimulus is being piled on stimulus at a time when the economy is looking, all things considered, remarkably healthy.

A lot hangs on what happens next. If bond markets really misbehave, we will have problems in all asset markets, especially equities. We might not be able to offer nearly as much assistance to the unemployed or businesses that have been eviscerated by the pandemic.

There are plenty of Cassandras who say this is exactly what will happen. The simple fact is that nobody knows. We are back to the impossible game of forecasting.

Bond markets have recently reversed back to where they stood at the time the pandemic started. Optimistically, that might just be a financial market signal that the end is in sight. But it might be the start of a big problem. Nobody knows but there are plenty willing to guess.

My guess is that markets are merely normalising (with a worry that they could overshoot). Bonds need to be on the front pages.