The central bankers’ Catch-22

Governments and central banks have manoeuvred themselves into a financial mess that shows no sign of getting better. Debt to GDP ratios continue to climb, with many industrialised nations over 100% (and Japan has gone well over 200%). It normally takes a major war to raise levels this high! Meanwhile central banks are now purchasing more and more government debt, typically with newly created money. This won’t end well, and I’ll try to explain why.

Central bank purchasing of government debt helps to keep yields lower than they would otherwise be. This is because they can buy debt with newly created money, at no cost to them. The rest of the market has to use real money, and hence is more concerned with risk and a decent rate of return, if for nothing else to cover the rate of inflation. The only reason central banks start buying government debt is because of the inability of the government to place debt on the market at the rates the government wants. So while a investment bank might be willing to buy debt at 3%, a central bank would be happy to undercut this.

Today, large portions of government debt are being funded by quantitative easing programs. If central banks cease buying government debt, then yields will rise as the market will demand higher prices. If central banks continue to buy government debt, this will lead to price inflation (especially in assets) as most debt is bought with newly created money. While central bank buying initially helps to keep yields down, overtime the resulting inflation causes the market to demand higher yields on the debt in order to compensate for the debt being paid back with devalued money. So any new debt that is still bought by the market demands a higher price. This puts further pressure on the central bank to intervene and buy more debt.

So regardless of what central banks do, yields on government debt are set to rise higher than they currently are. This means governments have to divert more tax revenue and borrowing to pay interest rather than paying for public services. This leads the government to either borrow more or print more to make up the difference, setting in place a viscous circle.

This puts governments in the position of an ever greater proportion of spending being used to service the debt. The more money is printed, the higher interest rates in the market will go (note this is different to the official central bank rate, which would almost certainly be kept as low as possible). This is the great irony of inflation – money is printed in order to keep interest rates low, but over time the price inflation forces interest rates to rise.

There comes a point where only the central bank will buy government debt – all private actors are demanding too high a price. What options does a government now have?

1. Keep printing money, ultimating end in hyperinflation (default in all but name), followed by a depression. Many of the 20th century hyperinflations were the result of out of control government debt.
2. Openly default – refuse to pay back the debt. Any banks holding large amounts of government debt go bust, as they don’t have enough capital to protect against such a loss – and they can’t be bailed out this time, as the government doesn’t have the money either. Massive deflation and depression.
3. See the catch22 coming up, and make drastic cuts in public spending to not just balance the budget, but to generate a surplus that can begin to pay off the debt. While and until the economy adjusts (which it will), there will be a recession/depression. Even in this scenario, it may require default on any debt which matures soon.

So whatever happens, we have a recession or depression. There is no way out without one. So, we either choose when and how it it happens, or we allow our creditors to do it for us when the proverbial hits the fan.

And by the way, what the UK coalition government is doing is not #3:

JPhelangraph1source – including inflation adjustments

As the author of the linked article, John Phelan, has said:

The British economy is walking a tightrope. On the one hand it has deficits the size of Greece; on the other it has interest rates as low as Germany.

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