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In my article Growth and Debt: Is There a Trade-off? I
have stated the “Iron Law of the Burden of Debt”: The liquidation
value of total debt doubles every time the rate of interest is halved.
I have
received several comments from thoughtful readers.
Steve Heller of the website Golden Rule
writes:
You say: "For example, a $1000, 4% perpetual pays $40 per annum to its
holder who can sell it in the secondary market at any time. The catch is that
he may recover only part of his original investment if the interest rate has
fallen in the meantime." This is of course incorrect; the value of the
perpetual [bond] goes UP (proportionately) if interest rates have fallen,
which is the whole point of the article. So this will confuse your readers,
which I assume you don’t want to do. A credit for my correction would
be nice.
You are absolutely right, Steve. The correct reading of the statement,
as you noted, is: “the owner of a British consol
(perpetual) can sell it in the secondary market at any time; the catch is
that he may only recover a part of his original investment if the interest
rate has risen in the meantime.” Thank you for pointing out this error,
thus giving me the opportunity to make the correction.
Here is a letter from a European correspondent:
Dear Professor Fekete,
I am a professional in the financial business and an
avid reader (and distributor) of your writings. I would like to take issue
with a few points in your latest article.
1.
You say that the liquidation value of debt depends on the rate of interest.
In my opinion this is wrong. If I owe $1000 to a bank, $1000 in Federal
Reserve notes plus interest specified on the note will always liquidate my
debt, regardless how the rate of interest may have moved away from the rate
specified on the note. I believe there is even a law in New Jersey
prohibiting banks from demanding more money in settlement of a loan than the
face value of the note plus pro-rated interest, in case the loan is retired
before maturity.
2.
I believe you confuse the “liquidation” value with the
“present” value of the loan, that is, the amount for which the
bank could sell the securitized debt to a third party.
3.
You seem to worry about the problem of doubling the present value of debt
when the rate of interest is halved. This raises the question ‘cui
bono?’ Take the U.S.
and China.
Why should the U.S. care
if the present value of its debt to China
doubles? The interest payment has not changed, nor has the amount due at
maturity. And why should China
worry? On the contrary, China
should be happy. In case they wanted to sell their U.S. Treasuries, they
could get twice the face value, according to your calculations.
Please regard these questions more as a feedback than a criticism. I wish you
were right as, instinctively, I do like the thought that gold is the only
ultimate extinguisher of debt, regardless of the outcome of this debate about
the present value of total debt.
Perhaps you could give me some hints where I could find further reading
material to help me understand your point.
Regards,
Mario Rossi
founder of “Umbria
for Ron Paul”
Here is my answer:
Dear Mr. Rossi,
Thank you for writing. I greatly appreciate your
interest in my work.
1.
If as a corporate treasurer you have sold a $1000, 30-year bond and the
interest is halved next day, you could liquidate that debt only if you are
willing to shell out a sum closer to $2000, even in New
Jersey. Nobody will sell your bond back to you for
$1000, because it yields twice as much as do the new issues of the same face
value and same maturity. I am not familiar with the laws of New
Jersey governing personal bank loans, but if there is
such a law, it is price fixing that will not work in the long run.
2.
I am not confusing “liquidation value” with “present
value” of debt. The two are one and the same, and depend on the rate of
interest. What is involved here is the discounted value of the stream of
payments capitalized at the current rate of interest. If the latter changes,
so will liquidation value, and the relationship is inverse.
3.
The U.S., China,
and everybody else, ought to worry deeply about the runaway present value of
total debt in consequence of serial halving of the rate of interest. Among
other things, it means the sudden disappearance of liquidity. Both the U.S.
and China would suffer,
for different reasons, if the marketable U.S.
debt became unmarketable.
As a practical matter, the Chinese hoard of $1 trillion in U.S.
paper is already dead as a doornail. It is impossible to liquidate any
significant part of this investment without taking huge losses.
As far as the U.S.
is concerned, the end of ready marketability for its debt would make the sale
of its future issues on the present scale very problematic, if not
impossible. The only option left would be the direct monetization of Treasury
debt by the Fed, but that would trigger hyperinflation in very short order.
I have been writing on the problem of the ballooning
of liquidation value of debt in a falling interest-rate environment for the
past eight years or so. My papers are archived on my website www.professorfekete.com .
Here is another letter from a correspondent in the U.S.:
Professor:
I have read
your recent article discussing the liquidation value of debt with great
interest (no pun intended). However, I was unable to follow your logic
completely, although doubtless you will have a solution to my quandary.
It
seems to me that your theory depends on the nature of the debt. Unless made
up of perpetuals in the sense of British consols that never mature, which is clearly not the case
here, the problem is hardly more than a minor irritant.
I
fail to see how the U.S.
public debt could be considered as equivalent to perpetuals.
While it may be perpetual in the sense that it will
never be paid off, it is nevertheless composed of notes, bills, and bonds,
each with a specific maturity date. Therefore, since as you maintain that the
debt will never be paid off, with which I agree, it will have to be rolled
over and replaced by new issues with more distant maturity dates.
The
extent of the increase in liquidation value of total debt will not be
inversely proportional to the decrease in the rate of interest as you
suggest. We can only say that the difference between the aggregate debt and
the present value of streams of discounted interest payments is inversely
proportional to the difference between the old and new rates, surely a much
smaller quantity.
Thank you in advance for your response.
Yours, etc.,
Abe
Cinderby
Here is my answer:
Dear Abe,
Nobody sees the
future and we don’t know at what rate the maturing debt will be rolled
over if, indeed, market conditions will even allow it to be rolled over. As
standard accounting practice, under these circumstances the most pessimistic
assumption short of outright default must be made, which is that the
aggregate debt never matures and so its liquidation value is calculated as
that of the defunct British consols.
Having said that, I grant you that to a large extent the liquidation value of
total debt is in the eye of the beholder. Governments naturally put a most
optimistic low value on it. If chartered accountants want to stay faithful to
the well-tested ethical standards of their profession, then they will apply
the most pessimistic assumption. Of course, in the present situation they
don’t do that. Whether this is a well-reasoned decision on their part,
or a result of arm-twisting, we are left to guess. There are alarming signs
suggesting that the public perception is leaning towards the faithful
accountant’s formula in assessing the liquidation value of total debt. Government projections on the future of debt is for the
birds.
You
must ask yourself the question why British consols
were discontinued. If they were a reasonable way to finance government under
the gold standard then, from the government’s point of view, they would
be a trillion times more reasonable under the regime of irredeemable currency.
Bonds that never mature? You just print up bank notes to pay the paltry
interest a couple of times a year, surely a routine exercise with our present
printing technology? Never worry about another refinancing? No greater bliss
would be imaginable for a bailout-oriented government financing scheme.
British consols had to be discontinued soon after
the pound sterling became irredeemable because of the public perception that,
ultimately, the government will be unable to shoulder the implied runaway
liquidation value of debt. The public forced the hand of the government to
kill the consols. The bid/asked spread became so
wide that it was no longer meaningful to talk about the market value of consols (in today’s lingo, consols
became a toxic asset).
Exactly the same thing is happening to the 30-year, 10-year, 2-year, 1-year
government debt as well, as the world is being treated to a spectacle of
shrinking maturities. The perpetual U.S. debt is not a well-thought-out
construction. It is a makeshift to last only as long as the present
incumbents at the Treasury do. The runaway liquidation value scares more and
more investors. They know that they can never collect on their Ponzi-ticket.
The marketability of government obligations is evaporating.
To be sure, that point has already been reached by the Chinese-owned portion.
From the point of view of China the U.S. debt is a toxic asset. U.S. debt in
Chinese hands has no definable value: any time the Chinese want to sell a
sizeable amount, all bids are withdrawn. The Chinese are stuck with it. They
have to wait for their money until maturity. But who knows what the
purchasing power of the dollar will then be? The best the Chinese can do is
to “grin and bear it.” They can’t even say
“ouch”, because this would further hasten the deterioration of
marketability of their paper.
The
periodic warnings from China that the U.S. government should display greater
fiscal responsibility and it should follow a stricter monetary regimen sound
like whistling in the dark.
Every refinancing of the fast maturing U.S. debt is a major disaster,
considering the dwindling number of real investors. Entire new issues are
taken up by bond speculators who are in it for the fast buck. They expect to
reap risk-free profits when they turn around and dump the paper in the lap of
the Fed. The Fed does not mind: it is happy to pay the blackmail, to maintain
the façade of business as usual.
The
perpetual debt is like nuclear fuel. There is a threshold beyond which
chain-reaction sets in and the debt-tower of Babel self-destructs. Under the
regime of the irredeemable dollar the value of government bonds can vaporize
just as easily and unexpectedly as stock values, and there is nothing the
government can do about it (short of making the dollar redeemable). When the
last holder of the bag gets scared the last bubble, the U.S. government bond
bubble, will have burst.
The
supply of fools in the world is very large indeed, but it is not infinite as
the Big Fix cowboys in Washington assume. It takes more than starting an
avalanche of bailout bonds to defeat the Iron Law of the Burden of Debt.
Best,
Antal E. Fekete
www.professorfekete.com
Professor,
Intermountain Institute of Science and Applied Mathematics
Missoula, MT 59806, U.S.A.
DISCLAIMER
AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING
THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL
ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND
SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT
IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS
TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
Copyright
© 2002-2008 by Antal E. Fekete
- All rights reserved
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