Post-apocalyptic zombie finance

By 2014, International Monetary Fund official John Lipsky remarked March 21, the debt-to-gross domestic product (GDP) ratio of the Group of Seven countries will reach 100%, and the governments of the industrial world will carry the highest debt burden since shortly after the end of World War II.

That is bad news; worse news is that governments are shoveling money into the world banking system to finance the debt expansion. Following the great bank bailout of 2008, the global banking system is socialized de facto, shifting its resources towards government debt and away from private sector financing.

Governments averted a financial apocalypse in 2009 by bailing out the bankrupt banking system. But who will bail out the governments? The answer for the time being is that they will bail themselves out at the expense of the private economy. In the post-apocalyptic financial world, private banks have turned into flesh-eating zombies that cannibalize the private economy in order to finance government borrowing requirements not seen since World War II.

 

The shift in economic power toward governments and their auxiliaries, the major banks, is unprecedented in peacetime. And it seems to be the intention of the Barack Obama administration "not to let a crisis go to waste", as the president’s chief of staff, Rahm Emanuel, famously declared. The trillion-dollar federal health plan on which the US House of Representatives voted March 21 will effectively nationalize a sector comprising 14% of the US economy - on top of the de facto nationalization of the banking system.

Figure 1: Government debt replaces loans on the books of American banks



American banks have reduced their loan book by US$350 billion - more than a fifth - since early 2009 and bought $300 billion of Treasury securities. Remarkably, the most aggressive buyers of US government debt during the past several months have been global banks domiciled in London and the Cayman Islands. They borrow at 20 basis points (a fifth of a percentage point) and buy Treasury securities paying 1% to 3%, depending on maturity.

This is the famous "carry trade", by which banks or hedge funds borrow short-term at a very low rate and lend medium- or long-term at a higher rate. This works as long as short-tem rates remain extremely low. The moment that borrowing costs begin to rise, the trillion-dollar carry trade in US government securities will collapse.

Between November and January, the last month for which Treasury data are available, foreign private investors (overwhelmingly banks) bought $60 billion a month of Treasury notes and bonds - an annual rate of $720 billion, or about half the total annualized borrowing requirement of the US government.

Figure 2: Foreign purchases of US Treasury securities, private banks vs central banks

 

Note that the central banks of the world have not increased their holdings of US government securities to a significant extent. Their net purchases are running at a modest $20 billion a month, or an annual rate of $240 billion.

The US Treasury has become dependent on global private banks. According to Treasury data, $108 billion of the $180 billion in net foreign purchases of US Treasury securities during the three months through January came from London and the Cayman Islands.

Figure 3: Yield on inflation-index five-year US Treasury securities



Most remarkable is the willingness of the world to finance the American deficit at real interest rates of less than 0.5%, as measured by the yield on five-year inflation-indexed Treasury notes. The extremely low real yield implies very low growth expectations over a five-year horizon. We appear to have something like Japan’s "lost decade" of the 1990s, in which banks purchased government securities at yields of less than 1% with effectively free money from the central bank.

Figure 4: Net purchases of US Treasury securities by geographic origin, three months through January 2010



Where are the banks getting the money to lend to the US government? From the US government itself. The Federal Reserve has increased bank reserves by $1.4 trillion since the beginning of the crisis, feeding funds into the banking system which the banks immediately lend back to the government, along with $300 billion of additional funds freed up by the reduction in loans to the private sector.

Figure 5: Monetary base



The monetary base is growing at a 40% annual rate. Under normal circumstances, this would lead to double-digit inflation. As long as banks reduce lending to the private sector, and buy government securities that replace lost tax revenues, the result is a so-called liquidity trap. With 20% under- or unemployment in the United States, according to a February 2010 survey of 20,000 US households, labor costs will remain depressed. Commodity price inflation will not translate easily into consumer price inflation.

This sort of zombie equilibrium persisted for two decades in Japan's moribund economy; in theory, the US Treasury and the financial system could keep it going indefinitely. But there are a hundred ways in which this arrangement could go wrong.

Weaker governments like Greece and Spain, or even the United Kingdom, could snap the chain. A shift out of US dollars in response to monetary inflation could force the Federal Reserve to raise interest rates. An attempt by investors to ease out of the carry trade could provoke a stampede for the exits. Japan has managed to keep its bubble going for 20 years. But Japan did so on the strength of its domestic banking system under the supervision of the Bank of Japan; the United States depends on the reserve status of the dollar, which makes less and less sense when the Treasury is flooding the world with US liabilities.

We have never seen anything quite like this before, and one hesitates to make forecasts about an arrangement so absurd and unstable that the list of potential break-points is endless. Now that the whole world is buying US government debt on borrowed money, it makes no sense to own it. It will end badly - but it is too early to specify just how and when.