The 10th Man

Toga! Toga! Toga!

July 21, 2016

I’m watching the Trump phenomenon with some mix of horror and amusement, like I suspect most people are.

I will say up front that I am no fan of Trump. I sincerely wish Gary Johnson would become president, having been a Libertarian long before it was fashionable (and when the candidates were a lot less viable).

The weird thing about Trump is that the gold bug guys, by and large, are all-in for him, which is head-exploding. Trump, who never met a creditor he wouldn’t screw, who threatens to balloon the debt even further, to the point where it requires direct monetization, that is who the gold bugs want for president. Doesn’t sound like Austrian economics to me.

Anyway, as I’ve mentioned before in The 10th Man (and here in Forbes), Trump would be very bad for bonds. Government would get bigger, not smaller, and the increased supply would weigh on the bond market, driving interest rates higher.

But the problem is actually much worse than that. Both candidates for president have increasingly grandiose visions for the sorts of things government should do, and I don’t see any scenario in 2017 where the deficit doesn’t widen sharply.

And that’s not even taking into account the usual demographic math about how Social Security is bankrupt, etc.

Sayonara

But the debt problem is most acute in Japan, obviously, where debt to GDP is now about 240%. Japan was insolvent at a debt-to-GDP ratio of 120%, so the rest is just gravy.

Oddly, interest rates across the curve are negative, so it’s not like anyone worries about default. Interest rates might be positive and quite large if the BOJ hadn’t bought up a majority of bonds and created a scarcity of duration. So now most of Japan’s external debt is actually owed to the BOJ and is not external at all.

What if the Ministry of Finance simply defaults to the BOJ? Does a tree make a sound if it falls in the forest?

This is in fact being seriously considered. Basically, it has been suggested that the government swap out all those bonds for one giant perpetual zero-coupon bond (i.e., no maturity), which is effectively the same as canceling it out.

So Japan goes from 240% debt to GDP to 40% debt to GDP, and guess what? Then they can go back to building roads and trains and bridges to nowhere, like they were in the ‘90s.

Like I said, this is being discussed seriously. The actual cancellation of debt. Think about it: back when we started doing QE, people were freaking out about what would happen when the Fed sold bonds back into the market. That was never going to happen—that was never the intent at all.

Japan is not the only country in checkmate. Italy is also stuck, as is most of Europe. And we will be someday, too. If Japan cancels the debt, it will set a very important precedent. It will also disincentivize people from ever buying government bonds again in the future.

Meanwhile, Back at the Ranch

So after messing around with monetary policy for the last eight years, central banks and policymakers are not pleased with the product of their effort. Developed economies are still mostly poo, labor markets are a mess, and nobody is happy.

Enter Keynesian stimulus. Governments globally would love nothing more than to crank up the spending machine and start building roads and trains and bridges to nowhere. We hadn’t done this in the past because… well, we couldn’t afford it. We can’t now, but if we could just make all this debt go “poof,” we could afford anything.

The obvious trade here is gold. Let me explain why.

Most people think hyperinflation happens like this:

You print the money
You build the bridge

But in reality, it will happen like this:

You borrow the money
You build the bridge
You print the money
You buy the bonds back
You cancel the bonds

Voila—now you have the bridge and you have the money, just like in the first example, except through a complex series of steps, so you don’t actually look like a hyperinflationary banana republic.

I bet that either Hillary Clinton or Donald Trump, in the homestretch of the campaign, will be making very extravagant promises about infrastructure spending. You heard it here first.

Rocket Fuel

So if debt doesn’t matter and we’re going to build roads and trains and bridges to nowhere, it means that shorting this market is a huge waste of time.

It will end badly someday, but keep in mind that people have been predicting disaster for the last 45 years, when Nixon took us off gold. We could have 15 more years of this crap.

What is the alternative? Austerity, of course. Austerity sounds so depressing, though. Austerity is really just a very derogatory term for fiscal discipline. We live in a freaking fantasyland, where anything goes. Similar sentiments were expressed in Weimar Germany. The party is just getting started.

Editor’s Note

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Jared Dillian
Jared Dillian

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