Government Bonds, Money and South-East Asia: The Great Deception

December 17, 1997

When we undertake the dynamics of financial analysis, all too often we look at what we can see and ignore the dynamics happening beneath the surface. Deceptions increase when we make incorrect assumptions about simple elements of truth and understanding.

Japan in 1989 was experiencing an 8% growth rate, low and stable inflation. And stock markets and real estate values were reaching record levels. Dominance in manufacturing and technology made them the richest people on earth, and money was so abundant that they were exporting it to the rest of the world. Like Japan in 1989 - to understand the coming collapse - we must look below the surface to really understand what is happening.

Myth #1, Government Bonds

Government bonds do not represent wealth! They represent a financial promise of a future generation. The ability or willingness of the future generation to repay these promises is at best uncertain, especially since the obligation was undertaken by the current generation. Given that the present generation is unwilling to pay for its present services, it does not necessarily follow that the next generation will be willing to pay for its own services, plus the debt including interest of the prior generation. At best, government bonds represent an intangible asset. Should the value of government bonds approach zero, either through default or inflation, the tangible assets of a nation, its capacity to produce food, goods and services does not change.

Consider a country that produces $200 of which the government wishes to spend $100. The first way the government can accomplish this is to tax $100. This is straight forward, what you see is what you get. Another option is deficit financing, possibly raising $80 in taxes and $20 through the issue of a government bond. This has the same real effect on the economy. $100 is still taken out of the economy. Perception is somewhat different as people think that taxes are lower and that their wealth has increased by the $20 government bond. For the next year, we will assume that government spending on services is to remain at $100, taxes at $80 - and assume an interest rate of 10% on the government bond. Then the government will issue a new $22 bond and take $102 out of the economy, $80 from taxes and $22 from bonds. However, as it is paying $2 in interest, this money is going back into the economy so that the net effect on the economy is $100 taken out, the same as if the tax rate was $100. People now have $42 in government bonds and have received $2 in interest. They perceive that their wealth and income have increased. This is all just perception. Tangible assets in the economy have not changed. And of the $200 produced, they still only get $100 and the government is getting $100, the same as if the tax rate were $100. Another option is for the government to raise $80 in taxes and create $20 in new money. Again, it still remains, of the $200 produced, $100 is taken by the government, though in this case, the $20 in new money causes inflation. Perceptions are that as taxes are only $80, people are better off than when taxes were $100, though as there is some inflation, not as well off as when governments issue bonds to finance their deficits.

However, the real effects on the economy are the same, whether the $100 in government spending is financed through $100 in taxes, $80 in taxes and $20 in bonds, or $80 in taxes and printing $20 in new money. How the government finances its spending does not change what they take out and what is left for people to consume.

Let us review the long term implications of all three methods of how governments finance their spending.

1) $100 in taxes financing $100 in spending. This is very basic. What you see is what you get.

2) $80 in taxes and $20 in bonds financing $100 in spending. Over a period of years, there is a large accumulation in government bonds. People feel that they are better off than in case #1 as taxes are 20% lower and they are accumulating all of these government bonds. However, what they really have to spend is the same as #1. Some day there is a demand to repay the bonds. The government, not having any significant assets, only debts, must raise taxes in order to do so. If $10 in bonds are to be redeemed, then taxes must be raised by $10. In essence, $10 is taken from the economy to give $10 back to the economy. This amounts to a zero sum game for any amount of government bonds to be redeemed. To the economy as a whole, the real value of government bonds is nil. On an individual basis, some people may be taxed less and receive more, but for the economy as a whole, what is given in bond repayment must first be taken in taxes. The policy risk is that one day investors will realize that government bonds do not represent wealth, but only represent the government's ability to transfer wealth amongst different investors. If bonds and taxes are equally distributed among all people, then they have zero value, for one must tax himself in order to repay himself. When investors question the governments ability to effect this wealth transfer, either on moral grounds (children being forced to pay for the spending of their parents) or on financial grounds (bond levels have reached a level where repayment is above the ability of those asked to repay) then the value of the bonds will also approach zero.

3) $80 in taxes and $20 in new money financing $100 in spending. Over time, this will lead to increasing levels of inflation. In an evironment of financial instability, people will question the value of money, resulting in their unwillingness to hold it as an asset.

Myth #2, Fiat Money

Fiat money today does not represent any tangible asset. It only represents the financial strength and goodwill of governments. When these disappear, the value of money will also disappear. This is happening on a daily basis in Asia. It is best illustrated by a picture of an elderly Korean woman standing in front of one of the shut down commercial banks. The doors to the bank are guarded by riot police. Her life savings are in the bank - which the bank cannot repay. The government has guaranteed repayment, but it to has no money. It really does not matter as the value of the currency decreases 10% per day.

The investor must then ask themselves: Do we hold tangible assets or intangible assets?

In light of the above, let's review some of the recent events in Asia. The Japanese government is looking to provide up to 12 trillion yen in loans to small companies, which are having difficulty with their commercial bank financing. These are essentially companies which appear bankrupt, and do no longer qualify for commercial loans. It is another one of the bail-outs that the Japanese government will attempt as it refuses to accept any failure. The government is also looking to inject 10 trillion yen to help the banking system. While they are at least admitting that they may have a problem, the level of support to be provided is far short of what is needed. Moreover, the proposal to borrow the funds does not address the central problem that there is too much debt. It only shuffles the debt. The obvious answer would be to redeem U.S. Treasury Bills. However, in order for the U.S. government to accept this as a viable solution for the Japanese problem, the U.S. governement would be obliged to raise taxes to fund the hugh redemptions - thus suffering all the obvious negative political implications. This begs the question: Is the American public willing to reduce their living standard in orfer to honor their financial obligations to the Japanese? While the Japanese could sell their U.S. securities to other investors, this relies on the continuance of the greater fool principle, and calls into question the value of a debt that the borrower is unwilling to pay.

Korea

The country is bankrupt, the banks are bankrupt, and many company's are bankrupt. External debt is now reported to be as high as US$171 billion, most of which can not be repaid. Most of this debt is to foreign banks, and it is large enough to bankrupt many of the largest banks in the world. There are rumors that Swiss Bank Corp. or UBS may have a large Korean debt exposure, which may explain their hasty merger. What is certain is that whoever holds this debt may face economic collapse. Let us be clear of the roll of the IMF in these financial crises. Their benefit to the host country is at best limited. Their loans bail out the foreign lenders who made the poor loans in the first place. The IMF does not change the debt levels in a country, and this is why the currency value of all countries in South-East Asia receiving IMF assistance continues to fall. They are just as bankrupt as before the IMF arrived. As for Korea, it now appears that the IMF must lend US$150 billion, or some foreign banks will fail.

The effects of the financial collapse are starting to have major effects on the economies throughout Asia. In particular, the collapse of the Korean won will have a major effect on China and Japan. The economic slowdown is already decreasing unit sales in the region at a time when more manufacturing capacity continues to come on stream. Now collapsing prices will feed on decreasing unit sales, destroying the profitability of many companies. In the last two quarters (April to September), Japan has experienced a major contraction in economic growth. Since then, problems have intensified and we note that November car sales in Japan dropped 20% from year earlier levels. Now the value of the Korea won has collapsed, which will greatly add to Japan's financial problems.

If we accept that government bonds and currencies are at best an illusion of wealth, and that stock markets trading at 5 times book value may be over-priced in view of falling profits and currency upheaval, then the only investment alternative is gold. Realizing this, governments have driven down the price of gold. In order for the world to continue to believe in the government promoted illusion, the price of gold must continue to fall. If the world were not on the edge of an economic collapse, the price of gold would not be so low.

The seeds of today's financial problems were sown many years ago, and it is impossible to say when it will all implode. Still on a daily basis, we see a quickening of the impending doom. Soon the world will realize that the king has no clothes... that which was, is no longer. It is then that gold will rise to incredible heights.

Gold is still being mined and refined at the rate of almost 2,600 tonnes per year.