One of the striking ironies of our modern financial system is that government bonds are considered safe-haven investments, while gold is a “barbarous relic” to be avoided at all costs. Since the 2008 financial collapse, the bond market has been on a tear, which has only served to reinforce the notion that government bonds are “safe.”
Meanwhile, the financial media argues that gold is no longer relevant to today’s investors, despite the fact that gold has been around for thousands of years, while government paper for only a few hundred.
A quick look at the history of government-issued bonds in the 20th century reveals potential pitfalls and offers some important long-range perspective on the current multi-decade bull market in bonds.
Not all Government Bonds are Safe all the Time
When making any sort of investment – whether in government bonds, real estate, or gold – a prudent investor aims to not only earn a return on capital, but to receive one’s initial capital back in full. With safe-haven assets, capital preservation is often the primary objective, while capital growth takes a back seat. This begs the question – how well have government bonds preserved investor capital in the past?
When it comes to paying back the principal on its debt, governments have a checkered history. In this article, I want to focus on a period that most closely resembles our current “Great Recession” – the Great Depression.
Following World War I, the League of Nations – the precursor to our modern United Nations – issued a report showing 62 sovereign states had been loaned a total of $149 billion by 1936. By the end of that year, 27 of the 62 governments were in default and unable to pay back the principal.
If you look at loans that just the United States made to other nations, the default rate is worse. Of 40 sovereign states that the American government issued loans to following the First World War, 23 defaulted on their obligations.
The most notable country at the time to default was Great Britain. Its currency, the pound sterling, was the world’s reserve currency at the time. Great Britain’s inability to pay its debts in full after World War I was a precursor to the pound losing its privileged role as a reserve currency.
Are We Any Safer Today?
Today, the US government has borrowed more than it ever has before. At the time of writing this, it has more than $17 trillion in debt. Consequently, the Federal Reserve’s balance sheet has ballooned to the unprecedented figure of nearly $4.5 trillion. About $2.5 trillion of that is in government Treasury notes, while $1.7 trillion is in mortgage-backed securities.
This debt represents a systemic risk to the liquidity of the entire financial system. Whether the government has both the resources and the will to pay back this debt in its entirety is dubious. As we’ve seen governments have been either unable or unwilling to pay their debts in the past. And even countries privileged enough to have a world reserve currency are not immune, as was the case with Great Britain.
The United States’ current position is not so dissimilar. The US Dollar is the longstanding world reserve currency leader. As a result, the US maintains a privileged financial condition over the rest of the world when it comes to their public finances. And yet, for the first time in its history the public sector now outweighs the private sector. And this is a trend that looks to continue as the public sector is steadily growing will the private sector continues to struggle post 2008.
The growing debt burden of the US poses a risk to its privileged financial status, to the holders of its debt, and to the entire world who relies on the US Dollar. The following quote is a sobering reminder.
A great civilization is not conquered from without until it has destroyed itself from within.
– Ariel Durant
Welcome to the Monetary Madhouse
Today we live in a monetary madhouse erected by our central banks. Distortion and absurdity prevail, not clarity and stability. Instead of private investors looking for win-win profit opportunities in a free market for money and credit, we have central banks using “forward guidance” to dictate where capital should flow. Today’s decade long bull market in bonds and the giant balance sheet of the Fed are a direct result of central bank intervention.
Today, nearly all government bonds are bought based on interest rate speculation and rarely are they held to maturity. What does this imply? These bonds trade hands without a care given to whether or not they will see a dime paid back in principal. It’s simply assumed the borrower (the US government) is good for it.
In any other market, the lender is highly concerned with whether or not the interest and the principal will be paid and returned in full. The lender would not part with his or her capital if repayment of the principal were not expected.
But this all just doesn’t seem to matter anymore. As long as its debt remains marketable, the US can keep only paying the interest and then roll its old debt by issuing new debt as a replacement. This means the merry-go-round of debt keeps on spinning, the debt continues to grow, no principal is ever paid down and yet no one seems to bat an eye or question where (when) does it end?
We don’t know the future, but we can know the past. Government bonds have enjoyed the label of “risk free” return for a long time. This was a foolish thing to do then, and given the mountain of debt amassed in today’s financial system, it is even more foolish to assume now. At the end of the day, government debt works the same way as any other debt does – it’s a promise to pay. History shows governments can and do break their promises for a number of reasons just like any other human being. Gold on the other hand isn’t promise, it’s payment. In a world where there doesn’t seem to be a good answer for “How are we going to pay all this debt?” gold, far from being a “barbarous relic,” could very well be what saves us from financial barbarism.