Sunday, 8 May 2016

The safe asset scarcity problem, 2050 edition

S&P forecasts a serious shortage of safe assets by 2050 if the developed nations, in particular, do nothing to adjust their fiscal finances in the light of ageing populations. This has serious implications for government and investor behaviour - and the future of the ratings agency that issued it.

Here is S&P's hypothetical sovereign ratings chart out to 2050. Yes, ratings - although as we shall see, ratings will become largely irrelevant in the weird world of the future.

Clearly the price of sovereign bonds will rise significantly, particularly for those in the three "A" categories. S&P doesn't indicate which nations would be the issuers of these rare breeds, but it is a fair bet that their sovereign bonds are already trading at negative rates for some distance along the yield curve. So we are looking at fully negative yields for certain countries in the not too distant future.

The "A" team

These countries will be paid to borrow. Of course, no-one will really want to buy interest-bearing bonds: zero-coupon bonds would trade at a premium. But the extreme scarcity of safe assets would mean these countries can issue whatever they like. So these countries will refinance existing debt and lock in negative rates for as long as they possibly can, And from their issued debt, they will earn enough to fund a large part of their state pension liabilities. For these countries - the primary producers of an extremely scarce and very valuable commodity - their own sovereign debt will become an asset, not a liability.

Of course, they will have to ensure they keep their "rare breed" status. So along with negative rates would go fiscal policies to maintain a primary surplus and encourage saving and investment. The capital share of income would have to be rather high. For an elderly society, this should be ok. Capital tends to be owned by the old, and although pensioners don't generally save, they do live on the returns from capital.

However, nominal returns on investment in these countries will be very low, and nominal interest non-existent. Pensioners would have to dis-save rather than live on interest income, and rely on negative rates and deflation to maintain the real value of their capital even though the nominal amount is reducing. This is pretty scary for your average golden ager suffering from money illusion. We would therefore expect severe demand deficiency as ageing populations adopt frugal lifestyles due to inadequate interest income and worry that their savings will run out before they die. Deflation would be deeply entrenched and unresponsive to central bank policy. 

And this creates something of a problem. Negative yields along the entire sovereign yield curve imply either deeply negative policy rates or an inverted curve. Which of these applies depends on the central bank's response to entrenched deflation. Does it accept that an elderly society is naturally deflationary, and simply maintain policy rates sufficiently low to ensure that government can afford its pension liabilities (it's a wonderful thing, having complete control over the supply of a very scarce and very valuable commodity)? Or does it try to curb deflation?

If the central bank decided to try to curb deflation, it would have to raise (not lower) short interest rates and sell (not buy) its own sovereign debt - hence the curve would be inverted. This should be obvious if you consider that in a fully negative carry environment, debt is the issuer's asset and savings are a liability. If balance sheets are reversed, so must be policies aimed at influencing portfolio decisions.

But using monetary policy alone to push back on the economic effects of a demographic shift is like trying to hold back the tide. It won't work, and you risk being washed away. In my view, monetary policy in these countries would be far better used to support a fiscal policy that guarantees reasonable income to the old and thus puts a floor under demand. Both must be credible over the longer-term, otherwise the old will save the money in case the income is withdrawn by a future government. There could be an argument for insulating this form of fiscal/monetary cooperation from the political cycle, perhaps by using some form of Fiscal Council.

So the A-team should embrace negative yields, negative rates and deflation. For them, these are benign.

The B-team

A large number of sovereigns will fall into this category. Many, though not all, will also have ageing populations.

The problem that S&P highlights is the fact that elderly entitlement programmes in these countries assume a much larger working population earning far more money than is likely to be the case. These governments would struggle to raise the money from taxing younger people to pay generous pensions to the old, and unlike the A-team would not be able to cover pension obligations from earnings on negative-rate debt.

Nonetheless, these governments will be able to borrow more cheaply than they can at present. After all, there will be a severe shortage of safe assets. And when there is a severe shortage of anything, people look for cheaper substitutes as prices rise. B-team bonds are still investment grade, and far more plentiful than the gold-plated A-team bonds. Investors prepared to accept some risk in return for a lower price would be likely to opt for these. So bonds with a "bbb" rating in 2045 would be significantly more expensive than bonds with a "bbb" rating now, and yields correspondingly lower - with spillovers to corporate bonds too. There wouldn't be much in the way of interest income for investors in these countries, though capital would appreciate nicely.

So pensioners would have a double income problem: interest on savings would deliver little, and government would be under pressure to cut entitlements. Shifting the balance of pension provision more towards the private sector would not solve this problem. In the end, all pensions must be paid from the earnings of younger people, either through taxation and redistribution or through higher saving to increase the capital share of income. (If this isn't clear, I recommend reading John Eatwell's paper.)

We would expect these economies, like the A-team, to suffer severe demand deficiency as both the old AND the young adopt frugal lifestyles, the old because they are income deficient and the young because of high - probably compulsory - saving and/or high taxes. Deflation would be widespread, and central banks would be under pressure to counter it. If present practice is anything to go by, very low or negative policy rates and persistent QE would be the order of the day. S&P's chart tells us that today's "exceptional" monetary policy is in fact the new normal.

So what is the solution? Well, first we need to understand what the problem really is. S&P would like us to believe that these governments must "do something" to fix the damage to their fiscal finances caused by rising unfunded pension commitments. But I think this entirely misses the point. It is not governments that need to change their behaviour, but investors who need to change their attitude.

In a demand-deficient economy, squeezing household incomes with higher taxes, entitlement cuts and compulsory saving does not "fix the fiscal finances". It makes them worse, as falling output destroys the tax base. And this makes government debt less safe, not more. Tolerating higher debt/gdp may actually be in investors' own interests.

Indeed, if the world is to raise output sufficiently to support all these pensioners - including those in the A-team countries - B-team governments will probably have to spend a lot more. When the private sector is determined to save instead of spending, governments need to spend, even if this means much higher government debt/gdp. Public investment, demand support (such as a basic income) and targeted welfare all help to revitalise economies.

In the world of the future, interest rates will be persistently very low. B-team sovereigns will be able to borrow cheaply, and those that have their own central banks (which ideally would be all of them) can support the price of their sovereign debt. Innovative products such as GDP-linked bonds could be used to relax the government borrowing constraint. And risk-averse investors faced with severe safe asset shortages will have little alternative but to fund them.

I wonder whether, in the safety-scarce world of the future, we might see a power reversal. Rather than governments fearing a buyer's strike, perhaps investors will fear a government strike. A government that refused to sell its bonds to investors who demanded policies it considered harmful would be quite something.

The junk team

According to S&P the junk team could be as large as 25% of all countries by 2050. This is laughable. The world is getting richer, not poorer - yet sovereigns are becoming riskier? Really?

Even in the junk team, the safe asset squeeze is likely to depress interest rates. And these countries compete with other risky asset providers such as startups. So interest rates for even quite risky prospects could be significantly lower than they are now.

But risky though they are, these countries are likely to be those with the best growth prospects. In a world of deflation and stagnation, is it really sensible to regard the only bright spots as "speculative"? They will be the principal sources of global growth, and as such far more promising - and arguably safer over the longer-term - as investments than the moribund bonds of declining civilizations.

So investors need to change their attitude to these, too. Unless there is stable long-term investment in the junk team, neither the B-team nor the A-team can be regarded as "safe". The fortunes of the junk team are crucial for the survival of the rest.

And finally....

The future of ratings agencies

It's a great chart. But what it is really telling us is that S&P's way of assessing the creditworthiness of sovereigns belongs to a bygone age. In the new world, junk is safe, debt is an asset and investors fear governments. So ratings will be meaningless in future, and ratings agencies, redundant.

So long, S&P. It's been nice knowing you.

Related reading:

In the countries of the old
Rethinking government debt
Bond yields and helicopters
The liquidity trap heralds fundamental change
When governments become banks
The land of the setting sun - Pieria
The foolishness of the old - Pieria


  1. They're making it up with value extracting political deals with the third world.

    Like so:

    Military deals, like France selling Australia some subs, or the current fight US has with Pakistan about fighter jets. Which is okay, because the US makes bank supplying the Saudis with weapons for the Yemen war.

    And the various efforts at controlling the commodity cycles (relationship with dollar/euro) such that Westerners get the benefits of high prices and non-westerners get the downsides of low prices.

    As such, I do not expect that the stage will be over domestic demand and getting creditors to be reasonable about first world debt profiles, but ever more hostile geopolitical circumstances with countries outside the West.

    1. Well, that is historically how humankind has dealt with the problem of excess capital. War.

  2. Thanks, very good.

    It is just a fallacy that most of the developed countries can lose the safe asset status by 2060. And there is always enough safe assets in the world as it's a relative game.

    It is almost like requiring that enough safe assets (by austerity) needs to be destroyed to preserve enough assets. It doesn't make sense for the whole.

  3. These are the same rating agencies that gave diced sub prime mortgages the veneer of investment grade assets - why even take these agencies seriously?
    Chris L