The Very Large Bubble of Government Debt


In yesterday’s Daily Reckoning we left off with a simple question: how do you invest during an inflationary boom? Today, some concrete ideas. And the simplest idea of them all-when you consider soaring government deficits-is to sell government bonds and buy beaten down, world-class equity.

Mind you, this is if you want to be in the equity market at all. There is a very good case to be made for NOT being in the equity market this year, or only being in those asset classes and single stocks you think will appreciate (or grow earnings) faster than the rate of inflation.

But let’s be more direct and say that this is still a bear market. The bear market began in 2000 with the popping of the tech bubble. The Fed fought back in 2003, setting a low-interest rate policy the rest of the dollar-pegged world followed. This kicked of leveraged booms in residential housing, credit derivatives, and stocks, bonds and commodities.

All those bubbles are popping. You do not wipe out twenty five years of credit and leverage excess in a mere eighteen months. We are barely halfway through the liquidation/loss realisation phase. The essential question is which assets are going to perform the best as governments inflate and create a new bubble in government debt? And by the way, it’s going to be very large bubble.

Forget the $1.8 trillion deficit the Obama White House admitted to today. Forget the A$60-$70 billion deficit Wayne Swan is going to shove down your face tonight. The true scope of government borrowing is breathtaking, and rather sickening. More importantly, you have to wonder where the money is going to come from, and what will happen when it’s not forthcoming from private investors.

Consider the chart below, courtesy of Niels Jensen, writing in John Mauldin’s “Outside the Box” e-letter. Niels shows that according to IMF estimates, twelve governments around the world (the ‘Dirty Dozen’) will have to issue $10.2 trillion in bonds to cover future banking losses and funding requirements in the credit markets as a result of the ongoing financial crisis.

The ‘Dirty Dozen’ and $10.2 Trillion in New Bonds

Ten trillion is a huge number. But there’s every chance the number is, in fact, a conservative estimate of government borrowing requirements. It is based on smaller than expected losses in the banking sector (the bogus scenarios modeled in the U.S. Treasury’s ‘stress tests’) and a lower-than-average increase in public borrowing to deal with a financial crisis.

The IMF estimate is that public sector borrowing will grow to an average of 27% of GDP in Western or industrialised countries. But according to a study by economists Carmen Reinhart and Kenneth Rogoff published last year, governments almost always underestimate the amount of public borrowing that takes place in the wake of a banking crisis.

They do because-as the government here in Australia has done-they underestimate the blow to tax takings that comes from lower bank lending and lower economic growth. Tax takings fall while spending generally increases, especially borrowing to subsidise lending in key sectors like say, high-risk mortgage lending and property development. Think of the AOFM’s role in buying securitised residential mortgage backed securities and Ruddbank.

So how big could government bond borrowing needs get? Under the ‘best case’ scenario (lower loan losses, quicker economic recovery) Rogoff and Reinhart say public sector debt would grow to an average of 40% of GDP, leading to global borrowing needs of $15 trillion-50% higher than the IMF’s estimate. But that’s just the best case scenario.

Using the chart below, Reinhart and Rogoff suggest that in previous banking crises, government borrowing as a percentage of GDP has risen to an average of 86%. Under that scenario, now you’re talking $33 trillion in global government bond issuance in the coming five years to deal with the rest of the losses in the banking system.

The Mother of All Bubbles in Government Debt

You can see why we think all this talk of recovery and rally is a bunch of hokum. Maybe it won’t be quite 86%. Or maybe it will be more. But we know for a fact that global governmetns are going to flood with world with bonds in the coming years. But will investors buy them? If they don’t, you can expect much higher bond yields and much more money printing. That means inflation.

If you think this is just an American problem, think again. Professor Paul Kerin of the Melbourne Business School says Australia’s government has already over-responded to the crisis with its policy response. Writing in yesterday’s Australian, he says, “I estimate the 2008-09 and 2009-10 deficits announced tomorrow [tonight] will exceed $32 billion and $55 billion respectively, and that net debt will exceed $250 billion by mid-2013.”

“In the past half-century, the cash deficit has never exceeded 4.1 per cent of GDP — that was in 1993-94, when unemployment was running in double digits. Net debt has never exceeded 18.5 per cent of GDP — that was in 1995-96, the sixth straight year of deficits run to fight high unemployment…Yet the 2009-10 deficit will exceed 4.5 per cent of GDP — topping our 1993-94 record. And net debt will exceed 17.4 per cent of GDP by mid-2013, beating the 1995-96 record.”

As you can see from the chart below, the government’s deficit spending and borrowing ambitions have already steepened the Aussie yield curve. This makes long-term debt more expensive for ALL borrowers in Australia and will probably push up mortgage rates too, gagging the rebound in the housing bubble and jeopardising the one sector that’s held up the economy through the early stages of this so-far mild recession.

Australia’s Yield Curve Steepens

One last note on this before we move on to the investment strategy. A lot of readers ask how hyperinflation can happen in Australia if the U.S. dollar is weakening against the Aussie dollar. Further, you might wonder how the expanding American deficit has any bearing on the fiscal stability of the Australian economy. They are great questions.

There are four factors that we believe will lead to an even weaker fiscal position in Australia and lead to more borrowing and a weaker Aussie dollar-despite the circumstances that are undermining the U.S. dollar. Or to be plainer, U.S. dollar weakness is not going to be enough to keep Australia’s currency sound.

So what are the four factors? First, government tax takings are going to fall more than expected. This is already the case. Lower commodity prices are going to compound the problem in the second half of the year. Barring a full recovery in the job market, the government is factoring in revenues that will not be there, while increasing spending.

But the big increase in Aussie government borrowing will come elsewhere. If indeed there is a “second half” to the capital crisis in American and European banks, it means financing needs for the Australian economy are going to have be backstopped by government guarantees or direct loans (Fed style, a la the TALF).

Sectors that the Australian government may have to borrow on behalf of or loan to include the commercial property market, the residential property market, and the corporate bond market. Right now the Australian Office of Financial Management reckons it won’t have any trouble selling $1.4 billion per day to finance growing government deficits. But how much larger will Australia’s borrowing needs become if the government must become the lender of last resort to all these other credit markets?

And if Aussie government-competing with all those other countries for global savings-can’t sell its debt abroad-how do you think it will pay for it? The Reserve Bank will do what the Fed, the ECB, the Bank of Japan, and the Bank of England are doing. It will print money to buy government bonds. It will monetise the debt. Quantitative easing will begin in Australia and inflation will have arrived.

Does that seem impossible to you? Is it just Doom and Gloom pornography? We’re certain a lot of people will find this scenario absolutely unbelievable. But in a worldwide credit depression where government borrowing needs amount to nearly one third of all global savings, you have to wonder how Australia is going to raise money against the likes of the U.K., Japan, and the U.S. If it can’t do it, it’ll have to print.

So back to the question. What does an investor do? Well it’s worth noting that Microsoft appears to be preparing for massive inflation by borrowing. The company is selling $3.75 billion in debt in order to buy back some of its own shares. Obviously Microsoft reckons the real value of the debt will diminish with inflation while the current purchasing power of the borrowed money allows it to buy back its own shares.

It’s a nifty trade and provides the example of buying equity in world-class businesses at cheap prices. There have to be a lot of investors in the world out there who see the end-game of this explosion in government debt and would much rather buy equity. That alone means the “weight of money” argument for equities could send shares higher.

We have to admit we are extremely dubious of this strategy because it says nothing about how these businesses will perform in a world saddled with so much debt. But we suppose if you are a truly a long-term investors and have decades to wait, buying equities at these lows is, a) a much better idea than buying government bonds, and b) about the only sensible investment strategy if you’re going to stay in the equity markets.

Incidentally, Swarm Trader Gabriel Andre has been thinking along these lines himself lately. He’s applied his Swarm system to the ASX/200, looking for entry and exit points on Australia’s largest stocks. His aim is to find which Aussie blue chips present long-term buying opportunities and which are looking mighty over-bought.

Mind you, Gabriel is a technician. He doesn’t look at fundamentals at all. Still, we’ve been reviewing the early results of testing the Swarm on blue chips for the purpose of issuing buy, sell, and hold recommendations. And we have to say, it’s looking pretty intriguing.

But let’s say you don’t want to buy-and-hold blue chip stocks. And let’s say you want to be in the market and not just in gold, vodka, bullets, and canned goods (although if you are preparing in that way, you should check this out). If you’re a “financial survivalist” what else can you do?

Try uranium and lithium (as investments, not meals). In late November, we tipped an Aussie-listed uranium producer in Diggers and Drillers. The stock is up 90% since then. And this was a relatively “safe” stock because it’s already producing from mines in Africa, with plans for a joint venture in the Northern Territories. It also owns some excellent ore bodies in Queensland, if the government there ever decides that it would like a uranium mining industry.

We reckon the government WILL decide that because energy is an industry that’s going to survive the credit crisis. In a recent Diggers and Drillers weekly update, we reported that China is building twenty one-gigawatt nuclear reactors at the moment. China will not be able to supply its own uranium needs. Australia, with over 30% of the worlds proven uranium reserves, is in position to capitalise, should it so choose.

According to Scotia Capital Inc. China strategist Na Liu, China’s nuclear industry will consume 15,700 tonnes of uranium per year by 2020. “At this rate,” she writes, “China’s currently known uranium resources can only last for five to 10 years. Clearly, in our opinion, it is imperative for China to secure long-term supply through imports or investment.”

That “other investment” is why we’ve drilled down further into the roster of junior explorers in the coming issue of D&D. The explorers and prospect generators are starting to look interesting. We’re also going to have another look at lithium.

Back in May of 2008 we profiled the rare earths industry, including Australia’s two best rare earth stocks (both of which became recommendations, both of which got slaughtered in the market correction, and both of which have doubled from the lows after partnering up with Chinese investors).

In that report prepared for subscribers, we also looked at lithium. Enhanced battery life and power is becoming a key issue for a world filled with mobile telecommunications devices. It’s also critical for hybrid-electric cars that can store an electric charge. One of the stocks we profiled in that report has just signed a letter of intent to build a lithium carbonate processing plant…in China.

So you see, for the resource speculator, an inflationary boom can be the best of times. It is a high-risk exercise. But junior resource stocks are one of the asset classes the CAN go up faster than the rate of inflation. And if, as we believe, the explosion in government bond issuance is going to lead to an inflationary rally in stocks, then dabbling the junior resource stocks and small caps is like hitching a front seat on a rocket.

Remember, this is pure speculation. You only hope your rocket is like Richard Branson’s new Virgin Galactic space plane, and note the nuclear missile Slim Pickens rides in Dr. Strangelove.

And what about red wine? The bottle shop across the street from the Old Hat Factory is closed for renovations. In its clearance sale, we were able to pick up a few bargain bottles of Penfolds Bin 389 Cabernet Shiraz. That is wealth you can either drink or store. We’ve done a little of both.

But you can also sell it! There appears to be a roaring trade in Penfolds wines on e-Bay. There are certainly worse things you could spend depreciating paper money on. We’re also hearing that the 2004 vintage of the Penfolds Grange is the best ever. Can’t wait to find out.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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4 Comments on "The Very Large Bubble of Government Debt"

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7 years 5 months ago

Great article. Not sure though if ‘bubble’ is quite the right analogy for Government debt, because it’s not the kind of thing that can spontaneously unwind.

The big worry with the indebtedness to me is the political ramifications of governments wholly dependent on private central banks for their daily keep. Oh to be a central banker over the next twenty years!

Coffee Addict
Coffee Addict
7 years 5 months ago
If the talking heads are suggesting a “10%” correction this week and this view is supported by both technical and value based analysis then get prepared. I’ve started selling some of the “speculatives” because they WILL get slaughtered in any correction. Getting the axe to the portfolio is not an easy task though. For what it’s worth here’s my “Woody’s Round-up”. 1. OSH – I’m holding. If there is a Chinese order book for PNG LPG it has a green light from the Chinese Government (GoC). This decision will be as much political as it is economic and the GoC… Read more »

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