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J. Toporowski - EURO Government Bonds

J. Toporowski - EURO Government Bonds

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GOVERNMENT BONDS AND EUROPEAN DEBT MARKETSJan Toporowski
‘The international financial system is already in such a state in which as soon as the holesin one place start to be patched up, new ones appear in a different place.’ Kalecki 1932.
Introduction
Just as mainstream economics discovers how to model financial crisis actual eventsreveal that the crisis is much deeper and this greater depth is expressed in the serialcharacter of the crisis. Current models show crisis as a shock in a dynamic stochasticgeneral equilibrium, with contagion effects arising because heterogeneous agents hold asassets each others’ liabilities (see, for example, Goodhart, Sunirand and Tsocomos 2004).However, the actual course of events since the 2007 financial crisis emerged seems tosuggest that, far from a resumption of general equilibrium after the ‘shock’ of that crisis,financial systems have succumbed to a series of shocks. The discussion of financial crisishas moved from modelling the resumption of general equilibrium among agentsabstracted from the real world, or empirical data, to a rather more practical discussion of policies and institutional mechanisms for stabilising financial systems.This paper discusses the role of Government debt markets in managing such crises. Thefirst section of the paper discusses the mechanisms by which a well-managedGovernment bond market may stabilise capital markets in nominal, or cash-flow, terms.The second section looks at the crisis in European government bond markets andsuggests ways in which those markets may be converted into stabilising mechanisms for European capital markets. The conclusion outlines some implications of the analysis for an ‘optimal’ government bond issue.
1. Bonds and capital market stability
Since the Modigliani-Miller studies of the late 1950s it has been widely assumed that thecomposition of financial instruments in capital markets is merely the aggregation of individual agents’ financing and saving preferences and has no serious implications for the functioning or liquidity of those markets. This is usually because finance theorylargely omits considerations of liquidity: The standard definition of financial equilibrium,a situation in which no further arbitrage is possible implicitly assumes that marketliquidity is available on demand. As recent events have demonstrated, such liquidity has adisturbing tendency to disappear when it is most urgently required (See Nesvetailova2010).1
 
In the paper that follows financial stability refers to the maintenance of the money priceof financial assets. These money values are the key parameters for maintaining paymentson banking and financial commitments. This is for two reasons. First of all, with theexception of inflation-related derivative instruments, or index-linked bonds (see below),the cash payments that issuers of financial instruments make are related to the nominalvalue, and not the value of such instruments in relation to goods and services. Secondly,and perhaps even more importantly, payments on financial obligations are moneycommitments. They cannot be replaced by delivery of goods and services. Wherepayments on financial obligations are hedged by other assets, those assets have to be soldto raise money in order to meet those payments, or money borrowed against their nominal value. In other words, financial instability is a default on money obligations, andnot on real ones.This does not mean that inflation in markets for goods and services may not threaten thestability of banking and financial markets. It may do so as part of a general debt deflationproblem, or a devaluation of money contracts. But the result is a macroeconomicproblem, rather than strictly a default on payments commitments arising out of theoperations of banking and financial markets.In an earlier study, I argued that, in a capital market with debt and equity, a highproportion of bonds in the portfolios of market participants tends to stabilise the market.This is because bonds have an ‘assured residual liquidity’, which anchors prices andexpectations in the market for those bonds. Financial intermediaries’ balance sheets canbe constructed in such a way that future payment commitments may be matched withassured future payment receipts. By contrast, shares or common stock have no ‘assuredresidual liquidity’. The wider dispersion of possible future values makes these stockspreferred vehicles for speculation, i.e., purchase for capital gain rather than income. Anextended period of capital market inflation boosts equity prices and this distorts thepreferences of investors towards equity, and encourages equity financing without stablemarket values (Toporowski 2000, pp. 23-24). Index-linked bonds, or hybrid bondscurrently recommended as a source of bank capital, are clearly in between theequity/bond distinction, having the appearance of bonds, but without the assured residualliquidity of equity. Index-linked bonds invite potentially destabilising speculation againstfuture inflation, and hybrid bonds may arouse similar speculation against bank insolvency.A high proportion of bonds in the capital market therefore makes those markets morestable and less speculative, because of the limited scope for capital gains. In turn, suchreduced variability would make for more consistent portfolio and financing choices, anda sounder basis for the expectations of market participants. The greater stability of themarket should be reflected in the stability of an ‘average’ portfolio of financial assets.However, once portfolios become heterogeneous the ‘average’ portfolio becomes lessrepresentative. Two recent trends in particular have increased the heterogeneity of portfolios. The first is the rise of specialist funds, such as private equity funds, or hedgefunds, with much less diverse portfolios. The second is the absorption of large quantitiesof government bonds by central banks: For example, some two thirds of U.S. government2
 
bond issues are held as long-term investments by central banks and their associatedsovereign wealth funds. This greater heterogeneity therefore makes for less stability inthe market if the full variety of portfolio holders is not present in the market at any onetime.While corporate bonds could in theory provide stability for the capital market, in practicethey are less efficient stabilisers than government bonds for two reasons. First of all,corporate bonds still have some element of risk associated with them. It is thereforeimprudent for central banks to guarantee the market for corporate bonds, in the same waythat central banks can guarantee the market for government bonds. Secondly, most issuesof equity are to repay corporate debt. This means that, in a phase of capital marketinflation, corporate bond issues are more likely to be reduced, rather than increasing
paripassu
with the increased value of equity. An overinflated equity market may end up on avery thin foundation of corporate bonds.It is true that government bonds too are not perfect stabilisers of the capital market: Thegovernment’s fiscal balance tends to vary in a counter-cyclical way, while the stock market moves with the business cycle, or slightly ahead of it. The result is that the issueof government securities varies inversely with stock prices. However, this is in any casecomplicated by institutional factors, such as the absorption by central banks andsovereign wealth funds of government securities, due to chronic international tradeimbalances. The capital market may still be efficiently stabilised if there is a permanentstock of government debt outstanding that can be converted into long term bonds duringthe boom, taking liquidity out an inflating capital market, and then converted into shorter-term securities to provide stable liquid assets for the banking system in the recession.The banking system too benefits from holding large quantities of government bondswhich, contrary to the view of fiscal conservatives, do not squeeze out lending to theprivate sector. They may do so in a commodity money setting. But in a credit economy,credit is enhanced, rather than restricted, by the availability of larger quantities of readilyrealisable government bonds. The stabilising influence of government securities in bank portfolios is well illustrated in the case of U.S. banks. In 2006 their holdings of U.S.Treasury securities
in nominal terms
were more or less the same as they were twentyyears before. On the eve of their biggest banking crisis since the Great Depression, U.S.banks held negligible amounts of Treasury securities.Therefore, as Minsky argued, a government bond market embracing all financialintermediaries and managed by central bank is essential for stabilising investmentportfolios (Minsky 1986, 33-37). The alternative is more extreme financial cycles and,with the build-up of debt in the economy, an eventual condition of ‘serial’ crisespreventing economic recovery. It should also be pointed out that the above remarks applyto Government borrowing in its domestic currency. The fears of Government default, thatwere so widespread in European financial markets, have a rational foundation in the caseof borrowing in foreign currency. In the case of domestic currency, default does not arisebecause the government always has two options available to manage its internalborrowing. First of all, a Government can increase taxes (for example on holders of 3

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