Nearly a century ago, Thomas Marshall, Woodrow Wilson’s vice president, remarked, “What this country needs is a really good 5-cent cigar.” Today what our country and the rest of the world need is a good risk-free store of value. The current paucity of such investments is creating harmful distortions around the world, fueling unsustainable increases in the prices of items as diverse as Minnesota farmland and the Swiss franc.
It is evident in a recent sale of German short-term bonds, in which investors accepted a negative rate of interest. In other words, they were willing to pay the German government to store their euros for them temporarily.
That is a sign of a “disturbance in the force” of global finance if there ever was one, although the same thing happened with U.S. Treasury bills in late 2008. The fact that it now happened with German bonds but not T-bills shows concerns about another volatile variable, the dollar-euro exchange rate.
The vital importance of having a risk-free and relatively liquid way to store wealth is something people don’t think about much in modern economies. Yet it has bedeviled societies for millennia. Until the late Middle Ages, the primary alternatives were precious metals, whether minted into coins or not, and real estate. But coins need to be safeguarded, and properties need to be administered. This isn’t easy for many people. Moreover, land cannot always be sold quickly or in small increments. So people needed a safe, liquid alternative.
Italian city-states like Venice partially solved the problem when they created public debt funds called monti in the 12th century to fund their frequent wars. Forerunners of modern bonds, the IOUs from citizen loans to these funds could be bought and sold so that the original investor could get cash even if the loan had not matured.
These established a precedent in which, if done in moderation, government borrowing could create a relatively safe investment vehicle.
The Dutch and British established modern bonds. Some were perpetual bonds, called “consols” in Britain. These paid fixed interest on the face value, but if the owner needed to take principal out, he had to sell the bond to another investor.
This extremely safe option for whoever wanted to store value from one period to the next proved an enormous advantage to the Dutch and British economies. Alexander Hamilton understood this and argued for a prudently managed national debt as a potential “blessing” to the new American republic.
And thus, on the whole, it has been. Over the decades, we have benefited enormously from the existence of Treasury bonds as a risk-free investment for those who wanted to store value. But the debt has passed the level of being prudently managed.
Moreover, even bonds that are issued by prudently managed governments are a reliable store of value only as long as that nation’s central bank keeps inflation in check. If not, the purchasing power derived from the stream of interest and principal payments over the life of the bond may be less than what was originally invested.
The high inflation in the 1970s while Arthur Burns and G. William Miller chaired the Federal Reserve erased investors’ value on a massive scale.
More recently, investors face enormous economic uncertainty, caused in part by unprecedented central bank creation of the new bank reserves that are the basis of the money supply.
So investors seeking a store of value that is impervious to both default and inflation are in a quandary. Should they:
Buy gold? A good idea five years ago, but now so expensive that it is highly risky going forward. Houses or commercial real estate? Risky when prices continue to fall. Farmland? An even greater bubble than gold. A U.S. money-market fund? Only months ago, these held 35 percent of the short-term borrowings of European banks holding much bad debt.
Put money in savings accounts and certificates of deposit? That’s a safe option for households, though they pay virtually no interest, but not for large businesses or institutional investors.
Flee to the relative stability of another country, like New Zealand or Japan? What if a dollar only gets you 78 yen going in and it takes 95 yen to buy a dollar when you want to get out? And how can a tiny economy like New Zealand absorb the panicked savings of millions of people without its exchange rate moving into a situation like that of Japan?
Europeans fleeing the uncertainty of the euro piled into the Swiss franc, forcing up its value to a degree potentially devastating to this export-dependent nation. Its central bank has fought the rising value of the franc vigorously, but at the risk of internal inflation. Moreover, those buying francs in a panic run the same risks as in Japan – getting out may involve not just a haircut, but a scalping.
The lack of a risk-free investment even drives people to accept negative returns, as with German bonds now. Buyers of these don’t want to put the funds into European banks that are riddled with bad debt and don’t want to take on the exchange rate risk of moving money to the United States or Japan.
This desperate search for safety is part of what is driving bubbles in farmland and drastic fluctuations in exchange rates. And it may get worse before it gets better.
© 2012 Edward Lotterman
Chanarambie Consulting, Inc.