GOVERNMENT BONDS AND EUROPEAN DEBT MARKETS

Jan Toporowski

‘The international financial system is already in such a state in which as soon as the holes
in 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 events
reveal that the crisis is much deeper and this greater depth is expressed in the serial
character of the crisis. Current models show crisis as a shock in a dynamic stochastic
general equilibrium, with contagion effects arising because heterogeneous agents hold as
assets each others’ liabilities (see, for example, Goodhart, Sunirand and Tsocomos 2004).
However, the actual course of events since the 2007 financial crisis emerged seems to
suggest 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 crisis
has moved from modelling the resumption of general equilibrium among agents
abstracted 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. The
first section of the paper discusses the mechanisms by which a well-managed
Government bond market may stabilise capital markets in nominal, or cash-flow, terms.
The second section looks at the crisis in European government bond markets and
suggests 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 the
composition 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 theory
largely omits considerations of liquidity: The standard definition of financial equilibrium,
a situation in which no further arbitrage is possible implicitly assumes that market
liquidity is available on demand. As recent events have demonstrated, such liquidity has a
disturbing tendency to disappear when it is most urgently required (See Nesvetailova
2010).

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In the paper that follows financial stability refers to the maintenance of the money price
of financial assets. These money values are the key parameters for maintaining payments
on banking and financial commitments. This is for two reasons. First of all, with the
exception of inflation-related derivative instruments, or index-linked bonds (see below),
the cash payments that issuers of financial instruments make are related to the nominal
value, and not the value of such instruments in relation to goods and services. Secondly,
and perhaps even more importantly, payments on financial obligations are money
commitments. They cannot be replaced by delivery of goods and services. Where
payments on financial obligations are hedged by other assets, those assets have to be sold
to 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, and
not on real ones.

This does not mean that inflation in markets for goods and services may not threaten the
stability of banking and financial markets. It may do so as part of a general debt deflation
problem, or a devaluation of money contracts. But the result is a macroeconomic
problem, rather than strictly a default on payments commitments arising out of the
operations of banking and financial markets.

In an earlier study, I argued that, in a capital market with debt and equity, a high
proportion 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 and
expectations in the market for those bonds. Financial intermediaries’ balance sheets can
be constructed in such a way that future payment commitments may be matched with
assured future payment receipts. By contrast, shares or common stock have no ‘assured
residual liquidity’. The wider dispersion of possible future values makes these stocks
preferred vehicles for speculation, i.e., purchase for capital gain rather than income. An
extended period of capital market inflation boosts equity prices and this distorts the
preferences of investors towards equity, and encourages equity financing without stable
market values (Toporowski 2000, pp. 23-24). Index-linked bonds, or hybrid bonds
currently recommended as a source of bank capital, are clearly in between the
equity/bond distinction, having the appearance of bonds, but without the assured residual
liquidity of equity. Index-linked bonds invite potentially destabilising speculation against
future inflation, and hybrid bonds may arouse similar speculation against bank
insolvency.

A high proportion of bonds in the capital market therefore makes those markets more
stable and less speculative, because of the limited scope for capital gains. In turn, such
reduced variability would make for more consistent portfolio and financing choices, and
a sounder basis for the expectations of market participants. The greater stability of the
market should be reflected in the stability of an ‘average’ portfolio of financial assets.
However, once portfolios become heterogeneous the ‘average’ portfolio becomes less
representative. 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 hedge
funds, with much less diverse portfolios. The second is the absorption of large quantities
of government bonds by central banks: For example, some two thirds of U.S. government

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bond issues are held as long-term investments by central banks and their associated
sovereign wealth funds. This greater heterogeneity therefore makes for less stability in
the market if the full variety of portfolio holders is not present in the market at any one
time.

While corporate bonds could in theory provide stability for the capital market, in practice
they 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 therefore
imprudent for central banks to guarantee the market for corporate bonds, in the same way
that central banks can guarantee the market for government bonds. Secondly, most issues
of equity are to repay corporate debt. This means that, in a phase of capital market
inflation, corporate bond issues are more likely to be reduced, rather than increasing pari
passu with the increased value of equity. An overinflated equity market may end up on a
very thin foundation of corporate bonds.

It is true that government bonds too are not perfect stabilisers of the capital market: The
government’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 issue
of government securities varies inversely with stock prices. However, this is in any case
complicated by institutional factors, such as the absorption by central banks and
sovereign wealth funds of government securities, due to chronic international trade
imbalances. The capital market may still be efficiently stabilised if there is a permanent
stock of government debt outstanding that can be converted into long term bonds during
the 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 bonds
which, contrary to the view of fiscal conservatives, do not squeeze out lending to the
private 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 readily
realisable 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 twenty
years 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 financial

intermediaries and managed by central bank is essential for stabilising investment
portfolios (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’ crises
preventing economic recovery. It should also be pointed out that the above remarks apply
to Government borrowing in its domestic currency. The fears of Government default, that
were so widespread in European financial markets, have a rational foundation in the case
of borrowing in foreign currency. In the case of domestic currency, default does not arise
because the government always has two options available to manage its internal
borrowing. First of all, a Government can increase taxes (for example on holders of

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government bonds) in order to service its debts. Secondly, the Government can always
refinance along the yield curve, e.g., reducing short-term interest rates and issuing short-
term bills, the proceeds of which can be used to buy in long-term government bonds.
Such short-term bills are usually readily held by banks because of their liquidity: on
maturity, the Government can usually repay the bills through a new issue of bills. Only in
extreme cases, such as in conditions of hyperinflation, would such debt management be
impossible.

2. Stabilising European capital markets

Within the Eurozone the cyclical issue of government securities that was mentioned
above as an impediment to efficient capital market stabilisation has, in practice, turned
out to be less of a factor in the issue of government securities because, contrary to their
best intentions, the founding fathers of the European Monetary Union have failed to
harmonise the respective national business cycles of member countries. Harmonisation
was supposed to be a condition for joining the monetary union. However, when
harmonisation failed, the effect of the common monetary policy should, if monetary
policy works as intended, make business cycles diverge even more: The common
monetary policy set by ‘average’ conditions in the Eurozone would tend to be too
inflationary for the countries in a boom, and too deflationary for those countries
experiencing recession.

In principle, such a situation should keep a stable supply of government bonds in the
Eurozone capital market. However, the institutional rules of the Eurozone are resolutely
hostile to government bond stabilisation of the capital market. The fact that there has not
been a major capital market crisis (notwithstanding the current serial government bond
crises) says rather more about the immaturity of the Eurozone capital market than about
any natural equilibrium properties that it may have. The hostility to government bond
stabilisation arises out of the view prevalent in the most powerful country of the zone,
Germany, that central banks should not in principle hold government bonds in their
portfolios, other than for repurchase purposes, because to do so would be to monetise
government deficits. This, it is believed, is inflationary. This principle is incorporated in
the rules that are supposed to make the Eurozone central banks ‘independent’ of
governments. The result of this reluctance to hold government debt is that the ECB
instead monetises private debt or issues its own paper. Such private debt, issued and
monetised to excess, is causing serial crises.

The outbreak of the crisis in 2008 placed different financial pressures on different
governments. Without central bank management of the government bond market,
premiums emerged on bonds issued by different governments. As the table shows, these
premiums are unrelated to the actual debt/GDP ratios, but are largely influenced by
perception of banking crises in different countries. Yet in Greece, which set off the
Eurozone crisis in 2010, there has been no bank crisis.

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Government Debt and Bond Yields

Government Debt as % of GDP Spread of 10-year

Government bonds
2010 2013 over German bunds
(basis points) (Jan.11)

Greece 130 144 880

Italy 118 120 196

Belgium 100 106 134

Ireland 94 105 625

Portugal 83 92 423

France 84 90 47

Hungary 78 80 522

UK 77 86 63

Germany 75 77 0

Austria 70 75 58

Netherlands 66 74 23

Spain 63 79 270

Source: International Monetary Fund, Financial Times (11 January 2011) and author’s
calculations.

Germany itself, whose government issues the benchmark bonds for the Eurozone, owes
the stability of its government bond market less to the prudence of its government, and
more to its pension system which is obliged to hold large quantities of government bonds,
with maturities matched to pension liabilities. The German pension system therefore not
only stabilises itself against the problems of pension fund maturity that have wrecked
equity-dependent American and British funded pension schemes. By buying in large
quantities of government bonds, the German pension system also helps to stabilise the
market for such bonds and keeping the yield on 10-year bonds at a low of 3.26%.

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However, in general institutional investors’ holding of government bonds cannot be an
effective stabiliser for the market in such bonds. It works in Germany because the
distribution of income and wealth is relatively equal, and pension funds there have a
correspondingly greater influence over the capital markets. Most other countries in the
Eurozone have a more unequal distribution of income and wealth. This gives their
pension funds less influence over their capital markets. The institution that is, most
generally, best placed to maintain a liquid market in government securities is the central
bank, in particular because it has the capacity to expand and keep its balance sheet liquid
in a way that other institutions cannot.

Conclusion: An ‘Optimal’ Government Bond Issue?

The above analysis suggests that three conditions must be in place to avoid serial crises
of financial systems. First of all, the supply of government bonds in private portfolios
should be sufficient to maintain the liquidity of private capital markets. Secondly,
participants in banking and capital markets should be obliged to hold government paper
in some proportion of their portfolios (as German institutions are obliged to hold
government securities). Thirdly, central banks should maintain a liquid market in
government securities. Only in such conditions can capital markets maintain the stable
liquidity necessary to price assets in accordance with their assessment of the economic
prospects of the issuer of financial paper.

Thus the determination of the ‘optimal’ govt bond issue should not start with some
arbitrary ratio of government debt to GDP, or fiscal deficit, let alone some nebulous
Ricardian prospect of being able to repay all the debt in the future, as Barro and some
New Classical theorists have suggested. In a capitalist system with sophisticated financial
markets, the starting point has to be the size and value of the capital market that needs to
be stabilised. This determines the issue of risk-free government paper that must be held in
private portfolios. Only the government and its central bank can do this because only the
government can operate along the whole yield curve all the time, and such policy must be
integrated with monetary policy and, as recent events have shown, with the function of a
lender of last resort.

References

Goodhart, C.A.E., Sunirand, P., and Tsocomos, D.P. (2004) ‘A model to analyse
financial fragility: applications’ Journal of Financial Stability vol. I no. 1, pp. 1-30.

Kalecki, M. (1932) ‘Czy możliwe jest „kapitalistyczne” wyjscie z kryzysu’ (Is a

„capitalist” way out of the crisis possible) Przegląd Socjalistyczny 2/10, pp. 1-2.

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Minsky, H.P. (1986) Stabilizing an Unstable Economy New Haven: Yale University
Press.

Nesvetailova, A. (2010) Financial Alchemy in Crisis: The Great liquidity Illusion

London: Pluto Press.

Toporowski, J. (2000) The End of Finance: The Theory of Capital Market Inflation,
Financial Derivatives and Pension Fund Capitalism London: Routledge.