• In a free-floating fiat currency regime, sovereign bonds are the same as sovereign cash. They do not represent a promise to pay. Rather they are an accounting concept used to measure economic activity over time.
  • There is no bubble in sovereign bonds and the concept of valuation here is meaningless. Bonds are different from any other asset class because they have a terminal value and a maturity structure. They are simple math. No need to put bells and whistles there.
  • If the risk of default of a sovereign bond is 0%, then the only other risk is inflation. If also inflation is 0%? We happily hold risk-free currency in our pockets. Sovereign bonds are just like a savings account with the government instead of a private bank. How much do you get for a 1-year CD with your local bank at the moment? Why should 1-year T-bills yield 100bps more given that it is also better credit?
  • There is no natural rate of interest. Economics is a social science and there are many different equilibria.
  • However, over the very long run, interest rates have fallen from 25% in Babylonian times to almost 0% now in a consistent fashion through the ages. This is a result of the inevitable advances of innovation and the subsequent creation of extra surplus capital accumulation. There is no mean reversion in interest rates.
  • The only time interest rates have deviated from this long-term decline is when there has been a disruption on the supply side which had resulted in the subsequent destruction of capital. Wars and natural disasters or trade barriers and embargoes could be the cause of this.¬†
  • Negative interest rates are just one state of equilibrium. It may seem that they are central-bank imposed, however, the central bank only follows the market forces in their attempt to manage the debt burden.
  • Every single attempt by the central banks in the developed world to raise interest rates post the 1980s has been unnecessary as the economy has had plenty of surplus capital and labor on the back of years of peaceful technological advancement and no negative supply shocks. It has also backfired and led to recessions because of the increasing debt burdens.
  • Recessions are a balancing act. However, if economic balances are not resolved each following recession becomes more severe than the preceding one.
  • As the economy moves away from manufacturing, which requires heavy upfront investment, to services which require much less investment, and now to digital technologies which require even less investment, interest rates substantially lose their power to affect economic activity.
  • If it were not for externally-driven rising healthcare and education costs, US would have fallen in a deflation already in the mid-1990s.
  • If it was not for the decline in the labor participation rate after the 2008 financial crisis, the US unemployment rate would have been much higher. In addition, the jobs created in the last 8 years are predominantly in the service sector, low-wage, and in many cases, without benefits.
  • Yet interest rates affect the balance sheet of the financial sector. However, the effect is asymmetric. Lower rates push asset prices higher and make debts easier to service, but they do not cause an economic boom. Higher rates, on the other hand, cause asset prices to fall, but do nothing to liabilities which stay unchanged. This creates financial imbalances which eventually also cause economic imbalances.
  • Therefore, central bank interest rate policy may be effective in managing the financial economy but it can become a lose-lose game in servicing the real economy.
  • As a result, on one hand, there is an increasing demand for the medium of exchange from income-poor and debt-laden private citizens and for the unit of safety from savings-rich creditors. And, on the other hand, there is inadequate supply of both from the public sector.
  • This is not a recent phenomenon. We had a similar environment in the early 2000s. The market responded by creating fake-safe private assets (repackaged mortgage CDOs and the likes) which allowed the income-poor to buy real estate while it also provided a seemingly safe-haven for the savings-rich.
  • That did not work out well eventually.
  • The rise of cryptocurrencies in the last few years is just the more modern equivalent of these fake-safe assets. They are a result of the advances in technology but they also are a response to this broken monetary transmission mechanism which eventually led to the current inefficient income generation model. ¬†¬†
  • Cryptocurrencies simply fill in the void left by the central bank in its refusal to extend its balance sheet to the public at large. There is no other way for the public to receive the medium of exchange other than direct from the central bank at no cost: the private debt super-cycle in the developed world reached its peak in 2008, while the Work=Job=Income model broke down already in the 1990s. ¬†
  • In the past, we used to call this kind of money creation by the central bank/government direct, ‚Äúhelicopter money‚ÄĚ. It has a lot of negative connotations because of recent historical examples of autocratic rulers printing more money than the economy needed (and often for their own personal use). However, there are plenty of examples in earlier history when ‚Äúhelicopter money‚ÄĚ actually worked in restoring and stabilizing economic growth.
  • Examples of that are the Roman Republic and the Song Dynasty in China when there was a solid institutional infrastructure guaranteeing social accountability.
  • The modern equivalent of ‚Äúhelicopter money‚ÄĚ is central bank digital cash (CBDC – or some version of that). Given the rapid spread of cryptocurrencies, CBDC is inevitable. I wonder, though, whether CBDC would only be introduced after the next financial crisis forces the authorities‚Äô hand.
  • In the present environment of large capital and labor surpluses, CBDC is unlikely to cause a runaway inflation unless it really is misused. The existence of solid institutional infrastructure in the developed world, however, makes that less likely.
  • However, there are still technical hurdles to the wider use of CBDC. Even with good intentions and with impeccable system of checks and balances, the world is too complex for human central planning.
  • What is the right amount of CBDC to inject in the economy? For how long? Does everyone get the same amount? Etc. ¬†
  • Luckily, harnessing the enormous amount of data we have created using advanced machine learning and with the help of the blockchain to organize and store it, policy makers can draw conclusions about economic activity in real-time and thus supply the medium of exchange on demand.
  • Technological advances causing bigger and bigger capital and labor surpluses, the move from services to the digital economy causing lower and lower demand for investments, the introduction of CBDC making interest rate policy obsolete, what happens to our savings? What use is it to us? Can we live without financial assets?
  • This is not a trick question. Developed world governments have been buying up their own debt back and corporates have been buying back their own shares. Maybe that is a trend reflecting the new economic reality as described above‚Ķ ¬†