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Asia Nikkei Business – December 13, 1994

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December 13, 1994

Special Contribution: Two US Economists Tell the Story

Market Says NO to Inflated Government FRB Shifts to Tighten the Market

The US economic policy remains uncertain while disruption of stock and bond market occurs in and outside the US, in addition to the twisting phenomenon in the Congress and the Government after the Congressional election. Two economists, well known for their innovative viewpoints, tell us “how to read the market.”

Government Bonds Abandoned in Every Advanced Country

Martin Armstrong, Head of Princeton Economic Research Center

The world economy now embraces a crisis which the market has not yet perceived as it is. The true crisis is the liability crisis of the governments of advanced countries. In every advanced country, the government bond market prices are falling. 10-year redemption government bond prices dropped by 21% in Italy, by 18% in UK and by 17% in France since the beginning of this year. The government bonds of longer redemption terms dropped at higher rates.

What is happening now is the escape of capital from the public sector to private one. The market unconsciously senses that further accumulation of government bond is dangerous. On the other hand, at the end of last year, Walt Disney Company in the US issued corporate bonds with 100 year redemption term, which were then all sold out. The market does not trust governments but gave credit to the life of Mickey Mouse.

Some may doubt if this is true. But, go to France to witness this. French investors are selling German bonds. On the otter hand, German investors are selling French government bonds, and the British investors, German government bonds. As a whole, government bonds are abandoned everywhere. It is not only the Federal bond that is abandoned. The Federal government liability was doubled with increased borrowing of 1000 billion dollars during the eight year Reagan regime (1981 – 1988) while the financial state of local governments at the state level remained well balanced. The total surplus reached 60% of the amount of Federal liability. Therefore, the total liabilities of the public sectors as a whole were not so bad as they looked at Federal level.

But now, the financial state of all the states and local governments in the US is in the deficit. The Federal liability showed a slight decrease but it is far from the balanced state. Last year, the total amount of bonds issued by local governments reached 180 billion dollars.

Let me repeat that this applies not only to the US. Due to the increase of government liability, the economy is immersed in deficit in Canada, Europe and even in Japan.

What can governments do? If they cannot borrow any further, they resort to tax increase. But, judging from the share of income in GDP, the limit is up for every country. That is to say, they cannot increase the income any further. Swedish government is the first to experience this. If Japan increases the consumption tax rate, the same thing will happen. If you look at this situation reversibly, this is the reason why government bonds are not sold well.

The market says “No” to inflated government. Take a look at the US. At the beginning of this century, the labor population of the US consisted of those who are engaged in agriculture by 17%, manufacturing by 20%, service industry by 17% and government employees were only 22% of the rest. But now the government employees are close to 40%. If you include the population who earn a living by welfare and the population without a job, one half of the labor population produces no additional value whatsoever. It is clear that this kind of “management” does not work.

Disneyland could sell 100-year redemption bonds but US government had difficulties in selling 30-year redemption government bonds. 70% of the income came from the government bonds of short term redemption of less than 5 years. In fact, the financial deficit decreased slightly mainly because the interest payment was reduced temporarily. But, this shift will raise the short term interest rate, imposing heavier burden of interest payments in the future.

Recall the previous night of the Great Depression in 1927. The long term interest rate of Germany was 6% higher than that of the US. The US government cut the official discount rate by 0.5% to cause capital flow to Europe. The market considered this a liability crisis in Europe. The bond market collapsed everywhere and the stock market sky rocketed absorbing the surplus capital. In a panic, the FRB (Federal Reserve Board) raised the official discount rate to 6%. The stock prices slumped, resulting in the plunge of the government bond prices. The UK government declared half-year moratorium to redeem the government bonds. Capital has “consciousness under subconsciousness.” The similar thing may be happening today. It may be a forewarning that the US government bond prices plunged by 20% in September…

If you invest in the US, you have no choice but the stock market. But, as the market refuses the government as a whole, the trend has historical context. You should keep your eyes wide open.