Exploding the myth of the all-powerful Bond Market

Article by former bond trader Vince Gomez and Mark E Thomas

Introduction and Summary

Every time someone in British politics proposes funding public services properly, the bond market’s reactions get wheeled out like a loaded gun. Spend more on the NHS and the markets will panic. Hire more teachers and investors will flee. Suggest running a larger deficit and the warnings become apocalyptic: the UK, we are told, will face the kind of punishment meted out to profligate less developed countries or non-monetary sovereigns such as Greece. It is one of the most effective political rhetorical devices of the past four decades, but is it true?

A hard look at reality shows that it is a dangerous myth – one which suits a few people and institutions but harms the economy overall and most of the public. The bond market is very powerful compared with, say, a business, but it is impotent when faced with a determined central bank in control of its own currency:

• The bond market is an 800-pound gorilla;
• Our central bank is King Kong;
• With King Kong on our side, we can afford anything we can physically do.

The key imperative for responsible governments is to ensure that they establish control over King Kong, so that they can manage their economies for the benefit of the population as a whole; they should not remain in thrall to the bond markets.

The Bond Market is an 800-pound gorilla

It is true that bond market participants are large financial institutions with resources which dwarf those of most people or even most businesses. Black Rock, for example, has over $14 trillion in assets under management, over $3 trillion of which is bonds.

The claim that bond markets rule is straightforward: the UK government depends on private investors buying its bonds, known as gilts, to finance public spending. If those investors lose confidence, they will stop buying, borrowing costs will spiral, and the government will be forced to cut spending or face a crisis. Therefore, public services must be kept lean, and much of what the state once provided should be handed to the private sector, which the markets trust rather more than they trust elected governments. Accept this logic, or face the consequences.

According to this logic, governments which seek to ignore the bond markets will inevitably be punished. That is the conventional story of what happened to Liz Truss, whose debacle has become one of the most widely quoted examples in explaining why the UK government ‘cannot afford’ to drive national renewal, and one of the most powerful arguments in favour of continued austerity. But as we shall see, it is not true.

Our central bank is King Kong

To be clear, not all central banks are King Kong. If your country does not borrow in its own currency – in many emerging markets, the government borrows in dollars, for example – it is not King Kong, because it cannot create dollars. If your country is part of the Eurozone, your national central bank does not control that currency – the ability to create euros is controlled by the real King Kong: the European Central Bank.

But if, like the UK, the US, Japan or many other countries, you run a fiat currency system and borrow in your own currency, your central bank is King Kong: it can create money in any quantity it thinks is necessary.

King Kong banks can create money whenever they feel it is needed. And they do. The Bank of England has, via  Quantitative Easing (QE), created £895 billion since 2009, of which £875 billion was spent on buying gilts.

And this helps explain what really happened to Liz Truss.

By contrast with the Liz Truss approach, although the Johnson/Sunak government handled the pandemic badly overall, they got at least one thing right. Once ministers understood that without a lockdown, hundreds of thousands of UK citizens would die needlessly, they found a way to fund a furlough scheme. At that time government debt stood at around 85% of GDP. From Cameron onwards, Prime Ministers had been arguing that such debt was dangerously high and there was “no magic money tree,” so there was no way of funding UK public services adequately. Surely, then, it would be impossible suddenly to find a spare £70 billion to pay for a furlough scheme? In fact, no: the UK became the first country to use money creation by its central bank to finance the scheme directly. The Treasury simply instructed the Bank to buy up the bonds issued by the Debt Management Office, without even troubling the bond markets. King Kong flexed its muscles and the gorillas were nowhere to be seen.

Similarly, when Mario Draghi became head of the ECB at the height of the Eurozone crisis, he announced that he would use his King Kong powers to preserve the integrity of the Eurozone:

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

As soon as he said that, yields on Greek and other peripheral country bonds fell sharply. The 800-pound gorillas had to give up.

In Japan, betting against government bonds was once popular, but the trade ended up with the nickname, ‘the widow-maker trade’ as the losses it generated for traders ruined the careers of so many would-be gorillas.

In the US, bond traders have a saying, “don’t fight the Fed [the US Federal Reserve]”.

In every case where King Kong decides to act, the gorillas back off.

With King Kong on our side, we can afford anything we can physically do

But even King Kong has limits. While the Bank of England can effectively print money in any quantity it wants, it cannot print doctors, nurses, scientists or construction workers. Therefore none of the financial analysis means spending potential is unlimited. The limit is set by real-world resources.

Keynes made this point clearly in a BBC radio address in April 1942. This is how he replied to the financiers (whom he addressed as “Sir John”) who were concerned with where the money would come from to rebuild Britain after the war. “The money?” Keynes replied. “But surely, Sir John, you don’t build houses with money? Do you mean that there won’t be enough bricks and mortar and steel and cement?” There would be plenty of those, Sir John agreed. Enough labour? Yes. Enough architects? The conversation grew uncomfortable at that point. Keynes drew the logical conclusion: “If there are bricks and mortar and steel and concrete and labour and architects, why not assemble all this good material into houses?” His correspondent remained unmoved, still wanting to know where the money was coming from. Keynes had his answer ready: “Anything we can actually do we can afford.”

The real constraint, now as in 1942, is physical resources. If a government directs more spending into an economy already running at full capacity, prices will rise. How much the economy can absorb before inflation accelerates is a legitimate question, and the answer changes depending on conditions. Do we have the doctors, the nurses, the teachers, the builders, the engineers, the materials? Those are the questions that determine what is possible.

Right now we have unemployment among doctors and nurses and a large number of unfilled vacancies, and yet as a leaked report seen by the Financial Times makes clear, the former Health Secretary planned to cut staff recruitment drastically. The FT noted that, “Streeting may face questions on the plan as he prepares a leadership bid, with the argument that the previous Conservative government, led by Rishi Sunak, was too generous to the NHS unlikely to go down well with Labour members.”  How could he even try to justify such a plan? The bond markets of course. As his plan put it, “[The previous manpower plan] is a path to financial ruin and would bankrupt both the health service and the country.”

The damage done by politicians who fail to understand our monetary system and by the institutions that keep them ignorant is already huge –  the leaked report is a perfect example of the risk that, if we do not tackle the myth, the damage will only accelerate. The only thing we genuinely cannot afford is politicians who are in thrall to the bond markets.

Conclusion

A small number of people benefit from the idea that bond markets rule. A much larger number believe it. Including many in government. And that belief prevents governments from delivering what voters want and need: economic renewal.

The facts are clear: while the bond markets are powerful, like 800-pound gorillas, they are no match for a determined King Kong central bank. For that reason, taming King Kong by rewiring our financial institutions to make them work for the public good is an essential task for government.

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