Normally, I’m too much of a rational economist to spend long periods of time in a casino—I just can’t get past the idea of a negative expected return. But several days ago while in Las Vegas for an academic conference, I decided to drop a few chips on the roulette table. Impulsively, I put the entire amount on number 33, recalling the jersey worn by Grant Hill, my favorite basketball player while I was in school at Duke University. Amazingly, the little silver ball came to rest on that very number and my loose change paid out 35 times the original bet!
Somewhat perversely, one of my greater insights of the week came at the roulette table rather than from one of the academic talks. Now, I certainly am not the first observer to draw parallels between investing and gambling in a casino. But the common comparison is to investing in the stock market. Instead, I’d like to discuss how the sovereign debt markets can resemble playing against the house.
At a casino, the house sets the rules and governs the payouts. They have decided that my winning bet pays 35-to-1 (giving me about a –5% expected return), instead of a fair rate of 37-to-1 (which would provide a 0% expected return). And the rules of the game can change. In Monte Carlo, roulette wheels have only a single green zero, while the Las Vegas casinos have added a green double-zero. The subtle impact is to slightly reduce the probability of any single number hitting, though the payout remains constant at 35-to-1, thus boosting the casino’s expected profits (and increasing my expected losses). A small change to the rules of the game tilts the profits more heavily in the casino’s favor.
One of the crucial differences between investing in sovereign debt issues instead of investing in, say, corporate bonds or stocks is that you are, in a sense, playing against the house rather than against other market participants. For example, when a corporation issues a bond, the capital markets establish the appropriate yield on the bonds. The individual company can do very little to influence the coupon or yield on their bonds. And, to the extent the market functions well, the company will pay an appropriate cost of capital and the purchasers of its bonds will receive a free and fair market return for bearing the risk associated with that bond.
In order to set fair prices, efficient markets require market participants that are not constrained and base their buying and selling decisions on a balance of risk and return. The presence of large non-economic participants that have no regard for a return to risk destroys one of the core assumptions underlying efficient capital markets. Like it or not, governments have the power (and with increasingly high debt burdens, increasing motivation!) to create non-economic regulations and incentives that tilt the rules of the game in their favor. Massive amounts of quantitative easing around the globe are examples of this behavior. In the United States, the Federal Reserve implemented “Operation Twist” with the stated goal of lowering the yields on long-term government bonds: Their expressed intent was to push prices away from an efficient market outcome. Their motivation may be a noble one, to stoke the engines of the U.S. economy and provide impetus for job creation. The pernicious side effect, however, is to reduce the profits to investors and increase the profits to the “house”—a transfer of wealth from savers and into the hand of borrowers—chief among them the U.S. Treasury.
Quantitative easing is but one recent example of what economist Carmen Reinhart and others1 have described as “financial repression.” Broadly speaking, the term refers to government policies that channel funds toward their own debt, typically at below-market rates. These policies do not have to be direct market activities. Other examples include imposing ceilings on interest rates, regulating direct lending to the government by captive domestic audiences such as pension funds or banks, and restrictions on cross-border capital movements.
The current period is not the first time in modern history that our global economy has been faced with crushing debt burdens. In their paper “The Liquidation of Government Debt,”2 Reinhart and Sbrancia describe the historical context of financial repression in the post-World War II era. After running high deficits to finance the war, governments tried to return their fiscal houses to order. Government policies such as Regulation Q in the United States capped interest rates, and the heavy capital controls associated with the Bretton Woods system kept domestic savers captive in their home markets. This combination of suppressing interest rates and incentivizing or regulating debt purchasers led developed economies to incur negative real interest rates in about half of the 1945–1980 period. Negative real interest rates provide low costs of borrowing as well as liquidate the existing stock of debt. Reinhart et al. measure the amount transferred from savers to government borrowers by multiplying these negative real rates by the stock of government debt.3 To put the size of this wealth transfer in context, Table 1 displays for a few countries the size of the savings as a percentage of GDP and as a percentage of government taxes.