April 28, 2011

War, Debt, Health Care how are they related?

And a lesson on America’s AAA Bond rating

By Melvin J. Howard

Remember that old song War What Is Good For? Absolutely nothing well that’s not so true at least not when it came to financing it. You have probably heard about Bond no not James Bond.

I am talking about the financial kind. So just what are Bonds a Bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest. There are many kinds of bonds but for this entry we will be focusing on Government Bonds. One of the first persons to master the Bond market was Nathan Rothschild. Master of universe at that time, he boasted that he was the arbiter of peace and war, and that the credit of nations depends upon his nod.

Nathan Mayer Rothschild, founder of the London branch of what was, for most of the nineteenth century, the biggest bank in the world. But it was the bond market that made the Rothschild family rich real rich. Lord Rothschild, Nathan's great-great-great-grandson. Said of Nathan he was 'short, fat, obsessive, extremely clever, wholly focused I can't imagine he would have been a very pleasant person to have dealings with. The Battle of Waterloo was the culmination of more than two decades of intermittent conflict between Britain and France. But it was more than a battle between two armies. It was also a contest between rival financial systems: one, the French, which under Napoleon had come to be based on plunder (the taxation of the conquered); the other, the British, based on debt. Between 1793 and 1815 the British national debt increased by a factor of three to more than double the annual output of the UK economy. This increase in the supply of bonds had weighed heavily on the London market.

Now let’s jump to the other side of the Atlantic to another war the Civil war in America and how the North really won. The South's ability to manipulate the bond market depended on one overriding condition that investors should be able to take physical possession of the cotton, which underpinned the confederate bonds if the South failed to make its interest payments. Collateral is; after all, only good if a creditor can get his hands on it. And that is why the fall of New Orleans was the real turning point in the American Civil War. With the South's main port in Union hands, any investor who wanted to get hold of Southern cotton had to run the Union's naval blockade not once but twice, in and out. Given the North's growing naval power in and around the Mississippi, that was non-starter. If the South had managed to keep New Orleans until the cotton harvest had been offloaded to Europe, they might have been able to sell more cotton bonds in London. The Confederacy had miscalculated. They had turned off the cotton tap, but then wasn’t able to turn it back on. By 1863 the mills of Lancashire England had found new sources of cotton in China, Egypt and India. And now investors were rapidly losing faith in the South's cotton-backed bonds. The consequences for the Confederate economy were disastrous. With its domestic bond market exhausted and only two paltry foreign loans, the Confederate government was forced to print unbacked paper dollars to pay for the war and it’s other expenses, 1.7 billion dollars' worth in all. Both sides in the Civil War had to print money. But by the end of the war the Union's 'greenback' dollars were still worth about 50 cents in gold, whereas the Confederacy's 'greybacks' were worth just one cent. The situation got worst by the ability of Southern states and municipalities to print paper money of their own.

With ever more paper money chasing ever fewer goods, inflation exploded. Prices in the South rose by around 4,000 per cent during the Civil War. By contrast, prices in the North rose by just 60 per cent. Even before the surrender of the principal Confederate armies in April 1865, the economy of the South was collapsing, with hyperinflation remember this word I will come back to it later. Was the partner of the North in the defeat of the South. Those who had invested in Confederate bonds ended up losing their shirts. The North pledged not to honor the debts of the South. In the end, there had been no option but to finance the Southern war effort by printing money. It would not be the last time in history that an attempt to buck the bond market would end in ruinous inflation and military humiliation. The fate of those who lost their shirts on Confederate bonds was not especially unusual in the nineteenth century.

The Confederacy was far from the only state in the Americas to end up disappointing its bondholders; it was merely the northernmost delinquent. South of the Rio Grande, debt defaults and currency depreciations verged on the commonplace. Latin America in the nineteenth century in many ways foreshadowed problems that would become almost universal in the middle of the twentieth century. Partly it was because Latin American republics were among the first to discover that it was relatively painless to default when a substantial proportion of bondholders were foreign. It was no mere accident that the first great Latin American debt crisis happened as early as 1816, when Peru, Colombia, Chile, Mexico, Guatemala and Argentina all defaulted on loans issued in London just a few years before.

But by the later nineteenth century, countries that defaulted on their debts risked economic sanctions, the imposition of foreign control over their finances and even, in at least five cases, military intervention. Defeat itself had a high price. All sides had reassured taxpayers and bondholders that the enemy would pay for the war. Now the bills fell due take Berlin Germany for instance. One way to understand the post-war hyperinflation was a form of state bankruptcy. Those who had bought war bonds had invested in a promise of victory; defeat and revolution represented a national insolvency, the brunt of which necessarily had to be borne by the Germans creditors. At the conference at Versailles, which imposed an unspecified reparations liability on the fledgling Republic the total indemnity was finally fixed in 1921, the Germans found themselves saddled with a huge external debt with a nominal capital value of 132, billion 'gold marks' (pre-war marks), equivalent to more than three times national income. Although not all this new debt was immediately interest-bearing, the scheduled reparations payments accounted for more than a third of all hail Hitler’s expenditure in 1921 and 1922.

Hyperinflation seemed to be the word of the day after the First World War. Austria - as well as the newly independent Hungary and Poland - also suffered comparably bad currency collapses between 1917 and 1924. In the Russian case, hyperinflation came after the Bolsheviks had defaulted outright on the entire Tsarist debt. Bondholders would suffer similar fates in the aftermath of the Second World War, when Germany, Hungary and Greece all saw their currencies and bond markets collapse. It could be easy to associate hyperinflation with the costs of losing world wars; it would be relatively easy to understand. Yet there is a caveat in more recent times, a number of countries have been driven to default on their debts. Either directly by suspending interest payments, or indirectly by debasing the currency in which the debts are denominated.

There is a slight gamble involved when an investor buys a bond. Part of that gamble is that an upsurge in inflation will not consume the value of the bond's annual interest payments. If inflation goes up to ten per cent and the value of a fixed rate interest is only five, then that basically means that the bond holder is falling behind inflation by five per cent.' As we have seen, the danger that rising inflation poses is that it erodes the purchasing power of both the capital sum invested and the interest payments due. And that is why, at the first whiff of higher inflation, bond prices tend to fall. In 1975, as inflation soared around the world, the bond market made the casino’s look like a pretty safe place to invest your money. At that time when US inflation was surging into double digits, peaking at just fewer than 15 per cent in 1980. That was perhaps the worst bond bear market in history.' To be precise, real annual returns on U.S. government bonds in the 1975 were minus 3 percent, almost as bad as during the inflationary years of the world wars. Today, only a handful of countries have inflation rates above 10 per cent and only one, Zimbabwe, is afflicted with hyperinflation.'"" But back in 1979 at least seven countries had an annual inflation rate above 50 per cent and more than sixty countries, including Britain and the United States, had inflation in double digits. Among the countries worst affected, none suffered more severe long-term damage than Argentina.

Inflation has come down partly because many of the items we buy, from clothes to computers, have got cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia. It has also been reduced because of a worldwide transformation in monetary policy, which began with the monetarist-inspired increases in short-term rates implemented by the Bank of England and the Federal Reserve in late 1975 and early 1985. Also trade unions have become less powerful. Loss-making state industries have been privatized. But, perhaps most importantly of all, the social constituency with an interest in positive real returns on bonds has grown. A rising share of wealth is held in the form of private pension funds and other savings institutions that are required, or at least expected, to hold a high proportion of their assets in the form of government bonds and other fixed income securities. With every passing year, the proportion of the population living off the income from such funds goes up, as the share of retirees’ increases. In a graying society, there is a huge and growing need for fixed income securities, and for low inflation to ensure that the interest they pay retains its purchasing power. As more and more people leave the workforce, recurrent public sector deficits ensure that the bond market will never be short of new bonds to sell. People forget just months before President Bush's election, in September 2000, the National Debt Clock in New York's Times Square was shut down at $5,676,989,904,887 it ran out of room. Bush agreed with the principle of paying down the debt but did not have a committed specific date for eliminating it. That lack of commitment on President Bush’s part was a tale tale sign of things to come. When Bush entered the White House, his administration ran a budget deficit in seven out of eight years. The federal debt has increased from $5 trillion to more than $10 trillion when Bush left office the national debt stood at over 11 ½ trillion dollars. The National debt now stands at over 14 trillion dollars.

That is why it is so imperative that health reform take root and not go back to the status-quo with out it we are on a collision course to debt hell. An estimated $2.26 trillion was spent on health care in the United States, or $7,439 per person. Health care costs are rising faster than wages or inflation, and the health share of GDP is expected to continue its upward trend, reaching 19.5 percent of GDP by 2017. As a proportion of GDP, government health care spending in the United States is larger than in most other large western countries. On top of that, there is substantial expenditure paid from private insurance. A recent study found that medical expenditure was the cause for 60% of all personal bankruptcy in the United States. According to Dr. David Himmelstein of Harvard University who helped author the study, "Unless you're Bill Gates or Warren Buffett, your family is just one serious illness away from bankruptcy for middle-class Americans, health insurance offers little protection.

The US spends more on health care per capita than any other UN member nation. It also spends a greater fraction of its national budget on health care than Canada, Germany, France, or Japan, In 2004 the US spent $6,102USD per person on health care, 92.7% more than any other G8 country, and 19.9% more than Luxembourg, which, after the US, had the highest spending in the Organisation for Economic Co-operation and Development (OECD). Hold tight here I am going to have to mention politics hear I know I know but there is no getting around it. Now I know most Republicans would rather not see our country crushed by hyperinflation, depression or default on America’s debt i.e. not lifting the debt ceiling just to prove an ideological point or to try to thwart President Obama’s domestic agenda. If that is the case it is distressing and malice for these issues are far too important to be playing politics with at this time. But history tells me that is exactly what is going on. Extreme conservatives that would be today’s Tea Party fought recovery in the last depression, and Roosevelt did not spend enough to get us out of it. It took World War II to provide the excuse for the enormous deficits that finally jolted the economy out of depression and into overdrive. You might ask yourself why borrow and spend i.e. Economic Stimulus? Let me give you an illustration why? Money flows in circles: you get paid; you spend it, and the store pays someone else, who spends at another store. But what if everyone only spent 10% and saved 90% in the bank? The circular flow of money would dwindle away to nothing, all the money would end up in the bank, the stores would shut down and we'd all be out of work and broke. You know like some of your friends and relatives are now!