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I've surmised from years of reading the economic press that there's really only one bad thing that can happen in a capitalist economy: bondholders not getting paid. Heck, lots of commentators argue that war is good for the economy, a natural disaster is good for the economy, the broken window fallacy is a mainstay of Keynesian economics. However, bondholders not getting paid is something that should be prevented at all costs! The federal reserve is doing $40 billion a month of bond buying with electronically printed money (quantitative easing) so the bond holders get paid!

"I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody." - James Carville

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That's not really how it works. Bondholders don't get paid all the time. This is priced in and isn't a problem for a capitalist economy unless the actual rate of defaults significantly exceeds the expected rate of defaults as predicted by bond ratings.

Massively fraudulent credit ratings on mortgage bonds was one of the things if not the thing that precipitated the 2008 housing/economic crisis. Your comment reads like you think bond ratings are mostly accurate but recent history tells us they can't really be trusted.

Yes, massive fraud is one factor that can cause bond defaults to significantly exceed those predicted by credit ratings. Other reasons can include disruptive technology, natural disasters, armed conflict, and other "black swan" events.

What does "priced in" actually mean? A low probability event should be priced in, with the appropriate small but non-zero coefficient. If you get hit by a "black swan event" couldn't you say that your model failed to account for it?

In practice, "black swan" is supposed to mean effects which we underestimate or fail to predict at all. The definition requires not just rarity but an event which hasn't been seen before, and is only only understood in retrospect.

You can try to leave a general hedge for unknowns, like never giving anything >99% long term confidence. But actually pricing black swan problems accurately should be impossible, pretty much by definition.

It just so happens that people, when making predictions, are not very good at accounting for ("pricing on") those kinds of events.

Ha ha. No they (the people who make real deals/trades/decisions) are just focused on their bonus. Having said that they also care a bit about their bonus. And of course their bonus is important too. Have I missed anything?

I think you're mostly comprehensive there. You missed out two things though: they care about their bonus, and secondly, how that bonus compares to their peers (which could be summarised as "their bonus").

After which they blame the "bad model" and immediately pass on to constructing newer, presumably better models. The fact that maybe, just maybe, trying to model such a thing as a modern-day economic system is futile never crossed these people's minds.

You are being unfairly downmoderated. It is of course not a given that modeling economic systems is impossible, but there is considerable debate as to e.g. what degree prices are random/unpredictable. Everyone agrees the problem is extremely difficult, and it seems somewhat unlikely that there would ever be such thing as a universally applicable financial model. So the remaining question is, of course, to what degree are these models useful? I do not believe there is sufficient evidence to reject the idea that the models are of no utility, especially in the context of failing to price in risks. The contrary position is equally viable, and I would hope anyone with what they considered to be a knock-down argument would do more arguing than knocking down.

Fair point, but the whole impetus for this reporting is that Fitch, one of the big 3 ratings agencies, has raised the issue and acknowledged that the full effect of battery technologies exceeds the time frame of their rating methodologies and so they're urging utilities to diversify into clean energy. I know that doesn't absolve them of past sins or even imply that they can be trusted, it just struck me as ironic that a warning from one is the basis of this post and discussion. They're doing their job here.

Less fraud than you might think. It was more the model where house values would increase or level off not crash, which meant worst case was recovering X% vs 100+% where x% would still cover the outstanding loan. Which allows you to slice and dice very low risks loan value from junk, not because most people are going to pay back, but because the houses have high inherent value.

Their scapegoat was the model. In reality they could probably make a model that gave whatever rating the client desired. That is the fraud, they weren't working in the interest of the investors they were working in the interests of the investment bankers.

https://www.youtube.com/watch?v=19amWOc1GJ8

https://www.youtube.com/watch?v=whlzFWwVv98

In any organization whoever pays the bills tends to get what they value - because they can decide to pay someone else if they feel they're not getting it. All the "arms-length", "neutral" stuff - even if truly well intentioned - get impacted by whatever the payer wants.

In case of mortgage bonds, the bill payers were bond creators who wanted to get the loans off their books as quickly as possible. The buyers should really know better but they too were largely managers whose salary was paid on % of assets basis with no real downside impact on their own wealth.

Can you cite evidence of actual fraud in the typical bond rating?

Note: making wrong assumptions (explicitly stated) about the future is not fraud. I.e., "I think housing will never go down" is not fraud.

That's not really how it works either. Bondholders usually trust the ratings agencies (this trust is often mandated by law for pension funds, etc.) which have often basically lied about ratings because they were paid by the issuer.

When challenged on this they usually claim the first amendment (i.e. license to lie), although S&P went a step further and downgraded the US in a fit of rage when the SEC started investigating them for ratings fraud in 2011. Ironically interest rates on US treasuries went slightly down afterwards.

> although S&P went a step further and downgraded the US in a fit of rage when the SEC started investigating them for ratings fraud in 2011.

At the time, the US government was actively considering whether to default on US Treasuries. The downgrade wasn't some petty revenge.

At no point even during the height of Republicans' "government shutdown" was the US government ever actively planning on defaulting on US treasuries.

Their rationale was, in any case, that "entitlements spending" was too high:

https://www.theguardian.com/business/2011/aug/06/sandp-debt-...

The entire rest of the market (and the other ratings agencies) were just about able to determine that if you have the keys to the cash printer you're actually not in danger of running out of cash and political bickering doesn't translate into risk of political suicide.

The white house and congress was deadlocked, the government was shut down, and the treasury was not legally authorized to borrow more to make payments. There was talk of a trillion dollar coin to side step the national debt cap. This was a really big deal, and people were scared the maneuvering wasn't going to work in time. It totally justifies a small credit rating downgrade.

It was pure political theater. Any attempt to actually trigger default would have been political suicide for whomever tried it.

When actual credit events look likely it triggers a sharp rise in interest rates. It looks like this:

https://4.bp.blogspot.com/-9UVV9J6AdU0/TzxG9W26TsI/AAAAAAAAC...

That did not happen. Nothing happened. Not even a blip. The market (correctly) assessed this as being the usual partisan political bickering.

Oh come on. This is partisan hackery. This "theatre" did in fact cause vital government functions to shut down. I was personally on a project where I had to stop work because our checks were sitting on a table in Washington and a major milestone meeting was canceled because the government was furloughed and would not be there, throwing the entire project schedule off. This was replicated thousands of times across the economy.

Even the ghost of a chance of going down to the wire as to whether a bond payment would be missed by a single day on US obligations, is in itself tremendously disruptive. The economy is structured around U.S. debt as being the safest paper there is. Don't downplay just how dangerous dicking around with this for partisan points was.

No, playing up the fearmongering as you are doing right now is partisan hackery. The main Democratic talking points centered around fearmongering, after all, which was almost as stupid as the Republicans temporarily shutting down the postal service, etc. in a fit of pique.

As I said before: the markets correctly characterized the debt ceiling negotiations as a bunch of drama queens on both sides of the political divide acting up & a storm in a teacup because neither side is politically suicidal.

However, a fair number of tea party members in congress were actively promoting defaulting on the debt. That's different than some random guy with a page on the internet. That's a lawmaker with a vote who can affect the outcome. So their political career would be hurt. The election wasn't the next day, it would have taken a long time to replace those yahoos and the damage would have been done. Examples:

Ted Yoho, rep for Florida, http://www.rollingstone.com/politics/news/the-tea-partys-gov...

Trump (who isn't in congress, but had a shot at being president: http://mediamatters.org/research/2016/05/08/media-slam-trump...)

yes, it is nuts, but people who vote in congress supported it, and the pres. candidate of one of our two parties also said that.

Actually, most of the Republican party is in the process of committing political suicide right now. Enough with your vacuous false balance.

You are right sir. And after the ratings agencies downgraded US debt, they actually appreciated in value. Because anyone who understands government finance knows that issuer's of currency cannot default on their own debt instruments unless they want to.

Check out HyperNormalisation by Adam Curtis - should be on interest.

Almost.

Various parties are required to trust that anything rated D or whatever is risky. They aren't required to trust that AAAAAA+ means risk-free.

Excuse me for stating the obvious. Nothing is risk free. Indeed even cash is not risk free.

Right, and nothing on the planet is black, because there always some minor light reflection.

In real life, this sort of sophistry only makes terms like "risk-free" and "black" useless.

Not all bond holders get paid, however one's who bonds support a public pension will get paid. the courts and government have already shown a great disdain for the law (bankruptcy) and will pay one class before another even if the law specified other. Also, tax payers are on the hook for any and all failed bonded backed pensions.

I fully expect that energy companies have already started to diversify and buy into industries that could disrupt their earnings. Good successful corporations know when to move, RJ Reynolds is probably the best example of a company diversifying when its main product started to become a liability.

Private investors and tax payers are the only victims. The first because their investment is gone and the second who has to pay to fix the the public employee pension funds that may have purchased the same bonds which means the first party is actually stung twice

Ultimately, a company has to pay up, or liquidate what it has in order to pay its debts. If it can't do that, then those who hold equity get shafted. That's just a function of the capital structure.

A government uses debt to pay for stuff. If it defaults on its own debt, it hurts its ability to generate funds without printing currency. So if a government defaults, it not only incites domestic panic and foreign wariness of its markets, it also loses the ability to affordably borrow to pay for programs that can right the ship.

Even for companies where bonds are pricing in a substantial probability of default, it's a big deal if they fail to service their debts. Sprint can survive a 30% drop in its stock price. It probably can't survive defaulting on 30% of its debt.

Well, not getting paid is a pretty good incentive to make sure the expected rate of defaults closely approximates the actual rate of defaults. Maybe bondholders ought to try that sometimes.

> The federal reserve is doing $40 billion a month of bond buying with electronically printed money (quantitative easing) so the bond holders get paid!

Nope.

The US Federal Reserve did three rounds of QE, and round three ended in October, 2014. This is not an ongoing program.

https://en.wikipedia.org/wiki/Quantitative_easing#US_QE1.2C_...

> the broken window fallacy is a mainstay of Keynesian economics

No that is actually not true. You'll find the broken window theory espoused by dingbat modern economists[1] and business people[2] but not hoary old Keynesians and NeoKeynesians. Keynesians believe somethings different which is that if you have a demand and production shortfall due to excess debt and fear (dread zero bound), then the government can help by creating demand. AKA borrow money to pay for labor and materials and use that to build useful stuff. Experience from WWII in the US shows that it'll work even if the stuff is not very useful.

[1] Because modern economics isn't an applied science practitioners are allowed to believe what they want about the real economy.

[2] Leaned about the broken window theory at the country club bar.

> there's really only one bad thing that can happen in a capitalist economy: bondholders not getting paid.

Maybe I over-read it at the time, but I got the same feeling after reading a history of the 1500s Mediterranean countries (Braudel's "The Mediterranean and the Mediterranean World in the Age of Philip II"), more exactly that the a very great injustice had been made to the bankers of the time (mostly the Genoese and Fugger family) for not getting their money back from the King of Spain, to which they had lent a lot of money (it's like they had gotten a big haircut on present-day Government bonds). There's an interesting discussion about that at this link: http://history.stackexchange.com/questions/4432/what-were-th...

It might be just true. Destroying value is not such a big deal since after all value can always be created.

But when bonds default people start losing trust in fiduciary instruments. And trust is much more difficult to build than pure value.

Agreed, but I find it funny/dangerous how bond markets can get into risky positions and then demand to be bailed out because they basically argue that bonds shouldn't be risky.

Fannie/Freddie bonds before the housing crash were a perfect example of this. All the information marketing the bonds came with specific warnings that they were not backed by the US government and didn't carry any "explicit or implied" government guarantee. Of course, this turned out to be bunk, and the bond markets knew it, which is why Fannie and Freddie were able to borrow money at lower rates than everyone else. When push came to shove, everyone knew Fannie and Freddie were too big to fail and the government would have to bail them out. I wouldn't be surprised if history repeats itself.

> Destroying value is not such a big deal since after all value can always be created.

?! I'm not sure what you mean by that, but value is rather hard to create. Certainly the value in real estate and physical goods. Stock value and services are a bit more ephemeral.

But the reason Keyensian hole-digging makes sense is that labour is a wasting good - you can't store the output of people who would otherwise be unemployed, and having people unemployed does long term damage to productivity.

Almost. Hole-digging isn't any meaningful sort of employment, it's merely a tactic to put dollars in the hands of consumers, increasing "aggregate demand" (consumer spending), which DOES provide employment, as that spending is spent on OTHER people's otherwise-unemployed labor (not the hole-diggers' labor)

>>Almost. Hole-digging isn't any meaningful sort of employment

We aren't talking about literal hole-digging. There are a ton of infrastructure projects in America (highways, bridges, etc.) that could use the labor in construction.

Bonds are not net value, just an asset and an equal liability. Default is just a redistribution.

I think that's undervaluing the time value of money.

How? A debt is a promise to transfer. A default is equivalent to a repayment plus a theft.

The only sense in which value is destroyed is if the money ends up in the hands of someone who less productive at invest it. But that can't really be predicted. If value is lost in a default, the value was already destroyed in the past, regardless default choice.

My point was that the only reason to take out a bond in the first place is time value of money: the auto industry needs them for its inventory and input parts. Bond markets seizing up present a problem for this kind of company, because it's possible to be profitable but bankrupt due to cashflow issues if the company cannot roll over its bonds when they fall due.

Bankruptcy causes real destruction of value as inventory is sold at liquidation prices and the concentration of knowledge and organisation that makes a firm valuable in the first place evaporates.

Debt is trivial for private banks to create t siphon off wealth creation.

I'd say wars since Vietnam have eroded quite a bit of trust.

>broken window fallacy is a mainstay of Keynesian economics

That's a crass (although depressingly common) straw man of one of Keynes' views.

He mentioned that paying people to dig a hole/fill it up was one way - though emphatically not the most efficient way you could escape from a liquidity trap.

The reason why digging holes was suggested is if it wasn't a useless economic activity it wouldn't be politically acceptable. If the government employed workers produced anything of value they would compete with private companies.

"It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly ‘wasteful’ forms of loan expenditure rather than for partly wasteful forms, which, because they are not wholly wasteful, tend to be judged on strict ‘business’ principles. For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest; whilst the form of digging holes in the ground known as gold-mining, which not only adds nothing whatever to the real wealth of the world but involves the disutility of labour, is the most acceptable of all solutions." - Keynes

There was his observation that if building ships full of war stuff and sending them across the Atlantic for the U-Boats to sink was enough to shake off the great depression the US certainly didn't need to wait ten years for the Germans to declare war.

If one looks at the composition of debt 1920-1950 what happened during WWII is the US government essentially took all of the commercial and consumer debt onto it's own books.

Planet Money did a great episode on Argentina, which decided at some point to default on its debt.

http://www.npr.org/sections/money/2016/03/11/470136949/episo...

Argentina didn't decide. It couldn't pay the interests anymore. It was a snowball of crazy high interest rates in a foreign currency. You can't pay your debt if it's much higher than GDP growth even with a surplus. And Argentina had neither growth nor surplus, thanks to the idiotic IMF economic plans with a currency pegged to the US dollar.

A better point might be, why were they lent money in the first place?!?

Debt to GDP ratios can also be described in terms of how long it takes to produce GDP equal to the debt. Owing 100% of GDP is owing one year's product. Whether that's a significant dividing line depends on rates of interest and growth.

And to a de-facto government.

When a company fails the bond holders get paid first. Bonds are also the rich man's way of getting paid by governments. Lending money to finance war has always been a nice way to trap governments.

> Bonds are also the rich man's way of getting paid by governments.

Unless the government, which has the power to break the agreement, breaks the agreement.

The history of finance is well-woven with the thread of sovereign defaults.

When this happens is it true that if a person had invested in private or publicly listed companies their money would have been safer?

I'm just thinking that by the time a state defaults on bonds the "rich man" may be facing a bundle of problems.

How much would diversification help in those circumstances?

> When this happens is it true that if a person had invested in private or publicly listed companies their money would have been safer?

For a while during the 07-09 financial crisis, Coca-Cola bonds were priced by the market as less risky than Treasury bonds.

If your investments are all inside the country That defaults on its debt then yeah your fucked anyway, but if you're investing in a country's debt and you have little other exposure to said country, then their defaulting on the debt is the only thing that's fucking you. Argentinas default is the best example of this problem.

> When this happens is it true that if a person had invested in private or publicly listed companies their money would have been safer?

Large multinational corporations are probably safer than the riskiest countries if that's what you're asking.

They may be much safer, or they may be completely gone in any random afternoon. I guess, strictly speaking, that makes them safer.

nit: quantitative easing was ended in October 2014. The Fed is not currently buying bonds and is doing a combination of selling off some bonds and letting others mature.

While I don't agree with everything you said, you are right that modern economics puts a lot of emphasis on the bond market.

Their reasoning is that the bond market is like a giant, distributed bank. Bondholders borrow short-term, and invest long-term, thus providing liquidity for businesses that need to make long term investment.

The problem is, we have no idea what the actual economics of liquidity provision is. The standard Diamond–Dybvig model is used to justify bailing out the banks (and also the "shadow" banks, i.e. the bond market) when things go bad. But if the Diamond–Dybvig model is correct, then liquidity provision is a mechanical process that could be done just as well by the government, and the bond market is just a way to get the free market to do this at exorbitant cost.

We need better theories to understand liquidity. I think the best work in this area is by Holmstrom and Tirole. Holmstrom's nobel price should help raise the profile of this work.

https://www.bloomberg.com/view/articles/2016-07-18/bond-trad...

>My rough definition of a financial crisis is that it's when someone borrows money from someone else, and can't pay it back, and it is politically and socially unacceptable not to pay it back.

Most of the bondholders are pension funds and (re)insurers, which makes not getting paid have knock-on consequences for the rest of the economy.

A questions, is the broken window a fallacy if it forces you to spend money when instead you were just going to put it into the bank, and there is already enough money in the banks.

It's not. That's the original Keynesian analysis of the liquidity trap. Dollars have no inherent stored value, so putting them to use can improve economic productivity, even if the reason they start moving is silly.

Breaking windows is a stupid way to crate liquidity though. Better to do some debt-financed spending without destroying anything. For example, the USA's CCC and TVA, that started ending the Great Depression.

Is that an argument in favor of China's relentless infrastructure spending?

Unless we're talking about physical cash under a mattress, "stored" dollars in banking are put to use through loans and investments.

That's why I think a war with the US and China would never happen. Too much debt wouldn't be paid and it isn't actually profitable.

Well, they say that the economy has never gotten in the way of a war. I wouldn't completely rule it out. Most likely there would be some sort of skirmish, but not a full war.

But do recall that people said the same thing before World War I. All you need is some yahoo to kill the wrong person .

It's deflation, the fear is deflation...

People of Ireland here...

Can confirm.

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