For the past several years, really since the financial crisis began in late 2007, the financial world has repeatedly been warned of two evils. The first is called moral hazard. It’s the notion that if we don’t hold people and institutions responsible for their bad decisions, they are likely to repeat their behavior. Moral hazard explains why banks have been reluctant to refinance mortgages, even when the banks themselves may have been to blame for issuing mortgages that could never be paid off. The second is what’s known as kicking the can down the road. This is the notion that if we take our debts and extend their duration, that we will somehow be inflicting pain and suffering upon future generations.
Both positions are defensible, if you really insist upon defending them, but both fly in the face of history and human behavior. The reality is, both people and the institutions they create have short memories. For all the talk about moral hazard, we seem to have a new financial scandal every couple of years. Despite every attempt to regulate the financial behavior of corporations, banks and investment houses, at least a couple per decade will, to appropriate an expression, “go rogue” and leave investors holding the bag.
Barely 10 years ago, the news was filled with stories of the malfeasance of Enron, Parmalat, WorldCom, Computer Associates, Adelphia, Xerox, AOL, Merrill Lynch, Freddie Mac and many more. In the past two years, it’s been Lehman Brothers, Olympus, Barclays, JP Morgan Chase, Standard Chartered Bank and who knows how many more to come, with Bernie Madoff sandwiched in the period between the start and finish of the decade. These scandals involve only American, European and Japanese companies; they don’t begin to touch the rampant corruption of the BRIC nations, those well celebrated rapidly growing economies. From these examples we understand with stunning clarity that moral hazard is not in fact a deterrent to bad behavior, which is why we have laws that even occasionally have teeth, and financial malefactors who are actually sent to jail from time to time.
The second evil is also not what it has been made out to be. Kicking the can down the road is a form of behavior with an extremely honorable past. The process of pushing debt into the far future has rescued the world financial system more than once. In 1722, with the collapse of what has become known as the South Sea Bubble – really the collapse of many so-called bubble companies in England, France and the Netherlands – the global economy, such as it was at the time, was on the verge of imploding. The British government issued gilt securities with a duration of 100 years to pay off the debts incurred and re-floated the economy and was followed by the French and the Dutch. At the end of World War I, a destitute Britain issued another round of 100-year bonds to pull itself out of a severe depression. During the 1890s, when America’s railroads were going through a period of consolidation, and multiple bankruptcies, over 90 percent of bonds issued carried 100-year durations.
Today, 100-year bonds are beginning to come back into vogue in a limited way. Norfolk Southern, the rail and shipping giant, issued $250 million worth of 100- year bonds in 2010 and sold out in days. Both Yale University and the University of Pennsylvania have issued them, as have Anadarko Petroleum Corp., Apache Corp., The Walt Disney Co., Coca Cola Enterprises Inc., Federal Express Corp., Ford Motor Co. and International Business Machines Corp. Could 100-year bonds be the answer to the phenomenal debt overhang that is currently dragging down the global economy?
At the moment, while the U.S. Treasury says that it is studying the impact of issuing such bonds, the trend has been in the other direction. Given the need to constantly refinance current debts and to inject money into a weak economy, the average duration of U.S. Treasury securities is around five years. In the UK, which has a longer history of dealing with long duration bonds, the average duration is closer to 14 years. While the Treasury studies, the appetite for such bonds certainly appears to exist, judging by the increasing number of companies that are taking advantage of today’s ultra-low interest rates to lock in the cash they need now in return for a promise to pay in what they believe will be deflated future money. Indeed, by pushing out duration, the Treasury would be doing nothing more than taking advantage of obvious investor interest, given how well existing corporate and institutional issue have sold. No less a bond expert than PIMCO’s Bill Gross has given a tentative endorsement to the idea, writing that, “The primary basis for making this judgment [to issue extreme long duration bonds] will be the magnitude of the federal government’s long term financing needs; which, at present, are sufficiently bleak as to make the case forcefully.” Gross goes on to say that the effect of such bonds would likely be to flatten or even slightly invert the yield curve, but not seriously enough to cause distortions.
Moreover, the volatile returns from alternatives and equities over the last 10 years have caused pension fund managers to seek safer strategies where the cash flow from their assets can be matched more closely to the their liabilities, particularly pension obligations. So-called liability investing, as a result, is on the increase.
For those who really do worry about saddling our grandchildren with debt, and who really do worry about the moral hazard inherent in pushing the debt a century down the road, there are methods of dampening the impact. First, make the bonds subject to a lottery that would allow the Treasury to recall one percent or more of the bonds each year, depending upon the state of the interest rate environment. In years when the economy was strong and interest rates rise above the rates paid by the bonds, investors will not grumble about forced redemptions. This process has been used successfully for years in sovereign debt issuance by other nations, and is a routinely accepted practice.
Second, the major cause of current government indebtedness is rising pension costs. Government worker pay in most cases is now comparable to private sector earnings, so it no longer makes sense to subsidize government worker pensions with tax dollars that are, in effect, a double tax on non-government wage earners. The current pension obligation bubble will have mostly disappeared by 2050, when the overwhelming majority of Baby Boomers will have died, leaving a steadily declining drain on governments. Take the pension bubble out of future government spending, and 100-year bonds begin to look less like kicking the can down the road and more like a good investment to put away for your grandchildren.