In today’s issue:

  • In government, but not in power
  • The new bond vigilantes are in control
  • What do Clinton, Truss and Trump have in common?

Former President Bill Clinton is famous for all sorts of things. Not all of which voters bargained for when they elected him. But did you know who was really in charge of his White House?

His chief strategist James Carville gave it away:

“I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would want to come back as the bond market. You can intimidate everybody.”

As Liz Truss can tell you, the bond market has a history of pushing governments around. Put one foot wrong and the bond market can even unseat a government.

How? By allowing borrowing costs to spike. Nothing makes a politician panic faster than having to pay serious interest on the national debt.

Of course, this only happens when governments borrow too much money in the first place. Even a small jump in interest rates can push interest expenses over the edge when you’ve got a big enough debt to roll over.

But the point is that over-indebted governments are not really in control of their own policies. They need the backing of the bond market. Without it, there’s a crisis.

And that’s what happened to Bill Clinton. The start of his presidency saw the Great Bond Market Massacre. About $1.5 trillion was lost on bonds as prices plunged and yields soared.

Clinton’s famous fiscal conservative stance was the result of this crash. He didn’t have a choice but to try and get the budget back under control. And yet, he gets credit for doing it. As though it was some sort of political masterstroke.

The crash of 2022 rewrote the record books for bond market massacres, with almost $10 trillion in bond losses alone. But few governments seem to have adjusted in the way Clinton did. Austerity wasn’t exactly on the ballot in any elections this year.

Perhaps we’re just too far gone. Voters have decided to ride the bond market for all its worth, even if it ends in a crisis.

But I suspect something else is going on…

Who controls the bond market?

We know bond markets control overindebted governments. But who really controls the bond market?

It’s supposed to be investors – you and me, considering where to put our savings. We could invest them in stocks and hope for capital gains, or buy government bonds for the certainty of their returns.

When we weigh up the investment proposition of bonds, there are several things to consider…

Is the government going to go broke and default on the debt?

Will inflation rise, devaluing the returns we get on bonds?

Will interest rates rise, pushing bond prices lower?

The interest rate at which the government can borrow is determined by how investors answer those questions. Higher risk makes investors demand higher returns. And so, when a government gets into financial trouble, bond yields rise.

But that’s just the theory. In practice, government bond markets are far less of a free market.

The many faces behind bond market prices

Under Bill Clinton, it was the bond vigilantes that were accused of manipulating the bond market. These financial market speculators bet that bond yields would rise dangerously high under Bill Clinton because of deficits. Their bets moved markets. And the higher interest rates on government bonds forced Clinton to sort out the budget.

On the one hand, the bond vigilantes were viciously criticised by politicians. How could financial market speculators be dictating government policy? It’s anti-democratic, for a start. And yet, it was those same bond vigilantes who forced the government to get its house in order in the first place. Without their intervention, the US would’ve gone on borrowing. So perhaps they deserve the credit for the US’ brief dalliance with a balanced budget. Bill Clinton should be thanking the bond vigilantes for his excellent reputation.

Regardless, after the 2008 crisis, something similar happened. The International Monetary Fund’s former chief economist explained it in an article for The Atlantic in 2009: “The finance industry has effectively captured our government.” The symbiotic relationship between the two gave financial institutions great political power.

Symbiotic? Yes, they needed each other to bail each other out.

Here’s how it worked. The finance industry bought government bonds to finance the government. And the government bailed out bust financial institutions. One couldn’t survive without the other’s financial backing.

That explains why politicians were so keen to bail out bankers in 2008. When the bankers were warning of carnage in markets, what they really meant is that the government wouldn’t be able to borrow enough money to finance its deficits. And so politicians gave them whatever they asked for.

Until someone else came along to pay for government deficits…

The new bond vigilantes

The strangest thing about the emergence of Modern Monetary Theory in 2020 is that governments and central banks had been practicing it for more than a decade anyway. They’d created money to buy government bonds, thereby financing government spending.

They called it quantitative easing (QE). And claimed that financing the government was not the purpose. But as I keep telling my daughters, good intentions are not enough to keep you out of trouble. You have to consider the actual effect of your actions. And buying bonds helps finance governments, whether you say so or not.

QE turned out to be a lot more difficult to end than expected. That’s because governments became reliant on its power as a financing mechanism. Especially in Europe during the European Sovereign Debt Crisis which followed 2008.

The European Central Bank quickly discovered that it had rather a lot of power over politicians under its bond buying programmes. If Greek or Italian politicians refused the IMF’s reforms, the ECB would allow bond yields to creep up. The prospect of life without QE was so terrifying to the Greek and Italian politicians that they caved in every time.

Implicit in all this is that central banks had taken over the bond market. They were using the same mechanism that turned Bill Clinton into a fiscal conservative. But it had become a weapon of the central banker.

In 2016, I was sitting in a pub in Limerick when Michael Noonan walked in and sat behind me. To this day I regret not asking the Irish finance minister some awkward questions about the ECB’s role in pressuring governments during the sovereign debt crisis.

Liz Truss, however, has been telling everyone who will listen about the Bank of England’s role in her removal. She was a harsh critic of the Bank, and threatened to reform it. And so she was ousted when the Bank failed to buy government bonds to prop up the government, as it had so many times before.

And that’s the point I’m trying to make. Government debts are now so high in Western countries that governments rely on central banks to buy bonds. Whether central bankers oblige or not is entirely up to them.

So, bond markets controlled governments in the 90s. Financial institutions did in the 2000s. And now central bankers do. They use the bond market as their lever of power over politicians.

The Bank of England didn’t fancy a Liz Truss government. So it got rid of her by allowing the bond market to crash.

Do you think officials at the Federal Reserve like the idea of a President Donald Trump?

Or do you think they’ll try and keep him on a tight leash by allowing bond yields to strangle him at every turn?

If you want to know what central bankers are going to do next, click here.

Until next time,

Nick Hubble
Editor, Fortune & Freedom