Today, I’d like to dig into what I believe is a financial sleight of hand which politicians have pulled on you, in the hope that it doesn’t blow up until they’re safely working as a lobbyist for the financial services industry. But few people understand what it really means when government funds buy government bonds…
Despite this being the most important issue at hand for everyone on either side of retirement, I’ve never encountered anyone who has actually done anything about it. It’s just too…uncomfortable to acknowledge. It’s much easier to ignore the problem.
That is, unless you’re reading this… In which case, you need to sit up and pay attention now to avoid a potentially nasty surprise.
I’m talking about what occurs when governments set up a fund that invests money to meet some sort of future benefit payment, but the investment they choose is government debt. It sounds like a prudent and sound thing to do. But, as you’re about to discover, this simple act turns two liabilities into an asset – an accounting version of alchemy. It is alchemy that is only exposed when the fund runs dry and disaster strikes.
Shockingly, this issue could also trigger a sovereign debt crisis by exposing, what I believe to be, the “sleight of hand” that has occurred with our money, leaving the government itself broke.
For today, I’m going to use the National Insurance Fund (NIF) to explain how all this plays out, and what’s really going on. But the same applies to an endless list of government funds around the world which were ostensibly set up to save money to meet future entitlements.
You see, the opposite happened. That money was spent by the very governments which claim to have it saved up and safely invested for future use.
Here’s how the sleight of hand works as I see it…
Governments promise us all sorts of expensive things. These become the government’s liabilities – future payments which will supposedly be met. Keep that fact in mind: government promises to pay are government liabilities.
Largely because of demographic change, many of the government’s promises have long been known to be unaffordable. In response, governments set up various funds like the National Insurance Fund. The idea is simple. We pay money into these funds and that money is invested. Then, when we need it, we sell the investments and use the money to pay for the unaffordable promises.
But here’s the trick: that money is invested in government debt – a government liability itself. One that is used to raise money to fund annual spending.
In other words, the money “invested” on our behalf by the government to save up for future government liabilities is spent by the government. It is used to fund the government’s day-to-day activities.
Of course, an asset is left in the fund – a government bond. But to me the sleight of hand is that the government has combined two liabilities – its government bond and its promise to pay money out to people in the future – into an asset in a fund. This is downright bizarre.
It’s also very confusing, I know. But for some reason, people understand the same concept when you change the entity carrying out the same sleight of hand.
Imagine a company that owes its workers retirement payments in the future. It establishes a pension fund, which invests the money set aside for future retirement payments. But it invests those funds into the company’s own bonds. The company is thus borrowing and spending the very money that was set aside for employee’s retirements.
What’s wrong with this? Well, it doubles up the risk and negates the whole purpose of the exercise. Why provision for company employees’ retirements if the risk remains the same – that the company goes bust, dragging down both the company and the retirement fund in one go? The whole point of a provision – a fund – is that it is not dependent on the entity which gave the initial promise of a retirement payment.
Governments play the same game. They make a promise, establish a fund to pay for this promise, and then borrow that money for everyday spending. If the government were to go bust, it would leave the fund dry. This negates the whole point of establishing that fund in the first place.
In 2010, former Pensions Minister Steve Webb revealed to Parliament the state of affairs at the NIF:
“Where does the money go? My understanding is that the fund is a bit like a soft bank that lends money to the rest of public sector, so that the Government need not borrow it from elsewhere.”
There are several reasons why governments do this. It helps fund their government spending, for example. Or, as Webb put it, the NIF has “essentially become a kind of easy credit option for the Government.”
But, more importantly, consider how a scheme like this falls apart. The moment when you realise it was a sleight of hand.
When the withdrawals of the fund begin to outweigh contributions to the fund, which under 2019 estimates was expected to occur in 2025 for the NIF, suddenly the tailwind to government financing reverses. The fund must begin to sell investments (government debt) to pay for withdrawals, or it must be topped up by the government, as is the plan for the NIF.
Either way, the government’s finances feel the strain twice over. The lack of funding, and having to pay for the outlays it had supposedly been provisioning for.
Shockingly, the National Insurance Fund will run dry. Don’t just take my word for it. I’ll let the Government Actuary’s Department (GAD) break the news:
However, we project that without extra support in addition to National Insurance contributions, the Fund balance will fall rapidly to exhaustion in around 2033. Treasury grants would be required from around 2030.
All this was estimated before COVID, of course…
What does all this mean for you?
In the funds which will supposedly go to paying for our future, you will find the very same government debt which the government would have to raise in order to pay for the benefits promised.
The money to pay for our future is not in the fund, in other words. It is a liability of the same entity which would have to pay the outlays anyway.
Do you think the government will be able to afford the “grants” the GAD mentions to top up the fund?
I’m not so sure that’ll be politically viable with taxpayers who will be paying thrice over. Firstly, to fund the payments to dependents. Secondly, to pay for the government debt in the fund which is being sold by the fund. And thirdly to pay for the new government debt which must be raised to make the payments under “grants”. All of this comes with interest, of course.
Perhaps worst of all, without the financial backing of the NIF and similar funds all around the world, governments may simply not be able to fund themselves anymore. They may go bust, just like Greece did during the European Sovereign Debt Crisis. The problem is that we’re talking about nations like the UK and the United States, not a small individual country.
Of course, it remains far more likely that governments will simply turn to central banks to finance their deficits. A political promise kept in devalued money is better than one broken. But this is extremely inflationary.
The thing is, not all forms of money are at the whims of politicians and their central bankers.
For now, cryptocurrencies like bitcoin are a solution in search of a problem, unless you live in Argentina. The thing is, we might discover that’s effectively where we end up living, if I’m right about how the government’s promises will unravel…
If you agree all of this is going to come to a head during your retirement or before, then the reason to understand cryptocurrencies becomes ever more obvious.
Editor, Fortune & Freedom