Sherlock Homes & the Mystery of Rising Debt & Falling Rates

A dialogue between the Master and his trusty sidekick, Dr Watson, at 221B Baker Street, unpacks the most intriguing paradox in contemporary economics. Rising government debt levels should drive interest rates higher. Instead, interest rates are plunging to zero and below. As Holmes explains, our ultimate fate might be in the hands of an evil genius.

The door of Holmes’s study flung open. Dr Watson manifested himself, apparently flustered. Without removing his bowler hat, he began.

“Holmes! I come hot foot from the City with three extraordinary pieces of information. First, interest rates have been halved to a new historic low of 0.25 percent. Second, government expenditure is rising well beyond forecasts. Third…”

Holmes raised a pale, delicate hand.

“You are about to tell me, my dear Watson, that despite the fiscal impecunity of our government, their bond yields are falling even further…

“I am dumbfounded, Holmes. You deduced my third point precisely…”

“Elementary, my dear Watson. You see, as a citizen of the modern world and a man of science, I have made a study of modern political economy and I have finally resolved a mystery that has challenged me for years…”

“Mystery, Holmes?”

“Indeed, my dear Watson. All of economic theory hitherto suggests that indigent governments seeking to raise additional debt, as time goes by and their debt-to-GDP ratios deteriorate, should have to pay higher costs for their borrowing. As their debt costs go up so they should be obliged either to address their deficits by judicious frugality or suffer the indignity and extreme dislocation of default.”

“Ah, Holmes, by frugality you are speaking of the need for – as it is called in liberal circles – austerity…”

“Austerity, my dear Watson, was once considered a virtue throughout Christendom, especially in the Presbyterian tradition from which I hail. Alas, it is now regarded, perhaps by a majority, as a cruelty inflicted by the rich upon the poor. It is simply, as a certain lady recently said, a matter of living within one’s means. No, my point is much more substantial. It is that the very laws of economics have changed.”

“My esteemed friend, I cannot know what you mean. The laws of economics are surely immutable, just like the laws of physics.”

“The answer is no, my trusted friend. On both counts. Neither the laws of economics nor those of physics are immutable. Let me explain.”

Holmes sat back in his reclining chair and inhaled deeply on his pipe. He wore a scarlet silk dressing gown adorned with dragons, evidently Chinese. He gestured to his friend to make himself comfortable.

“You see, my dear Watson, classical as well as so-called Keynesian economics assumes that there are supply and demand curves for money itself, though in the Keynesian model the demand function for money arises out of the volume of savings and investment, which must always remain, by definition, identical. As a government seeks to borrow more, so the price of money – its borrowing costs – ceteris paribus, will rise. A fortiori, increased government borrowing is associated with increased government spending which puts upward pressure on interest rates. In addition, a heavily indebted government borrowing in foreign currency is likely to carry higher default risk than a lowly indebted one and will therefore be required to pay a higher risk premium.”

“But that is not what has been happening of late, with a number of highly indebted governments bonds yielding negative returns for their bondholders, most notably the Japanese.”

“Precisely so, my dear Watson. Because the normal laws or rules of economics have been warped by the sheer volume of government debt outstanding in the world economy. Since 2008-09, and well before in the case of our Japanese friends, the independent central banks whose task it is to conduct monetary policy have sought to cut interest rates in order to stimulate sluggish demand. At first they sought as well to create liquidity in the banking system in order to forestall another banking crisis – and that remains an issue for the Eurozone. Now, all things being well, a stimulation of demand should feed through to more robust growth and, in time, interest rates should edge back to historically normal levels.”

Holmes drew open a drawer of his desk and pulled out a sheet of paper on which he had scribbled some figures in his spidery hand. Watson, who had been schooled by the Master in the art of observation over many years, could not fail to notice that the drawer contained a point 450 short-barrelled Webley revolver with an ornate mother-of-pearl handle.

“That is not, of course, what has happened” continued Holmes. “And the mystery is: why? Well, my dear Watson, the reason is now staring us all in the face.”

“I am intrigued, Holmes.”

“The figures on this sheet of paper, which I have obtained by recourse to the new-fangled internet contraption, and which I shall make public soon, reveal that government debt has been rising faster than GDP in the so-called developed world for a long period – since well before the financial crisis. In fact, there has never been so much aggregate debt as a proportion of global GDP as there is today. Now, increased levels of government borrowing have an effect on the real economy which post-Keynesian economists called crowding out. This mechanism is easily explained. It is self-evident that increases in government spending and deficit financing suck up available financial resources in the economy which might otherwise be dedicated to consumption in the personal sector and to investment in the business sector. Simply put, my dear doctor, for every one Pound or Dollar or Euro raised in government debt, demand is reduced by at least – and possibly more than – one Pound or Dollar or Euro.”

“And you are saying that this is a new idea, Holmes?”

“In fact it has been around for years, but only now do we see that government debt has its own self-reinforcing cycle which is dragging the finances of Western nations towards the precipice. The central banks cut interest rates to raise demand. Borrowing costs for governments issuing in domestic currency fall. Governments then say, Well, money is cheap, let’s borrow some more to stimulate the economy. This crowds out consumption and investment in the private sector – and demand falls even further. So the central banks decide to cut interest rates further to stimulate demand… and so on and so forth in a monetary and fiscal reductio ad adsurdam.”

“This is most disturbing, Holmes, where will it all end?”

“Ah, my dear Dr Watson, that is precisely the question that I am working on right now. It’s more disturbing than you can possibly conceive, I fear.”

Holmes set his gaze on an unseen object in the middle distance and drew deeply once more on his pipe.

“Consider the studies of young Hawking – the Cambridge Professor of Physics who is apparently an admirer of my rigorous methodology. Once a spaceship ventures beyond a certain proximity to a black hole in space, it may never return. It crosses an Event Horizon beyond which all of the laws of Einsteinian physics no longer work. Gravity crowds out (so to speak) all the other forces of Nature. In similar fashion, somewhere just after the Credit Crunch of 2008, the Western or developed world crossed its own economic Event Horizon and entered what young Hawking would call a Singularity. Only, unfortunately, mainstream economists have not realised the true significance of this event. The laws of economics have now changed utterly.”

“My dear Holmes, I am a simple doctor of medicine. I am afraid you have lost me.”

“Very well, my dear Watson. My conjecture is that once a debt star (if you will allow me so to call it) gets beyond a certain density, it collapses in on itself. It becomes a financial black hole which just sucks in all matter (money) that comes within its gravitational reach. There is no prospect of those in its orbit ever escaping, because the debt will never be even partially repaid. As its density grows so, in these extraordinary conditions, interest rates actually decline further until they reach the absurdity of negative levels. And it does not stop there either. The central banks will use whatever tools they think appropriate, including paying for government projects with imaginary, invented money which has the ultimate effect of dis-incentivising work itself.”

“But surely, Holmes, if this were so, those rating agencies would warn us of the perils we face.”

“My dear doctor, remind, me, if you will, what exactly is it that rating agencies rate?”

“Why surely, Holmes, they rate the credit standing of the issuer. His ability to meet his obligations to service his debt; that is to pay interest and to repay principal in accordance with his obligations.”

“I am afraid that you have allowed yourself to be deluded, my dear Watson. What they actually rate is the probability that a borrower might default in the coming year based on their perception that other market participants will continue to provide finance. In the case of corporate borrowers, this may be equated to their credit standing, as you put it. However, for governments, to them alone is reserved the luxury of being able to print money in order to service the interest on their outstanding debt (so long as it is denominated in domestic currency). Of course, this is not a privilege that the countries of the Eurozone enjoy as they have relinquished monetary authority to a state-within-a-superstate – the European Central bank. (Hence my immediate concerns there). Hitherto, however, governments have generally followed the precautionary principle, knowing that increased debts would lead to higher rates and hence to an unsustainable interest burden – which has political consequences. Now that rates no longer increase with rising debt levels, they consider themselves beyond the strictures of economic theory. The Japanese, a wily and subtle people, know that their government will never repay its debt. But because it costs nothing, nobody despairs.”

“So we are doomed to our fate then, Holmes? Shall we just be sucked deeper and deeper into this financial black hole?”

Holmes regarded Watson for a moment and then re-fixed his gaze once more to the unseen object in the middle distance.

“Surely, Holmes, much of this government debt is held outside the so-called West in surplus countries. I think I read that much of America’s US$19 trillion debt burden is held in the form of Treasury bills and bonds in China…”

“Another cause for concern, I fear, my dear Watson. I have it on good authority that a certain person has insinuated himself deep within the bowels of the Chinese Central Bank…”

“Surely not…”

“The evil genius himself. My nemesis, Professor Moriarty. The future of the global financial system now depends on whether the Bank of China chooses to continue to buy Treasury bonds which it can then use as collateral for the growing US Dollar denominated activity of that rising country’s commercial banks. If, at any moment, those purchases cease, then the financial black hole will collapse faster – and a terrible future of accelerating deflation awaits us all.”

“A monstrous prospect, Holmes. What can we do?”

“I must away at once to the Orient. There is a boat leaving Limehouse for Shanghai in but one hour. By fox-like cunning and ingenious disguise, I shall penetrate the Central Bank of China in order to find out Moriarty’s intentions.”

And with that, Holmes plunged his hand into the drawer and took out his elegant pistol, which, contemplating for a moment, he slid into his pocket. With a deft flick of his wrist he discarded his silk dressing gown and donned his cape and deerstalker.

Whereupon, Watson following, he flew down the corridor, and exited the front door into Baker Street. Watson was about to offer a low “Good luck, Holmes”. But the Master’s silhouette had already vanished in the swirling mist.