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Big Bearish Banks

By James H. Nolt

Already among renaissance Italian city states, incessant wars were financed by bonds and annuities, while the merchant banks that issued this long-term credit on behalf of states became a powerful and predominantly bearish interest. The rise of bond markets, more than any other factor, powered Europe’s rise to world dominance.  

Bond markets facilitated voluntarily mobilizing the liquid capital of merchants and other wealthy investors for large-scale collective enterprises, including overseas expeditions and wars. Small Italian city-states like Venice, Florence, and Genoa could defeat even enormous empires, notably the Ottoman Empire, by exploiting the same leverage principle we have explored during the last two columns.

Leverage for countries works far better for war mobilization than mere taxation. Suppose Venice has ordinary tax revenues of 100,000 ducats and operational expenses of 60,000 ducats, leaving a normal surplus of 40,000 ducats. If war suddenly breaks out, this surplus is available for outfitting the navy. However, if instead the same funds are reserved to pay interest on bonds, then Venice could sell 800,000 ducats of bonds and devote the ordinary surplus to paying the 5 percent interest on this debt. A vastly bigger fleet can be financed using debt leverage. Victory might lead to new revenues that help pay down the debt.

The rich merchants of Venice and similar merchant republics preferred lending their idle cash to the government by buying its bonds rather than paying higher taxes. They earned interest (the coupon rate of the bond) for cash that might otherwise be idle and not earning a profit. Furthermore, any merchant needing funds to outfit a mercantile expedition can easily sell his bonds, realizing their cash value.

Again, like last week, we see the magic of credit. Instead of having his capital taxed away, the savvy merchant buys a government bond. His capital changed form from cash to a bond, but did not diminish. If he needs cash again, no problem; just sell the bond. On the other hand, the government now has his cash and can spend it to outfit a fleet, so overall demand has expanded bullishly by financing government expenditure with credit.

Most people know something about the stock market, since many own stocks, and the average performance of the stock market is reported daily on public media as a bellwether of economic health. Yet the bond market is larger and older than the stock market. Far fewer people understand bonds and their short-term cousins, bills.

Since their invention in Italy, bonds were used first and foremost to finance war. Bonds were seldom used for industrial finance until the 19th century, when they were a principal means of railroad finance. By the late 19th century, bonds were among the tools used by leading investment banks to finance the creation of enormous corporations.

Bonds are like bills except that they are issued for longer periods measured in years (up to 30) and typically include a fixed interest rate called a coupon rate. The coupon rate is paid on the face value of the bond, which is usually different than its current market value. Like a bill, the face value of a bond is the amount the issuer promises to pay to redeem on its maturity date, say $10,000. If this bond has a 5 percent coupon rate, then each year before maturity it pays $500 to the current owner.

If 5 percent is currently a high interest rate, then this bond (ignoring risk) may sell at a premium, i.e., its market price might be above $10,000. On the other hand, if other interest rates you could earn are typically higher than 5 percent, the bond will sell at a discount. Thus, fluctuating interest rates have a strong influence on bond prices. When interest rates go up, bond prices go down, and vice versa.

Bonds (like bills) may also be sold at a bigger discount if the issuer (either a government or a large corporation) is considered more likely to default. The more leveraged the issuer, the more likely its bonds will fall in value. Of course, defeat in war or even winning a long and costly war is bad for bond prices. If you want to understand more about the impact of bonds on world politics, read my book International Political Economy: The Business of War and Peace.

Throughout history, most governments do not issue bonds directly via an auction. Most rely on investment banks to underwrite the bonds on their behalf. Whereas underwriting bills is the routine business of investment banks, the bond business is more episodic, but often more lucrative. In future columns I will detail how this is done via the initial public offering (IPO) process. For now, just understand that for most of history rich investors trusted banks more than governments, so they are more likely to buy bonds if an investment bank is involved.

Large-scale bond issues that governments require to finance wars and economic development are typically too risky for smaller banks to handle, so usually only the largest and most powerfully connected banks will do such business. They are confident they can handle it because they have close ties with political leaders and pay careful attention to government plans and finances. Being large, they also have a long list of wealthy clients and brokers as potential customers of a new bond issue.

Banks in the bond business often hold much of their own capital in bonds too. Having inventory makes it easier to meet customer needs on demand, just like having cash in the vault means you can dispense cash to any customer who wants to make a withdrawal.

Since bonds may last for many years, they are very sensitive to the ever-changing value of money. The face value of the bond is denominated in a specific currency, such as dollars or yen. If the value of that currency falls because of inflation, then the bond is also worth less. Conversely, currency deflation raises the real value of bonds. Therefore bondholders and the banks that underwrite them typically do not like inflation, since it reduces the value of debt. On the other hand, the issuers of debt may benefit from paying off the bonds with inflated currency worth less than the money they originally got when they first sold them.

Since the same large banks do both bond and bill business, their broad influence on credit expansion allows them to oppose excessively bullish leverage that might pump up profits and prices for debtors, but cause inflation and therefore undermine the real value of debts (bonds, etc.) to the detriment of the creditors. Thus the biggest banks often have a strategic bearish bias. They periodically rein in credit when expansion is too bullish for their own interest. I defer until next week discussion of how this results in titanic bull-bear battles.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photos courtesy of Wikimedia Commons

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