SERIOUS MONEY:JAMES CARVILLE, the political strategist behind Bill Clinton's successful 1992 presidential campaign, once quipped: "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.", writes CHARLIE FELL

The market for public debt securities has determined the fate of nations since the republic of Venice issued the first tradable bonds in 1171. The Venetian issue of interest- bearing debt enabled the city state to finance war without having to resort to high taxes that would have crippled the local economy. The subsequent consolidation of the republic’s position as a maritime commercial giant owed as much to its ability to issue transferable debt securities as to its military prowess.

The Venetian innovation was soon adopted by other Italian city states including Florence, Genoa and Siena, but government debt financing did not proliferate across the European continent until the 16th century, when the Dutch republic issued government bonds to fund its lengthy war of independence against Spain.

The Dutch perpetuities promised fixed annual coupons and the indefinite flow of interest payments ensured their popularity among wealthy families, who intended to live off the income for generations. The success of the Dutch system contributed to its imitation by other nation states and to the emergence of the first bond market vigilantes.

Indeed, the ability to access a relatively cheap and reliable long-term financing source played an influential role in the defeat of Napoleon by the British in 1815 and in the American civil war triumph of the Union over the Confederacy in 1865. Bond market vigilantes, most notably the Rothschild dynasty, determined the fate of emerging nation states right from their beginnings.

As the financial crisis that erupted two years ago has led to a dramatic deterioration of public debt positions across most developed economies, bond market vigilantes are back in vogue.

The focus to date has been on the southern European countries facing the most acute difficulties, but the fiscal deterioration is widespread. Japan, Britain, the US and several European countries all face testing positions. Indeed, in an unprecedented peacetime development, total developed- country public-sector debt, excluding off- balance sheet and contingent liabilities, should exceed 100 per cent of gross domestic product (GDP) this year.

A number of European countries have already exceeded the 100 per cent level or are likely to do so in the near future. Britain and the US are likely to approach this percentage soon afterwards, while Japan’s public debt ratio is already north of 200 per cent and rising fast.

The predominant public policy concern behind the explosion in fiscal deficits and government debt ratios has been to act as a countervailing force to private-sector deleveraging and prevent a repeat of the Great Depression. The unprecedented support operations undertaken have not only been successful in returning the global economy to a growth path, but have also been financed at historically low interest rates.

However, deficit financing is unlikely to prove as painless once near-zero interest-rate policies are removed and bond market vigilantes focus their attention on the currently dangerous and ultimately unsustainable debt trajectories.

Significant fiscal adjustments are necessary, simply to stabilise government debt ratios, and the primary fiscal balances that would need to be generated to return debt ratios to pre-crisis levels are not achievable. Furthermore, successful fiscal consolidations of recent years have typically stabilised debt levels and not delivered any sizable reduction.

More importantly, the swing from fiscal deficit to surplus that accompanied successful fiscal restraint typically occurred in the face of rising real growth, falling nominal interest rates or both. Nominal interest rates are already at historic lows and are almost certain to increase. Meanwhile, real growth is likely to disappoint due to continued private-sector deleveraging.

The diehard bulls will point to the improvement in the US government debt ratio in the years immediately after the second World War as proof that current fiscal positions are not of immediate concern. The gross debt ratio dropped from 122 per cent in 1946 to below 75 per cent in 1952 and fell below 50 per cent more than a decade later in 1964. The comparison is flawed.

Firstly, the US Federal Reserve committed itself to maintaining an interest rate of per cent on Treasury bills upon US entry into war in 1942 and this practice established an upper ceiling for long-term government bonds of 2½ per cent. The policy continued until the Treasury Accord of 1951, even though inflation surged and nominal economic growth soared following the removal of price controls.

The large differential in interest rates and growth contributed to a sharp reduction in the debt ratio.

Secondly, significant pent-up private-sector demand replaced government spending as the primary driver of demand following the war.

Savings rates were high at roughly 8 per cent and balance sheets were underleveraged with outstanding household debt at less than 20 per cent of GDP. Contrast the economic picture of the 1950s to today, where households are struggling with debts amounting to 96 per cent of GDP.

Current debt trajectories are clearly unsustainable and the position looks even worse once off-balance sheet and contingent liabilities are considered. The structural bull market in government bonds that began in 1982 is over.