A Warning from Chicago

Sometimes enough is enough.

When Goldman Sachs recently tried to sell $454 million of bonds issued by Chicago’s Sales Tax Securitization Corporation (the bonds are secured by sales tax revenues) it couldn’t find enough buyers. According to Bloomberg’s Shruti Singh, the bank ended up having to take $75 million of the bonds on its own books. This was despite STSC’s bonds being more highly rated (AAA for the top tier) than those of the city (A) from which they had sprung, and despite the price being reportedly “adjusted.” Not only that, Chicago’s sales tax revenues have been increasing and the STSC is structured as a "bankruptcy-remote" entity under Illinois State law, meaning that if Chicago were to go bankrupt, the STSC could still benefit from sales tax revenues.

Deals can struggle occasionally and there was a lot of new paper coming onto the local debt market at the time, but the yield premium of STSC bonds over benchmark Triple-A bonds has been widening.

Investors were getting twitchy.

I wonder why (not really).

Singh:

Tensions between Chicago Mayor Brandon Johnson and the city council are growing over how to close next year’s nearly $1.2 billion deficit. On Monday, the council’s finance committee rejected Johnson’s revenue plan, thwarting his budget proposal as the first-term mayor wants to levy new and higher taxes on companies and the ultra-rich.
“The city’s current budget issues combined with soft market technicals from recent outflows did result in slightly wider levels which just shows that you can’t ever really insulate a bond from underlying fundamentals no matter how hard you try,” said Dora Lee, director of research for Belle Haven Investments, which owns Chicago general obligation and sales-tax bonds among its approximately $22.9 billion of muni assets.

And here’s John McGinnis in the Manhattan Institute’s City Journal:

[Chicago Mayor Brandon] Johnson’s challenge was to balance a city budget that is more than $1 billion out of whack. He blames the city’s plight on Donald Trump, though reduced federal grants constitute only a tiny portion of the deficit. In fact, the city’s red ink flows from the loss of federal subsidies designed to combat a pandemic that ended years ago, as well as from structural imbalances caused by a large workforce, whose pensions and wages are higher than necessary.
New taxes on business dominate Johnson’s proposals, showing that the mayor is indifferent to Chicago’s greatest need—attracting more businesses to increase economic growth. The most obnoxious is a $21 per employee per month “Community Safety Surcharge” on companies with more than 100 workers. Few other major cities impose such a tax. Of those that do, Chicago’s would be the highest.
Johnson touts his proposal as a tax on the “ultrawealthy,” but it will drive away new businesses and discourage existing ones from hiring more Chicagoans, including low-income workers. Mayor Rahm Emanuel’s elimination of the previous $4 per employee per month head tax was widely hailed as showing employers that the city was open for business. Johnson seems determined to send the opposite message.
The mayor’s budget also proposes raising the personal property lease tax on businesses from 11 percent to 14 percent. This tax hits any leased factors of production that a firm uses to provide its own products and services.
While other cities levy similar taxes, 11 percent is already higher than the rate in almost all of them; 14 percent is uniquely burdensome. Chicago services aren’t so great that the city can afford to price itself out of the market.
To balance a substantial portion of the budget, Johnson has also raided Tax Increment Financing funds. These funds accumulate over time from the city’s sales tax to support capital projects in specific districts. They're designed to fund capital improvements; Johnson is using them for operational expenses.

And speaking of nervous bond investors, Veronique de Rugy has been writing about what will happen when the Social Security and Medicare Trust Funds run out of money, two bombs currently set to explode in the early 2030s. What to do? De Rugy sets out a number of options, some less politically painful than others. Unsurprisingly, she reckons that whoever is in charge in Washington at the time will shy away from pain, or, to put it more accurately, short-term pain:

Among longtime Washington hands, the conventional wisdom is that legislators will take the easy route: preserve every benefit, avoid serious tax hikes, and finance the gap entirely with new debt. Benefit cuts are politically unthinkable, and so are large tax increases.

That is probably right, but what would it mean?

De Rugy:

According to the Congressional Budget Office, maintaining all Social Security and Medicare benefits by borrowing would add roughly $115 trillion to the deficit over the next thirty years. That’s $70 trillion in shortfalls and the rest in interest payments. On a real basis, using a 2% real discount rate, the present value of that $70 trillion is on the order of $40 trillion—greater than the current $38 trillion national debt…
The danger, of course, is that Congress will borrow and then be unable or unwilling to repay such a massive amount of debt. A debt crisis will eventually erupt, leading to default or inflation. History has no shortage of examples of other countries’ unsustainable social spending causing debt collapses. It can happen here. And when people see that event coming, we will see a flight from Treasury debt and inflation in its anticipation.
So far, markets do not appear to believe that Congress will simply borrow everything, enact no reforms, and fail to restore fiscal order. If markets did, we would already see the repricing—rising yields, a weaker dollar, or inflation expectations, and inflation itself drifting upward. Surely, as the saying goes, America will do the right thing, even if after trying everything else.

Perhaps.

But like those investors growing wary of STSC debt, are investors in Treasurys beginning to fret? In a Capital Letter from April 2024 entitled “Warning Light Flashing Gold,” I looked at the gold price:

After rising sharply during the financial and eurozone crises (it traded above $1,800/oz in 2011) for the usual “safe haven” reasons, as well as QE-fueled inflation concerns, it drifted quite a bit of the way back. However, [the price of gold] has, with an interruption or two, moved up since September 2018 (when it was trading not far below $1,200). Gold hit $2,000 during Covid-19 (more inflation fears, this time vindicated) before giving up ground again, trading down toward $1,600 in August/September 2022. The price then moved up again, a rise which has been accelerating. Priced at roughly $2,000 in February, gold is now trading at or around $2,400, touching all-time highs in nominal terms.

That was then.

Among the reasons I gave for the increase were the persistence of U.S. inflation, growing geopolitical tension, and increasing worries about the amount of debt that OECD countries were piling up. Were some market players hedging themselves against (or speculating on others doing so) the arrival of “fiscal dominance” in the U.S. and elsewhere by looking for somewhere else to put their money?

“Fiscal dominance” was, as I noted, a concept that had been neatly defined by Charles Calomiris of the St. Louis Fed in 2023 as follows:

The possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low.

“To put it bluntly,” I wrote, “it refers to a situation in which a country’s finances have deteriorated so badly that its central bank can no longer keep control.” Calomiris had warned that “the prospect of this occurring soon in the United States is no longer far-fetched.”

I returned to Calomiris in the most recent Capital Letter, quoting among other passages from 2023 this:

[I]f global real interest rates returned tomorrow to their historical average of roughly 2 percent, given the existing level of US government debt and large continuing projected deficits, the US would likely experience an immediate fiscal dominance problem. Even if interest rates remain substantially below their historical average, if projected deficits occur as predicted, there is a significant possibility of a fiscal dominance problem within the next decade.

The moment of crisis then occurs “when the bond market begins to believe that government interest-­bearing debt is beyond the ceiling of feasibility,” a moment brought closer as the interest rate needed to attract buyers moves up, a process that cannot continue indefinitely. At some point, a government bond auction will “fail” in the sense that the interest rate required by the market on a new bond offering is so high that the government withdraws the offering and turns to money printing as its alternative.

And so we come back (sort of) to that Chicago bond deal or, far more ominously, to De Rugy’s warning of a “flight from Treasury debt.”

Gold is now trading at about $4,115, off its recent dollar peak of $4,350, but far above April 2024’s $2,400.

This has triggered talk of the “debasement trade,” the search by investors for alternate safe havens for their capital due to the danger that governments will not only fail to tackle their debt, but attempt (essentially) to inflate a good portion of it away.

Writing in the British left-of-center magazine, the New Statesman, Will Dunn introduced his readers to the “bond vigilantes,” a concept that probably came as a shock to some of them. Readers of Capital Matters are better informed, but some may not be aware that the term “bond vigilantes” (which was long predated by the phenomenon) is attributed to economist Ed Yardeni.

As historian Adam Tooze explained some years ago:

“Bond Investors Are The Economy’s Bond Vigilantes”, Yardeni once declared. “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.” As Yardeni later spelled out: "By vigilantes, I mean investors who watch over policies to determine whether they are good or bad for bond investors … If the government enacts policies that seem likely to reignite inflation”, Yardeni elaborated, "the vigilantes can step in to restore law and order to the markets and the economy."

Scott Sumner in EconLib elaborates:

This is an example of reasoning from a price change. If bond traders fear that government policies are likely to lead to higher inflation, this may result in higher interest rates (via the Fisher effect). But higher interest rates due to the Fisher effect are not a contractionary policy. In order to prevent… inflation from occurring, the government must stop engaging in inflationary policies. Bond vigilantes won’t solve the problem.

This is true, but their presence (evidenced by rising yields) can be a useful warning sign that trouble may lie ahead. If bond investors (who are de facto lenders or buyers of loans), believe that a country is borrowing too much and/or that its inflation rate is accelerating, they will want a higher interest rate in return for lending it their money. A prudent government would do well to heed the signal contained in that rising yield. Another important price signal is relative interest rates. If a country’s interest rates are moving up when compared with its peers, that is often a bad sign.

One of the many reasons that the eurozone crisis (of which we may be approaching another installment, but more on that some other time) was allowed to brew for so long was that the European Central Bank effectively set the tone for interest rates throughout that zone, a (quasi) one size fits all approach that did not fit the very different economies within the currency union. The idea that all these economies had “converged” was an absurdity in which only a central planner could have believed. The result, reinforced by the simultaneous muffling of the signals that different currencies would once have sent meant that lenders kept on lending too cheaply to countries that needed to cut back, not spend still more. Making matters worse was the unspoken understanding that there would be bailouts if things got too grim. The result was catastrophe.

But back to Will Dunn in the New Statesman:

At a meeting in No 10 in September of this year, one source heard a special adviser ask: “What are gilt yields?” A government whose opponents were destroyed by the bond markets, and which is paying those markets £300m a day in debt interest, apparently employs people who have not taken five minutes to understand how they work.

A gilt is a British government bond.

Britain’s debt/GDP ratio is about 100 percent. Its budget deficit is about 5 percent of GDP.

Earlier this year, Britain’s Labour government, which has a massive parliamentary majority, was unable to push through some welfare spending cuts.

One investor shared with me the analysis they’d done on the cost of the Labour rebellion. With around 100 Labour MPs prepared to rebel against the government when it attempts fiscal consolidation, they thought it was reasonable to expect that this would add 75 basis points (or three quarters of a percentage point) to the interest on government debt. Over the course of the parliament, they said, this works out to an additional premium on debt of £1bn per rebel MP.
What these rebel MPs fail to understand, the investor said, is that “the role of ministers and chancellors and MPs has changed, because anyone could be speaking to the markets.” There is now a much greater potential for an MP or minister to “say the wrong thing” and incur a market reaction, they told me. “We’ve never been in that scenario before, really, as a country, where that much scrutiny has been placed on people with no training or background… It’s like a child playing with a nuclear reactor.”

Despite James Carville’s quote ("I used to think that 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 everybody), the U.S. is, due to its economic and military strength, somewhat immune from bond vigilante pressure.

As I explained the other day:

The dollar, and by extension, Treasuries typically benefit from being, as one senator once put it, the healthiest horse in the glue factory. And so it is less surprising than it might seem that, for all the recent turbulence, foreign ownership of treasuries has increased. Most of the other “horses” are it appears even closer to, so to speak, their sticky end. The euro, for example, is a fundamentally flawed currency, and many EU states are heavily indebted. Japan is battling inflation, and its debt/GDP ratio is over 200 percent. Crypto currencies are what they are (opinions differ). The problem with the Swiss Franc (which has trended up against the dollar for years) is that it is too illiquid (there are not enough Swiss Francs around). The problem with the offshore yuan? Do I really have to explain?

In some respects, this blessing has also been a curse. It has allowed the U.S. to pay (relatively) little attention to the bond vigilantes and to borrow (and to build up unfunded liabilities, such, soon, as Medicare and Social Security) to a degree that is far from prudent.

In the end there will be a reckoning.

The Capital Record: Sound & Vision

We released the latest of our series of podcasts, the Capital Record. Follow the link to see how to subscribe (it’s free!). The Capital Record, which is hosted by financier David L. Bahnsen makes use of another two formats to deliver Capital Matters’ defense of free markets. The original podcast continues, but if you want to watch David talk, please click on the YouTube link.

The 269th episode (Podcast/YouTube)

Now that New York has elected a self-avowed socialist as its mayor, many are concerned with how to combat his dangerous ideas and policies. In this episode of Capital Record, David offers the wild suggestion that one way to defeat Mamdani’s ideas is to not replicate them ourselves! From class warfare to price controls to government ownership of production, Mamdani does not have a monopoly on bad ideas in 2025. For conservatives to win this debate, they need to be debating on the right team.

The Capital Matters week that was . . .

Tariffs

Josh Robbins:

Article I of the Constitution explicitly grants the power to impose tariffs to Congress, not the president. In fact, the Constitution gives the president no power at all to dictate the nation’s trade laws. To be sure, the president has many foreign policy powers under Article II — he is the commander in chief of the armed forces, he can receive foreign ministers, and, with the Senate’s advice and consent, he can make treaties and appoint ambassadors. But none of these powers authorize the president to impose taxes on imports. In fact, during the November 5 oral arguments before the Supreme Court on the delegation of tariff authority, Solicitor General John Sauer conceded this point…

Rich Lowry:

Worse, sweeping tariffs make imported materials that are used to manufacture goods in the U.S. — so-called inputs — more expensive. As a result, manufacturing becomes less cost-effective. Right now, for instance, the price of heavily tariffed steel has been on the rise. That’s good for steel companies — a small slice of the economy — but bad for all the other firms that use the steel to make stuff…

Veronique de Rugy:

The goal of tariffs, in part, was to raise manufacturing employment. Given that more than half of U.S. imports consist of intermediate goods — inputs used by American manufacturers — these tariffs inevitably raise production costs. That alone should make the trend of a weakening manufacturing sector unsurprising. New data show that 58,000 manufacturing jobs have been lost since “liberation day.” Other forces are at play, of course, but one thing is clear: Since 2016, the trend line has not moved in the direction populists promised it would. Manufacturing losses are accelerating, and the United States is losing blue-collar jobs, not adding them…

Canada

Matthew Lau:

Canadian Prime Minister Mark Carney recently presented his first budget. It follows nearly a decade of ruinous economic policy under Justin Trudeau, which resulted in Canada suffering by far the worst real GDP per capita change of any country in the G7 from 2015 to 2025 and a collapse in business investment so that in the second quarter of this year, machinery and equipment investment per worker in Canada was less than one-third of what it was in the United States…

France

Andrew Stuttaford:

For all his Mamdani-level inexperience, Bardella is clearly emerging as a political figure in his own right. He’s no longer just a stand-in for Le Pen, and this evolution is reflected in a shift, at least in his rhetoric, in a more economically liberal direction. Hitherto the RN has been a classic horseshoe party of the right, with its right-wing positions (on immigration, say) accompanied by leftist economics. That’s where the party’s heart still lies, but Bardella knows that if he is to win the presidency, he will need the votes of more traditional, typically older conservatives, who have no interest in anything that smacks of socialism. Judging by some of the leftist positions that the RN has been taking in parliament, squaring that circle will not be straightforward. Indeed, it could sink him….

Hemp

John Puri:

The longest government shutdown in U.S. history ended not-so-climactically last week when Congress passed a short-term funding bill, which should keep the government running through January. Lost in the drama was a ride-along provision that former Senate Majority Leader Mitch McConnell (R., Ky.) had been trying to advance for years, previously without success. Now put into law, it threatens to destroy the $28 billion hemp industry that developed after Congress inadvertently legalized its products years ago….

Interest Rates

John Puri:

Directionally, however, Trump is getting his way on monetary policy. The Federal Reserve Board of Governors, which Powell chairs, has already cut interest rates twice this year, from 4.5 percent in September to 4 percent today. But the president wants rates to be cut by much more, much more quickly. By expanding credit, Trump believes that lower borrowing costs will stimulate job creation and economic growth, lower barriers to homeownership, and boost the stock market, which he views as a barometer of his success.
These are understandable aims in themselves, even if distorting the price of money is the wrong way to pursue them…

Climate

Andrew Stuttaford:

Investing yet more money in inferior technology to get an even more inferior result is quite something even in the wretched annals of climatism and those who feed off it. Wind companies are telling the markets this is a blip. Maybe, maybe not. There is a reason that one of the markers of humanity’s advance has been a reduction in its unhealthy dependence on “mother” nature…

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