Why hold cash?

A couple of days ago, I looked at the housing market and mortgages, especially the US government-sponsored enterprises "Fannie Mae" and "Freddie Mac". The hook for the story was the news, slipped out on Christmas Eve, that the government is considering doubling its existing support for these two agencies, to maybe $800 billion. Some thought that the move might presage forgiving a proportion of the mortgage debt, though it seemed more likely to me that it was about making reassuringly generous provisions against loss from defaults.

One aspect I had overlooked was, who exactly might need this reassurance. The biggest holder of mortgage-backed bonds from Fannie Mae and Freddie Mac is and has been for a long time, reportedly, China. Back in 2008 when the credit crisis was under way, a Chinese commentator pointed out that China stood to lose heavily if those bonds decreased in value.

If bonds are perceived as having an increased risk of default, buyers in the market expect a higher income to compensate. Since bond income is fixed, the way that the yield increases is that the traded price of the bond falls. So, a potential capital loss for existing bondholders, including China.

The bigger picture is the need for governments to keep interest rates low, to prevent further collapse in the housing market for political-economic reasons, but also to keep down the cost of servicing the government's own debts. This is especially important because national debt has ballooned, not only because of official intervention in the markets but because there is more unemployment benefit paid out and less tax coming in. Damping the interest rate is forcing the government to take on further debt, which makes it even more vital to keep the rate down... it is a vicious circle.

Calculating total debt is difficult, but it's generally accepted that in the USA, the combination of public and private debt is higher than ever before, even when compared to GDP. Some will also factor-in a notional amount of debt, relating to the government's future obligations in terms of social security and medical care. One of those people is David Walker, formerly the US Comptroller-General, who toured the country from 2007 onwards to warn of coming economic difficulties. This commentator has estimated the debt at $57 trillion.

Debt is either repaid or defaulted. But default would affect all owners of the bonds concerned, including US pension funds and other collective investments, so to some extent this would be cutting off one's nose to spite one's face. And cheating outsiders would be dangerous - a "credit strike" by foreigners (China alone probably owns $1 trillion-plus of Treasury debt, directly and indirectly) would cripple the debt-dependent US with rapidly-rising interest rates. The dangers might not be merely economic, either.

So debt is going to be paid off the hard way, and that means a long and painful period as people spend less and start to pay-off their loans, and pay more in taxes. The picture is much the same in many advanced economies - it's thought the UK is in an even worse situation - and developing economies are still greatly dependent on trade with us Western spendthrifts.

Is there anyone who won't be affected? Perhaps there is a country that balances its budget, does not let its economy be unsettled by flows in and out of international cash (see what happened to Iceland), and doesn't trade much with the rest of the world; but if such a place exists, it's probably a very poor country anyway.

One question that I think will be asked time and again in the coming years, is whether democracies can take action that is tough enough and quick enough to deal with the problem. Politicians seeking re-election will be tempted to apply the brakes too gently. But if they do not act decisively, especially in trimming public expenditure, those who still have money to lend will be the disciplinarians instead - interest rates will rise. Deferring the treatment will only mean nastier medicine later.

Unfortunately, that's what I think will happen, and so I believe we face a period when it will be very important to get out of debt, and quite rewarding to have cash savings. In fact, that has already been so when you look at the last decade; but I think it will continue to be so for some years yet. Yes, there are some who will use short-term trading to make good gains - look at how the market bounced in 2009 - but if we are in a "secular" (long-term) "bear market", there is more probability of loss than gain. "Bear market rallies" can and do break the fortunes of bold investors. For the more cautious, currently itchy to get a better income than the bank offers them, I suggest we are still in a phase where the return OF your cash matters more than the return ON it. The grass on the other side of the fence may be greener, but there are hidden predators concealed in that grass.

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