How bonds make — and break — nations

0:06Pushkin. Shadow banking sounds pretty scary. This is the non-bank part of the financial system, which we've talked about before on the show. Private credit is one big growing part of shadow banking. But it's not the only part, and it's certainly not the biggest part. Much larger is the bond market, over$100 trillion worldwide. And the bond market is playing an increasingly important role in financial crises. Bonds really can make or break a country. This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I am reporter Ethan Woo here in the New York studio, joined today by FT Alphaville editor Robin Wigglesworth, who has written just a tome of a magazine piece, you know, 20 million thousand words on bonds, their history and why they should terrify us.

0:57Robin, is this the longest piece you've ever written and that I've ever read? I hope not. It definitely isn't the longest piece I've ever written, but it's probably the longest piece I've written just on the bond market, which not everybody loves as much as I do, but I think they should, which is why I wrote this. Katie Martin and I, on some of these Tuesday episodes, we've talked about how bonds are hot again and how they're the new trade. And I think it's difficult to understand bonds as a threat to the financial system because they're seen as stable, right? They're seen as a place you put your money, you collect a sensible yield, you hold it to maturity.

1:29Maybe you sell it or whatever. But it's not like a stock that it's going to be down 50 % and then, oh, you're broke. So what is that miss, Robin? What is it about bonds that makes them go in the same conversation as a financial crisis? First of all, it's just a bigger market. But like stocks can't make or break the fate of a country. The bond market can and frequently has through centuries. And more recently, actually, bonds are bigger than banks. So basically, for the past thousand years, banks have kind of been the engine of capitalism. That's where like credit is extended. Credit's kind of the fuel for the modern economy.

2:05But over the past, let's say decade or so, bond markets actually extend more credit, make more loans are more important than banks. Yes. And I think that's like this huge kind of change to the entire financial ecosystem that we don't really have our arms around completely yet. Yes. No, this is such an important point. And I just want to highlight and reinforce that. Our mental model, in a very broad sense of people that have some awareness of finance, is 2008. We had banks are holding all this crap and the banks are going down and they're getting billed out and JP Morgan's talking to the treasury and all this stuff.

2:41It's about banks. And I think people assume because banking crises have been an important part of financial history and because we have such a massive banking crisis so recently in modern memory, that's how all financial crises originate. But that is perhaps decreasingly the case because of the move that you highlight in your piece, Robin, of risk from the banking system to the bond market. And we'll get into this a little bit in more detail. But I want to take us back, Robin, as you do so nicely in your magazine piece, all the way back to the 12th century, to the birth of bonds. You can't talk about bonds without talking about war.

3:16Yeah, that's right. The first bond was born out of a war and it's kind of accidental. Venice went to war against Constantinople, didn't have money to pay for it. So the Doge, the ruler of Venice, issued a loan to all its citizens. They all had to lend him money at 5 % a year, but they could trade that loan. They could trade their pieces of it if they needed to raise cash. And unfortunately, Venice got its ass handed to it by Constantinople. So they lost the war. They weren't able to repay the loan. So it became permanent. And that became the first ever bond, the prostiti. And since then, because it was actually worked out as a pretty good, nifty invention, good way for city states or countries to fund themselves, it kind of evolved and grew in France and Netherlands, especially which is kind of a country that pioneered modern capitalism.

4:04And then to the UK, where it became the consul market, the UK government bond market, which literally helped it defeat Napoleon. Wait, hang on, hang on. Bonds beat Napoleon. You're going to have to explain that. Yeah, bonds beat Napoleon, right? Almost the unvarnished truth. But basically, it boils down to the fact that, you know, in war, sometimes generals can win it, strategy, tactics. But quite often, it's like who can last the longest? And the UK had a smaller economy and fewer people than France. So how was it able to withstand so many years of warfare against a much larger country? Well, it was able to maintain armed forces, pay for its ships, pay for its soldiers much better because it issued bombs.

4:47It issued long-term bonds to people in the UK. France couldn't really do that. They had some banks in Paris they could borrow money from. It was mostly more short-term debt. So it was harder for France to muster the full might of its economy, whilst the UK was able to do so. So in a meaningful way, bonds did help beat Napoleon. Got it. So just you fast forward a few centuries, and for the most part, we're talking about sovereign bonds, Bonds issued by governments to fund wars, to fund public works projects, whatever it might be. But then in the later part of the 20th century, it's not just sovereigns that are issuing bonds anymore.

5:22It's also corporations. Yeah. For basically almost a thousand years, it was all governments. I mean, a few big companies. So the first corporate bond was actually in Amsterdam. It was a Dutch East India company. But it was almost all governments until basically the modern era. The 60s and 70s and especially 80s, things started to change quite radically. Because first of all, bigger companies, more big companies started issuing bonds in Europe as well after World War II. They needed to rebuild their countries. And then in the 80s, you had the birth of junk bonds. Right. So non-investment grade bonds, kind of riskier bonds.

5:54That was pioneered, not invented, but really championed by a guy called Michael Milken, who's a bit of a controversial figure. And inside a trading probe, he got snagged by that in the late 80s. And he was pardoned by Donald Trump just a couple of years ago. I mean, this guy's very much still around. Very much still around. He runs a big global conference. And frankly, to his credit, what he did, he turned a kind of sketchy market for dodgy companies into a very legitimate funding avenue for hundreds of thousands of companies around the world. It's literally a multi-trillion dollar market that is a valuable component of the financial system.

6:29And then also around the same time, you had the birth of securitization. Again, the technique basically had been around for a while. you take lots of individual loans, package them up in a big bond. But in the 80s, that really started evolving and took off and ended in tears, as we know, in 2008. You mentioned at the top, Robin, bonds can make or break a country. Could you talk about what you mean there? So let's deal with the making side. I mean, if you look at the modern world around us, it is to a very large extent, an underappreciated extent, made by bonds. So the US financed the purchase of louisiana with bonds the railways were built with bonds tesla's cars are financed by bonds it's not the stock market that finances the building of these cars tesla borrows money in the bond market to make these cars make its factories netflix borrows money from the bond market to make its content yeah but also sometimes because bonds are quite often a cheap easy way for big companies and countries to borrow money you know some countries aren't as disciplined as maybe they should be.

7:34So debt crises have been around for millennia. Literally, the first debt crisis I know of was in something like fourth century BC in Greece. There were some statelets in Greece that borrowed money from a big local rich temple, and then they all defaulted and the temple went bankrupt. But today, literally, countries like Zambia, Ghana, Pakistan, Sri Lanka are in debt crises. And to a large extent, that is caused, or at least the main symptom is they borrowed a lot of money through bonds. And bonds are different from the old loans. They used to borrow money from other countries or from banks. And look, that's painful as well.

8:11But at least you can fundamentally get all those bankers into a room and kind of work something out sooner or later. With the bond market, it actually makes things a lot more complicated. Yeah, you got a million people to talk to. It's way more fingers in the pot. So I like this point. And that kind of brings us to today, Robin. Bonds are a cornerstone of the financial system. Pretty much every government uses them to borrow. Pretty much every company uses them to borrow. So what's the problem? What's the other side of bonds today? And why are you writing a book on it? Well, that's a very good question, because it is a fairly nerdy subject.

8:45I mean, I love the subject because I think it's important. And I think it's important because we have seen a shift towards bond markets globally for several decades now. But after the financial crisis, there's been a step change. A huge shift has happened. The big lesson we took out of 2008 is that banking crises are incredibly painful because banks aren't just institutions that trade bonds or make loans. They do the payments. They sort out salaries. They take out deposits. So they are hugely important to society. And when they go belly up, that is exceptionally painful. So we essentially have strengthened the banking sector.

9:24And it might not seem that way because obviously we've seen a few US banks go kind of belly up and Credit Suisse was being Credit Suisse and finally kind of keeled over as well. But broadly speaking, the banking sector is vastly stronger today than it's been for generations. That doesn't mean that there won't be banks that fail, but they'll fail in more manageable ways. There'll be fewer of them and it won't cause as many systemic problems, at least for the time being. but we've kind of squeezed risks out of the banking system and pushed it into the bond market and that's a great home for it that's a great place for it but it doesn't mean that that risk has disappeared it's just kind of morphed and changed its nature and become more decentralized which is good but it means it's harder to monitor and when things break bad they kind of break bad in a quite nasty way and they're very hard to tackle because the bond market is more decentralized than banks were.

10:19You had a very nice line on this in your piece that I think drives the point home. In finance, risk is like energy. It cannot be destroyed, only shifted from one place to another. As it gets shunted around, its consequences can morph in little understood, even dangerous ways. And I think that's the point here. It may not be that risk has increased because the bond market has grown in prominence. It may just be that risk has been transferred from the banking system to the bond market after we've seen all these post-2008 regulations tightening controls around the banking system. And that's kind of the point about talking about shadow banking, right?

10:53Shadow banking is like, and a lot of people have said this, it's a really amorphous broad term that includes a bunch of stuff that doesn't share characteristics. It literally just means not banks, right? But the point is exactly that we don't know quite where the risk lies, right? We We know now in hindsight that risk was in the banking system in 2008. And now it's not exactly clear where it is. And that's the scary part, right? I think you nailed it, Ethan. That's exactly it. It's not knowing that is kind of the scary part. But I think the bond market is a positive thing, right? It has helped reduce risks or at least ameliorated the overall riskiness of the financial system.

11:31Because like I said, we have centuries of horrible experiences of banking crises. They're not fun at all. They're extremely painful for individuals and for economies as a whole. And bond crises, you know, they can also be very painful. You could argue that 2008 was at least partially a bond crisis. We came very close to bond crisis in 2020 when the banking system actually held up pretty well when COVID rattled financial markets. But broadly speaking, this is a good thing, right? It's good that risks have kind of been squeezed out of banks and into markets. markets kind of that's where risks should be but you know these things have unintended consequences and i think they might be inherently unknowable or so difficult to fix that the fixes are unpalatable we will never be able to stomach them or get enough global agreement to do so yeah certainly absent another crisis like after 2008 we're able to do all these things with banks because there was a very strong political conviction across the world that that cannot happen again.

12:38It will happen again at some point when we've forgotten the lessons. But for the time being, I think we should more look towards the bond market and maybe see what we can do there to make things a little bit better, I think, for everybody's sake. Good things can be scary too. Yes. All right, Robin, thank you very much. We'll be back in a minute with Long Short.

12:59Welcome back. this is long short, that part of the show where we go, long a thing we love, short a thing we hate. Robin, we did the show with Katie Martin last week on the case of the soft landing. Man, I'm reversing course. I'm short the soft landing. I think this narrative has gone way too far. And the problem is the same problem it's always been, which is inflation, which is wage growth is still high. And we have just never seen in US economic history, wage growth that we're getting right now consistent with what the Fed wants, which is 2 % inflation. I think inflation is probably going to stabilize a little higher than people are comfortable with.

13:33And it's going to create some difficult choices for the central bank, which could include raising the inflation target or a variety of other creative measures. But I think people are thinking too narrowly and too simplistically about the soft landing. And whenever a market narrative goes this far, you got to short it. Yeah. I mean, that's quite compelling. I have to admit. I'm long soft landing i'm team no landing but i think that was well put so i think my long is nintendo okay on the personal side look i'm playing zelda tears of the kingdom with my kids and i've been playing nintendo games on and off for most of my life and it blows me away how a company that old so storied can still just be just a creative juggernaut it is so interesting and vibrant and fun and creative.

14:17And seeing my kids rediscover the joys of some of these characters I grew up with has been magical. But with a slightly more pragmatic hat on, I think the Mario film, which I haven't actually seen yet, kind of shows that Nintendo is maybe starting to monetize its intellectual property a little bit more aggressively. You don't see that many Mario films or Zelda films. You don't see mobile games, even though everybody knows they would sell. Nintendo has always been very conservative and careful about these things. And if they start even tapping into some of the potential of this, I mean, it's huge.

14:50Because people forget that as much as we talk about Barbie or an Oppenheimer as big blockbusters this summer, or longer run like the Marvel Cinematic Universe and the grip it has over modern cinema, other franchises like Star Wars or even Mickey Mouse, the biggest franchise in history, the biggest grossing franchise in history is Pokemon. and he has zero cultural clout among us adults right i i don't get it i had to buy my son like a gold nintendo pokemon card in metal gold in france this summer and it's in spanish he doesn't understand it but it's his it's his prize possession he's shown to all his friends and he loves it and like they have just printed money through t-shirts toys caps pokemon cards and all that jazz.

15:37And frankly, it seems that this is something that has more staying power than some of the stuff that I grew up with. You got to catch them all in English, Japanese and Spanish. That's the quest we're on. Exactly. For the record, Tears of the Kingdom, amazing game. Where is Mario Odyssey 2? Where is it, Nintendo? Please deliver. Thank you very much. Amen. Robin, thanks for being here. We'll be back very soon. And listeners will be in your feed again on Thursday with another episode of Unhedged. Catch you then. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein.

16:12We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free. A 90-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.

16:45We'll be right back.