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Government Bonds are Strange

January 12, 2012

If there is one thing I’ve learned from the “Is Debt a Burden?” debate, it’s that government bonds cause a lot of confusion. There are a lot of ways to think about them.

Paradigm #1
Government bonds are like corporate bonds or personal debt. We lend the government money, and eventually it will pay us back.

This paradigm is very appealing because it is so easy to understand. People lend the government money, the government spends it now, and later, the government pays them back. To the people doing the lending, it does not feel like a tax. They buy the bond iff they think they will benefit from it. Thus, the lender’s expected lifetime utility is higher due to the bond purchase. When the bond comes due, someone else will have to be taxed even more to make up for the interest payments which have accumulated.

The government does not consume anything itself. When the government pays back bonds, it’s not like the president and members of Congress personally spend less. They either reduce spending in other areas or increase taxation. In both cases, the benefits to the bondholders are not balanced by costs to the government, but by costs to the taxpayers and former beneficiaries of the government programs cut.

Paradigm #2
Government bonds are like taxes, combined with a promise to tax more tomorrow.

If the government creates a bond, and a citizen buys it, it’s like the citizen is voluntarily paying a tax. The bond purchaser does not gain any claims to real resources, nor do they get any consumption value from the bond. Later, the government promises to tax someone and give that money to the bond holder. The bond holder might pay some of the tax to pay themselves back, but probably not all of the tax. To the bondholder, it looks like an asset. To the government, it looks like a tax now that they get to keep, followed by a tax later that they have to give to the bondholder. To some random taxpayer, it looks like a way to delay taxation. To each party, the bond looks different.

When people focus on the seen, debt financed government spending seems to be lower cost than taxation financed spending for people today. What is unseen is the crowding out from the bond purchase. Resources the government uses cannot be used by the private sector. Crowding out can either be in the form of lower private investment or lower private spending. Because effective fiscal stimulus will lower the amount of monetary stimulus which the central bank will do, all but the most dedicated macroeconomists won’t be able to see the crowding out.

Paradigm #3
Government bonds are like temporary money.

Suppose that the government doesn’t want to tax to pay for spending. Some might say that they have two choices: print or borrow. Under this paradigm, they only have one choice: print money. The government can either print small denomination, highly liquid fiat currency which does not earn interest (usually), or it can print large denomination, less liquid fiat currency which does pay interest. Both of these types of fiat currency do not correspond to any real natural resources, such as gold and their value is entirely determined by what the government feels like they should be worth.

The big difference when it comes to inflation/spending when it comes to these two types of fiat currency (reserves and bonds, btw) is that bonds promise to self destroy. When the government pays back debt, it does not keep the bond and respend it*, the bond goes away.

Expectations matter when it comes to monetary policy. If the central bank increases the money supply tomorrow and promises to reduce it in two days, prices tomorrow won’t change, especially in an environment of low interest rates (I can’t bring myself to say liquidity trap). People will simply hold the money just as they were holding the bonds. Without future expected inflation, people have no reason to play hot potato with the money they have. Since bonds promise to destroy themselves, they are like a temporary monetary injection and thus will have less of an inflationary impact than paying for spending by issuing currency or reserves.

* The government rarely actually pays back debt. Normally, the debt is “rolled over”, meaning the government issues more debt to pay for its past debt. So, empirically, this paradigm is usually flawed, because government debt is fairly permanent.

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