Saturday, November 26, 2011

What is a Bond?

Lotsa people write about the question "What is Money?". There's a collection edited by John Smithin under that title with some papers with some good & not-so-good answers. And of course there are Alfred Mitchell-Innes' papers. But a lot of people seem to be get confused by bonds, by what is usually called (government) debt. They get obsessed about interest - and forget about the principal.

A text for today's sermon by one fellow who was not confused (my emphasis) :

"Much has been said of late about Federal finances and inflation, the gold standard, etc. Let me make the facts very simple and my policy very clear. In the first place, government credit and government currency are really one and the same thing. Behind government bonds there is only a promise to pay. Behind government currency we have, in addition to the promise to pay, a reserve of gold and a small reserve of silver. .."

ADDRESS OF THE PRESIDENT DELIVERED BY RADIO FROM THE WHITE HOUSE May 7, 1933

Currency and credit(debt/bonds) are really one and the same thing. All they are is promises. Go back to WiM for a moment. One way of thinking of things is that money, state money, currency, dollar bills, reserves IS the same thing as a government check. When one transfers this state money, one just endorses the check over to someone else. The good thing about this is that it very clearly shows that money here, as everywhere, is a credit/debt relationship between two economic actors.

OK, bonds: They usually have a principal & a coupon. In other words you buy them for (around X dollars) They pay off, (antichretically? ;-) word of the day) little baby coupons. And then you get the principal X dollars back.

But one can have zero coupon bonds or bills where you just get a fixed amount of dough at some specified time. Obviously, a regular bond can be chopped up into a bunch of zero-coupons representing the principal, and each coupon interest payment. And regular bond is just a bankroll of these zero coupon bonds put together.

So what is a (zero-coupon) (government) bond? Well, nothing but a post-dated government check. A government check with a date in the future. Or alternatively, a dollar bill with a date in the future printed on it. Again, a one year bond of 2011 is just a 2012 dollar bill. These dollar bills with a future date on them trade at a discount, not at par. That's what interest is. That's all. (There were a couple auctions in the depth of the depression in the 30s when the brilliant innovative superbondbull financiers of the day paid negative interest -hey its OPM - see Depression Decade by Broadus Mitchell)

But many people think that somehow bonds are different from currency. That a dollar bill is something other than an all grown-up, mature bond. Some tyro MMTers or fellow travelers think that while bonds are debt or liabilities, currency, fiat money is not. That it would be magically good if the government printed only current dollars, = bonds with a current date on them, that the Treasury having to sell future dollars = bonds for current dollars is a constraint on the Treasury & government spending. That the bonds are somehow the liability behind the asset of fiat money & this cockamamie procedure is done because of double entry bookkeeping. (Of course each bond, each dollar is already an asset/liability credit/debt pair.)

The (maximally confused) mainstream (and even some good economists are confused) think that somehow dollar bills with future dates printed on them "back" dollars with current dates, back current spending, that there is some government budget constraint - which amounts to the brilliant observation that government spending equals government bond issuance plus government currency issuance. In other words, if you have ones & fives in your wallet, your spending is the amount of evil rotten seignorage ones you spend, plus the good wholesome sterilizing fives you spend.

If you believe such things, the question which should always be on your mind when studying so much that is called "economics", and which is made clear by concrete examples like checks & dollar bills, is :

Are you insane?

12 Comments:

OpenID abellia said...

I think some people don't like bonds not because they worry about solvency, but because they provide interest to holders for no risk at all - no economic activity. Also, bonds represent future money, and we don't know how much money may be needed in the future or who should have that money - yet we continue to issue these obligations. The Fed can drain excess cash by issuing more bonds, but this seems unlikely if the government is trying to tighten and reduce spending.

Bonds are complicated when more simple solutions exist - say, a tax policy based on the current inflation rate and/or distribution of assets. One could even have a negative tax when necessary -- all part of the same system. In other words, the goal, I hope, is to regulate the money supply and distribution of that supply, and bonds are a crude way to go about this business.

Getting rid of bonds would also get rid of the mindset that the country has obligations that it might be unable to meet.

Wed Jan 18, 06:45:00 AM  
Anonymous investment in farmland said...

Interesting about zero coupon bonds. Have never really quite understood how those work.

Sat Feb 18, 07:25:00 PM  
Blogger Calgacus said...

Sorry for not replying earlier, abellia. No time to reply to your comment still.

investment in farmland - the thing is that everything in economics & most other disciplines is so simple it is hard to understand, and usually explained atrociously.

Zero coupon bonds are very simple - they are exactly dollars with future dates. Regular bonds, with principal & coupons are just sums, bankrolls of ZCBs. And that explains how ZCBs were first offered as independent securities ion the 80s before governments sold them directly.

A broker would just have a regular bond & "virtually" split it up, sell the pieces to investors, and take a little vig for himself as always.

Sun Feb 26, 02:26:00 AM  
Blogger Roger Erickson said...

Calgacus,
You seem to know a bit about the history of bonds. May we correspond by email?
Roger Erickson
rge (at) OperationsInstitute (dot) com

Thu May 03, 11:14:00 AM  
Blogger joebhed said...

Why don't we take up here on your blog whether all money is debt?
As you failed to respond at RMMs.
Ready when you are.

Thu Aug 09, 06:01:00 AM  
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