Government Bonds are Just Like Government Money

Government debt is not like private debt.  Government debt, government bonds, are really just another form of the government-issued fiat money obligations – just like paper money.  There really is little difference between government bonds and that paper money in your pocket – except that the bonds pay interest and are harder to cash at 7-11.  Yves Smith at NakedCapitalism points out what I’ve mentioned before:

what is the functional difference for the federal government between Treasury securities and bank notes? Both are liabilities of the federal government. But liabilities of what? The only obligation they enforce on the government is the promise to repay with more paper (or electronic bank credits, if you will). For all intents and purposes, bank notes, reserve deposits, and Treasury securities are fungible: they are obligations to be repaid in the same fiat currency.

I’m looking at a five dollar bill right now. It says “Federal Reserve Note” across the top. It has an oversized picture of Abraham Lincoln in the middle. It also says “this note is legal tender for all debt, public and private” in the lower left, signed “Anna Escobedo Cabral, Treasurer of the United States.” On the back, I see “The United States of America” up top and “In God We Trust” underneath with a picture of the Lincoln Memorial in the middle, labelled “Lincoln Memorial” for those who don’t know what it is. But, I’m trying to figure out why Geithner and the gang couldn’t just reel off a bunch of these and some Jacksons and Benjamins and pay people?

Now I’m looking at a Canadian Twenty. It sure is colourful. It has a bunch of French on it and a picture of the Queen. But, other than that, it’s really no different than the American fiver. “Ce billet a cours legal/ This note is legal tender.”

I have some Euros and Mexican pesos too. But these central banks don’t say anything about their obligations. Very dubious! At least they’re colourful like the Canadian money.

How ‘bout a British tenner? Dickens on the front, and the Queen on the back (she’s everywhere). A-ha. Here’s what I’m looking for. It says “Bank of England. I promise to pay the bearer on demand the sum of ten pounds.”

I think that gets me to my point, actually. From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].”

So, the U.S. government could legitimately stop issuing bonds altogether if it wanted to. When people complain about the admittedly enormous government debt, they don’t think of the mechanics of the issue. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.

If you’ve following, then you realize two things.  First the government* can always pay off it’s bonds.  Second, there’s no budget constraint that forces the government to “borrow in order to spend”.  Instead, the government chooses to borrow (issue bonds) to meet any difference between spending and tax collections.  It’s a political and policy choice.  The government could spend by issuing credits to bank accounts (electronic checks) which would create bank reserves. Or the government could just issue new paper currency to pay for it’s spending.  Either way, it’s essentially the same:  the government issues a paper (or electronic) obligation to pay in the future.

So what’s the difference?  Well there is one key difference.  (no, it doesn’t have to do with inflation).  Money or bank reserves issued doesn’t pay interest.  So people have limits on how much they want to hold.  So they then spend it and the money goes into circulation as people buy, sell, and trade things.  The real economy grows because the medium of exchange is more plentiful.  What happens when bonds are issued instead?  The holders of bonds earn interest.  That makes them comfortable just sitting on the bonds and collecting interest from the government at no risk.  There’s no exchanges, no trading, no buying, no selling.  No economic activity.  The political preference for borrowing over issuing money/credits means a subsidy to a narrow class of people to take their wealth out of circulation.