Monday, January 26, 2009

Why Buy Government Bonds?

There is a common assumption that government bonds are safe assets during times of crises, but is there any logic behind this?

Today, the national debt stands at around $10,600,000,000,000.

While one could divide this number by the population of the United States in order to find each citizen's share of the burden, this would be incorrect from an economic standpoint, as children and the aged do not usually pay taxes. A much better number to divide the debt by would be the amount of the potential U.S. labor force, which even includes those whom are currently unemployed: in 2008, the labor force of the U.S. stood at 155.2 million.

Therefore, each citizen in the labor force owes about $68,387 to the government.

If you are purchasing government bonds today, you are betting that each citizen will pay you back your money through what is left over from their taxes.

And where do taxes come from?

The private sector.

If the economy is experiencing a recession, and if the private sector is in bad shape, there will be less federal tax revenues available to pay back government bonds.

How does the government fix this problem?

They issue more debt at a lower interest rate in order to pay back the old bonds.

The only reason the government can do this is because today's bond buyers are essentially dumber than yesterday's bond buyers: in other words, the government is a Ponzi scheme.

Unless the government issues bonds at a negative interest rate (it should be self-explanatory to a bond buyer why this would be a stupid investment since it would be better to hold onto cash), the principal of the national debt will still be higher, which will offset the lowered rates. In other words, the taxpayers will still owe more money.

One could think of it this way: if an individual takes out a loan for $10 at a 10% rate for one year, they are essentially obligated to pay their lender $11 back at the end of the year. If the individual can not pay the $11 loan back at the end of the year, they could borrow another $11 in a year, but even if they can convince a new lender that they should only be given a 5% rate, they will now owe $11.55 at the end of the second year! In other words, the second lender is essentially dumber than the first lender, because they offered a lower rate to an individual that failed to pay their debt on time; what's more, there is even greater risk involved on the newer lender's behalf, since the borrower must pay even more money back at the end of the year.

The only reason an even newer lender might accept such a scenario the third year may be because they believe an even dumber lender is going to come along the fourth year, but the scheme is mathematically doomed to end when the interest rate is below -100%, and/or when the entire economy is consumed by the legalized fraud. This could take decades, but the problem will slowly accelerate.

And if one thinks massive monetary creation should save government bonds, they'd be dead wrong. Inflation results in higher interest rates and higher prices, and therefore, the real value of the bonds will still be lower--if hyperinflation occurs, the bonds will be worth almost nothing--unless they are used as collectors' items in a few hundred years.

To those whom say we are experiencing deflation at the moment, let me remind you that it was not long ago when the housing market was said to produce infinite returns.

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