Saturday, January 12, 2013

How Bonds Work (and Why a $1T Coin Won't Work)

In the Austrian School of economic theory, government debt causes "inflation." That inflation might or might not result in higher consumer prices, which causes some confusion among politicians, pundits, and the public when they hear claims that governmental debt causes inflationary pressures. Reasonably, people assume inflation always means price increases. However, what the economists are describing is a bond market response to debt financing.

As I am going to discuss in another post, Paul Krugman has abused the term "inflation" when discussing Austrian economic theory. As a professor, he certainly understands that Austrian/Chicago School theorists use the term inflation to mean any devaluation of fiscal reserves. Basically, dollars lose value because the bond market doesn't have faith in the government to behave responsibly.

Bond markets are strange, powerful monsters. Upset the bond market and you'll find interest rates skyrocketing. Treat the bond market wisely, issuing low-rate debt that is as low-risk as possible, and a government can finance infrastructure projects or new programs quite affordably. The key is that people have to see the bonds of a local government body, a state, or the federal government as nearly risk-free if investors are going to accept ultra-low interest payments.

Let's create a hypothetical situation.

The stock market and commodities are experiencing high volatility. Each week, the market rises or falls up to 5 percent. The volatility bothers some investors, including you, so these wise and risk-averse souls turn to low-interest but secure government bonds.

For our hypothetical bond example, let us assume that "Zorkland" sells $100 bonds with a 10-year expiration, yielding 5 percent annually. Over a decade, the Zorkland treasury will pay $50 in fixed interest and have to return the initial $100 face value to the last holder of the bond.

Now, imagine you purchased this bond and hold it for five years. You invested $100 in the bond, helping your government finance projects or wars, or even payment to other bond holders — bonds do resemble a pyramid scheme at times. During that fifth year, you need access to cash. Desperate for liquidity, you sell your $100 bond for $90 to another investor. You did not lose money, since you earned $25 in payments ($5 for five years) and received $90 from the new bond owner. You gained a net $15 — not much, but better than a loss.

Examining your side of the transaction, you might have done better or worse than people investing in other asset markets. Stocks might have done well. Metals might have done well. If other investments paid 15 percent a year, then there will be little market for your bond. Why buy a bond when other investments offer better returns? As a result, investors might soon offer less than $90 for a bond; paying less results in a greater real return. Bond prices falling means the investors are seeking a higher rate of return to compete against other asset markets or investors fear the government issuing the bonds might not be able to redeem the bonds at expiration. Either way, less demand equals higher interest rates.

The second owner of the bond, having paid $90, still receives $5 annual payments. While this is still 5 percent of the face value of the bond, the second investor is receiving a 5.5 percent annual dividend. That is because $5 is 5.5555 percent of $90. The new bond holder discovers in two years that Acme Widget stock is rising 20 percent annually and pays a small dividend, so the holder sells the bond to yet a third investor. This time, the bond sells for $80. The second owner has neither gained nor lost money, excluding the effects of inflation, and can now buy the better investment in Acme Widgets.

The last bond holder receives three years of payments, seven having elapsed, and gets to redeem the bond for face value. This last investor, therefore risked $80 for a net return of $35 at the maturity of the bond. That is a 43.75 percent return on the original $80. Not a bad deal at all for the final investor.

From the government perspective, the bond with a fixed annual payment was going to cost $50 no matter what. Ah, but things are not that simple.

As the bond went from hand to hand, the effective interest rate increased from 5 to 5.56 to 6.25 percent. As existing bonds yielded better interest to their holders, the government had to promise a higher interest rate on any new bonds issued. The interest rate the government paid on bonds likely increased a full percentage point ("100 basis points") and this caused a cascade effect throughout the economy. Welcome to inflation.

Higher "coupon rates" (the annual payment to bond holders) mean the government must raise more debt financing (selling yet more bonds and causing a debt spiral), increase taxes (potentially causing an economic slowdown or voter revolt), or cut spending on programs people want.

In reality, things are far more complex. Governments issue bonds with a variety of maturation periods. You might find two-year, five-year, and ten-year bonds in a market. The more distant the maturity, typically the higher the interest paid. Why? Because it is much harder to predict the financial situation in ten years than in two, so there is more risk associated with a ten-year bond. To convince people to finance public debt and wait ten years to redeem the principle amount, governments pay higher interest.

In the current situation of the United States bond market, the Federal Reserve is actively, intentionally, distorting the bond market to keep interest rates low. That is why we are not seeing consumer inflation and economists like Paul Krugman can say, "See! Things are fine with the current national debt." The Federal Reserve is buying bonds from the Treasury. The Fed is not, technically, part of the Executive Branch. It is an independent body chartered to maintain the currency and inter-bank lending.

As the U.S. debt increases and people trust the government less, the price of bonds falls and interest rates increase. But, what if the Fed steps in and pays an artificially high price for bonds? This keeps interest rates low and bond prices high, creating the illusion all is well. The Fed becomes the "investor of last resort" in the bond market. At some point, though, the Fed won't be able to buy any more bonds. Then, the bond market will collapse and instead of a slow decline in price and increase in yield we will witness a sharp shift in the bond market. At least that is the fear of many of us with an Austrian School perspective.

For the Fed to indefinitely support the bond market, it would need to increase the money supply. Increasing the supply devalues the dollar, causing some inflation but not the horrible spike of a bond panic.

Basically, President Obama and Congress are gambling that the Fed can overwhelm the natural tendency — and purpose — of the bond market. As long as the Fed engages in quantitative easing, it can keep masking the debt problem. But, QE will end at some point.

There has been chatter (and I'm not linking to the stories) that Treasury could mint a $1 trillion coin, deposit it with the New York Fed, and then the Federal Reserve could continue to buy federal debt in the form of bonds. Such ideas are absurd — and dangerous. I don't care how many "brilliant" economists accept this idea as plausible. Do these morons imagine the markets won't see right through such manipulation? Right now, the markets are responding to the distortions caused by Fed policy. Since bonds are offering weak returns, money is flowing into equities and driving up stock prices. Commodities are also benefiting.

But, the game has to end someday. How will it end? Badly. Not even a magical $1 trillion coin will fool the markets. I happen to believe that any additional gaming of the system will spook the bond market and equities markets. Talk of endlessly printing money or minting magical coins will spook the market as badly as an abrupt halt to Fed bond purchases.

The more stable and better managed a government, the smaller the gap between short-term and long-term bond yields. This is known as the "yield curve" and reflects how much people trust leaders to behave responsibly. Higher interest is always a warning sign from the market to the leadership: manage your money better.

I realize this post has simplified bond concepts to the point investors and economists might cry foul. My goal with this post was to explain why rising interest rates reflect poorly on a government, and how governments can mask the actual market pressures. I hope this helps a few people understand why Austrian economists do view the current situation as inflationary, even if consumer inflation is modest.

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