July 7, 2011: What is a Treasury Bond?

Answering this question is trickier than it may seem. The ignorance is everywhere and even Nobel Prize winning economist Paul Krugman does not get it. I do not know of any politicians who get it either.

The misunderstanding stems from gold standard logic. Our transition from a gold standard to a fiat currency has left some economists behind thinking it is still the 1870s.

Under a strict gold standard, a government can only spend gold that has been mined and is in their vaults. If a government desires to spend more gold than it receives in gold tax revenue, than the difference must be financed by borrowing gold from the private sector or other governments. The government cannot spend gold that it does not possess, hence the financing.

This borrowing would occur through the issuance of government debt, and an investor would be wise to keep an eye on the solvency of the government before deciding what interest rate to demand.

A fiat monetary system, like the one we have in the United States, has radically different implications for the role of government “debt.”

Under a fiat system, money does not exist until the government spends. The government literally spends money into existence; money comes from nowhere.

Imagine the first day of a new fiat government. You demand a tax from your citizens in your currency, but no one possesses this new currency. How can your citizens pay tax in a currency that doesn’t exist? Under a fiat system it is impossible for the government to run a surplus in its first year. The first fiscal year has to be a deficit. How can you ask your citizens for more currency than exists? Similarly, it would be impossible to borrow money that doesn’t yet exist.

In a fiat economy, taxation and borrowing does not finance government spending. It is reversed. Government spending allows the government to impose a tax and government spending allows the government to borrow its currency.

In a gold standard deficits are not sustainable. In a fiat economy surpluses are not sustainable. This is not up for ideological debate; this is accounting.

Now that we understand the basics of a fiat economy, let’s imagine a scenario where the government runs deficits for the first 5 years. Each year they are spending more money into existence than they take out of existence through taxation. If their spending is not producing goods and services then inflation will clearly result. Inflation can make commerce more confusing, and so it is decided that something must be done. Taxes could be raised, but implementing tax policies can be slow and unpopular. If only there was a way to take money out of the system without force…

Enter the Treasury bond. The Treasury bond is simply a security designed to entice investors to take currency out of circulation. The maturity determines how long the principal is taken out of circulation and the interest payments keep investors happy. No coercion or taxation necessary!

Everyone wins.

The word bond brings up connotations of “financing spending” but the idea of a sovereign government with the power to create money financing itself through debt issuance is illogical from inception. If I could rename Treasury bonds I would call them “monetary manipulation contracts.” That is their only functional role in a fiat economy.

That is operationally how a Treasury bond functions in a fiat economy. Government deficits can continue indefinitely, but government surpluses cannot. Treasury bonds and taxes do not finance spending, but help regulate inflation.

It’s a weird system, but it’s the one we have.

I just hope the Treasury keeps issuing 30 year Treasuries. My portfolio loves the combination of high volatility and low correlation to other asset classes.

July 17 EDIT: Here is a different way of understanding the role of taxation and bond sales. We can easily conceptualize how our tax dollars disappear and how spending comes from nowhere by simply realizing that our government has infinite reserves. When we pay our taxes, our payment is added to to the governments infinite reserves. That is how our money effectively disappears because any amount added to infinite still just gives us infinity.

The same logic applies to spending. Because the government has infinite reserves, a deficit never has to be financed through taxation or bond sales. They still might both be useful, but they are not used for financing a deficit.

Money comes from nowhere when it is spent by a fiat government, and goes nowhere when a fiat government receives payment. When doing the arithmetic it is very clear.

So why would a fiat government tax?

Taxation creates a demand for fiat currency and drains liquidity. Remember how banks used to issue their own bank notes? They had an intrinsic value because they could be used to extinguish a liability at that bank. A fiat currency works the same way, except that the currency is used to extinguish an imposed tax liability. Without the imposition of the tax liability, there is no intrinsic value of the currency. It would just be a massive bubble fed by faith.

Why sell bonds if we have infinite reserves?

Bond sales drain liquidity for the duration of the bond and provide the fed with an inventory of government securities to trade. Bond sales are simply an extension of monetary policy because their only use in a fiat economy is to manage the amount of money in the economy. A fiat economy could very easily run deficits without debt issuance, but inflation would result. Thus, bond sales are only a tool for controlling inflation.

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