Am I correct in understanding how government bonds work?

[Culain]

From what I understand, a bond is an I.O.U. People purchase bonds with the goal of receiving a profit in interest at maturity. The government issues a bond out to investors (foreign or local), to pay back the bond (with interest) the government attempts to profit from the principle amount. The US runs an annual deficit so it resorts to either printing or borrowing to service the debts. Printing raises the rate of inflation while borrowing adds further interest because you must borrow at a higher rate to pay back the previous loan plus interest.

 

The current national debt is total amount of funds owed through government bonds, not accounting for inflation or unfunded liabilities.

 

Anyways, I have some friends who have invested into bonds and are adamant that they will receive a profit at maturity. They argue that even though inflation is rising by roughly 2% a year the government will pay them back 4%, a gain of 2%. This shouldn't be possible. Is there something I'm missing here like hidden costs or taxes?

 

 

 

[MrCapitalism]

I think you're missing the dissimilar effects of price inflation.

 

If the government is borrowing more money in part to pay his 4%, then this process is removing money from other uses and transferring it to your friend. This has no change in the total money supply, and negligible price inflation.

 

If the government is creating new money in part to pay his 4% gain, then this inflation (of the monetary kind) will result in a change in prices. However, as a holder of government debt, he's going to be receiving this new money first before general prices have changed to reflect it's existence. Thus, his profit is the difference between the current amount of money in existence, and the new inflated quantity transferred to him by the mature bond.

[Pepin]

From what I understand, a bond is an I.O.U. People purchase bonds with the goal of receiving a profit in interest at maturity. The government issues a bond out to investors (foreign or local), to pay back the bond (with interest) the government attempts to profit from the principle amount. 

 

Perhaps nitpicking, but the term profit may not be accurate. I believe the theory of debt is that it can be useful when there are initiatives taken that will increase your income by more than the total borrowed amount. For instance, you may choose to go greatly into debt, but you may use the money for a college education. If all works out, though you are paying 7% interest, your income will likely increase by 15%.

 

Bad debt is debt where there is a net loss in investment of the borrowed money. This is somewhat subjective on the individual level. Someone who goes greatly in debt to buy a brand new car is probably not making that great of a decision, as the car's value will depreciate by 25% after the first year. But, if the individual really cares about the car being brand new, then this decision could be said to be profitable. But on an institutional level where there are clearly defined goals, a net loss can clearly by measured. A government program which is debt financed whose returns are less than the borrowed amount were not worth it.

[Daniel Unplugged]

For the purpose of this post I will refer to an increase in prices as inflation, and money printing as, well, money printing.

 

A government bond is nothing more than a fixed term loan to a government.

 

Merely printing money does not necessarily cause inflation. Try this thought experiment:

 

The federal reserve prints up a trillion in new notes. It sticks them all in a warehouse, and doesn't tell anybody what it has done. Does this cause inflation?

 

No. Prices will not change at all due to this. For the printing of money to cause inflation, it needs to be spent on goods and services in the real economy. This is why the Fed's QE program has not caused rampant inflation. (Almost) all of the money it has printed up to buy government bonds has not been spent in the real economy, it is just sitting in the vaults of the worlds banks.

 

Arguably the most important equation in economics is MV=PQ.

 

M= money supply

V= money velocity

P= the general price level

Q= the quantity of goods and services sold.

 

P and Q havent moved much the last 5 years. Since M has been greatly increased, it must be true that V has greatly decreased, and it has.

 

What all this means is that the US monetary system is a ticking time bomb. Should the money velocity increase back to it's normal level, and the money supply remain unchanged, there will be a period of very high inflation. If (when) the money velocity picks up, it remains uncertain whether the Fed will be able to prevent an economic catastrophe.

Anyways, I have some friends who have invested into bonds and are adamant that they will receive a profit at maturity. They argue that even though inflation is rising by roughly 2% a year the government will pay them back 4%, a gain of 2%. This shouldn't be possible. Is there something I'm missing here like hidden costs or taxes?

Your friends correct, as long as:

 

1. They don't have to pay tax on their profits.

2. The government actually repays their loan.

2. The inflation rate is what the government says it is.

4. The inflation rate does not increase much prior to the bond expiring.

 

They are taking on a lot of risk for a miniscule return.

[shirgall]

Anyways, I have some friends who have invested into bonds and are adamant that they will receive a profit at maturity. They argue that even though inflation is rising by roughly 2% a year the government will pay them back 4%, a gain of 2%. This shouldn't be possible. Is there something I'm missing here like hidden costs or taxes?

 

Government has a ton of ways to pay the interest on bonds. Nothing stops the government from borrowing more money to pay of your bond as others have pointed out, but the government's collateral for paying back bonds is the ability to take money from people by force. When Obama says "pay our bills" this is what he means. The collateral of a US bond is your blood and treasure.

 

Inflation is an increase in the money supply due to what amounts to printing new notes. (A note is like a bond, but it can always be redeemed for its face value--modern reserve notes are payable in... reserve notes instead of gold and silver before 1972.) Inflation is what amounts to a wealth tax. It makes all money worth less by increasing its supply. The really wealthy are not damaged by this because they are the ones that typically get the lion's share of the new money that is printed. The rich get richer. The poor are unaffected. The middle class is shafted, again.

 

Treat the purchase of government bonds as an investment. It has some risk, and the interest you earn is intended to offset that risk. Government bonds are considered really low risk and are considered the best hedge against inflation.

[Culain]

Thanks for the replies I seem to have a slightly better grasp of it now.