Jan 30, 2009
What happens when government does not take in enough money in taxes as it spends? It borrows. How does it do that? It issues bonds. A bond is a certificate for a loan. If you buy a government bond, or any kind of bond, for that matter, you are loaning the entity from which you bought it money. The bond contains a rate of interest which you get during certain time periods for corporate bonds, or at the end for government bonds. The rate of interest paid is directly related to the demand and supply of bonds. If there is a big demand for your bonds, you can offer a smaller rate of interest than if you have to “force” people to buy them, which requires a larger rate. (For the sake of this article we will not complicate the model by talking about selling bonds on the bond market, prior to maturity, although the same economic rules hold.)
Government bonds do not have as high an interest rate as corporate bonds, and one main reason for this is safety. Companies do go out of business, and there is a possibility that the bondholders might not get their money. But what is the likelihood that the government will go out of business? Not much. Investment managers like to show good returns for their companies by purchasing bonds, but a large part of their portfolio will be in “safe” bonds. The safer bonds are public utilities bonds and the like, AND government bonds. Even though the fund managers want to get a respectable return, they do not want to take too much risk, so a large part of their portfolio will be in safe investments. The safest bonds are government bonds.
Now you are a corporation who needs a very expensive piece of equipment and you do not have enough profits saved up to buy this machine. Not buying this machine will mean that your business will come to a dead stop because you will not be able to make a component of your product. So you issue bonds. The problem is that your bonds are competing against a ton of safe government bonds. In tough economic times there is a “flight to safety,” which means investors are more likely to buy “safe” bonds than regular corporate bonds. In order to get people to buy your bonds, you must offer a high rate of interest to entice them away from the government bonds. But this raises what is called “the cost of capital.” This means that the corporation will have to make more money on their product to pay the higher interest rate than they would if they did not have to compete with government bonds.
This is similar to a situation where you need a car for work. You have no choice but to buy a reliable car. But because your credit rating is not as good as that of your neighbor, Fred, you get charged a higher rate of interest to buy the car. Both you and Fred are competing for the same available money. Because he is “safer” than you, his “cost of capital,” the interest on his car, is less. If your personal budget is already strained, you will lose weight quickly, because you still have to get to work, but will not be buying your usual quota of food. If you cannot make the payments because of the high interest, the car gets repossessed, and you are out of work completely.
Now, how does the company make more money to pay the larger rate of interest? In a competitive market, it cannot raise prices, because most of their customers will go to its competitors. It could improve the product, it could do better advertising, but none of these things guarantee success, and they cost money, which was the problem in the first place. In truth, the company might not be able to buy the machine, or, having bought the machine, not be able to keep up the interest, or the cost of capital. They then will declare bankruptcy, or just go out of business.
So when government tells you that it will spend tons of money to help the economy, and taxes are not scheduled to pay for these expenditures, remember there will be many more safe government bonds available to compete with corporate ones, which will be crowded out of the market, making it harder for companies to borrow money in the bond market. Government deficit spending (sound familiar, President Obama) to help the economy is actually helping to kill it!