On the All Powerful Bond Markets

This week’s learning is part 3 of a 12 part series on The Ascent of Money by Niall Ferguson. (Parts 1, 2)

Thanks to frequent warring among Italian states, rich citizens in Florence lent money to the government and received interest in return. These investors were then allowed to sell their bonds to other invest, thus creating a “market” for these government bonds.

We are all affected by the bond markets in 3 ways –

1) Most of the money we put away for our retirement are reinvested in the bond markets
2) A fall of value of government bonds results in higher interest rates resulting in painful consequences for borrowers. Let me explain that –

Let’s assume you own Japanese government bonds worth $100,000 dollars that normally gives interest of 1.5% (=$1,500). Now, the Japanese economy is doing well and the markets value these bonds at $102,000. Thus, the interest rate goes down to 1.47% (1,500/102,000) to compensate. Similarly, if the Japanese economy is doing badly or if investors fear a Japanese default, the value of these bonds will go down so the investors get a price that compensates the risk they take.

If the goes down to $80,000, the new interest rate is 1,500/80,000 = 1.88%. All of a sudden, the whole Japanese economy suffers a massive rise in interest rates. Thus, the bond markets control every price of stock, mortgage, or loan you pay! And the power in the bond markets is that it can punish poor financial regulation by reducing value of bonds, raising interest rates, and thus, making a deficit even harder to meet.

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Sketch by EB

Thus, a downward move by the bond market leaves the government with 3 options –

1) Default on a part of its debt realizing the bond market’s worst fears
2) Reduce expenditures to appease it
3) Increase income by raising taxes

While bonds were created to control government spending, it has ended up dictating it in a crisis.

And, like the Bond created by Ian Fleming, it has the license to kill.