The Way Government Bonds Work: Lessons for Matt Bai

Thursday, 23 September 2010 07:35

Reporters for the NYT who write on economic policy issues should know the way government bonds work. However, that is apparently not the case with Matt Bai. In defending an earlier article in which he referred to the bonds held by the trust fund as "iou's," Bai responded to a reader's question:

"The principle to which you’re referring is that the government guaranteed all of this Social Security surplus money (which it spent) with Treasury Bills. The reality is that redeeming that trillions of dollars in debt would require issuing trillions more in debt."

Bai's statement is of course true, but that is the case with all government debt. For example, suppose Mr. Bai decided to buy $100,000 of 30-year Treasury bonds. If he did this the government would turn around and spend the money that Bai had lent it. Bai seems to think there is something sinister in this story, but in fact that is usually what happens when a government or company issues bonds: it spends the money.

Thirty years from now, in 2040, Bai will go to cash in his bonds. When he does this, the government will be forced to borrow another $100,000.

This is the same story as the bonds held by Social Security. It is really very, very simple. The government will have to redeem these bonds just like any other bonds. Now, Mr. Bai apparently wants the government to default on the bonds held by Social Security. It could do this just like it could default on any of the bonds it has issued.

The people who would not get the Social Security benefits that they had paid for certainly would have good cause to be very angry if this happened, since it is a policy that is difficult to justify. Of course they may advocate that the country default on its other bonds, which might be appropriate if the country really is in such bad fiscal shape that it can't meet its obligations to its retirees.

As a practical matter, Bai is badly confused about the nature of the country's debt burden. The debt that the country is now accumulating because of the downturn need not pose any long-term fiscal burden since the Fed can just hold the bonds and repay the interest to the government.

The longer-term projections showing a serious deficit problem are all driven by projections of exploding health care costs. If we don't fix our health care system then we will face serious economic problems, one of which will be the budget deficit. However, as all economists know, the real problem is with the health care system.