Whenever I listen to the news and hear about multi-billion, even trillion dollar national debts, I always wonder where on earth does all that money come from?
So yer, how does government borrowing actually work?
Well it kinda goes like this…
Governments raise taxes to pay for schools, hospitals, roads and many other services. But tax revenues alone don’t always cover it. To make up the difference, they also take out loans, known as ‘bonds’.
Bonds (also known as Gilts) are sold on the financial markets and are bought by insurance companies, pension funds, investment funds and other financial institutions. They act as a hedge when the stock market is down and provide a reliable form of interest income.
Individuals can also buy into government bonds, although this tends to be through a pension or investment fund.
Further demand for bonds is driven by central banks like the Bank of England, who are able to ‘print money’ to buy government bonds. This process is called ‘quantitative easing’.
Not all bonds are created equal
When a government wants to borrow money, it issues bonds onto the financial markets. The bond is essentially an agreement that the government will borrow a sum of money for a period of time, say for five years.
At the end of the five year period they return the money to the owner of the bond. In addition, they make regular interest payments to the bondholder.
Different factors determine the interest rate. One of the biggest factors is risk. If a government has not been able to manage its finances well, it may end up defaulting on the bond (e.g. not paying it back).
With this increased amount of risk, the bond will require a much higher interest rate to attract investors. Some bonds from particularly risky governments will struggle to sell at all.
Credit rating is everything
Just as people have a credit score that determines the loans and rates of interest they can get, so too do governments.
Credit rating agencies like Standard & Poor, Moodys and Fitch assess the ability of a government to make regular interest payments and repay their loans on time. The lower the perceived risk, the better the credit score. This results in lower rates of interest and higher demand for the bonds.
So in a nutshell…
Governments borrow money from large financial institutions like pension funds, insurance companies and banks, in exchange for regular interest payments. Some governments are financially more appealing to lend to than others – which means they get more demand for their bonds and lower rates of interest.
Thanks for reading 🙂