Polymath A (mostly) technical weblog for Archivale.com

November 20, 2012

Why I don’t feel sorry for municipal bond holders

Filed under: Personal — piolenc @ 2:31 pm

Thirty years ago, people were telling me to invest in government bonds for security and guaranteed yield, and wondering why I was too stupid to follow their advice. Now, people are wringing their hands over the plight of bond-holders facing default, and wondering why I don’t sympathize. Let me explain.

It all comes down to the question of what is a government bond. For the sake of contrast, let’s compare a typical “muni” or municipal bond, issued by a city government, with a bond issued by, say, a commercial bakery.

Both are instruments of debt; essentially, the bondholders are lending money at an agreed rate of interest for a specified period to the organization issuing the bonds.

The key difference between them is in who contracts the debt, and who pays.

When the Directors of ABC Bakery, Inc. vote to issue corporate bonds, they are, in effect, promising that at the appointed time ABC will repay the bonds’ principal, plus the agreed interest, out of what they make selling dinner rolls and cinnamon buns. If the appointed time arrives and the bonds are not repaid, ABC will be forced to repay them, and if they can’t, to liquidate and pay off bondholders from the assets of the company. The directors who voted the bond issue, being shareholders in the firm, stand to lose all of their investment in that event. If irregularities are found in the bond issue or in provision for repaying it, they may even be civilly or criminally liable as individuals. All of these circumstances tend to promote prudence and forethought.

When the City Council of Anytown votes to issue municipal bonds, on the other hand, the councilors are not incurring debt on their own behalf. Instead, they are promising the bondholders that, when the time comes, the Council will reach out and rob the taxpayers of the city of the amount needed to repay the debt. The councilors are not themselves liable except as individual taxpayers, and there is no recourse against them in the event of a default. They have much to gain, and nothing to lose by a bond issue. In effect, they can buy their constituents’ votes with the taxpaying citizens’ own money.

In other words, government bonds are a promise to steal and to use the proceeds of the theft for the purpose of bribery. By any consistent standard, such a bargain would constitute criminal conspiracy. Unfortunately for the honest taxpaying citizen, this particular crime is sanctioned by the very government on which he relies to suppress crime. And let’s be very clear on this: trust in government bonds is based on the fact that the taxpayer is not offered the option of not paying; he pays or else. This is no secret, and anybody who buys this debt knows that it is being contracted on behalf of third parties, without their consent. In the case of long-term bonds, those who will be forced to repay them may not even be born yet.

As a practical matter, and especially for the sake of political self-preservation, politicians avoid imposing special assessments or earmarked tax increases to cover bond repayment, and try to stagger bond maturities – all so that bonds can be paid out of current revenues.

But now consider what happens when government revenues decline, as is happening nearly everywhere today. Faced with three alternatives: cut spending, raise tax rates or go deeper into debt, politicians typically dismiss the first alternative out of hand on the grounds that the people have a duty to maintain them in the manner to which they have become accustomed, reject the second because of political risk, and eagerly embrace the third. Now, instead of using bonds for capital improvements and paying for them out of revenues, debt is being incurred to cover shortfalls in the very revenue that is supposed to retire it. It doesn’t take a degree in applied mathematics to know that this is unsustainable, and that a point will soon be reached where the interest on the bond repayments will exceed revenue. At this writing, this is almost the case in at least one American city.

These days, buying government debt isn’t just a criminal act; it is also a stupid one. Yet people continue to “invest” in this cynical bargain, apparently confident that somebody can be made to pay it off.

And they wonder why I don’t feel bad when it doesn’t work out that way.

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