Bonds issued by governments are generally regarded as risk free in the sense that it is assumed that there is zero default risk. The implicit assumption is that if a government could not redeem its bonds it always has the option of printing more money. This assumption has always been flawed as holders of bonds issued by Napoleonic France, pre-revolution Russia and China would have found. Many of these bonds still exist but are traded as collector items for aesthetic reasons.
In more recent years experience with Argentina, Brazil and Mexico in the mid-1980s has also showed that this is a fallacy when the bonds are issued in a foreign currency and bought by foreign investors. In most OECD countries today, however, these government’s securities are generally regarded as providing a risk-free return. In the early part of this century Japanese governments ran significant deficits, funded by bond issues, to try to break out of their deflationary slump. Despite continuing current account sur pluses and massive foreign currency reserves they had to suffer the indignity of being warned by rating agencies that the status of their debt was under review.
December 27, 2008
THE RISK-FREE FALLACY OF GOVERNMENT BONDS
June 27, 2008
DISCOUNT RATE AND OPEN MARKET OPERATIONS
The most commonly used central bank tools are those of adjusting the discount rate, to affect the price of money, and buying and selling government bonds, to affect the level of money supply. The discount rate is the rate at which banks can borrow from the central bank. In practice the transmission mechanism is often through the interbank market. The Federal Funds rate, for example, is the rate at which US banks with cash and deposits with Federal Reserve banks in excess of their reserve requirements will lend to banks that have a shortfall:
Discount window. Banks that regularly borrow from the central bank will find themselves being charged punitive rates. The discount window provides a mechanism for the central bank to influence the level of shor t-term interest rates through its role as the lender of last resort. Their ability to influence rates at the long end of the yield curve is more limited. The use of the discount window is highly visible.
Open market operations. The final way in which central banks can influence money supply is through open market operations. If the central bank wishes to increase money supply then it intervenes to buy government securities. It does this by “printing” cash. If it wants to reduce money supply then it sells government securities. The effectiveness of open market operations is due to the effect of the money multiplier. The central bank has a very long lever.
The central bank can choose the term of the securities it buys or sells and while its effectiveness is limited in can influence yields at a particular maturity. Its action in terms of money supply and its impact at the short end enjoy considerable leverage but as just one more participant in bonds at a par ticular term it has no such gearing.