Government Bonds are Strange Currency
Prerequisites: What is Money? and Interest Rates.
As you may recall, money has three uses: Medium of Exchange, Unit of Account and Store of Value. The unit of account can only be performed by one good. People must be able to tell each other prices in a common unit. The other functions of money can be performed by any good, but different goods can be better or worse at it. For example, barter may be used to purchase goods and stocks or commodities can be used to store value. In fact, of all goods, money is usually a poor store of value compared to metals, investments or even durable goods. Sovereign debt is similar in many ways to currency: it is backed by the government with no value other than a government's promise to accept it for tax payments, it is a fixed denomination in the same units as currency and it isn't tied to capital or any claim on a specific asset, such as land. When a government defaults, I would expect deflation from the wealth effect and from a debt deflation effect as banks had to write down losses on the government debt they held. The wealth, or Pigou effect occurs because the less money people have, the less they will spend. The less government bonds people have, the less money they will spend. Having a lot of bonds allows you to spend more both because you can exchange them for goods and because people with large stocks of bonds are less likely to invest in capital and less likely to invest much out of their current income. Bonds are a substitute for other methods of moving purchasing power forward in time. Defaulting on debt is similar to destroying money in that it does not destroy real assets, only claims on those assets.
Replacing cash with bonds is deflationary. Bonds earns interest, which makes them "Good money" by Gresham's Law, which states that bad money chases out good. Another way to put this is that if the opportunity cost of using one type of money is higher than that of another type of money, people will use the one with the lower opportunity cost. Spending cash gets rid of an asset that is going down in value. Spending a bond gets rid of an asset that is going up in value. Not only that, but it is a lot easier to spend cash than bonds, so people will spend cash at a much higher rate than they do bonds. Hence, if the government replaces bonds with cash, the rate of spending (MV) will go up and inflationary pressure will increase. Secondly, Ricardian Equivalence would suggest that people expect the bonds to be destroyed in the future. When the government pays off a bond, it is destroyed, but the money used to purchased it is simply transferred from taxpayers to bondholders. The lower amount of total assets available in society creates deflationary pressure.
When the bond comes due, the government has 3 choices that exactly match those they face when they spend.
1 Tax money from citizens, use the money to pay off the bond, which destroys the bond and takes spending power from the taxpayer and gives it to the bondholders.
2 Print money to pay
3 issue more bonds - kick the can down the road a bit
Since taxes take money out of the system and then add it back in as spending, it is neutral in regards to inflation in the long run. If the government maintains the high spending level, it is inflationary if the government spends money faster than the private sector, deflationary if the government spends money slower than the private sector and neutral otherwise. Keynesians emphasize the potentially inflationary effects of government spending during a recession because of the government's ability to spend a lot of money quickly. It's an empirical question just how fast the money can be spent and the answer has eluded economists despite a lot of effort being spent trying to answer it. The deadweight losses from taxation may eventually overwhelm the gains from the additional aggregate spending. However, if bonds are used to finance the short term spending, the deadweight losses are delayed until a later date. Purchasing power is transferred from those who buy the bonds to the government. The buyers of bonds do not reduce their spending by as much as they would have had the money simply been taxed away, since they have an additional asset which they can use to purchase things or to store value (the bond itself). Other people in society may see the rising levels of government spending and brace themselves for higher future taxes. Theoretically, they could brace themselves by storing up assets with which to pay taxes, or they could liquidate assets and consume as much as they can now in order to make themselves a less appealing target for future taxation. I am of the opinion that people would react to a belief in higher future taxation by purchasing more durable goods and trying to avoid high tax brackets by producing less. Both of those actions are inflationary, adding to the pressure caused by the government spending itself. Finally, the simplest way to pay for government spending is to print the money. Print and spend is perhaps the most effective way to cause inflation known to man. The newly printed money does not have to be explicitly spent by government agencies, but can be simply handed out (known as a helicopter drop) to politically powerful groups.
Printing money is clearly inflationary, and both paying off debt and defaulting on debt is deflationary (it destroys the bond without altering the amount of non-bond currency). Theoretically, there should be some ratio of monetizing and payment/default that would minimize the price level impact of a country which had to default. For example, printing 20% of your debt worth of currency and defaulting on 30% of the debt might allow a government to maintain stable prices while repudiating half of the value of the debt that had to be paid by taxpayers. Holders of the debt would suffer 30% losses, but at least they would not suffer the full 50% and they would not have to deal with hyperinflation either. Such a move would probably result in financial upheaval, but any hyperinflation and/or default would also, so I don't see that as a big downside. Such a policy could conceivably be linked to a payment to banks simultaneously to maintain the overall solvency of the banking sector. Given the number of countries whose governments can not pay their debts through taxation alone, the price neutral ratio of monetization and default should be investigated.
As you may recall, money has three uses: Medium of Exchange, Unit of Account and Store of Value. The unit of account can only be performed by one good. People must be able to tell each other prices in a common unit. The other functions of money can be performed by any good, but different goods can be better or worse at it. For example, barter may be used to purchase goods and stocks or commodities can be used to store value. In fact, of all goods, money is usually a poor store of value compared to metals, investments or even durable goods. Sovereign debt is similar in many ways to currency: it is backed by the government with no value other than a government's promise to accept it for tax payments, it is a fixed denomination in the same units as currency and it isn't tied to capital or any claim on a specific asset, such as land. When a government defaults, I would expect deflation from the wealth effect and from a debt deflation effect as banks had to write down losses on the government debt they held. The wealth, or Pigou effect occurs because the less money people have, the less they will spend. The less government bonds people have, the less money they will spend. Having a lot of bonds allows you to spend more both because you can exchange them for goods and because people with large stocks of bonds are less likely to invest in capital and less likely to invest much out of their current income. Bonds are a substitute for other methods of moving purchasing power forward in time. Defaulting on debt is similar to destroying money in that it does not destroy real assets, only claims on those assets.
Replacing cash with bonds is deflationary. Bonds earns interest, which makes them "Good money" by Gresham's Law, which states that bad money chases out good. Another way to put this is that if the opportunity cost of using one type of money is higher than that of another type of money, people will use the one with the lower opportunity cost. Spending cash gets rid of an asset that is going down in value. Spending a bond gets rid of an asset that is going up in value. Not only that, but it is a lot easier to spend cash than bonds, so people will spend cash at a much higher rate than they do bonds. Hence, if the government replaces bonds with cash, the rate of spending (MV) will go up and inflationary pressure will increase. Secondly, Ricardian Equivalence would suggest that people expect the bonds to be destroyed in the future. When the government pays off a bond, it is destroyed, but the money used to purchased it is simply transferred from taxpayers to bondholders. The lower amount of total assets available in society creates deflationary pressure.
When the bond comes due, the government has 3 choices that exactly match those they face when they spend.
1 Tax money from citizens, use the money to pay off the bond, which destroys the bond and takes spending power from the taxpayer and gives it to the bondholders.
2 Print money to pay
3 issue more bonds - kick the can down the road a bit
Since taxes take money out of the system and then add it back in as spending, it is neutral in regards to inflation in the long run. If the government maintains the high spending level, it is inflationary if the government spends money faster than the private sector, deflationary if the government spends money slower than the private sector and neutral otherwise. Keynesians emphasize the potentially inflationary effects of government spending during a recession because of the government's ability to spend a lot of money quickly. It's an empirical question just how fast the money can be spent and the answer has eluded economists despite a lot of effort being spent trying to answer it. The deadweight losses from taxation may eventually overwhelm the gains from the additional aggregate spending. However, if bonds are used to finance the short term spending, the deadweight losses are delayed until a later date. Purchasing power is transferred from those who buy the bonds to the government. The buyers of bonds do not reduce their spending by as much as they would have had the money simply been taxed away, since they have an additional asset which they can use to purchase things or to store value (the bond itself). Other people in society may see the rising levels of government spending and brace themselves for higher future taxes. Theoretically, they could brace themselves by storing up assets with which to pay taxes, or they could liquidate assets and consume as much as they can now in order to make themselves a less appealing target for future taxation. I am of the opinion that people would react to a belief in higher future taxation by purchasing more durable goods and trying to avoid high tax brackets by producing less. Both of those actions are inflationary, adding to the pressure caused by the government spending itself. Finally, the simplest way to pay for government spending is to print the money. Print and spend is perhaps the most effective way to cause inflation known to man. The newly printed money does not have to be explicitly spent by government agencies, but can be simply handed out (known as a helicopter drop) to politically powerful groups.
Printing money is clearly inflationary, and both paying off debt and defaulting on debt is deflationary (it destroys the bond without altering the amount of non-bond currency). Theoretically, there should be some ratio of monetizing and payment/default that would minimize the price level impact of a country which had to default. For example, printing 20% of your debt worth of currency and defaulting on 30% of the debt might allow a government to maintain stable prices while repudiating half of the value of the debt that had to be paid by taxpayers. Holders of the debt would suffer 30% losses, but at least they would not suffer the full 50% and they would not have to deal with hyperinflation either. Such a move would probably result in financial upheaval, but any hyperinflation and/or default would also, so I don't see that as a big downside. Such a policy could conceivably be linked to a payment to banks simultaneously to maintain the overall solvency of the banking sector. Given the number of countries whose governments can not pay their debts through taxation alone, the price neutral ratio of monetization and default should be investigated.