An Analogy for Bonds


A quick short story centering around the debt foundation of the financial system.

The economy is complicated. There are many different participants, different rules made for everyone, and situations where perfect information isn't available to make accurate forecasts of the future. Let’s simplify the economy quickly for this analogy and take a look at a system with only three participants.

In this theoretical economy, you are a service provider. Your value is in selling your time and labor.

You have a friend who creates goods. Their value is in the specialized production of real commodities. When someone wants something material, they go to your friend.

You have another friend who is a bit lazier. They want to be able to reach their goals and live a certain quality of life, but don’t want to be held accountable and be forced to provide real value to you and your friend in exchange.

This lazy person comes up with a great idea. If they can’t get all the money they need to finance their lifestyle now, why not just borrow it from you? They name this debt contract a bond, and pitch it to you saying that they are about to get a real job, and if you just loan them some money now they will pay you back plus interest in the future. You trust your friend, and since they don’t have any history of not paying back debt or running massive deficits, you agree to lend them the money.

The borrowed money is then used to buy goods from the material producer and enrich your indebted friend in the present. They do get a job, but still only make 50% of what they owe for the month. This is called running a budget deficit.

Your lazy friend has one more trick up their sleeves. While you the provider of services and your friend the producer of goods have to create real value to acquire money, your friend has a magic machine which allows them to trade any debt they owe into cash.

They use this machine to pay off the previous debt to you, plus the interest you were promised. You both continue on with this exchange of lending money for risk free return of principal and interest. Eventually, even the producer of goods is lending money, and lots of it. You both start calculating your net worth to include how much your lazy friend owes you, and plan your retirements around this friend producing real value and then paying it to you through all the interest on the debt. You are oblivious to just how little real work your friend needs to do to get cash to alleviate their debt.

All this debt being monetized means that there is much more cash entering the economy. When you originally lent, let's say 100 dollars, that money didn’t leave the system. The lazy friend spent it on goods from the producer, who then had possession of that cash and could use it to buy services from you. You were paid back your principle and interest with money that never existed before. If there had been 100 dollars total in the economic system, there are now 200.

You are happy, because the 100 dollars you lent has now turned into 103 dollars with no risk to the principle, just by buying these bonds from your lazy friend. However, there is a problem. The producer now feels very wealthy, as they have just sold all these goods to the lazy friend and gotten full of cash. They come to you and want you to work at their retail store, and offer a bunch of money for you to do it. You agree.

The prices of goods begin to rise, as the producer feels wealthy from all the unhindered demand and cash infusions which give less incentive to innovate or produce at the same levels as before. This decreases the supply of goods and increases what the producer feels like they can charge for the same value provided. You now have a decent job at the retail store providing your services, but all the goods you used to buy are 2% more expensive. You figure you should start lending out a higher percentage of your cash in order to get a nominal return so that you can keep pace with the rising costs. You don’t see it, but this yet again increases the money supply, and the cycle is repeated.

Your lazy friend is now 30 Trillion dollars in debt. The prices of every real good have skyrocketed, your producer friend has had to leave and work far away from you where living and producing is cheaper, and he hasn’t given you raises at your retail job to keep up with the inflation in the prices of goods required for living. You don’t aggressively advocate for yourself and instead become frustrated and radicalized. You look around for other places to place the blame, and eventually are slowly squeezed into lower standards of living than you had in the past. All the while, your lazy friend can pay for whatever they want. More tanks? Got it. Millions of armed slaves? Of course. Farmland, real estate, transportation, gold, companies, utilities, you name it. Anything that you think would be valuable to buy yourself, your friend is buying. It gets to the point where you have to start buying what your lazy friend is just to hopefully ride the monetary wave up to higher prices as they acquire it. You start owning companies you think they might cut deals with, houses they might buy, and commodities they might need in a vain attempt to keep up with the increase in the supply of money.

This game ends a couple of ways.

The first is that your lazy friend may eventually admit they have borrowed more money than they are able to pay back, and default. This would be the best case scenario, but incredibly painful for everyone in the system. Remember, you started calculating your net worth in how much your friend owes you. The bonds were not actually risk free, as there is no way to be free of risk. They simply transferred risk off of the individual and onto the entire system itself, so that if your lazy friend fails, everything fails. All the high prices would collapse as the money supply shrinks dramatically and everyone feels incredibly poor. However, now that there is no one buying up all the real wealth in an unfair and irresponsible competition against those who provide real value, the economy can finally begin to rebalance and work as it was intended. However, your lazy friend would never regain credibility and would likely be prosecuted. Seeing as the magic money machine prevents this from ever having to happen, and considering how it would lead to the end of the lazy friend, the second scenario is much more likely.

The second senario is that the risk becomes so apparent that you and the producer begin to see it. You stop lending more money to the lazy friend. Who would ever lend money to someone 30 Trillion dollars in debt that doesn’t provide a similar level of real value? The lazy friend still needs to be lent money to finance their lifestyle, but without enough lending going on, is forced to just print the money without there ever even being a legitimate loan to them issued. This accelerates the increase in the money supply, and now no real entity in the economy even has the debt as an asset. The interest on bonds starts to have deeply negative real yields, and the cycle reinforces until the currency itself has no real value remaining. Those holding what people wanted to buy anyway like houses, land, gold, and other commodities ride the waves and preserve their wealth. Those holding the cash or debt are slowly diluted away until they have no purchasing power remaining.

In the second scenario, people start holding washing machines instead of savings accounts, because any real asset outpaces the inflation which is occurring. Historically, a strong authoritarian government would take control, issue a new currency which they say will be stronger and totally different, and then go to war with someone that they blame for all their problems. I see one possible alternative monetary system which only recently emerged which could potentially send us on a different and more beautiful course, but only time will tell.

The moral of the story is, don’t lend money to your lazy friend. Even if you’re getting a positive real yield, you have transferred risk from the individual to the system, and have continued the cycle which will inevitably cause you to be begging for raises and hoarding washing machines as well. Opt out peacefully.