Why do governments issue bonds?

Governments borrow money to cover the shortfall between the amount they raise through taxes and duties and the amount they spend. In the long run the amount a government borrows is a result of political choices, in the short run it is influenced by unexpected events, such as weak growth.

A government’s financing options are to run a balanced budget (i.e. for its expenditure to equal its revenue), issue bonds or, if the country has its own currency, print money. Governments do not normally borrow money directly from banks, although banks may buy government bonds.

Governments typically finance the great majority of any expenditure from taxes but tend to have persistent budget deficits, i.e. to spend more than they raise. A budget deficit of 10% of GDP is exceptionally high, and such a deficit is generally the result of an economic shock, which causes both tax revenue to fall and government expenditure to rise. We saw such high deficits in the wake of the credit crisis. A more typical, but still large, deficit would be 3% of GDP. A deficit is typically financed by issuing bonds, but the great majority of government expenditure would still be funded by taxes. In Europe and North America the money raised from taxes is between 25% and 50% of GDP, comfortably exceeding that provided by bond investors. Having observed that governments typically finance budget deficits by issuing bonds, in the following sections we consider why they do not typically use the other options open to them i.e. printing money or borrowing from banks.

Governments, or at least their central banks, do print money and this can be used to finance deficits. However, this is rarely actively employed as a policy; rather it usually occurs passively with the central bank responding to demand for notes and coins from the public. Most economists and central bankers view printing money as dangerous and are loath to recommend it as they fear that inflation may get out of control. In recent years we have seen central banks engage in ‘Quantitative Easing’, where central banks, having reduced their interest rates to near zero and finding the economy still weak, have tried to stimulate the economy by buying bonds. This is sometimes described as printing money, but the intent of the action is to stimulate the economy rather than fund budget deficits and elaborate means have been employed to preserve this distinction.

Some governments will borrow directly from banks, but this is generally because their domestic bond market is not sufficiently developed. Where a country has a developed market for its government bonds, then it will generally avoid borrowing from banks. The use of a bank to finance sovereign borrowing tends to interfere with the setting of both fiscal policy (taxation & spending priorities) and monetary policy (interest rates). It is easy to imagine a government declining to make a prudent increase in interest rates because of its impact on the cost of financing a fiscal deficit funded by banks.

In summary, governments fund most of their expenditure through taxes, but bond issuance is the principal secondary source of finance. Other means of financing deficits such as printing money or borrowing from the banks have a history which suggests that they have adversely, and on occasion materially, distorted the way an economy works.