Among financial assets, sovereign debt of advanced economies has the special status1 of being considered risk-free. The conventional theory being that the state can always print enough money to re-pay its debt. Indeed, as there is no requirement for governments to invest borrowed money on ventures which preserve capital, the only way this debt could be risk-free is through money printing.
Central banks are the body with control over the money supply however, and they are not required to backstop sovereign debt. On the contrary, major central banks have a mandate to limit inflation, constraining their scope for money creation. Far from being free of risk, sovereign debt is not designed with a sound strategy to avoid cycles ending in crisis2.
Lending without borrowing
The source of risk for any debt is twofold: the borrower's potential to spend their credit in ways which end up making losses, and the incentive on the borrower to save costs by evading repayment. In the case of sovereign debt, even a fallback to money printing can be undesirable due to its economic side effects, potentially making default a more attractive option.
If the borrower had no power to spend the money lent, nor discretion to avoid repayment, then there would be no credit risk. This would effectively remove any borrowing party from the loan structure though, which may not seem possible – but it is.
Creditless Bonds in the Liquid Interest Bearing Reserve Accounting system are such a loan without borrower. A creditless Bond is an asset paying a Cash amount (the Bond's face value) to its holder, on the Bond's maturity date, and earns a yield by being issued at a price below face value.
When a Bond is issued, the Cash it is bought with is simultaneously destroyed, while an amount of Cash equal to the face value is created in the holder's account at maturity (at which point the Bond no longer exists). These transactions are disciplined, as the money supply is bounded by the same pre-determined 6% growth trajectory in all circumstances. The yields at which Bonds are issued are precisely constrained to ensure this.
The Bond market serves the same purpose as is fulfilled by sovereign debt in a conventional monetary system: to price and trade the time value of money, ie. how much a unit of Cash delivered on a future date is worth today. The economic reasons Bonds have a yield are also identical, such as time preference, or liquidity preference.
Although a Bond has no borrower, it involves another party besides the Bond buyer, namely all other holders of Cash. When a Bond is issued, the amount of Cash in circulation drops, increasing the scarcity value of Cash for all remaining Cash holders, up until the Bond matures. This is effectively the inverse of the banking model, as banks increase the money in circulation when issuing a loan3, which reduces the scarcity value of existing deposits.
The soundness of Bonds goes even deeper than rules making default impossible. Contrary to the natural conflict between lender and borrower, Bond and Cash holders are fully aligned in their interest to protect the value of both assets. An incentive does not arise therefore to even contemplate deviating from the rules.
Bond mechanics in detail
Bond issuance and settlement operates on a daily cycle. Every day, the set of Bonds now matured are replaced by Cash in their holder's account. At the same time, an auction takes place allowing Cash holders to bid for Bonds maturing on any future date of their choice. Any bids above the issuance price for that date results in a Bond being created by the system, and Cash proportional to the issuance price being destroyed.
Cash holders benefit from Bond issuance, as the same reserves are available to defend the price of a smaller amount of Cash in circulation. In exchange, the interest rate on Cash is reduced, to balance the yield earned on Bonds and not increase the money supply.
The issuance of Bonds is in fact mirrored for out of circulation Cash, meaning the same proportion of Cash is converted to out of circulation Bonds as is done in circulation. This makes the share of interest earned on Cash and Bonds insensitive to the ratio of Cash in and out of circulation.
The money supply limit is defined as , where is the time in years4 since any Cash first entered circulation. The amount of Cash in existence is guaranteed to remain below this money supply limit, for all time, irrespective of Bond auction outcomes. In addition, each Bond earns the maximum yield, and Cash generates the maximum interest, which is achievable within this constraint.
Equivalent yield curves
To better understand how the 6% money supply growth is allocated across interest paid on Cash and Bonds, the tool below computes the yield curve for the same proportion of Cash and Bonds as in the US Dollar system. The face value of Bonds and US Treasuries in existence is taken to be equal for each maturity date, while the amount of Cash in circulation is set to the M1 measure of USD money supply5.
- This is not just economic theory, but enforced as the official accounting standard, through regulation such as the Basel rule asset risk weighting.↩
- See Principles for Navigating Big Debt Crises for a detailed analysis.↩
- This process is analysed by the BoE.↩
- A year is defined as 365.2425 days.↩
- Data sources: US Treasuries outstanding, USD M1, US Treasury Yield Curve↩