Wednesday, October 14, 2015

How to use credit to virtually extend your total available budget vis-à-vis government bonds

joão pestana

Today, I bring the subject of economics to the table. As you may or may not know, a bond is like an IOU (I owe you). To put it in a very simple way, if my friend Peter is in need of some money, I can lend him some of mine and he will give me in return a promise of future payment — the IOU. This may or may not be subject to an interest rate. After some time has passed, the day comes when the bond Peter issued to me is maturing — reaching the end of its life. Peter will give me back the money he borrowed with the agreed interest, if any, and I will give him back his bond.

If I have money stored which I don't use, it's better for me to invest it. Lets say that Peter and I agreed on a 1 000 € loan of 1 year at 2% interest rate. If I just had my money stored away, I'd still have the same 1 000 € after the year has passed. Since I invested it in Peter, I have now an extra 20€ and Peter was able to start his own business — or something like that.

In a sense, that's how government bonds work. Because the expenditure of the government exceeds its revenue, it must issue bonds in order to fulfil the budget. When you hear the expression that the government debt is some percentage of the GDP (gross domestic product) what it means is that the government expects to have an expenditure that is larger that the revenue by that same amount. Lets say that the debt is 125% of the GDP and the GDP is 1 000 000 000 €, then the total expected expenditure by the government is 1.25 times larger. In this example, there would be a need to issue a total of 250 000 000 € in government bonds at some interest rate.

But wait! Isn't a high public debt a bad thing? Well... Many economists disagree on that. The fact is that without issuing government bonds, there would be public sectors and services lacking funds to operate — like hospitals and schools — and government workers without wages. Anyone can buy government bonds and, if purchased in the country's own currency, it's free from credit risk. This happens because even if the government lacks the funds to redeem the bond at maturity, it can do so by raising taxes, issue new bonds to pay for the maturing ones or simply print more money (given that it has its own central bank). The return you get from government bonds may be lower that most investment opportunities, but it's essentially risk-free.

I bet you're now wondering that what I mentioned above is very nice trick, but it probably won't hold up. Get a new loan to pay for the old one? Yes! That happens everyday and it's the basis of what I want to explain to you. I intend to show how someone can increase his or her total available budget by some amount almost permanently. The main idea is that, in a zero interest rate situation, you could ask for a new credit of 100 € maturing within a month and every next month you borrow another 100 € to pay for the previous one. It sounds like a lot of trouble, but if you think about it you just increased your total wealth by 100 €!

Many credit companies that issue credit cards for consumption use have several ways of payment. The most typical is that you pay a yearly premium for the use of the credit card — something like 20 € — and than you can have fractioned payments or full repayment within 30 days. The fractioned payments have an interest rate associated with the ease of the financial burden, but the full repayment usually does not. How does this work? It's quite simple and I'll just illustrate with a numerical example.

Lets imagine that Sarah has applied for a credit card with a 300 € line of credit and interest free if the she repays the full amount within 20 days of the invoice's issue. The invoice is issued on the 6th day of every month. If she is granted the application on the 1st and doesn't use the credit card in the first week, the invoice is issued with 0 € to pay. Then, on the 7th day, Sarah decides to use her credit card and buy a bicycle for 150€. After 30 days, the invoice is issued for the amount that Sarah used and she needs to pay it by the 26th. If she receives the invoice on the 6th, pays the 150€ back on the same day and on the next day she goes on a 2-day trip to the beach which also costs her 150€, by using the credit card to pay for it, Sarah has increased her total budget by 150€. So long as she keeps using the credit card for an expenditure of 150€ every month, her debt will continue to be pushed forward indefinitely in time.