Where do governments spend money?
Running a company and running a government are not so different; Both have responsibilities to stakeholders, and both require money to operate.
While governments are responsible for the improvement of their citizens’ quality of life using limited budgets and resources, companies are responsible for ensuring consistent returns for their shareholders using a finite number of employees and limited funds.
Governments spend money on different areas, all of which help provide necessary services to citizens. These areas include: Transportation, infrastructure, security, national defense, social programs, education, and healthcare.
As you can probably imagine, these activities are costly. Raising money to ensure they are consistently managed is no easy feat.
Raising money as a government
Governments raise money through a several activities. Some of the most important ones include:
- Personal Taxes: Not so common in the Middle East, or at least in the GCC, but extremely common elsewhere; Governments take a portion of their citizen’s annual income to cover the costs of the activities above.
- Corporate Taxes: A country’s government also taxes corporations operating in that country; A portion of all revenue generated by a company must, by law, be paid to the government. Think of it as a fee for allowing the company to operate in that country.
- Fines & penalties: Ever gotten a speeding ticket or a parking ticket? Well, that money funds government operations. So in a way, the more dangerous you are on the road, the more bridges you build. Look at that, your recklessness builds bridges!
- Revenue: Participating in economic activities (eg. increasing tourism, selling oil, manufacturing aluminum) can also generate profits for governments. Some governments rely more on this than others.
- Printing Currency: As we’ve touched on slightly in our post about how the economy works, governments can literally print additional money (precisely as seen in Money Heist on Netflix). This is not free of consequences though, so don’t take it as lightly as it sounds.
- Borrowing Money: Last but not least, and as official and authoritative as they sound, governments can’t grow money on trees. They too need to borrow money sometimes. In fact, they do so more often than you’d think. A government can borrow money from other countries, individuals, or corporations to fund its operations. We’ll discuss this in more detail below.
In this post we’ll ignore most of the cool mechanisms above and, instead, focus on the most boring one: Borrowing Money. We choose to focus on this not because we are boring people, but because this money raising mechanism is the most relevant in the context of individual investments.
Now, imagine how hip you’ll sound the next time you try explaining this at a loud, crowded lounge.
A government bond is nothing more than a fancy name for an agreement between a government and a lender. This agreement outlines the conditions the lender and the borrower agree to. Typically, the agreement looks something like this:
I as a lender agree to lend the borrower (the government) $100 today, in return for $105 next year.
Although over-simplified, this is exactly what government bonds represent. When you dig deeper into how bonds work, you immediately start to see small contractual differences worth mentioning:
Governments issue bonds for specific durations. These durations are what we call a bond’s “maturity”.
For example, a 3-month bond matures after three months; The lender can expect his money back plus interest three months after issuing the loan or purchasing the bond.
On the other hand, a 20-year bond with an interest rate of 3% means the lender will get his money back after 20 years, but will earn 3% every year until maturity.
As we have discussed in our post on interest, the more risk you take as a lender the more you should get compensated for it.
That said, not all government are created equal. The current and future stability and reliability of a government directly impacts how expensive it is for it to borrow money.
For example, investors consider the governments of developed countries more stable than those of developing countries.
So naturally, the interest rates you can expect from U.S. or Canadian bonds are lower than the rates you can expect from, say, Middle Eastern governments. In theory, you risk less lending money to the U.S./Canada than you do lending money to Middle Eastern countries. In theory (pause with intentional lack of clarity).
The exact same processes described above can apply to companies as well! In fact, raising capital by issuing corporate bonds is a major source of income for companies.
The primary difference between corporate bonds and government bonds is that corporate bonds are a lot riskier, therefore offer more lucrative interest rates.
It is a fact that corporations fail more frequently than governments do, so it is only natural that they reward you more for taking on this additional risk as an investor.