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Part 16. How governments pay back money

Let's continue our sets of accounts from Part 15 and look at how government borrowing is paid back. Let's consider that the life of the bonds is 3 months, after which the principle is paid back to the bondholders along with interest at 4% per annum.

Currently the money from the bond sale is sitting idle in the government's deposit account, so the first thing is for the government to spend some of this money. Let's create a new bank account for a government contractor called Contractor's Deposit Account at 2nd Bank into which the government pays £25,000 for services undertaken. Figure 16.1 shows the transfer.

Government's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £40,000 (CR) Paid for services undertaken £25,000 £15,000 (CR) Contractor's Deposit Account 2nd Bank Description Debits Credits Balance Starting balance £0 Received for services undertaken £25,000 £25,000 (CR)

Figure 16.1 Deposit transfer for services undertaken.

We will carry out a deferred settlement double entry as usual, as shown in Figure 16.2.

1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £25,000 £25,000 (DR) 2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £25,000 £25,000 (CR)

Figure 16.2 Deferred settlement for the deposit transfer.

The balance sheets of 1st and 2nd Bank are shown in Figure 16.3.

1st Bank's Assets Mortgage Loan Account #1 £100,000 Mortgage-backed Securities £50,000 Digital Reserves £45,000 Total assets £195,000 1st Bank's Liabilities 2nd Bank's Deposit Account £25,000 Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Government's Deposit Account £15,000 Total liabilities £195,000 2nd Bank's Assets 1st Bank's Loan Account £25,000 Equity Release Loan Account £50,000 Digital Reserves £5,000 Government Bonds £20,000 Total assets £100,000 2nd Bank's Liabilities House Seller's Deposit Account £70,000 Deposit Account #4 £5,000 Contractor's Deposit Account £25,000 Total liabilities £100,000

Figure 16.3 Balance sheets of 1st and 2nd Bank.

The government's deposit account has been reduced to £15,000, and currently has insufficient funds to pay back the bondholders after the 3 months is up. However, the government can raise money from people and businesses through taxation. Let's assume there is tax due from the house seller and their tax bill is £26,000. The tax payment is shown in Figure 16.4.

House Seller's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £70,000 (CR) Tax paid £26,000 £44,000 (CR) Government's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £40,000 (CR) Paid for services undertaken £25,000 £15,000 (CR) Tax received from house seller £26,000 £41,000 (CR)

Figure 16.4 House seller's tax paid.

The deferred settlement double entry is shown in Figure 16.5.

2nd Bank's Loan Account 1st Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £26,000 £26,000 (DR) 1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £26,000 £26,000 (CR)

Figure 16.5 Deferred settlement for the tax payment.

Although plenty of transactions would have taken place between the issue of the bonds and the redemption, for simplicity let's assume it has been 3 months since the issue and it is now time to pay the bondholders.

The interest on the bonds is 4% per annum, which over 3 months is equivalent to £200 per bond. Therefore each bondholder will receive £20,200. Let's start by paying the public or retail bondholder — the house seller. The repayment transaction is shown in Figure 16.6

Government's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £15,000 (CR) Tax received from house seller £26,000 £41,000 (CR) Bond repayment £20,200 £20,800 (CR) House Seller's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £70,000 (CR) Tax paid £26,000 £44,000 (CR) Bond repayment received £20,200 £64,200 (CR)

Figure 16.6 Bond repayment to house seller.

The related deferred settlement double entry is shown in Figure 16.7

1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £25,000 £25,000 (DR) Borrowed by deferring settlement £20,200 £45,200 (DR) 2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £25,000 £25,000 (CR) Owed by deferring settlement £20,200 £45,200 (CR)

Figure 16.7 Deferred settlement for the bond repayment to house seller.

The other bondholder is 2nd Bank. We will reintroduce 2nd Bank's Earnings account and transfer the funds into this, as shown in Figure 16.8.

Government's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £15,000 (CR) Tax received from house seller £26,000 £41,000 (CR) Bond repayment £20,200 £20,800 (CR) Bond repayment £20,200 £600 (CR) Earnings 2nd Bank Description Debits Credits Balance Starting balance £0 Bond repayment received £20,200 £20,200 (CR)

Figure 16.8 Bond repayment to 2nd Bank.

The related deferred settlement double entry is shown in Figure 16.9

1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £25,000 £25,000 (DR) Borrowed by deferring settlement £20,200 £45,200 (DR) Borrowed by deferring settlement £20,200 £65,400 (DR) 2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £25,000 £25,000 (CR) Owed by deferring settlement £20,200 £45,200 (CR) Owed by deferring settlement £20,200 £65,400 (CR)

Figure 16.9 Deferred settlement for the bond repayment to 2nd Bank.

After the bond-related payments are made, the balance sheets of 1st, 2nd and Central Bank now look as shown in Figure 16.10. The blue arrows indicate the outstanding balances that need settling. Central Bank is included as we will need it to settle between banks.

Central Bank's Assets Mortgage-backed Securities £50,000 Total assets £50,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £5,000 1st Bank's Digital Reserves £45,000 Total liabilities £50,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 2nd Bank's Loan Account £26,000 Mortgage-backed Securities £50,000 Digital Reserves £45,000 Total assets £221,000 1st Bank's Liabilities 2nd Bank's Deposit Account £65,400 Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Government's Deposit Account £600 Total liabilities £221,000 2nd Bank's Assets 1st Bank's Loan Account £65,400 Equity Release Loan Account £50,000 Digital Reserves £5,000 Government Bonds £20,000 Total assets £140,400 2nd Bank's Liabilities House Seller's Deposit Account £64,200 1st Bank's Deposit Account £26,000 Deposit Account #4 £5,000 Contractor's Deposit Account £25,000 Total liabilities £120,200 2nd Bank's Equity Earnings £20,200 Total equity £20,200

Figure 16.10 Balance sheets after the bond-related payments are made,.

2nd Bank's earnings account is currently overstated, for reasons which will become clear, but we will correct that once we haved settled. Now let's partially settle within each bank. First, we can transfer £26,000 from 2nd Bank's Deposit Account to 2nd Bank's Loan Account, as shown in Figure 16.11.

2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £25,000 £25,000 (CR) Owed by deferring settlement £20,200 £45,200 (CR) Owed by deferring settlement £20,200 £65,400 (CR) Transferred to loan account £26,000 £39,400 (CR) 2nd Bank's Loan Account 1st Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £26,000 £26,000 (DR) Received from deposit account £26,000 £0

Figure 16.11 Transfer from 2nd Bank's Deposit Account to 2nd Bank's Loan Account.

And we can transfer the same amount from 1st Bank's Deposit Account to 1st Bank's Loan Account, as shown in Figure 16.12.

1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £20,000 £20,000 (CR) Owed by deferring settlement £20,000 £40,000 (CR) Transferred to 2nd Bank £40,000 £0 Owed by deferring settlement £26,000 £26,000 (CR) Transferred to loan account £26,000 £0 1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £25,000 £25,000 (DR) Borrowed by deferring settlement £20,200 £45,200 (DR) Borrowed by deferring settlement £20,200 £65,400 (DR) Received from deposit account £26,000 £39,400 (DR)

Figure 16.12 Transfer from 1st Bank's Deposit Account to 1st Bank's Loan Account.

We are left with 1st Bank owing £39,400 to 2nd Bank which we can exchange for some of 1st Bank's reserves. To do this we first transfer this amount from 2nd Bank's Deposit account to 1st Bank's Loan Account, as shown in Figure 16.13.

2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £25,000 £25,000 (CR) Owed by deferring settlement £20,200 £45,200 (CR) Owed by deferring settlement £20,200 £65,400 (CR) Transferred to loan account £26,000 £39,400 (CR) Transferred to loan account £39,400 £0 1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Previous balance £25,000 (DR) Borrowed by deferring settlement £20,200 £45,200 (DR) Borrowed by deferring settlement £20,200 £65,400 (DR) Received from deposit account £26,000 £39,400 (DR) Received from deposit account £39,400 £0

Figure 16.13 Transfer from 2nd Bank's Deposit Account to 1st Bank's Loan Account.

As this is in exchange for reserves, we decrease 1st Bank's reserves, as shown in Figure 16.14.

1st Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £45,000 (CR) Transfer reserves £39,400 £5,600 (CR) Digital Reserves 1st Bank Description Debits Credits Balance Previous balance £45,000 (DR) Transfer reserves £39,400 £5,600 (DR)

Figure 16.14 Decrease of 1st Bank's reserves.

And increase 2nd Bank's reserves by the same amount, as shown in Figure 16.15.

Digital Reserves 2nd Bank Description Debits Credits Balance Previous balance £5,000 (DR) Transfer reserves £39,400 £44,400 (DR) 2nd Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £5,000 (CR) Transfer reserves £39,400 £44,400 (CR)

Figure 16.15 Increase of 2nd Bank's reserves.

Finally we write down the government bonds account at 2nd Bank since the bond has been paid back, no longer exists and hence has no value. This is shown in Figure 16.16.

Earnings 2nd Bank Description Debits Credits Balance Starting balance £0 Bond repayment received £20,200 £20,200 (CR) Bond write down £20,000 £200 (CR) Government Bonds 2nd Bank Description Debits Credits Balance Previous balance £20,000 (DR) Bond write down £20,000 £0

Figure 16.16 Government bond account write down.

The final balance sheets of all banks are shown in Figure 16.17.

Central Bank's Assets Mortgage-backed Securities £50,000 Total assets £50,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £44,400 1st Bank's Digital Reserves £5,600 Total liabilities £50,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 Mortgage-backed Securities £50,000 Digital Reserves £5,600 Total assets £155,600 1st Bank's Liabilities Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Government's Deposit Account £600 Total liabilities £155,600 2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £44,400 Total assets £94,400 2nd Bank's Liabilities House Seller's Deposit Account £64,200 Deposit Account #4 £5,000 Contractor's Deposit Account £25,000 Total liabilities £94,200 2nd Bank's Equity Earnings £200 Total equity £200

Figure 16.17 Balance sheets after the government bond repayments.

Usually the lengths of government bonds vary from a few months to decades, and as governments tend to be large borrowers, they contribute substantially to the money supply. Governments do not want to default on their debts and so borrowing is constrained by the amount already borrowed, tax revenue they can raise and the cost of borrowing. Governments are also closely connected to central banks as we will see next as we look at quantitative easing.

back to Part 15