The Economy: 4. Bonds, Gilts, Stocks and Shares

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Welcome to Understand the Economy, the series that takes you back to basics to explain the way economics affects our everyday lives.

In this episode, Stocks and Bonds.

No, not some kind of medieval punishment.

Well, that financy stuff with bread braces and pinstripe suits.

And the bond market?

That's even more mysterious.

One of Bill Clinton's political advisors once joked that he wanted to be reincarnated as the bond market because everyone is scared of the bond market.

Liz Truss knows what he meant.

She absolutely smashed the record for the shortest time as British Prime Minister because the bond market decided it had had enough of her.

So, stocks and bonds matter.

But what are they?

Let's do bonds first.

Let's say you want to borrow £100 from a friend.

You could just shake hands on it and promise to pay her back, but you could instead write an IOU.

You could write down, I promise to pay my friend Wendy £100 on whatever, New Year's Day of the year 2020, whatever.

Or you could tweak it a bit.

You could write, I promise to pay the bearer of this IOU £100, etc., etc.

At first, that bearer is your friend Wendy but Wendy could then turn around and sell your IOU to someone else.

Now when New Year's Day rolls round you have to pay them and that third person might sell it on yet again and maybe none of these people are really convinced that you're good for the money so your IOU, your written promise to pay £100

actually trades for £90.

Or if everyone is convinced you're a deadbeat, maybe it trades for a few pennies.

I think we can all agree that this is quite a weird way for a person to borrow money.

But if you're a company or a government, it's not weird at all.

It's totally standard to borrow money by writing down IOUs.

These IOUs are called bonds, and when people buy and sell these bonds, these promises to pay at some future date, that's the bond market.

I'm joined in the studio by, well, my friend Wendy, Professor Wendy Carlin of University College London, and she's leading Core Econ, which is an international project to reform the way undergraduate economics is taught.

So Wendy, would you lend me £100?

Well Tim, I wouldn't buy a Tim Harford bond.

This is very harsh indeed.

It is harsh actually but the truth of the matter is even though I'm your friend what I want if I'm going to buy a bond is to be able to sell it.

So that means that other people have to have faith in this Tim Harford bond.

They're probably unlikely to because there are other much sounder bonds that they could buy.

For example, a government bond.

So that means that your bond would just crash in price.

Right.

So sorry.

No to that offer.

Okay, well

I am talking to an economist after all, and economists deal in harsh truths.

So I understand that bonds are sometimes called guilts, just to confuse things because they used to be gold-edged.

So you wouldn't lend me any money, harsh but fair, but you would lend money to, say, the British government.

So what's different about that?

Unlike you, Tim, the British government will last a very long time.

So I can be very confident that the British government will pay back my £100

in 2025, 2030, 2050, whatever the date on the bond is.

And I might just run off with your money and then you wouldn't know where to find me, whereas you always know where to find the British government.

Their address is well known.

That's right.

And lying behind that is the government's ability to raise taxes.

So So the government's a very special kind of institution, lasts forever and has this tax raising capability.

What sort of people or what sort of institutions like to lend money to governments?

Pension funds.

They want to hold some very safe assets that they know that they will be repaid and they'll be able to use those funds to pay out the pensions which they're obliged to do.

So that is clear enough, I think, from the point of view of the investor, the person lending money to the governments.

But why would a government have to borrow money in the first place?

I mean you said it yourself, they can raise taxes.

Why does the government have to borrow?

One good reason is when they want to invest.

So they've got plans, for example, for the green transition.

The benefits are going to flow in to the economy many years down the track, but they've got to make those investments now.

So that's one example.

When the government is borrowing in a recession, it's helping people.

So some people have lost a job.

Government borrowing will help to pay the unemployment benefits that helps those people to continue to purchase their weekly groceries, for example.

So should we be worried when governments borrow money?

Because it seems that we sometimes are.

Yes, sometimes we should be very worried when governments borrow money.

So

if you think about it like this, suppose that we know that it's going to cost more every year to run the health service.

So there's no point thinking about that as something that should be borrowed for.

The government has to raise taxes to pay for that increase in spending in the health service every year.

After the mini budget of September 2022,

why were people selling UK government bonds at that moment?

What was it about the budget that prompted that response?

The budget made people very uncertain about what the British government was up to.

They literally did not understand this mini budget and began to feel that the prospects for the British economy were very uncertain.

And when things become uncertain, that's when traders sell bonds.

And that's exactly what happened.

And the bond price crashed.

When the price of the bonds goes down, that means that they're less attractive.

And so that means that the interest rate that the government has to pay is higher.

Now, the Bank of England stepped in and started buying government bonds.

So what happened there?

Why did the Bank of England feel it needed to take action?

This related to pension funds.

When the price of bonds fell, it upset the financial arrangements in these pension funds and they suddenly needed to get hold of cash.

And the only way they could get hold of cash was to sell the bond, some of the bonds.

So just think about it like this.

The bond price has gone down.

That's caused a problem for these pension funds.

The only thing they can do is to sell bonds.

Yep, you've you've got it.

It made the problem worse because it made the price of bonds go down by more.

I've heard this described as a death spiral, which is never a phrase you want to hear.

Or a doom loop.

It's not good.

Not good.

I mean, I've got the Bank of England press release here, and they were trying to prevent a financial crisis, a full-out 2008-style financial crisis with big institutions going bankrupt.

That's right.

That's the reason that they stepped in and started buying the bonds.

And that stabilised the price.

Interestingly, that tells us, I think, that bonds are not just

government, the thing that governments use to borrow money.

They're almost like

the Lego blocks of the financial system.

They're being traded and bought and sold and held and used as the basis for contracts between all of these big financial players.

And then if something weird happens to the market for bonds, totally separately from the effect on government borrowing costs, totally separately from the effect on our mortgages, it can break the financial system if we're not careful.

That can happen.

So a guilt is another name for a government bond.

Bonds are ways for the government to borrow money.

But sometimes companies need money too to build new factories or offices, for example.

So how might they get it?

One thing they could do is to do the same as governments do, to write those IOUs, to sell bonds.

But they could do something else.

They could sell shares instead.

Here's another bit of history with Victoria Bateman about one of the UK's first companies to publicly sell shares.

The East India Company was founded in the year 1600 on a cold New Year's Eve by the Earl of Cumberland and a group of 218 investors.

So the Earl of Cumberland had his sights set on the Spice Islands, present-day Indonesia and the surrounding islands, with an eye to getting his hands on the pepper and the cloves that could enliven the types of food that Brits were used to eating.

So, the voyage would obviously be very treacherous.

You had the stormy seas, you had the risk of piracy, and you also had to face other foreign powers, other European countries that were also trying to get a piece of this action overseas.

So, this was an expensive business, and it was a risky business.

So, Cumberland pulled together a group of 218 people who were interested in putting up the money to fund this venture.

But they were only happy to put up this money if they got something in return.

So, between them, they potted together and raised £68,000.

And in return for that, they receive shares in the company, becoming its first shareholders.

And as shareholders in the company, they are then entitled to a slice of the pie, to the profits.

And so, when the ship returns to England in 1603, filled with its cargo of cloves and pepper, and when that cargo is sold, the profit that's made from that cargo is split between the various shareholders.

So, by 1614, the company had had a series of successful voyages.

More and more people wanted a piece of the action.

Anyone can go into a coffee house in the city of London, see what's available to buy, and be matched up with someone who wants to sell.

And these coffee houses also act as hubs of gossip about what's going on overseas, what's going on in international trade, what are the latest battles the East India Company has had to fight, what are the latest territories that it's managed to make inroads in?

And so you can then, based on the gossip, think: is it worth buying that share at that price or would you rather invest in something else or wait and see what happens in the future?

But financial dealings in the East India Company started to outgrow this small coffee house, and so eventually a bigger building was sought with a proper dealing room and a coffee room on top.

By 1812, a rule book is introduced.

And this rule book includes, for example, rules that you're not allowed to play football whilst you're having your coffee.

And eventually, of course, it becomes the London Stock Exchange.

Victoria Bateman.

And, you know, I never realised that football was banned on the floor of the London Stock Exchange, but now I realise I needed to know that.

Wendy Carlin, so you can buy and sell shares in a company, and if you have a few shares, that's described as having stock, and these shares are traded on the stock exchange.

Victoria Bateman said that shares were a stake in the future profits.

So is that what drives the share price up and down?

Yes, you can think of the stock exchange as accumulating the views of all the countless people in this country and around the world who hold shares in a a particular company, and the stock exchange just accumulates those views from the people who are rather pessimistic about the future profits of the company, people who are optimistic, and the share price will reflect the accumulation of all of those ideas with the people who have downbeat ideas selling, the people who are very optimistic buying, and the price will be the outcome of those buying and selling decisions.

Whenever you own or you have a pension, then that pension fund will own shares.

So if there are big moves up or down in the FTSE 100 or one of these indexes of large companies, then that will mean that the situation of your pension fund has either improved or deteriorated.

And that could down the line have some implications for your pension.

Professor Wendy Carlin, thank you very much.

So anyone can lend a company money in return for a share of their profits, but if the ship sinks on the way back from Indonesia, you will lose that money.

Lending the British government money is generally seen as a safer place to store your savings or your pension.

But whatever you do, don't accept a bond in the name of Tim Harford.

Understand the Economy was presented by me, Tim Harford, and produced by Phoebe Keen.

The researchers were Drew Hindman and Mariana Brain.

The editor was Claire Fordham, and it was mixed by Gareth Jones and Nigel Appleton.

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