WE’RE REGULARLY REMINDED that the government’s overall plan for the economy is to ensure that Ireland gets back to the bond markets – escaping from the clutches of the EU-IMF bailout.

But given how so much of the public policy debate these days focusses on Ireland’s finances – and, specifically, where we get our money from – it can often feel like the debate is going over your head unless you understand what exactly the bond markets are.

So, to try and make you a little more comfortable with that kind of discussion, here’s our crash course to what the bond markets are.

Why we need the money

First of all, we should define exactly why we need the money. Governments, like anybody else, need to match the money that they spend with the money that they take in.

If a government’s policies mean it doesn’t have the tax income to pay for its spending programmes, it has to plug the gap somewhere – and it does that by borrowing money.

By comparison, the Budget for 2012 outlined expected income of €39.2 billion and total spending of €64.4 billion. Obviously that €25.2 billion gap needs to be plugged – so Ireland, and any other country, does this by borrowing the difference.

Obviously if times were good we wouldn’t need to borrow at all – and this was the case for much of the last decade – but given the current state of affairs, with less people working to pay income tax and more people needing social welfare help, Ireland’s got a gap that needs filling.

So – that’s what we need to go there. Now to explain what exactly the bond markets are.

Forget your preconceptions

Most people have a relatively straightforward idea of what the ‘national debt’ is. People often think that if a country borrows money, it does so from other countries – bringing around the situations like the ones Bono and Bob Geldof campaign about, encouraging richer countries to forgive the debts of poorer ones.

This is only true some of the time – and it’s almost never true for First World countries any more.

When a developed country like Ireland needs to borrow money like we’ve explained above, it doesn’t go to a bank or to another country – it instead sells bonds.

A bond, to put it in layman’s terms, is an IOU: a piece of paper sold to an investor, which guarantees them a fixed payment every year until its repaid. “I, Ireland, agree to repay your €10,000 in ten years’ time – and to pay you 5% interest every year until then.”

It’s not just countries that do it. Large corporations and banks do it too – and even Manchester United issues bonds occasionally, as it did in 2010, to keep the show on the road.

How they’re sold

The fixed annual payment – basically, the interest rate that Ireland pays in exchange for selling the bond – is called the yield. (That’s what is meant when you hear someone say, ‘The yields on Irish bonds are really high at the moment.’)

This yield is fixed and agreed at the time the bond is issued, through an auction system where investors tell Ireland how much they’re willing to lend, and how much interest they want as a result.

Once the bids are in, Ireland (or, more specifically, the National Treasury Management Agency which does all of this stuff on Ireland’s behalf) then decides which ones it likes best – naturally, the ones demanding the lowest interest rate – and agrees to sell bonds to those people.

This is where supply and demand comes into play – if there is higher demand for the auction, the chances are that investors will have to offer a lower interest rate in order to get the bond at all.

But remember why investors are lending to us in the first place. They’re doing it as an investment: a way of keeping their money safe, while turning a profit at the same time. So they’re going to want a decent interest rate.

A double-edged sword

But there’s also a second purpose to the interest rate. Fundamentally, the reason an interest rate is being paid is to reward the investor, who could have put their money elsewhere – and to make sure that they get some return on their investment.

So there’s a problem if a country looks like it’s about to go belly-up. A country whose financial future is unsound – and which may not have the money to repay an investor when their bond is due to be repaid – is going to be asked to pay a higher rate.

That’s because an investor is thinking this: “If I’m lending Ireland €10,000, and I’m worried I’m not going to get it back, I’m going to make damn sure I get a decent pay-off in the meantime.”

Eventually, if people have a totally negative opinion of a country and its ability to repay its debts, the interest rate they’ll demand becomes too high – and reaches a level the country simply can’t afford.

A moneylender who can’t break your legs

That level varies from country to country. Most people believe that 6% is too high for a European country to pay for a 10-year bond. Thankfully, there’s a thriving second-hand market where bonds change hands on a minute-by-minute basis, allowing countries to see how much it would pay in theory if it was holding an auction that day.

In Ireland’s case, we stopped issuing bonds when the yield on the second-hand market got to 6%, and lived off our savings until the yield got to 9% and we went for a bailout.

At the time our bailout was confirmed, Germany – which is usually seen as the benchmark by which other countries compare themselves – would have paid 2.5%.

If you’re frozen out of the markets like that, your options at that point are stark and simple. You can either…

• Cut back on your spending and raise taxes so that you reduce your need to borrow (this is the idea behind the Fiscal Compact – it puts a limit on the government deficit, encouraging countries only to spend within their means)
• Go to another lender like the ECB or the IMF, who’ll impose strict terms and conditions on your loans;
• Simply tear up your loans and tell people they won’t get paid back. This is called defaulting. ”Sorry lads, I know you’ve got that IOU, but I’m walking away.”

A default might seem like an easy and obvious solution – but remember that the whole point of this exercise is to keep a low interest rate, so that you can borrow more cheaply.

A country with a history of default will find it more difficult to find someone to lend to them again – and will see higher interest rates as a result.

Argentina did it in 2001 – writing off $132 billion of debt – and is still paying the price. It held an auction to sell some seven-year bonds (that is, loans which were due to be repaid in seven years’ time) last November, and paid 9% interest.

If and when Ireland gets back to the bond markets, if we were charged 9% for a seven-year bond, we’d be heading straight back to the Troika.

Explainer: What did EU leaders agree this week in Brussels?