The Free Market 14, no. 8 (August 1996)
A wealthy broker of questionable repute is trying to sell a mutual fund. If it stock goes up, he says, you profit. If it goes down, he adds, he’ll send you a personal check to put it back on par with the original purchase price. He promises do this forever. Thus its value can’t decline, no matter how much you buy.
Clearly, something’s fishy. How can the investor be sure the broker will pay? What happens in the event of default? What are the precise terms on which he is to subsidize its value? Even more strange, why is the broker making the offer in the first place? Does he have anything to gain from this? If not, why is he resorting to such desperate tactics?
We are not likely to find this deal offered in the private sector. If we did, the broker would probably be a crook. Yet the U.S. government is thinking about offering just such a deal: a magic bond whose face value is indexed by the inflation rate. A $1,000 bond would rise with the price level, so its real face value would always remains the same.
Some inflation fighters see this bond as an enticing prospect. In their view, the indexed bond has many advantages. It penalizes government for bringing about inflation, thus discouraging the practice. It reduces volatility in the bond market. It allows investors to protect themselves from inflation. Most fundamentally, its market yield reveals much-needed information about real interest rates and inflation expectations.
All of these arguments fail, but let’s consider the last one first. The interest rate reflects not only savings and the return on capital, but also underlying monetary activity. Real rates are maybe 2 percent, but adding inflation and inflationary expectations, the nominal rate could be ten percent or higher. To get the real rate, it’s easy enough to subtract out present inflation (as measured by the CPI).
But how can we know how much nefarious “expectations” add to the interest rate? That’s what the indexed bond is supposed to clarify. Since its future face value will always be increased when prices go higher, investors will trade with that in mind. The difference in yields between the indexed bond and regular bond should give us precise data about inflation expectations. Now the central bank can do a better job. Voila!
Too bad it doesn’t work out that way. Interest rates aren’t so easily sliced into neat compartments. Other factors can affect the yield of a bond besides expected inflation. These include the risk of default, the value of dollar in overseas markets, the size of the deficit, and future government liabilities. All add static to the system and all are in a black box.
If we could conjure up the “real” rate, it wouldn’t be much help to investors or money managers. What we actually need is the “natural” rate of interest, which is the only pure reflection of the “time preferences” of economic actors. We’d never know for sure whether an indexed bond is telling us the truth about the natural rate or not.
Contrary to neoclassical theory, moreover, expectations are not always perfectly rational. The future of inflation, and every other economic trend, always contains an element of uncertainty, with or without an indexed bond. Believing that this bond can tell us the natural rate not only misleads investors; it may encourage the government and the Federal Reserve to be less sanguine about fighting inflation than they presently are. It’s no skin off the Fed’s back that the bonds pay higher rates.
Here’s a major clue that these bonds are a bad deal: Treasury Secretary Robert Rubin is their leading advocate. He says it they would be a great inflation hedge for investors. Before becoming Mr. Mexican Bailout, Rubin was a head of the Goldman Sachs investment banking house, which has profited handsomely from its government bond dealings. He is man for whom money is never too loose. We have reason to doubt that his first priority is ridding the world of inflation.
So what’s the real reason for issuing the bond? Early in the Clinton term, the Treasury reshuffled the government’s bond portfolio from longer term to shorter term bonds. This accounting trick, invisible to the public, lowered the overall federal outlay and won the White House some propaganda points for “lowering” the deficit.
But the Treasury’s decision also had a political downside from the White House point of view. With short-term debt, the markets are more sensitive to government machinations. For several years, U.S. government money managers have been frustrated and hobbled by the bond market. It respond very quickly to sudden and unexpected monetary manipulations.
The government is concerned that any action will provoke a mass selling of bonds, especially those held by foreigners, a fear that has marginally restrained them. Bill Clinton has been reported to be very frustrated with this. He suggested at one meeting that he would like to be reincarnated as something truly powerful, like the bond market.
To create more flexibility for itself, the government now wants to shift back to longer bonds, but without having to pay the higher yields such bonds usually carry. Thus the indexed bond, which slices off the inflation premium usually attached to such bonds. Thus it is designed to make 30-year bonds more popular and the bond market less volatile. At the same time, it is supposed to reduce the market’s sensitivity to inflation, and increase the likelihood that people will buy and hold bonds regardless of future prices levels.
The irony is that far from correcting one of the major consequences of debt—the volatility of the bond market—such bonds only end up increasing it. That’s because it removes a major incentive for the central bank to keep a somewhat tight rein on the money supply. With a high number of indexed bonds floating in the marketplace, the central bank can expand the money supply without facing the prospect that its debt issues will suffer a fall in value.
There’s also the great potential for added expense. Sometimes governments are so in debt that paying interest on bonds, and paying off bonds that have matured, increases the debt level in ever-increasing spirals. That can create a spending-debt-inflation spiral. That’s why governments typically issue these bonds only as a last resort, and why, until recently, they were a favorite trick of third-world regimes.
The presence of indexed bonds suggests that the government’s money managers are planning an inflation, possibly a huge one. They hope that issuing these bonds will make their inflation pain-free for investors and themselves. It shouldn’t surprise us to see a major debt monetization effort begin after these bonds have been marketed worldwide.
That’s why talk about these bonds is a very bad sign for the future of the dollar. The media will tell investors that anyone who expects inflation should get out of gold and even stocks and buy bonds that are inflation-proof. Some people may be fooled, but smart people will realize that there are other issues to consider.
Under the best of circumstances, these bonds are only guaranteed to hold their real value, not necessary earn more than the average rate of return. For investment purposes, then, they are no more or less likely to earn money than any other bond. There is also the tax issue. If the face value of a bond increases, the government will consider that to be a capital gain. If the bond is sold before maturity, the investor is hit with a tax again.
Even the supposed “guarantee” of increased face value is in doubt, because so much rests on how the government chooses to calculate the inflation rate. The CPI is merely a price index and it may or may not capture the actual rate of inflation. In recent days, the Treasury had been agitating for a radical revision to make the CPI even less accurate than it was before. The Republican Congress has already approved one arbitrary revision.
The CPI is thoroughly politicized, a fact which the indexed bond can only reinforce. The government can change the rules at any time. For example, it might issued the bonds to be indexed by inflation, but then use the phony “core” inflation rate as the standard. This measure subtracts food and energy and anything else that might be going up “too fast.” The government can change the formula at anytime with no obligation to indemnify those who were misled.
What if an unexpected inflation emergency strikes? As with the crooked broker who promises his stock will never go down, there is no guarantee the government will actually pay up. Who doubts that in a situation of hyperinflation, it would suspend indexation when the rate reaches 18 or 20 percent? It could also refuse to redeem, or extend the maturity date for all federal securities. At the very same time, it could force pension plans to buy federal bonds.
It doesn’t matter how likely any of these scenarios are. If only of these contingencies are slightly possible, the purpose of the bonds—to guarantee a profitable payoff so as to reduce market uncertainties—is destroyed.
When an investor buys any bonds, he is also buying into a government promise. But some government promises are better than others. More than likely, it will pay the face value of any bond it issues. It may be late. It may have a negative real value. But with an indexed bond, it is much less likely to keep up its end of the bargain. The government’s supposed guarantee is not to be trusted.
The whole point of an inflation hedge is to be free from government machinations, not dependent on them. The indexed bond will succeed only in fooling unsophisticated investors and dulling public opposition to inflation. It may be a good deal for the government—an inflation-free ride!—but for the rest of us, the government’s magic bond is no more than a sleight of hand.
