May 23, 1996
"Indexed Bonds are a Win-Win-Win Policy"
San Jose Mercury News
By Timothy Taylor
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AFTER YEARS of chewing on the idea, the U.S. government has finally swallowed
hard and declared that it will soon begin to issue indexed bonds; that is, bonds
whose return will rise and fall to offset inflation. This is a win-win-win policy,
for investors, for the government, and for public policy.
There's a word for investors who bought 10-year U.S. government bonds in 1972:
suckers. Those bonds promised to pay 6.2 percent annual interest. But since inflation
during those 10 years averaged 8.7 percent, the investor was actually losing 2.5
percentage points of buying power each year.
By contrast, indexed bonds guarantee to pay perhaps 3 percent more than the
inflation rate (the exact margin would be set by the market), whatever inflation
turns out to be. For investors who want a guarantee that their nest egg won't
be scrambled by inflation, indexed bonds are unbeatable.
Some invest in gold as a hedge against inflation, but over the last 50 years,
gold prices have only protected against about half of inflation risk. Stocks offer
no protection against inflation at all; they tend to fall in value as inflation
Perhaps the only other inflation protection is to buy real goods, like a house.
But as people have learned when housing prices collapsed in New England, Texas
and California, the housing market presents risks of its own.
For the government, indexed bonds offer a chance to reduce spending. The principle
is the same as an adjustible-rate home mortgage loan; if you're willing to accept
the risk of paying more if inflation rises, you can pay a slightly lower interest
rate to start. With indexed bonds, since the government is now willing to accept
the risk of paying more if inflation rises, it can borrow at a lower interest
How much could the government save? Say that over the next few years, the government
issues enough indexed bonds to account for 10 percent of its $5 trillion in debt.
This proportion isn't unreasonable; in Britain, which has been issuing indexed
bonds since 1981, about 15 percent of government debt is in this form. The government
should be able to pay about 0.5 percent less interest on indexed bonds, according
to mainstream estimates.
So here's a back-of-the-envelope calculation: Saving half a percent on $500
billion in indexed bonds would save the government $25 billion a year in interest
payments. That's a nice chunk of change.
Of course, if inflation rises, then government will have to pay higher returns
on its indexed bonds and interest costs will rise. But from a public policy point
of view, this should be considered more of a benefit than a risk.
Right now, it is uncomfortably true that the U.S. government would benefit
from a surge of inflation. Borrowers tend to benefit from inflation, because they
can repay their debts in cheaper inflated dollars, and the U.S. government is
the biggest borrower in the world.
The reason will be familiar to anyone who bought a home in the 1960s, and then
experienced the joy of seeing their mortgage debt seem smaller and smaller as
its value was eaten away during the high-inflation 1970s. Similarly, a year of
10 percent inflation would knock $500 billion off the real value of the U.S. government's
$5 trillion in debt.
The Treasury Department hasn't yet announced the details of its indexed bonds.
What exact measure of inflation will be used? What will the precise tax treatment
But experience in Britain, Canada, Australia and Sweden has shown that indexed
bonds are workable. It's only a matter of government deciding deep down in its
heart that it will surrender the option of reducing its debts through inflation.
Indexed bonds mean that the government will pay the price in additional interest
costs if inflation is allowed to rise, and citizens will have an opportunity for
better protection of their savings and their future against a resurgence of inflation.
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