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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 rises.

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 rate, too.

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 be?

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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