The Mises Institute monthly, free with membership
Volume 14, Number 8
The Government's Magic Bond
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
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
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
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
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.
Ron Paul is a former Congressman and the Mises Institute's distinguished counsellor