5 GOVERNMENT DEBT

COMMISSION OF ENQUIRY

World-wide

A new structure for financial stability

Proposed Agenda 2013

Drafted in Collaboration with

Graham D Hollick FCIS FIBSA CeMAP and others

By The Proposer And Chief Researcher

Edward C D Ingram

DISCUSSION TOPIC 2

1.1. WEALTH BONDS

Government Bonds will be restructured as ‘Wealth Bonds’ so as to preserve wealth by indexation to AEG% p.a. (the letters given to an index of Average Earnings Growth), using a definition of AEG to be agreed by the commission or the government concerned, e.g. to GDP, (aggregate National Income).

1.2. KINDS OF WEALTH

It will be shown that there are two main kinds of wealth – (a) investments such as property - the kind that demands a willing buyer, and which is inflatable and unstable, and (b) the kind that stores saved income, which is more stable and is lent. (c) AEG-linked Bonds are a special case in which the wealth should be safe if it is held to maturity, but the bond itself can be sold before maturity at a market value. In that regard, shorter dated bonds are safer and less volatile than longer dated bonds. A variable true rate with a pre-defined formula might be considered for longer dated bonds or some Open Market Operations might be used, if more stability of wealth (tradable price) is needed.

A MEASURE OF WEALTH

At the end of the day, all acquired assets such as property and equities are acquired from someone’s income or by using unpaid time creating the wealth. Time and income resources are limited but they are the source employment when the wealth that they represent is spent, and they are the source of stored wealth when saved, lent, or invested. Those resources and stores of wealth can all be valued in terms of stored income or income’s worth.

1.3. MOVEMENT OF WEALTH

It will be shown that if the true rate of interest (nominal less AEG% p.a.) is negative, then wealth (spendable income) moves to the borrower; and that if the true rate of interest is positive wealth (spendable income) moves to the investor / lender. In both cases, positive or negative true interest, this occurs at the rate of true interest per annum multiplied by the sum involved. For example:

1.3.1. Six years’ income borrowed at 5% true interest transfers 30% of a year’s income per annum from a borrower to a lender / investor. Indexation at the rate of AEG% p.a. (zero true interest) transfers no wealth: the amount of income that is borrowed is the amount that gets repaid if we count the payments in units of average income. In this sense, zero true interest, or indexation to AEG% p.a., is free borrowing.

1.3.2. Despite this ‘zero cost’ a return on an investment of AEG% p.a. offers a return to the lender / investor that includes the current rate of real economic growth. This is because, broadly speaking, and if the definition of AEG is based upon aggregate income (GDP), AEG% p.a. is above the rate of prices inflation by the rate of real economic growth.

1.4. The preferred indexation candidates are the average annual earnings per person, (AEG% p.a.), or per working person, or GDP.

1.4.1. This restructuring of government bonds will significantly reduce wealth risk both for investors, and for borrowing governments, compared to using fixed interest rate bonds or...

1.4.2. ...using bonds index-linked to prices. Remember: a return equal to AEG% p.a. incorporates a return equal to the rate of real economic growth. Bonds linked to prices do not provide a store of wealth to the extent that they fall short of the AEG% p.a. index. This is explained with illustrations in my draft book in chapter 4 and in all the preceding chapters that may be needed to consolidate this somewhat non-instinctive concept; or is our education to blame?

For a prices-linked bonds, the true return above the better selected index (AEG or GDP - but GDP embeds other factors such as demographics) is variable if the interest coupon is fixed, and it would be confusing to make a provision to vary the coupon rate so as to overcome this instability, net of tax for all parties.

And it is not so easy to sell bond linked to prices given that it would not match the liabilities of pension funds and it would not relate to other investment forms like property and equities that are driven by AEG indirectly.

1.4.3. There is the wealth, (stored income), offered to the tax payers by investors when they buy the bond, and

1.4.4. There is the call on the income, (the wealth), of tax payers, in servicing and repaying the bond, which is created by the issuance of the government bond.

1.4.5. By safeguarding the wealth of both parties through indexation, this should reduce borrowing costs (remove the wealth risk interest rate premium) and help to improve the credit rating of the borrowing government.

1.4.6. There should be further significant benefits from the removal of the ‘wealth effect’ from this domain. The wealth effect significantly enlarges a business cycle.

1.4.7. The accounting (cash flow) and wealth risk dynamics of doing this is a major improvement: it will assist a government contemplating an economic recovery stimulus because, as a recession takes hold the true interest cost of servicing the bond does not increase as AEG% p.a. goes negative and as GDP falls.

1.4.8. Nominally, (in money cost), the liabilities of tax payers (government), would reduce because of the negative indexation to AEG or GDP during a recession. Thus the liabilities, (the call on the ‘% of income’ of tax payers), remains unchanged, meaning that the call on the ‘% of income’ of taxpayers remains unchanged, as the economy moves into and out of recession. This cost stability and reduced risk premium will also assist the government’s credit rating.

1.4.9. In other words, the removal of the wealth risk premium should reduce the borrowing cost. The true interest rate should reduce. This assumes that a strong market for these bonds (with no, or reduced, wealth risk) can be found. The commission will examine this issue and the appropriate indexation to use, later. At the end of Chapter 4 of the draft book an example is given of the terrible cost of using a fixed interest rate bond - in the 1980s in the USA. The government was paying around 9% true interest at one point as a cost of reducing the high level of inflation. It is better that everyone knows in advance and by agreement  what are the cost and the benefits involved in lending and in borrowing. AEG-linked bonds achieve this. I seeI have repeated this in the next paragraph.

1.4.10.  Due to the removal of risk-to-wealth for borrowers (tax payers), there can be significant advantages. For example, there are instances in which the use of fixed interest rate bonds has raised the cost-to-wealth (the true rate of interest has risen) as the inflation rate has reduced. For example, at right: (USA 1980 - 2010) the true cost of the early bonds issued when inflation rates were high, reached around 9% p.a. due to the subsequent fall in the rate of inflation; and in Europe currently, as recessions took hold, true rates of interest (fixed nominal interest minus the GDP Growth rate) have risen so far as to give investors a true rate of return (wealth transfer) at least twice as great as is obtainable from a long term equity investment (4% - 5% p.a.). True rates of interest on government bonds have played around in the 10% p.a. area in both cases. This is a significant cost to making an economy work well compared to the 1% p.a. or so true interest rate that it ought to cost to protect the wealth invested in an AAA rated AEG-linked or a GDP-linked government bond.

1.4.11. In contrast, the current open market (willing buyer) value of USA government bonds is so inflated that it has virtually locked monetary policy into QE for fear of a collapse in the tradable value of fixed interest bonds.

1.4.12. And housing values are just as vulnerable to an interest rate rise.

1.4.13. The Bank of England was reported by Dr Stals (retired Governor of the South African Reserve Bank) to be contemplating inflating their deficit away at a 10% inflation rate, which would rob investors, including banks invested in bonds, of most of their associated (inflatable) wealth if carried out. Note: AEG-linked wealth is not vulnerable in these terms.

1.5. NOTE ON MORTGAGES.

A. Mortgages can also be funded by AEG-linked Bonds. It may be preferred to base the definition of AEG% p.a. on the middle 60% of incomes and even to subdivide this between the younger and the older employed people, when designing a particular financial product such the repayments schedule for a mortgage bond. But if the level of Payments Depreciation (read the draft book) is high enough the arrears level to be expected will still be very low for any AEG-based index. Remember, the definition of AEG used does not in any way ‘fix’ market prices, including the market rate of true interest used for raising funds to lend.

B. Finding enough borrowers to balance the supply with the demand at the market rate is the role of the lending industry. Without the distorting effect of arrears which characterises current mortgage models, there should always be a true rate of interest which can balance the supply of funds with the demand for them. Similarly for government bonds: because everyone will be fishing in the same investment pool and ideally, with a level taxation playing field, true rates will be determined in the (less distorted) market place.

OTHER USES FOR AEG-LINKED BONDS

There are plenty of other uses for AEG-linked Bonds.

For example, if the bond is styles as a repayment as is the case for an ILS Mortgage, and which can be used as a model for government bonds too, then investment managers will be very interested - they like a high cash inflow.

Such bonds will stabilise the fund and make it more attractive to many investors. Annuities can be funded in this way. And defined benefit pensions can be funded at a defined cost to wealth. But remember that a unit of wealth is based on an index of incomes and not that of an individual's income. If we define a unit of wealth as a National Average (year's) earnings (an NAE),then how long it will take a particular person to earn an NAE will vary from time to time and from person to person.

The point of using such units is that if 1 NAE is lent and a zero true rate of interest is added, then that 1 NAE remains 1 NAE. But if more interest is paid then that 1 NE will grow and eventually become 2 NAE. The concept gives us a means of communication.

SUMMARY

In summary, there is no reason to use fixed interest bonds of any maturity date. Fixed interest bonds destabilise costs and benefits and introduce more volatility in value and prices than necessary.

ALL READERS AND COLLABORATORS

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eingram@ingramsure.com

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