GDP bonds are a really bad idea, part 3

By Felix Salmon
February 22, 2012
a bad idea when Jonathan Ford proposed it in August 2009, it was a bad idea when Shiller wrote about it in December of that year, and it's an even worse idea now, because Shiller's decided to kick it up another five notches or so.

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Can countries issue equity? Greece is making a stab at it, giving its bondholders GDP warrants which start paying out “in the event the Republic’s nominal GDP exceeds a defined threshold”. Chances are, the market won’t give the warrants much value; they’re more symbolic, really, of Greece’s good faith.

But Bob Shiller is much more ambitious when it comes to such things: “Countries should replace much of their existing national debt with shares of the “earnings” of their economies,” he writes in the Harvard Business Review.:

National shares would function much like corporate shares traded on stock exchanges. They would pay dividends regularly. Ideally, they’d be perpetual, although a country could always buy its shares back on the open market. The price of a share would fluctuate from day to day as new information about a country’s economy came out.

This was a bad idea when Jonathan Ford proposed it in August 2009, it was a bad idea when Shiller wrote about it in December of that year, and it’s an even worse idea now, because Shiller’s decided to kick it up another five notches or so:

Greece’s real GDP fell 7.4% in 2010. If its Trills were leveraged substantially—say, five to one—then the dividend paid on them would have fallen by about 40%. This would have done much to mitigate the crisis, making it easier for Greek taxpayers to bear.

This is almost literally incomprehensible. I spent a long time on the phone today with Shiller’s co-author Mark Kamstra, and even he had no real idea what Shiller was talking about here. I can see how an investor might try to leverage an investment in Greek Trills (a Trill being a bond paying one trillionth of GDP every year, in perpetuity) by buying those bonds with borrowed money. But I can’t see how Greece itself could do so. Shiller doesn’t spell it out, but these things would obviously be symmetrical: Greece would have to pay out five times its annual GDP growth in good years in order to get these large savings in bad years. And that seems like a clear recipe for unsustainable debt growth.

Even Kamstra concedes as much. “I think that a country would not issue a levered Trill,” he told me. “I think it gets you in a lot of trouble.”

But even if you put aside the insane concept of leveraged Trills, the idea behind them is still really bad. Kamstra tried to persuade me that the price of Trills would be less volatile than the S&P 500, and he might be right during periods of relatively normal interest rates. But when rates fall, it seems to me that he’s clearly wrong. A perpetual bond like a Trill is valued by adding up the present value of its income stream: how much is this year’s payment worth to me today, how much is next year’s worth, and so on. When you apply a discount rate, future coupon payments are worth less the more distant they are, and the sum of the total converges to the value of the bond.

If the coupons are steadily increasing, however, the math becomes very dangerous. The coupons will rise at the rate of nominal GDP growth, which in the US will probably be somewhere in the 4% to 5% range over the long term. As a result, if you’re a risk-averse person who wants a perpetual US government security and your discount rate is say 3%, then the expected value of a singe Trill is actually infinite. Of course, no security trades at a price of infinity. But the fact that valuations can get so high in a low-interest-rate environment is all you need to know about just how volatile Trill prices could get.

The point here is that Shiller seems to think that the price of Trills would be driven mainly by “new information about a country’s economy”. But he’s wrong about that. new information about a country’s economy tells you quite a lot about what its GDP might do in the next few years. But if you’re holding a perpetual bond, fluctuations of 1% or 2% in the value of short-term coupon payments are not going to make much difference to the value of the bond. What really makes a big difference is the interest rate you use to calculate net present value. In other words, while Trills are designed to respond to news about the economy, in fact they would be an incredibly noisy and volatile instrument reacting mainly to changes in long-term interest rates.

But what if I’m wrong and Kamstra’s right, and economic news is more important than discount rates? At that point, measuring GDP accurately becomes extremely important: the markets would care greatly about differences of just a percentage point or two.

Except, you really can’t measure GDP to within that degree of accuracy. Here’s a recent paper from the Bureau of Economic Analysis:

Measuring the accuracy of national accounts esti­mates is a long-standing challenge for three main rea­sons. One, the early GDP and GDI estimates are based on partial data and are intended to provide an “early read” on the general picture of economic activity for decision-makers. These early estimates are revised as more complete and accurate source data become avail­able. Two, the source data for the national accounts come from a mix of survey, tax, and other business and administrative data; these source data are subject to a mix of sampling and nonsampling errors and biases that cannot be measured in terms of standard errors. Three, the national accounts are regularly revised to re­flect the changes in the economic concepts and meth­ods necessary for these accounts to provide a picture of the evolving U.S. economy that is relevant and accurate for today’s economy. These updates range from ex­panding the definition of investment from investments in plant and equipment to include investments in computer software to updating seasonal adjustment factors to reflect the most recent seasonal patterns.

What does all this mean in practice? Thomas Dall at the BEA helped me out, taking one recent datapoint as an example: nominal GDP at the end of the first quarter of 2009.

When it was first reported, that number was $14.097 trillion. But then three months later, in July 2009, it was revised upwards, to $14.178 trillion. A year after that it was revised back down, to $14.05 trillion, and a year after that, in July 2011, it came down further, to $13.894 trillion. In other words, between July 2009 and July 2011, the GDP figure for the first quarter of 2009 was revised down by $284.3 billion, or 2% of GDP.

And Dall didn’t pick that datapoint because it was particularly noisy: it’s the only one we looked at.

This is bad news for any government thinking of issuing Trills. Governments, after all, go to great lengths to issue easily-understandable series of bonds with fixed coupons, so that the financial markets can price them easily and have a transparent yield curve. The only people welcoming GDP bonds with open arms would be in futures markets, where traders love volatility and try to make lots of money off it.

Which, of course, is the whole reason that Shiller is pushing this idea so aggressively. Shiller is a principal in a company called MacroMarkets, which exists to create “innovative financial instruments to facilitate investment and risk management” — a/k/a volatile new derivatives.

If Trills existed, you can be quite sure that MacroMarkets would immediately create futures and options based on Trills, trying to make money off their volatility. The volatility would depress the price that governments could sell the Trills for, but at the same time it could make a fortune for Bob Shiller. “Bob’s experience in the markets is that if there isn’t enough volatility in the price of the contract, the speculators lose interest in the contracts,” says Kamstra.

So let’s discount Shiller, here, as someone who’s way too conflicted to take at face value about such things. GDP bonds are like most financial innovations: they’re much more likely to do harm than they are to do good. And no country should even dream about issuing such things until some big corporation has blazed the trail first, as a kind of proof of concept. Lots of companies, from Walmart to ExxonMobil, do better in good economies and worse in bad economies: it might make sense for them to issue GDP bonds. Let’s wait until one of them does, so that we can get a feel for how such bonds behave, before we ask our governments to follow suit.

I feel we’ll be waiting a long time. If it’s true that the price of a GDP bond can skyrocket when interest rates fall, that bond would be extremely dangerous for any company issuing it. The market value of the company’s outstanding bonds could easily exceed the company’s enterprise value, with the result that technically shares in the company would be worthless. I can’t imagine any CFO or corporate treasurer risking it. And neither should any finance minister.

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