I n t h I s c h a p t e r y o u w I l L

I n f l a t i o n F i g h t e r s
f o r t h e L o n g Te r m
B
Y
J
OHN
Y. C
AMPBELL
AND
R
OBERT
J. S
HILLER
Treasury Secretary Robert Rubin an-
nounced on Thursday that the govern-
ment plans to issue inflation-indexed
bonds—that is, bonds whose interest
and principal payments are adjusted
upward for inflation, guaranteeing their
real purchasing power in the future.
This is a historic moment. Econo-
mists have been advocating such
bonds for many long and frustrating
years. Index bonds were first called for
in 1822 by the economist Joseph
Lowe. In the 1870s, they were cham-
pioned by the British economist Wil-
liam Stanley Jevons. In the early part of
this century, the legendary Irving
Fisher made a career of advocating
them.
In recent decades, economists of
every political stripe—from Milton
Friedman to James Tobin, Alan Blinder
to Alan Greenspan—have supported
them. Yet, because there was little
public clamor for such an investment,
the government never issued indexed
bonds.
Let’s hope this lack of interest
does not continue now that they will
become available. The success of the
indexed bonds depends on whether the
public understands them—and buys
them. Until now, inflation has made
government bonds a risky investment.
In 1966, when the inflation rate was
only 3 percent, if someone had bought
a 30-year government bond yielding
5 percent, he would have expected
that by now his investment would be
worth 180 percent of its original value.
However, after years of higher-than-
expected inflation, the investment is
worth only 85 percent of its original
value.
Because inflation has been mod-
est in recent years, many people today
are not worried about how it will affect
their savings. This complacency is dan-
gerous: Even a low rate of inflation can
seriously erode savings over long peri-
ods of time.
Imagine that you retire today with a
pension invested in Treasury bonds
that pay a fixed $10,000 each year,
I N T H E N E W S
How to Protect Your Savings
from Inflation
◆
The overall level of prices in an economy adjusts to
bring money supply and money demand into balance.
When the central bank increases the supply of money, it
causes the price level to rise. Persistent growth in the
quantity of money supplied leads to continuing
inflation.
◆
The principle of monetary neutrality asserts that
changes in the quantity of money influence nominal
variables but not real variables. Most economists believe
that monetary neutrality approximately describes the
behavior of the economy in the long run.
S u m m a r y

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C H A P T E R 2 8
M O N E Y G R O W T H A N D I N F L AT I O N
6 5 1
regardless of inflation. If there is no in-
flation, in 20 years the pension will have
the same purchasing power that it does
today. But if there is an inflation rate of
only 3 percent per year, in 20 years
your pension will be worth only $5,540
in today’s dollars. Five percent inflation
over 20 years will cut your purchasing
power to $3,770, and 10 percent will
reduce it to a pitiful $1,390. Which
of these scenarios is likely? No one
knows. Inflation ultimately depends on
the people who are elected and ap-
pointed as guardians of our money
supply.
At a time when Americans are liv-
ing longer and planning for several
decades of retirement, the insidious ef-
fects of inflation should be of serious
concern. For this reason alone, the cre-
ation of inflation-indexed bonds, with
their guarantee of a safe return over
long periods of time, is a welcome de-
velopment.
No other investment offers this
kind of safety. Conventional govern-
ment bonds make payments that are
fixed in dollar terms; but investors
should be concerned about purchasing
power, not about the number of dollars
they receive. Money market funds
make dollar payments that increase
with inflation to some degree, since
short-term interest rates tend to rise
with inflation. But many other factors
also influence interest rates, so the real
income from a money market fund is
not secure.
The stock market offers a high rate
of return on average, but it can fall as
well as rise. Investors should remem-
ber the bear market of the 1970s as
well as the bull market of the 1980s
and 1990s.
Inflation-indexed government bonds
have been issued in Britain for 15
years, in Canada for five years, and in
many other countries, including Aus-
tralia, New Zealand, and Sweden. In
Britain, which has the world’s largest in-
dexed-bond market, the bonds have of-
fered a yield 3 to 4 percent higher than
the rate of inflation. In the United
States, a safe long-term return of this
sort should make indexed bonds an im-
portant part of retirement savings.
We expect that financial insti-
tutions will take advantage of the new
inflation-indexed bonds and offer in-
novative new products. Indexed-bond
funds will probably appear first, but in-
dexed annuities and even indexed mort-
gages—monthly payments would be
adjusted for inflation—should also be-
come available. [
Author’s note: Since
this article was written, some of these
indexed products have been intro-
duced, but their use is not yet wide-
spread.]
Although the Clinton administration
may not get much credit for it today,
the decision to issue inflation-indexed
bonds is an accomplishment that histo-
rians decades hence will single out for
special recognition.
S
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