Friday, November 6, 2009

TIPS as Seen Through Governmental Eyes

The following two documents are a MUST read for those considering the purchase of TIPS.

Minutes of the Meeting of the Treasury Borrowing Advisory Committee (pdf)



Click to enlarge.

First, I want to sum up the ex-ante vs. ex-post thing. When looking ahead, inflation expectations imply that TIPS save the government money. That's the ex-ante part. However, when looking backward, inflation ran hotter than expected. That's the ex-post part. As an investor in TIPS, this condition serves me VERY well. In other words, the government did not expect me to make as much money off of TIPS as I have. I don't see this changing much as I look into the future.

Second, I want to point out the stagflation sentence. I don't want anyone to miss it.

The member noted that the "pro-cyclical benefits" argument for issuing TIPS also breaks down in stagflation environments.

Should stagflation appear, the good deal that TIPS have been becomes even better relative to the debt the government could have offered me. The government gets a VERY rotten deal on inflating away the debt away if I'm sitting in inflation protected treasuries. Let's just put it that way.

GAO: Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges

Economists conducting ex-post analyses have concluded that the TIPS program has been less cost-effective for Treasury than nominal securities.

In contrast, other economists who have studied the issue argue that from an ex-ante (before the fact) basis, TIPS are not more costly to issue than nominal securities and that the relative cost of the TIPS program to date in part reflects start-up costs that will not be incurred again.

Gotta love those "other economists" who love using predictions of future inflation instead of tried and tested actual inflation. What do you suppose the thinking is? Well, no need to wonder. They'll tell you.

The time horizon of the analysis affects the results since, over the long run, the average amount by which actual inflation exceeds expected inflation will roughly equal the average amount when the opposite is true.

Tell that to Zimbabwe, the Weimar Republic of Germany, or the Roman Empire. Surely there must be something in the document to support my wild accusations of future financial instability. Let's see. Maybe a chart would do it.



I should die of old age right on schedule. Those expecting immediate short-term financial apocalypse will no doubt be sorely disappointed. This can drag on for decades. Rome did not fall in a day.

My burden will not be placed on my grandchildren though. Like many forward-looking Japanese peering into the never ending pile of government debt, I have chosen not to have any children. Should other people become as financially defensive as I am, then demographics will be a future source of financial instability.


Are Western Governments Going Broke?

The underlying problem which deficit spending does not solve is compounded by demographics. Japan’s government is hoping that continued borrowing can be financed at low rates by pensioners who will be cashing out of their pensions but seeking safety. However, we suspect that Japanese pensioners will begin to consume their savings as they downsize their lives into their twilight years (which tend to last much longer in Japan, as the number of Japanese centenarians shows).

That means interest on Japanese bonds-which already one fifth of the Japanese budget-will consume even more of the nation’s resources, if the older population clams up with its money. And like in the U.S., you’ll see the government borrowing more and more of every new yen spent, with more of that borrowed yen going to pay a previous creditor. That’s bordering on Ponzidom.


So why would I pick stagflation over Japan's deflation long-term? Japan exports physical goods to us. We export paper dollars to them. We will always want Japanese goods in exchange for our freshly printed dollars. I think that pretty much goes without saying. However, what would happen if Japan started losing their interest in our paper dollars? Then what?

5 comments:

EconomicDisconnect said...

Mark,
I noticed the government is really ramping up TIPS issuance this year. Do they expect some benefit?

I have some old depression era cartoons up if interested.

Stagflationary Mark said...

GYSC,

After reading through the links and attempting to read between the lines I think I finally see what is going on and it does seem to make sense to me.

Here's the thinking in summary form.

It SHOULD cost me more to own TIPS. The inflation protection is a form of insurance. The insurance should not come free of charge. In fact, I expect to pay a bit more for the insurance. I'm taking on less risk and that is worth something to me.

That said, it is NOT costing me more for the insurance if the last 13 years are any indicator. I am being paid extra to be insured. How crazy is that?

So why is this happening?

Here's my theory. Investors are not rational! I've seen it over and over again on the TIP message board. I will offer one specific example to somewhat prove my point.

I claimed that although I own TIPS, I would do much better if inflation averaged just 0%. I wouldn't have to pay any tax on the illusionary inflationary gains. Inflation can only hurt me as it requires me to pay more taxes.

I claimed that I'd rather earn 1.5% with 0% inflation, than 11.5% with 10% inflation. So what was the response?

"Not me. If you have money on the sidelines waiting to invest, 11% return sure beats the slopply returns today. To some degree, you can control spending, but you don't have much control over interest rates. I am SICK and TIRED of not making any money on my investments!! The way our government is spending money, there is no doubt that SUPERINFLATION is right around the corner. I want to buy TIPS, but I will wait til the return gets better."

He'd rather earn 11.5% with 10% inflation and be taxed on the full 11.5% than simply earn 1.5% with no inflation at all (and very little for the government to tax). You explain it to me why he thinks this way and we'll both know. Maybe it has something to do with the part of the brain that thinks 99 cents is a LOT cheaper than a dollar.

We also saw this thinking in cost of living adjustments to Social Security. At least somebody gets it.

Letter: Obama's $250 check to Social Security recipients is bogus (Nov. 4)

http://www.gazettetimes.com/news/opinion/mailbag/article_f972c8b8-c927-11de-8512-001cc4c03286.html

"First, since the cost of living has decreased by almost 5 percent this past year, the average Social Security recipient will have about $725 more in purchasing power next year. Simply put, the argument that the lack of a COLA hurts recipients is bogus."

I can't speak for the 5 percent decrease, but I can say that prices did come down. We did experience deflation. Seniors were actually getting a good deal anyway as prices dropped. They didn't need an additional bonus.

People only seem to think in nominal terms, not in inflation adjusted terms. That's actually part of the scam of inflation. The government has done TOO good a job at pulling wool over the eyes of Americans.

If we are paid 2% more per year and prices rise 2% more per year that should be the same as being paid 2% less per year as prices fall 2% per year. However, people don't think that way. They get outraged if the latter happens and they also postpone purchases based on things getting cheaper. Go figure.

This is one reason I think TIPS are are a bargain when compared to nominal treasuries. I'm actually being paid to be insured.

Stagflationary Mark said...

GYSC,

"If we are paid 2% more per year and prices rise 2% more per year that should be the same as being paid 2% less per year as prices fall 2% per year."

I meant to add one thing to that but didn't. When I say "paid" I mean in the form of wages AND interest.

If my goal is to maintain purchasing power and that is all, then both of these two situations are identical to me.

1. I earn 2% on my savings per year and things become 2% more expensive per year.

2. I lose 2% on my savings per year and things become 2% cheaper per year.

The typical investor sees things much differently though, as seen by the fear of owning TIPS in a potentially deflationary environment.

Deflation cannot ruin my TIPS investment. Deflation can't hurt the purchasing power of my TIPS investment. Only inflation can do that. The more inflation that appears, the worse I will do (after taxes).

That's yet another reason I like TIPS. I can root for deflation while having at least some inflation protection.

dearieme said...

It's at this point that I remind myself that the Bank of England's own pension fund is largely invested in Index-Linked Gilts - those are our equivalent to your TIPS.

Now why on earth would the pension fund Trustees do that? And why would the pension scheme members (presumably) approve?

Perhaps because they have had a particularly clear view of the calibre (and incentives) of our politicians?

Stagflationary Mark said...

dearieme,

Indeed.

I am similarly reminded that our very own Ben Bernanke was (is?) very fond of Canadian Treasuries (in his personal portfolio) while he was "helping" to decide OUR monetary policy!

Perhaps he had a very clear view too.

I am also reminded that the bulk of Bush's and Cheney's fortunes were sitting in Treasuries heading into the housing bubble bust. Go figure.