econgineers

The latest economic crisis has brought to our attention that the Government and BOE have some tools available to manage the crisis, like fiscal and monetary policy, and have been actively using these tools to avoid the economy going into a severe recession.
Unfortunately, these tools seemed to be somewhat limited.
The Bank Rate is at 1.5%, and maybe even reaching zero in the near future. Such low rates, are not attractive to foreign investment or internal savings, and tend to devalue the domestic currency.
Additionally, rate cuts lose potency as the rate approaches zero, especially when further cuts are already priced in by the market.
On the fiscal side, the government have decreased VAT and increased public spending. However, rational forward looking consumers and businesses expect future tax increases, therefore would be saving now to pay higher taxes later (under “Ricardian Equivalence”), resulting in a no real increase in consumption.

Looking into what other solutions and tools could be made available for the government, it jumped to my attention that they do not have market instruments that are linked to Unemployment, GDP and Net Lending. I mention these macro-economic indicators as they are key to the current crisis.

How would such instruments be useful for the Government?

By creating financial instruments linked to macro-economic indicators HM Treasury would be offering a hedging tool to investors, whilst reassuring the market of government’s commitment to control these macroeconomic indicators within ranges that would be beneficial to the economy.

Another aspect to be considered is that we would create “Forward Expectations” by providing a macroeconomic information term structure. By trading instruments of short, medium and long term linked to macroeconomic indicators we are literally building the curve of information, which maps market future expectations, telling us where the market expects these macroeconomic indicators to be in 2, 5, 10 and 20 years time. This information will be observable data, and very useful for the government, as they will be able to use this information in their budget planning, fiscal and monetary policy.

These new instruments could help manage economic cycles, as corporations will be able to hedge against negative economic effects; i.e. by buying “GDP Linked Bonds” that would offer a positive income (in the form of higher coupons) if GDP would decrease in their specific industry or sector. The additional income in the event of a recession, would help corporations to carry on with their business, would allow them to offer training to their staff and invest in technology and research while sales are slow, preparing for when the markets pick up again.
This would decrease bankruptcy in negative cycles, would decrease government’s costs in retraining unemployed people, decrease unemployment claims, and would decrease the risk of unemployment Hystoresis.
In effect, it will reduce the amplitude of the fall in recessions and moderate the gain in up-cycles.
In positive cycles these securities will guarantee the government additional income, to prepare for the economic down cycles, when companies will be entitled to receive higher yields.

Secondary markets will appear, Corporations and Banks will issue their own bonds and derivatives using as underlying the sovereign macroeconomic linked bonds or the macroeconomic indicators themselves, increasing liquidity and market transparency.

This theoretical proposal outlines conceptually new financial instruments, “Macro Linked Bonds”; it seems to successfully offer Governments and Corporations effective tools to manage economic cycles.

by Andrea Graves
26.Jan.2009