The Baroness and the Bond Market
Margaret Thatcher, who died today at the age of 87, transformed the U.K. by breaking the unions and privatizing large swaths of the economy. Less remembered is her role in the development of the inflation-indexed bond market in the late 1970s and early 1980s. This multitrillion-dollar market provides both retail savers and pension funds with an important tool for portfolio diversification. It also gives investors and policymakers important information about the state of the economy.
The oldest known indexed bonds were issued by the government of Massachusetts in 1780. However, these unusual instruments were quickly retired once the revolutionary war ended. Nothing like them was seen again for centuries. In 1975, the U.K. started offering non-marketable savings bonds that would maintain their real value even in the face of double-digit inflation, yet these "granny bonds" weren't helpful for pension plans trying to honor commitments to large numbers of retirees. Moreover, the prices of these instruments had little informational content because they couldn't be traded.
When Thatcher came to power in 1979, the U.K. was beset by the malaise of stagnant productivity growth and rapid price increases. Economists argued that this created a vicious circle because the volatile inflation rate deterred investors. Restoring confidence in price stability could therefore break the negative feedback loop and boost growth.
Thatcher and her ministers decided to establish the government's commitment to slow and stable inflation by promising to compensate lenders for changes in the price level. The principal on these inflation-indexed gilts would rise with the Retail Price Index and pay a coupon that would be proportionate to the principal. These securities make it nearly impossible for highly indebted governments to cheat creditors by letting prices systematically rise faster than expected.
On the other hand, inflation-linked bonds reward governments that preside over periods of declining inflation in the form of lower debt-service costs. These bonds therefore created a strong incentive for Thatcher and her ministers to keep their word and bring inflation under control. Nearly one-quarter of the U.K. government's total debt is now inflation-indexed.
The driving force behind this policy was Nigel Lawson, then a junior minister within the Treasury and later the Chancellor of the Exchequer. Archives put online by the Margaret Thatcher Foundation provide some insight into how the Treasury and Bank of England thought about these matters at the time. Some of their concerns, such as the extent to which investor demand would affect the Bank of England's ability to hit its monetary targets, may seem quaint to today's readers. The overall analysis, however, was sound. It foreshadows what happened in the United States almost two decades later when the Treasury Department finally decided to issue TIPS.
(My colleague Clive Crook was actually involved in those discussions as a junior civil servant at the Treasury. He tells me that civil servants who worked for Lawson joked about calling the new securities NIGELs. To the best of Crook's recollection, the acronym stood for "New Index-Linked Gilt-Edged Loans.")
Thatcher's decision to issue inflation-indexed gilts was unambiguously positive for the development of the world's financial markets. Traders and policymakers regularly use the difference between the yield on normal government bonds and indexed equivalents to determine the market's expectations for inflation. Savers are now able to safeguard the purchasing power of their savings without having to speculate on commodities or employ other risky strategies. Pension plans, many of which promise to provide beneficiaries with constant real purchasing power after retirement, are finally able to hedge their liabilities.
The Iron Lady had many accomplishments. Let's not forget this one.
(Matthew C. Klein is a contributor to the Ticker. Follow him on Twitter.)