Convertible Indexed Consols

Consols. Low transaction costs and safe nominal flow.

Indexed. Safe real flow.

We could index them to different consumption bundles, and even account for international differences.

Convertible. There is still one big risk with the indexed consols: the risk that the government will rig the index. If the index used is the CPI or the GDP deflator, that index is defined by an agency of the U.S. government, the same government you are lending to. What is to stop the government from solving its debt service problem by telling the agency to change the index formula so that the CPI rise this year is not 15%, which when added to the base of 1% makes the consol yield 16% this year, but 0%, or even -5%, so the consol yields 0% this year? Since the asset in question is a consol, this does more than solve the debt service problem: it solves the debt problem completely. Once the nominal interest is reduced to zero, that does the job, since there is never any principle to repay.

The solution is to make the consol convertible. It must include a clause saying that the holder may, at his option, convert a $1,000 indexed consol into a $1,000 unindexed consol--- an escape hatch.

Suppose the government has issued a $1,000 consol paying 2% plus the CPI, and also issues unindexed consols each day at whatever interest rate makes the consol sell for $1,000 that day (we can relax this assumption later).

Thinking in terms of models, and conditional statements generally

Models are conditional statements: If the Assumptions are true, Then the Conclusions are true. Thus, we need to start by thinking about conditional statements. Most people have a lot of trouble with them.