Shiller on Sovereign GDP-linked Bonds

In a recent article, Noble prize-winning economist Robert Shiller makes the case for countries moving from conventional bonds to sovereign GDP-linked bonds. A sovereign GDP-linked bond pays the bondholder only if certain economic conditions hold — for instance, if GDP grows at no less than a certain rate, is above a minimum level, or both.

The main argument in favor of countries issuing GDP-linked bonds is that it will minimize the cost of an economic crisis. If economic conditions deteriorate enough, then the country will limit bond payments without falling into default and will be able to increase spending domestically (instead of transferring money out of the country). Certainly, there are pros to issuing GDP-linked bonds, but there are also cons.

The following passage captures the key difference between conventional and GDP-linked bonds:

The basic idea is simple enough. Governments issue GDP-linked bonds to raise funds, just as corporations issue shares. By issuing such bonds, governments pledge to pay in proportion to the resources they have, measured by their countries’ GDP. The price-to-GDP ratio of GDP-linked bonds is essentially analogous to the price-to-earnings ratio of corporate shares. The difference is that GDP is an order of magnitude larger than corporate profits represented by the stock market.

What Shiller is describing is more a stock than a bond. Issuing a bond means asking for credit. A bondholder is entitled to payment according to the type of bond contract (fixed coupon, floating coupon, principal paid in a “bullet” or “sinking fund” scheme, etc.). Buying a stock means becoming a small partner of a large firm. A stockholder is not entitled to receive any payment. The issuer may or may not distribute dividends. The main motivation for buying stocks is receiving capital gains: selling the stock at a higher price than it was bought at. In the case of a bond, the issuer bears the risk of business going south. In the case of a stock, the holder bears the risk of the business making losses. This is why stocks have a higher return. What Shiller is arguing for, then, is to shift the risk from the government to the GDP-linked “bond” holder.

However, investors may prefer sovereign bonds over GDP-linked bonds to have the certainty that (short of default) they will get paid. In contrast, by purchasing GDP-linked bonds, investors are assuming the risk of the country’s future business cycle.

Further, that risk is going to be priced into the GDP-linked bond (i.e., it will sell for less). And this can represent a significant cost for the issuer since the amount of nominal debt needed to acquire a certain amount of cash will have to increase. This matter might be of particular importance for developing economies.

There is yet another negative effect to take into account. Shiller points to the important problem conventional bonds cause during financial crises: debt becomes harder to service. This problem, however, also imposes a constraint on policy makers: a policy maker finds it less costly to face an economic crisis than to face an economic crisis plus a default (or higher debt service). Limiting policy makers’ discretion has its advantages.

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Nicolás Cachanosky

Nicolás Cachanosky is an Assistant Professor of Economics at Metropolitan State University of Denver. With research interests in monetary economics and macroeconomics, much of his recent work has focused on incorporating aspects of financial duration into traditional business cycle models. He has published articles in scholarly journals, including the Quarterly Review of Economics and Finance, Review of Financial Economics, and Journal of Institutional Economics. He is co-editor of the journal Libertas: Segunda Época. His popular works have appeared in La Nación (Argentina), Infobae (Argentina), and Altavoz (Peru).

Cachanosky earned his M.S. and Ph.D. in Economics at Suffolk University, his M.A. in Economics and Political Sciences at Escuela Superior de Economía y Administración de Empresas, and his Licentiate in Economics at Pontificia Universidad Católica Argentina.