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An index for all reasons

Sun 27 Jun 2010 by mskala Tags used: ,

There are probably as many reasons to save money as there are savers. One of mine is as follows: I don't want to be forced to change my lifestyle. In particular, after I'm retired and living on the savings I create today, I don't want to find myself in a situation where, because of changes in the world beyond my control that affect prices, the money I put aside to buy goods for myself during retirement is no longer enough to cover the kind of lifestyle I intended for myself, and so I'm forced to cut back. I want someone else, not me, to be accountable for cutting back to make sure I don't have to, and I'm willing to pay money up front in order to remove belt-tightening from the list of things I have to take responsibility for.

Accordingly, I have a substantial fraction of my savings invested in an exchange-traded index fund that holds what are called "real return bonds" (RRBs). These are bonds indexed to the Consumer Price Index. The ordinary kind of bond has what is called a "par value," measured in dollars; you buy it, and then the issuer pays you a certain percentage of the par value every six months until the maturity date, and then pays you the par value on the maturity date. The exact details of indexed bonds can vary, especially in other countries where there are similar but not identical products available, but the usual deal with the Canadian RRBs is that the par value, instead of being a fixed number of dollars, is a fixed number of dollars multiplied by the (unitless) Consumer Price Index (CPI).

In theory any government or corporation could issue bonds like this, but in practice most of them are issued by the Federal Government. The Province of Quebec also issues them in significant amounts. The fund I hold, as a matter of policy, buys bonds from the different issuers and series in proportion to the amounts issued (so it's a market-weighted index) but the exact rationale for and consequences of that kind of indexing are beyond the scope of this posting.

So: every month Statistics Canada as part of its normal operations computes a value for the CPI, representing how much it costs to operate the average Canadian household. Every six months when I get a coupon payment from the bonds, it's paid as a percentage of that expense. So if household expenses in general increase or decrease, the coupon payments I get fluctuate in sync. Instead of my income in dollars being fixed, I can count on my income as a multiple of the average Canadian household being fixed. If I was spending half what the average household spent; or exactly what the average household spent; or five times what the average household spent; I can count on being able to continue doing that into the future.

But the devil is in the details, especially the way the index is computed. What does it mean, "average" household expenses? One thing we could do would be sit down and figure out what a Canadian household buys in a month and in what quantities. That list is traditionally called a "basket" in this context but it might be better to call it a "pile." And then, month after month forever, we figure out how much it costs to buy that stuff, and that's the index.

That simple fixed-basket calculation has the big disadvantage that people's buying habits change over time. The average Canadian household is a moving target. Suppose we made up the basket in 1990; guess what, Internet access wouldn't have been in it. So if we evaluate the cost of running a household today in 2010 based on the 1990 basket, we're going to get a number that doesn't include the cost of Internet access; and yet if I retired in 1990 I would want to be able to have Internet access today. The risk of not having money to pay for Internet access in my retirement - or some comparable new future thing I can't even imagine yet today - is something I want my savings to insure me against. There are also issues of products that might stop being available in any practical way. An index basket designed in 1910 would include significant weight on horse-drawn transportation. Horse-drawn transportation is actually pretty expensive today, but that's because it's an obsolete specialty service now, not because of any real relation to the cost of transportation in general. I don't want that to factor in a big way in determining my retirement income. So although I said I don't want to change my lifestyle, there are subtleties to that statement: being insured against changing my lifestyle does not mean time stands still.

Maybe a better way, and in fact what Statistics Canada actually does when computing the index that's used for the bonds I hold, is to update the basket periodically. By means of surveys and such they figure out what the average Canadian household spends money on at any given time and then they factor that into the index. So if people start spending money on Internet access and stop spending it on horses and buggies, those changes will be incorporated into the index and my bonds that I bought to maintain my position relative to the average Canadian household, will continue serving their purpose.

That's all well and good as long as the changes that occur over time are good ones. Sure, if nowadays people have Internet access and they didn't before, the index should reflect that. What if the changes aren't good? In particular, it sure looks like the whole world is headed for some pretty tough times. The standard of living of the average Canadian household is going to decline. One example I've seen used in discussions of "hedonic adjustments" (a US thing not directly relevant to this discussion) is that when incomes go down, people are going to eat less beef and more chicken, because chicken's cheaper. So the index will reflect that - and my retirement savings that I put aside thinking they'd pay for me to eat beef in the future, now will only cover eating chicken.

That's the kind of risk I wanted to be insured against, so the bonds have already failed to live up to their promise, but make no mistake, it's actually much worse: we don't have the agricultural resources in the world for all the Chinese and Indians to eat as much beef or chicken as Canadians do, so what will inevitably end up happening is that it won't be chicken instead of beef, it'll be soybeans instead of chicken. The average Canadian household is going to go veg. And being forced to become vegetarian is absolutely one of the risks I want to be insured against.

So if the index changes to reflect the fact that average Canadians are being forced to make lifestyle changes I don't want to make, then the index doesn't protect me. I want an index that tracks the cost of not being subjected to those changes. On the one hand: it must reflect changes like the introduction of the Internet. On the other hand: it must not reflect changes like the food crisis. Fundamentally, I want it to incorporate the good changes and not the bad ones.

What it comes down to is that I don't want to live like the average person, I want to be part of the privileged elite. It's easy to claim that from a long view, the effects will tend to cancel out and the CPI will still serve me. If the index reflects the cost of running an average household, and I want to live better than that, okay, I buy enough bonds to cover twice the expenses of the average household, and then I've got plenty of extra money I can use to support a more luxurious lifestyle, whatever that means to me. In the future I can count on still being at twice (or five times, or whatever) the average standard of living, even if things get really bad for the proles.

As long as the gap between rich and poor remained constant, it seems like that would work; if living like a rich person today means having five times the average income, it should still in the future. The problem is that the gap is growing, and likely to continue growing. What I really want is insurance that I will stay on the rich side of the gap, whatever it happens to be. That brings us to the proposal: I think it would be really cool if I could buy bonds indexed to the income of the richest 2% of Canadian households. The CPI as it stands measures the cost of living as an average person, which really is the cost of living as a poor person because they are the majority and will be more so when I retire. It's the cost of keeping up with the Coopers. If there were a similar index reflecting the cost of living as a rich person - keeping up with the Lodges - then by buying the two in appropriate proportions, I could construct a portfolio that hedged the risk of living at any chosen point on the spectrum. It would properly cover both "I do want to buy Internet access when everybody else chooses to" and "I don't want to give up meat when the average household is forced to."

Now, from the point of view of what we might call the Right, it's clear that that makes sense. It's reasonable to guess that lots of people will feel at least somewhat as I do, and then if there's a demand for a product like this it's likely someone will figure out a way to provide it. The thing that I think is really interesting, though, is that I see a way for the Left to love it too. Hence my title of "An index for all reasons."

If someone sells a bond that requires them to pay me a certain fraction of the average income of the richest 2% of Canadian households, what do they hope will happen to that number? Well, if it goes up a lot then they'll owe me more money; so they want it not to go up a lot, or even to decrease. The existence of a large pool of such bonds, especially if they are issued by the government, means there are going to be entities out there with power, money, and a strong incentive to want the gap between rich and poor not to be too large. I kind of think that might be a good situation to create.

So if the government issued bonds indexed to the average household income of the richest 2% of households, it would be good two ways: on the Right, from my individual perspective, it would be good because it would protect my retirement. On the Left, from a social perspective, it would be good because it would encourage the government (or any other issuer) to eliminate the rich-poor gap. It seems like something we should all be able to support.

I'm not the first to suggest financial obligations tied to the rich-poor gap; I've seen it, for instance, proposed as something that international agencies like the IMF should use to force governments to redesign themselves along more Leftist lines. I don't think I've ever seen it proposed on the sub-national level of the bond market, though, and I think my proposal is a little more plausibly something that could ever happen, because it has a solid supply/demand case for why people would want such products individually, independent of the claimed social benefits.

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Steve C
I really REALLY like this idea.
Steve C - 2010-06-28 01:20
Brilliant work. I'm totally stealing it for my campaign platform.

If you want to live as a carnivore, you need to kill 10 herbivore quadrupeds per year. That's the rule of the jungle.
Owen - 2010-06-28 03:59
This sounds like the kind of ingenious. rational thing that politicians don't do. But congratulations - I always like socio-political devices that satisfy opposite tendencies.
Axel - 2010-06-28 08:28
I'd love to own some of this, if any government gets up the spoons to offer it. I wonder what sort of nominal interest it would bear...
Eric - 2010-06-28 22:06
Tony H.
This carries a certain echo of Protagoras vs Euathlus - the Greek sophist law teacher and his pupil, and the agreement that the fees were due only when Euathlus had won his first case. After some time with no cases, Protagoras sues Euathlus, and each reasons that he will win. Well, you know the story.

Of course your index isn't a binary case of win/lose, but some sort of negative feedback loop that, as negative feedback generally does, should keep things from oscillating. Whether to try to carry the analogy further, invoke hysteresis and the arbitrage potentially exploitable in the corners...

I think the larger view is that those who are in a position to sell things like this kind of bond rarely "lose", whatever happens in the market.
Tony H. - 2010-06-30 12:23

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