Why 4.0% Fixed Rate Bonds Could Solve the Financial Crisis

In previous articles I have written for Business Insider, I made the following statements: (1) Fannie Mae, Freddie Mac, and the Federal Reserve mismanaged long-term rates for the last 20-five years; and (2) one solution that will help solve the current global financial crisis is for the United States to establish a long-term fixed rate of 4.0% on future long-term bonds and securities.  In this article I am going to explain with more detail and reasoning the justification for making those statements. 

At the heart of my argument is accepted Financial Theory, which says that one should be able to see a very tight relationship between bond (security) rates and one’s expected view towards inflation for the period of a bond’s life.  So along those lines, I think it is important for us to look at how “inflation”, as represented by the yearly change in the Consumer Price Index (CPI), has occurred over an extended period of time in the United States.  Exhibit 1.0 shows the yearly percentage change in the Consumer Price Index for the last 97 years of recorded data.

consumer price index

Even though there are numerous ways one can evaluate Exhibit 1.0, I feel the following best describes what the Exhibit is really telling us.

First, it tells us that the value of money in the United States varied quite significantly during the period that encompassed Two World Wars and a Great Depression (i.e., between 1910-1950).  During the first 40-year period shown on Exhibit 1.0, the value of money in the United States changed “wildly” (with significant percentage changes) almost every year in terms that reflected both inflation and deflation.
Second, since 1950 (for the last 60 years) Exhibit 1.0 tells us that periods of deflation have rarely occurred and when they did, it was only by a very small amount and only for a very short period. 
Third, outside of the fifteen year period (1968-1983) when the average change in the CPI index was 7.32%, inflation has averaged only 2.64% for 45 of the last 60 years as represented by (1950-1968 and 1983-2010). 

Now the heart of my argument for the 4.0% solution is that the above history should give the U.S. confidence that we can manage inflation at/near/or below 3.0% in our long term future.  My claim is that it is entirely valid to look at the near 100-year period of CPI change as shown in Exhibit 1.0 as happening in four distinct periods: (1) the crazy world period, 1913-1950; (2) a post-war, U.S. dominant period, 1950-1968; (3) a readjustment period for the U.S., 1968-1982; and (4) a Globalization period which has been primarily led by U.S. business, 1983-2010.

As to the fourth period mentioned, if there is any question as to the leadership role that the U.S. has played in globalization then Exhibit 2.0 should reduce those doubts.  Exhibit 2.0 shows the decline in various world stock markets during the 18-month period between the summer/fall of 2007 and March of 2009.  In effect, Exhibit 2.0 shows that nearly all major stock markets fell as much or more than did the primary two U.S. stock markets, somewhat substantiating the old idiom about what happens when the U.S. catches a cold. 

MSM indices

Now it is my contention that there are two primary factors at work that have been keeping inflation low in the U.S. for the last 27-year period of time: (1) significant enhancements in productivity relating to technological advances; and (2) globalization (i.e., having products produced at significantly lower costs using labour in developing countries). 

It is hard to argue against these two factors because “inflation” is typically associated with too much money chasing too few goods.  And considering the nearly $1 Trillion of new Mortgage and National Debt that was created annually in the U.S. over the past fifteen years, it is hard to believe that inflation could have stayed low with all that extra money thrown into the system.  Take that additional debt money out of the system, and inflation would have even been less than it was recently.

The 4.0% solution takes the position that the U.S. should be able to continue to invest in Globalization (whether with China, India, Russia, Africa, Brazil, etc.) and continue to take advantage of technological advances to keep inflation at or well below 3.0% in the long term future.  Sending out this 4.0% message for long-term U.S. debt would establish a benchmark long-term rate for the rest of the world to emulate, thus dropping the rest of the world’s long-term rates, too.  And if you want to reduce your principal and interest debt payments, one sure fired way is to reduce rates.

Still in doubt?  Then consider that in 1983, the beginning year of the last 27-year period of low inflation, the personal computer had yet been introduced for general public consumption.  Data records were kept in drawer files, not disk files.  In 1983, the internet only existed in a limited way within the intelligence arena of the U.S. military.  In 1983, there was no such thing as an iPod, Google, Cisco, cell phones, CD’s, battery-driven cars, drugs to combat AIDS, etc.  In 1983, the economies of China, India, Brazil, etc. were embryonic to say the least.

Now what the 4.0% solution will do is this.  It will encourage business investment.  If there is one thing investors and business hate, it is “uncertainty”.  It is very, very difficult to make bold investment decisions when the future is uncertain, and the 4.0% solution (which is based upon solid rationale) will significantly reduce investment and business “uncertainty”.

The 4.0% solution (because of its historical low value) will also make future potential projects more affordable and defendable than they would have been otherwise in the past.  Whenever a business project is considered, a determination is made as to the validity of that project by estimating future cash flows, which are discounted over time.  The 4.0% solution will reduce discount rates and thus will likely make some projects justifiable that could not be justified using higher inflationary assumptions.

In addition to the business investment stimulus, the 4.0% solution will also offer the last refinancing cycle for qualified homeowners with good credit, which will reduce U.S. long-term mortgage debt by $3.6 Trillion and add an immediate boost to the U.S. economy of more than $100 Billion every year for several years out as you discount those new cash flows.

The 4.0% solution must be viewed as an ironclad commitment that would lock the Fed into a stable monetary policy at the expense of losing a little flexibility.  In total, there is no better solution for the U.S. to take now than the 4.0% route.  It will stimulate investment and business while reducing Debt, which is something that cannot be said about the current U.S. policy for stimulating our economy.  

Jim Boswell (MBA, MPA, BA) directed the analytical risk monitoring activities of Ginnie Mae’s $500 billion portfolio of mortgage-backed securities for twelve years (1988-2000), including the period of the S&L crisis.  His recently published book, Crush Depth Alert, Fourth Lloyd Productions, explains in detail with supporting exhibits, graphs, and tables the factors that led up to the financial crisis while offering solutions on how to move forward.  This is a follow-up to two  earlier Business Insider articles (May 18, 2010 and June 14, 2010) by Boswell, called “Fannie and Freddie Need to Go—Now” and “How 20-five Years of Mismanagement at Fannie and Freddie Created the Financial Crisis”.

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