By Yasin Kürsat Önder
I investigate the introduction of GDP-indexed bonds as an additional source of government borrowing in a quantitative default model. The idea of linking debt payments to developments in GDP resurfaced with the 1980s debt crisis and peaked with the COVID-19 outbreak. I show that the gains from this idea depend on the underlying indexation method and are highest if payments are symmetrically tied to developments in GDP. Optimized indexed debt can eradicate default risk, halve consumption volatility, and increase asset prices while raising the government’s debt balances. These changes occur because an optimally chosen indexation method does a better job at completing the markets.
This is not the first paper on this kind of bond that I mention on the blog. Visibly, we are dealing with market incompleteness and people are suggesting particular assets to complete the market. Here, one asset is proposed that has characteristics that make it resemble more a stock share than a bond: highly variable dividends that depend on how an underlying asset (the national economy) performs. Under some metric, this asset is optimal, but can it really complete the market? That is unlikely. For this to happen you would need a menu of different assets that would be individually priced on a competitive market. We are still far from that. But if the constraint is that you can only have one asset, then this paper shows how it would look like.