[Mb-civic] An article for you from Michael Butler.

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Michael Butler (michael at intrafi.com) wants you to see this article on Economist.com.



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GERMANY'S ECONOMY
Mar 14th 2006  

Germany issues its first inflation-linked bond

OF ALL the world's cities, Frankfurt is perhaps the most likely to have
a museum devoted to money. Granted, it lacks the scale and buzz of New
York, and it has abandoned any serious pretensions to rivalling London
as Europe's prime financial centre; but it is nevertheless the
birthplace of the Rothschild banking dynasty, the city of the euro and
the home to both the European Central Bank and the once-mighty
Bundesbank (OMB), which dominated European monetary policy until the
euro came along in 1999.

Since then the OMB has had to face up to its loss of clout by painful
stages. Last week it witnessed the slaughter of another sacred cow when
for the first time the Federal Republic of Germany issued a bond
indexed to inflation. Indexation of financial contracts had been
outlawed in Germany in 1948, with a few exceptions that needed the
Bundesbank's say-so. Britain has been issuing inflation-linked bonds
since 1981 and America since 1997. Other issuers include France and
Italy. Some $830 billion of index-linked government bonds are
outstanding. There is increasing demand for these bonds, not least to
meet the pension requirements of baby-boomers in both Europe and
America.

Some exhibits in Frankfurt's Money Museum, a fine building tucked
beside the OMB's monstrous home in suburban Frankfurt, help to explain
why forbidding indexation was such a sacred cow in Germany. But this is
not the only lesson that visitors learn. The first item you see is a
real member of the bovine species--a beautiful, stuffed
example--because cows were an early form of money. (The Latin word for
money, PECUNIA, is derived from that for cattle, PECUS.) The PIeCE DE
RESISTANCE is an impressive-looking game console. With a joystick that
controls the money supply you can play at being a central banker. The
more money there is in circulation, represented by a tide of light
rising up one column, the greater the velocity and price of goods and
services, represented by light rising up another column, until
inflation takes hold. Then you must race to dampen the money supply
ahead of rising prices, without setting off a deflationary spiral (all
too easy). After a few roller-coaster rides, you have a certain respect
for Alan Greenspan, Jean-Claude Trichet and the gang.

During the Weimar Republic the Reichsbank, then Germany's central bank,
played this game for real and sensationally lost control. The
acceptance of constantly rising prices, known as inflationary
expectations, seized the minds of the people and the entire world of
commerce. Indexing prices to inflation only made things worse: it
reached 1,024% in 1922, which was just about bearable, but galloped to
105,700,000,000% during 1923. Paper money became the cheapest form of
heating fuel. By October 1923, 4.2 billion Reichsmarks could (or might)
have bought you a dollar. Anyone who had supported Germany's effort in
the first world war by buying government bonds got almost nothing in
return when a new currency, the Rentenmark, was introduced in November.
But inflation was halted.

That is the background which prompted the 1948 currency law to forbid
indexation clauses without the Bundesbank's permission. This was always
refused, except for some long-term rental agreements. The indexation
taboo caused a problem in the run-up to European monetary union,
because the ecu, the currency basket that was the forerunner of the
euro, was classed as an index, not a currency, by the suspicious
Bundesbank. Only after 1987 were German citizens grudgingly allowed to
hold private accounts in ecus.

So last week's issue of EURO5.5 billion of bonds linked to the
harmonised index of consumer prices in the euro zone (excluding
tobacco) is a landmark for Germany. Unfortunately not many German
investors were interested: about 16% of the bonds were sold nationally;
most were placed elsewhere in Europe, especially France. But it's a
start. Gerhard Schleif, co-head of the German Finance Agency which
handles government borrowing, intends to add another EURO5 billion-10
billion to the same issue over the next two years. While interest rates
and inflationary expectations are low this is the cheapest way for
governments to borrow money.

Curiously, Germany may have ditched its aversion to
indexation--acknowledging that inflation is no longer the monster it
once was--just as central banks are making markets think about
inflation once again. With official interest rates already rising in
America and Europe and with the Bank of Japan's announcement last week
that "quantitative easing" would end, markets have begun to think that
money will not be ultracheap for ever. Governments and other borrowers,
after a few years in which credit has been almost ridiculously slack,
may now find investors a little more demanding.

The immediate losers from this might not be borrowers, but pension-fund
managers and life-insurance companies, especially those supporting
defined-benefit schemes or those which have guaranteed investors'
returns. Such funds have been trying to limit their downside risk by
running out of equities into bonds (and in the process helping to push
bond yields down). Some companies have even been offloading their
pension liabilities to big insurers in return for "bulk annuities".