Purchasing Power Guarantees for Deferred Payments
Author: David Finch

A MEASURE INTRODUCED in Finland in May 1955 appears to be one of the first steps taken by a banking system to introduce, in its pure form, a device that has long been advocated by theoretical economists. Most savings banks in Finland introduced at that time a new form of time deposit for their customers. In future, money could be deposited for one year, and at the end of the year the bank would undertake to credit the account with the amount that the cost of living index indicated was necessary to restore the account's original purchasing power.1 The account would bear 4¾ per cent interest, 1½ per cent below the prevailing rate on deposits without the purchasing power guarantee. Since this step was taken at a time when there was, in other countries, a rising practical interest in the device, it seems useful to re-examine closely the advantages claimed for such an arrangement and to study the practical problems and fears that have made such experiments rare.


A MEASURE INTRODUCED in Finland in May 1955 appears to be one of the first steps taken by a banking system to introduce, in its pure form, a device that has long been advocated by theoretical economists. Most savings banks in Finland introduced at that time a new form of time deposit for their customers. In future, money could be deposited for one year, and at the end of the year the bank would undertake to credit the account with the amount that the cost of living index indicated was necessary to restore the account's original purchasing power.1 The account would bear 4¾ per cent interest, 1½ per cent below the prevailing rate on deposits without the purchasing power guarantee. Since this step was taken at a time when there was, in other countries, a rising practical interest in the device, it seems useful to re-examine closely the advantages claimed for such an arrangement and to study the practical problems and fears that have made such experiments rare.

A MEASURE INTRODUCED in Finland in May 1955 appears to be one of the first steps taken by a banking system to introduce, in its pure form, a device that has long been advocated by theoretical economists. Most savings banks in Finland introduced at that time a new form of time deposit for their customers. In future, money could be deposited for one year, and at the end of the year the bank would undertake to credit the account with the amount that the cost of living index indicated was necessary to restore the account's original purchasing power.1 The account would bear 4¾ per cent interest, 1½ per cent below the prevailing rate on deposits without the purchasing power guarantee. Since this step was taken at a time when there was, in other countries, a rising practical interest in the device, it seems useful to re-examine closely the advantages claimed for such an arrangement and to study the practical problems and fears that have made such experiments rare.

The theoretical support among economists for a purchasing power guarantee for deferred payments is most impressive. Marshall in 18862 strongly advocated the use of a standard unit of purchasing power in contracts for deferred payments, and reaffirmed this view in 1911.3 Jevons4 even earlier thought so much of the proposal that he suggested that it be made compulsory, after a short transition period, for “every money debt of, say, more than three months’ standing [to] be varied according to the tabular standard”5 of purchasing power. Keynes6 advocated the issue by the U.K. Treasury of “bonds of which the capital and interest would be paid not in a fixed amount of sterling but in such amount of sterling as has a fixed commodity value as indicated by an index number.” More recently, the proposal that the U.S. Government should issue a bond whose value would be guaranteed in terms of purchasing power was enthusiastically supported by such eminent economists as Milton Friedman,7 Fritz Machlup,8 and Sumner Slichter.9 Economists in some non-English-speaking countries have also supported the concept. In France, Courtin,10 Gael Fain,11 and Sauvy12 have proposed purchasing power clauses of various forms to meet current French problems. In Latin America, Javier Márquez has urged the widespread use of guaranteed purchasing power bonds to secure additional resources for development.13 In China, S.C. Tsiang14 supported the use of an indexed savings certificate to overcome some of the disadvantages of the inflation.

In financial circles, on the other hand, the weight of opinion has been overwhelmingly against this “artificial” device. Jevons’ arguments were rejected by Bagehot.15 Keynes’ proposal was dismissed by Sir Otto Niemeyer16 of the Bank of England with the assertion that no one would be interested. More recently, the case made in the United States by some economists before the Patman Subcommittee was attacked vigorously by business economists and in the replies of the Treasury17 and the Council of Economic Advisers.18

The weight of financial opinion has been shown as impressively in the lack of practical application—at least until recently. There are still only a few scattered examples of the use of the device in its “pure form,” i.e., using a price index to measure the adjustment needed to assure a contract with stable purchasing power.19 Even before the use of the clause by banks, Finland provided the broadest application. Government securities with a partial purchasing power guarantee based on price indices have been issued there since 1944. During succeeding years, a range of private securities with similar clauses, which have also been used in some private mortgages, has been issued. In Sweden in 1952 a large cooperative, the Kooperativa Forbundet, issued a bond with a partial guarantee. In the United States there was an early official application of the index principle in Massachusetts in the “equity bills” of 1742 and the “Massachusetts depreciation notes” of 1780, both based on the aggregate price of a few items.20 An interesting modern application using a full index number was made in 1925 when the Rand Kardex Company, at the instance of Professor Irving Fisher, issued a 30-year bond with interest and principal linked to the wholesale price index. The U.S. Government in 1946 accepted a contract in which payments were determined by the movements of a cost of living index.21 In Mainland China, time deposits with a guarantee related to an index based on the prices of a few major commodities were allowed during 1950–52. Official proposals for security issues with an index guarantee have been made in Chile and Israel.

The device in a form less precise than that which involves the use of a price index has been much more widespread. In many Latin American countries, deposits in domestic banks may be denominated in U.S. dollars, a device intended to have the effect of stabilizing their purchasing power. In France the Pinay Loan of 1952, providing repayment guaranteed at a price related to the free market rate of the napoleon, was another variant. This loan was followed in France by issues of semi-governmental corporation bonds which had their purchasing power guaranteed by reference to the average price received for the corporation’s product. Thus the Coal Corporation issued a bond repayable at a price related to the wholesale price of coal; railway bonds were related to the price of a third-class railroad ticket for one kilometer; and those of the Electricity Board were tied to the price of a kilowatt hour. In Austria there was a similar issue by the electricity authority.

In many countries and over periods stretching far back into history, there have been many arrangements tying payments to specific prices. Jevons22 recalled the way in which the colleges of Oxford and Cambridge were obliged by law to lease their lands for corn units, which had the effect over the long period of maintaining the purchasing power of their endowments. Marshall23 referred to the payment of tithes being related to average prices of wheat, barley, and oats. In the German Republic of 1919–23, the price of rye was widely used as a deflator for contracts of all types. Gold clauses have been common in many countries, and they show a remarkable persistence in the face of many legal obstacles. In Greece, particularly, there is widespread use of the gold sovereign as a unit of account in spite of a law making the gold clause unenforceable.

Price indices have been widely used in the related sphere of wage contracts. Both in private arrangements made between a trade union and individual employers and in public arbitration, the insertion of a cost of living clause has become quite normal. Even when no such clause is formally included, the relationship between wages and cost of living is normally in the forefront of any negotiation to such an extent that, in times of rising prices, it almost invariably is the basis on which negotiations begin.

In the following discussion, attention will be centered on the use of purchasing power guarantees in a rather narrow sense. There will be no discussion of their application to wage contracts or pension arrangements. Attention will be focused on the denominating of debts, either private or governmental, in a form which provides that final payment be varied in accordance with an index. Only indirect reference will be made to guarantees under which the return is related to gold, dollars, or the price of the debtor’s product.24

Theoretical Basis for Purchasing Power Guarantees

The importance of the economic consequences for the economy as a whole of the adoption of purchasing power guarantees would, of course, depend on the range within which these guarantees were applied. The effects of their application in a single transaction or by a single firm would be almost negligible. At the other extreme, it has actually been suggested that the inclusion of a purchasing power clause should be made compulsory in all contracts.25 Some of the opposition encountered by supporters of purchasing power guarantees may, indeed, have been in part a reaction against such a sweeping proposal, which in any event clearly goes too far. Even if purchasing power guarantees were widely used, it might still be more advantageous, for many purposes, to write contracts without them.

Proposals for the use of purchasing power guarantees in loan contracts are based directly on the observed uncertainty about the future value of money. The whole subject would be dropped immediately if it could be established that the value of money—i.e., the general price level—was definitely stabilized. Any practical proposals are therefore predicated on the assumption that, for the country in question, there is uncertainty about future general price movements.

Private debts

The problem which purchasing power guarantees are intended to solve is shown in its simplest form in the settlement of a private debt. When a businessman borrows, he necessarily undertakes one risk, i.e., that he will be able to invest the funds economically in his own business. This is a risk which his judgment and knowledge of his business make him well fitted to bear. But he also undertakes another risk, i.e., on future movements of general prices. This element of uncertainty is wholly unrelated to his ability as an investor in a particular line of business. If the general price level rises, he is given an unwarranted gift. If it moves down, he is subject to an unjustified penalty. There is, in consequence, an element of gambling when borrowing is in terms of money, and this can reduce significantly the efficiency of a private enterprise system. Instead of systematically weeding out inefficient investors and encouraging only the efficient, a wholly arbitrary selection occurs with the general movement of prices. Marshall aptly compared this with the inefficient adjudication of land frontage in olden times.26 Decisions then were based on measurements made by the judge actually stepping the distance, heel to toe, and the variation in the length of the judge’s foot made the outcome unpredictable. This unnecessary uncertainty was overcome by the better definition of a unit of length; similarly, it is claimed, the arbitrary element in contracts resulting from general price movements can be overcome by use of purchasing power clauses.

The problem of uncertainty about the future course of prices is not identical with the problem of inflation. With inflation, however, the range of possible price movements is so increased that the problem of uncertainty is much accentuated. Consequently, it is primarily in countries which are suffering from inflation or have a history of inflation that the purchasing power clause should be given most attention.

To illustrate the problem a little more precisely, let us take a country with an active mild inflation. For simplicity, let us assume that the price expectations of everyone are the same. If prices were stable, a borrower in this country might feel that he could invest funds satisfactorily and pay 10 per cent for the money. However, if he should expect prices to rise—let us assume an expectation of a 20 per cent price increase with a considerable feeling of uncertainty about the actual outcome—he would be willing to pay more than 10 per cent, but it is quite improbable that he would go so far as to offer 32 per cent. If he should offer 32 per cent and prices rose by only 10 per cent, he would lose heavily and might be put out of business by the high interest payments. He probably would offer no more than 20 per cent, and even then he might feel somewhat unhappy about the gamble he was taking. On the other hand, the lender might not regard even the payment of a rate of 32 per cent as equivalent to a 10 per cent real return. He normally would fear the possibility of a greater rise in prices more than he would value the possibility of a lesser rise; in other words, he would prefer a certain outcome and would be ready to pay some insurance premium for it. Therefore, when faced with an offer of 20 per cent for interest when he expected prices to rise by 20 per cent, he would feel quite reluctant to carry out the transaction. He would make a comparison with alternative direct outlets for his savings—buying real estate, obtaining foreign currency, or buying inventories of goods. With his price expectation, the alternatives would seem good even if they should yield no return other than the hedge against inflation. Moreover, consumption would tend to increase for there would be no reward to offset the usual preference for present goods. The funds he would make available to the borrower would be reduced, and the borrower would have to restrict his operations. The economy as a whole would lose as productive investment was cut back in favor of consumption and direct, less productive, investment in inventories, foreign currencies, and real estate. The loss would be due directly to the defective standard of values in the loan investment—use of money terms in loan contracts injecting a stultifying element of cost separating the borrower from the lender. In extreme cases, the standard would be so inefficient that loan operations would take place without a common medium; such operations would be almost as cumbersome as were barter transactions before the introduction of money.

If the contract were made in terms of stable purchasing power, the obstruction to investment would be removed. The borrower with a contract to pay back at the end of the year an amount of money determined by the general movement of prices would be free to offer the full 10 per cent he believed he could earn. If prices should fail to increase as much as he expected, then he would suffer no loss, since his contractual repayment would fall. If prices should rise more, then he would still not be in difficulty, for his investment would increase equally in value, giving him the extra profits needed for repayment. The lender confronted with a real 10 per cent yield would find the sterile alternatives of increasing consumption or purchasing real estate, foreign currency, or inventories much less attractive and would raise the amount he offered for lending. The country would gain both from the improved distribution of savings and the consequent greater productivity and from the increase in total savings and investment.

In countries suffering from inflation, the improvement in the lender-borrower relationship would also be strengthened, since, with a purchasing power clause in the contract, the stigma of usury that would attach to any attempt to insist on high nominal rates of interest in order to ensure a proper real return would be avoided. The purchasing power clause might imply a money rate of interest of 54 per cent when prices rise by 40 per cent, but it could not be characterized as usurious. As debt contracts could thus more easily be adapted to the requirements of both borrowers and lenders, the use of private savings would be broadened and the volume of savings increased, thereby accelerating the creation of a well-developed economy.

The legal and social sanctions against usury in money terms give rise to a paradox in discussing the use of a purchasing power clause. The analytical discussion seems to show that, if anything, the borrower would gain more than the lender from the use of the clause—simply because interest payments are likely to be larger relative to his net income, and to have their real value stabilized would have a greater stabilizing effect on real income. Yet it is apparent that in a country with even a mild inflation the borrower in fact would seem to gain from the conventional form of contract, and that in comparison with the lender he would be the one reluctant to change to a purchasing power clause. The explanation lies in the interest rate enforced by law or social custom—an interest rate that does not clear the market but instead forces the lending agency to work out some form of rationing of credit. The borrower who receives a loan does not pay a full market price for it, and he gains in comparison with a purchasing power loan in which he pays a competitive rate. The existence of this “gain” is, of course, no evidence at all that borrowing would not be more efficiently organized on a purchasing power basis. The theoretical advantage of the purchasing power clause, with the greater flow of funds that it is likely to ensure and the competitive determination of their direction, is simply the advantage of a price system over an allocation system.

Government debts

The advantages of the purchasing power clause in government securities are, of course, similar to those in private contracts, but the relative importance of the arguments is changed substantially. The prime economic consideration is simply the increased flow of funds that the clause might ensure. By offering a certain return in real terms, the government can effectively compete with the alternative direct hedges which the investor might consider. In comparison with a higher money interest rate (the possible alternative method of obtaining extra funds voluntarily), the purchasing power security is attractive to the saver as it always has the extra insurance of preserving the return if there should be a runaway inflation. From the government’s side, the advantage over a higher interest rate is also considerable. The government gains, just as a private business does, if its outpayments move with its receipts. In particular, a government borrowing under inflationary conditions would find the high interest payment burdensome if it succeeded in limiting price increases. The advantage of a purchasing power clause is particularly great for a government when the borrowing in this form is undertaken as part of a strong price stabilization program after a period of rising prices. At that time, the public is likely to expect further price increases and a purchasing power clause will be very attractive, while if the program is successful it will cost the government nothing.

Furthermore, a purchasing power clause in government securities circumvents the prestige problem. Simply for prestige reasons, a government is always unwilling to pay a high nominal rate in money terms. Therefore, in practice, the government in a country with significant price increases normally has paid less than the rate of the price increases; this makes the real return on government bonds negative and naturally inhibits the flow of savings. A purchasing power clause would enable the government to float loans at respectably low interest rates and at the same time insure a net real return to the investor.27

Under some circumstances, the purchasing power device might have the advantage of lowering the cost of existing borrowing. The argument, as advanced by Keynes, is that the Treasury gains from adapting its issues to the desires of the investing public. He cited the gain achieved by issuing both short-term and long-term securities, thereby tapping different markets and enabling the borrowing to be done more cheaply than if one market alone had to absorb the total borrowing. Since some people desire the security of guaranteed purchasing power, the Treasury, by adapting its securities to this preference, can lower the over-all cost of borrowing, the new securities having a lower yield than existing ones. This argument is clearly valid if significant inflation is avoided for the life of the securities. However, its general validity is very doubtful, for it is apparent that in many countries inflation has reduced to zero the real return on government securities. It is quite improbable that investors would recognize this openly by accepting a purchasing power bond with a negative yield, and hence the Treasury could not lower its average cost. Keynes to some extent recognized this objection, and attempted to meet it by ethical considerations, saying that, of course, the Treasury could gain by expropriating investors by severe inflation, but he assumed they would not wish to consider this as legitimate.

Control of inflation

The advantages of the purchasing power clause are that a stable standard for deferred payments would enable the members of a community to satisfy their desires more efficiently than under the present money standard. It is normally understood that one consequence of the improved standard, with its higher return to savers, would be increased voluntary savings. From this has sprung the hope that the device has an important place in limiting inflation. This hope has usually been accorded a central place in any argument in favor of the use of the clause; but its value for this purpose can by no means be indicated simply, and even with extended analysis the result is still open to conjecture.

It is fairly clear that an addition to savings is to be expected from the widespread application of the purchasing power clause. Use of the clause would assure savers, particularly in a country with a history of inflation, a return which they would value more highly than that available to them on fixed money interest obligations. To the extent that greater rewards bring higher savings, total savings would be increased. It is, of course, not proven that this positive relationship always holds. In particular, an argument used against it is that the capital loss suffered in an inflation by the holders of fixed money obligations stimulates them to save more to rebuild their assets. However, this perverse reaction to higher returns seems likely to be the exception rather than the rule. The increase in effective savings seems likely to be significant, especially where the greater return on loans through a purchasing power clause is able to induce a significant substitution for sterile savings in the form of gold and foreign currency.

The whole of the increase in effective savings would by no means necessarily be a factor in reducing the inflationary gap. Many offsetting increases in expenditure would nullify its effect. Insofar as the increase in savings is stimulated by the issue of private securities with a purchasing power clause, the extra savings would flow to private investors and have little deflationary impact. Spending would be merely changed from spending on consumption to spending on investment. The switch would assist only indirectly in the control of inflation. It would make it easier for the central bank to control the money supply, for the increased savings to be expected would diminish the pressure to expand bank credit. It also might permit some reduction in the program of government investment if part of the essential capital growth were provided from private sources. Further, by introducing a competitive (higher) interest charge, free of the restraints arising from fears of usury, the use of the clause might reduce the clamor for loans which frequently renders ineffective the government’s campaign for tighter credit.

Equally, if the increased savings should flow to the government through sales of official securities with a purchasing power clause, there might be some offsetting increases in expenditure. If the proceeds of the securities were allocated to a particular public enterprise, it is not improbable that the investment program might be expanded, and thus part of the anti-inflationary impact of the savings might be neutralized. Even if the receipts should flow to the government as a whole, expenditures might rise. Many governments have absorbed far greater increases in receipts originating in increases in the prices of exports and yet, as they were at the same time increasing expenditures, they have not narrowed the inflationary gap. It should, of course, be noted that, even though inflation might not be halted, a government would still welcome the increase in its loan receipts, perhaps preferring investment to the cessation of inflation.

The position is further complicated by the possibility that the purchases of the new securities may be financed by sales of existing assets as well as by new savings. To the extent that the central bank supports existing securities, the new funds might be illusory. If the credit injected by support should go to private issues, there would be a net inflationary impact. Moreover, apart from direct support operations, there would be a similar impact from any tendency of the clause to bring about a reduction in the real value of cash balances that the public are willing to hold. However, it is probable that this reduction would be small in any country with a recent history of inflation, for the public would already have reduced their holdings to minimum working balances. On the other hand, any decline in the real value of the currency that the public are willing to hold is of exceptional importance. It is in the issue of currency that the government has its safety valve in an inflation. To cover the same real deficit by an issue of currency would, in future, cause a greater inflation if the real value of the public’s holdings of currency should be lowered by the improved alternative store of value.

In addition to the current effect of the issue of government securities with a purchasing power clause, there is the problem of the impact of their financing in later years. If the inflation should continue, there would be increased outlays on debt service, which might accentuate the inflationary pressures at that time. There is some justification for this concern, but it should be made clear that the problem arises solely from unwise government finance. To the extent that the government is enabled through the purchasing power clause to invest and this investment yields a net return greater than the interest charge, there should be no accentuation of inflationary problems. An increase in the debt service in money terms does not indicate a loss to the government, for the return from the government’s investment also rises in money terms. The government will find that the taxation base rises pari passu with the servicing charge. Of course, the government does forego the gain it would make if investors would accept a money claim that depreciated, but it is precisely because the public will not accept these claims in sufficient quantity that the government turns to the new type of security.

The danger that does arise from the purchasing power clause is that an unwise government, which does not use the funds to expand its real capital, would find itself saddled with a debt service not balanced by a growth in real output. There is a strong danger that eventually such a government would be led to a repudiation of the debt; the purchasing power clause would accentuate this danger, since the government would have greatly reduced power to repudiate the debt implicitly by inflation.28

There has been some fear expressed that, by insulating a new group of people from the ravages of inflation, a purchasing power clause in government securities would reduce the political opposition to inflation and thereby tend to perpetuate the evil. This argument does not appear to be very weighty. Inflation will continue to cause inconveniences to the mass of the people, because of the loss in value of the currency held by them. Workers will still lose owing to the lag in adjustment of wages. The clause would only reduce the depth of discomfort for a group which would still have many inconveniences. Moreover, the use of the clause in the private sector might mean a net gain for the influence of anti-inflationary forces. This group of debtors, normally considered politically powerful relative to creditors, would no longer have an interest in inflation. Without the clause, price stabilization is ruinous for debtors, since they are saddled with interest charges bearable only when prices rise continuously.

It is sometimes felt that the device may speed up inflation by its destruction of the money illusion. Its effect on the holding of money has been discussed above. There is, however, the possibility that it might affect the pricing of services and thereby the speed of a cost inflation. It would seem, for example, that, if the use of the clause in loan contracts should lead to its use in wage contracts, a more rapid rise in wages than would otherwise occur might be induced. However, there seems to be little practical importance in this consideration. In most countries, trade unions are already well prepared to press for the association of claims for higher wages with movements in the cost of living, and in this respect they have little to learn from the use of price indices in loan contracts.

This discussion of the effect of the purchasing power clause on the control of inflation shows that each case has to be studied individually. It seems clear that, with wise management, some contribution could be made. However, the contribution might not be large and it would seem best to regard it, even in favorable circumstances, as supplementary to other measures, particularly budgetary reform, which have to bear the main burden.

Control of deflation

One of Marshall’s principal arguments was that widespread use of an index clause would reduce the severity of depressions. The major reason for this belief was that, with widespread use of the clause, the occurrence of unexpected price declines, which would normally occasion the bankruptcy of many debtors, would have a reduced impact and therefore loss of confidence would be avoided. With the lesser impairment of confidence, the volume of investment could thus be maintained more satisfactorily.

Unfortunately, the device would not be able to remove fully the effect of falling prices in increasing the burden of interest charges and capital repayments. Since there is the alternative of holding cash, the return on securities with a purchasing power clause could never fall below the expected rate of price decline. Because of this limitation, it is likely that the yield on such securities would rise in a depression, and there would not be the stimulus to new investment which Marshall seemed to expect. Moreover, to the extent that it operated, the introduction of the clause in periods of deflation would cause some stimulation of saving and hence some depressive effects on spending. In view of the ready availability of the alternative weapon of deficit spending, it seems difficult to credit the device with a significant contribution in this field.

Practical Disadvantages of the Device

It is clear that the majority of practical financial experts are dubious about advocating any use of a purchasing power clause. It may be argued that much of the opposition arises from innate conservatism. From long experience, banking circles have learned to be skeptical of new devices and believe strongly that any changes should be made slowly and cautiously.29 By its nature, the use of this clause is likely to be a break with past experience and not a gradual evolution. Although this is a disadvantage, it should not be considered of great importance. With adequate study, it should be possible to judge the proposal on rational grounds without giving undue weight to a fear of unknown factors.

The opposition has, in the past, also been due in part to apprehension about the feasibility of using an index number for measuring changes in obligations.30 In the days when Jevons and Marshall were advocating the tabular standard, these apprehensions may have been well founded, since it is difficult to provide legal definitions of commodities so that prices can be established exactly. However, with the growth of statistical organizations and statistical measurements, this problem has been solved, for practical purposes, in many countries. Wage contracts have been tied to cost of living indices, and in World War II such arrangements withstood the heavy strain of wartime distortion, which raised very justifiable complaints about the accuracy of the indices.

Still other criticism has originated in too ready an acceptance of the money illusion. It has been suggested that the use of the clause unloads “the whole burden of monetary depreciation on the debtor’s shoulders.”31 Of course, it does increase the money payment made by the debtor when there is an inflation, but only to the extent needed to insure that the real burden is constant. Thus the clause actually prevents the burden of the monetary depreciation being borne by the creditor and establishes in its place a balanced position in which neither debtor nor creditor loses.

In no sense, however, do these points of weakness in particular arguments cover the whole basis for practical opposition. There are many sound reasons for believing that the practical problems which would arise are important. These problems all stem from the double standard implied in the proposal—the existence of one form of money, legal tender currency, side by side with another monetary unit, the unit of purchasing power used in loan contracts. This double standard would necessarily create problems of three types: first, the problem of establishing a dividing line beyond which the purchasing power clause cannot be used; second, the problems arising from the pure accounting difficulty of converting purchasing power clauses to money terms, for payments and for balance sheet purposes; third, the problem for banks, and to some extent for other firms, of obtaining a balance of assets and liabilities in this new form to avoid gambling on the future value of money.

The problem of establishing a dividing line may be of little significance if the economy is relatively stable. Technically, the introduction of the clause should not provide very much greater competition with existing money-priced securities than is already provided by equity securities, particularly when account is taken of investment trusts. But in a country where the expectation of inflation is great, there will undoubtedly be a considerable movement toward the new clause. Even in Finland, where prices have in fact been quite stable in recent years, there has been a strong tendency for the use of the clause to spread from one application to another. This spread is to be expected if the advantages are as great as is claimed. However, the spread has to be stopped somewhere. It cannot be permitted to encroach on ordinary currency. If, for example, private banks were permitted to issue banknotes denominated in purchasing power units, there would necessarily be an extremely rapid inflation in nominal money values as the public attempted to reduce their holdings of the official currency. To limit the encroachment, it would presumably be necessary to prohibit demand deposits having this form. Consequently, the banks as a group would probably suffer some loss of funds through the competition of other financial agencies with the power to offer this clause. Equally, life insurance companies might suffer—not because of legal prohibition of the use of a purchasing power clause but simply because, if expressed in terms of purchasing power units, some forms of policy would probably be too cumbersome to use.

The cost and inconvenience of using two units would be noticeable if the clause should become widely used. The inconvenience of calculating the purchasing power equivalent in money of monthly installments on small debts would be great to both the borrower and the lender. Equally, the complication in companies’ accounts would be considerable, at least at first. The accounts with purchasing power clauses would either have to be revalued periodically or carried on the books in a unit different from that used for current transactions. These inconveniences, however, do not seem to be sufficient to destroy the general value of the clause. They might be expected to limit its use, some contracts always remaining in money terms.

The problem of balancing assets and liabilities in this form, or at least those subject to the general price movement, would be rather more difficult to meet. Banks clearly must denominate in purchasing power terms roughly equal amounts of loans and deposits. If they do not, a rapid price movement in the wrong direction could destroy their equity. Since a substantial amount of these liabilities would necessarily be in money terms, banks would be forced to make most of their loans in money terms. This would reduce the scope of loan contracts to be made in purchasing power terms and, to some extent, would weaken their value, since the companies receiving part of their capital from money loans might prefer to extend some money loans rather than to extend purchasing power credit to their customers; thus they would keep a balance of assets and liabilities denominated in money. This problem should not be overstressed because it is based on an imbalance which is necessarily, on the average, less than the imbalance at present existing in any normal company; a revaluation of assets in accordance with a general price movement would cause a more significant variation in the real net worth at present than is conceivable if money claims had a purchasing power clause.

The problem of balancing would be aggravated for banks by the marked difference between the liquidity of their assets and the liquidity of their liabilities. If at any time the public suddenly expected significant price increases, there might be a massive movement from money-denominated time deposits to deposits with a purchasing power guarantee. The banks would have to attempt to match this movement in liabilities by a similar adjustment in outstanding loans, but under present banking practices there would be a significant delay before obligations fell due and hence before their terms could be varied. Technically, the banks could safeguard themselves by any of several devices: they could refuse to accept deposits with a purchasing power guarantee on such occasions; they could discourage such deposits by rapid changes in the returns on such accounts relative to others; or they could insert in their loan contracts a conditional clause giving them the right to add a purchasing power provision. Clearly, any of these solutions would considerably complicate the practical business of banking.

These practical problems, for the most part, merely diminish the advantages to be gained from a purchasing power guarantee, but still leave some positive benefit from its limited use. Apart from limiting the enthusiasm for the clause, they serve to demonstrate the greater long-term gain from a policy of stable prices as opposed to the policy of a stable standard for deferred payments. There can be no question that a single stable standard is preferable when it is obtainable.

In addition, there are innumerable practical problems that may arise because of special circumstances. There are, in particular, political problems in timing which will be dependent on circumstances. The introduction of the clause, not accompanied by other measures, at a time when price increases are growing, might well be taken as meaning that the government had relaxed its efforts to control the problem. In some countries with a previous history of inflation in which somewhat similar clauses were used, the introduction of clauses that are tied to a specified index may, because of the earlier experience, create expectations of further instability.

In some countries there may be a problem of confidence in the index that is used, and doubts about its reliability might hinder sales of government securities that contain an index clause. In some countries there may indeed be no reliable index available; under these circumstances it might prove useful for an international body to advise on the construction of a suitable index. However, even when the index is considered adequate, there necessarily remains some possibility that it will be distorted by price control and subsidy measures concentrated on certain items included in it.

In addition, action might be essential on a number of specific legal problems. The legal enforceability of purchasing power clauses would have to be established beyond question. In several countries, notably Germany and perhaps France, there is evidence that an index clause in private contracts may be unenforceable at present. In many other countries, doubt will remain about the eventual enforceability of such a clause until the government explicitly declares that it will not be abrogated by subsequent legislation.32 Aside from the doubts about enforceability, certain legal limitations are also often imposed upon securities with index clauses. It appears that they cannot be classified as negotiable instruments; and it would seem that such securities would be classified as ineligible under many trustee laws. There is little reason for perpetuating these limitations. However, it would seem somewhat extreme to go as far as one suggestion—namely, to prohibit trustees from investing in fixed money claims on the grounds that historical evidence of inflation indicates that they are the really risky investments!33

Application to Standardized Examples

The merits and dangers of the use of the purchasing power clause differ widely according to the circumstances of the country. To summarize the arguments, it is therefore useful to present separately the results of the use of the clause under four distinct standardized sets of circumstances.

Example A. Country with chronic inflation, little chance of budgetary reform, negligible public holdings of government debt, and high velocity of circulation of money.

In such a country inflation has to be taken as a datum. The problem is to make it less disruptive, For this purpose, the purchasing power device is well suited if applied to private contracts. It should materially increase voluntary private savings and reduce the waste of savings in the form of foreign currency and inventories and other forms of inefficient direct hedging.

Its application to government securities is rather debatable. The existence of chronic inflation may imply a tendency to overspend, which would prevent the extra savings obtained by the government from reducing the degree of inflation. Furthermore, the weakness of the government may create the hazard that the securities would eventually be repudiated.

A major problem to be watched would be the possibility that the clause might so drastically reduce the willingness of the public to hold money that the economy would be pushed toward hyperinflation.

Example B. Country with inflation but with a new anti-inflation program with reasonable chances of success.

Here, the uncertainty about price movements is very great, and the a priori case for the use of purchasing power guarantees is strong. The political acceptability of anti-inflation programs might be materially increased by prior widespread use of the clause in private contracts, since it would reduce the losses of the debtor class through stabilization.

For government securities, the argument for such clauses is also strong. The government should make good use of the additional loan receipts to assist it over the hump of effective action. Given the success of the program, the government’s borrowing would be considerably cheaper than under the alternative monetary form as, in the light of recent experience, the public would attach a high value to the purchasing power clause.

The main problem here seems to be the long-run one of perpetuation of the clause after stabilization. Once used, the arrangements seem likely to persist, and the government might consider it unsatisfactory to have a permanent two-standard monetary system.

Example C. Country with normal stability but with a short-period problem of inflation and with large public holdings of government securities.

In this example the use of the clause in private contracts would prevent the disturbance imposed by unjustified transfers from creditors to debtors and, to a limited extent, might reduce direct hedging. However, as the savings pattern of the country is firmly established, it is unlikely to have been distorted as extremely as when there is chronic inflation. Moreover, direct controls might limit the damage of direct hedging. The economic gains from the use of the device in private contracts might, therefore, be relatively small in comparison with the gains possible in less stable countries.

Issuance of government securities with a purchasing power clause would probably expand substantially the flow of savings to the government, mainly at the expense of private investments, but also from additional savings resulting from the higher rate of return. It could, however, be quite disturbing to the prices of the already existing mass of money-denominated securities. Through attempts to shift from these securities to the new ones with purchasing power guarantees, there would be a considerably increased pressure for higher interest rates. This might be desirable, but most Treasury officials, and probably the majority of economists, would not so regard it. It might be possible to minimize this disturbance by restrictive arrangements making the issue open only to small savers, to provide only limited transferability, and to impose penalties for redemption before a relatively late maturity. It should also be remembered that any attempt to obtain for the government the same amount by raising the rate of interest on conventional securities would be equally disturbing to the market.

Example D. A country with normal stability and an advanced economy.

As a permanent arrangement, there is an advantage—argued by Keynes—for the Treasury in adapting itself to the market. Theoretically, it could gain by issuing securities with a purchasing power clause at a very low rate of interest—the rate being set low enough to attract only a small group of investors. However, it would be implausible to expect a significant gain in any practical case, for in the past 20 years every country has shown some tendency toward price inflation. Also, it is probable that even a small marketable issue might prove disturbing to the money illusion, and hence to the bond market in times of limited inflation. Again, some competent economists might regard the effect on the bond market (it would push rates up when price increases occur) as desirable, but the weight of opinion would regard this as a significant disadvantage.


I. Details of Some Recent Applications

Savings accounts in Finland

Most Finnish credit institutions, although not the largest savings bank, introduced on May 2, 1955 deposit facilities with a purchasing power guarantee. The deposits had to be made for a fixed term of one year, and the minimum deposit permitted was 30,000 markkas (US$130). The interest return was 4¾ per cent, in comparison with 6¼ per cent on six-month time deposits without the guarantee. The return was not exempt from state taxes as was the return on other time deposits.

The guarantee provided that, if the cost of living should rise by 2 per cent or more over the October 1954 level, the value of the deposit in money terms would be increased proportionately. There was no provision for a reduction of the deposit if the cost of living index should fall. The April 1955 cost of living index was in fact 5 per cent below the October 1954 level; there was therefore no protection against a 5 per cent price rise.

Apparently, the Finnish banks had found that instead of holding deposits many of their customers preferred to invest in the government securities with a purchasing power clause, which have been issued in Finland for several years. However, depositors made very little use of the new deposit facilities during the first months after their introduction, according to some reports, because of the adoption of the October 1954 price index as the standard. The banks, moreover, have so far not made arrangements to include a purchasing power clause in their loan contracts. Apparently the contingent liability is covered by holding government securities with a purchasing power clause.

Public utility bonds in France

Electricité de France, a government corporation, was the first to issue in France securities containing a purchasing power guarantee in terms of the product made and sold by the issuing authority. In October 1952 it issued bonds at 16,000 francs, with annual interest equal to the average selling price of 100 kilowatt hours in the preceding year or 720 francs, whichever was the greater. They were to be redeemed between 1958 and 1968 at the average price of 2,000 kilowatt hours at the date of repurchase or 16,000 francs, whichever might be the greater. The selling price was to be calculated by dividing the total revenue of the company from sales of electricity by the number of kilowatt hours sold.

At the time of issue, the selling price of electricity was under 8 francs but over 7.2 francs per kilowatt hour. Consequently, the interest payments had full guarantee for upward price changes and a limited possibility for decline. The principal, on the other hand, had no possibility of being reduced, and a full guarantee only when prices had risen by more than 2 or 3 per cent. The method prescribed for calculating the selling price of electricity was such that some decline in the average price was to be expected even if all specific rates were left unchanged, since the use of industrial power, the charge for which was lower than the average, was likely to expand more rapidly than the use of electricity in general.

The issue was very successful and was followed by similar ones for coal, railways, and gas, as well as other electricity issues. The public preference for these securities over securities without a purchasing power provision was shown by a substantial difference in yield. In April 1955, the difference reached a peak when the yield on securities of public industrial enterprises with a purchasing power clause was 3.72 per cent, while the yield on securities of the same enterprises without such a clause was 5.95 per cent.

Savings deposits in Mainland China

During a rapid inflation in 1949, the Peoples Bank in Mainland China introduced the Parity Deposit System, under which time deposits were calculated in terms of commodity units. In Shanghai each commodity unit consisted of a fixed quantity of medium-grade rice, cotton fabric, peanut oil, and coal briquettes. It appears that, at this stage, the system had a full index clause allowing variations up and down. In May 1950, when there was more hope of price stability, the system provided that the principal and interest could be withdrawn either in terms of currency or of commodity units. Bank loans are also reported to have been converted to a purchasing power basis when the Parity Deposit System was introduced, thereby providing the bank with the necessary hedge.

II. Selection of the Price Index

If commodity price movements were uniform, there would be no problem in the selection of an appropriate price index to be used as a basis for a purchasing power guarantee, for all indices would give the same result. But, of course, price movements are far from uniform, and there is a bewildering array of possible prices and price indices that could be used and would give varying results. In selecting from these possibilities, many considerations should be borne in mind. Although some of these considerations will be particular to the case in question, many of the more important factors can be analyzed in advance.

Especially for countries where inflation has already been severe, and which are therefore the most likely to introduce a purchasing power guarantee, there is, however, one point of primary importance. In such countries the use of any price index would create an obligation that was more stable in real terms than obligations denominated in terms of money. Any differences between the various measures of price movements will therefore be much less significant than the difference between any one of them and a money standard to which no purchasing power guarantee has been attached.

The simplest device that has been suggested consists of denominating the loan in terms of the selling price of the borrower. This is the procedure followed by the French public utilities. The advantage of this price is, of course, a reduction of the risk for the borrower that his debts will grow in money terms without a commensurate increase in his ability to service them. On the other hand, there is the disadvantage to the lender of a variable purchasing power of the loan in terms of his expenditures. If the borrower’s selling price rises less than the general price level, the lender bears the loss. Abstractly, it would seem that the risk involved in sectional price movements might be more properly borne by the borrower simply because he should be more expert in determining the future comparative prosperity of his industry. Moreover, some of the sectional price movements will be related to differential rates of technological advance, in which case price declines may indicate improved, rather than lessened, ability to service the debt. The significance of these arguments would seem to be sharply reduced if the sector price were defined on a broad basis; for example, a sector as wide as agriculture.

In the particular case of public utilities, there are further considerations. The movements of public utility charges are notoriously a poor indicator of the degree of inflation. In almost every country they move much less and much more slowly than the general price level. Consequently, a purchasing power clause expressed in terms of public utility charges would still leave the lender with a reduced real return in the event of inflation. Moreover, when the utility’s debts are tied to its own selling price, it seems probable that there would be an even greater reluctance to vary the selling price. This would not only reduce the inflation hedge to the lender; it would also have the unfortunate effect of underpricing the utility, with the consequent problems of perpetual overdemand or overinvestment supported by subsidies.

The use of individual selling prices introduces into the bond market a bewildering array of standards. Instead of the relatively simple double standard—money for current payments and an index for deferred payments—there is a multiple standard with increasing complexity for the investor and one that would probably inhibit attempts to obtain more liberal standards for trustee investments. If there is an intention to encourage the widespread use of a purchasing power clause, it would seem desirable to standardize its form as much as possible.

Another single price that has been widely used is that of gold or of foreign exchange. Gold (or dollars) has the advantage of being precisely defined and a sensitive index of inflation. Furthermore, the historical use of gold in payments has made its use for deferred payments more easily comprehended than the use of abstract indices. On the other hand, this history has made both courts and governments sensitive to the implicit challenge to the sovereign right of a country to determine the legal tender. Consequently, such clauses are illegal in many countries, and it has proved easy to pass retroactive legislation making any present legality of doubtful permanence.34 Also, the precision of the price of gold has suffered in recent years. Governments have so many regulations affecting the prices—both official and free—of gold and foreign exchange that any price chosen for a purchasing power clause is subject to the danger of arbitrary variation, arbitrary exclusion from variation, or even disappearance.

Moreover, the use of gold or foreign exchange as a standard of reference has further disadvantages. Whereas the selling price of public utilities is likely to underestimate the degree of price inflation, the price of gold or foreign exchange is likely to overestimate it. Through speculation, the depreciation of the local currency in terms of gold is likely to be much more rapid than in terms of local goods. Although this unrepresentativeness might be somewhat reduced if most deferred payments were on a purchasing power basis, thereby eliminating some of the desire to speculate, it is certain in any significant inflation to cause borrowers to lose unduly as they overcompensate lenders. It therefore partly fails in its purpose to remove risk in loan contracts.35

For government borrowing, the use of a gold clause in favorable circumstances is rather advantageous. In particular, if the government is attempting to raise a loan in a stabilization program after a period of inflation, the free gold price is likely to be particularly favorable to it. The gold price will have overstressed the inflation and is likely to fall significantly if the stabilization is successful. In such circumstances, the government has much to gain and little to lose from a gold clause.

Particular prices—whether of gold or of the goods sold by the borrower—are necessarily inferior for the basic purpose of a purchasing power clause. The arguments for the clause are based directly on the need to avoid the distortion arising from movements of the general price level. This purpose can be achieved only if a direct attempt is made to obtain a representative price index in which the special factors affecting individual prices are submerged in an average that measures only the general pervading influence of inflation or deflation.

But, although the object is to measure general prices, there is one basic question on which a decision is required. Which is more appropriate, the measurement of prices paid to producers of goods and services or the measurement of prices paid by consumers? If, as is ideally desirable, the measurements covered all producers’ prices and all consumers’ prices, the two would be identical in a closed economy. But, in an open economy, the two may differ significantly, for producers’ prices include the prices of exports, while consumers’ prices exclude the prices of exports but include the prices of imports.

The two price indices differ only when the terms of trade vary. If there is an adverse movement in the terms of trade, the use of a producers’ price index will cause the lender to lose in terms of consumers’ prices while the use of consumers’ prices would cause a loss for the producers. The choice between them thus becomes a question of which side should bear the uncertainty of loss (or of gain if the terms of trade improve). Since it seems that the uncertainty would weigh more heavily with the borrower, his debt payments being more significant to his net income than the interest receipts would be to most lenders, the decision would seem to be in favor of using producers’ prices. This, of course, is not directly relevant when the government is borrowing, insofar as the intention is to maximize the savings offered to it. However, even a government may wish to provide for a lightening of the real burden of its debt when there is a severe loss in terms of trade.

Theoretically, it would seem that the index used should be as inclusive as possible, covering as many prices as is feasible. In practice, of course, the index will have to be compiled from a limited sample of data, weighted to represent classes of goods. The extent of the coverage might depend primarily on the number of items for which standardized prices are available and the size of the statistical staff available to compile the index. There is, however, a possibility that in some countries the sample might be deliberately kept small to increase the likelihood that people would understand it. An index based on prices of five or ten major commodities might be sufficiently simple to be understood widely, and at the same time accuracy of measurement would not be sacrificed.


Mr. Finch, economist in the Finance Division, is a graduate of the University of Melbourne, Australia, and the London School of Economics. He was formerly a lecturer in the University of Tasmania.


The exact provisions are reproduced in Appendix I.


In his Reply to the Royal Commission on the Depression of Trade and Industry, 1886, reprinted in Official Papers by Alfred Marshall (London, 1926), pp. 9–12. The proposal is also set forth in an article in the Contemporary Review, March 1887, reproduced in Memorials of Alfred Marshall (London, 1925), pp. 188–211.


In a letter to Irving Fisher, reproduced in Memorials of Alfred Marshall (London, 1925), p. 476.


W. Stanley Jevons, Money and the Mechanism of Exchange (New York, 1898), Chap. XXV, “A Tabular Standard of Value,” pp. 318–26. (First published in 1875; page references are to the New York edition published in 1898.)


Ibid., p. 324.


In evidence before the Committee on National Debt and Taxation (Colwyn Committee), Minutes of Evidence (London, 1927), Vol. I, pp. 278 and 287.


Joint Committee on the Economic Report, Monetary Policy and the Management of the Public Debt (82nd Congress, 2nd Session, Washington, 1952), Replies to Questions … for the Use of the Subcommittee … (Wright Patman, Chairman), p. 1105.


Ibid, p. 1106.


In “We Can Win the Economic ‘Cold War,’ Too,” New York Times Magazine (New York), August 13, 1950, pp. 7, 22–26, and in later letters and addresses. His proposal began the discussion leading to the examination by the Patman Subcommittee. A thorough theoretical analysis of the proposal with a favorable conclusion is given by Richard Goode in “A Constant-Purchasing-Power Savings Bond,” National Tax Journal (Lancaster, Pa.), December 1951, pp. 332–40.


According to Le Monde (Paris), May 23, 1954, he proposed the use of the cost of an hour’s unskilled labor as an index for loans.


La Lutte contre inflation et la stabilisation monétaire (Paris, 1947). A price index deflation is suggested.


L’Observation Economique (Paris), October 1949, p. 7. The issue of bonds by public utilities denominated in terms of the selling price of their product is advocated.


Javier Márquez, “Bonos de Poder Adquisitivo Constante,” El Trimestre Económico (Mexico, D.F.), January-March 1954, pp. 6–43.


Economic Review (Shanghai), April 6 and May 10, 1947.


Walter Bagehot, “A New Standard of Value,” The Economist (London), November 20, 1875. Reprinted in The Economic Journal (London), Vol. II (1892), pp. 472–77.


Committee on National Debt and Taxation, op. cit., p. 633.


Joint Committee on the Economic Report, op. cit., pp. 142–45.


Ibid., pp. 888–89.


In Appendix I, the details of several of the more important applications are given.


W. C. Fisher, “The Tabular Standard in Massachusetts History,” Quarterly Journal of Economics (Cambridge, Mass.), Vol. 27 (1912–13), pp. 417–61.


The U.S. -Cuba Sugar Agreement of 1946 provided that the price paid by the Commodity Credit Corporation for Cuban sugar should be linked with the monthly indices of the U.S. Bureau of Labor Statistics. The text is quoted in Arthur Nussbaum, Money in the Law, National and International (Brooklyn, 2nd ed., 1950), p. 305, footnote 32.


W. Stanley Jevons, op. cit., p. 319.


Memorials of Alfred Marshall (London, 1925), p. 197.


In Appendix II, the form of the guarantee is discussed in detail and the merits of various indices are analyzed.


W. Stanley Jevons, op. cit., p. 324.


Memorials of Alfred Marshall (London, 1925), p. 193.


There would possibly be substituted another prestige problem, i.e., the implication that, in resorting to loans with a purchasing power guarantee, the government’s credit is weak. However, this would not seem a valid implication in view of the use of such clauses by the Finnish Government and French governmental institutions, and of the proposals for its use by the U.S. and U.K. Governments.


The power would be reduced but not eliminated because the repayment of a purchasing power bond must be linked to a past price index. Repayment of a debt adjusted in terms of a price index calculated for some earlier date would still permit some reduction in the real value of the settlement.


Robert Giffen made this point explicitly in his article, “Fancy Monetary Standards,” The Economic Journal (London), Vol. II (1892), pp. 463–71.


E.g., Walter Bagehot, op. cit.


Arthur Nussbaum, op. cit., p. 306.


The law in many countries is set forth clearly by F. A. Mann in The Legal Aspect of Money (London, 2nd ed., 1953), Chap. IV, “Methods of Negativing the Effects of Nominalism,” pp. 103–34. The strongest action against such clauses appears to be the decision of the Allied Control Commission in Germany in 1947 which declared all such attempts invalid. In Revue Economique (Paris), March 1955, which deals with the experience with index clauses in France, Joseph Hamel expresses somewhat greater doubts about their validity in France than that shown by Mann.


Proposed for the United Kingdom by the author of a series of articles entitled “Agenda for the Age of Inflation,” The Economist (London), August 25, 1951, pp. 435–37.


Arthur Nussbaum, op. cit., p. 280, lists over 30 countries in which legislation affecting the validity of gold clauses has been passed.


In some circumstances it fails completely. For example, in the United States the devaluation of 1933–34 caused a 70 per cent rise in the price of gold while other prices were approximately stable. This caused the burden of loans with a gold clause to increase sharply—extremely sharply when account is taken of the fall in commodity prices after many of them were contracted. Consequently, there was strong agitation by debtors against the enforcement of the gold clause, which led to the passing of abrogatory legislation.