Economics

Was There Ever a ‘Risk-Free Rate’?

We have had a good deal of financial agonizing of late about whether problems with the U.S. government’s debt limit might mean a loss of status for Treasury debt so that we would no longer have a “risk-free [interest] rate.” Well, not having one is not much of a problem, because there never was a risk-free rate, or a risk-free anything else—including government debt.

Lending money to a sovereign power, which might just choose not to pay you back, has occasioned many a lender’s loss. An essential distinction is that the debt is that of the government, not of the country. Consider the bonds of Czarist Russia or the Confederate States of America.

Sovereign debt was never risk free, and financial history is replete with defaults by governments on their debt. Carmen M. Reinhart and Kenneth Rogoff (This Time Is Different) chronicle 250 such defaults since 1800. The notion that sovereign debt is “risk-free” should be considered primarily a marketing slogan for borrowing governments and bond salesmen.

European banks are staring at potentially huge losses on sovereign debt in their portfolios. This reflects a long history and much precedent: one key purpose of banks going back at least to the founding of the Bank of England in 1694 was to lend money to the government in exchange for getting charter privileges.

Reflecting this, it is commonplace to find regulatory policies and bank capital requirements written to encourage banks to hold a lot of government debt. In the United States, this was extended by regulatory policies to encourage banks to hold large quantities of the government-sponsored debt of Fannie Mae and Freddie Mac, and also of their preferred stock, in order to promote housing. These policies exacerbated the hyper-leveraging of the housing finance sector.

An irony is that the banks themselves represent indirect government debt, since their most stable funding sources are deposits guaranteed by the governments.

The lack of a risk-free anything forces us to contemplate a difficult truth. The financial universe, like the physical universe, is Einsteinian, not Newtonian. There is no absolute frame of reference. There are only many financial things, all moving with respect to each other, with constantly changing exchange rates between them, all subject to various risks and to guessable, but unknowable, uncertainties.

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