A dangerous lie about debt

August 21, 2013

I have spent much of the last five years searching for financial villains. The 2008 crisis and the extremely slow subsequent economic recovery have exposed a deeply flawed system, and some people, groups or ideas must be responsible.

There are many obvious culprits: greedy bankers, undercapitalised banks, lax monetary policymakers, reckless governments, weak international institutions and imprudent lenders and borrowers. They’re all guilty, but some of the worst offenders are intellectual – the dangerous ideas that encouraged overconfidence during the credit bubble and ineffective policy in the aftermath. Financial theory is a big problem. In particular, I accuse the risk-free rate of return of being the devil’s work.

Some aspects of the theory have already received a great deal of criticism, but the complaints are mostly quite technical. Beta, or market return, is too often dressed up as alpha, the extra return attributed to an investor’s skill (or luck) picking particular investments. And the distribution of daily returns is actually not mathematically normal, as much of the theory assumes. But I think the problem starts right at the beginning, with the assumption that there is a readily available, perfectly safe investment. The theory basically compares the range of likely returns on every other investment to the certain gain from the risk-free alternative. Additional returns are expected to compensate for additional risk.

Stocks are not risk-free – their future prices are unpredictable. Corporate bonds might default. That leaves bonds issued by the most creditworthy governments. Financial modellers generally start with the 10-year U.S. Treasury bond. Some sophisticated practitioners now use inflation-protected bonds (called TIPS in the United States), but the theory was developed in the 1960s and 1970s, when such instruments did not exist. The theoretical need for a risk-free security was so great that the ravages of inflation were simply ignored.

But even TIPS do not offer a perfectly predictable and safe real return, because they rely on a somewhat arbitrary measure of inflation. Besides, if the U.S. government gets into serious enough trouble, it could decide to restructure its finances – perhaps eroding the real value of fixed debts through inflation or simply imposing a write-off on TIPS. But even if super-safe versions of TIPS could be designed, they wouldn’t solve the most substantial problem of a theory which starts with a risk-free rate. It looks at investments the wrong way.

Finance should not be underpinned by the idea of an investment which is supposed to be totally safe and secure. Such investments are exceptional in our world, where the future is necessarily unknown. It is much more sensible to base theory on investments which serve a genuine economic purpose – funding the durable assets which make the overall economy more productive. That process is risky and uneven, the opposite of safe and secure.

From this perspective, all bonds look like distinctly non-standard instruments. Even when, like TIPS, their returns are linked to the inflation rate – shockingly rare in practice – their relation to the unavoidable vagaries of the real economy is indirect and asymmetric. There are losses from defaults in unexpectedly bad times, but no gains when GDP or corporate profitability is expanding faster than expected.

The prevailing theory also leads finance professionals, bankers and regulators to treat bonds as the standard investment and welcome governments’ supposedly safe debt as a safe holding for banks and long-term investors. Straight thinking leads to the opposite conclusion. Since well-run governments only borrow during relatively bad times, larger amounts of sovereign debt are signs of higher risk of loss through inflation or default.

Similarly, without the belief in a risk-free rate, investments would not be organised in a rigid hierarchy of riskiness. The supposed ability to compare measure risk against a risk-free base underpins the creation of highly leveraged portfolios. An unexpectedly strong economic wind can easily demolish those financial structures, leaving a heap of losses.

Everyday investors too often expect all bank accounts to be totally safe, a bias which carries political weight. The financial crisis would have been much less debilitating if governments and banks could simply have written down the value of their unaffordable debts and everyone started again. But that was impossible without sowing panic in a population unaccustomed to the idea that all investments are inherently risky.

In other words, the devil finds work for faulty theory. The siren song of safety, like the chimerical lure of quick trading profit, distracts investors from paying attention to the serious business of building a solid economy.

Of course, the risk-free rate is not the ultimate financial villain. It can’t be, since there were crises long before anyone dreamt up the idea. Still, the world cannot be rid of the curse of severe financial crises unless this demon is recognised and eliminated. I look forward to the bonfire of this particular intellectual vanity.


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As I’ve pointed out in several posts, our (the USCA) financial system is indeed modeled by the game Monopoly. As with any game, it has a single winner and all other players are losers. That’s just fine when lives are not at stake. The game is a very long one in comparison to all others. But the results are always the same. This game that we have been playing has been going on to long now. Most of the players have lost and many have left. More are starting to realize that they have lost and will soon leave. The few winners left are beginning to beg the players not to leave so they can finish in their triumph. Our system depends on confidence, and that confidence is rapidly disappearing. We need to start a new game or the consequences will be dire. Many other emerging economies can see this happening and are trying to change the game and/or play a different one. I think the world is bracing for the inevitable end of this game and are trying to prepare. It won’t be long now I fear. I think the final sign or stage will be a significant crash and the talk that the US Dollar is no longer the world currency. It’s already starting to show as more and more deals are being made now in other currencies.

Posted by tmc | Report as abusive

William Blake once prepared a list of ‘wise sayings’ belonging to the Devil. Most were similar to “To make an omlette you must break a few eggs”. I think it is time for an economic equivalent. Off the top of my head:

1) Government bonds are risk free investments.
2) Trading of shares can allow you to beat the market.
3) Regulators protect investors.
4) Compound interest can make you rich.
5) If everyone works hard we can all just live off passive investments.
6) The central banks are independent of the government.
7) Monetary policy is for the greater good.
8) Fiscal policy is fair.
9) The 1% just work harder than you do.
10) Fractional lending works to stimulate the economy.
11) CPI measures inflation.
12) Asset bubbles pop rather than deflate.
Et Cetera, Et Cetera, Et Cetera.

Posted by BidnisMan | Report as abusive

I concur that blame for the 2008 (or was it actually 2006/07?) crash is wide-spread, but the greatest blame lies at the feet of the Federal Reserve (remember Alan Greenspan’s statement about irrational exuberance?) and lax governmental enforcement. As sad as it might be, human nature is to push a limit, and when no limit is imposed, humans will continue to push. No limits led to the sad state of affairs in which we find ourselves. The larger question is why was this allowed to happen? My offering: For at least three reasons, the Bush Administration needed rapid economic growth and assume the attitude of ‘damn the torpedoes, full speed ahead’. 1. To quickly turn the recession of 2000/01; 2. To, in part, finance his wars in Afghanistan and Iraq; wars for which taxes were not raised to finance; 3. lastly, to keep the US population happy during a time of war (i.e., a prospering population, not threatened by its sons and daughters being drafted for war, is very amiable to war). Quite literally, I am a good ‘old country boy who is not considered to be the brightest bulb in the pack. But, it was apparent to me that the supposed economic boom (and why it was allowed progress) would end in a train wreck. To believe that our elected officials and other government officials responsible for monitoring the economy did not see the likelihood of such a wreck is simply naive.

Posted by bald1 | Report as abusive

Edward, you are breath of fresh air for a tired audience.

Perhaps the thinking behind Islamic bonds has a place, with no fixed interest, but everyone sharing the prosperity (or otherwise) of the business.

Posted by GrahamLovell | Report as abusive

“It is much more sensible to base theory on investments which serve a genuine economic purpose – funding the durable assets which make the overall economy more productive.”

Current tax law and financial regulation encourage debt creation based solely on inflating the value of existing assets. Roughly 70% of the debt instruments created by our financial institutes today are based on real estate. This has to change before the investment in new capital formation needed for a more productive economy can occur.

Posted by changeling | Report as abusive

I agree totally with the following comment, if only this was the guiding light for all:

“It is much more sensible to base theory on investments which serve a genuine economic purpose – funding the durable assets which make the overall economy more productive.”

Posted by abnewallo | Report as abusive

> “Beta, or market return, is too often dressed up as alpha, the extra return attributed to an investor’s skill (or luck) picking particular investments.”

My bank balance doesn’t care whether I profit/suffer from Alpha or from Beta. So I’d better understand both, and in some degree it would help if I can separate the two so as to more accurately analyze what’s going on.

Posted by matthewslyman | Report as abusive