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.