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Devil’s work

21 Aug 2013 By Edward Hadas

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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