GMAN 507 Bonus Assignment: The Market Risk Premium

Today, on the economics blog Marginal Revolution, economist Tyler Cowen wrote the following (the bold-face was added by me):

It is often claimed that the governments of the United States, the UK, and Germany should spend more money because they can borrow at low rates, thus raising the present expected return on the investment considered as a whole.

Maybe, but keep in mind that the interest rates on quality government debt are down, in part, because the risk premium is up. Non-governmental investments are perceived as riskier.It is also possible that governmental outputs are perceived as riskier, as those outputs will be evaluated by consumers.  Note that Kenneth Arrow’s “the government can spread around the financial risk” point does not eliminate this more fundamental risk, namely the risk associated with the quality of government output, just as there is a risk associated with the quality of private sector output.  Michael Jensen made this point in 1972.

You might think the government investments are “low hanging fruit” in terms of quality.  Maybe yes, maybe no, but the low real interest rate doesn’t signal that, rather it signals merely that people expect to be repaid.

In this argument for more government investment, the notion of government investments as low hanging fruit is doing a lot of the work. [link]

Based on what we discussed our last two classes (on Saturday, and on Monday), and your understanding of bonds, interest rates and bond prices, comment on the above.

Be Sociable, Share!

If you enjoyed this post, make sure you subscribe to my RSS feed! You can also follow me on Twitter here.

25 comments for “GMAN 507 Bonus Assignment: The Market Risk Premium

  1. Lisa
    May 31, 2012 at 3:10 pm

    Governments that are already have a U.S. National Debt of $15.7Trillion (http://www.usdebtclock.org) should borrow more because interest rates are low? If they never pay it back, how can it raise the expected return?

    -Lisa, GMAN507

  2. Maureen
    May 31, 2012 at 4:45 pm

    I agree with Lisa. During times of economic turmoil, investors will turn to “risk-free” instruments to ride out the storm. Since corporate bonds are considered far more risky, the T-Bill yields then move to abnormally low yields. Investors assume the US Government has no credit or default risk. That will not be true if the government continues to spend (fueled by the low cost of money) and when their investment targets are not economically productive. We will have a heavily indebted government with potential for insolvency. Hardly a risk free instrument.

  3. Todd Burger
    May 31, 2012 at 5:36 pm

    I’m with Lisa – the safe harbor of bonds, while better than a negative return – are not helping to fix the issues governments face.

    If you review the last 50 years of rates it’s clear we are on the downside of the bell curve (http://www.forecast-chart.com/interest-treasury-10.html) Let have honest, and clear changes in policy and before rates start to rise and not longer support investment in the public sector.

  4. May 31, 2012 at 9:13 pm

    But where does the equity risk premium figure in all of this? And what about its application to government output?

  5. Nomi
    June 1, 2012 at 2:08 pm

    I think that government Bonds are not risk-free, there is risk with them, its the “fake” perception of the world that UK, USA, and Germany will pay them in case they are in high-debt, no solvency, public sectors, and the public itself going broke. Like we saw in 2008 and 2009 the government has the ability to borrow at low rates, bring solvency and create consumer lending with infusing banks with trillions in cash. The reality is no-one can keep borrowing forever, to payoff “old debt.” I think the government should borrow when necessary in times of crisis, but always look to lower the debt whenever possible. Going further into debt and building trust that “one” will pay you back?? I think that’s a bad part on any investor or nation whom is lending. Yes, USA has a AAA rating, but its because they were able to refinance and prolong the debt, reality wise as other nations continue to grow, “economically and militarily” they will be less reluctant to let any “competitor country” borrow at less interest rate. Which brings the question whether China is planning to use the massive debt against us in the future??

  6. Matt
    June 2, 2012 at 9:59 am

    With the recent poor Jobless number report (most important economic number to me) being a drag on the stock market and consumer confidence. As the market risk premium increases investors tend to look for safe places to park their money (T-Bonds).
    The US, UK and German governments are still viewed as the safest places to park money (Germany has been a safe haven in the EU). In terms of international investment these 3 governments can attract investment at very low rates right now.
    So, Why would the fed want to buy US bonds – because it wants to increase the price of bonds and lower interest rates thus increasing the money supply and hopefully increasing economic investment. When interest rates are low the public should in general be more entrepreneurial and productive thus boosting the economy, job market and consumer confidence.

  7. Susan
    June 2, 2012 at 11:07 am

    After hearing about all of the layoffs to happen at HP and other companies, I think the public still perceives these investments as risky. Consumer confidence is still low. As we have learned, everything has a risk and the majority of us are risk averse. There needs to be a significant additional return over the “risk free” rate to entice the average investor to invest in the market portfolio.

  8. Norton
    June 2, 2012 at 1:46 pm

    Much like my peers before me, I’m not convinced that increasing government spend today would be a wise choice. I think there have been several example before where increased borrowing due to low rates didn’t positively affect government outputs (Greece?). In fact it only drove up the debt and further exasperated the situation. I think there are many other things to consider before increasing spending (start with the rate of return).

    The equity risk premium today is high because of the disparity between the volatile private market and the low government bonds.

  9. Lisa
    June 2, 2012 at 2:00 pm

    Equity risk premium is the extra return (+/-) that investors collect/give for taking that risk by investing their money into stocks. It is a part of the market risk premium that pertains to stock equity. Normally, the equity risk premium of a stock is higher (higher risk but higher return) than the market risk premium of a bond or t-bill (less risk but lower return). If governments borrow more money because the rates are low, it will have an effect on the market risk premium; which has a greater effect on the overall population rather than the government alone (“government can spread around the financial risk”). Will the future hold a time where market risk premiums of bonds, t-bills, etc will be HIGHER than equity risk premiums of stocks– leading to lower payouts for stock?

  10. Dorothy Golubski
    June 3, 2012 at 11:59 am

    I’m in agreement with all points that the government should not borrow more just because interest rate are low. There really is no “low-hanging fruit” investments that is risk-free, as per Nomi’s point.

    This will clearly introduce additional default risk to government bonds, potentially lowering the government rating again and decreasing its value. The U.S. government rating was already downgraded from AAA to AA last year by S&P. Also, if you look at what happened in the market on Friday with stock returns dropping, S&P falling and T-Bills dropping to an all-time low, there is a clear message that the global financial markets are unstable and investors are extremely risk adverse. Further increase in spending & debt will only exacerbate the already fragile markets. With the news on Friday that “U.S. 10-year yields fall to record low under 1.50%”, this means that the Risk Free Rate has fallen and thus Market and Stock required rates of return will also fall.

    To Lisa’s last point, it seems that Greece is already in the situation where their government bonds are potentially higher risk than equity risk premiums. Let’s certainly not allow the U.S. Government to get to this situation and instead drive up our GDP, export market and more wisely spend tax revenues.

  11. Neetu
    June 3, 2012 at 9:27 pm

    Plenty of analysts gasp at such ideas that each time the US government creates another Treasury bond it adds a value to the world economy or piling new debt on debt can possibly speed the recovery. Many other interest rates in the U.S. are connected to the 10-year yield. So a low-yield Treasury can mean businesses are enticed to borrow money, meaning that they will have more money to spend and, hopefully, create jobs and stimulate the larger economy. Likewise, it makes for low-cost mortgage borrowing, which may help nudge prospective buyers into a sluggish housing market. But above all, it means low-cost government borrowing, meaning that the government is paying small amounts of interest on recently issued debt. This may boost the economy but it could encourage the government to act irresponsibly. With such cheap borrowing, some say the bond market is encouraging the U.S. government to borrow more and more money.
    The US 30 year bond yields closed near the lowest since December as the Fed purchased $1.8 billion of longer term Treasuries. Treasury 10-year note yields traded at almost record lows in Germany which has worsened the European debt crisis. Although treasury bonds are seen as safe alternatives to risky investments, but low treasury yield means that people foresee little inflation and higher market risk premium. Once people decide that US and German bonds are not such a great store of value, “the rush to find parking spots in a very small car-park will be on”, as mentioned in Adrian Ash’s article of May 31, 2012.
    “The bond market is not imposing discipline on us as borrowers,” says Kim Schoenholtz, professor of management practice at NYU’s Stern School of Business. “Often countries are compelled to [consolidate] when markets charge them a risk premium. For the moment markets are not charging the U.S. a risk premium.”

  12. Vicki Stokes
    June 4, 2012 at 11:07 am

    As was mentioned, the lower rate on government debt is due to the higher risk premium. With failing government economies seen globally, consumers should reconsider where government bonds fit within their portfolio. They’re not so risk-free as we assumed. The market risks due to unemployment and the recession has also contributed to the lower interest rates. In the US, in spite of growths within some business sectors, consumers are not spending because of the uncertainty in the job market. This has been considered a reason for the prolonged recession. In spite of the tax reductions for businesses, hiring levels have not increased significantly. In addition, the argument that lowered taxes on the wealthy will create jobs has not come to fruition. Evidently, consumer spending effects on job creation has not been factored into this faulty hypothesis. Therefore the ability of the governments to pay back these debts will only increase the risk. Savvy investors will steer clear of governments that continue to grow their debt within a global recessionary period, leading to an increase in the price for their bonds. This higher cost to the investor may lead them to consider purchasing debts of countries with lower debt and healthier economies leading to higher interest rates and lower bond prices.

  13. Sharice Tippens
    June 4, 2012 at 11:34 am

    I believe the government is acting irresponsibly by continuing to borrow at Low rates. The equity premium allows investors to gain high returns for the risk associated with the stock market and clearly this is needed to stimulate the stock market. However, when I look at the big picture I question the vision of our nations leaders because we the people are required to pay off the nations debt through taxes. I shutter at the thought of my children, grandchildren, and possibly great grandchildren trying to clean up the “sins of the father.” Although interest rates are low what happens when we can no longer lower the rates; is another QE required, which solves a short term solution and creates a long term problem.

  14. Cordia
    June 4, 2012 at 12:30 pm

    It appears that Tyler Cowen was trying to point out that investors are not analyzing government output when assessing government debt as a safe-haven. With the downturn in the market, I would think that stocks would be more affordable, and with high ERP, arguably more profitable in the long run. It leads me to believe that it’s in the markets best interest to keep bond prices as low as possible. However, government output has slowed tremendously – even “powerhouse” China slipped below double digit GDP growth. In that respect, shouldn’t hesitant investors analyze the strength of the government’s output before blindly stashing cash there? I’m under the opinion that calling government bonds “risk free” is going the way of the dodo bird. Also, this would lead me to believe that even the ERP is overstated. Here’s a good article I found from my favorite airplane periodical, the Economist:
    http://www.economist.com/node/21550273

  15. Christie
    June 4, 2012 at 2:43 pm

    For so long the opinion was that governments must spend more to grow the economy, and this worked. As many in the cohort have pointed out, the instability of our government’s finances right now make this philosophy more risky. Those risk-free bonds will become increasingly risky to investors as the risk-free premium increases. The result could be that investors either hold their money or the opposite, they choose to focus on stocks since inherent risk of stocks is expected. The nominal risky interest rate on bonds does not include a default risk premium or a liquidity risk premium . . .yet. Might investors require those safety measures if government bonds become risky?

  16. Michael Cann
    June 4, 2012 at 4:13 pm

    I agree that the government should not borrow more just because of the “low Hanging Fruit.” If the US and other similar governments continue to borrow, where will it end? The national debt continues to rise and almost seems like an unobtainable payback goal at this point. So they think… why not borrow more?! I agree with Cordia that the government is going the way of the dodo bird, and is not learning from any of their past mistakes. No risk investments?? they don’t exist. With the government just making its way out of a recession, is it best to plunge back into debt? and even more so, Is the US out of trouble yet? So why would it be a prudent investment to spend more money?… Just because its cheap?

  17. Vicki K
    June 4, 2012 at 5:53 pm

    There’s no such thing as free lunch, hence there’s no such thing as a true risk-free security anywhere in the world. Everything has risk intrinsically built into the system, so opportunity costs and tradeoffs need to be taken into serious account. As our national debt has gone up to an unimaginable number, it would not be wise for the government to continuing borrowing or spending. Despite the low rate, the risk is still very high. ‘Buy what you can afford ’ should be considered at this point in time. Also, from Cordia’s link, it is a good time to save more.

  18. Alejandro Herrera
    June 4, 2012 at 6:42 pm

    Our government pays debt with debt. Right now interest rates to borrow for our government is low, but as with credit cards……once our government becomes a risk, risk premiums will climb and our credit ratings will be lowered. We will not be able to borrow money when we really need it. There is such a thing as good debt when it has a positive benefit. Bad debt is borrowing to prolong dealing with our true issues.

  19. William Hall
    June 7, 2012 at 5:40 pm

    I do believe that the Government has gone to the till too many times. Our National debt is 15.7 trillion. It has an annual coupon payment of almost 400 million per year. However, I understand why we keep borrowing. The argument for borrowing is the money is cheap and it can prop up an ailing Economy. As the Economy grows and becomes healthy interest rates will go up and bonds will be less attractive. At this point people will start investing else where, getting higher returns, paying more taxes and increasing the GDP. All of this in turn should eliminate the need for the Government to continue issuing bonds. I think we experienced this during the years that Clinton was President.

  20. Molly O'Kane
    June 8, 2012 at 10:45 am

    Investors need a vehicle to combat inflation and many use a combination of high risk (start ups, stocks, ect.) and low risk government bonds to increase their return on investment. The government debt is already getting to a point where the bond ratings are decreasing, signalling to investors an increase in risk. With this change, investors may chose to decrease investments in other high risk investments, thus decreasing the flow of cash into the economy, to bring their portfolio risk back into a level where they are comfortable. This would be an opposite effect to what the government is trying to accomplish with borrowing at low interest rates. With a stall in FCF in the economy it will have a trickle down effect. Like many have mentioned above, with jobs, company spending, and consumer confidence.

  21. Molly O'Kane
    June 8, 2012 at 10:49 am

    One other thing to consider is many invest in government bonds due to the liquity, because of the preceived low risk there are many investors still interested in investing, which means that investors perceive they can sell at any time and get their money back out. However, once investor confidence decreases and bonds are not traded as frequently, many may ask the government to buy the bonds back. This is where the trouble will begin. If the government can’t meet its obligation.

  22. Shari
    October 8, 2013 at 11:01 am

    “The true cost to the economy of government is
    the expenditures it makes, not the taxes it collects.
    Government can either collect taxes today or issue
    promises (currency or bonds) to pay for its purchases
    in the future. When the government increases the
    money supply, it can cause inflation, and if it issues
    bonds, it can “crowd out” the private sector.”

    An excerpt from an article published by Global Financial Data-where they offer 4 ways the US can address gov’t debt.Here’s the link: https://www.globalfinancialdata.com/News/Articles/Government_Debt.pdf

  23. Bill Holsey
    October 18, 2013 at 6:41 pm

    The statement in the blog appears to be from a Keynesian point of view which advocates increased government spending (which is typically done through borrowing) to help increase aggregate demand and grow the economy. However, is it really worth increasing the federal deficit to help stimulate the economy through a never ending cycle of selling more government bonds?

    Congress seems to have the view that it is permissible to continuously raise the debt ceiling, thus perpetually passing the US debt on to our children/grandchildren.

    Is borrowing/spending by the US government really the answer to prosperity? For the first time in history, an increase in the debt ceiling and political brinksmanship caused a downgrade to the US Government credit rating from AAA to AA+ on August 5, 2011. Due to higher risk, interest rates on US Treasury bonds have fallen making them less attractive to investors. Of course, there is no “risk-free” investment. Eventually when the US Government credit rating returns back to AAA, bond prices will rise again. Investors risk that their initial investment will be worth less than when the bond was originally purchased.

    So, what is the long term effect on the economy? When does the government begin to put less emphasis on borrowing? Perhaps a better alternative is to develop more programs and offer additional tax incentives to entrepreneurs and small businesses for a sustained growth of our economy. This would include an expansion into thriving new industries (such as solar, biotechnology, wind, geothermal, electric cars) and the upgrade of our outdated infrastructure (including our roads and bridges).

  24. October 18, 2013 at 7:06 pm

    These are good points, Bill. I suggest though, that you revisit the post once we discuss the concept of the market risk premium in class. I look forward to your comments then.

  25. Bill Holsey
    December 13, 2013 at 10:46 pm

    The risk premium is defined as the expected return over the risk free rate. Lower interest rates have enticed the government to continue borrowing. However, this is not sustainable for the long term health of the economy because it puts the national credit rating at risk and grows the deficit. The article suggests that we should examine the “quality of the government output”. There is a substantial amount of waste in government spending. Federal spending was $3.5 T for 2012 with estimates of up to 10% used on unproductive or unnecessary programs (www.heritage.org). One could say that the quality of output of the federal government is unacceptable. As the article suggests, “people expect to be repaid”. This implies that Americans expect their government to spend and invest wisely with minimal waste and maximum benefit to the country. One could argue that the risk premium will never really be low because Americans expect a lot from their government. Over the years, personal income tax rates have steadily increased. Yet in many instances, Americans are not pleased with how efficiently our government is run.

Leave a Reply