De Fault of the Government

Apologies for the bad pun above, but there’s a lot of talk about default, and the uncertainty has made investors sell off short-term Treasuries. From this week’s Wall Street Journal:

Banks are dumping short-term government debt, usually one of the most plain-vanilla investments available, amid fears that Congress and the White House won’t reach an agreement by Thursday to raise the debt ceiling. The stock market, meanwhile, has reacted sharply to every sign of success and failure as talks in Washington grind on. [link]

I read a related post on the Buttonwood blog of the Economist. That’s their finance and economics blog, for those who don’t know.

They write about Treasuries or rather, sovereign debt, and its risk-free status. Why should sovereign debt be risk-free, they ask? Just because a government can print its own money to pay off its debt (in a worst-case scenario) does not make it risk-free.

Given this baleful history, the idea that sovereign debt is “risk-free” is puzzling. When it comes to the purchasing power of an investor’s money, what does it matter if the loss comes in the form of a formal default or erosion in real terms?

The answer to that conundrum may be that default happens suddenly, whereas inflation and depreciation are slower, giving investors more time to adjust by demanding higher interest rates to compensate for their losses. This is particularly true in the case of short-term debt, such as Treasury bills; inflation is unlikely to do serious damage to a portfolio in the course of a few months. [link]

I agree. Treasuries are not truly risk-free. There are tremendous risks associated with any sort of debt, and public debt in particular. However, the concept of the risk-free rate in finance is important. It is, after all, where “it all begins.”

The concept of a risk-free asset is quite useful in finance. For a start, it provides the base from which other assets can be priced. Corporate borrowers pay an interest premium over the risk-free rate; equities have offered a higher long-term return than government bonds to reflect their higher risk. But what is the true risk-free rate? Multinational companies can borrow at a lower rate of interest than some governments: compare Apple with Greece, for example. And although America is the world’s biggest economy, its government does not borrow at the cheapest rate on the planet: Japanese yields have been lower for many years and German long-term yields are now significantly below those of Treasuries.

Where America does have a substantial advantage is that it borrows in the world’s reserve currency—the dollar—and that its debt market is by far the most liquid. The result is that Treasury bills, in particular, play a vital role in the system as cash equivalents and as collateral for short-term loans and derivative contracts.

Treasury bills are seen as risk-free in this context in that they are instantly and universally acceptable to all participants in the system. They are the oil that lubricates the global machinery of finance. That was the real risk of the latest stand-off: not that America would not pay its bills, which it could easily afford to, but that the system would grind to a halt.

The system of course did not grind to a halt. As we saw in 2011, when Standard and Poor’s downgraded US debt, people bought more government bonds. Things have been fairly volatile (to put it mildly) over the last ten years or so, but one thing has stayed the same — in times of uncertainty, people buy Treasuries, either long-term or short-term. It is the liquidity, ubiquity and “dollar-ness” of the Treasuries that makes them risk-free. And these characteristics are unlikely to disappear in a short period of time, mainly because markets need them.


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