The Risk Free Rate Of Return

The risk free rate of return is the rate of return an investor could earn with “zero risk”. Since the global financial crisis and Asian financial crisis, we’ve been reminded constantly that there is no such thing as “zero risk”.

But the risk free rate of return is useful for comparing the rate of return other assets earn in relation to it. There is no point taking enormous risk to earn a slightly higher return than you could get from government bonds.

The standard global “risk free” rate of return is the 3 month US Treasury bill rate. For New Zealand investors, we could use the 90 Day Bank Bill Rate. As of writing that’s 2.71% on an annualised basis.

That means that if we wanted to lower our private sector risk and rely on the government, and had access to the institutional money markets, we could make 2.71% a year with low “risk”.

The problem with this sort of thinking is that it uses one metric – the “risk free rate of return” – as a decision making tool. The other risks your investment will be exposed to can be ignored.

For example, during the Asian Financial Crisis, many governments defaulted on their sovereign debt. This was in 1997. Attracted by high yields and assuming that governments would always pay their bondholders back, investors piled into markets in Thailand, Malaysia, Indonesia, Korea, Russia, Argentina and Brazil.

Many were heavily burned by forgetting that some countries have completely different attitudes towards debt repayment. Look at Greece – it has survived in the euro zone so far only because hundreds of billions of Euros has been transferred to it by other member countries.

It would have been cheaper for the Eurozone to underwrite Greece’s structural deficits since it entered the Eurozone fraudulently. At least then the true picture of the Eurozone’s complete failure to pursue balanced budgets would have been there for the world to see.

Because the common currency established a central “risk free rate of return” available from the European Central Bank, it effectively subsidised the interest rates payable by poor governments in Greece, Portugal and Spain.

Ratings agencies and investment banks papered over the enormous problems in the European economies to enable continued debt issuance and debt rollovers that failed to address the sick problems in their economies.

Even Germany has enormous external debt to GDP because it has pursued expensive social policies while reforming its economy and lowering labour costs. France has failed to lower labour costs and improve competitiveness, making it an economic zombie doomed to default at some point in the future.

The problem with financial theory is that its proponents will argue that concepts like “risk free rate of return” don’t lead to bigger problems when applied on a global scale. That’s patently false.

If financial theorists didn’t pollute the world with their fake models and theories better suited for the complexity of a village cattle market, groupthink – an entire industry thinking that government debt has little to no risk – would not have occurred on a scale this bad.

Coming back to the risk free rate of return in New Zealand, it is unlikely that New Zealand would default on its debt. But we have no idea about what could happen to New Zealand’s economy over the next decade.

Treasury and Reserve Bank predictions are relied on by the government to conduct “long term budgeting”. All of the predictions are wrong. All of the predictions are arrogant. We would be better off if they came clean and admitted – we can’t predict the state of government finances and when we’ll return to surplus.

As an example of the poor thinking behind these forecasts, cast your mind back to 2008. The National government engaged in “fiscally neutral tax cuts” that cut personal income tax and raised GST simultaneously.

Funnily enough, all that happened was the loss of billions of dollars in tax revenue over the past couple of years. When you add in the cost of the Christchurch earthquake, that’s billions of dollars in extra borrowing the government has taken on.

Forecasts for tax revenue have consistently been revised downwards. That’s because we’re in the stage of a multi-year recession where companies who have been trucking along suddenly default on all of their tax obligations. Even though IRD can be secured creditors, if there’s nothing in the entity they don’t get a dollar.

We need to move away from messy thinking about risk and reward. Using the risk free rate of return is insane in an era where we really have no ability to predict which government will be at risk of default next. The past few years have surely shown us that what finance academics think is clearly not in touch with this thing called “the real world”.

I’d appreciate your comments on this. Do you think that economists and financial “experts” are living in a fantasy world?