Most who have studied basic courses in economics or finance are familiar with the concept of the “Capital Market Line,” which attempts to show the theoretical relationship between expected rates of return and risk. Look at the graph shown below, where risk is measured on the horizontal axis and expected return on the vertical scale. Risky securities are those whose returns display greater variation about their averages over time, formally measured as the standard deviation of returns. In the graph, point B represents a riskier investment in comparison to security A. The greater the standard deviation, or risk, the greater should be the expected rate of return.
We have no argument with this appealing intuitive concept—higher risk is commensurate with a higher reward or expected rate of return. Rather our argument is with the idea that the left end of this line is, or should be, anchored by the short-term rate of return (represented by RFR, for risk-free rate) to cash or very short maturity assets (e.g. Treasury bills). Really?
Let’s think about that proposition for a moment. What is “low risk” about fiat cash, or for that matter a Treasury bill? The money supply is abused by greedy or desperate central banks trying to impose an inflation tax upon the private sector or seeking to monetize previously issued government debt. In fact, inflationary financing is the covert means, denied to the rest of us, by which a government can actually default on its real debt obligations. Even were that not the case, the supply of fiat money is also subject to the lending vagaries of private banks as they seek to maximize profits and make loans with “excess reserves.” The double “ponzi” scheme of both these processes makes the “return” to holding cash very uncertain. With its value at risk, fiat currency even held over the short term cannot be viewed as a “risk-free” asset. Nor can Treasury bills, whose return is paid in a fixed quantity of fiat currency. Moreover, the rate of return to cash and cash equivalents is typically vigorously manipulated by the policy of the Central bank. Consider the recent period when the nominal yield on T-bills is close to zero and the real return is negative. It makes no sense to believe these rates are market determined, as rational investors should not enthusiastically choose to lock in negative real rates of return. How investing in a T-bill earning a negative real rate of return could be viewed as “risk-free” is beyond us. Bob Rathbone, a Boise area financial advisor, aptly refers to the investment in such as the “paradox of security.” The “paradox” is that, seeking security, investors are willing to accept a guaranteed loss after the effects of taxes and inflation are accounted for. What is risk free about that? Perhaps we should ask those who have lived through a hyper-inflation or the recent Russian fiat money meltdown, or even a vigorous and variable period of inflation such as the 1970’s in the U.S., if they think the holding of money or Treasury debt was risk free.
The sad truth is that there is no “risk-free” asset class. At rock bottom, there is a base level of uncertainty that is an inescapable characteristic of the natural world. Sadly, men and their institutions have often added mightily to this. One might be tempted to think of a particular commodity, such as a precious metal, as a good candidate to be called a “risk-free” investment. The problem is that the price of any single asset can vary due to market conditions—as holders of individual commodities over a period of time can testify. Worse, outside of speculative price movements, holders of commodities typically derive no rate of return. This gives their holders a tremendous disadvantage over time relative to real income-producing assets. If there is no “risk-free” rate of return, what is an appropriate standard rate of return to which all others can appropriately be compared? In Capital as Money, our suggestion for a yardstick is the broad rate of return to productive capital.
In a capital-as-money economy, the benchmark return would be that of a tradeable share of a broad index of capital. Such an asset could be used as a store of value, a medium of exchange, and the good in which all other goods are conveniently priced. Because it is a real asset, sustained inflation, typical of fiat money economies, would be logically eliminated. With appropriate capital-deepening (see Capital as Money), there is good reason to suppose that the real rate of return to broad productive capital would converge to the long-term average growth rate of the economy (of course the real and nominal rate of return would be same in the absence of fiat money and, therefore, inflation). This return would be available to all simply by holding index shares of the capital market or “money balances.” Would higher rates of return be available? Of course, on those assets whose risk was perceived to be greater.
It is to the broad, sustained rate of return to productive capital that other available rates ought to be logically compared. Isn’t the real rate of return to the broad capital market, itself, highly variable and uncertain? We would argue that much of that variability is due to the marginal product of capital being viewed and valued in a fiat-money world. Fiat money shocks, in turn generating shocks in interest rates, inflation, employment, credit and output, are the prime cause of short-term variability of the rate of return to broad capital. Remove the central bank, fiat currency and the fractional-reserve banking system and you might be surprised at how stable the average marginal product of capital (which is also capital’s return) really is. What about government bonds? It might not be attractive in a capital-as-money economy for a government to engage too strenuously in bond-financing. First, it would have to pay bond holders a rate of return that would compare favorably to the average rate of return to capital in order to encourage investors to buy its bonds. Second, principal and interest payments would have to paid in terms of units of real productive capital, which is “money.” Third, there would be no convenient fiat-money escape hatch to allow for covert stealing and devaluation of government debt. Politicians would be brought back to the hard reality of real tax financing of government expenditure, unpopular to the public, but politically more honest because it makes all of us aware of the ratio of government spending to real GDP (that is, of what the government is really expropriating from its citizens).