Tuesday, September 22, 2009

The Fallacy of the Risk Free Opportunity Cost

In finance the opportunity cost of an investment is often the risk free rate. The rate used is US government treasury bills, or US debt. That is a promise by the US government that if you give them dollars now that they will give you the same amount and some extra at a certain date in the future. It is clear why people may think this is risk less. The government surely will repay you your dollars and interest at that date in the future. Even if the government can't raise the dollars to pay you, it will issue more debt. After in recent history every treasury bill has been paid. Certainly the future will be just like the past and even if the government can't raise the dollars in though taxes or debt it can always print up the difference. This means in any circumstance you will indeed get your dollars back.

Finance Professor Craig Wisen of the University of Alaska Fairbanks taught us a little about scams in his real estate class. There are certain words used that are clear warning signs that something my by wrong. Use of certain words and phrases like "sure deal" and "can't lose" were included in his lessons. The use of the phrase "risk free" is just that, a warning bell all smart investors should be wary of. Considering this is commonly used as the opportunity cost, economist ears should perk too.

The reason the risk free asset is riddled with risk is simple. The future value of the future dollars in uncertain. It doesn't matter that the payment is certain. What can those dollars purchase in the future?

According to USA Today the unfunded liabilities of the USA government is at 59 trillion dollars. http://www.usatoday.com/news/washington/2007-05-28-federal-budget_N.htm If you think thats bad, think again that article was published in the middle of 2007. Thats before any of the Bush stimulus and Obama bail outs. At that time the average US house holds would have had to pay 31,000 dollars per year for 75 years to extinguish the governments liabilities. On top of that lets also not look into US personal debt. The government budget is around 2.6 trillion. http://www.warresisters.org/pages/piechart.htm

Bottom line can an organisation that owes 59 trillion ever pay it off with budget of 2.6 trillion yearly? True we do have a GDP around 14 trillion, or we had before the economic down turn began. One might say thats only about 4.5 times the GDP. Well lets not kid our selfs. This would be like a bank lending you 590,000 dollars when you earn 140,000 dollars yet your discrestionary income in 26,000. You can only afford less than 26,000 dollars a year to service the debt. No rational bank would do such a thing. It is obvious that the US government will default on its liabilities. The person arguing that the asset is risk less will reminded me that the government will simply print up what it can not come up with by issuing debt and with taxation. This is true. I forecast the government printing away the 59 trillion dollars in liabilities. This is defaulting on the debt by monetizing it. This monetization will cause significant monetary and price inflation. The question becomes who wins and who loses.

Losers - Benifeicaries of US Liabilities and US dollar holders
Medicare and Social Security
Military Benefits
Government Employee Benefits
US Dollar Creditors

Winners - Owners of US Liabilities
US Government
US Dollar Debtors

So I ask you Wall Street, is there any risk in a risk free asset? What will your future dollars buy you when your treasury bill matures? What it the future of the US Dollar? How can we trust a financial system that believes in such risk free assets? Fiat currency failures are as certain death and taxes so long as fiat currencies exist. There is no such think as a risk free asset and opportunity cost needs a new ruler in the world of finance.


  1. Jeff Hummel seems to think a default is likely as well


  2. Now that U.S. treasury notes are no longer the 'zero risk' investments they once were thought to be what do you think is secure enough to replace them as the baseline by which we try to measure differences in interest rate risk?