The finance professors at New York University’s Graduate School of Business Administration all had experience on Wall Street, just steps away from our classrooms, when I earned my M.B.A. there in the mid-1980s.
They taught me that the yield on U.S. Treasury bills represented a “risk-free” rate of return. A T-bill’s short term to maturity immunized it from serious loss of value if interest rates happened to rise, they said, while the U.S. government’s vast financial strength made default unthinkable. Thus, the rate the government paid on T-bills was a pure representation of the cost of money in the short term. We could use this rate as a building block to determine the cost of capital for all sorts of purposes, by adding premiums for various types of risk.
I found it difficult to accept that anything could be “risk-free.” I was a journalist in those days, and journalists are naturally sceptical, especially of absolutes. It’s tempting fate to call something the “safest” or “fastest” or “best” of its kind. An “unsinkable” ship sank in 1912. The New York Mets won a World Series in 1969. Anything can happen, and if you wait long enough, it probably will. So it seemed dangerous to assume that anything could be truly risk-free. My teachers may have been wizards on Wall Street, but I suspected they underestimated the world’s ability to surprise us.
Someone on Wall Street finally agrees with me. With its announcement this week that it is adopting a negative outlook for the credit rating of Treasury debt, Standard & Poor’s now acknowledges the risk that my finance professors once called unthinkable: that a time may come when the government of the United States of America fails to pay the interest and principal on its debt in full and on time. In recognition of this possibility, said the S&P analysts, the national credit rating could be reduced from AAA sometime in the next 6 to 24 months.
This does not mean that default is inevitable, or even likely. In all probability, any cut in the federal debt rating will still leave it in the AA range, well within the “investment grade” category. I happen to think a federal default is exceptionally unlikely, because I do not believe there is more than a 1 or 2 per cent chance that the Federal Reserve would let it happen. For all the Fed’s vows that it will never “monetise” the national debt by just printing money to pay it off, I am firmly convinced that if push ever comes to desperate shove, the Fed will do exactly that. It will opt for a period, even a long period, of high inflation over the even more destructive consequences of a national default.
But my professors were wrong; the idea of any debt obligation as “risk-free” has been exposed as a myth. There is no such thing as risk-free in this world. All we have are comparative risks, some larger, some very small, in a set of relationships that constantly change.
Dinosaurs ruled the world, until they didn’t. So did Romans. Chances are good that they once thought of their positions as risk-free, too.