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scepticus

Is 0% The Correct Value For The Risk Free Nominal Rate?

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A quick thought to complement the 'here to stay' thread.

Wind back to the 18th or 19th century and the gold standard. Gold is your base money, analogous to central bank base money today. Gold is risk free to the C18/19 holder of it, and it confers a 0% nominal rate. Sure banks will borrow it from you and pay better rates but that isn't risk free (since the deposit is not insured) so the rate you get from keeping the gold in your sweaty palm (0) is the risk free rate.

That was a system that was quite stable for quite some while. In more recent times we seem to have got used to the idea that there can be money for no risk even though such an option was never on the menu before the invention of fiat money. So on the poll I vote for 0% being the natural rate of nominal risk free return. I added some other options.

Lets see how much consensus there is....

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Ha! an interesting thought and one of those simple expressions that's I rate more highly thatn some ridiculously hard math! Maybe I can answer to your satisfaction. There never is actually a risk free rate - for example in a free market if debt was trading at 0% then you can be pretty sure the money is highly likely to be useless soon (so the seller wants out and the buyer wants a punt), or it's such a sweet deal you it goes upp at 200% tomorrow or was all given to some banker instead. Gold is another good example - it's worth a fortune, it's heavy, and it's bloody obvious you've got it. Gold (like all wealth should) has a cost of carry. I like the idea of a balanced credit market and it could go to a nice place (I think) ... but If I were to tell you about it I'd start swearing at the bank of england and be scary.

Don't forget this applies everywhere. Even that banker who has leveraged 4x GDP or everybodies money to bet on two strippers he's paying to have a knife fight is ultimately going to lose his job if they run off with it or draw (of course his boss will take the winner ... and we can only hope it ends like Carmen).

Like most things in economics - take the meanings of the words, turn them around, look at the world like a new-born child that still thinks houses are for living in, and then gaze in bewordment at how it all runs the other way around! That's a modern phenemone but should be f*****g obvious as markets are reactive and the BOE has done the same thing for 30 years.

In summary, the 0% is a relative rate because the participants expect money to be worth less shortly (either to them or to both) to the point it is benefecial. It also makes for a confidence trick due to people's centering on 0 as a win/lose emotional pivot

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I voted for No. 1 since I don't believe there's a natural risk free rate.

The C19th was characterised by a series of depressions, culminating ultimately in the Great Depression. Stable? Not by any commonsense definition of the word.

Commodity money = a barter economy! Monetary economies require single commodity exchanges facilitated through a third agency that specialises in the activity of producing payments and settling accounts i.e. banks. The risk free rate (so-called) is the cost of providing banking services to the market unless artificially suppressed by the currency issuer.

As an aside, the Russian risk free rate (for instance) doesn't appear to be trending to 0.

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I think "risk free" is the problem, there is always risk. Your gold could be stolen. By trying to artificially remove risk, the system is skewed, and there is no longer a natural equilibrium.

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A nominal risk free rate is a rate of return which guarantees return of nominal principal.

It is entirely possible to construct such a thing in a fiat economy by simply blanket guaranteeing all deposits. While we don't quite have such a blanket guarantee (and of course it can always be reneged on by the guarantor), to all intents and purposes it is a sufficiently strong constraint that it makes sense to talk about a nominal risk free rate.

All of which says nothing about the real rate of return - the poll and the question isn't about real rates of return though.

The point is while the current bank rate is not 100% nominal risk free, it is far far far closer to that than the monetary regime was prior to 1930.

And HAM, I think the guiding rate of capitialism you are talking about would not be the risk free rate, it would be the average rate of real return across the economy, would it not?

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I went for due to high inequality but I don't expect inequality to improve for possibly hundreds of years. Wealth gets divided every time the rich have more than one child. With zero yield assets have to be sold to keep up the rich children's standard of living.

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A quick thought to complement the 'here to stay' thread.

Wind back to the 18th or 19th century and the gold standard. Gold is your base money, analogous to central bank base money today. Gold is risk free to the C18/19 holder of it, and it confers a 0% nominal rate. Sure banks will borrow it from you and pay better rates but that isn't risk free (since the deposit is not insured) so the rate you get from keeping the gold in your sweaty palm (0) is the risk free rate.

That was a system that was quite stable for quite some while. In more recent times we seem to have got used to the idea that there can be money for no risk even though such an option was never on the menu before the invention of fiat money. So on the poll I vote for 0% being the natural rate of nominal risk free return. I added some other options.

Lets see how much consensus there is....

When was gold ever risk-free?

I'd consider it particularly high-risk. The lesser risk is that its purchasing power is very volatile. The greater risk is that one becomes a high-value target for crime.

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real returns come from production of things people want.

Investing borrowed pieces of paper in a place that deals in lending pieces of paper in reality offers no return at all.

Sure, you can have your pieces of paper back ( 100% nominal return) that is easy.

But is that really the point of having a means of exchange?...simply trading the means of exchange in the hope you can create a little wealth...sure some players will gain, but they cant possibly unless someone else loses.

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... the rate you get from keeping the gold in your sweaty palm (0) is the risk free rate.

I hear you, but I worry about opportunity cost!

Surely if you are holding that gold there is a risk you are missing out on investment returns?

It is not unthinkable that you'd be better off using your wealth to beget more wealth (spend gold to build a gold mine)?

Somewhere on the spectrum of investments, it would seem you can do rather better than "keeping in sweaty palm" without shouldering significantly more risk. The most obvious is a "nice safe loan" to a Sovereign power which can pay back all its debts by taxing its peasants. This assumes you aren't a peasant.

The main problem here is as follows - if the Sovereign bond is lower risk (inc opportunity cost) than the 0% sweaty palm, why does it pay a higher interest rate?

I need more coffee.

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real returns come from production of things people want.

real returns come from production of things people want.

...

But is that really the point of having a means of exchange?...simply trading the means of exchange in the hope you can create a little wealth...sure some players will gain, but they cant possibly unless someone else loses.

I strongly agree with this, and think economists regularly pull the wool over their own eyes by working in "pounds and dollars"... it's like using one uncalibrated ruler to measure another!

It is very hard to abstract debt and money away from real economic activity of productivity (the bolting together, digging, facilitating, thinking, drawing, smelting, imagining, shipping, etc).. but when you do then they become even more weird than ever!

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I voted for No. 1 since I don't believe there's a natural risk free rate.

The C19th was characterised by a series of depressions, culminating ultimately in the Great Depression. Stable? Not by any commonsense definition of the word.

I find myself in the unusual situation of agreeing with you.

Further since no 2 periods can ever be compared, its moot.

(edit to point out we dont even have "zirp" we have a +ve rate in some countries and a -ve rate in others across a rather wide spectrum)

Edited by R K

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I find myself in the unusual situation of agreeing with you.

Further since no 2 periods can ever be compared, its moot.

(edit to point out we dont even have "zirp" we have a +ve rate in some countries and a -ve rate in others across a rather wide spectrum)

Of course two periods can be compared - Piketty has done it.

Any two periods can be compared on any number of metrics. The risk free rate is only one and also on this metric periods can be compared, as I have showed.

As for contrariness, all I will say is that if rates are raised and velocity of base money doesn't also rise thereafter then rates will be coming right down again quick smart.

The only hope for the rising rates camp is a 2003-2006 scenario where a rise is rates is followed by a rise in inflation and rising house prices followed by a rise in rates then rinse and repeat. You have to believe animal spirits can be roused to take risk by a base rate hike which then feeds on itself to see future rates at 2%!

But even then the illusion must lead to a subsequent bust.

The degree to which sensible people still believe that CBs can drive the bank rate over anything but a matter of weeks continues to disappoint me.

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Of course two periods can be compared - Piketty has done it.

Any two periods can be compared on any number of metrics. The risk free rate is only one and also on this metric periods can be compared, as I have showed.

As for contrariness, all I will say is that if rates are raised and velocity of base money doesn't also rise thereafter then rates will be coming right down again quick smart.

The only hope for the rising rates camp is a 2003-2006 scenario where a rise is rates is followed by a rise in inflation and rising house prices followed by a rise in rates then rinse and repeat. You have to believe animal spirits can be roused to take risk by a base rate hike which then feeds on itself to see future rates at 2%!

But even then the illusion must lead to a subsequent bust.

The degree to which sensible people still believe that CBs can drive the bank rate over anything but a matter of weeks continues to disappoint me.

So the burning question is how did you vote?

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I don't think that there is ever a "risk free rate". Physical assets carry the risk of theft; even sovereign bonds carry the risk of default.

The nearest thing to a risk free rate must be the "safest" sovereign bond.

I answered with option six. The reason rates are so low is that the weight of savings is so high that it has engulfed the number of productive uses it can be put to in the economy. On top of this QE has bid down the yields on sovereign bonds and investment grade corporate debt by buying it up with "newly minted" CB money.

My gut feel is that the underlying cause of this savings glut is two fold:

1. The increasing age of the population in the developed world who are seeking to live off accumulated savings and hence seeking a yield from these savings. These savers are likely to be "target savers" meaning that as interest rates fall their propensity to save rises as they try maintain a "target" income level and hence need to retain more capital.

2. Globalisation. Businesses in the developed world that require significant capital (eg. manufacturing) are reluctant to take on debt given that they cannot, with any certainty, predict that they will be able to compete with overseas producers in the medium term. Hence they do not want to leverage uncertain future cashflows. Meanwhile in the emerging economies the newly created middle class can still recall what it was like to be poor and is hence saving heavily. The lack of euroean style welfare provision compounds this desire to "save for a rainy day". This saving has overwhelmed even their economies stock of investment opportunities as companies face reduced demand in export markets (for the reasons set out in 1 above) which is not being compensated for by increased demand at home.

This analysis leads me to the conclusion that increasing interest rates would actually result in an improvement in worldwide demand. This can't be right so I'm fully expecting to be shot down. :ph34r:

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I don't think that there is ever a "risk free rate". Physical assets carry the risk of theft; even sovereign bonds carry the risk of default.

The nearest thing to a risk free rate must be the "safest" sovereign bond.

I answered with option six. The reason rates are so low is that the weight of savings is so high that it has engulfed the number of productive uses it can be put to in the economy. On top of this QE has bid down the yields on sovereign bonds and investment grade corporate debt by buying it up with "newly minted" CB money.

My gut feel is that the underlying cause of this savings glut is two fold:

1. The increasing age of the population in the developed world who are seeking to live off accumulated savings and hence seeking a yield from these savings. These savers are likely to be "target savers" meaning that as interest rates fall their propensity to save rises as they try maintain a "target" income level and hence need to retain more capital.

2. Globalisation. Businesses in the developed world that require significant capital (eg. manufacturing) are reluctant to take on debt given that they cannot, with any certainty, predict that they will be able to compete with overseas producers in the medium term. Hence they do not want to leverage uncertain future cashflows. Meanwhile in the emerging economies the newly created middle class can still recall what it was like to be poor and is hence saving heavily. The lack of euroean style welfare provision compounds this desire to "save for a rainy day". This saving has overwhelmed even their economies stock of investment opportunities as companies face reduced demand in export markets (for the reasons set out in 1 above) which is not being compensated for by increased demand at home.

This analysis leads me to the conclusion that increasing interest rates would actually result in an improvement in worldwide demand. This can't be right so I'm fully expecting to be shot down. :ph34r:

I think inequality is the main driver for low rates. If I want to pay back a loan there are two places I can get my money from.

1) a saver spending his savings

2) some one taking out new debt and spending

The rich savers haven't been spending for years. Debt repayment has been totally dependent on new borrowers borrowing more and more money and spending it into the economy.

This worked fine until the world woke up to what was going on realized it wasn't sustainable and there was a credit crunch.

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it's only 0%because the tax take on everything else has gone through the roof.

not rocket science.

it's artificial.

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Interesting spread of views here. No general consensus even on HPC about the actual cause of ZIRP.

If policy makers are equally diverse in their views one can see why they have a difficult task!

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Interesting spread of views here. No general consensus even on HPC about the actual cause of ZIRP.

If policy makers are equally diverse in their views one can see why they have a difficult task!

well,the rates are set by CBs...thats the cause.

They do it buy setting a rate they pay, and they keep the market controlled by buying everything in sight.

Thats the cause.

I think the reason they do it is what you are seeking.

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I have changed my vote because I hadn't seen the option above. I think it is permanent because of wealth inequality. All the debt is held with one group of people all the money is held by another. with the rich not spending the debt can't be serviced and the banks end up bust.

Still interested in your take.

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And conversely, if they raised the taxes on the rich as in the post war years, inequality could be reduced and the national debt paid down.....all these factors reducing the supply of savings which would start to cause rates to come back.

I don't think it is necessary to tax the rich. Just print money to the tune of the money you would have tax them and spend it into the economy as if you had.

I remember a mission impossible show where there was a camera pointing at the gold they took a picture of the gold and stuck it in front of the camera so they wouldn't know that the gold was missing.

As long as the rich can still see their money when they log on to their bank account they will be happy and they aren't spending it anyway so what is the problem.

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I don't think it is necessary to tax the rich. Just print money to the tune of the money you would have tax them and spend it into the economy as if you had.

I don't agree. If the rich own the capital then the newly printed money spent by the helicopter recipients ends up back in the hands of the rich. Its a road to nowhere, and its essentially what we have been doing for 40 years already. The fiscal deficit is basically money printing in all but name, and to what extent has it reduced inequality?

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I agree with this.

Cheers, I thought you would. Ultimately to reduce inequality what is needed is the re-distribution of non-financial capital. I can only forsee this happening via deflation, coupled with a monetary regime that avoids positive real rates. That kind of general market-led deflation with gentle negative short rates is the most powerful rebalancing process I can envisage.

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I don't agree. If the rich own the capital then the newly printed money spent by the helicopter recipients ends up back in the hands of the rich. Its a road to nowhere, and its essentially what we have been doing for 40 years already. The fiscal deficit is basically money printing in all but name, and to what extent has it reduced inequality?

OK then say I had £20,000 in the bank which I could spend on buying a car. Buying the car would stimulate the economy.

If I don't buy a car what is wrong with the Government spending £20,000 on fixing pot holes which would also stimulate the economy?

If later I do decide to buy the car surely that is the time to bring in austerity.

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