Key Points
- Abandoning the assumption of a positive risk-free rate alters our conceptions of money, monetary policy, and investment risk. Managing volatility, the traditional measure of risk, may now prevent us from achieving our investment objectives.
- Direct money creation—like dropping money from a helicopter—is the widely discussed next step in central bank monetary policy experiments. Such direct money printing raises the long-run risk of inflation.
- Today's fear of deflation has produced a sale on inflation hedges such as commodities, bank loans, high-yield bonds, REITs, and emerging market equities. Investors can protect their portfolios from inflation and improve their expected returns by diversifying into such cheap inflation-hedging asset classes.
The risk-free rate is central to both finance theory and investment practice. Today, however, we are confronted with growing evidence that the real world is so far away from offering a meaningfully positive risk-free rate that much of this finance theory is of doubtful merit. Abandoning our theoretical construct of a risk-free rate importantly changes our understanding of money, monetary policy, investment risk, and most importantly for investors, our optimal portfolio allocations.
Evolving Forms Of Money
Root of all evil? Hardly. Money is the medium by which we trade the goods and services we produce in exchange for the goods and services produced by others. When a farmer wants to exchange a bushel of corn for a gallon of gasoline or I want to exchange an hour of investment advice for the evening's dinner, how is such exchange practical without money?
We also use money as a store of value, facilitating intertemporal exchange. We use money to trade time and effort today for goods and services we plan to consume many years from now in our retirement. A negative real interest rate is similar to a storage cost. This interest expense may be bearable for a period of months but erodes the effectiveness of government currencies, bank deposits, and government bonds denominated in those currencies as long-term stores of value.
Persistent negative real interest rates raise the question of whether other instruments and technologies can perform the functions of money: a unit of account, a medium of exchange, and a store of value. As a unit of account, we now have virtual currencies using blockchain technology beginning to compete with government currency. Nonetheless, for the foreseeable future we must still pay our taxes in the currencies created by the governments that collect those taxes.
As a medium of exchange, we no longer need to use bank notes or funds held in bank deposits. Today we can effectively exchange a bit of our ETF portfolio for a cup of coffee. All that is required is linking a credit card or mobile payment app to a brokerage account with a transaction account sweep feature. Soon this integration of payment processing, custody, and brokerage will become more seamless.
As a store of value, we can hold liquid securities that represent claims on real assets in place of bank deposits. Today's negative real rates incent us to favor real capital, which provides positive long-term real expected returns, as a long-term store of value over cash and government bonds, which currently pay negative real rates.
