A GOVERNMENT with debt denominated in its own currency need never default, or so the theory goes. It can simply print more money to pay off the debt. In practice, however, countries do default on local-currency debt: six have done so in the past 15 years, including Jamaica, Russia and Ecuador. Before this week’s budget deal, markets had feared that America could join the list, if only in a technical sense.


 From the point of view of a creditor, however, the ability of a government to print money is of little comfort if the result is higher inflation (for domestic investors) or currency depreciation (for foreign ones). Investors who bought Treasury bonds in 1946, when yields were around current levels, did not suffer a formal default. But over the following 35 years they lost money in real terms at a rate of 2% a year. The cumulative real loss was 91%. By that standard, Greek creditors, who recently suffered a 50% loss via default, were lucky.


 Given this baleful history, the idea that sovereign debt is “risk-free” is puzzling. When it comes to the purchasing power of an investor’s money, what does it matter if the loss comes in the form of a formal default or erosion in real terms?

The answer to that conundrum may be that default happens suddenly, whereas inflation and depreciation are slower, giving investors more time to adjust by demanding higher interest rates to compensate for their losses. This is particularly true in the case of short-term debt, such as Treasury bills; inflation is unlikely to do serious damage to a portfolio in the course of a few months.

Twenty years ago there was much talk of “bond vigilantes” who would respond to irresponsible fiscal policies by forcing up the interest rates on government debt. With the bond vigilantes on the prowl, any short-term real loss suffered by investors would be recouped in the form of higher real rates as the government’s debt was refinanced.

But by buying bonds in the name of “quantitative easing”, central banks are influencing interest rates of all maturities these days. By holding down bond yields, the authorities are employing a policy some have dubbed “financial repression”, in which real returns on government debt are reduced. The idea is to make investors buy riskier assets, such as equities and corporate bonds. In effect, the bond vigilantes have been neutered.

One way of protecting the real value of investors’ bond holdings is to buy inflation-linked debt. The repayment value and interest payments on such bonds are normally tied to a well-known inflation index. But even these bonds may not be completely risk-free; it is possible to imagine that future governments may find ways to redefine the inflation measure for their own benefit. And foreign buyers of inflation-linked bonds are still at risk from currency depreciation.

Inflation-linked bonds are extremely attractive to pension funds, since they are a neat match for the funds’ liabilities. So such bonds are snapped up quickly and tend to trade on low real yields; sometimes, those yields are even negative. An asset is hardly risk-free if it guarantees a real loss.

The concept of a risk-free asset is quite useful in finance. For a start, it provides the base from which other assets can be priced. Corporate borrowers pay an interest premium over the risk-free rate; equities have offered a higher long-term return than government bonds to reflect their higher risk. But what is the true risk-free rate? Multinational companies can borrow at a lower rate of interest than some governments: compare Apple with Greece, for example. And although America is the world’s biggest economy, its government does not borrow at the cheapest rate on the planet: Japanese yields have been lower for many years and German long-term yields are now significantly below those of Treasuries.

Where America does have a substantial advantage is that it borrows in the world’s reserve currency—the dollar—and that its debt market is by far the most liquid. The result is that Treasury bills, in particular, play a vital role in the system as cash equivalents and as collateral for short-term loans and derivative contracts.

Treasury bills are seen as risk-free in this context in that they are instantly and universally acceptable to all participants in the system. They are the oil that lubricates the global machinery of finance. That was the real risk of the latest stand-off: not that America would not pay its bills, which it could easily afford to, but that the system would grind to a halt.