There's No Such Thing as a Risk-Free Lunch

In times of global turbulence, like today, investors flee to safety, looking for "risk-free" assets in which to park their money. That usually means US government debt or the bonds of large, developed European nations. The AAA rating of this debt is supposed to reflect its status as a "risk-free" asset. In fact, our whole banking system is based on holding this kind of AAA debt as reserves, as the risk-free bedrock that supports the ability of banks and investors to lend.

But with the US flirting with default and Europe struggling to keep its monetary union from blowing up, investors are beginning to wonder: where do they turn to find a risk-free asset now?

We may be about to pay a big price for indulging in the illusion that government debt is risk-free. Remember the old free-marketers' slogan about how there's no such thing as a free lunch. When the government gives you anything, somebody always has to pay for it, somehow. Usually, we all end up paying in the end.

The same thing applies to AAA debt: there's no such thing as a risk-free lunch. There are growing signs that Western governments have abused their power to issue AAA debt. The illusion of a risk-free haven is about to come crashing down, and we will all pay for it.

Recently, Daniel Indiviglio pointed out the vast expansion of AAA debt in recent years.

If demand for an asset ballooned by 300% in a decade, then you might smell a bubble. This describes the rise of AAA-rated debt. In 1999, about $1.5 trillion AAA-rated securities were issued globally. In 2009, AAA-rated issuance peaked at over $6 trillion. Are we in bubble territory?

In fact, we've already had one AAA debt bubble. Fannie Mae and Freddie Mac, the big government-sponsored mortgage lenders, used their implicit government guarantee to ride off of the federal government's AAA rating and flood the housing industry with cheap, "risk-free" money. And we all know how that ended.

The big picture is that our political leaders found themselves with the ability to raise large sums of money at minimal interest rates by relying on America's AAA status. So they abused this power, using it to raise unlimited funds for any and every goal they thought was desirable. Want to encourage homeownership? Create a whole lot of AAA mortgage debt. Want to engage in pork-barrel "stimulus" spending? Want to bail out big auto companies? Want to prop up spendthrift state governments and public employees' unions? Create a whole lot more AAA debt.

This has been the whole policy of the Obama administration and congressional Democrats. Their agenda depends on the assumption that they can just float the whole thing on a bottomless sea of AAA debt.

The Europeans did the same thing, and the eurozone will likely go down in economic history as a giant mechanism for exploiting the AAA rating of the big Western European economies (read: Germany) in order to float the generous welfare states of Southern Europe.

The premise propping up all of this AAA debt is that the US and the other big Western governments will always be good for their debt because they have the power to tax. Here is where the markets have accepted the basic premise that leads to the abuse of AAA debt in the first place: the view that force and coercion are practical, that the government can just wave its guns around and get whatever it wants. Want to provide affordable health care to everyone? Just pass a law. Want to bail out collapsing financial institutions? Just have the Fed print a lot of money. Want to service a rapidly growing debt? Just raise taxes. Have gun, will borrow.

But a gun is not a magic wand that produces wealth. Quite the opposite, the more force a government uses, the less wealth there is to seize. Greece is the end of that line. They have reached the point where they can't tax their way out of debt.

And Greece offers a warning about how excessive debt can spiral out of control. What is sinking Greece and the other PIIGS is not just the problem of servicing their existing debt. It is the prospect of having to roll over that debt at much higher interest rates. Bonds issued at artificially low interest rates a few years ago start coming due, and since there isn't enough cash to pay them down, they have to be refinanced at interest rates which, for Greece, are now in excess of 30%—and that's on short-term debt.

This crisis is already hitting Europe, yet we're not even thinking about it here. For America, the immediate prospect is not that interest rates on our debt will rise to 30%, but that they could rise to 5%. Currently, the federal government makes annual interest payments of about $200 billion on a total debt held by the public of about $9.5 trillion. (The other $4.5 trillion in debt is money the federal government owes to itself, by way of such financial fictions as the Social Security Trust Fund.) That's an average interest rate of about 2%. A return to historically normal rates of interest would produce a dramatic increase in the cost of all of the new borrowing we're doing and all of the debt that we have to roll over.

The danger, as one observer puts it, is that we will face "a sudden and massive re-pricing of Western sovereign risk." In other words, we will finally have to pay for our risk-free lunch. The only question is why this hasn't happened yet. The usual speculation is that US rates persist at low levels because investors looking for a safe place to put their money have nowhere else to go. But a lot of people are already figuring out that the developing world currently has more vibrant economies and lower debt ratios.

The US is still a long way from becoming Greece, but avoiding the risk of a debt spiral will require a swift reversal of course and the realization that America's AAA rating actually needs to be maintained through cautious fiscal management. We need to end our dependency on growing and unlimited quantities of AAA debt.

Or at least we need the president to stand up and admit, "My name is Barack Obama, and I am a AAA debt abuser." The first step is realizing that we have a problem.