If Capitalism Is So Great, Why Does it Need “Risk-Free” Government Debt to Work?

This is a thought that has been gnawing at the back of my head ever since I began getting a master’s degree in finance last fall, and I cannot contain it any longer. I got radicalized by “risk-free” interest rates.

I’ll be done with my studies in early May. This program does not make me an expert in finance by any means, but there is one concept that has been continually driven into my head in every single class, and I want to share it with you all so you can see the fraudulence of the neoliberal and right-wing narratives that government should stay out of markets.

In every single situation that I have been taught to analyze, at some point I have used the risk-free rate as a baseline or a variable to calculate the value of a company or asset. It is quite literally, a foundational variable of finance.

Despite their façade of extreme independence they like to construct, our capitalist markets actually depend on the government to be a risk-free guarantor of debt. If it weren’t for the government providing risk-free lending and borrowing, none of this stuff would work. The answer every professor gives to the inevitable question of “what happens if the risk-free rate ceases to be risk-free?” is always something along the lines of “we have much bigger problems at that point and then none of this matters anyway.”

No matter how badly our American programming wishes us to be independent of the government, that’s just not how it works. The money that supports your entire life is backstopped by the government. Every single debt we pay or are paid, and every single asset we own or wish to own, depends in large part on monetary policy. Central banks set interest rates based on inflation expectations, or at least they should be, as Jerome Powell and the Federal Reserve have so helpfully demonstrated for us since the 6% inflation print that changed the world in November of 2021.

Inflation and how central banks do or don’t react to it plays a large part in the foundational aspect of what money and this whole economy is all actually worth, because interest rates simply reflect the present cost of money, which is the denominator of asset values. In 2021 the cost of money was basically 0% and Dogecoin was the most valuable asset on planet Earth, now it’s 5% and your annoying neighbor has stopped asking you to buy it (actually, meme coins are worse than ever but that’s a blog for another day).

It doesn’t take a finance degree to get the gist of where this is headed, and I have a question for the skeptical capitalists out there.

What is $1M in 5 Years Worth Right Now?

When you buy a stock, you are buying a portion of its future cash flows. These future cash flows form the basis of a fundamental valuation of the company, because, well, cash flows are kind of the whole point of why any company exists in the first place (we would be honored if you would contribute to Splinter’s cash flows with a subscription!).

A discounted cash flow analysis is one of the foundational methods for both valuing private companies and evaluating whether publicly traded companies are over or under-valued (it is not without its flaws, of course).

Let me walk you through the math, it’s very simple. So simple a libertarian economist can understand it.

First, you put the future cash flow in the numerator. Let’s say your company expects to generate one million dollars in cash flows in five years. To value that expected cash flow five years in the future, you must discount it back to now because it is not presently worth one million dollars. This is the same dynamic you see with lottery winnings, where taking the money now is always more valuable than the scheduled payouts over time. A dollar today is worth more than a dollar tomorrow, etc… I’ve given you two of the variables you need to prove this maxim to be true, we just need one more, called the risk-free rate.

What is the risk-free rate again?

The rate you get paid for lending the government money in the Treasury market!

It’s so safe there’s no risk to it! The government is the most dependable financial partner you could ask for!

Yes that same incompetent government we supposedly can’t trust to regulate markets! Don’t worry this all makes sense to us!

So back to your company and its one million dollars in five years. To do this calculation, we need to take the corresponding risk-free rate (the rate we would get paid over the same time period by buying a five-year U.S. Treasury Note and guaran-damn-teeing ourselves a profit). It is currently trading around 4%, which we’ll use for simplicity’s sake.

To discount the cash flow to present day, you put that figure in the numerator, then the denominator is simply just one plus the risk-free rate to the power of time (in this case, years).

$1,000,000 / (1.04^5)

Which means that one million dollars in five years at current risk-free rates is currently worth $821,927.11.

At 1% risk-free rates, one million dollars in five years is worth $951,465.69.

See What I’m Getting at Here?

Nothing changed except for government policy, and the present value of that cash flow increased by nearly 16%. Neoliberalism is a lie proven by the math at the base of capitalism. If the entire global economy functions on the premise that lending money to an entity is risk-free, I’d say that entity is pretty fucking important to how the market operates.

Add in the fact that “the world’s largest, most-important financial market” is also the most liquid $27 trillion you’ll find on planet Earth (and Japan has basically constructed their entire monetary policy on top of it), and anyone who wants to “get [government] down to the size where we can drown it in the bathtub” is just proposing a way to shrink the global economy. When you can print your own money and finance the printing of other countries’ money, “debt” isn’t this big spooky thing the same way a credit card bill can be. Besides, this decade-plus of loose monetary policy capped off by an inflationary crisis proved the MMTers right: it’s not tax receipts that are the guardrails on monetary and fiscal policy, it’s inflation.

In this case, debt is actually an asset because we’re talking about more than just math on a spreadsheet. This is what soft power looks like.

The Reaganesque notion that “the most terrifying words in the English language are: I’m from the government and I’m here to help” should be utterly foreign to bond traders, as risk-free rates provided by the government form the bedrock of that entire industry. Our libertarian tech overlords in the Valley built some of the largest fortunes ever off the back of the government’s historically low interest rates from 2008-2021, and few industries got hit harder than tech once the Fed pivoted and made everyone look at all those lofty future cash flow projections in a different light.

There is simply no greater aid to the market than the government backstop that at a certain level, returns are risk-free. What that rate is helps define the entire market.

This is why stocks and bonds were crushed in 2022, as the Federal Reserve jacked up the Fed Funds Rate 75 basis points at a time from near-0% all the way up around 5% right now. They were the fastest rate hikes since the 1980s, and every company on the planet had to get re-valued in this new world with a higher cost of capital.

In 2022, the S&P 500 had its third-worst year since 1975 behind the tech bubble fully capitulating in 2002 and the Great Financial Crisis of 2008—all because of interest rates. Sure, there had been a gigantic bubble created by cheap credit and government stimulus in 2021 and at least a mean reversion and likely more to that excess was inevitable—but 2022 was a real crisis—especially for the traditional 60-40 stocks-bonds portfolio.

On the year, the S&P 500 got hit nearly as hard (-19.44%) as it did in Q1 2020 when COVID created a financial panic not seen in over a decade and finished down 20% for the quarter.

All over risk-free interest rates!

Determined entirely by the government and its (lackluster) response to mounting inflationary pressures in 2021!

So screw the neoliberal fairy tale that markets can somehow exist independently of government policy. I’m learning how to price markets right now and I’m being told by every professor and book I open that I cannot do that without interest rates, which all follow the government’s lead. The entire fundamental basis of cash management and company valuation is based on the premise that government debt is risk-free. If it wasn’t, this entire system would instantly collapse in a panic.

Anyone with just a cursory knowledge of how the financial calamity of 2008 unfolded knows that credit dried up for everyone, and as Markus K. Brunnermeir wrote for Princeton University, “during these times, everybody lends only against Treasury bonds as collateral.” There are a lot of people in this country who dream of the fallacy of divorcing markets from government, but the math at the base of markets themselves proves that to be impossible.