In a well pondered choice various alternatives are analysed; then, the best with respect to the others is chosen. So we make decisions choosing the best available alternative.
This simple process, besides being common sense, is also the base of economic and portfolio choices. Investment choices are in fact usually well pondered and not taken on the spur of the moment.
The risk-free rate represents the return an investor can expect to earn if he or she wants to take no risk. On average that should be in line with the rate of inflation. The risk-free rate has always been represented by the rate of return on government bonds, as it could be taken for granted that the probability of default of a state was so remote as to be negligible.
The risk-free rate becomes then the basis of investment decisions, the one that can allow to decide what risks to accept according to the expected return associated to those risks The lack of a risk-free rate creates confusion among those willing to take risk and suggest those not willing to keep their money (figuratively speaking) under the mattress. Mostly this means keeping cash in the bank, with very low returns but immediate availability if need arises.
The effect becomes extreme in the event of a crisis, as uncertainty pushes many to avoid risk. The consequence, lacking a risk-free rate, is an increase of funds in bank current accounts.
In times of a well-functioning economy, this would translate in higher investments as banks would then lend the money to those willing to take risks. Now, however, banks are reluctant to lend to companies because of a combination of increase in bad loans and uncertainty over capital rules (politicians seem to change their minds every week on how much capital banks should keep as a guarantee for their loans).
At the same time, entrepreneurs are themselves reluctant to increase their debt as they fear their investments will not be remunerated because of a bad economy. One of the effects of the crisis has been the disappearance of the risk-free rate. Yields on government bonds have started to include a part of credit risk (the probability the State will not pay its debts). This effect could look unimportant, but has, as we have seen, very strong implications.
The problem is not limited to Italy or the Euro area. It is in fact known that on one hand the United States lost its AAA rating, and on the other Germany is starting to worry and get worried in that it has to back-up the Euro (it is by far the biggest beneficiary), but to do so it risks having to use so many resources that buyers of German bonds will ask for higher yields just because of a perceived increase in credit risk (the latest Bund auctions in fact have shown weak demand and yields above 2%. The signal is alarming, as it may mean convergence of Euro area yields in view of a common treasury being perceived as more and more likely).
The problem is not limited to Italy or the Euro area. It is in fact known that on one hand the United States lost its AAA rating, and on the other Germany is starting to worry and get worried in that it has to back-up the Euro (it is by far the biggest beneficiary), but to do so it risks having to use so many resources that buyers of German bonds will ask for higher yields just because of a perceived increase in credit risk (the latest Bund auctions in fact have shown weak demand and yields above 2%. The signal is alarming, as it may mean convergence of Euro area yields in view of a common treasury being perceived as more and more likely).
It is necessary for politics to start again from here: re-establish that government debt is really risk-free means re-creating a basis of trust necessary for economic expansion.
At present, unfortunately, it looks like European leaders are far from this awareness. On one hand they are offering bridge loans to countries in difficulty, but that can at best solve a temporary liquidity crisis, not a solvency crisis. On the other hand they seem to be pushing for a recapitalisation of the banking system. The latter risks sending out the dangerous signal that some countries are expected to default. For what other reason would reserve have to be increased? If in battle one reinforces the second lines, it is rational to think one is readying for a retreat. In Europe the enemy is within, not in the speculators who, according to politicians who have brought us in this crisis because of their incompetence and incapacity to solve problems, are the cause of all evils.
Speculation is at best a comfortable scapegoat to throw to electors who do not have the cultural, critical, but above all self-critical capabilities (they voted in the present lot) to get to the right conclusions.
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