The potential downgrade to AA in the U.S. credit rating has exposed one massive fallacy of modern finance: there is no such thing as “risk-free” investment. Much of the modern finance canon will need to be re-written, or better still, scrapped altogether. However this discovery has considerable implications even for those of us who adhere to more rational investment philosophies.
 
Risk-free investing is central to modern financial theory. The Capital Assets Pricing Model, which postulates an optimal “frontier” of investment possibilities, assumes that frontier is reached by a judicious mixture of risky investments and risk-free investments or leverage. The Black-Scholes options valuation model assumes the options can be hedged by buying or selling the underlying security, borrowing or investing the proceeds at the risk-free investment rate. Modern risk management assumes that some assets are without risk, so that the Basel system of capital regulations rates government securities of OECD governments at zero in their capital adequacy calculations. The Efficient Market Hypothesis and the Modigliani-Miller Theorem don’t depend on the ability to borrow and lend risk-free, but even if those shaky pillars of the modern finance edifice still stand (though undermined by other considerations) the Standard and Poor’s threat to downgrade the United States’ credit rating has nevertheless wrought considerable theoretical havoc.
 
Over lengthy periods of time, the ability to reinvest annual returns risk-free is simply not there. The eighteenth century calculation of Dr. Richard Price showing that a penny invested at the birth of Christ would have grown by Price’s time to an immense golden ball, was fallacious. There had been no continuous society other than China in which such an investment could even theoretically have been made and even in China the proceeds’ value would have been destroyed by the inflation of the Mongol period.
 
Even in more modern times, the calculation that the Native Americans who sold Manhattan for $24 in 1626 could have kept more or less even with the buyers by the simple expedient of investing the proceeds at 6% compound interest, to get $149 billion today, falls down by the fact that no safe 6% investment, compounding over nearly 400 years, has been available. Even though the Dutch government has been a satisfactory credit risk over the period, and yields fairly close to 6% were available on Dutch government paper in 1626, there has been no way to reinvest the money safely and get a 6% return for most of the intervening 400 years. The 197 years of the Gold Standard, from Sir Isaac Newton’s establishment of it in 1717 until its abandonment in 1914, saw interest rates no higher than 3% for almost all of the period. $100 invested at 6% for 197 years gets you $9.67 million; the same sum invested at 3% gets you only $33,800 – nowhere near enough for our unfortunate Native American sellers to have kept up with rising Manhattan real estate prices.
 
In the twentieth century, smug proponents of equity investment have shown that the U.S. stock market brought an average annual real return of around 7% over the century as a whole. But suppose in 1900 you had invested in the German stock market, the Austro-Hungarian stock market or the Russian stock market. In all three you would have lost all your money at some point in the century, thus being prevented from achieving a satisfactory return by the end of it. Indeed, the losses were large enough and prevalent enough that even an investor who like Keynes’ infinitely sophisticated Edwardian consumer tracked down 1900’s emerging markets and diversified fully would have achieved a lousy return – for one thing, the truly greatest economic success stories of the twentieth century, such as Korea and Saudi Arabia, were completely un-investible in 1900.
 
If you had told your 1900 investor of these difficulties, he would have smiled in a superior manner and suggested a truly risk-free investment – in Consols, maybe with a few U.S. Treasuries mixed in for good measure – and he would have been killed by inflation, even if he had avoided adding German government bonds to the mix.
 
In 1991, it would have appeared completely clear how safety could be achieved – by buying U.S. Treasuries, maybe with a mix of common stocks to guard against inflation. Needless to say, as a long term investment, that looks much less reliable today. Today’s safety-conscious investor would probably go for a spectrum of emerging markets investments, in the hope that 21st century economic growth would provide commensurate returns.
 
They would very likely be disappointed. None of the much-vaunted BRIC economies, for example, can be said to be decently run. Brazil is a democracy, but with an oversized state written into its constitution and an electorate that has gone for a series of dozy socialists (who have been blessed by a massive rise in commodity prices, but that won’t last forever.) Russia has gone from hopelessly corrupt to malignantly corrupt to mildly benignly corrupt – and looks likely to revert to malignantly corrupt again next year if Vladimir Putin returns to the presidency. India is a democracy, but with an electorate that persistently re-elects a party whose mainstream reflects the most foolish features of 1930s Fabian socialism – and unexpectedly rejects the only government that had produced genuine reform, that of Atal Bihari Vajpayee in 1998-2004.
 
A year ago, China might have been thought an exception to this generalization. Even for those of us who don’t sharing the Tom Friedman view that “China is awesome” it had appeared on the economic front at least to have discovered some secrets that had eluded others. Like the Japanese governments of 1955-90, the system might not bear close inspection from either a democratic or free-market viewpoint, but it appeared to work.
 
Evidence in the last few months is increasingly showing that China’s approach is less successful than it appears, and that international investors’ ability to profit from China’s success is highly problematical. The Chinese banking system once again seems to be teetering on the brink of collapse under the weight of its bad debts. The Chinese rail disaster indicates that, while Chinese infrastructure investment is blessedly free from the appalling cost bloat of equivalent U.S. investment, it is nevertheless subject to a very high degree of corruption. China’s high speed rail network appears to have little more in the way of safety features than the Cabinet-Minister-slaughtering George Stephenson’s Rocket of the 1830 Rainhill Trials. 180 years of safety advances appear to have been ignored by China in the rush to build the government’s prestige investment.

Finally the succession of accounting scandals in China’s small-cap public companies demonstrates that overseas investors in Chinese companies have no effective means of ensuring that their rights are protected. Only the overpriced behemoths with serious government links or a reflection on China’s international prestige may be safe – and being overpriced, they are unsound investments anyway.

The pessimists’ answer is to put the lot in gold, maybe with a mild diversion of resources to oil, silver, copper and platinum. While in the short term these look an excellent bet, I am not in the long run a “gold bug” even though I believe that a Gold Standard would be much more satisfactory than the current monetary arrangements. Consideration of price changes since the stable pre-1914 gold parity of 3 pounds, 17 shillings and 10 pence an ounce suggest that a price today of around 400 pounds or 650 dollars represents an appropriate equilibrium. Even accounting for the rise in global population and wealth since 1914, it is difficult to justify an equilibrium gold price above $1,000 an ounce. Consideration of mining costs, around $400-500 per ounce for the major operators, suggests a similar equilibrium price level, even with a Gold Standard.

Of course, based on 1980’s speculative peak, peak gold prices of $2,500 or even $5,000 are justifiable, but those would be short-term and unstable maxima, to be followed by a lengthy and punishing bear market such as occurred in 1980-2000. Thus even gold at today’s prices is by no means a risk-free investment. Supply/demand considerations suggest that with the economic growth in emerging markets $100 oil may appear cheap in a few years, but oil is a difficult and expensive commodity to hold, and the major oil companies are subject to substantial political risk.

Thus even the supposedly “defensive” investments of commodities and energy are by no means risk-free at current prices when long-term considerations are taken into account.

It’s not surprising that “risk-free” investments do not abound today; the world has been subjected to a fifteen year period of money creation during which assets of all kinds have been driven up to un-sustainable prices. Not only are the tenets of modern finance nonsense in these markets, but the tenets of traditional finance also offer little hope for the investor anxious to preserve his capital About all that is feasible is to put money in a diversified portfolio where the losses over the next few years will be smaller than in the market in general.

That may appear a very un-ambitious and pessimistic goal, but what do you expect from a Bear?

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)