The backstory of the risk-free asset: how government debt became "safe"

Book Chapter

Boy, Nina (2014) The backstory of the risk-free asset: how government debt became "safe", in Goodhart, Charles; Daniela Gabor; Ismail Ertuerk; & Jakob Vestergaard, eds, Central Banking at a Crossroads. London: Anthem Press (177–187).

​​Collateral has since antiquity been used as a safeguard for contractual obligations, such as debt. But how did debt, and in particular government debt, itself become the most common form of collateral in the financial system? In other words, how did government debt become 'safe'? The safety of sovereign debt corresponds to the establishment of sovereign creditworthiness: from sovereign bonds being charged a significantly higher interest rate than commercial loans in the Middle Ages to circulating 'unsecured', that is, no longer requiring additional security in the form of either collateral or a high interest rate but trading merely on 'full faith and credit'.

    Premised on the government's power to tax and print money, modern finance theory and standard economics have treated the safety of sovereign debt as an assumption that has been fundamental to the main pricing models for stocks and derivatives in the form of the risk-free asset. Economic history at the same time however tells us that "there is no such thing as a perfectly safe sovereign" even if the "whole development of capitalist institutions can be seen as a succession of attempts at addressing the problem of the production of safe assets" (Flandreau 2013: 24). Safety, as Alberto Giovannini, advisor to the European Commission from 1996-2010, notes, "is, of course, a relative concept, being determined by human perceptions" (2013: 3). How can one make sense of both these stories: sovereign safety as an axiom of modern finance as well as its historical contingency, relativism and dependency on perception?

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