Interesting post on what, at first glance, seems to be a relatively straightforward topic. Clearly implementing the idea of a risk-free rate in building return expectations is much more complex in practice! However, I am struggling to make the connection between growth (be it productivity, GDP, or something else) and the concept of a risk-free rate.

I have always thought of the risk-free rate as purely representing the time value of money. Government debt has long since been used as a proxy for that element and to be sure, the validity of that proxy is clearly questionable given the poor fiscal state of so many major economies today. Yet the connection to growth and a bedrock rate of return escapes me.

In my mind, growth does not come without risk. Someone somewhere is putting capital at risk in order to achieve that growth. Further, falling back on the idea that the risk-free rate conceptually represents the pure time value of money, one can think of several examples in which growth and the time value of money become divorced.

For example, in a stagflationary economy, productivity growth would be declining while inflation was increasing. Or perhaps a less extreme (and more desirable!) scenario representing the same disconnect would be the proverbial “goldilocks” economy whereby economic growth was being realized without creating undue inflationary pressures. A risk-free rate derived from a growth metric in both of those cases would appear to me to be unable to capture the essence of what a risk-free rate is designed to measure. I’d be keen to hear your thoughts on this point of view.

Best,

Jason