Economist Writing Every Day

There are several requirements for Ricardian Equivalence:

1. Individuals or their families act as infinitely lived agents.
2. All governments and agents can borrow and lend at a single rate.
3. The path of government expenditures is independent of financing choices

Assumption 2) appears patently absurd on its face. I certainly cannot borrow at the same interest rate that the US Treasury can. QED. Do not pass go, do not collect $200. The yield on 1-year US treasuries is 3.58%. I can’t borrow at that rate… Or can I?

Let’s do some casuistry.

What is a loan?

It’s a contract that:

• Provides the borrower with access to spending
• with or without collateral
• with a promise to repay the lender at defined times, usually with interest.

So, when you borrow $5 from a friend and pay it back on the same day, it’s a loan. The contract is verbal, there is no collateral, the repayment time is ‘soon’ with flexibility, and the interest rate is zero.

A mortgage is a collateralized loan. You borrow from a bank, make monthly payments for the term of the loan, and accrue interest on the principal. The contract is written, the house or a portion of its value is the collateral, and the interest rate is positive.

What about a Pawnshop loan? Most of us are probably unfamiliar with these. In this circumstance, a person has valuable non-assets that and the pawnshop has money.  They engage in a contractual asset swap. The borrower lends the non-money asset to the pawnshop as collateral and borrows money from the pawnshop. The pawnshop borrows the non-money asset and lends the money to the borrower. The borrower can use the money as they please, but the pawnshop can not use the non-money asset – they can simply hold it. They collect interest in order to cover their opportunity costs.

One outcome is that the borrower repays the loan and interest by the maturity date and reclaims their non-money asset. Another outcome is that the borrower retains the option to default without any further obligation. But they lose the right to reclaim their property according to the repayment terms. If the borrower exercises the option to default, then the pawnshop acquires full rights to the non-money asset. The pawnshop often resells the asset at a profit. The profit is relatively reliable because the illiquidity of the non-money asset allows the pawnshop to lend much less than its retail value. That illiquidity is also why the borrower is willing to accept the terms.

If we accept that the pawnshop contract is a loan, which is just a collateralized loan with a mostly standard default option, then get ready for this.

Assume that an investor has a portfolio of non-money assets. The efficient frontier of a portfolio allows them to minimize their portfolio volatility for any desired rate of return (so long as it exists among assets). By mixing US treasuries into the portfolio, which we assume earn interest at the risk-free rate, an investor can achieve any level of portfolio volatility and commensurate return. This means that most investors have US Treasuries among their non-cash assets.

You can Pawn your US Treasuries

And you can do it without facing the extortionary liquidity discount.

Say that, due to a temporary tax increase, you want to borrow money in order to spend it on consumption. You’re happy to repay the loan in the future when the temporary taxes expire. As it turns out, you can do it all at the *same interest rate* that Uncle Sam enjoys.

Say that your treasury note matures in 3 years. Let’s assume, for the moment, that the yield doesn’t change over time. As of March 3, 2026, that yield is 3.58%. That means that a note paying $10k in three years, with semi annual coupons of $350, has a current price of $9,983.07. That’s how much money you can access if you sell your note.

Then say that you wander around for 2 years. You spend on consumption and have a grand old time. The note that you sold still has a year until it matures. Considering your circumstances, you try to decide whether to re-acquire your treasury note, or to let it be lost to the markets. If you continue living your life without re-acquiring the note, then you exercised your option to default. You just lost your collateral and you owe nothing to anyone. If you instead choose to reacquire your asset, then you must pay for it. With 1 year remaining until maturity, the going rate for an identical treasury note is $9,994.16. That’s how much you must pay if you want to get your collateral back.

What just happened? If you re-acquire your collateral, then you repay $9,994.16 two years after borrowing $9,983.07. That implies an annual interest rate of 0.056%. Therefore, by putting up collateral, an individual can borrow at an interest rate *far below* the rate at which the US government borrows. Of course, this analysis ignores the foregone coupon payments that were paid over that two-year period. If we include those in the opportunity cost of funds, then the interest rate works out to be exactly 3.58% per year.

And, anyone who owns US treasuries can access the same low rate in order to consumption smooth to their heart’s delight. Given the ubiquity of US treasuries among portfolios, the ability to borrow money at the same rate as the federal government appears not so absurd. And it resolves the knee-jerk absurdity of assumption #2 for Ricardian Equivalence.