Allison's Ode to the Second Moment


Welcome to the 35th issue of Allison’s Ode to the Second Moment, a newsletter about the risks criminals face in dark places...and pensions too.

Dark Market risk premium

As regular readers know, I have a yen for studying risk in unusual places. The market on the dark web fascinates me. The dark web is a corner of the Internet that you can only reach anonymously. Once there, you can find online bazaars peddling drugs, stolen credit cards, weapons—you name it. There are levels of dark; as you go deeper, it gets more sinister. I have only visited (for research purposes) the first level, which is mostly a marketplace for drugs—primarily cannabis products, cocaine, MDMA, and stimulants.

The market for illegal drugs always struck me as inefficient. In a functioning market, the person who bears the most risk earns the highest premium. But that didn’t seem to be true with traditional drug dealing. Street dealers earn pennies while shouldering a large share of the risk.

My take on the dark web speculated that it had the potential to restructure the illegal drug market and provide a more efficient risk allocation. Or not.

Authorities recently shut down the two biggest bazars, AlphaBay and Hansa. Law enforcement went after the people running the sites and now have the users’ information (buyers and sellers). One of the Alphabay administrators committed suicide in a Thai prison. Dark web users, a paranoid bunch to begin with, are panicking.

When AlphaBay first went off line, many assumed it was an exit scam. When a buyer and a seller meet on the dark web and agree to a transaction, the money (normally Bitcoins) sits in escrow until the goods are received and deemed acceptable by the buyer. Vendors risk the website suddenly shutting down and the site administrators taking all their money in escrow. AlphaBay had become the largest market—the administrators could’ve made off with millions of dollars by disappearing, and left the vendors without any legal recourse.

But it turns out law enforcement was behind the shutdown. AlphaBay, like Silk Road, got big and attracted too much attention from law enforcement.

Does this mean the end of the dark web? I doubt it. I’d guess more bazars will pop up to replace AlphaBay, but I doubt any will grow to its size. It seems it is now optimal to start a dark web market and when it reaches a certain size, shut it down, and take the Bitcoins in escrow. I’d guess, going forward, the risk of exit scams will increase, making the dark web a little riskier for its vendors.

But as one user pointed out on Reddit, it is still less risky than street drug dealing.

Okay, back to pensions—what you came here for

Large companies increased their 401(k) contributions. This may be the economist in me, but compensation is compensation. Higher 401(k) contributions are probably offset by smaller salary increases. In theory, this shouldn’t matter too much. However, a 401(k) contribution can be riskier because, if the economy tanks, it is easier to cut contributions instead of salaries. Employers rarely cut wages, as they’d sooner fire people. But pension account contributions are often cut when economic times get tough.

I can’t help but wonder…. is the increase in contributions a sign of economic pessimism?

There’s a consensus that Millennials are good, cautious savers. Not so, says the IMF. They are concerned that Millennials have less non-retirement wealth compared to their parents at their age. The reasons why is more student debt and less homeownership. I am less concerned. Student debt often signifies an investment in human capital. That means higher earnings over a lifetime and more wealth accumulation in the future. And when it comes to homeownership—I think it’s over-rated.

But this does concern me

Economists are worried that the economy has become less dynamic. There’s less job-hopping, interstate movement, and good entrepreneurship. One reason why could be more employers make their workers sign non-competes. I once associated non-competes with bankers getting a long paid vacation. But it turns out even low-paid service workers have non-competes and no one pays them a garden leave. Non-competes leave them stuck in low-paying jobs or shut out of the labor force.

Idaho just made it easier for employers to impose non-competes on employees. The story also claims Idaho aspires for a thriving entrepreneurial tech community—but you can’t have it both ways.

How do non-annuitized retirees behave?

Such an interesting question. We don’t know the answer in this crazy defined contribution world we live in. The UK provides us with an interesting experiment. Until 2015, almost everyone there had to buy an annuity with their retirement savings. British people really hated it, especially in a low-rate environment that made annuities very expensive. Now they don’t have to annuitize, the change was called “Pension Freedom.”

Former Pension Minister Steve Webb has declared Pension Freedom a “Great Success.” The evidence of his proposition: now that retirees are stuck with a very difficult financial problem (with limited government guidance), they are seeking help from financial advisors. Webb also argues people like having more control and few blow their money on boats and sports cars.

He does concede there are some problems. The biggest one he identifies is people who take all their retirement money, invest it too conservatively, and risk inflation.

Uh, sure. But two years and a booming stock market is not an adequate time frame to judge Pension Freedom. Annuities' main benefit is predictable income for life, no matter how long you live or what happens to markets. It is easy to manage money for two years in a bull market. A 10- or 20-year or uncertain investment horizon is much harder to manage. Before we draw any conclusions, let’s check back in with the liberated retirees when they are 85.

Questioning some long-held economic truths

Some economic relationships we take for granted and maybe should question:

1. Covered Interest Parity (CIP). It claims foreign exchange derivatives explain cross-country differences in interest rates. Even if exchange rates were volatile, the no-arbitrage condition implied by CIP meant their value made some sense.

Maybe not any more. It turns out the CIP relationship is breaking down because of a segmented money market and distortions from central banks’ large balance sheets. There may be arbitrage out there for the taking—well, for some people anyway. It is less a breakdown of economic theory and more a reflection of a world where there isn’t a single risk-free rate.

2. This is not really overturning an economic truth; it is more overturning a long-held misperception. John Cochrane reminds us that the level of interest rates doesn’t influence spending or investment decisions. The risk-premium does. After all, returns are the sum of the risk-free rate and the risk premium. There's limited evidence the risk-free rate really matters.

Truer words were never spoken. Though I disagree on a few points. Cochrane doesn’t buy the argument that a low risk-free rate produces a reach for yield and more risk taking. In theory, yes, but in practice there are institutional pressures on pension funds to do just that. Maybe pension funds are the only ones reaching for yield, but they do make up a non-trivial share of investors’ money.

Cochrane thinks the Volker-era confused people. Back then, rates were high and there was a recession. Perhaps rates did matter back then. After all, interest rates were super high—more than 20%. Maybe when rates are very high, they do alter saving and investment decisions. It is possible that jacking rates up to 20% has a bigger impact on behavior than a quarter-point rate hike does when rates are near-zero. There’s that confusing non-linearity again.

Still, Cochrane makes an important point. We’d be spared a lot of nonsensical Fed commentary if people believed him.

And finally…

3. It turns out you can’t pay people to go to the gym. Maybe we’re all irrational or just really hate the treadmill.

Until next time, Pension Geeks!


P.S. A quick programing note. I may be less regular with my newsletter in August. Fear not, Pension Geeks, I will be back in September.