Allison's Ode to the Second Moment


Welcome to the 48th issue of Allison’s Ode to the Second Moment, a subversive newsletter because it argues, loud and proud, that markets are (weak form) efficient.

Everything is fine, except that one thing that makes everyone miserable

I have a theory that things really aren’t so bad. In fact, they’ve never been better in terms of quality of life for almost everyone. But there is one aspect of life that has gotten worse: the world feels riskier and more uncertain. Technology is changing how we live and communicate and it threatens our jobs. What’s low risk today may not be low risk tomorrow. We tend to focus on the first moment when it comes to well-being, jobs, wages and power, but maybe we care more about the second moment—the fear we’ll lose it all.

When people are faced with more uncertainty and hard-to-manage risk, they tend to do strange or horrible things. The Royal Economic Society awarded a prize for a 2015 paper that estimates how weather shocks, a huge source of risk in an agrarian economy, are correlated with Jewish persecution. It could be that risk and uncertainty are posing a similar role in today’s civil strife. If so, perhaps we need policy that aims to reduce the costs of individual and systematic risk.

Of course, that has a cost…even if it is efficient

I believe more expected reward usually comes with more risk. If you want to reduce risk, you need to pay for it. Though sometimes we chose between two options that offer the same reward and one has more risk than the other. The riskier choice is inefficient. For example, a well-diversified portfolio eliminates unnecessary, inefficient risk.

That's why pooling is efficient. If you buy an annuity, you can get a higher income than self-financing retirement because insurance companies can pool risk. People who die young subsidize people who live to 117. Pooling also suggests value for the government. Governments can offer pensions and pool risk across and within different generations (both longevity and assets risks). They can force everyone to buy health insurance or they can guarantee everyone has a well-paid job.

This all sounds good in theory, but then there are those pesky incentives. Politicians also have an incentive to promise more for less, especially when costs are far into the future. Pooling reduces reduces risk, but it does not eliminate it. The government still bears the risk that a generation lives longer than expected, that growth is permanently slower, or that people prefer a well-paid government job they can’t be fired from to a low-wage job. Government pooling works best when the cost of the remaining risk is recognized and paid for. But it rarely is.

When we weigh policy proposals, like a jobs guarantee during times of low unemployment, the costs/benefits tend to get most of the attention--for good reason. But an equally important consideration is the cost of reducing the risk of structural job loss and who pays for it.

Maybe efficiency is over-rated

It seems that privatizing pensions in China increased education funding. For many years, China financed retirement with an unfunded pay-as-you-go system. A study estimates that moving to a self-funded individual account system was correlated with spending more on education. Now, it is hard to clearly claim causation, but it is still an interesting example of the consequences of a risk transfer.

Private pension accounts transfer risk to individuals. You might think that putting the risk on the government is more efficient. But, as we’ve seen in state and municipalities in the US, the risk is often underpriced (if acknowledged at all). If the risk does not go well, one day the politicians must make hard choices: raise taxes or cut services to children.

OR maybe the problem is we don't take enough risk

Other times, I wonder if the problem is that the risk-free return is too high. I don’t mean the price of treasury bills. I mean other measures of risk-free. Sitting in your parent’s basement and playing video games is a low-risk decision. You are not exposed to the potential for rejection and testing yourself on the world. A night in with Netflix can be more compelling, with a high degree of certainty, than venturing out. It could be we are more risk-averse or that technology has increased the risk-free rate of leisure.

Not if evolutionary biologist Heather Heying can help it. She takes her students on risky, outdoor field trips so they learn how to deal with risk. She is not alone. After Penn State tried to eliminate field trips to places without phone service, the students fought back. Heying argues exposure to risk is a critical part of education.

Unemployment is low, so why aren’t wages going up?

I hear two reasons why wages aren’t going up. 1. The monopsony story: there are only a few large employers who exercise market power over their employees and under-pay them. 2. The monopoly story: employers earn monopoly profits and are too greedy to pay their workers more. Maybe that is true sometimes, but every employer? Even small-business owners? Many low-wage employers, fast-food franchise owners, are in competitive markets and are price takers.

Paul Krugman argues it could be risk-related. Increasing wages means employers lose the option to pay less if there’s a recession. They’d rather pay out discretionary bonuses. Discretionary pay preserves the option of cutting pay if times get tough. 401(k) contributions are often treated this way. Employers make bigger contributions in good times, and cut them when the economy tightens. Perhaps wage and salary data isn't telling us the whole story.

What will cause the next crisis?

Fellow pension geek, Philip Coggan, will soon stop writing The Economist’s Buttonwood column. I will miss his risk insights there. Last week he speculated what will cause the next financial crisis. He is worried about corporate debt:

So investors are getting less reward for the same amount of risk. Combine this with the declining liquidity of the bond market (because banks have withdrawn from the market-making business) and you have the recipe for the next crisis. It may not happen this year, or even next. But there are already ominous signs.

I can't predict the future, but a disconnect between risk and reward is never a good sign.

Some personal finance advice

Sometimes it is okay to take money out of your pension account. It is not great though. It is important to think about liquidity risk when you make your contribution.

When people see high-deductible/HSA plans, they tend to think—more risk, I’ll take higher premiums, please. But, depending on the risks you face, HSAs can be less risky and offer a higher reward.

Until next time, Pension Geeks!