Allison's Ode to the Second Moment


Welcome to the 57th issue of Allison’s Ode to the Second Moment, a newsletter that regrets nothing.


Personal finance gets no love. In both academia and industry, corporations and institutional investors get most of the attention. I understand why, as they have more money and, historically, more needs. They also face an easier problem than the average household. The typical household must save, invest and spend with many sources of uncertainty and very little room for error. We tend to think the more money someone has, the more they need a smart, sophisticated solution—but often the opposite is true.

When people ask me what kind of economist I am (and people really ask that question—I think they are fishing for information about political affiliation because they think economists are still trapped in 1960s ideological debates), I always say I am a life-cyclist (not the answer they were looking for). I am open to many different macro and financial models, but for me, the consumption smoothing problem drives my thinking. How should households save, invest, and spend? What kinds of human capital investments make sense? How do macro and financial shocks increase households’ risk?

You can imagine my frustration with the state of personal finance, which at best gives watered-down advice meant for institutional investors (their objective is wealth accumulation and not consumption smoothing), and more often the advice is self-serving, inconsistent, and stunningly ignorant of the risks that households face.

So, I wrote a manifesto for personal finance. I explain how we should think about the risks households face and propose tools to address their needs. There is no uniform solution and no one has all the right answers. We do, however, need more rigor and a better intellectual framework to approach this problem. I welcome a better discussion as well as your thoughts and comments.

Excessive Risk?

There is an interesting debate brewing among many smart economists about whether low rates caused “excessive” risk taking. It is an interesting conversation, but it fails to answer three questions:

  1. Who is taking all this excessive risk?

  2. What is excessive?

  3. Does it matter?

The economists looked at stock market indicators for answers. But it seems to me that a better way to answer the first and second question is to look directly at asset allocation. Has investment in risky assets increased as the risk-free rate fell? Josh Rauh noticed pension funds invested more in alternative assets during the last ten years.

Pension funds must earn certain returns in order to justify their crazy discount rates. Managers are also judged on their performance relative to other managers. So it is not outrageous to presume that a smaller return on risk-free assets can encourage pension fund managers to turn to alternative investments. Apparently, in exchange for no liquidity and high frees, these assets offer a higher expected return, though I am skeptical of the high returns they claim. Their return calculations are based on the value of non-market securities, and this seems sort of sketchy to me. The opacity may be part of the appeal. You can’t deny that alternatives’ high ‘returns’ make an under-funded situation look much better than it is.

It is not just pension funds, either. University endowments are also into alternatives. For example, they make up 50% of Yale’s endowment!

Is this excessive? That is matter of judgment and probably hindsight. If all these alternative assets pay out 15% consistently, people will say that was shrewd risk taking. Or, if these assets underperform the S&P in all markets, people will say it was excessive.

Even if it is excessive, is it a problem? If the risk goes south, then taxpayers will need to make up the difference one day.

Can We Blame the Fed?

A related question asks if low rates are the Fed’s fault? Rauh cautions that even if pension funds are taking too much risk, you can’t put that on the Fed. Low rates also reflect the market’s demand for safe assets. This demand comes from abroad and domestic institutional investors, so we can accuse them both of excessive risk and buying up everything that’s risk-free, depending on the investor and what side to the argument you want to take.

That’s just the short end of the curve. Historically, the Fed has not had much impact on long-term rates, the assets pension funds invest in. The impact of QE is still not clear. But apparently the Fed was surprised that corporate pensions have been buying more bonds. This may be putting downward pressure on the long end of the yield curve and be behind the “inversion.”

The Risk We Cannot See

I see government debt as a risk. I know that may sound obvious, but some people disagree and don’t think debt is risky because, for them, leverage is always an opportunity. I think it is because they can't comprehend a world where paying off debt requires sacrifice. Most people under 40 can’t remember a period of high inflation or interest rates.

But the world is full of risk and uncertainty (the risks you can’t anticipate). If everything goes to hell and you have no income, you still need to pay your debts. Policy makers can’t predict the future, and we don’t know the future of trade, demand for the dollar, or how technology will impact the economy. The more debt we have, the less room we have to deal with setbacks.

So perhaps we should be concerned that debt payments may soon exceed our military spending. Also, don’t forget how much of the military budget is taken up by debt in the form of military pensions and retirees’ health care. This also gives the military less space to respond to uncertainty.

But I worry about things I can’t predict, most Pension Geeks do. Who else would write about stagflation the week unemployment hit 3.7%.

In Other News

Until next time, Pension Geeks!