Welcome to the 62nd issue of Allison’s Ode to the Second Moment, a newsletter about how even while the world might change, we still can’t change the risk-free rate.
I had the pleasure of working with Ned Phelps in graduate school. We met once a week or so and debated the state of the economy. It was exactly what you think graduate school will be like before you go, but it rarely is.
I bring this up here because I’ve been thinking a lot about structural changes in the economy. Ned taught me that the economy regularly goes through structural changes, and when it does, the old rules no longer apply. The relationship between unemployment and inflation might be different, how the risk-free rate influences the macro economy might change. Last week, I argued that the optimal firm size and level of market concentration might change, too.
And the economy has changed significantly since the 1990s. Technology has changed how we work, communicate, trade, and transact, so it makes sense that some of the old relationships don’t apply. I don’t think that this means that people won’t work in the future, or that robots will come after us. But it could mean that we need to think through the old relationships and the ways in which we measure the health/success of the economy. This is not necessarily bad—just different.
I reckon that this is the ‘problem’ with Millennials. We’ve all seen many stories about how terrible they have it—they are overwhelmed with student debt, they don't buy cars or houses, and are mostly single. But perhaps none of these are actually bad things. Maybe these are just rational choices in the new economy. If there’s a bigger premium on education (or a bigger cost to not being educated), making an investment in human capital may be a better bet than buying a house. After all, Millennials came of age during the financial crisis, so they know that real estate is a risky bet. They also saw that college graduates weathered the crisis more successfully.
And with regards to the no-car thing, Millennials tend to live in cities—another economically rational decision in a knowledge economy—so they don’t need cars as much as previous generations.
Before we decide that there’s something wrong, perhaps we should think through how we measure economic success at different ages. A structural economic change could mean that our old metrics are no longer valid.
Public pensions get desperate
Maybe it’s the stock market volatility. Maybe it’s just common sense. But public pension funds are finally coming to terms with the fact that they don’t have enough money to pay for the benefits that they promised. They are taking a hard look and realizing that the risks they’ve taken have not paid off, they are accounting for the true costs of their liabilities, and are leveling with unions and taxpayers about realistic future promises and higher taxes.
Just kidding! They are trying to get creative instead, because they think that there is a free lunch somewhere if they look hard enough. Some states are hoping that legalized marijuana will offer a solution. But with a $3.8 trillion shortfall, that’s a lot of pot. I guess every bit helps.
Other states are considering infrastructure bonds. The details are murky, but it sounds like these states will sell bonds in order to finance infrastructure projects, and that only pension funds can buy them. These bonds offer a yield that is 2% above 30-year treasuries and must be held for 10 years. The write-up describes the bonds as risk-free, so pension funds won’t need to seek out stocks or private equity. But they don’t sound risk-free to me. First of all, the bond’s ability to pay out depends on the health of the local economy, which is correlated with the size of the tax base—and that is pension fund's primary source of income. Also, it sounds like there won’t be a deep secondary market for these bonds (even when they can sell them), and that’s some serious liquidity risk.
Maybe it’s a good thing that Chicago is issuing plain old pension bonds. These are normally a terrible idea, but at least what makes them terrible is clear to everyone. You can’t count on risky investments to make up for years of under-funding. Just look at multi-employer plans in the US and the UK.
The risk-free rate
The risk-free interest rate is the most important price in financial markets. The yield that it offers is a market price, one that all financial decisions are based on. Think of pretty much every financial formula—Black-Scholes, or whatever you use to find an efficient portfolio, any forecast worth its salt—the odds are that the risk-free rate is in it.
The risk-free rate determines how much risk people take. If someone needs a higher return in order to reach their goals, they must take more risk or scale back their goal (I’m looking at you, pension funds!). That sounds simple, but it’s also where so many things can and do go wrong.
Someone always believes that they can create a risk-free investment that offers a higher return than the market rate. Take those infrastructure bonds, which promise a higher risk-free rate, but they are not actually risk-free. The risk may be hidden as liquidity risk or tail risk, but it’s still there.
Matt Levine writes about Robinhood Financial LLC, which promised a 3% interest rate, 60 basis points above the t-bill rate. This was presented as risk-free because the account was called “savings and checking,” but there was no real guarantee. Robinhood claimed that they are so efficient that there is a free lunch for consumers. That's a bad sign. No wonder everyone was skeptical, they may be investigated, and now Robinhood has changed their message.
Here’s the other thing that makes the risk-free rate so important. It is a market price, but everyone has an opinion on what they think it should be—and that has nothing to do with the markets.
Take monetary policy, which strives to alter the risk-free rate (in the short-term allegedly) in order to influence the economy. Many pundits, and even the President, think that the Fed should keep the risk-free rate below the natural market price indefinitely. They think that will juice an economy with an unemployment rate under 4%. This is the big difference between macro and financial people. Macro people think that the big cost to lowering the risk-free rate is inflation, while finance people worry more that manipulating the most critical market price indefinitely causes distortions and instability.
I am open to the idea that the world has changed. The market risk-free rate may be lower than it was in the 1990s. But the channels in which it impacts the economy may also have changed, which is all the more reason to accept the risk-free rate for what it is.
In other news
People are still worried about leveraged loans
The lump of labor fallacy is not a fallacy in China
More on Jeff Brown’s smart insurance play
The annuity explainer the world needs
Until next time, Pension Geeks!