Allison's Ode to the Second Moment

Welcome to the 64th edition of Allison’s Ode to the Second Moment, a newsletter that believes that there is no free lunch in finance, except maybe index funds—and this newsletter.

The tipping point

First, some personal news: Last week, I started a new column at Quartz (for their new membership program) called “Tipping Points.” Each week, I’ll describe a new source of risk that is reaching a tipping point and might alter the economy as we know it.

Last week, my first column discussed the rural/urban divide. In many ways, this is the defining issue facing the global economy. Any major economic transition—currently, the move from an industrial to a tech economy—creates winners and losers, at least initially. And the losers are often poor. What makes this time different is the geographic divide. Educated urbanites benefit while the poorer and more rural places are left behind, and this is creating the rising political and economic tensions that we are seeing in pretty much every developed market.

Thus, we are now trapped in a vicious cycle. Getting ahead in this economy requires not just an education, it also requires living in a big city. Before, the upwardly mobile might gain some human capital in the city and eventually move to the country. Now, maintaining their economic edge requires staying in the city for their entire working lives. Meanwhile, cities offer few opportunities—and high costs—for people with less education. This new dynamic is in many ways the byproduct of a knowledge economy that thrives on creative clusters and is automating many routine jobs. The result is that different segments of the economy live apart from one another, and the cultural divide grows bigger and bigger. This leads to more populism and resentment (on both sides of the political aisle), counter-productive economic policies, and less appetite for redistribution. It is also a terrible waste of talent and resources.

I am optimistic that the wealth will be more widely shared...some day. But it might take a very long time for this to happen. The first industrial revolution also created large wealth disparities that resulted in social unrest and counter-productive policies. Eventually, though, the riches were more equally shared, but it did take a few hundred years and the right policies.

Finding a way out of this situation remains the biggest and most important policy puzzle of our time.

Does debt matter

When I first started working with financial economists, I was not surprised they constantly made fun of macroeconomists. Everyone makes fun of macroeconomists (I know, because I technically am one!). To be fair, the macroeconomy is impossible to model, and yet macroeconomists try so hard because someone has to do it. The financial economists have a valid point, though, in that many macro models have no meaningful role for risk (and no, a half-hearted error term does not count!). And without risk, there is no role for financial markets. And financial markets are a pretty important part of the economy.

Macro is making some progress on this front, but it is slow going and requires a major rethink. I am sympathetic to the struggle. And yet, in Olivier Blanchard’s Presidential address this year, he argued that if the economic growth rate exceeded interest rates, countries could run deficits forever and increase welfare.

I must admit that I was unclear about what risk-free interest rate he was referring to, since he kept jumping back and forth between the t-bill and 10-year bond rate. Nonetheless, he illustrated the difference between finance and macro. In finance, risk is central—it is what makes that interest rate go up or down. Blanchard did concede bond prices may contain risk premium, so he suggested maybe only run deficits for useful things such as expansionary policy during a recession.

No arguments there! In fact, that sounds like a good reason for prudent fiscal policy during good times. It buys you some insurance (and low rates) when you need it. Sensible people can disagree about how big and sustained counter-cyclical fiscal policy should be, but that’s not the argument politicians and pundits make today. It seems like both parties agree that debt does not matter—good times or bad, discretionary spending or structural. And I can see why they think so. People have short memories and it has been a long time since interest rates or inflation has been high or uncertain. But that does not mean that there’s not a risk. Bond yields are market prices, and risk premiums can be endogenous.

I don’t mean to sound bitter about all of this, but it is hard out there for a Pension Geek. Our lives consist of valuing assets and liabilities, telling everyone that they don’t match up, being ignored, and then picking up the pieces when it all goes to hell. It’s frustrating to see risk left entirely out of the debt debate.

However, cheers to Greg Ip, who tried to explain why an inverted yield curve causes a recession rather than simply arguing that it does so for mysterious, scary reasons. I am not sure that I buy it, but I appreciate the effort.

Jack Bogle

There was sad news about the great Jack Bogle, a man who was to retail investing what Sam Walton was to retail spending. The index fund is one of the most important financial innovations since the ATM, but it has definitely been getting a significant amount of unfair criticism lately. I heard someone on CNBC argue that hardly any money is actively managed anymore. Sure, maybe that’s true—but only if you think “hardly any” is 80% of assets!

Even Bogle was concerned about how the index fund market evolved in his later years. But I think he would have been glad to see people put aside their fears and celebrate the index fund, which is the closest thing to a free lunch in finance.

Until next time, Pension Geeks!