Allison's Ode to the Second Moment


Welcome to the 65th issue of Allison’s Ode the Second Moment, a newsletter about the risks few talk about in polite company.

Interest Rate Risk Lurking in the Shadows

With a new presidential election in view, everyone’s favorite topic has returned: fiscal policy. Every candidate has a favorite tax policy, and economists are lining up to ease fears about debt levels. Now this may surprise you, but I am not worried about debt. I am worried the real risk that gets way too little attention.

It is true that if there’s low, predictable interest rates it is fine to run up big deficits every year. The problem is we don’t know if rates will be low and predictable forever. Odds are they won’t be, especially if debt levels rise.

The risk we need to be talking about is rate risk because rising interest rates may pose a serious risk to the economy. Markets and policymakers have short memories, and we’ve had low rates for a long time. People my age can scarcely remember a time when rates were high and unpredictable. I worry everyone, not just the government--also households and firms, have become accustomed to a low rate world. The debt debate, where people talk about future debt levels or even monetizing debt without even mentioning rate risk, shows how remote this risk feels for many people.

Now that rates are starting to go up a bit, we should wonder what it means. I’ve always believed in mean reversion for bonds, or I’ve assumed rates can’t fall forever before they return to their higher long-term average. I believed in mean reversion because that was how bonds traditionally behaved. But, hey....maybe the world has changed. If you believe there’s a natural rate, you could argue it is changing over time. So rising rates could mean one of three things:

1. The natural real rate is about 0 to 1%. If that’s the case, the recent rate rise could be a blip and rates will fall back down and all will be great.

2. the natural rate is now between 2 and 4%, so rates are moving to their new average but won't go too much further and all will be well.

3. history will prevail and in five years 10-year bond yields will be around 8% and there will be trouble.

I should clarify that rising rates aren’t a Fed issue. The Fed has less control over interest rates than many people realize. The rates I am concerned about are market prices. Rates could go up for many non-direct, Fed-related reasons, including higher expected inflation and less demand for US bonds from Asian and oil-rich countries.

If rates do increase significantly, it will create winners and losers. Just think of all those pension funds' higher funding ratios! Debtors, especially the ones who need to roll over their debt, will fare worse. The Fed is concerned about leveraged loans but, to some extent, we are all leveraged.

But to some extent this time is different. A big rate increase (which is not crazy if you think the past is a good guide for the future) means a big structural change for a low-rate economy. This can create many new, unforeseen risks.

Smart or Irrational?

Tyler Cowen points us to a new NBER paper on behavioral economics. It argues that smarter people make better forecasts and long-term decisions. This does not sound so surprising. But here’s the thing (or one thing) that annoys me about the behavioral literature, it often assumes behavioral biases are universal.

They are universal to some extent, but there’s lots of evidence that we become more rational (or conform to the behavior predicted by classical economics) with age and experience. This study highlights another source of heterogeneity: intelligence. So perhaps next time someone tells you that economists are silly because they assume people are rational, we (economists) should say, “We only assume some people are.”


Another risk I am worried about (my new column is turning me into a pessimist) is the future of innovation, which is how economies grow and do more with less. But there are reasons to worry that we may be facing what Ian Bremmer calls an “innovation winter.”

Innovation could slow because of less immigration. There are changes coming for H1-Bs visas, a visa many innovators have had at one point, that will favor advanced degree holders (probably good). But more nationalism may reduce labor flows in the future.

Also, less trade and fewer students going abroad will mean less collaboration—a critical component of innovation. When we reflect on what may turn out to be a golden age of globalization, increased innovation may be one of the unsung triumphs of the era. Many benefits from the tech economy came from the most talented people in the world coming together and feeding off each other’s creativity and knowledge.

As economists tally the winners/losers and the costs/benefits of a more global world, they rarely include the productivity gains from innovation that globalization made possible, but perhaps they should.

Spending Innovation

Thankfully innovation is happening in an area in which I have a special interest: retirement spending. Asset management traditionally focused on how to invest when you are in the saving years. But knowing how much to spend and how to invest while spending is a very different problem that requires a completely different strategy.

There are some new innovations here, more 401(k) plans are offering automatic drawdowns to retirees. The idea is to save retirees’ fees (if they roll over into an IRA and invest in something more expensive) and get them on a steady spending schedule. It’s a good start, but this is not a DB plan. There is a the risk of overspending or underspending. A better plan involves automatic drawdowns paired with an investment strategy that aims to ensure the drawdowns remain steady (or increase with inflation) for as long as a retiree needs.

Long-Term Care

“What about long-term care?” you might ask. Maybe retirees fear spending because they know there’s a good chance they’ll need that money to pay for an expensive end-of-life care.

A report from UBS estimates 85% (!) of healthy couples age 65 will need some form of long-term care during retirement. Moreover, there is a lot of uncertainty around what that expense will be and a large, unpredictable inflation rate. The median couple will spend $184,000 in long-term care costs, and 10% will spend more than $1.0 million! UBS estimates that a couple retiring with $1.0 million (way more than most people have) faces a 32% chance of financial ruin over long-term care expenses.

It is no wonder insurance companies tend to lose money on these policies and won’t/can’t offer them at a reasonable rate. The UBS results suggest many affluent couples will need to turn to Medicaid.

It seems like there must be a better way to finance this risk. This may be the retirement crisis risk we aren’t talking about.

Other News

Until next time, Pension Geeks!