Allison's Ode to the Second Moment

Hello,

Welcome to the sixty-sixth issue of Allison’s Ode to the Second Moment, a newsletter that loves a good story, even if it turns out to be total fiction.

The stories we tell

I highly recommend this essay by Lars Hansen, which offers some great insights on how to think about just about everything. The world is full of uncertainty, and yet we must constantly make decisions about policy, our investment portfolios, and even which subway to take.

When I started my book (out April 2—pre-order now!), I had the idea that economic and financial models are really just parables. Using math as their language, they tell a simplified story in order to teach us a lesson about how the economy works and how to manage uncertainty. The parable form is a powerful way to tell a story. For example, parables are one big reason for Christianity originally catching on. And math is a powerful language in itself, even though it is inaccessible to most people. My book takes financial models and retells them using a traditional parable structure—stories about people facing risk and uncertainty.

Lars’ essay discusses the limitations of these parables. They need to be simple because their objective is to illustrate economic relationships in a complex world with many moving parts. The storyteller must make choices about what to include, but this is where judgement—and our personal values—comes in. There is no truly objective research or economic models, and no one parable, whether it’s Keynesianism, neo-classicalism, or neo-Keynesianism, is the best description of every economic relationship.

We are living in times during which people distrust experts. Sometimes this is for good reasons. Even experts, with all of their knowledge and data, operate under uncertainty as well. When experts describe the world and the economy, they make choices that reflect their values and life experiences. This does not mean their research and recommendations don’t have value—quite the opposite. Experts might be biased, but their training and the research processes subjects their bias to some rigor. Successful models tell stories that align with the data. That’s more than most people can say about whatever story they’re pushing.

Just because our descriptions of the economy aren’t perfect, it doesn’t mean that they aren’t valuable. We need to somehow make sense of things. Otherwise, we are just groping around in the dark.

I am not doing Lars’ essay justice here. You should read the whole thing for yourself.

Income risk stories

Here’s a personal story of my own that illustrates his point. When I was in graduate school, I used a large panel survey to estimate household income risk, which was the gold standard of data back then. I estimated that household income had become riskier since the 1980s.

A few years later, economists got their hands on Social Security Administration records. They discovered that income risk, if you assume that risk is volatility, has not increased after all. Income volatility has been pretty stable since the 1980s. Who knew? We often hear a different story; that people face more risk than ever before.

Here is an example of why it is important to use the right model to tell your story. Most people think that volatility is risk (it is the title of this newsletter, after all) and it is the standard risk measure in finance. But volatility does not tell the whole story. The Social Security wage data also reveals more negative skew during recessions, which is to say that income drops more during recessions than it used to, and sometimes does not recover. There is more systematic tail risk.

These are important stories. There are policy implications that depend on the risk that people face, and identifying the nature of the risk you face helps you plan and take steps to hedge and insure.

There are also several useful lessons in this parable. One lesson is that having the right data is important; it is what validates your story. But great data today can be less useful tomorrow; better data might come along totally change your story. This parable also helps us to understand why two different stories can be helpful. Both measures of risk, volatility and skew, tell us something important, even if they say different things.

Parables about leveraged loans

The Financial Times offers a nice illustration of this idea, too. It asked two different experts’ for their take on leveraged loans. Many people, including the Fed, are worried that the private sector has taken on too much debt and that this can pose a risk to the economy. One expert thinks that leveraged loans make the system more vulnerable, even if they won’t cause a recession. The other thinks that they aren’t risky at all. I suppose which person you believe depends on which story you think is more compelling. But in a world in which we can’t possibly know the future, hearing both arguments is always useful.

However, maybe the story we should really be worried about is that of Taiwanese Insurance companies. They are the ones buying lots of that corporate debt. Hope nothing goes wrong there!

Sometimes the world changes, and your story has to, too

I’ll admit that some people can beat the market, but very few can beat every market. Take Bill Gross, the Bond King. He made active bond management a hot strategy, but he did it while bond prices went up for 30 years. Now that bonds aren’t so hot, neither is his strategy. That’s the thing about active management: it works until it doesn’t.

+1 for the efficient markets parable

Other stories


Until next time, Pension Geeks!

Allison