Allison's ode to the second movement


Hello, All,

Welcome to the 24th issue of Allison’s Ode to the Second Moment, a newsletter firmly on the side of science, our best tool for minimizing risk, even if it doesn’t eliminate it.

Another thing Millennials​ just don't understand

For most of modern financial history, inflation was a big deal. It, like all asset prices, could be variable, unpredictable, and sometimes large. It imposed many costs on the economy. Inflation risk made it hard for firms and individuals to make long-term investment decisions and increased the cost of borrowing. But in the post-Volcker era, we’ve only known low, stable, and predictable inflation. Thanks, in large part, to the fact that this is the explicit objective of monetary policy.

This happy state of affairs has been going on for so long that about half the American population has never experienced a serious bout of inflation. They don’t even know what inflation risk means, which may explain why young commenters ruthlessly mock older pundits who even utter the words “inflation risk.” Some are so confident inflation risk is no longer an issue they argue the Fed should lighten up on inflation and persue other policy objectives or adopt a variable inflation target.

To be fair, it is possible we’re so clever these days and monetary policy is so powerful (and politically independent) that large, unpredictable bouts of inflation will never happen again. After all, for the past several years deflation was the big risk. Now there are signs inflation is picking up, and some smart people expect it to reach 2% and stay there as the economy continues to pick up steam.

I think a good rule of thumb is to assume that whenever people start saying we’re so smart we’ve totally eliminated any risk, it is time to start worrying again. I am not saying America is about to resemble Weimar Germany any time soon, but the complacency worries me.

Inflation might become less predictable and variable in the future, and we may not be prepared. Pension funds and retirees have been cutting back on their inflation protection.

No, gold is not a good hedge.

Another lurking debt bomb

Speaking of lurking risks, economic growth looks unstoppable. To the astonishment of everyone in politics, the stock market keeps going up and the labor market keeps improving. But there is more uncertainty and all this good news could turn on a dime if tax reform doesn’t pan out.

There’s not much we can do about it. Some are stockpiling dehydrated food and building bunkers. I prefer to prepare myself by looking at household balance sheets. It gives you a sense where the risk is hiding. After the financial crisis, different forms of credit dried up, but there was an explosion in car and education loans. Car loans have topped a trillion dollars and one in five borrowers are subprime.

The possibility of higher interest rates (because we still care about inflation) may create new risks in this market. Compared to home or student loans, it is relatively easy to default on a car loan. This will probably not cause a major financial crisis, but it is worth keeping an eye on.

After all, the time to worry about debt isn’t after it becomes a problem—just look at Illinois and Dallas.

State retirement plans

One major issue with retirement accounts (like 401(k) plans) is lots of people (especially with lower incomes) don’t have one. In the past few years, there’s been a big push to expand coverage by having the federal government and states offer retirement accounts. The state programs are more comprehensive. They offer plans to small businesses, and include automatic enrollment, a feature that dramatically increases participation rates.

I have some concerns about the state plans. How they’ll select investment options is unclear. There was talk of offering a guaranteed return floor (because state budgets are so flush with cash, right?). I agree guaranteed returns inaccurately specify retirement risk and are more expensive than states realize. I also have mixed feelings about not subjecting the plans to ERISA.

These concerns aside, who can argue with the concept? It is very expensive for small, low-paying employers to set up and administer retirement accounts. Offering an alternative that features auto-enrollment has the potential to dramatically increase coverage and that’s a very good thing.

And yet a resolution was passed by the House last week that would prevent states from offering plans that featured auto enrollment for small businesses. The concern seems to be that this would crowd out the private market for small plans. Personally, I think that the market needs some crowding out. The fees are absurd. True, that’s due in no small part to the regulatory costs associated with ERISA. Perhaps small plans need to a pass on that and, in that case, perhaps administering the plans should be left to the government.

Things will get better, but not soon enough

Regular readers know I am a techno-optimist. I love economic history and it seems many things we are experiencing now happened during the Industrial Revolution. Men are losing their jobs and are worried they’ll never be employable again. There’s social unrest, populism, and xenophobia. But the last time, it all worked out and today we all are enjoying higher living standards and more wealth than people had in the 18th century.

History could repeat itself. I think the odds are that it will; humans are natural innovators and like to make themselves useful. Techno-pessimist Tyler Cowen argues that may be true, but even if it is, the transition period was terrible, lasted a very long time, and still has a bad influence on policy. The current, messy transition will probably last the rest of our lives. The idea that people in 2150 will benefit from our sacrifice isn’t so comforting.

A fair point. There are many signs that the world is going to hell. The news is fake and the leaks are real. Robots don’t pay taxes and the British people don’t eat biscuits anymore.

Good thing General HR McMaster understands risk better than anyone.

Until next time, Pension Geeks.

Allison