Cold air and a hot economy
Do higher rates really matter after all?
Photo by Vadim Sherbakov on Unsplash
Hello,
Welcome to Known Unknowns, a newsletter that offers a safe space in our higher-forever economy.
The Economy Is on Fire: Is It Too Hot?
The jobs report was solid, the stock market is soaring, and consumer spending remains strong. This is a hot economy. It seems higher interest rates aren’t significantly dampening economic activity. But what does that mean? Perhaps r*, the neutral rate, is around 2% in real terms—close to where we are now. Or maybe the Fed’s tools are less effective after a prolonged period of near-zero rates. If that’s the case, it adds to the list of problems associated with low rates.
Are things too hot? It’s hard to say. There are signs of resilience, but I’m concerned about transitioning from a zero-rate economy to a higher rate (like 4 to 6%) one. The 10-year bond doesn’t suggest we’re heading back to 2019 anytime soon, and we have an economy accustomed to very low rates.
For instance, I know several people buying homes who are opting for adjustable-rate mortgages. They’ve been told—yes, told!—that rates will drop in a few years, and this expectation is baked into their financial projections. While rates might fall, I wouldn’t bank on it.
Another concern is private credit. While it’s not a massive part of the debt market, it’s increasingly important. Some firms borrowing in private markets are struggling to make interest payments, which are floating rate. Instead of defaulting, they’re rolling missed interest payments into the principal—a worrying trend. Between this and optimistic homebuyers, it seems many are treating higher rates as temporary.
Does this pose a systemic risk? Probably not, but it could create problems if the private credit market contracts or experiences a wave of defaults. Sooner or later, we’ll need to adjust to a higher-rate reality.
On a related note, the push to get more retail investors into private assets needs to stop. I’m not against private markets—they provide value and have a role in institutional portfolios. But private equity and credit have likely grown beyond optimal size, another byproduct of near-zero rates. Shrinking them back to size might create challenges.
Fixing College
A potential shift in the next administration could involve reforming American higher education. Few institutions have lost as much trust and credibility, often deservedly so. Issues range from frivolous majors and grade inflation to overreactions like offering milk and cookies after elections, embracing extreme politics, and even reports that students can graduate from elite schools without reading a single book.
I’ve written before about how the mission of creating a national elite has corrupted universities, diverting them from their original purpose: education and knowledge production. Crafting an "elite" inevitably becomes a political project.
However, the situation is fixable. American universities still house brilliant professors, curious students eager to learn, and produce groundbreaking research. This holds true not only for top-tier institutions but also for schools across the country.
For Bloomberg, I suggested more schools adopt a Philosophy, Politics, and Economics (PPE) program. Originating at Oxford, many American universities already offer versions of it. PPE is excellent for developing critical thinking and analytical skills. Employers should focus less on where students went to college and more on what they studied, with rigorous programs like PPE earning cachet.
Another reform: double-blind grading, like in the UK. In this system, exams are graded by the professor (or TA) and then re-graded by a professor at another university. This reduces grade inflation since students can’t appeal to anonymous graders, and it ensures consistent standards. Employers could evaluate what students achieved academically, regardless of whether they attended Harvard or Texas A&M.
Judging students by their university accomplishments rather than their high school coaching feels more meritocratic. It maximizes the potential of our diverse higher education system, elevates talented students and professors, and depoliticizes elite schools.
Pension Geek Alert
As a long-time fan of Larry Kotlikoff, like all Pension Geeks, I’ve read his work for years. I was thrilled to join his podcast, where we discussed the challenges of retirement finance, why it is an important problem, and many other things too.
Until next time, Pension Geeks!
Allison
"Another reform: double-blind grading, like in the UK. In this system, exams are graded by the professor (or TA) and then re-graded by a professor at another university. This reduces grade inflation since students can’t appeal to anonymous graders, and it ensures consistent standards."
As someone who has taught in both the US and the UK systems, and has been deeply involved in the so-called "double-blind grading" in the UK as an external examiner for several universities, let me assure you that the UK system does nothing whatsoever to reduce grade inflation, nor indeed to ensure consistent standards. It often increases grade inflation (the external examiner says, "this would earn an A at my university, so you should give one here as well" far more often than the converse), and since external examiners have no idea how the course was taught, it is impossible for them to distinguish a brilliantly original answer from one that was carefully prepared for in the lectures, so the idea that it ensures consistent standards is something of a joke.
The one good thing that it does do is remove personal bias, in the rare cases that occurs - where a professor deliberately downgrades through personal animosity or upgrades through favoritism. But personal bias like that is rare, and can (at least in the downgrading case) be dealt with much more effectively through a robust internal appeals system, or else through anonymizing examinations.
The double grading system at British universities is quite unbelievably expensive, as well as appallingly time-consuming for all concerned (you literally have to pay to bring outside professors in to every university department and give them days to work through hundreds or thousands of examination papers), without actually achieving its supposed aims.
If Private Credit is something that should not be in the hands of "retail", then what do you turn to for something not as highly correlated as most options open to "retail"? I have been only an accredited investor for a few years and already find it frustrating the options that are now moving to the "qualified" tier. Are we to take BTC or Crowdfunding as our only choices (I'd rather buy a Lotto ticket). I'd hate to loose my access to vehicles that are providing inventory bridge loans or senior, asset based capital to strong small and medium businesses.