Known Unknowns


Welcome to Known Unknowns, a newsletter that took 10 years to notice the world changed.

How the financial crisis changed everything

When I was in Zurich a few weeks ago, Richard Clarida made a speech that got me thinking. He spoke about the low-rate, low-inflation environment and how it poses challenges for monetary policy. But it was this figure in his presentation that really stuck with me.

I think we all knew that r*, the natural risk-free rate, has been falling over time. But I did not appreciate the big drop after the financial crisis. It fell more than 150 basis points and stayed low. More than 10 years on, we can call it a structural change.

What can explain it? Well, you know all the usual suspects, i.e., demographics, productivity, etc. But it mostly comes down to supply and demand. Foreign governments and investors have been buying low-risk assets from industrial countries since the Asian financial crisis in the late 1990s. Meanwhile, US and European financial firms need safe assets as collateral, for regulatory purposes, and to hedge equity risk. The big demand drove up prices. Yet a growing demand for safe assets pre-dates the crisis. What did change in 2008 was that the supply of safe assets fell. This was when investors realized many AAA assets from the private sector weren’t so safe after all.

The increased demand for risk-free assets is an under-appreciated aspect of globalization. It arguably contributed to the financial crisis, and it means a structurally lower risk-free rate, which has all sort of implications we are only starting to understand. The risk-free rate is the foundation of how finance works – and I don’t just mean how it alters the channels of monetary policy. It has been a total disaster for defined benefit pensions, which must make much larger contributions, take more risk, or close their plans – they are doing all three.

The risk-free rate shows up in just about all asset pricing models. It determines how much risk investors take because, if the risk-free rate is low, they either have to scale back their plans, save more, or take more risks. Investors and households carrying more risk on their balance sheets is significant. It can have impact on how much people consume, invest, their job choices – everything! A structural shift in the risk-free rate is a structural change to the entire economy. It changes behavior and just means there is more risk in the economy – and who knows what any of that means?

I am student of Ned Phelps, so when I say “structural,” I don’t mean “permanent.” Even structural prices can change – they just change less frequently or change with other structural variables like technology. So, I don’t think this is an invitation to run up debt for a few reasons. One, risk premiums can change on a dime, so bond yields can still go up for riskier and longer-dated bonds. Two, the demand for risk-free bonds is not as stable as it appears. Asian governments’ and investors’ demand has leveled off. They are buying more debt in their own countries. Social Security is starting to run deficits instead of “buying” bonds. Those are two of the biggest buyers of safe assets, so perhaps demand will fall and prices will, too.

A big jump in the risk-free rate could cause all sorts of problems because we’ve adapted to a low-rate world.
These are truly extraordinary times. Usually, financial instability comes from very high risky asset prices, but now it is the risk-free assets that are super expensive – maybe too expensive (whatever that means).

Aging and the risk-free rate

Changing demographics is one reason why r* is presumed to have fallen. But I’d like to unpack that a bit more, as there are several theories why that may be. It could be that, if people expect to live longer, they save more, which means a bigger stock of saving and lower r*. But savings is not that much higher than it was under the old DB plan regime, at least in American and Europe. But I’d buy that there’s more savings coming from Asian countries to finance their future elderly spending.

Another theory is that an older population is less productive because fewer people work, so they decrease r*, which represents a return to capital. Though labor force participation is higher than it was in the 1960s (when fewer women worked) and rates were high then.

I’ve also heard that older people invest more in safe assets because they de-risk as they age and have less human capital. The popularity of target date funds is consistent with this narrative. But because rates are so low, many advisors are rethinking the 60-40 split and pushing savers to hold equity for longer. This will decrease the demand for fixed income. Besides I am not sure older people are in less-risky assets anyhow. I created the figure below from the 2016 Survey of Consumer Finances. It shows that the share of risky assets in household financial portfolios is consistent across different age groups.

I don’t see a huge de-risking as people age, even if I think they should. Perhaps the demographic contribution to low rates is not so significant.

Technology and market structure

One thing is clear: This is not the economy of the 1960s. The risk-free rate is just one big change; globalization and technology could mean the ideal market structure is different too. This is why I am wary of the antitrust fervor to break up big tech. Yes, there are many concerns that big tech firms pose to the economy, e.g., less competition, and yes bigger can mean more systemic risk. But I think the government making private companies smaller is a big deal, before we do it, we should have good reasons why. I still like the consumer harm standard. You can measure it, and it is clearly bad. Breaking up big for the sake of bigness is not a reason. That’s especially true if markets have changed, so bigger means lower prices – not higher. This is one reason I don’t expect the TD/Schwab merger to result in higher fees. We may live in a world where we need scale to lower prices. The scope of modern anti-trust seems to be higher prices for consumers. I am not sure how that will go down.

Besides, big today does not always mean big tomorrow. Network effects aren’t necessarily a durable natural monopoly the way a power grid is. I mean, just look at Facebook: It got so boring, and I hear the kids aren’t even on it anymore.

In other news

Richard Robb wants us to rethink rationality.
A threat to Fed independence comes from within.

Until next time, Pension Geeks! Have a happy Thanksgiving.