Known Unknowns


Welcome to Known Unknowns, a newsletter that can’t predict the future or tell you what asset price is about to collapse, but it does know how to value pension liabilities.

Will there be a recession 2020?

I have no idea. Expansions don’t die of old age; the odds of a recession don’t increase over time. Expansions usually end with an adverse economic shock, and those are, by definition, impossible to predict. There are many sources of potential shocks – China, trade wars, Iran, beggar-thy-neighbor currency wars, maybe an increase in oil prices.

Rather than predict when and what will cause a recession, it is more productive to worry about how resilient the economy is to a shock. This is more telling and much easier to measure. There are also sources of vulnerability, many firms with not great credit are carrying lots of debt, politics are so toxic we can’t count on fiscal policy, and central banks are already in expansion mode, which could mean they don’t have much ammunition left if there is a bad shock (unless you still believe in the expectations hypothesis).

But who knows? Since 2010, at least a dozen things that should have caused a recession did not – and this could go on for another 10 years.

By the way, it is curious Ben Bernanke believes that lowering rates on the 10 year bond will boost the economy. If near 50 basis point real rates doesn't do much, why would 0? And if the Fed does do QE again and the yield curve inverts will we have to endure endless recession speculation?

Is there a risk-free bubble?

I am not sure asset bubbles really exist. I am probably too much of a believer in efficient markets. But, suspending my disbelief for a minute, suppose the biggest bubble is in risk-free assets? It may sound impossible; after all, risk-free assets by definition are supposed to deliver a certain return – that’s why they are risk-free. Now what is risk-free is relative. It depends on your time horizon and investment goals. But, for the sake of argument, let’s call risk-free relatively short government bonds.

Those who believe in bubbles usually define them as an asset whose price is bid up by speculation, so much so that prices exceed their fundamental value, but one day prices drop suddenly and financial carnage ensues (and then everyone knows it was an asset bubble and confirm they do indeed exist). Risk-free assets offer a certain return – supposedly. But since many bond holders don’t hold their debt to term, or borrowers need to roll over their debt, even treasury prices can be a source of risk.

Prices are high for low risk assets in part because of speculation, but mostly because demand is large because foreign governments want to manage their currencies. Meanwhile financial firms and pension funds need bonds and bills for regulatory purposes and collateral. Some investors just want low-risk assets if they fear risk or just want to hedge it. Meanwhile, the supply of low-risk assets is somewhat fixed because only a few countries produce low-risk bonds. A big price drop would require a sudden collapse in demand. That seems unlikely – people don’t suddenly decide they aren’t risk-averse. Though political and regulatory risk is a potential concern.

However, risk-free assets pose more systemic risk than any other asset. They are used in almost every asset pricing formula. They also are the foundation of the debt market. There are concerns the low rate is propping up zombie companies, increasing the leveraged loan market, and encouraging more risk-taking among investors who need higher yields to meet their obligations. We live in a zero, or negative, real risk-free world now. If any other asset got so expensive for so long and everyone was exposed to it, people would call it a bubble.

The state of retirement

Some personal news, I am no longer a staff writer at Quartz, though I will continue to contribute there, like I did since the launch. More news next time on my next project.

For my last story, I covered my favorite topic, the state of retirement. It is sort of mixed. Here’s the quick-and-dirty: Yes, few people have enough money for maintain their life styles in retirement. If, by retirement, you mean 25 to 30 years and a 70% replacement rate and enough money to pay for long-term care. But no one ever had that much money. When we were in a DB regime, few people had pensions – and many of those pensions were underfunded. Moving to a DC regime not only increased coverage, it made it clearer how little money anyone has, just because there is more transparency and better incentives. Don’t hate on DC pensions; they are merely the messenger.

By most accounts, the average retiree never had more wealth – and that is true across the income distribution. The problem is they still don’t have enough to finance the retirement they want or expect. 20 to 30 years of retirement with a 70% replacement rate may just not be realistic in a DC or DB world, especially with such low interest rates.

This is not just a boomer issue: Many protests and civil unrest this year were about pensions, because people’s expectations (and in all fairness, what they were promised) do not always match reality.

What can be done? Save more, work longer, and get more financial education. Stop thinking of retirement/work as binary states. Part-time or gig work will feature in most people’s old age, and that is not necessarily all bad. We also do need to make realistic promises and have a stable safety net so people can plan and have realistic expectations. Oh, and state and local pensions need to use proper discount rates.

In other news

I sometimes think central banks overstate their power to control the economy as part of their communications strategy, but this is going a little far.

John Cochrane demonstrates why macroeconomists need to learn finance.

Until next time, Pension Geeks!