Known Unknowns


Welcome to Known Unknowns, a newsletter about how to manage risk—and if you can’t do that, then at least how to worry about uncertainty. This week (and hopefully just this week!) I’m coming to you from Scotland, a place with a long history of dealing with pandemics.

Recession is nigh

I’ve always believed that most recessions are caused be exogenous unforeseen shocks. You can’t predict what will take an economy down, but you can assess how resilient it is. Resilience can’t prevent a recession, but it can mean that the effects are a lot less severe. And on that front, I’m somewhat optimistic. We’re experiencing the coronavirus with fairly healthy household balance sheets, as well as a resilient financial sector. Corporate balance sheets are another story, which is why the widening corporate spread is so concerning. But with strong households and a financial sector, it seems that once the virus is controlled, assuming it does not drag on for a year or more, the economy will recover. A well-targeted fiscal stimulus would certainly help.

However, in terms of long-term structural impacts, I do worry about what this will mean for our faith in our institutions. After the financial crisis—or to be honest, since Paul Volcker—people have seen the Fed as capable of effectively steering the economy. Most commentators in the media and in industry tend to think that monetary policy can do more than it really is able. But that belief made their limited tools all the more powerful.

A few months ago, I was talking to some central bankers about how they deal with uncertainty, and they all listed how proactive they were being—cutting rates to near zero, QE, or negative rates. I asked whether that left them with any ammunition if something unpredictable came along. And they all said, “Sure, there’s lots we can do—like currency manipulation.” I remember thinking, I hope it’s not a global shock—and here we are.

And after recent surprise rate cuts, QE-by-another-name, and liquidity measures, I noticed a change. People said that they didn’t expect this to do much, which technically was correct—Monetary policy doesn’t really do much for the real economy. But they do alter expectations and confidence. If the Fed is seen a powerless through all of this, it could remain less powerful because the expectations channel won't be so effective anymore. And that is troubling. Has the Fed lost its hard-won credibility?

Our belief in the ability of government institutions to deal with crisis is also being put to the test. A big part of why there is so much angst right now is that we are facing uncertainty (in the Knightian sense) more than risk—which we can quantify. There’s so much we don’t know. Risk management when facing uncertainty is much more difficult, because reducing risk always comes at a cost. One big reason why South Korea was more successful is extensive testing and transparency produced lots of data. And data is what turns uncertainty into risk, and that enabled them to manage it.

I also worry about the future of globalization. It is generally growth enhancing; because diversification is efficient. But it also can creates systemic tail risk, which we never bothered to manage. And that tail risk may stick in people’s memories for a long time.

The bond market

The stock market has everyone’s attention right now, but what’s happening in the bond market is actually more important. I am always surprised that people are surprised that a negative correlation between stocks and bonds doesn’t always hold during extreme market turmoil.

But even as rates move all over the place, I worry the record lows may have long-term implications and may even last longer than the bear market. Yields never fully recovered to their pre financial crisis levels, and while the stock market may bounce back once some kind of end is in sight, increased risk aversion may keep yields lower for longer.

Of course, last time I speculated that less global integration could be a long-term impact of the coronavirus. And that means less demand for U.S. bonds, and higher yields. But I suspect that’s a while off. So, if the government does a big debt-financed fiscal stimulus, I hope they issue long-dated treasuries to pay for it. These debts will probably be around for decades, so why take on roll-over risk?

Labor market

On to happier topics! You may have heard that people can’t commit and that they change jobs a lot. But actually, the opposite is true. Job change rates have been trending down, and that worries economists, because job changes mean promotions and higher salaries. It turns out that one reason why people don’t change jobs more frequently isn’t about risk aversion, complacency, or a lack of dynamism. Rather, a big part of lower job turnover, currently at about 40%, is because firms have gotten better at hiring people. Thirty-five years ago, 25% of people had been at their current job less than a year, while now only 20% of people are. It seems that employers are now better at screening and hiring the right people.

Maybe Linked-in is providing some value after all.

What’s a better investment—education and/or a house?

I’m sick and tired of the narrative that millennials can’t afford a house because of student debt. There’s no evidence that that is true. Actually, the more debt you have, the more likely you are to be a homeowner, because people with lots of student debt tend to be high-earning professionals.

There is a decline in homeownership among millennials, but it’s mostly among non-degree holders. Home ownership is actually up among the college educated, even though these people tend to live in expensive cities.

And even if college debt was keeping someone from buying a home, why is that bad? A college education increases your lifetime earnings and reduces the risk of long-term unemployment. What is your house doing for you?

In other news

Here’s how the government funded the opioid epidemic.
Inflation expectations are way down—and it’s not just TIPs illiquidity.
When you account for Social Security, wealth inequality has not increased.
The stakeholder economy is coming for your pension.

Until next time, Pension Geeks!