Known Unknowns

Hello,

Welcome to Known Unknowns, a newsletter that—just this one time—will give you free financial advice--a free lunch. Be skeptical.

Inflation: dead or latent?

Pension Geeks are different than most people because we spend so much time thinking about the long term. Pension obligations are made 50 or even 70 years in advance, and we often finance them today. So when people say things like “we don’t need to worry about inflation or debt because interest rates are low,” we get confused. This may be true for the next 5 or 10 years, but 30 years from now? What about 50? We are making obligations now that last for a long time, and therefore it seems risky to assume low rates and inflation will last 50 more years.

And what about inflation? Is this a thing of the past? I am starting to think inflation is like the measles and inflation targeting is the vaccine. Inflation is low for many reasons, including globalization, technology, demographics, and well-anchored expectations from good, credible Fed policy. Inflation is often self-fulfilling as when people expect high inflation, then prices go up. But if they believe the Fed will keep inflation in check, they needn't worry and inflation stays low. Nearly 40 years of low inflation expectations is the great achievement of modern monetary policy.

But we can't take this situation for granted. We can blow that credibility by threatening to monetize debt or find Fed appointees who promise to keep rates low forever. Just because you’ve eradicated something with a good policy does not mean it can’t come back. People forget the costs that inflation risks pose to the economy. Instead, they get complacent and think we have way more policy flexibility than we do. And when credible economists voice concern, we’re told to not trust the experts.

This doesn’t mean high inflation will reappear any time soon, but—if we aren’t careful—it could one day.

Bringing risk to macro

A few months ago, I attended the Macro Financial Modeling meeting in New York (it was way more exciting than that sounds). This group was put together by Lars Hansen and Andy Lo to better incorporate macro and finance. After the financial crisis, it became clear they were not well integrated.

Critics and commentators like to say economists did not see the crisis coming because we assumed people were rational or something, but the real problem was many macro models lacked a meaningful role for the financial sector, let alone the possibility of systemic risk. Several years ago Lars and Andy decided to address this issue.

I conducted a series of interviews with top scholars, policy makers, and financial executives at the meetings. Three of them are now available to watch. One was with Tobias Adrian, of the International Monetary Fund (IMF). He is one of the best thinkers on bond risk premia, and we talked about capital controls and if all this talk about increasing debt leaves out financial risk. I also spoke to Credit Suisse’s Wilson Ervin about what he learned from the financial crisis and what we should be worried about going forward. He made me nervous! In some ways the system is more resilient, but post-crisis regulation has created some new sources of vulnerability.

I also spoke to Andy and Lars about the future of macro finance. Here is a write-up of the event and the progress that’s been made. I also suggest you check out the all-star panel from the meetings. And there is more to come!

The Best Investment You Can Make

There is one investment that I suggest people lever up to make because the odds are overwhelming that it will pay off: education. Of course, not all degrees are equal. I am not suggesting taking out $50,000 in loans to get a Master’s degree in Gaelic language—unless that’s your passion and you don’t mind the debt. But if you get a vaguely useful degree, odds are it will increase your lifetime earnings. This is a much better bet than investing in an IPO.

So it’s weird Elizabeth Warren wants bail out people who made this investment, even though it is paying off for most of them. This is the most regressive policy coming from a progressive candidate I can remember.

Now some people, often those from lower-income families take out debt, drop out, and don’t see those higher earnings. They tend to be the ones in default. A better use of the money would be to help them make it through college. Programs that lower drop-out rates are labor intensive and expensive, but worth it.

I am curious what all you Pension Geeks think of the push for more vocational education. I agree that it is probably more efficient than liberal arts for all. But I worry about mobility. In the 20th century, sending more people to college was a great equalizer. I worry that college for a few really means college for the wealthy.

Some Advice on Retirement

I was excited to see this story from The Washington Post on spending in retirement. This is an issue that gets way too little attention. That may be because there are no easy answers. A strategy that provides predictable income that lasts a lifetime is a hard financial problem, unless you buy an annuity, and lots of people don’t like to buy them. So I was disappointed the story suggested a risky portfolio and using RMDs (?!!!) as a spending rule. RMD rates were intended to make sure people paid taxes, not as a spending strategy.

If you follow this strategy, how much you spend will vary each year depending on how markets do. No worker would accept such variable pay, unless he or she worked at a hedge fund and made a gazillion dollars. Why should a retiree who faces a limited income and large health expenses do this?

I prefer this advice from The Wall Street Journal that suggests working longer. It makes your income last longer, is less risky, and can even prolong your life. However, a longer life is actually not great from a financial perspective.

Or even better, Bill Sharpe is doing it right. He defines risk in income terms and runs simulations to compare strategies (I've been there). He and I think the foundation of any plan is a predictable income floor for life, and then we'll go from there when we take income risk. We must make income the investment objective. But this will require a major rethink of how we approach retail asset management.

Also, three think tank economists also shared their retirement plans.

In Other News


Until next time, Pension Geeks!

Allison