Known Unknowns


Welcome to Known Unknowns, a newsletter that minimizes tail risk in bad times, and worries about it in good times.

The price of resilience

Life is always uncertain; many things will happen that you can’t predict or prepare for. Risk management is mostly about preparing for the things that you do anticipate—the probable risks. But it also often includes managing the improbable or things that we never imagined would happen.

The only way to manage uncertainty is through flexibility, and flexibility is expensive, whether it comes from having cash, liquid assets, or not relying on global supply chains. When there’s an unexpected bad and extreme shock, it’s easy in hindsight to say that we should have been prepared, had less debt, more available cash, and the ability to still make stuff. But when you do these things in good times, this is very expensive and puts you at a disadvantage. It’s like giving yourself three hours to get to the airport in case there’s a hundred-car pile-up, when it’s typically a twenty-minute trip.

There is often a trade-off between growth, efficiency, and resilience to tail risk.

I thought that this column in the Financial Times from Rana Foroohar was quite interesting. She argues that economists became so obsessed with efficiency that they neglected to put a value on resilience. It’s a strange argument, because there’s an entire field of economics dedicated to this question. Financial economics aims to put a price on tail risk and liquidity. It seems that “economists never thought about resilience” is the new “economists never thought about irrational behavior or inequality.”

But Rana does raise a valid point. Going forward, we need to think more carefully about what we’ll pay for resilience. The entire world experienced a huge negative shock, so right now we’re willing to pay any price. I hear politicians claiming that we’ll build a more resilient society and economy, one where we trade less—especially with China—and that there will be lower dividends, no share buybacks, and fewer mergers. There may be value in some of this, but it will also mean a slower recovery, more inflation, and less productivity going forward.

There is a danger in over-estimating the value of resilience and becoming fixated on tail risk to the point that you ignore more probable risks, or thinking that you’re resilient when you’re actually not, because your definition of flexibility is based on the last war. If there’s a global pandemic that turns countries in autarkies, relying on global supply chains makes you less resilient. But not always. There are also benefits from diversification. If one of your industries needs to shut down, maybe from a disease outbreak or disruption to your domestic supply chain, then the ability to buy stuff from somewhere else can also be useful. Trade also in some ways makes you more flexible, since you aren’t as tied to a single country’s labor force, skill sets, wages, etc.

Reopening the economy is often framed as a “jobs versus lives” trade-off, but that understates the various risks in both the economy and public health. Striking the right balance between standard risk, tail risks, and growth will be very difficult. It’s a good thing that we have financial economics.

The future of education

Odds are that someday we’ll forget about tail risk, or at least not worry about it as much as we currently are. Humans in the past learned to live with much graver risks, and have found a way to thrive. But some things will change, and I don’t just mean wearing masks at the first sign of influenza. A shock this bad tends to accelerate existing economic trends. Our relationship to technology will change. It was already changing, and has been in a constant stage of change, but this shock will accelerate it.

Take, for example, the first industrial revolution. Technology helped to produce goods such as cloth more cheaply, and they became more accessible to the masses. Handmade, high-quality goods still existed, but these were luxuries with a higher price-tag. The current technology is doing something similar to services. You can now see a trainer or take a class online relatively cheaply. The more high-touch the experience is, the more expensive and valuable it is.

Every student has now experienced online education, and they’re all familiar with its strengths and weaknesses. It’s not a great substitute for high-touch education, small in-person seminars, and one-on-one instruction for children with learning disabilities, to provide just a few examples. But it’s not bad for everything—and in fact, it may be better than big in-person lectures, which tend to be impersonal and lack discussion already.

If colleges open in the fall, large lectures may stay online, while small classes might still be taught in-person. This may be a better way to teach, virus or not. It unbundles the education experience. Students who can afford it will pay a premium for in-person attention, and also get a better education. Others will get something less personable, but not completely terrible.

I wonder if this could finally lower the cost of education. Its price has been growing over the past several years for many reasons, one being that it was hard to make education more efficient through the use of technology. It still involved people time. Also, universities were reluctant to go online because unbundling would disrupt their business models. This is no more.

But, like other transitions, the process will be messy. Some schools may close. Some online education will actually be terrible. But this was already in the works—it’s just now happening at warp speed.

I should be clear, I think this would work for higher education. I am not so sure how well technology scales for younger students. Andrew Cuomo tapped tech billionaires to "re-imagine" education at all levels. Once again, I think of the first industrial revolution and how it started universal schooling. The goal then was not just literacy; it was to train people to be complaint, factory workers who could work with, and for, people they weren’t related to. Our education system is not just about learning, it also provides the foundation of how we socialize and work with others.

I wonder what the tech community (not the best socialized people) has in mind and what the future will be like, how we get along, and relate to each other if school students spend their days learning online, alone.

Bonds and inflation

When you learn empirical finance—at least if you learn it properly—you take away a few important lessons about making any projection.

1.Past data is pretty useless, but it is better than nothing.
2.Very recent data is even more useless and noisy, so use as much history as you can.

There are some important caveats about structural breaks, but saying that the market is forever different is a high bar, and our judgment on these things tends to be terrible. Maybe that’s why I’ve always been annoyed/perplexed by every commentator who argues that both high inflation and large bond yields will never, ever happen again. This appears to be based on inferences from their 30- to 40-year lifetime (or at least in their memory).

Maybe there’s a structural reason that they’re right, and we can simply ignore the distant past. But I’ve never heard the reason why we can do that, other than some hand-waving about demographics, which never totally made sense to me.

It seemed that some of the trend was driven by trade, which both kept prices lower (because it was efficient, and low-wage people made stuff) and increased the demand for our debt. But even before the crisis, these factors were becoming less important. Foreign labor got more expensive, and demand for U.S. bonds had weakened. John Cochrane points us to this report from the BIS on what went wrong in the bond market recently among the broker dealers (the guys who normally make it function).

Under normal circumstances, dealers would be able to alleviate market stresses by absorbing sales and building up an inventory of securities. But dealers’ treasury inventories had already been stretched, especially from 2018 onwards, as they needed to absorb a large amount of issuance (Graph 3, right-hand panel). Far from there being a shortage of safe assets, there was a glut* in the run-up to Covid-19.

This could only get worse. There is lots more sovereign debt around now, and what happens if the Fed and the Bank of England stop buying it? Or what if they keep buying, if they want to keep rates low? That could be inflationary once demand returns.

Perhaps the post-COVID world will be a new structural regime. For the foreseeable future, there will probably be deflation and low rates. But longer-term, in a world with less trade, lots of debt, and significant monetary policy interventions we may end up with higher rates on the long end of the curve (where the Fed has less control) and higher, less predictable inflation.

In other news

You can imagine that pensions are not in good shape.
Jeff Brown doing Pension Geeks proud
Consumption smoothing with illiquid assets.

Until next time, Pension Geeks!