Welcome to Known Unknowns—a newsletter about the macroeconomy, risk, and the price we pay to pretend that they don’t exist.
Resiliency vs. efficiency
Any economic shock is followed by a period of reckoning. We tend not to realize the risks that we face until they totally take us out. Then, we rethink how our economy functions and which institutions we need. The Great Depression led to the New Deal because it became clear that an industrialized and more urban economy required some form of a welfare state.
I expect some big institutional changes to be coming our way soon. One favorite debate, at least according to the editorial page of the Financial Times, is the trade-off between efficiency and resilience. Buying all your goods from China, including PPE, may be efficient—but if you have a global pandemic, then it means that you’re not so resilient. Or, if you live in Texas, cheap energy is great when you blast your air-conditioning every August when it’s 110 degrees outside, but if there’s a crazy cold snap and your power gets shut off, you see that your system is actually not that resilient at all.
We already see the Biden administration taking on resiliency, as he is trying to revive domestic manufacturing. And we can expect some soul searching in Texas as well. But I’m not convinced that we’ll get the big overhaul, because the problem with resiliency is that it can be extremely expensive, and once we forget about the shock, we don’t want to pay for it anymore. It’s expensive if you define resiliency as the ability to seamlessly handle a once-in-a-lifetime tail risk that you never saw coming. People like cheap power and goods, and those things help the economy grow.
There are trade-offs, of course, and you want to be resilient to many potential setbacks. But preparing for everything, even the improbable things that we almost can’t even imagine, will mean significantly lower growth and hurting the most vulnerable (who benefit more from cheap goods and power) the hardest. I am not sure it is worth it.
When everyone thought I was a hopeless math student, I took my high school’s “stocks for jocks” class, where students learned what the stock market was and about things like compound interest. It was not a hard class, but in retrospect, it was good for me to have taken it, because it motivated me to pursue economics (so I eventually did learn a lot of math). One of the assigned texts was Peter Lynch’s One Up on Wall Street, which today seems crazy to me. Why did they teach high school students that good investing entails picking a few good stocks based on a trip to the mall? What’s even crazier is that most Americans still seem to think of investing this way.
When the market goes up, it’s easy to forget what investing is really about. The purpose of investing is moving money over time—and growing it, too. And that involves not only high returns, but also managing risk. The risk/reward trade-off is the central tension in finance, and there is no free lunch.
The exception, however, is when it comes to diversification. If you’re well-diversified, you get a higher expected return and less risk. This is why we should all own index funds and stay away from individual stocks (unless you view it as a hobby, and are thus prepared to lose money).
I think it’s great that so many people discovered the stock market this year. I have many friends who’ve never invested before who now feel empowered and thrilled that they made money. And I feel very strongly that more Americans should own stock. But we need to educate people on some investment basics first, and rather than obsesses about hedge funds and making day trading fair for all, why don’t we expand access to index funds and teach a little investing literacy? Investing is risky, and if you aren’t thinking about risk, you’re vulnerable.
I watched the GameStop hearings, and at first I was horrified that when Robinhood’s CEO, Vlad Tenev, was asked how his clients performed relative to the S&P 500, he said that comparing his users’ performance to another investment wasn’t appropriate. He explained that the better comparison was how they’d do if they had just spent the money. My first thought was, “Wow, this guy made a billion dollars in financial services and doesn’t know what a benchmark is!” (or is pretending not to know, I am not sure what’s worse).
But then I thought more about it, and I reckon that he might be right. If you’re day trading individual stocks, you should be prepared to lose that money and see the process only as entertainment. Of course, he did later say that Robinhood is meant to facilitate investment, so maybe I gave him too much credit.
Interest rates and inflation on the rise
Interest rates are going up, and so are inflation expectations. It’s way too early to know whether or not it really means anything bad, or if it’s the start of the long-waited mean reversion. But when parsing Fed speak on it, I’d like to make a few points.
The costs of high, unpredictable inflation are greater than the cost/benefits of below target (but not deflation) and stable inflation. It’s not symmetrical, so simply tolerating high inflation for a while is not ideal. And if high inflation does break out, the costs of reducing it and restoring the Fed’s credibility, are much worse than tolerating 1.5% inflation for a few years.
Also, it’s a false choice between inflation and unemployment. The modern Philip’s Curve argues that if you keep rates low to keep employment high, eventually low rates stop having much impact on the labor market. And at that point, what you get is both inflation and unemployment.
So, no, economists aren’t willing to tolerate unemployment because of their misguided inflation obsession. It’s more that we are humble about the fact that the Fed has no impact on the real economy, and that there is no free lunch.
I’ve been thinking a lot about how we cope with risk this year, and I’m beginning to think that having faith in the Fed is like having faith in a higher power. It gives people comfort that Jay Powell has complete control over the economy and long-term interest rates, and that a 25 basis point cut or increase can have a real impact on their lives, including in the areas of racial justice and climate change. But I tend to be more agnostic, and I think that the Fed can at best soften some sharp edges, but that’s about it.
Powell is more like a priest than a deity.
Don’t call it a comeback
I live near Little Italy, and this past summer I was struck that the mafia eventually came out of the woodwork. I guess they were always there, but they were not the force that they used to be in the city. That’s due to a variety of different reasons, a big one being that the economy is less risky. The mafia actually filled a risk reduction role, as it offered protection and capital to small businesses. Now crime is down, capital is more available, and racketeering is a challenge when New York retail is mostly populated by big chains. It is hard to shake down a Duane Reade.
But it looks like the mafia made a small comeback during the pandemic—at least in Italy, where they’re filling a void for cash-strapped small and medium businesses on the brink of collapse. I wouldn’t count them out in New York, either, if this all goes on much longer.
In other news
The very smart Ricardo Reis is doing the long overdue work and bringing macro and finance together. And, it turns out, when you account for risk—what had become the conventional wisdom (at least on Twitter) that if r<g then you can run huge debt forever, isn't quite right after all.
Until next time, Pension Geeks!