Welcome to Known Unknowns, a newsletter that defines risk in a novel way that you will find thoroughly unsatisfying.
What does risk really mean?
What does “risky” really mean? Some people think it means that something bad might happen. Some people also see potential upsides and possibilities. There’s no universal definition of risk, because it can mean many things in different contexts. Downside, upside, tail risk, immeasurable risk… It really can be idiosyncratic to your personal risk tolerance or the situation that you’re in. My mentor, Bob Merton, has a unifying definition of risk that is simple and at the same time illustrates why defining risk is so difficult. Risk is the opposite of safe. Safety defines risk by being its opposite—or risk is what safe isn’t.
This may sound sort of strange and esoteric, so let’s apply this definition specifically to financial markets, which is where risk is valued, bought, and sold. Markets not only have an important economic function; we can also look to them for lessons that we can generalize to other areas of life. A risky asset in finance is anything that’s not a safe asset; these include stocks, corporate bonds, CDOs, crypto, private equity, and, well, pretty much everything that’s not a short-term treasury bill, a money market fund, or a short-term repo. Well, kind of. And this is where things get complicated. Whether or not those assets are truly risk-free is a big and existential question that really depends on your investment goals. Rolling over short-term treasuries is not a risk-free strategy over a 20-year investment horizon, especially if there’s inflation, or if you have long-term liabilities. And there are always chances of runs, defaults, and market dislocation.
But for the sake of pragmatism, let’s say the risk-free asset is a 3-month treasury. And if that’s to be considered safe, then everything else is risky. In that way, safety defines risk. And this isn’t just an academic argument. It really does define risk, because the risk-free rate shows up in pretty much all asset pricing formulas—it truly defines and values risk.
But what if safety is mis-priced? In theory, the market price of safety reflects how much investors are willing to give up spending today for the promise of spending tomorrow. There may also be some convenience yield to knowing what your asset will be worth in the future, and because you can sell it whenever you want, that yield may vary with the business cycle.
In Bloomberg last week, I argued that the price of safety is mis-priced. Real yields have been negative for the better part of the last 10 years, and have been very negative since the pandemic. And the Fed has no plans to bring it above zero. I can understand a market negative real yield from time to time for convenience reasons. But all of the time? For decades? How can you explain that? Well, I blame the Fed and regulatory policy, as well as other countries buying lots of safe assets to manage their currencies. Lately, it’s been a lot of the Fed.
The risk-free rate is always being tinkered with by policymakers. Maybe it never actually equals the market price, but sometimes it’s more distorted than others, and it seems like it’s really off right now. And if that’s true, what does that say about the price of any risky asset? Perhaps that explains why crypto currencies are worth so much despite not offering much inherent value and having such a high Beta. When celebrities are hawking an esoteric risky asset, you know something is wrong.
Risk-free assets are the most systematically important asset in markets. They touch absolutely everything. And when it goes wrong, things get real. When market prices are not market prices for years at a time, risk gets distorted, and people subsequently take on more risk than they realize. I’m not predicting a financial crisis, but I do reckon that this could be why markets are just so weird right now.
Human capital is not risk-free
In that spirit, are investment bankers being underpaid? No: they should actually be paid less than people in private equity and crypto. Their jobs are less risky. The jobs may be more boring, but they also have more stability—not that jobs in banking are ever really safe or stable. They also have a high beta. But they’re probably more secure than a job at a crypto start-up.
What do we want our welfare state to be?
Somehow it has become conventional wisdom that the enhanced Child Tax Credit (CTC) was a good policy. The evidence to support this proposition is that childhood poverty rates fell last year, which is not surprising—if you give every family in America lots of money, they will have more of it. But does that make it a good policy?
I’m all about reducing childhood poverty—who isn’t? It’s shameful that the United States is the richest country in the world and has poverty rates above the OECD average. But the reduction of poverty is not how we should assess the success of this plan, because it’s not a poverty plan. When judging its success, we need to ask whether we could reduce poverty at a lower cost to tax payers, or in a way that’s less distortionary. What are the long-term impacts when we’re not in a weird labor market because of a pandemic? A large majority of the $100-odd billion goes to middle- and high-income families. That means that it’s not a poverty program. Also, it removes many incentives to work, which could create more poverty in the future. I think we can do better.
There’s a good argument to make that even if it’s not a poverty-reducing program, we need a massive middle to upper middle-class entitlement. I’m sure more money is better for families (assuming that it’s not inflationary, and I don’t think the CTC in isolation caused inflation), but even that’s not a sufficient reason to continue with the enhanced CTC. Because we can’t have everything—at least not without cutting other programs or raising taxes. And it seems to me that before we create a massive new entitlement, we should have a debate about our priorities, and people should campaign and win elections on this basis. There are always trade-offs, and if the risk-free rate increases, debt will get more expensive, and we can’t have everything that we want. Maybe that’s why voters don’t like the enhanced CTC—even if that’s confusing commentators on both the left and the right, who keep insisting that it works well because it reduces poverty.
Odds are that the enhanced CTC will not be in the slimmed-down Build Back Better, because it’s really not that popular. I hope that whatever baby BBB contains in the future is thoughtful, well-designed, and well-targeted. It probably won’t be, but I’m always an optimist.
Until next time, Pension Geeks!