Known Unknowns
The economy is getting real
Hello,
Welcome Known Unknowns, a newsletter that hopes, for your sake, that your retirement income is indexed to inflation.
Monetary Policy
These are crazy times. The unemployment rate is 3.9%, inflation is at 6%, and real interest rates are well below 0, all while the Fed is still doing QE. Yes, they’re phasing it out, and there are plans about increasing rates to something slightly less below zero over the next two years. But even after all the rate hikes, this is still a very accommodative monetary policy.
Accommodative monetary policy refers to when the real policy rate is below the natural rate (or the market risk-free rate). I agree that there are reasons to believe that the natural rate is lower than it was in the 1990s. There’s more demand for low-risk assets, more savings, etc. But I have yet to hear a compelling argument that the natural risk-free rate is negative. What model can explain that? Instead, it seems that we have monetary policy that’s juicing the economy indefinitely. They just plan on juicing it a little bit less in the future.
I feel like we’re reliving the 1970s, and not because we are facing similar economic conditions. Prices are much lower, and inflation dynamics are totally different. Better access to information and more international suppliers may be what’s keeping inflation from reaching the levels of the 1970s. The underlying economy is also much healthier. What reminds me of the 1970s is the rationalization from policymakers that inflation will go away, is not so harmful, or exists due to greedy corporations jacking up prices. These are all excuses that relieve policymakers from making hard decisions.
I came of age as an economist during the Great Moderation, and now I look back on those times and marvel at how naïve we all were. I was taught that we had learned what bad policy looked like, specifically that we shouldn’t mess with supply and demand, that information imperfections cause market failures, and that inflation is a monetary phenomenon. I was taught that the Great Moderation (low inflation, low interest rates, and low unemployment that persisted for decades) occurred in large part due to the fact economists knew what they were doing. However, that line of thinking sounds pretty deluded now—not just that we thought we could control the economy and prevent bad recessions, but what’s even crazier is that we believed we wouldn’t repeat mistakes from the past.
Cut to 2021—are we seriously talking about price controls?! So far, the government has not been talking about them explicitly, but blaming big company greed for inflation is either teeing it up or is already some sort of implicit price control. I guess it’s easier than admitting that the Keynesian stimulus went too far. And it’s definitely easier than doing the hard work to increase supply or pulling back on demand.
Some things are different from the 1970s, though. I’ve heard another economist mention that Forward Guidance (the idea that talking about doing something instead of actually doing it is an effective monetary policy because expectations are what matter) has made central bankers believe that they don’t have to actually do anything that will harm the economy in order to tackle inflation. They believe that if they just talk about doing something, it will have just as powerful an effect. This is starting to remind me of the arrogance we had back in my grad school days. After all, aren’t we really saying that economists (or lately, lawyers) at the Fed can outsmart the market? Now maybe I’m more of a finance than macro economist these days, because this all seems sort of absurd to me. No one outsmarts the market—at least not forever.
I hear many economists, on the left and right, calling for more aggressive rate increases and that the Fed should surprise the market with them. But financial markets may not like it. They are now built around negative real rates and predictable Fed policy. Most economic commentators talk about the trade-off between inflation and unemployment (a false choice, in my opinion). But the real trade-off could be inflation (and the Fed’s credibility) and financial stability (long versus short -run).
Now, I agree that the labor market hasn’t fully healed. Labor force participation has not yet recovered. A big part of this is early retirement, and there used to be a good number of people who retired but then changed their mind and returned to work. These people aren’t going back to work anymore, and while early retirements may be less of a problem than a 25-year-old dropping out of the labor force (and prime age participation hasn’t recovered either, and is becoming a bigger share of the drop-outs, I think the pandemic may have been very destructive when it comes to human capital in a number of ways), it’s still a problem. Early retirement means much less money over the course of retirement—a lot less. And this may depress consumption and also leave more retirees dependent on their reduced Social Security and Medicaid benefits. The longer they don’t work, the harder it is to go back.
This should be an issue for policymakers, but it’s more of a supply than a demand issue, which means that negative interest rates won’t do much to get people working again. I get it! Supply problems, which include incentives to work and skills, are more difficult to solve than simply talking about raising interest rates one day. But if we don’t address the problem, all we’ll have left is a smaller labor force and more inflation.
I’m worried about Chile
I don’t know much about Chilean politics, but I’ve always admired their pension system. Individual accounts can work well if they’re well-structured. Chile’s accounts weren’t perfect. Fees could be high, and lots of people in the informal labor market either weren’t covered or else couldn’t save enough. But it also provided income for lots of people and increased participation in Chilean asset markets, and Chile is not facing the entitlement bomb that every other country is dealing with. I’d take Chile’s pension problems over Brazil’s. But instead of just fixing what’s wrong (which would be relatively easy), there’s a plan in place (still not sure it if will actually happen) to “nationalize” the accounts. And that would be a pity.
DC plans have their problems, but when DB plans blow up, they really go down—and they take the economy with them. Just look at Puerto Rico. DB risk tends to be undiversifiable and non-transparent to beneficiaries, and this is a big issue if you live in a country that’s less than fiscally responsible (which Chile used to be, but may not be going forward). And the incentives are very hard to get right when it comes to politicians financing DB plans. As fellow Pension Geek, Andrew Biggs, told the Wall Street Journal, “These are programs that affect people over an incredibly long period, and yet they’re being governed by people whose time frames run from now until the next election.”
I’ll take my chances with a well-invested and annuitized individual account.
In other news
Things about tech we got wrong
Until next time, Pension Geeks!
Allison