Known Unkowns


Welcome to Known Unknowns, it is quite racy this week, I must say, for a newsletter about pension risk.

Can a high risk-free rate explain the sex recession?

The risk-free rate affects every financial decision. It features in nearly all financial models. When it’s lower, investors must take more risk in order to get a high return. Many quirks of our modern economy are due to the current low level of interest rates.

But there is one risk-free asset whose return is higher than ever: the returns from risk-free leisure. Suppose you’re wondering what to do next Saturday. You could go to a party, which could either be awful, fantastic, or just fine. Maybe you’ll have a life-changing, wonderful conversation. Maybe someone will insult you and make you feel bad, or maybe you’ll get hit by a car. So much risk! Or, what if you just stay in and watch Netflix, which is pretty certain to go well, even if you give up the chance of having a great time at the party?

Even 10 years ago, the stay-home-and-watch-TV option wasn’t nearly as compelling. The no-risk option was pretty boring; you actually had to leave the house to be entertained. I reckon that this may at least partly explain the sex recession, which is the fact that millennials are dating and marrying less than previous generations, despite access to better matching technology. Why risk Tinder when you can binge Game of Thrones?

And speaking of sex and economics, last week was my first every appearance in the Wall Street Journal. All about horse inbreeding and 1986 tax reform; I promise there’s a direct connection.

“Don’t spend 5% of your income on coffee,” and other good advice that has become controversial

I’m bewildered by the sensible personal finance advice and financial literacy backlash. Yes, it’s true that living standards are higher, people want/need more luxury goods and services, and average pay has not kept up. It’s also true that income is more unequal and that there’s the patriarchy keeping women down with their black coffee, while women seemingly need milky hot beverages.

But none of that is an excuse to spend $5 per day on coffee when you only make $30,000 per year. Life is unfair, and the more money you have, the more space you have to be financially sloppy. Low-income people have no room for error or money to waste. I understand why financial institutions full of rich people swilling Starbucks and telling everyone else to cut back is tone deaf and won't make poor people rich. But it’s still good advice. Many Americans would have to sell something or go into debt in order to come up with $400 in cash.

We live in a world in which small luxuries have never been more accessible, which for many families makes mindful spending more critical than ever. No, it’s not fair—maybe we should have a better safety net, or a wealth tax, but these ideals don’t pay for car repairs.

Now, I’m a tea drinker (and in America, tea at home is usually better than tea out), so perhaps I don’t understand how lattes are a necessary good for some. But arming people with sensible financial advice and knowledge shouldn’t be subject to debate. In fact, rationalizing mindless spending because life is unfair is what’s reckless and elitist.

Speaking of reckless and elitist…

When you study finance, a huge question is always what’s the right data to use. If the world/markets have undergone a major structural change, should you disregard that data when you estimate risk/reward or make forecasts? And how do you know when the structure of the economy will change again?

The answer to these questions is usually unknowable, so it’s often prudent to use as much history as possible, rather than depend on your flawed judgement. Thus, the insistence that inflation is dead and buried, and that the Fed shouldn’t worry about it, seems a little bit shortsighted to me.

Worse even is the fact that inflation can be self-fulfilling. People like to complain about the all-powerful Fed, but I think that monetary policy has been remarkably successful in the last few decades. Policy has overseen stable inflation, decent growth, and prevented a depression. And some of that success was due to well-anchored inflation expectations. Abandoning inflation targeting or monetizing debt is probably a bad idea, with the same intellectual vacancy as the practice of not vaccinating your children.

That said, I’m wary of precise targets. Inflation data is noisy, and it’s hard to deliver an exact rate. I think worrying about 1.8% or 2% or over-shooting to get 2% in average misses the point. But maybe it makes for interesting commentary.

On a somewhat related note, Lael Brainard wants to explore targeting long term interest rates. To which I say, “Huh? Has that ever worked?” I feel like the results from Operation Twist and QEs were pretty mixed. I’m curious as to why and how, considering how little we still know about the mechanisms of how short-term rates impact economic activity. It all sounds risky to me.

Should we root against tech IPOs?

The Uber IPO was not great. Mihir Desai has an interesting op-ed in the New York Times arguing we should’ve hoped for that outcome. I think we can all agree that something is broken with start-up finance. Whenever something blows up, we always look back and say, “That was clearly a huge problem—why didn’t it bother everyone at the time [see multi-levered mortgages that people clearly couldn’t afford]?”

I’m not sure what the outcome will be, but this whole situation with VCs investing in unprofitable companies and then the company going public and saying, “We never have and may never will earn a profit, but buy our stock anyway,” and then people actually buying the stock—that just can’t be good. VCs enable this because they figure that they’ll make money with the IPO. Desai argues that their reckoning is due—let’s hope the IPOs crash and burn. If that happens, maybe the market will start allocating capital to profitable companies, or at least companies that aspire to earn a profit, which is how functioning markets work.

I feel this too. But here’s what concerns me: lots of the money backing these unprofitable companies came from tax payers, teachers, and firemen and policemen, in the form of public pension assets invested in VCs. And if these investments bomb, taxpayers make up the difference with higher taxes or fewer services (kiss infrastructure goodbye).

Now, maybe that’s for the best, since taxpayer dollars should not be subsidizing unprofitable tech bros, and the longer it goes on, the worse it could get. And maybe things have to go pear-shaped so that pension fund managers will learn their lesson. Maybe if that happens, they’ll finally start acknowledging that risk exists. That would be wonderful.

But, ughh… I would hate to see taxpayers foot the bill for this, even as I know they will.

In other news

Baseball players are signing extensions because the upside to free agency isn’t what it used to be. Are they making a bad choice? It’s hard to know. It’s hard to make complex risk assessments—just look at the market for annuities.

AOC drove a stake through the heart of Pension Geeks everywhere when she took a stand against funding pensions.

Until next time, surviving Pension Geeks!