Weird is Normal
Three years ago, Nick Rowe produced this post describing a “weird world” – a world in which the equilibrium interest rate is at or below the long-term growth rate of the economy, rather than above it as we are used to. In such a world, bubbles are inevitably created as investors search for positive yield. This is also the world recently described by Larry Summers.
But I don’t think this world is weird. I think it is actually normal, and we have been living in a weird world of unstable Ponzi schemes that eventually crash and reset. Let me explain.
I’ve argued that investors have no right to expect real returns on safe assets (insured deposits, government debt and, increasingly, land/property) that are persistently above the real growth rate of the economy. I hadn’t done the maths to prove it, but intuitively I felt that an economy in which returns on risk-free savings were persistently above the growth rate could not possibly be in a stable equilibrium over the longer-run. There would be continual transfer of wealth from younger to older and from income-dependent to the asset-rich. The younger and poorer would gradually become either more impoverished or more indebted, while the older and richer became wealthier. Eventually the system would become unsustainable and there would be a crash in which asset holders lost considerable amounts of their wealth.
Andy Harless, it seems, agrees with me (my emphasis):
“Most economists think that the natural real interest rate is normally positive. I have my doubts, but never mind, because I'm ditching the whole concept. Once we start correcting for expected normal growth rather than expected inflation, we are clearly not dealing with a natural rate concept that can be presumed to be normally positive. If we are talking about a risk-free interest rate, then the need for physical capital returns to compensate for risk would make it very hard to achieve an equilibrium with the interest rate as high as the growth rate, let alone higher.”
So the equilibrium real interest rate should be at or below the growth rate of the economy. This means that when growth is very low – as it has been for the last few years - the equilibrium real interest rate would probably be negative. Mark Carney said exactly this about the UK economy in a recent speech:
“As its policy stance reflects, the Monetary Policy Committee (MPC) judges that the equilibrium real interest rate has been, and continues to be, negative.”
If the equilibrium real interest rate is negative, then real returns on risk-free assets should also be negative. If they are not, it is because actual interest rates are too high – and the result will be depressed output, unemployment and deflationary pressures. If the political power of holders of risk-free assets results in an interest rate policy that is too generous to them, therefore, it is bad for the economy as a whole. The implication of Carney’s remark is that UK savers holding risk-free assets (insured deposits and government debt) must continue to suffer capital erosion due to negative real interest rates for the foreseeable future. Looking at it another way, holders of risk-free assets must be taxed on their holdings. We can regard this tax as a charge for the government’s guarantee of those savings. Or, if you like, it represents the value of an unseen asset called “safety”.
To my knowledge we have never regarded “safety” as a positive asset. But the concept of “risk” as a negative asset is at the heart of risk pricing. The price of an asset is discounted by its perceived risk. The most valuable assets are those that are completely safe – there is no risk of loss. The least valuable are those where there is a high probability of loss. Investors expect to be compensated for the possibility of loss, so riskier assets give higher returns. In bond markets this is expressed as the inverse relationship between price and yield: the higher the price, the lower the yield.
But suppose we price the ABSENCE of risk – i.e. safety - as a positive asset? This is in effect what Harless is suggesting:
“But the concept of risk preferences models a subjective good – call it “security””
Instead of taking complete absence of risk as the natural position and adding a risk premium, we take average risk as the natural position and discount from it. This acknowledges that some risk is a normal part of life and complete safety is to a degree both abnormal and costly. By using the growth rate of the economy as the natural position, Harless further implies that that risk is necessary for growth and safety carries an economic cost. The real returns on genuinely safe assets should therefore be lower than the long-run growth rate of the economy, the difference being the negative real return on an extremely valuable asset called “safety” (Harless calls it "security", but I think that's confusing).
The price of the “safety asset” may be highly distorted. Investors unreasonably expect to receive real returns on safe assets that are at a premium to the growth rate. Remember I said that price is the inverse of yield? That applies to safe assets just as much as risky ones. If the return on a safe asset should be discounted relative to the growth rate, then for a safe asset to return a premium suggests it is either seriously undervalued or not really safe.
In the 1970s, government debt did return a premium to the growth rate, probably because of concerns about the safety of government debt in the post-Bretton Woods turmoil. But yields have been on a downward trend for 30 years, and government bonds from sovereign currency-issuing countries in good standing (I include Germany in this category because of its dominance in the Eurozone) are now generally trading at a discount to the expected growth rate. This is not weird. This is as it should be.
Not that there is anything wrong with safety. Safety is a good, and we don’t produce enough of it. Harless comments that “the history of interest rates and growth rates suggests that we have seldom produced enough security, but the deficiency today is clearly worse than usual.” People need to be able to save safely for their retirement and for other beneficial outlays. Discouraging safe saving by restricting the supply of safe assets is itself costly, because it forces investors to accept risk they neither want nor can afford. We need to enable people to save safely if they wish – not least because if they know they can always retreat into safe assets, they may be more willing to take some risk.
But we also need to charge those who seek safety a realistic price for their disengagement with the risk-taking that drives economic growth. We have always undervalued the “safety asset”. History shows repeated cycles of asset price & credit booms ending in crashes, as we would expect when there are unsustainable returns on safe assets. The Old Testament’s “debt jubilee” can be seen as a way of managing this – it created an artificial crash every 49 years. But it didn’t solve the problem.
Governments should create sufficient safe assets to meet demand, and price them sensibly. I say governments, though in practice the governments that can produce genuinely safe assets are small in number: recent events in the Eurozone have shown all too clearly what happens when government debt that is thought to be safe turns out not to be. But realistically the private sector cannot create genuinely safe assets without some kind of government guarantee. Caballero & Farhi, concerned about “fiscal limits” above which government debt is no longer regarded as safe, suggest private/public partnerships for the creation of safe assets. I’m afraid I think this is silly. If the private sector cannot create safe assets, there is no point in pretending that they can while imposing the real risk on government. Let government create them, and stop imposing arbitrary limits on debt/gdp.
Governments massively increasing production of safe assets (debt) to enable the private sector to save safely does of course raise a concern about the burden of debt service on future generations. But if the returns on safe assets are persistently below the growth rate of the economy, then debt service in the future would be sustainable: there would be no need for higher taxes in future to service government debt. In fact there would be a wealth transfer to future generations, representing the value of the “safety assets” that the current generation bought from future ones. Or, putting it another way, the current generation’s need for safety is met by means of a guarantee from future generations, for which the current generation pays through real returns on their savings that are below the growth rate.
Of course, there might be considerable problems convincing savers that it is reasonable for them to pay for safety through negative real returns. And there would probably be even more problems convincing them that risk-free savings should not give a return that they can live on comfortably without drawing on capital. But they have to learn. Safe saving is essentially a Ponzi scheme. If it is to be stable over the longer-run, it cannot give unsustainable returns.
I know this is a very weird way of looking at things. But then weird is the new normal. In fact it has been normal all along. We need to get used to it.
A model of the Safe Asset Mechanism: Safety traps and economic policy – Caballero & Farhi
Global safe assets – BIS
Why stagnation might prove to be the new normal – Larry Summers
The spirit of the season – Mark Carney
When governments become banks – Coppola Comment
America’s greatest export is its debt – The Week