So far we talked a bit abstractly about markets. Yes, we used some specific products for examples, such as white wine, rental apartments, and perhaps airline pricing, but we have not yet developed a particular market model specifically for a particular product. In this post, I want to do this for a particularly important market: the market for money. This post gives a first account of the basic insights and ingredients that underlie our understanding of credit markets and financial markets. You will see, I hope, that what we have learned so far, especially about supply and demand, while not enough to understand these markets fully, was also not in vain. It will come in handy.
This is the title of a new paper by Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, and Moritz Schularick (original paper, voxeu article). The paper is the result of a research project to calculate the rates of return on four major asset categories – equities, bonds, bills, and real estate – in 16 major developed economies going back as far in time as reasonable. (Quibble: Is that really everything? What about gold? currencies? commodities? paintings? vintage cars?)
The paper does nothing but compute long-run averages and standard deviations and draw graphs. No regressions, no econometric witchcraft, no funny stuff. Yet its findings are fascinating.
Some of the results confirm what „everyone already knew, kind of“:
- Risky investments like equities and real estate yield 7% per year in real terms.
- The risk premium (equities/housing vis-a-vis short term bond rates) is usually between 4 to 5%.
- There is no clear long-run trend (either up or down) in rates of return. (Take this, Karl Marx!)
Some of the results are interesting, but not particularly puzzling:
- The return on total wealth (average of the rates of return on all assets weighted by their share in the economy’s aggregate portfolio) exceeds the rate of growth of GDP. This confirms Piketty’s claim that r > g. In terms of the Solow model it means we are living in a dynamically efficient regime: we cannot make both present and future generations better off by saving less. Perhaps the most interesting aspect of this finding is its robustness: it holds for every sub-period and for every country. It really seems to be a „deep fact“ about modern economies.
- The return on risk-free assets is sometimes higher, sometimes lower than the growth rate of GDP. For instance, before the two World Wars, the differential between the risk-free rate and growth was mostly positive, so that governments had to run primary surpluses to keep debt stable. Post-1950, the differential was mostly negative.
- Negative returns on safe assets are not unusual. Safe rates were negative during the two World Wars as well as during the crisis of the 1970s. In recent times safe rates went negative again in the aftermath of the global financial crisis. These findings don’t disprove the „secular stagnation“ hypothesis of Summers et al. but they do put it in historical perspective. It seems that rates were unusually high during 1980s and the recent downward trend could just be a reversion to the mean.
But some results are really puzzling – even shocking from the point of view of standard finance theory:
- The return on risk-free assets is more volatile than the return on risky ones. I haven’t yet digested this fact fully. Does this mean that “risk-free asset” is a total misnomer? No, because „risk-free“ refers to the unconditional nature of the payoff of an asset, not the variability of its return. A bond is „risk-free“ because it promises a fixed cash flow irrespective of the state of the economy. Stocks are called risky, not because their returns are volatile, but because the dividends they pay are conditional on the performance of the company. So does this mean that people’s time discount rate varies a lot? Why? It can’t be consumption growth variability – because consumption is quite smooth. What’s going on?
- Housing offers the same yield as equities, but is much less volatile. Jorda et al refer to this as the housing puzzle. I’m not sure how puzzled I should be by this. I surely found the high average yield of real estate assets surprising. However, from what I know about house price indices and the myriad measurement issues surrounding them, I feel that one should be very cautious about the housing returns. I definitely would like someone who knows more about this look carefully at how they calculated the returns (paging Dr. Waltl!). One potential solution to the puzzle I can see would be differences in liquidity. Housing is super illiquid, equities are quite liquid. Couldn’t the high return on housing just be an illiquidity premium?
There is much, much more in the paper, but those were the points that I found most striking. I’m sure this will be one of the most important papers of the past year and will be a crucial source for researchers in finance, growth, and business cycle theory. Plenty of food for thought.
As a last example of the application of the idea that the world is probably free of easy arbitrage opportunities I here provide a brief introduction of the idea of financial engineering. Assuming the absence of arbitrage is all one needs to price financial derivatives. A financial derivative, perhaps a bit narrowly defined, is a financial product – that is a risky investment possibility – with payoffs that depend exclusively on other “basic” financial products such as bonds and stocks. You may want to google what bonds and stocks are if you do not yet know. For our purposes all we need to know is that a stock of a company has a value or price that substantially varies over time. The future price of a stock is uncertain today and this uncertainty can be quite large.
I recently stumbled upon a paper by Sornette and Cauwels of the ETH Zürich strikingly named “The Illusion of the Perpetual Money Machine” (.pdf). It makes for great reading and presents a solid case for rethinking the way we do things policy wise, particularly with regards to monetary policy. I’m not going to discuss much of it, for I wouldn’t know where to start. But maybe some thoughts. To use their words
Rather than still hoping that real wealth will come out of money creation, an illusion also found in the current management of the on-going European sovereign and banking crises, we need fundamentally new ways of thinking.
At first sight this may seem as an argument that should be shelved somewhere close to the crazy gold bug crowd. But it is not, for it is carefully argued and backed up by evidence rather than just some badly articulated gut feeling. Still, I feel like that argument needs some qualification: while indeed it is impossible to create real wealth out of money creation alone, it is very much possible to destroy real wealth due to a lack of money creation – and I would argue that we have seen that happen plenty of times in the past already, and not just in the past 30 years. Another seemingly key passage:
The discrepancy between the exuberant inflation of the financial sphere and the more moderate growth of the real economy is the crux of the problem we are currently immersed in.
In a sense this seems to be all part of a much bigger debate regarding the relationship between monetary policy and financial markets. And even though I’ve done quite a bit of reading over the past couple of months and in part even years, I still feel like I’m only scratching the surface here. Scott Sumner, for instance, makes a fairly decent case for “keeping finance out of macro“. I can find myself agreeing with a lot of it, even though it might seem overly simplistic. Basically, it is a central bank’s role to stabilize NGDP growth, and it should do whatever it takes to do so. As noted also by Sornette and Cauwels, monetary policy should not respond to “the vagaries of the stock market”, yet unfortunately it has too often done so in the past. On the other hand, the recent crisis has shown us that it might be difficult if not impossible to stabilize NGDP growth over a long period of time without taking the financial sector into account – so from that reasoning alone there seems to be a strong case to be made that finance cannot remain entirely out of “macro”.
In some way there seems to be little doubt that our modern financial system, while performing absolutely invaluable functions to the economy as a whole, has been working and continues to work in a fashion that some might argue is simply unsustainable. Yet it’s an entirely different argument to make that the almost 60% youth unemployed in Spain, just to name an example, should simply sit back and hope for the best while Europe faces incredibly tight monetary policy just because governments have spectacularly failed in the past and continue to spectacularly fail to this very day to regulate a financial sector that’s often based on (and extremely successful at) an enormous amount of rent-seeking that delivers little real benefits. Central banks have a role to play here through macroprudential regulation, for instance, and they should do so. But to argue that we need to keep money tight even though the real economy is in shambles just because the financial sector that we purposefully (and wrongly) deregulated would go on squandering any stimulus away makes no sense at all. It’s basically admitting that we screwed up, but since we screwed up all we can do it to continue to screw up.