Robert Shiller and Radical Financial Innovation

Robert Shiller, who shares this year's Nobel Prize with Eugene Fama and Lars Peter Hansen, is perhaps most famous for his ability to "predict the future." But he also has an impressive grasp of the past. As just one example, in my recent blog post on the history of inflation-protected securities, Shiller's paper on "The Invention of Inflation-Indexed Bonds in Early America" was the most useful reference. Shiller's ability to develop intuition from financial history has, I believe, contributed to his success in behavioral finance, or "finance from a broader social science perspective including psychology and sociology."

Rather than attempting a comprehensive overview of Shiller's work, in this post I would like to focus on "Radical Financial Innovation," which appeared as a chapter in Entrepreneurship, Innovation and the Growth Mechanism of the Free Market Economies, in Honor of William Baumol (2004).

The chapter begins with some brief but powerful observations:

According to the intertemporal capital asset model... real consumption fluctuations are perfectly correlated across all individuals in the world. This result follows since with complete risk management any fluctuations in individual endowments are completely pooled, and only world risk remains. But, in fact, real consumption changes are not very correlated across individuals. As Backus, Kehoe, and Kydland (1992) have documented, the correlation of consumption changes across countries is far from perfect…Individuals do not succeed in insuring their individual consumption risks (Cochrane 1991). Moreover, individual consumption over the lifecycle tends to track individual income over the lifecycle (Carroll and Summers 1991)... The institutions we have tend to be directed towards managing some relatively small risks."

Shiller notes that the ability to risk-share does not simply arise from thin air. Rather, the complete markets ideal of risk sharing developed by Kenneth Arrow "cannot be approached to any significant extent without an apparatus, a financial and information and marketing structure. The design of any such apparatus is far from obvious." Shiller observes that we have well-developed institutions for managing the types of risks that were historically important (like fire insurance) but not for the significant risks of today. "This gap," he writes, "reflects the slowness of invention to adapt to the changing structure of economic risks."

The designers of risk management devices face both economic and human behavioral challenges. The former include moral hazard, asymmetric information, and the continually evolving nature of risks. The latter include a variety of "human weaknesses as regards risks." These human weaknesses or psychological barriers in the way we think about and deal with risks are the subject of the behavioral finance/economics literature. Shiller and Richard Thaler direct the National Bureau of Economic Research working group on behavioral economics.

To understand some of the obstacles to risk management innovation today, Shiller looks back in history to the development of life insurance. Life insurance, he argues, was very important in past centuries when the death of parents of young children was fairly common. But today, we lack other forms of "livelihood insurance" that may be much more important in the current risk environment.

"An important milestone in the development of life insurance occurred in the 1880s when Henry Hyde of the Equitable Life Assurance Society conceived the idea of creating long-term life insurance policies with substantial cash values, and of marketing them as investments rather than as pure insurance. The concept was one of bundling, of bundling the life insurance policy together with an investment, so that no loss was immediately apparent if there was no death. This innovation was a powerful impetus to the public’s acceptance of life insurance. It changed the framing from one of losses to one of gains…It might also be noted that an educational campaign made by the life insurance industry has also enhanced public understanding of the concept of life insurance. Indeed, people can sometimes be educated out of some of the judgmental errors that Kahneman and Tversky have documented…In my book (2003) I discussed some important new forms that livelihood insurance can take in the twenty-first century, to manage risks that will be more important than death or disability in coming years. But, making such risk management happen will require the same kind of pervasive innovation that we saw with life insurance."

Shiller has also done more technical theoretical work on the most important risks to hedge:

"According to a theoretical model developed by Stefano Athanasoulis and myself, the most important risks to be hedged first can be defined in terms of the eigenvectors of the variance matrix of deviations of individual incomes from world income, that is, of the matrix whose ijth element is the covariance of individual I’s income change deviation from per capita world income change with individual j’s income change deviation from per capita world income change. Moreover, the eigenvalue corresponding to each eigenvector provides a measure of the welfare gain that can be obtained by creating the corresponding risk management vehicle. So a market designer of a limited number N of new risk management instruments would pick the eigenvectors corresponding to the highest N eigenvalues."

Based on his research, Shiller has been personally involved in the innovation of new risk management vehicles. In 1999, he and Allan Weiss obtained a patent for "macro securities," although their attempt in 1990 to develop a real estate futures market never took off.

Low Interest Rates, Savers, and the Recovery

This is a brief addendum to my recent post, "Do Savers Need to be Saved?"

Back in March, I wrote about Paul Krugman and Charles Plosser's takes on near-zero nominal interest rates and household saving. Both noted that households were deleveraging and the zero lower bound was binding. Both agreed about Krugman's diagnosis of a "persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy." But their suggested cures were quite different.

I just came across a piece written in May by Raghuram Rajan, new Governor of the Reserve Bank of India, called "Central Bankers under Siege," that takes on the same issue. He, too, makes a similar diagnosis but suggests different cures. In my post on savers and low interest rates, I discussed the income and substitution effects of low interest rates, and mentioned that near-retirees are commonly cited as examples of people for whom the income effect dominates. Rajan actually uses this exact example:

"First, while low rates might encourage spending if credit were easy, it is not at all clear that traditional savers today would go out and spend. Think of the soon-to-retire office worker. She saved because she wanted enough money to retire. Given the terrible returns on savings since 2007, the prospect of continuing low interest rates might make her put even more money aside. 

Alternatively, low interest rates could push her (or her pension fund) to buy risky long-maturity bonds. Given that these bonds are already aggressively priced, such a move might thus set her up for a fall when interest rates eventually rise. Indeed, America may well be in the process of adding a pension crisis to the unemployment problem."

Rajan and Plosser match up point for point. Here's Plosser:

"In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small...

I have heard from various business contacts that the low interest rate environment is spurring institutional and individual investors to “search for yield.” This may entail taking on more credit risk than these investors are typically comfortable with in a reach for yields that may ultimately be illusive and result in losses they are ill-equipped to handle. Very low yields may also be distorting other investment decisions, inducing firms to undertake long-run investment projects that may prove to be unprofitable in a rising interest rate environment."

Both Rajan and Plosser fear that lower interest rates won't help the economy because either the income effect dominates the substitution effect or because low interest rates will cause "reaching for yield." My fellow Not Quite Noahpinion author John Aziz suggests:

"Savers looking for a larger rate of return should... take their money out of low interest savings accounts and out of the failed financial intermediation industry and invest it into quality economic projects that create jobs and growth. This could involve buying the stock or debt of large companies that wish to expand, or it could involve starting your own business, or investing in a startup or a mixture of these things. The easiest way to return to growth — and thus higher interest rates, and higher returns for things like pension funds — is for today’s savers complaining about low interest rates to turn into tomorrow’s investors seeking out and pouring money into quality projects that increase incomes, create jobs and create products that people desire and want to use."

The question is whether low interest rates have the beneficial effect on investment that Aziz describes, or the harmful reach-for-yield effect. Returning to Plosser, Krugman, and Rajan, it is interesting that the three economists seem to diagnose what is ailing the economy quite similarly (a "persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy"), but make different prescriptions. First, they differ in their opinions of unconventional monetary policy:

• Plosser: "The first step is to wind down our asset purchases by the end of the year in a gradual and predictable manner. As I said, I see little if any benefit from these purchases, and growing costs. The second step is for the FOMC to commit to its forward guidance on the fed funds rate path, that is, to begin treating the 6.5 percent unemployment rate and the 2.5 percent inflation rate in the guidance as triggers rather than thresholds."
• Krugman: "Unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried)."
• Rajan: "We really don’t know. Given the dubious benefits of still lower real interest rates, placing central-bank credibility at risk would be irresponsible."

They also differ in their general policy prescriptions:

• Plosser wants removal of fiscal-policy-induced uncertainty: "There remains significant uncertainty about the choices that will be made. How much will tax rates rise? How much will government spending be cut? U.S. fiscal policy is clearly on an unsustainable path that must be corrected. Efforts by Congress and the administration at the end of last year reduced some of the near-term uncertainty over personal tax rates. But the impact of the sequester, the debate over the continuing resolution to fund the federal government beyond this month, and the debt ceiling, which will once again become binding in the spring, all have clouded the fiscal policy situation. So, the resultant uncertainty will likely be a drag on near-term growth. In my view, until uncertainty has been resolved, monetary policy accommodation that lowers interest rates is unlikely to stimulate firms to hire and invest."
• Krugman thinks the fiscal multiplier is large, and fiscal retrenchment would be destructive: "the logic for a biggish multiplier and the logic of the crisis itself are very closely linked: times like these, the aftermath of a credit bubble, are precisely when you expect fiscal multipliers to be large. And that in turn says, once again, that fatalism — or worse yet, demands for fiscal retrenchment — in the aftermath of such a bubble are deeply destructive."
• Rajan looks to helping households refinance, and (somehow) improving workforce capabilities: "We cannot ignore high unemployment. Clearly, improving indebted households’ ability to refinance at low current interest rates could help to reduce their debt burden, as would writing off some mortgage debt in cases where falling house prices have left borrowers deep underwater (that is, the outstanding mortgage exceeds the house’s value)... But it is also important to recognize that the path to a sustainable recovery does not lie in restoring irresponsible and unaffordable pre-crisis spending, which had the collateral effect of creating unsustainable jobs in construction and finance... Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes."

Popping the "Bubble" Bubble

Without a doubt, QE has been an incredible boon for financial markets. Backed by QE3, the SP500 stock index has risen by more than 12% year to date. Yet in spite of this increase in the stock market, overall real economic conditions remain relatively stagnant. Year over year inflation as measured by the core PCE price index ticks in at only 1.2% YoY, and last quarter's real GDP grew by only 1.4% YoY. This disconnect is a bit unsettling, because it suggests that bullishness in the stock market has failed to translate into broader growth. On this basis, some commentators, such as Frances Coppola, have argued that quantitative easing does nothing for the broader economy and worsens economic inequalities. But this concern can be reduced to an even simpler question: Has recent stock market growth just been a bubble?

There are a few reasons why this question is important. First, people make a lot of noise over the financial instability hypothesis that monetary policy is just fueling speculative excess. So for the sake of practical monetary policy, it matters if signs of a bubble are appearing. Second, if it can be shown that we are not in a bubble, and that recent financial market movements are based on fundamentals, this means that monetary policy is passing through to the economy. It's not just some scheme to enrich the wealthy. Moreover, the tools that we develop to analyze this issue can help us determine in the future if certain monetary policies are passing through to the economy. Third, analyzing this issue leads to some more insights on how finance and macro can work together. While I am sympathetic with Scott that finance should be kept out of theories of money, given that financial indicators function so well as forecasts, it would be a shame to not use as much data from the financial markets as possible.

Because this is a highly charged question, I want to make the conversation as concrete as possible. When I talk about a bubble, I don't just mean "stock prices are high". Rather, I want to define a bubble as when stock prices are "out of line" with the fundamentals of the underlying companies. What this means is that if China blows up next year, and the price of stocks fall, that doesn't mean the bubble popped. A blowup in China is an exogenous event that would change fundamentals, and prices would adjust as a result. The type of bubble that I'm talking about is a noise trader, "beauty contest" bubble, in which people go into a frenzy bidding up the price of securities on the belief that everybody else will bid them up as well.

So let's start by talking about how monetary policy affects stock prices. On first approximation, the value of a stock should be equal to the present discounted value of all dividend payments. Sure, there's excess volatility around the edges, but this simple model of cash flows is still accurate on average. In doing so, it gives us two ceteris paribus predictions about stock prices. First, a stock price should go up in response to higher expected future cash flows. Second, a stock price should go down with higher expected real interest rates, because a higher real rate reduces the discounted value of future cash flows. These are the two main channels through which monetary policy impacts stock prices. Monetary policy can either (1) raise the cash flows by improving the economic environment, or (2) lower the discount rate by maintaining an extended period of low real rates.

These two channels split quite nicely into a positive and negative take on the effect of monetary policy. If monetary policy raises stock prices because of current and future cash flows, that should be seen as a good sign of a recovering economic environment. This corresponds to "the Fed is improving the fundamentals of the economy." On the other hand, if monetary policy affects stock prices only through a lower discount rate, that is just a sign of an "immaculate conception", with stock prices rising without an improving economy.

Most market monetarists believe it's the former, whereas some fiscalists have made an argument that it's just the latter. But here's the kicker -- we should be able to distinguish the two by looking at the actual earnings data. By comparing the earnings of companies and the stock prices, we can actually make concrete the discussion about whether the stock market is in a bubble. In particular, we can distinguish between the two stories by looking at price to earnings ratios, or the ratio between the price of a stock and the earnings per share -- both in the trailing 12 months and 1 year forward estimates. If the fundamental story is correct, then we should observe that the price to earnings ratio stays relatively constant. Yes, stock prices are rising, but that's only because earnings are stronger. If the speculative excess story is correct, then the price to earnings ratio should be rapidly rising as the price is bid up, but the underlying earnings remain unchanged.

On this note, it doesn't look good for the bubble mongers. Below I have trailing 12 month and 1 year forward price to earnings ratio plotted for the SP500 index as a whole. The index P/E ratio is calculated through a market capitalization weighting process of the underlying index securities. What this shows is that, right now, stocks are quite cheap. The trailing 12 months PE ratio is at 15.5, a far cry from the heady tech bubble days with a peak P/E of 30 or even the moderate 2002-2008 period when the PE ratio tended around 18. The trailing 12 months ratios mean that prices aren't out of line with past performance. The fact that forward ratios are also relatively low and near the trailing ratios indicates that stock prices aren't up on the back of extremely optimistic future forecasts. Even though high PE ratios aren't sufficient conditions for a bubble, they're certainly necessary ones. If this is a beauty contest, it's awfully fair.

The moderate P/E ratio signals that people are not overpaying for performance. This isn't the 1990's -- market participants are not basing valuations off of overly optimistic views of future earnings. Rather, people are just paying reasonable amounts of money to buy into each company's earnings, resulting in reasonable stock prices.

Now, in my analysis above I glossed over one more channel that's relevant for the financial stability debate. It's possible that the liquidity provided by monetary policy encourages people to take riskier investments because they're "reaching for yield." But we should differentiate two versions of this hypothesis. The first is that people are over weighting risky sectors at the expense of safe ones. But this should not be a concern of policy because it's not systemic. When the reach for yield reverses itself, some stock investors will win, others will lose, and while there may be blood, policy makers need not wash their hands. On the other hand, if people are just pouring their money into stocks in general because they are dying for yield, then policy makers might be concerned. But the low PE ratios belie this hypothesis, so policy makers can still rest easy.

So if equities aren't a bubble, this means that the recent rise in stock prices corresponds to better fundamental performance for these companies. Therefore we should expect a pass through to the overall economy and for conditions to improve. Monetary policy was certainly not futile.

This can also give us a sense of where the economy is going as well. From the P/E ratios and the actual index level of the SP500, we can back out a quarterly earnings index -- both expected future earnings and actual trailing twelve months. By comparing expected earnings with the actual earnings one year later, we can actually evaluate how accurate forecasters were. Surprisingly enough, post dot com bubble, earnings forecasts were pretty accurate during normal times, and only when there was a policy failure (in 2008), was there a significant deviation. This suggests that earnings should continue to grow, and that the real concern shouldn't be on whether the stock market is getting frothy, but on whether overly contractionary monetary policy will send the recovery off course.

Now, this recovery may not be pretty. It's entirely possible for median household incomes to continue their stagnation. Remember, stable nominal GDP is consistent with almost any configuration of the real economy. You can have severe inequality, a low labor share, and inefficient labor markets and still have a monetary policy that keeps nominal GDP on track.

So if you want to avoid those bad, unequal, configurations, then you will earn my respect as you fight for targeted fiscal interventions. Just keep your hands off my monetary policy, because the most dangerous idea you can have is that it doesn't matter.

Update: Fixed some typos. Changed "monetary policy" in fifth sentence of first paragraph to "quantitative easing"

What Determines the Return on Gold?

Gold glitters, but from an investment perspective it does little else. It is backed by neither cash flows (like stocks are) nor a value at maturity (like bonds are). It's just a metal that, historically, has always been highly valued: a value that exists beyond its role in jewelry or in industry.

So what gives? Broadly speaking, when people make a bull case for gold, they tend to talk about two catalysts. First, they argue that because central banks are engaging in expansionary monetary policy, this will lead to massive levels of inflation that will drive gold prices higher. Second, they argue that gold is valuable because it acts like a panic button and serves as insurance against crisis. These in fact, were the primary motivators behind Paulson's famous bet on gold. In this post, I hope to show that the theory underlying (1) is flat out wrong, and that the logic behind (2) does not correspond to the actual challenging facing the world right now.

So let's first talk about inflation. The argument goes that since gold is a precious metal with "intrinsic" value, its price will rapidly appreciate in an environment of rapid inflation. Unlike a fiat currency, gold cannot be "debased" and therefore even if the Fed prints too many dollars, the gold coins will still hold onto their real value. In a world in which wheelbarrows of paper money buy only loaves of bread, gold will still make sure you can still eat. This value across all levels of inflation means that gold prices spike if inflation rises, and thus holding gold can hedge that risk.

Most arguments against this thesis have come down to (correctly) observing that central banks have not caused high levels of inflation. Given high levels of slack in developed economies, central banks are also unlikely to cause high levels of inflation. But this concedes too much. In truth, inflation hardly drives gold prices at all.

When people think of high inflation, they naturally gravitate towards the late 70's, early 80's -- a time of rapid growth in gold prices. But this was a special time for many reasons, not least of which was the United States decision to suspend dollar convertibility. But ever since those inflationary years, although gold has had its ups and downs, its price has actually been relatively uncorrelated with levels of inflation. In fact, if you look at the scatter plot below, you'll notice that the positive relationship between gold and inflation is almost entirely driven by three data points: 1974, 1979, and 1980. Once you drop those three years worth of observations, you go from the upward sloping dotted line to the solid downward sloping one. This suggests that inflation is actually a horrible predictor of where gold is going to go, and that we should look elsewhere for a guide.

So what is this other guide? Real rates. In fact, yearly return on gold is almost entirely determined by a the 10 year treasury yield minus the year over year inflation rate. To see this, consider the following scatter plot. Unlike the gold-inflation relationship, the real interest relationship is not driven by just a few data points. Both the 1970's and 2011 gold price spikes are explained by this relationship. Moreover, the relationship between the variables seems consistent through all levels of the real interest rate. This is evident from the fact that the non-parametric loess fit (the red line) and the linear fit are roughly consistent with each other.

This observation makes the most sense in the context of a Hotelling model -- a note that Paul Krugman has previously made. For a full explanation of the mechanics of the Hotelling model, I suggest you read Krugman's post. But the intuition for the model is that a higher real interest rate lowers demand for gold since the opportunity cost of holding it increases.

The relationship holds with more recent data as well. As seen below, the price of gold has been almost entirely determined by the yield on the 10 year treasury inflation protected security - a measure of future expected real rates. Admittedly, there is something puzzling going on. Whereas the historical relationship seems to run from gold growth rates to the level of the real interest rate, the gold price/TIPS relationship seems to suggest the gold price level is related to the level of the real interest rate. Nevertheless, the moral of the story is the same: higher real rates are bad news bears for goldbugs.

So why do people associate inflation with high gold returns, when in actuality gold returns are driven by real rates? It's because they reason from a price change and ignore the cause of inflation. The inflation seen in the 1970's and 1980's was very unique because it was the result of contracting aggregate supply, which had the effect of both raising inflation while also lowering the attractiveness of investment projects (i.e. lower real rates). However, inflation can also be the result of increasing aggregate demand. In this case, especially if the aggregate demand is pulling the economy out of a slump, the effect on the real interest rate is ambiguous to slightly positive. Therefore the relationship between gold and inflation is less clear cut.

This leads to an interesting conclusion about inflation hedges in general. Because there are two types of inflation -- supply and demand side -- it is important that you're careful with what kind of inflation hedge you're buying. If you're worried that "earthquake risks" will devastate the supply side of the economy, go ahead and buy gold. But if you're worried about a lack of central bank discipline, then you're better off buying the the 10 year inflation protected security while shorting the 10 year treasury.

So if gold isn't a good hedge against inflation, is it at least a good hedge against economic crises? Not all of them. If the crisis is one that leads to a fall in confidence and surge in desired savings, then real rates may fall and the price of gold may rise. But if the crisis is one that leads to a fall in savings and a rise in real rates, holding gold will end up exposing more of your portfolio to the worst of a crisis..

This is particularly relevant given recent Chinese and Indian economic stress.

If China undergoes a financial crisis, the most likely result will be capital flight. In this process, China will be forced to reduce its savings and investments as it rebalances. But in this case, since China will no longer be able to invest as many funds abroad, real rates rise and the gold price should actually fall.

Moreover, if China undergoes such a crisis its retail demand for gold will fall -- another strike against the insurance quality of gold.

Similarly, India's currency is under attack and its central bank may need to draw on its reserves of foreign currencies to stem the slide. Below I have a skew graph from a few weeks ago showing the depreciation that option markets were pricing in. As can be seen, there's quite a bit of depreciation risk in the tails. The effect of any such depreciation will be quite similar as in the Chinese case. Demand for foreign (i.e. American) assets will fall, thereby pushing U.S. real interest rates higher.

So while gold might have been good insurance it the past, it is not right now. Because the tail risks facing the global economy are much different than in the past, holding gold will end up amplifying risks instead.

The conclusion from all this analysis is that gold does not "march on a different beat." In the parlance of finance, it is not a source of uncorrelated returns. Nor is it a pure result of market psychology. In fact, given gold's relationship with real rates, it can be best described as a leveraged bet that real rates will fall. But with obscene amounts of volatility and low long run returns, it's not clear why anybody would want to hold gold at all.