Economic Stability Posted by: Dale Franks
on Tuesday, April 03, 2007
Over at SHC, Lance offers his take on the effects on investors of economic stability.
One of the real points of contention amongst those concerned with economic policy is the increased stability of economic growth and why it has occurred. It is also an area of real concern for investors, for economic stability has some interesting affects. My interpretation:
1. Increased stability leads to less risk aversion, thus an increase in valuation levels and declining yields. That is very profitable for those holding financial assets as stability increases (see 1981-2000.)
2. This affect is only temporary. The reduction in risk premiums and increases in valuation cannot go on forever. Once a new valuation range is set, long range returns on equities and other assets are actually reduced. While growth may be similar in aggregate, yields are lower*. We have seen that affect in recent years. Even the equity rally post 2002 has been unusually stable, and featuring unusually low returns for an upswing.
3. Minsky’s revenge! (pdf.) With a more stable world we take more risk, thus eventually leading to instability. Build me a safer car and I drive faster and less cautiously. When that percieved lack of risk is unusually profitable as point number 1 is occuring, the assumption of risk by economic actors can be exceedingly high. Think tech bubble or housing in California and other high flying locales more recently. Debt (or leverage) increases dramatically. Stability leads to instability.
4. This tendency toward instability does not erase all the gains of stability we see, but the loss is not insubstantial.
I don't find much to quibble with in Lance's conclusions, but I am interested in a few things. I'm just groping here; spit-balling as it were...
The last illustration of Minksy's Financial Instability Hypothesis cam in 2000, when the Internet Boom came crashing down, leading to a 40% devaluation of the S&P 500. That loss in value seems to have been the leadoff to a recession in 2001, as investors, seeing huge losses, began hoarding cash.
Even if the losses are paper losses, i.e., you purchased XYZCorp at $40, saw it rise to 90, then come crashing down to 43, you didn't actually lose anything, but you might certainly have made other financial and career decisions while XYZ was flying high, only to have those expectations dashed when your return dropped from, say 125% to 5%.
On the other hand, the resulting recession was rather mild. it never approached, for example, the horror of the 1981-82 back-to back recessions, with 12% unemployment.
What does this tell us?
I'm not sure.
But I think it shows, first of all, that there is a signifigant de-linkage that has taken place between Wall Street and Main Street. The linkage is still there, but a sustained, steep drop in asset values didn't throw the economy into a tailspin. Without the additional shock of 9/11, I think the economy would've gotten back on the rails more quickly than it did.
I think it also shows that policy tools are more effectively utilized than they were in the past. The Fed responded quickly to pump cash into the economy, bringing short-term rates down to nearly zero. indeed, there was some talk—which I engaged in at the time—of the possibility of deflation after the additional shock of 9/11. After all, the Fed can't offer an interest rate lower than 0%. If that isn't low enough, then you have a problem, which, thankfully, we evaded.
Another thing that I'm wondering about is the nature of the investor community. When stock prices plunged in 1929, it took the whole economy down with the stock market ship. That didn't happen in the short, but sharp correction in 1987, nor did it really happen post-2000.
Part of the problem in 1929 was the ability to buy stocks on leverage, an unfortunate practice that has been very shrply curtailed. For the most part, you buy stocks with actual money, rather than borrowed money, so you don't have to worry about margin calls any more. That source of instability has basically been eliminated.
Second, the percentage of investments coming from 401(k)s has puffed up like a tick, so that now, more than half of the population is invested in the stock market. This does a couple of things, I think.
It keeps investors in the market whether they want to be or not. It isn't all that difficult to shift investments in a 401(k), but it is just enough of a hassle that the average person doesn't do it much. After all, it isn't "real" money in the sense that it's part of their regular income. "Invest it and forget it" seems to be the rule of the 401(k) investor. That leaves a sizeable amount of residual of money that doesn't get pulled out of the market. So, instead of all investors scrambling to retrieve what cash they can, many investors just let it ride. This cushions the drop in asset values to some degree, and the investors themselves, who have never seen their 401(k) money in a check, aren't scrambling to grab it to meet current financial obligations. Indeed, for the most part, you can't get money out of a 401(k) anyway, you can only shift it between assets.
Also, 401(k) investors simply don't have access to risky investments for the most part. Most 401(k) plans offer investments that fall into a fairly narrow category of risk. So those investors simply don't participate in risky investments in the first place, which cushions them from a lot of speculative loss.
The other thing is that 401(k)s tend to be professionally managed funds. So, rather than millions of 401(k) investors screaming, "Sell! Sell!" into their phones, a relatively small group of institutional managers make fund allocation decisions to minimize risk in normal times, and limit losses during downturns.
But here's where it gets tricky, and we enter an area where I'm not sure anyone truly knows how to predict.
As long-term investment by the public at large continues, it seems to me that the effects could be as follows:
There is a sizable pool of long-term capital for investments of low to moderate risk. The ready availability of this money reduces risk premiums and returns for these types of investments. After all, risk premiums are high to attract investors and their money. If that pool of money is more dependable, risk premiums can be reduced.
Investors with lots of money, and lots of tolerance for risk, are more prone to reduce investments on lower-performing assets, and devote more of their money to higher-risk investments where the potential payoff is much higher...partially because those investors are using more money to chase that risk.
So, then, what happens if those risky investments fail? What I would hope is that the effects are felt most deeply by a relatively small number of speculative investors—even if the amount of money lost is higher—and the effects on the market as a whole are either a) cushioned for the majority of investors, or at least b) the effects on the economy as a whole are limited because the investments don't come out of perceived income, and therefore they won't set off cash hoarding among those 401(k) investors, driving us into a steep recession.
Even if there is a significant loss of value in the market as whole, due to risk bubbles bursting, that 401(k) money still flows in every month. After a short, sharp correction, we'd still see increasing investment, and valuations begin to rise as money continually pours in.
We've only had 401(k) and IRA plans since the 80s, and they've only recently started to become a significant component of investment. I'm not sure we really know what effect that type of investment has on the market, in terms of response to financial crises.
Think about it. What we really have is a large number of small investors, whose money, once invested, is essentially untouchable. You can shift it around, you can even borrow from it in some circumstances, but you can't pull it out. Also, we're not talking about the traditional investor, who is looking for income, or some financial advantage from his present holdings, and who therefore will respond more quickly to price fluctuations and corrections because they have an immediate effect on his finances.
We're talking about working schlubs who are sticking in $300 a month and who never actually see that money in the first place, since it comes right out of their checks before they receive them. And they don't have any expectation of touching that money for 25 or 30 years. So, as a matter of perception, the money in the 402(k) has no effect on their standard of living or income, so they largely forget about it, except when their quarterly reports come in, in which case they look at it for a few minutes, then bundle the kiddies off for baseball and ballet.
I'd expect that to increase the stability of the market over the long term, and, increasingly, sever the economy from market fluctuations. As more money flows in, I'd expect asset prices to rise, and to do so somewhat faster than earnings, leading to lower real returns. Sure, you'd still have price fluctuations and corrections, but will most investors care? I don't think so. Institutions would care, but I don't think their reactions would be as panicky as the reaction of 50 million individual investors involved in day trading.
I think—I think—that stability is increasingly a part of the market and the economy because the nature of investing is shifting to a long-term, steady investment influx, and because of improved monetary policy action. And, while we're on the subject, a much more steady and reliable fiscal policy when it comes to taxation, with taxes being both relatively low, and within a fairly narrow band, relatively steady.
But, I can't really be sure about any of this. I could be completely wrong. As Lance asks:
So is the increasing stability a long term feature or will Minsky not only be correct, but all the stability gains will unravel in the face of hubris and human error?
The thing is, humans are so prone to foolishness, this apparent stability might just be that: apparent stability.
Take tax policy back to the 1960s, or monetary policy back to the 1970s, and all bets are off.
I think it also shows that policy tools are more effectively utilized than they were in the past. The Fed responded quickly to pump cash into the economy, bringing short-term rates down to nearly zero. indeed, there was some talk—which I engaged in at the time—of the possibility of deflation after the additional shock of 9/11. After all, the Fed can’t offer an interest rate lower than 0%. If that isn’t low enough, then you have a problem, which, thankfully, we evaded.
Which lead to bubbles in the commodities markets and real estate. These infusions of cash stuffed into an economy that had already suffered an excess money creation capital goods boom simply created additional asset bubbles. What were businesses going to spend money on more computers and software? More factories when the ones they had were sized for an economy that had been artifically inflated by excess money creation to begine with? No, the money created was matched by governments around the globe who are pegged to the dollar and that money was used to bid up commodities on the gobal market and real estate prices in the U.S. The ultmate effect of these policies was to simply shift investments forward in time or allow people and businesses to invest in things that they otherwise would not, in some cases liquidating those positions later, as is happening now in the housing market. Business capital spending has also dried up, not because businesses have run out of cash (they have more of that than ever) but because the profitable uses for their funds no longer exist.
While the Fed is given credit for "reviving" the economy, in reality the ecomomy worked its way through the recession by its own natural balancing of supply and demand. The "stability" some are observing in reality is just a smoothing out of the business cycle, created by all of the dampening effects that the government puts on the economy. In the era since the Fed was created business cycles used to be more frequent, the troughs deeper, the recoveries stronger, and much more abreviated. Since 1983 the expansions have been longer, with less peak growth, the recessions have been milder (in a loss of GDP sense). But these recessions have also drug out for years with so-called "job-less" recoveries in the period from ’91-’94 and ’01-’04 when the economy was growing slowly but people who lost their jobs were very slow to get new ones.
Is that really better?
In the end the Federal Reserve can’t create anything except money, economic growth comes from advances in productivity and increases in population, things that creating money don’t really have much effect on.
After all, the Fed can’t offer an interest rate lower than 0%.
The Fed can’t offer an interest rate at all. The Fed doesn’t set interest rates, it creates or destroys money in amounts that affect the shortest of short term interest rates, the Federal Funds rate. While all other interest rates in the economy are affected by this money creation, to say that the Fed controls them would be an exaggeration.
Another thing that I’m wondering about is the nature of the investor community. When stock prices plunged in 1929, it took the whole economy down with the stock market ship.
I don’t have time for this one other than to say: No, it didn’t, you have your cause and effect relationship exactly and precisely backwards.
Dale, in follow-up to my response to you on morality, think about this for a minute:
The stability you’re talking about comes from, effectively, coercion applied to 401K investors that make it impossible for them to pull their money out of the market. Not to mention coercion that prohibits them from having their 401K statements put into hedge funds.
So, another thing that would immediately re-link the economy to stock market crashes would be - taking the libertarian path, eliminating the financial regulations, and letting 401K investors both invest in subprime mortgages and thirdworld debt, and also letting them pull their money at any time.
So... you’re in favor of government coercion here, huh, because of its pragmatic positive effects?
After all, if it wasn’t illegal for 401K’s to invest riskily, even tired, distracted, possibly insinuated as not-too-bright 401Kers would rather be promised 10% than 3%. And when the return comes back showing that their value has crashed, they’d rather have it in cash as well. Don’t kid yourself, it’s "lefty" government coercion that has created this happy brand of captive audience.
I’m still interested to know what your opinion/rebuttal to the above, Dale. I mean, this was a heck of a long post about a non-hot-button topic, and I waded through it and, from my POV, found you a contradiction. Reward me with a response.