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Justifications real for macro and pension fund worries

Figure note: Reduced-size Financial Times graphic. Click here for full FT graphic. (Site registration and article limit apply for free views FT articles and graphics.):

The markets dropped sharply again last week, with bond yields rising and U.S. stock markets falling sharply. Behavioral Keynesians (such as Robert Shiller in this recent New York Times article) and Minskyans have been among those noting that standard metrics suggest overvaluation relative to historical norms for price-earnings ratios, etc. Taking a Minskyan point of view, I have revisited this theme occasionally (for example here, here, and  here), suggesting the potential for a broad and large drop, the first since the financial crisis of 2009. The point is in part that regulations should not be loosened and that some important sources of financial fragility were not significantly reduced by post-2009 regulatory changes.

To some extent, one must blame the emphasis on a mostly monetary macro-policy response–in light of a situation in which the fiscal-policy response to recession was weak, especially in Europe, where euro-area institutions and a tendency to anti-inflation overkill prevailed. There, a relatively austere policy approach led to a weak and delayed response to depression in the European “periphery” of Greece, Ireland, Portugal, and Spain. The U.S. then had to formulate policy taking this lack of stimulus into account.

So, the Fed cannot be blamed for strong monetary policy action, given the stance of fiscal policies as they existed at the time. Moreover, the Fed need not allow interest rates on U.S. debt to rise excessively. Jerome Powell, the new Fed chair, seems to be somewhat oriented toward growth and employment as opposed to inflation control only. So a stimulus-reversal Treasury bond bust leading to an unintended collapse of this market will probably not happen.

For Minskyans, at the top of this post and  at this link is the picture (link is to a Financial Times article) on the part of private-sector corporate bond rates due to optimistic “animal spirits” (investor psychology). The two lines show the yields on (1) Treasury bonds or the equivalent which have near-zero default risk and (2) corporate “junk” bonds. The gray “mountain” along the bottom of the picture represents the difference between the two other series–the yield premium inducing investors to accept the default risk associated with the corporate debt. This portion of bond returns has been very low relative to historical norms–like the P.E. ratios mentioned earlier.

Sharp drops have occurred since I began following the fixed-income markets story a long time ago in energy-sensitive sectors and markets, along with places affected by political instability, conflict, and natural disasters–representing collectively a big part of the world’s population but not so far hitting the core countries and the financial strength and wealth therein.

As a mainstream economist, Shiller has referred in recent articles uncritically to volatility indexes that rely on standard models of financial market volatility. He saw a calm before the storm in low readings of such indicies. I blog occasionally that market returns and prices tend to follow fat-tailed distributions, which have not been embraced by the economics mainstream since the 1960s and early 1970s (external link is to a multiplier-effect.org). Benoit Mandelbrot–rightly known as a brilliant applied mathematician for developing the physics of fractals, roughness, etc.–is no less of a brilliant theorist for steadfastly adhering to fat-tailed stochastic models until his death in the 1990s. On the other hand, Shiller and other articulate mainstream (neoclassical) Keynesians have been right in their consistent stance that models suggesting market valuations are “rational” (incorporate all available information in a statistical sense) are rejected by time series evidence.

Completely random (atheoretic) models of financial markets tend to be wrong in the view of Minskyans. For example, balance sheets and macro financial ratios are hugely informative about the possibility of a crash or banking crisis. Qualitative clues in the nature of lending are also relevant to a Minskyan observer. But these time-series models are helpful in applied settings such as long-run pension fund analysis, where financial risk factors are not known for the relevant time frame.

The fat-tailed models bolster the case in a scientific way that pension funds (which we mentioned in this blog’s previous post) may be at risk in counting on average returns in excess of 7 percent. Big moves embodied at the extremes of distributions such as those studied by Mandelbrot help to make funds inadequate for many cohorts if funds roll the dice with risky “alternative” investments. (By the way, nonconstant volatility, also championed by Mandelbrot, only adds to the risk of inadequate long-run returns.) Hence, to return to the theme of my previous post, research based on non-Gaussian statistics lead me to side with the financially pessimistic view on public pensions forwarded in the In These Times cover story by Doug Henwood and Liza Featherstone to the extent they are in conflict with the views advocated Max Sawicky’s rebuttal.

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Personal note: I note the passing of my grandfather, Frederick W. Hannsgen, at age 103 earlier this month. He has been mentioned here before on the occasion of his 100th birthday and was noted for his investing acumen–though it must be noted he demurred from the post-Keynesian and MMT approaches to fiscal policy, as advocated in this blog. Notably in the history of the Hannsgens and of the chemical industry, he wrote an internal report leading a big energy conglomerate’s chemical division to commit to a massive entry into artificial rubber production.

The move paid off, and my grandfather proudly regarded the report as the biggest accomplishment of his business career. Later, after his company forced him out with a big lump sum, he became an assiduous full-time investor. He was an amiable and ever-upbeat skeptic of financial trendiness and risk-taking private-sector financial “high-flyers.” (Hence, he was among skeptics about the future solvency of public sector pensions holding “alternative” investments.) He will be greatly missed!

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