Merry times ahead? Or is the world economy steering toward trouble? In times of unorthodox monetary policies, neomercantilism and sovereign debt, how does one recognize financial shocks? What are good measures of financial risk?
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Measuring risk in today’s environment becomes important because first impressions can fool markets. The macroeconomic signs seem positive. Equity valuations are rising, even breaking old records; dividends and other yields are above average; China, the United States, the European Union and other financial markets seem to be in synch and their economies are growing strong.
But negative signals on the micro- and meso-levels (at least in the U.S. economy) also abound. For example, car sales are 11 percent below last year’s; the housing market is weaker today than it was two years ago; credit defaults are on the rise, with the delinquency rate on credit card loans rising to 2.42 percent in the first quarter from 2.15 percent a year earlier; durable goods orders are down, the inventory-to-sales ratio is 6 percent above the 10-year average and rising, and payroll growth is absent.
These are all indicators of the state of the economy. They are also measures of risk. The question is, are they good measures? As usual in economics, the answer is: it depends. It depends on the context in which the indicators are used and on what is being measured – real or financial markets.
Separation and inflation
Real markets, or the real economy, are those parts of the economy that produce goods and services, as opposed to those concerned with buying and selling financial instruments. In an ideal world, real and financial markets would mirror each other. Today, however – and for a considerable time – each has been leading a life of its own. This separation can best be seen by looking at what drives each market.
The drivers of value creation and growth in the real economy are productivity, investment and savings. In recent years, these three have been performing below their historical averages. For example, in the U.S., gross domestic product (GDP) grew at a rate of about 1.6 percent in 2016, compared with its average of 3.5 percent in the post-industrial period. Worldwide GDP grew by about 2.4 percent in 2016, slowing for the third consecutive year. This has come despite the application of expansionary fiscal policies in countries like China and India, or expansionary monetary policies, as is the practice in the U.S., or both at once, in the style of the European Union.
Inflation is already with us, either passing unremarked or reflected in higher valuations.
Financial markets, on the other hand, now seem to be driven by expectations about monetary policy – in other words, cheap money. (They used to be about real interest rates and productive investment as well, but that was long ago.) Cheap money allows financial markets to thrive and traded companies to drive up their valuations. It also allows governments to use fiscal policies to pump up economic growth, at least in the short term. But cheap money creates two perils of its own: inflation and the risk of financial shocks.
Worrying about inflation seems outdated today. If anything, the world is suffering from a deflation threat. But in fact, inflation is already with us, either passing unremarked or reflected in higher valuations. For example, in real markets, companies are suffering from rising production costs. But because they have diminished pricing power on the supply side, these firms cope with cost inflation by accepting lower profits.
In financial markets, inflation is hidden behind the general rise in asset valuations, especially for private equity, and other interesting phenomena such as the price of bitcoin, a higher buy-sell spread for foreign currencies, or duration management in bond and fixed-income investments. Another hideout for inflation has been the widespread use of share buyback programs by listed companies.
But cheap money’s greatest danger is that it increases the probability of financial shocks. This is because it creates imbalances in the demand and supply for credit. If these imbalances are not corrected through the pricing mechanism – that is, through higher interest rates – they lead to financial shocks.
How to get a hangover
Financial shocks happen regularly. Some would even claim that cycles of boom and bust are inherent in the financial system. It is evident that the last three crises leading to U.S. recessions – in 1990-1991, 2001 and 2007-2009 – were brought about by financial shocks, although some might debate the second. The explanation could be as simple as the one given by U.S. President George W. Bush (2001-2009): “Wall Street got drunk … and now it’s got a hangover.” Economists have different, more technical explanations for this binge-hangover cycle.
Explanation One: Central banks expand credit lines and at the same time lower interest rates. Usually, if central banks expand credit, borrowing costs should increase to stabilize money supply and demand. By simultaneously expanding credit and lowering interest rates, central banks create an imbalance between the natural interest rate – the one markets expect – and the one policymakers control. Agents of the economy, instead of saving and investing in accordance with their own subjective valuations, start to overconsume and overinvest at once. When all these imbalances become apparent, the shock occurs.
Policymakers, as political agents, can seldom resist doing something for the good of the economy
Explanation Two: In economies, new possibilities of investment regularly appear – for example, through technological disruption, new business models or new markets. These new possibilities generate more demand for credit. Higher demand makes interest rates spike, rewarding only those investments that are reasonably productive. Central banks, however, interrupt this process by stepping in and deciding either to lower interest rates or expand credit lines. This is because policymakers, as political agents, usually cannot keep themselves from “doing something for the good of the economy.”
By expanding money supply and keeping interest rates low, central banks curb the competition to discover productive new technologies, business models and markets. Instead, they encourage competition for the best access to cheap money, causing misallocations of capital. In other words, the economy invests too much capital in unproductive investments. Or as George W. Bush would say: “The economy bites off more than it can chew, and then it chokes.”
Here, two questions immediately arise. First, why can’t central banks, even if they indulge in fueling the economy with cheap money, simply raise interest rates at a later stage? The answer is that they lapse into a state of endogenous enthusiasm. They see what “good” they are doing and dismiss the risks their actions cause. And even if they could overcome their ebullience, once a credit-fueled economy gets going, no taper or winding-down restores the status quo ante.
The second question is why do these mechanisms always succeed in fooling investors? Anyone who invests has two problems to deal with. First, they need to acquire information about financial markets and monetary policy. However, no one can succeed in gathering the totality of such information. Second, they are exposed to a set of nominal prices in the markets and have to react. This means investors must balance incomplete information against the potential premium for alertness and arbitrage. Both are an inducement to herd behavior, as investors follow each other and the central banks’ lead.
Based on this understanding of cheap money and the causes of financial shocks, the usual ways of measuring risk seem inadequate in today’s environment. Conventional yardsticks are overly reliant on nominal terms and do not account for the mounting imbalances fueled by cheap money. This suggests we need alternative gauges of risk in financial markets. Under present conditions, the following three measures could prove useful.
First would be a comparison of total market capitalization to GDP. For the U.S. today, this ratio is over 140 percent. Anything above 100 percent means that the financial markets are over-hedging the real economy, i.e. they are betting it is worth more than the value it creates. And if this were not sufficiently troubling, it also means the danger of “malinvestment,” or the misallocation of capital in unproductive investments, is particularly elevated.
Many companies are borrowing to buy back shares, creating a false impression of solidity in their balance sheets
Secondly, compare share buybacks with the total equity in listed companies. As central banks pass on cheap money to commercial banks, most of it is going – by preference – to traded companies. Many of them are borrowing cheap money to buy back their own shares. This creates an impression of solidity in the balance sheets, but once interest rates rise or market valuations fall, servicing debt becomes expensive. Things become even more problematic when equity fails to sustain debt.
Third, measure the dynamics of bloating. This is done by comparing two ratios. The first is the ratio of share prices over profits, income and rents. The second is the spread between the central bank’s benchmark rate and the “natural” interest rate, using the Taylor rule as a proxy. If both these ratios correlate significantly, there is a bubble. To take one example, before the housing bubble burst back in 2007, the ratio of paid housing prices to income and rent correlated closely with the wide spread between the U.S. Federal Funds rate and the Taylor rule.
Even when the broader indicators point to a growing global economy, it is wise to measure the specific risks in financial markets. The most recent crises were triggered by financial shocks originating from imbalances in cheap money and interest rates. Today, we have good measures of financial risks in ratios of market capitalization to GDP, share buybacks to equity valuations, and bloating dynamics. All three point to accumulating risk.