Monday, July 14, 2014

Risk & Valuations, Part 9: The Greenspan Put

The complaint about the Greenspan Put is misplaced, in a way.  The Greenspan Put is the whole point of a functional central bank.  If the Fed could dependably put a floor under the nominal economy, then we could all operate a little bit more nearly to the regime of certainty.  We could all optimize more.  Equity premiums would be lower, labor compensation would be higher.

Many believe that this sort of optimization, created from a sort of misplaced expectation of certainty, was the kindling for the crisis in 2008.  Low rates, a sign of easy money, led to an over-leveraged economy and to a massive disruption in the American and world economies.

As Scott Sumner would point out, low long term rates are a sign of tight money, not easy money.  While real estate was bid up to high nominal prices, the level of mortgages compared to home equity was not especially high until home values collapsed.  Firms were less leveraged than they had been in 30 years.

Yet, even though the facts describe a situation much less explosive than the standard narrative would suggest, we still had the largest economic dislocation of a lifetime.

The standard narrative is that the Greenspan Put created a false sense of security - that markets basically underestimated the standard deviation of potential outcomes, and investors left themselves with no breathing room.  The tide went out and nobody was wearing shorts.

The real problem is that the Fed manufactured a black swan.  The problem is that a central bank will always have political risk, which is much more binary in nature than market risks.  NGDP level targeting with futures markets would go a long way toward removing this discrete variable from the risk profile of the American economy.  If some of the relationships I have outlined over these last several posts are accurate, stable growth in nominal demand might slightly increase debt leverage, but it would also increase labor compensation, prevent the excessive leverage that would accompany very high rates, and prevent the unplanned shocks to leverage that lead to disinvestment and unemployment.  It should lower equity risk premiums.  And, in general, it would incentivize more financial resources into the sort of risk-taking endeavors that grow an economy.

The public fear of inflation, then, is ironic.  The trick isn't in the comparison between the growing cost of living and growing incomes.  That's all going to come out in the wash.  The problem with low inflation is that business downturns can more easily turn into demand crises.  As long as interest rates and inflation are so low, there will be additional risk hovering over equity holders.  The low rate environment causes equity risk premiums to increase.  This affects equities themselves by decreasing the price investors are willing to pay for equities.  But, this also effects wages paid to labor.  Because the equity risk premium is higher, and because of the implicit risk-trade that firms make with employees, firms must demand a higher discount from the gross value of wages.  Low inflation, paired with a discretionary monetary policy, pushes down wages because it pushes up equity risk premiums.

The one caveat, however, is that, in the end, if we insist on having the most important product in the economy, the one product that is a part of every transaction, managed by a committee, then there will be some amount of discrete extreme downside risk, because committees always hold the possibility of making a huge error.  And, as I have discussed in these posts, if the local context of the economy is stable and certain, we will optimize for it.  Our participation in this economy means that we are preselected as optimizers.  The only alternatives to optimization are failure or exit.

But, a successful regime of NGDP level targeting, with a market-based indicator, would (1) create the sort of certainty regime that creates real added value in human experience and (2) move that discrete, black swan, committee-based outcome potential way out on the outcome distribution.  A FOMC would need to completely change the monetary paradigm to screw things up.  Simply being human, as they were in 2008, wouldn't be enough.

And, as where we now stand, there appears to be a near consensus among voters, economists, and FOMC members that the Fed in 2008 wasn't the problem, but instead was the necessary medicine.  And they are prepping to do it again.  In the 2000's, Equity Risk Premiums were at the high end of their range, risk free interest rates were at the low end of their range, corporate leverage was at the low end of its range, and the main area with significant levels of private debt was mortgages, which are almost totally the product of middle class household saving....Oh, I know, I know.  Every middle class household has a mortgage as a part of their conservative long term financial plan, but we all know a guy who knows a guy who totally leveraged up on real estate in the boom because he thought home prices would go up forever.  Even though the mortgage market is flatlined, so that even this explanation for an "overheated" economy is not available, the Fed is concerned about "financial stability".  So, before we get an NGDP targeting regime, the Fed is likely to create another NGDP shock, and just like last time, it will be blamed on a problem that doesn't exist, and everyone will pat each other on the back, and congratulate themselves for seeing bubble after bubble and popping them.  And the popping will be painful, especially for vulnerable households.  And greedy corporations and speculators will be blamed for making the supposed bubbles even as, incongruously, economic imbalances are blamed on their profits.  I don't see how this cycle gets broken, yet NGDP targeting does appear to be gaining acceptance.  Let's hope.


  1. (1) Nominal rigidity is a fundamental part of the model I am laying out here. In part 6 and 7, I describe the fixed for variable rate swap embedded in a typical labor contract. When outcomes reach variances beyond the range equity can handle, unemployment is a result.

    (2) I more or less agree with his analysis. I am optimistic about the economy. I am pessimistic about policy makers and the Fed. I believe that home prices would rise 30% or more in a healthy economy with reasonable money supply management, and I'm afraid that the consensus will misinterpret that as inflationary and push the Fed to kneecap us like it did in 2008. Despite pro-cyclical labor policies the Feds seem to be establishing a habit for during downturns and the likely drag on growth of things like health care, I think our economy is on fairly good footing, natural short term interest rates are probably already above zero and will rise fairly steeply, and the labor market will continue to be strong in the near term. I don't buy the secular stagnation story. I think it's based on a misinterpretation of recent developments and the concerns it projects onto the far future are mostly the product of imposing our moral norms on the future. The future won't care what we thought about work norms, wages, etc.

    (3) I'm not an expert, and I haven't found a good source of long historical data on these items, but it does look like corporate deleveraging since about 1990 has coincided with declining interest rates, which is a counter-intuitive expectation that I have outlined here. PE ratios were rising until the 2000s, which was a period of low growth and, apparently, deleveraging, which goes along with what I discussed in part 1:
    But, there is a lot to account for there, and it would take a lot of work to pull the information together to do a better review. Do you have a source for this kind of work?

  2. TravisV from TheMoneyIllusion comments section here.

    Thank you very much for your timely reply! Unfortunately, I don't have any sources on historical Japanese P/E ratios, etc.

    I'm a huge fan of your work and LOVE seeing some of Sumner's concepts applied to valuation / finance theory!

    1. Thanks, Travis. Being an independently operating contrarian, there is always a little voice in the back of my head, wondering if I'm going off the rails without knowing it. I think I have a small, but very high quality, group of regular readers, so it's always nice to get positive feedback from one of you. I'm glad you find my work interesting.

      And, I didn't completely answer #2 in your comment above. I'm not sure that the market expects an expansionary Fed. Eurodollar futures suggest a Fed Funds rate rising at less than 1% per year as we leave the zero lower bound, and topping out at 4% or less. That suggests muted expectations of both real growth and inflation, I think.