Should-Read: Carmen Reinhart and Vincent Reinhart: The Fear Factor in Today’s Interest Rates

Should-Read: Both Carmen Reinhart and Vincent Reinhart are very smart and very much worth listening to. But this is simply wrong. They have not looked under the hood of the model of Robert Barro (2005): Rare Events and the Equity Premium http://www.nber.org/papers/w11310 with sufficient care…

Barro’s model hinges on the requirement that there be no safe assets in his model at all—they have a price and an interest rate, which is what they would sell for/yield if they were to exist but if net demand for them were zero, but they are not there. In our real world, they exist: the entire point of Barro (and of Reinhart and Reinhart) is to explain why the very large quantities of safe assets that do exist in our world sell for such high prices/offer such low yields.

Moreover, in Barro’s model prices of risky assets are not low when disaster is feared, but high: the logic of his model is that stock prices were so high in 2000 because the chances of a future disaster were high, and that stock prices were so low in 2009 because the chances of a future disaster were low. “That’s crazy!” you say. Yes. “That can’t be right!” you say. But it is—that is what drops out of the math.

Moreover, most true geopolitical or even economic disaster scenarios generate not deflation but inflation—nominal government debts, even those of sovereigns with exorbitant privilege, become much less valuable. Fear of such disasters cannot rationally support high values for nominal government debt. Of course, “rational” is doing a lot of work here…

Carmen Reinhart and Vincent Reinhart: The Fear Factor in Today’s Interest Rates: “The theory of “rare disaster risk” has progressed considerably in recent years, owing to the work of the Harvard economist Robert Barro… https://www.project-syndicate.org/commentary/north-korea-fear-drives-low-interest-rates-by-carmen-reinhart-and-vincent-reinhart-2017-09

…The core insight is that no one can rule out the occurrence of an Old Testament-style event – war, famine, pestilence, or societal collapse. Such disruptions to a settled way of life slash output, consumption, and human welfare. Because they do not happen often, they are far removed from the smooth center of the probability distribution from which baseline scenarios are drawn. The experience of the Great Recession tells us what to expect from financial markets when output plummets: as inflation tumbles, so do nominal and real (inflation-protected) yields on Treasury bills. The yield curve flattens because owning a long-term term claim on a safe-haven asset is valuable insurance. As yields on Treasury securities fall, other spreads widen relative to them.

In the current context, geopolitical tensions create the remote possibility of a disaster – the odds of which shift daily – that would make everyone much worse off. We claim no special insight into the mind of Kin Jong-un, but knowing that there is an unknowable helps to make sense of current asset prices. In such circumstances, risk-averse investors, especially those more directly in harm’s way along Asia’s Pacific Rim, will want to insure against an adverse event by taking advantage of the expected financial-market effects now. Nominal, real, and inflation-break-even Treasury rates are lower than the cyclical position of the economy warrants, owing to investors’ perception of acyclical and atypical risk….

The growing perception of rare disaster risk has three implications. First, low interest rates do not necessarily indicate that advanced economies are mired in a low-growth trap as a consequence of adverse demographic trends and slow productivity growth. Rather, they tell us that competition for safe assets has heated up.

Second, this is no counsel for government to ramp up spending. The near-term cost of financing deficits is low because households are worried that the possible “seven lean years” will be very lean, indeed. If citizens are storing up for the worst case, are their leaders – even officials concerned about the cyclical management of aggregate demand – justified in throwing caution to the wind?

And, third, low policy interest rates in the advanced economies are not necessarily evidence of ample accommodation by the monetary authorities. This is because monetary-policy ease is measured in terms of the difference between the actual rate and the equilibrium rate. The current low policy rates maintained by the US Federal Reserve, the European Central Bank, and the Bank of Japan may not look so low if the equilibrium rate is actually low.

The idea of rare disaster risk complements other explanations for the current low level of real rates globally…