Should-Read: Ricardo Caballero, Alp Simsek: Risk intolerance and the global economy: A new macroeconomic framework

Should-Read: Secular stagnation as the result of a collapse in the financial sector’s risk-bearing capacity. Calls for a “somewhat comprehensive socialization of investment”, no? If the private sector cannot figure out a way to mobilize society’s collective risk-bearing capacity to bear the risks of enterprise, then the public sector is all we got, no?

Ricardo Caballero, Alp Simsek: Risk intolerance and the global economy: A new macroeconomic framework: “Interest rates continue to decline across the globe, while returns to capital remain constant or increasing…

…The reasons for this widening risky-safe gap are wide-ranging…. The secular rise of risk intolerance… [needs] a new macroeconomic framework suitable for this environment… to discuss the current global macroeconomic context, its underlying fragility, and the coexistence of low equilibrium interest rates and high speculation….

While there are a variety of contributing factors behind this widening risky-safe return gap, ranging from reduced competition in goods markets to technological changes, the dominant one is a steady rise in the equity risk premium since 2000, which was exacerbated by the Subprime Crisis and has only recently began to recede in the US, but has continued its rise in the rest of the G5 economies (see Figure 1). This rise in the degree of risk intolerance is a global phenomenon with significant macroeconomic implications…. In the current risk-intolerant environment it is important to… highlight… two potential gaps…. [O]utput but also risks.. need corresponding demands. If the demand for risk is insufficient, output and risk gaps emerge. These gaps feed into each other and have the potential to cause deep contractions….

Imagine… macroeconomic uncertainty rises… a reduction in economic agents’ desire to hold the risk produced by the productive capacity, embodied in… financial assets…. In this context, monetary policy works by reducing the opportunity cost of risky investments…. But what if interest rates cannot be adjusted enough to fully offset the rise in increased volatility? In developed economies… the zero lower bound…. In emerging market economies… concerns with sharp depreciations or inflationary spikes. Then a risk gap develops… reduces consumption through a wealth effect and investment through a standard valuation (marginal-Q) channel. This causes an output gap, which lowers profits and asset prices, and further increases the risk gap. This potentially deadly embrace between risk and output gaps can only be stopped by enough optimism….

This risk intolerant environment and perspective also permeates normal (non-recessionary) low-volatility times…. Depressed rates fuel speculation by relatively optimistic agents. When there is more speculation, the economy is even more exposed to a spike in volatility, as this could now wipe out optimists and lead to a deeper crisis due to lack of optimism…. Thus, speculation adds to the uncertainty perceived by the median agent and further lowers the natural rate…. In this environment, there is clear scope for macroprudential policy, because optimists’ risk taking (and the resulting speculation) is associated with aggregate demand externalities…. Macroprudential policy that restricts optimists’ risk taking can lead to a Pareto improvement (that is, we evaluate investors’ welfare according to their own beliefs). Moreover, the policy is naturally procyclical as the tightening of prudential regulation always has a negative impact on current aggregate demand–but this effect can be easily offset with interest rate policy when volatility is low, but not when there is a severe volatility spike and the effective lower bound is binding….

The world economy is currently ‘bipolar’, in the sense that there is a very short distance (in volatility space) between the current (good momentum, low volatility, high speculation) environment, and a global recession induced by a risk perception spike.