Some portion of the negative real returns on U.S. government securities can be explained by risk premia, but yet many other indicators of risk are these days not so extreme. Times appear pretty stable, if not exactly what we had hoped for. So how else might we fit these negative returns into a theory? Here is one attempt, by me:
1. Imagine that financial institutions and traders have to hold large quantities of T-Bills (and similar assets) to participate in financial markets. That may be to satisfy collateral requirements, to meet government regulations, to be credible in private market transactions, and so on.
2. The demand for these assets is now so high and so persistent that the assets have persistently low nominal returns and often negative real returns.
3. The holders of these assets do not however receive negative returns on their portfolio as a whole, when deciding to hold these T-Bills. Holding the T-Bills is like paying an entry fee into financial markets. And once they are in financial markets of the right kind, these market players can earn high returns by possessing special trading technologies (the technology may vary across market participants, but think HFT, hedge funds, prop trading, employing quants, and so on).
4. Let’s say you are not a major financial institution. Then you really will earn negative returns on your safe saving. You might try holding equities, but a) you are not wealthy and thus you are fairly risk averse, and b) as a small player you do not have access to these special trading technologies and indeed you must trade against those who do. You thus will often earn negative or low returns on your portfolio no matter what.
5. The implied prediction is that differential rates of wealth accumulation will be a driver of inequality over time. This seems to be the case.
6. This equilibrium is self-reinforcing. The crumminess of T-Bill returns drives some individuals into trading against those with special trading technologies, even though that means they do not get a totally fair deal. The ability to trade against these “suckers” increases the value of paying the entrance fee into the higher realms of financial markets and thus increases the demand for T-Bills and keeps their rate of return low.
6b. Bailouts and moral hazard issues may reinforce the high returns to the special trading technologies, at social and taxpayer expense.
7. In this equilibrium this is a misallocation of talent into activities which complement the special trading technologies.
8. Imagine a third class of agent, “Napoleon’s small shopkeepers.” These individuals earn positive rates of return on invested capital, though those returns are not as high as those enjoyed in the financial sector. You become a shopkeeper by saving some of your earnings and then setting up shop. Yet now it is harder to save and accumulate wealth for most people (the rate of return on standard savings is negative!), and thus the number of small shopkeepers declines. This hurts economic growth and it also thins out the middle class (“Average is Over”). Most generally, the quality of your human capital determines all the more what kind of returns you will earn on your financial portfolio and that is a dangerous brew for the long term.
9. Business cycles may arise periodically if those who control the special trading technologies periodically “empty out” the real economy to too high a degree; you can think of this as a collective action problem. Then the financial sector must shrink somewhat, but unfortunately the game starts all over again, following a period of recovery and consolidation.
10. The John Taylors and Stephen Williamsons of the world are right to suggest there is something screwy about the persistently low interest rates, and thus they grasp a central point which many of their critics do not. Yet they don’t diagnose the dilemma properly. Tighter monetary policy would simply add another problem to the mix without curing the underlying dysfunctionality.
11. In this model, fixing the negative dynamic requires financial sector reform of such a magnitude that real rates of return on safe assets rise significantly. That is hard to pull off, yet important to achieve.
11b. It would help for the Chinese and some other East Asian economies to diversify their foreign holdings into riskier and higher-earning investments. They need a new trading technology in a different way, and you can think of their demands for safe assets as a major market distortion. Edward Conard saw a significant piece of this puzzle early on, by noting that a globalized world will skew real rates of return on safe assets (it is easiest to overcome “home bias” on the safest and most homogenized assets of a foreign country). Singapore and Norway are to be lionized in this regard for their risk-taking abroad.
12. If you so prefer, monetary and fiscal policies can have the “standard” properties found in AS-AD models. Yet in absolute terms they will disappoint us, and this will lead to fruitless and repeated calls to “do much more” or “do much less,” and so on.
13. In this model, the activities of the Fed can be thought of in a few different ways. In one vision, the Fed is the world’s largest hedge fund and has the most special trading technology of them all. Forward guidance on rates is actively harmful and the Fed should instead commit to a higher rate of price inflation or a higher rate of ngdp growth.
13b. Under another vision of the Fed, they understand this entire logic. Interest on reserves is a last resort “finger in the dike” attempt to keep rates higher than they otherwise would be. Of course both visions may be true to some extent. (And here I am expecting Izabella Kaminska to somehow make a point about REPO.)
14. Unlike in models of demand-side “secular stagnation,” the observed negative real rates of return do not imply negative rates of return to capital as a whole and thus they do not have unusual or absurd implications. They do require some degree of market segmentation, namely that not everyone has access to the special trading technologies, but those who do have enough wealth to push around the real return on T-Bills, especially if China is “on their side.”
That is what I was thinking about on my flight to Tel Aviv. It should be thought of as speculative, rather than as a simple description of my opinions. Still, it fits some of the data we are observing today. Another way to put it is this: the recent secular stagnation theories need a much closer examination of the financial sector and its role in our current problems. We should focus on the gap in returns, rather than postulating a general negativity of returns per se.