An “entrance fee” theory of why some real rates of return are persistently low

by on December 10, 2013 at 2:42 am in Economics | Permalink

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.

Dan December 10, 2013 at 3:05 am

What would happen if the “suckers” just bought & held index funds, instead of actively competing against those with special trading technologies?

MPJ December 10, 2013 at 3:16 am

I share this question. It isn’t clear why financial institutions’ superior trading tech would imply low or negative returns for everyone else, from your point #4.

Rahul December 10, 2013 at 3:27 am

+1

As an aside, does HFT really make much money at the expense of the poorly equipped small time “suckers”? Or mostly from trouncing other HFT guys similar to themselves? I thought the latter, but I may be wrong.

HFT Trader December 10, 2013 at 3:43 am

HFT makes small amounts of money on large amounts of transactions. So the amount that you’re “paying” to HFT basically scales with how often you trade. The typical “small-time” buy and hold index investor who turns over his portfolio once every five to ten is virtually paying nothing to HFT. HFT can make a lot of money off of other HFT but obviously this still nets to zero. The big source of income is pretty much non-HFT participants that still trade a lot. This is a large category but includes day traders, people that have to dynamically hedge positions (e.g. options traders), people running longer-term strategies that still have high turnover (e.g. stat arg funds or trend followers), and various non-HFT market makers.

Some of these people are systematically deluded into thinking they can make money when they can’t. E.g. day traders, or even many active mutual fund managers that add no additional return to indexing. But many are willing to keep paying HFT because their strategy still is better even after transaction costs. For example a momentum-weighted portfolio (hold stocks that have been going up) is obviously going to trade much more often than a simple buy and hold index. You pay a lot more in trading costs (much of which goes to HFT in modern markets), but the risk-adjusted return advantages of momentum exposure are such that it’s certainly worth the cost.

zbicyclist December 10, 2013 at 10:17 am

i.e. that E*Trade baby is just a babe in the woods.

Samples of these commercials for those not watching US television: http://www.youtube.com/watch?v=hashPaU7Dpk

john personna December 10, 2013 at 10:41 am

Do we know that HFTs don’t bleed index fund operators as they do their daily portfolio adjustments, both rebalancing and adjusting for inflows and outflows?

HFT Trader December 10, 2013 at 11:50 am

Annual turnover on SPY is 2.99%. Which of course almost entirely consists of portfolio rebalancing. Mean returns per dollar of HFT volume is about 1 bp (1% of 1%). Other stat-arb funds do try to front-run index rebalancing in various ways. (The average horizon on this strategy is a couple of days, so this puts it in the purview of decidedly non-HFT quants). Academic research on the index premium suggests that it may be 50 bps for small-cap illiquid stocks over the past few decades. This is almost certainly an upper bound since 1) most of the turnover is in highly liquid stocks, and 2) almost all stat-arb returns have fallen in recent years due to crowding in the sector and lower transaction costs.

At most index fund holders are paying 1-2 bps a year due to index rebalancing costs. As for fund inflow and outflow, with ETFs these aren’t handled directly by the fund but by the Authorized Participants (APs) that act as market makers. (Incidentally most of the APs are HFT shops themselves, so ETFs have essentially outsourced the inflow/outflow trading to HFTs). The only cost the end-user bears with regards to inflow/outflow trading is buying/selling the actual ETF shares themselves. After that that the APs internally bear all the cost related to redemption or creation.

SPY trades at a .01 bid ask spread on a $180.96. Throw on a $25 commission to buy 1000 shares. That’s 1.6 bps in trading cost over the entire life time of the investment. At about $500 billion AUM index funds are at the very most “bleeding” $100 million onto quant funds.

(source below http://finance.yahoo.com/q/pr?s=spy)

yo December 10, 2013 at 5:37 am

It could be that index funds are also part of the “sucker” world. E.g. they react the wrong way, reducing their equity holdings in a downturn at fire-sale prices? This, in addition to 2% management fee.

HFT Trader December 10, 2013 at 5:44 am

It would be very rare for an index fund to charge 2% management fee. SPDR’s SPY index ETF charges 0.09% for example. Also index funds don’t dump their holdings in downturns. They’re mandated to stay fully invested in the index at all times. Their constituent investors might withdraw, which means the fund would sell to stay at 100%. But the bulk of the statistics I’ve seen says that retail investors (who make up most index funds) are the least flight-prone class of investors. Institutional investors liquidated at much higher numbers in 2008 rather than retail investors.

yo December 10, 2013 at 6:32 am

Interesting. I am convinced concerning the tendency for retail investors to remain invested in times of crisis. It sounds plausible, but I have also heard that some actively managed pension funds panicked in 2008 and switched their equity holdings massively to bonds.

Moreover, as a retail investor your bank advisors always try to steer you towards the products for which they earn more commission, which rarely includes ETFs or low-fee funds. Tends to happen more often to my grandma than with me, but they never fail to try and clutter me with junk every time I speak to them in the hope that I say “yes yes I give up”.

HFT Trader December 10, 2013 at 7:19 am

Oh, I agree with you. I was merely disputing the use of the terminology “index fund.” Generally that term refers to low cost funds that simply try to track an index. The term “actively managed fund” is more appropriate for the type of product your describing: 1%+ fees, high turnover and trading, managers varying market exposure over time.

anichini December 10, 2013 at 9:57 am

“I have also heard that some actively managed pension funds panicked in 2008 and switched their equity holdings massively to bonds.”

Ex-post what might appear to have been panic could actually be rational decision making. I heard this. Some large endowment funds did the only rational thing they could when (due to the seizure in the money markets) they suddenly found themselves unable to withdraw cash from their cash accounts – they redeemed their risk investments (eg equities, hedge funds) in order to pay university operating expenses. Think about that: for a while, their emerging markets equities investments were more liquid than their cash accounts.

While their motivation was not panic, the de-risking effect was the same as that in your panic scenario.

Brian Donohue December 10, 2013 at 11:06 am

Dude,

Vanguard.

JWatts December 10, 2013 at 9:44 am

What would happen if the “suckers” just bought & held index funds

Or just buy and hold any reasonably decent dividend stocks. Or at least a selection of 10 or so.

Pacemaker December 10, 2013 at 5:06 am

#9 is reminiscent of the Marxist view of business cycles.

Ray Lopez December 10, 2013 at 5:36 am

Marx is widely credited among capitalist economists as getting the ‘business cycle’ aspects of an economy right, even if he got the capital vs labor and class structure aspects wrong. So Marx is good for point #9.

A fine speculative post by TC, but I’m afraid he is spinning invisible clothes for the emperor. “Tighter monetary policy would simply add another problem to the mix without curing the underlying dysfunctionality.” – and what would that be? I wonder if honest money is seen as an evil by TC and other economists. Still worshiping the false god of Keynes?

Z December 10, 2013 at 11:16 am

I’m glad someone made this point. Marx was right about most of his observations. His prescriptions were insane, but he did a good job describing symptoms.

swedo December 10, 2013 at 5:24 am

Isn’t this a model, not a theory?

JWatts December 10, 2013 at 9:46 am

It’s more like a hypothesis.

Givco December 10, 2013 at 4:32 pm

For fun, I want to read someone’s “mood afffiliation” interpretation of this post. (Some cleverer than me.)

Paul Gowder December 10, 2013 at 5:53 am

Why can’t the suckers counteract this by investing in a portfolio of those with access to special trading technologies?

dbp December 10, 2013 at 9:25 am

I was thinking along the same lines. This is my response whenever someone thinks banks or oil companies or pharma companies are “screwing us”:

If you think they have such a great thing going, why not buy some shares of Exxon, or Merck or Goldman?

A real issue is that many of the most profitable firms are going private due to onerous regulations. The result is that the opportunity to invest in them is sealed-off from individual investors.

Rahul December 10, 2013 at 9:41 am

Good point.

Though sometimes in these mega-firms I wonder whether true value gets created in the long run for their shareholders or more for their upper management, directors and assorted connected individuals who can tweak a firms trajectory and exploit their insider knowledge, power and connections to line their pockets in ways outside of the traditional stock value framework.

amelanchier December 10, 2013 at 10:09 am

The problem is that the value of their screwing is already capitalized into the stock price. Only an increase in the intensity of their ability to screw would yield capital gains.

toosmallltotrade December 10, 2013 at 1:46 pm

The argument depends on a couple contentions in points 4 & 5 that empirically are not observed.
1) HFT (and other alpha generators) bleed little guys: On some aggregate level yes, but they are really just liquidity and information providers for the really really big guys (pensions/endowments/foundations/sovereigns and the gigantic mutual funds), for which they take a cut (which is huge on a per partner basis but not overall). And how much they bleed you directly corresponds to how much you trade, thus the class of investor you would be most worried about (buy & hold equity investor that tends to keep bonds to maturity) is not impacted significantly. Not getting a decent rate of return in bank accounts while saving for a new car isn’t great, but credit ease and availability offset the consumer impact to a substantial degree (by pushing people to buy on credit admittedly, which could be bad for other reasons). Those who can qualify for credit are irrelevant for our purposed because they have no investable wealth.
2) Differential rates of wealth accumulation: On face untrue. As a whole, alternative investment vehicles don’t outperform on a risk adjusted basis net of fees. You could make the derivative argument that those rich people lucky enough to be in “top-quartile” funds basically by accident get a multiplier effect on their wealth, but that is no more a systematic flaw than the fact entrepreneurs who happen to sell at the right time get a similar boost – luck begets inequality sort of by definition. One could buy the argument that risk premia are high / rates are low and thus being able to takes lots of risk and leverage due to net worth is an advantage, but this effect seems relatively ephemeral and is a post-crisis construction at best (before that, risk premia were absurdly low in retrospect).

Point that Treasuries, especially short term ones are almost never priced on the margin by “real” demand is a valid one, but there are issues with the argument even if you concede that point.

zbicyclist December 10, 2013 at 10:27 am

But who captures the value added? If a hedge fund charges very high fees, then it’s not the suckers who get the benefits.

Rahul December 10, 2013 at 11:00 am

Yes, but isn’t that critique equally applicable to the current hedge fund model?

Brian Donohue December 10, 2013 at 11:07 am

Few people doubt Alpha exists. The question is: how much of Alpha do the Alpha-finders share?

Robert Sams December 10, 2013 at 7:02 am

Very interesting post and #5 is crucial (it’s a geometric process). Two points.

1. I think that we can substitute “ability to leverage at near-treasury rates” for “special trading technologies” and get the same implied predictions yet put the relevant institutional factors into relief.

2. Your #1-3 still works with the wrong model of Treasury returns, as it implicitly models demand as if it’s coming from a “real money” portfolio sort of buyer. Those guys exist of course, and they’re basically buyers at any price (central banks, regulatory demand, etc.). But if we ignore CB policy expectations, the valuation is set in the leveraged market, which is much larger, and treasuries trade rich /not/ so much b/c people want safety and therefore want to buy them, but rather they trade rich because people want to /short/ them for hedging purposes (e.g., investor wants corporate credit w/o the interest rate risk.)

Sounds paradoxical, I know, but failure to appreciate this fact is the basic misconception of the entire “risk premia” way of modelling this stuff.

For any given treasury issue, X billion were sold by Treasury, but the outstanding amount of people long the issue will be many times X because of all those repo leveraged buyers of UST’s, and for every one of those repoed longs, there is a short on the other side doing reverse repo. The market clears with the repo rate, which can often be much lower than fed funds and indeed can go up to -300bps at times if the (primarily hedging) demand from shorts is extreme. (The effective repo rate in this market is rather different from the general collateral series you can pull from public sources.. it’s hard to get good data as it’s proprietary to the big IDB’s… why the Fed tolerates this degree of opacity, I’ve never understood.)

Treasuries can therefore be seen as a special financial “currency”, and the treasury market can be modeled as type of free banking regime, where the public debt is base money, the much larger qty of leveraged UST positions is broad money, and the repo market is an interbank lending market where USD cash is collateral instead of money.

Looked at this way, the phrase “shadow banking system” is a quite literal description. Turn a market monetarist lose in this parallel universe, and the low rate conundrum is due to UST “base money” not keeping up with demand and the Treasury is a tight fisted CB.

In this universe, the real return of treasuries isn’t the relevant variable, it’s the spread between the repo rate and the treasury yield, which acts as a sort of “fee” for the guy who wants a hedged Investment in a riskier asset and pari passu a benefit to the party who wants a leveraged bet that the Fed means what it says about ZIRP. In finance-land with its UST currency, that spread /is/ the ST interest rate, which is volatile and well-above zero.

Now we can define quite precisely your “entry fee” thesis: the entry fee is the relative credit terms (haircut’s, etc) you’ll get in this repo market. In a world of only non-bank dealers and traders, those terms are symmetrical b/c counter-party risk is broadly symmetrical. In the world of TBTF, naturally only the bank holdco’s get the best terms. So, to win the wealth-accumulation game in this world, be a bank or be a very good client of a bank.

Errorr December 10, 2013 at 8:41 pm

Um, public debt IS base money in the first instance.

Errorr December 10, 2013 at 8:46 pm

I find it funny that people were blaming the FED for QE creating a lack of safe assets. If the FED ended QEnthen there would be other problems. What people need to realize is that if people want more safe assets then go to the supplier and make the govt pish through some kind of massive stimulus. Let the treasury flood the market until demand from the FED is satiated and supply starts to exceed demand. Or just declare that payroll taxes will be 0 until we start to see rates creep up.

Rahul December 10, 2013 at 7:05 am

If indeed this is like an informal entrance requirement do we see very little T-Bill holding by entities that are not legally required to hold such instruments?

prior_approval December 10, 2013 at 7:11 am

So, how do interest rates look in a deflationary world? Not that the word ‘deflation’ appeared anywhere in the text, of course.

Cliff December 10, 2013 at 10:48 am

Perhaps because there is no deflation

Alex Godofsky December 10, 2013 at 7:37 am

Oh yes, #4 has been so true throughout the period of low interest rates, right?

market timer December 10, 2013 at 8:14 am

Now apply this entry fee idea in the context of the recent bank capital requirements (Basel III) and you have a paper.

Mort Dubois December 10, 2013 at 9:00 am

As a member of the small shopkeeper class, I think that #8 is brilliant. I like the whole analysis. Pretty good fit for reality, as far as I can tell.

Greg G December 10, 2013 at 9:01 am

Great post Tyler. This is exactly the kind of original and thoughtful stuff that keeps me coming back to MR.

amelanchier December 10, 2013 at 9:29 am

Doesn’t the model also imply that massive global fiscal contraction is very very desirable? (Reduce the supply of those safe assets.)

Errorr December 10, 2013 at 8:38 pm

Um, it implies the opposite. Safe assets are too EXPENSIVE so supply has to exceed demand.

TallDave December 10, 2013 at 10:11 am

5. The implied prediction is that differential rates of wealth accumulation will be a driver of inequality over time.

That happens anyway, though, simply because people who accumulate wealth generally continue to do so over their lifetimes of increasing wealth. I’m not sure how you measure the delta from this effect in particular. Also, I’m not sure I believe there are significant returns to specialized trading techniques, which strike me as just another form of arbitrage (which people have been complaining about since the dawn of trade itself).

8. Something like half of professional athletes declare bankruptcy within several years of retirement, despite being barraged with great advice. There’s no cure for bad decision-making.

10. Low interest rates are exactly what Fisher and Friedman predicted would be the end result of the successful Volcker/Greenspan/Bernanke inflation targeting policy, or any such successful policy (e.g. BOJ).

Brian Donohue December 10, 2013 at 11:01 am

#8. I suspect there is more ‘disintermediation’ going on along these lines. In a world where risk-free returns can be locked up passively, many folks hitch a ride on the markets. That world doesn’t exist so much anymore (although things are a helluva lot better than a year ago, when TIPs delivered negative real returns.) So, more old-fashioned ‘Millionaire Next Door’ type of wealth accumulation. I wonder if there are data on this.

Brian Donohue December 10, 2013 at 11:04 am

#10. Real interest rates are low, but (except for the short-end of the curve) no longer crazy low. I don’t think this is a mystery- still some Fed fingers on the scale, plus demographics. Willem of Occam is nodding his head.

Brian Donohue December 10, 2013 at 11:09 am

In other words, I challenge your premise. Interest rates are no longer extraordinarily low, like last year. 2012 was the heavy hand of the Fed. 2013 is the New Normal.

Jacob December 10, 2013 at 12:05 pm

As a financial adviser who serves retail investors, I agree with you about the price of market access. It’s not just in the low yields on Treasuries, but in a host of other fees including market data, commissions, and of course my own fee. But much of this has been democratized through low-cost brokerages and electronic exchange access – if anything the barriers to entry for “special trading technologies” broadly defined to include more than just HFT – stock-picking ability, risk management ability, the ability to short sell – all the things institutional investors pay fund managers for (at least in theory) – have fallen dramatically in recent years. Brian Donohue makes the excellent point above that there remains a question of whether fees are too large relative to ‘alpha’ (my how I hate that word) – they almost certainly are in the aggregate, but people often fail to consider that ‘beta’ is after all the aggregate performance of all market participants.

In any case, I take exception to point #4. If, in fact, low real yields on safe investments represent the “entrance fee” for market access, then paying that fee means access is available. The whole thrust of your indexing fans’ comments above is that no one is being forced to accept low or negative real returns simply by virtue of the high demand for safe assets – only the people who truly want to hold those safe assets, i.e. as an entrance fee, actually need do so. The rest can index, buy-and-hold, or pay up and invest with an institutional manager, who may or may not outperform his fees, depending on that always difficult-to-assess combination of luck and skill.

Michael December 10, 2013 at 12:20 pm

Assuming this theory holds (it makes a lot of sense on the surface), how can a central bank avoid a liquidity trap by expanding the monetary base? A basic income?

Errorr December 10, 2013 at 8:36 pm

Well the Keynesian argument is that it really can’t and only by driving of the supply of government debt can eventually lower their value to make returns positive again. You do this through stimulus, although there is nothing that requires that it be anything but antax cut or one time check to every American.

Of course the Central Bank can always keep the rate of return close to zero if it chooses by contracting the money supply.

Rick December 10, 2013 at 12:31 pm

Where is the evidence that those with “special trading technology” are earning out-sized returns?

“Hedge funds are having a rough year. Data compiled by Bloomberg shows that as an industry, hedge funds have returned an average of just 7.1 percent, a rate that pales in comparison to the 29 percent growth rate of the S&P 500 equity index.”

http://wallstcheatsheet.com/stocks/hedge-funds-score-low-returns-but-high-deposits-in-2013.html/

Michael December 10, 2013 at 1:10 pm

You could argue that hedge funds’ special trading technology is getting commoditized.

Markets are always getting more efficient–as soon as I spot an inefficiency and profit off of it, I take away that opportunity from someone else. HFT shops have been complaining about a race to the bottom resulting from their technological arms race. That would explain hedgies’ shitty returns this year.

csissoko December 10, 2013 at 12:50 pm

I had similar thoughts here:
http://syntheticassets.wordpress.com/2013/11/22/is-modern-finance-the-source-of-secular-stagnation/

A question that needs to be asked is whether our models of financial institutions are so flawed, that regulators who are trying to make the financial system safe are in fact undermining its ability to function.

Matt December 10, 2013 at 12:51 pm

“Special trading technologies (the technology may vary across market participants, but think HFT, hedge funds, prop trading, employing quants, and so on)”

Huh? I don’t see how all these unlike things get grouped together or how they do what you say they do. And this seems to be the key mechanism underlying the theory.

1. “hedge funds” is name for a particular fee structure for asset management. Hedge funds have not been doing well in the market lately. So it is apparently an “inferior trading technology,” at least in recent years.

2. You mentioned in the context of the Volcker rule a few days ago that prop trading is a trivial distraction. Whatever special advantages that places like Goldman have which allows them to earn outsized profits, it is not the sliver of prop trading they do, it’s the other stuff.

3. etc etc for HFT and quants. This just sounds like a list of mildly jargony terms that are used to put your average NYT reader into a “finance is scary, bankers are cheaters” mood.

Errorr December 10, 2013 at 8:32 pm

Well this is the best case for fiscal stimulus I have read yet.

If T-bills are too expensive then supply is too low. Flood the market with T-bills and use the money accumulated for investment of some kind. While us less government spending would still likely provide positive returns I would rather see a massive check cut to every adult. While some people may save the money or deleverage there will be enough investment by people to mean a positive rate of return in aggregate.

As long as the real rate earned on government debt is negative there is no cost to any government spending. No need to increase future taxes. The US has a blank check to spend whatever it wants because the borrowing will always be in fact a tax on financial transactions until the treasuries fall in price due to increased supply.

The question then becomes when is the equilibrium price of US debt such that the real return will be positive. At that point more debt will mean higher taxes in the future.

Of course the problem is that it is impossible to determine if the real rate of return for T-bills beforehand.

jpmirabeau December 11, 2013 at 12:53 pm

Perhaps it’s not so much “safe assets” but “low-information assets” that are no longer priced pursuant to CAP-M That is, the special asset class here is those assets that do not require much diligence before a counterparty purchases the assets or accepts the assets as collateral. Restated yet another way, it’s less about safety (i.e., low co-variance with market returns), more about “Know Your Obligor” and the Coasian transaction cost arising out of diligence on the underlying obligors.

Either way, some other potential implications:

Perhaps low-information assets are to some extent endogenous. Should we perhaps encourage the production of low-information assets via structured finance? Note that Dodd-Frank goes a long way to discouraging securitization (e.g., the risk retention rules). Contra MM, perhaps structured finance really is alchemy?

If low-information assets are now a factor of production, does the federal government perhaps have a role to play in synthesizing low-information assets? Fannie/Freddie MBS – which had an implicit government guarantee – were a low-information asset favored by the Chinese and others. Should perhaps the government provide credit guarantees on some asset classes, even just catastrophic guarantees (i.e., behind a first loss position taken by private capital via structure finance or credit insurance)? How should a free marketeer now appraise government catastrophic backstops on assets? Is the justification that low-information assets present positive externalities? Is this about putting some oil on some Coasian transaction costs (the obligor diligence costs mentioned above)? Or would the justification have something to do with multi-equilibria?

Related to the agency MBS, perhaps the housing bubble was the first manifestation of the low-information asset qua factor of production, in that case, a fetish for low-information assets developed by current account surplus countries managing their exchange rates?

Shack Toms December 12, 2013 at 10:48 am

It is an interesting article, but I have a quibble. Why is it necessary that HFTs make money by taking it from somebody else? I think it is entirely possible that they make money by adding value. The value they add may be in making markets more efficient by taking advantage of any deviation in price from the optimum. This means that low frequency traders experience less risk cost. In this case, both the HFT traders and the LFT traders are benefiting from the HFT activity. Of course only the good HFT traders correctly assess how the market price has deviated, these are the ones who stabilize the market around the optimum price and these are the ones who make money. So good HFT traders would make money at the expense of bad HFT traders, but the ones who make money are adding value by reducing the risk cost for those who are not timing the markets.

jqhart December 12, 2013 at 5:27 pm

This presents an opportunity for jurisdictional arbitrage. Start or grow companies that effectively does what most of a fee-paying services company does, but doesn’t have to pay the fee.

bogwood December 12, 2013 at 8:58 pm

There may be a role for less marginal surplus, particularly energy surplus, not necessarily the gross amount of BTUs but the net after production costs. Total net society wide profits( including paying for years from 1-20,60-90) are negative, corporations only show virtual profits by transferring costs to the government. The losses persist but are deferred. Rates are negative because returns,broadly considered, are negative. We are returning to the historical longstanding trend,negative rates, but with a very expensive complex society. Breakfast of consequences?

bogwood December 12, 2013 at 9:15 pm

Can you ad hominem a country? Norway is stupid to make a “profit”(burn natural capital) and invest in foreign virtual assets. They should save the assets in the ground. Now there may be geophysical reasons, like the Alaska oil fields where the assets have to be exploited now, but if not they are in an ideal Hotelling situation. (#11)

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