A subtle change has been made to the comments links, so they no longer pop up. Does this in any way help with the problem about comments not appearing on permalinked posts, readers?
I
think the problem here is more of this gross substitutability stuff and
marginal thinking that I am always going on about. The idea that
people seem to be stuck with is that an increased weighting to equities
and high-yield debt in some portfolios is an "increase in risk" and that
this in some way increases the danger of another financial crisis. But
a) the extent to which it's actually happened is hardly measurable, and
b) it isn't, any more than a budgerigar might grow up into a
tyrannosaurus rex. They're different things.
The credit bubble and house price crash weren't random outcomes
selected from the underlying distribution of financial asset returns;
they were specific events with their own causes, which is why they
appeared to be Black Swans to people who weren't paying attention to
those causes. That's not going to happen again, or at least not in that
specific way, not for a while.
As far as I can see, Brad, you're more right than the people worrying
about financial instability, because they're looking at this from a
partial analysis - they're looking at either the (small) empirical
evidence of people increasing holdings of credit-risk securities or the
theoretical arguments to the effect that the private sector has an
incentive to increase those holdings and saying - increase risk equals
bad.
You, for your part, are looking at the system as a whole and saying
that there's something close to a conservation law; that duration risk
has gone down, while credit risk (and equity risk) has gone up, for the
private sector.
Stein's view seems to be that the total amount of "risk" can go up if
the total amount of *activity* goes up (which is true, activity is
risky), and that in so far as the QE channel works by encouraging the
private sector to buy credit- and equity-risk securities and thereby ...
(cough mumble) investment in real entrepreneurial projects, then it's
possible that QE might encourage the kind of over-leveraged risky
structures that lead to financial fragility.
My view is that, while your view and Stein's are clearly better than
the partial view, this is all the sort of blackboard thinking you're
going to get if you start off by making the mistake of drawing supply
and demand diagrams denominated in generic "risk"! The attraction of
cash isn't that it's "safe" - ten year floating rate government bonds
would have zero duration risk, but they wouldn't be cash. The reason
that people hoard cash in liquidity traps is that it's *liquid* - it
preserves your optionality, and combines zero risk of being unable to
meet nominal liabilities, with instant convertibility into consumption
or investment goods. Cash is what you want to hold when you don't know
what to do next.
And people's decision about what they want to do next are driven by
animal spirits and expectations about an unknowable future. The kind of
thing that makes people take non-ergodic, non-insurable, non-hedgable
entrepreneutrial risk is really not very related to the kind of thing
that makes people move the equity weighting of their portfolio from 40%
to 45%.
If, at some future date, activity picked up and we had a normal
investment environment and yields were still at 2%, then this might be a
problem, as it would mean that people would be able to finance very
low-yielding projects, and as a result would be vulnerable to
comparatively small real shocks to either their refinancing cost or
their cash flows. But this is to assume that future massive mistakes
would be made.
The credit bubble and house price crash weren't random outcomes selected from the underlying distribution of financial asset returns; they were specific events with their own causes, which is why they appeared to be Black Swans to people who weren't paying attention to those causes. That's not going to happen again, or at least not in that specific way, not for a while.
As far as I can see, Brad, you're more right than the people worrying about financial instability, because they're looking at this from a partial analysis - they're looking at either the (small) empirical evidence of people increasing holdings of credit-risk securities or the theoretical arguments to the effect that the private sector has an incentive to increase those holdings and saying - increase risk equals bad.
You, for your part, are looking at the system as a whole and saying that there's something close to a conservation law; that duration risk has gone down, while credit risk (and equity risk) has gone up, for the private sector.
Stein's view seems to be that the total amount of "risk" can go up if the total amount of *activity* goes up (which is true, activity is risky), and that in so far as the QE channel works by encouraging the private sector to buy credit- and equity-risk securities and thereby ... (cough mumble) investment in real entrepreneurial projects, then it's possible that QE might encourage the kind of over-leveraged risky structures that lead to financial fragility.
My view is that, while your view and Stein's are clearly better than the partial view, this is all the sort of blackboard thinking you're going to get if you start off by making the mistake of drawing supply and demand diagrams denominated in generic "risk"! The attraction of cash isn't that it's "safe" - ten year floating rate government bonds would have zero duration risk, but they wouldn't be cash. The reason that people hoard cash in liquidity traps is that it's *liquid* - it preserves your optionality, and combines zero risk of being unable to meet nominal liabilities, with instant convertibility into consumption or investment goods. Cash is what you want to hold when you don't know what to do next.
And people's decision about what they want to do next are driven by animal spirits and expectations about an unknowable future. The kind of thing that makes people take non-ergodic, non-insurable, non-hedgable entrepreneutrial risk is really not very related to the kind of thing that makes people move the equity weighting of their portfolio from 40% to 45%.
If, at some future date, activity picked up and we had a normal investment environment and yields were still at 2%, then this might be a problem, as it would mean that people would be able to finance very low-yielding projects, and as a result would be vulnerable to comparatively small real shocks to either their refinancing cost or their cash flows. But this is to assume that future massive mistakes would be made.