On day one of Fixed Income School, you learn that bond prices mean-revert. While a stock or a house’s price can continue to increase as the company or land becomes more valuable, yields can only go so low. Nobody will pay to lend someone else money, or at least, they won’t pay much to do that. Bond prices can only climb so high before they fall. While some evidence shows that yields trended downward slightly as the world became less risky, they still tended to revert to a mean greater than zero.
It’s easy to blame Silicon Valley Bank for being blissfully ignorant of such details. They purchased long-term bonds and mortgage-backed securities when the Fed was doing QE on steroids! Did they expect that to last forever? Well, maybe that was a reasonable assumption, based on the last 15 years, but I digress.
Many of these smaller banks, particularly Silicon Valley, are in trouble because they were particularly exposed to rate risk since their depositors’ profit model relied on low rates. So, when rates increased, they needed their money—precisely when their asset values would also plummet. It’s terrible risk management. But, to be fair, even the Fed (the FED!) did not anticipate a significant rate rise. Stress tests didn’t even consider such a scenario, even as rates were already climbing. Why would we expect bankers in California to be smarter than all-knowing bank regulators?
According to the New York Times, Central Bankers still expect rates to fall back to 2.5%. Why? Because of inequality and an aging population. But how does that work, and what’s the mechanism behind it? No good answer, or not one that squares with data before 1985, but we can hope. Sometimes we just want something to be true and for it to be true for politically convenient reasons.
If you claim Social Security at age 70 instead of 62 the sum total of your accrued benefits will be 17% higher if you make it to age 82 (which is the male life expectancy at 62). And remember that’s low risk, inflation-indexed income; there’s no better deal on the market.
Of course, delaying benefits means fewer years collecting them, but if you end up living to your early 80s you’ll come out ahead. The figure below plots how much you’ll get from Social Security (inflation-adjusted and discounted using today’s TIPS curve) at each age depending on when you retire.
And if you already claimed Social Security you can still change your mind and get higher benefits.
But if you are already retired (or resolved on it this year) and the market is down, it may seem like delaying Social Security isn’t an option. After all, you still need to eat.
The economy is still short 4.2 million jobs, but as the virus (hopefully) recedes and remaining restrictions are lifted, these trends should continue. The labor market is on the road to recovery—or the cyclical piece of it is, anyway. But during each recession we see many prime-age men leave the labor force and never come back. This was the case during the last recession, too. Prime male labor force participation is still down nearly 1 percentage point from pre-pandemic levels, and this poses huge costs to the economy because a large number of productive workers are simply sitting out. This is terrible for social reasons as well, because work is important to feeling productive, for increasing stability, for marriage, and being fully productive members of society.
This is a difficult economic problem that falls under the category of “structural,” which means that the Fed’s tools are not well-equipped to deal with it. Even with a tight labor market and rising wages, men are simply not working.
Instead, we need to think more creatively and just fix what’s broken. The common answer is that some of this is driven by a skill mismatch and that there just aren’t many good jobs for men without a college degree. I’m not sure that’s true, it’s very hard to find a good plumber or electrician, which are very well-paying jobs that don’t require a college degree. But they do require skills and training. Community college is often the answer we are given, but it has a terrible track record, primarily because it’s trying to paper over a bigger problem, namely the terrible quality of secondary school, which often fails to properly educate our teenagers. It seems like if we really wanted to keep men from leaving the labor market, this is the low-hanging fruit. Many people drop out of community college, but high school graduation rates are at record highs (or at least they were pre-pandemic). We can raise standards and accountability and fund more vocational high schools. However, tech education has become less popular from the 1980s to 2013, even if the skills are still in quite high demand.
In Bloomberg last week, I argued that the price of safety is mis-priced. Real yields have been negative for the better part of the last 10 years, and have been very negative since the pandemic. And the Fed has no plans to bring it above zero. I can understand a market negative real yield from time to time for convenience reasons. But all of the time? For decades? How can you explain that? Well, I blame the Fed and regulatory policy, as well as other countries buying lots of safe assets to manage their currencies. Lately, it’s been a lot of the Fed.
The risk-free rate is always being tinkered with by policymakers. Maybe it never actually equals the market price, but sometimes it’s more distorted than others, and it seems like it’s really off right now. And if that’s true, what does that say about the price of any risky asset? Perhaps that explains why crypto currencies are worth so much despite not offering much inherent value and having such a high Beta. When celebrities are hawking an esoteric risky asset, you know something is wrong.
Risk-free assets are the most systematically important asset in markets. They touch absolutely everything. And when it goes wrong, things get real. When market prices are not market prices for years at a time, risk gets distorted, and people subsequently take on more risk than they realize. I’m not predicting a financial crisis, but I do reckon that this could be why markets are just so weird right now.
Guaranteed jobs or UBI are poorly targeted and do not match the needs of new workers and may even hold them back by offering the sort of guarantees that perpetuate wage stagnation. Instead, the new safety net should offer various programs to smooth out dips in income and offer benefits that are not tied to a single employer, including:
Wage insurance—benefits that account for a drop in income, not just a loss of employment
Income averaging—tax rates based on income over three or five years, not just a single year, which will make income more stable for workers in variable work arrangements
Providing contingent workers the opportunity to receive benefits, such as health care and sick leave, that are not tied to traditional employment
To protect themselves against income risk, Americans have resorted to stagnation. We can provide downside protection in alternate ways—so that Americans can feel more free to switch jobs, try alternative forms of work, or start new companies. The above-mentioned programs are a more cost-effective and efficient way to address the needs of the new labor force than the guarantee-oriented policies that receive more attention. These programs provide options that would provide more robust insurance that can help spur a more dynamic economy. The options are merely a starting point to think more creatively about how to support a changing economy and break the cycle of stagnation.
Economists are often reminded by well-meaning friends and strangers that economics is flawed for assuming people are rational when they’re not. It’s not always clear what these skeptics mean by rational — often it’s a propensity for making bad decisions. And there’s truth in that. People struggle to make sense of probabilities, especially in the midst of uncertainty. Just look at the difficulty most people have had understanding the effectiveness of Covid-19 vaccines.
We humans also tend to exaggerate remote risks and ignore more likely events. Even when we accurately assess risk, sometimes we procrastinate doing what’s in our best interest or make snap decisions we regret later.
But generally, the idea we could nudge people to make better choices by exploiting their behavioral biases was always oversold. It’s hard to persuade people to do something they don’t want to do, especially when you don’t fully understand their unique motives. And if data isn’t presented clearly and honestly, attempts to nudge people can be self-defeating when they don’t trust you.
While the economic case for reducing inequality isn’t clear, a moral case can be made. One could argue that it’s wrong for the few to have so much while the many have so little. But it’s not the Fed’s job to make moral decisions about the ideal distributions of wealth. This is an inherently political calculation—one that should be addressed through institutions directly accountable to voters. Moreover, the tools at Congress’s disposal—tax rates and control over benefits, for example—are better suited for taking on inequality. And these policies involve costs, too, in terms of growth. Voters should be the ones to decide whether they want to pay them.
The Fed’s role is to balance short- and long-term interests, making the hard choices that may harm the economy now in exchange for long-term stability and expansion. Once politics are involved, however, it becomes difficult if not impossible to make this trade-off. The Fed can do what it does because it has a narrow mandate: reasonable inflation and maximum employment. It needs to stay in its lane.
The pandemic and the work-from-home environment it spawned also led many economists to speculate that workers would become better adapted to technology, more efficient and strike a healthier balance between work and life. This, in turn, would leave them more mobile. A Microsoft Corp. workplace trends survey found that 40% of Americans are considering leaving their jobs this year. And many are doing just that, with 2.5% of the employed quitting their jobs in May, according to the Bureau of Labor Statistics’ Job Opening and Labor Turnover Survey. Although that’s down from the record 2.8% in April, it’s still higher than any other point since at least before 2001. Plus, consider that the quit rate was only 2.3% in 2019 when unemployment was just 3.6%, compared with 5.8% this May.
So the goal of tax policy should be taking as much revenue as you can while trying to minimize distortions. Some kinds of taxes are more distortionary than others. In order of least to most harmful, it goes
1. Consumption taxes
2. Income taxes
3. Wealth taxes
Cut to our current tax debate, where these concerns get no attention. The goal seems less about minimizing distortions/maximizing revenue and more about punishment, i.e., rich people for making too much in a zero-sum world and corporations for being greedy. Now, I think our tax system should be more progressive, too. But there are good and bad ways to achieve that goal.
Since last winter, 1.8 million women have left the labor force entirely—neither working nor looking for work. At first, closed schools and the high cost of child-care options seemed responsible. But economists who have crunched the numbers argue that closed schools can’t explain higher female unemployment. Women with young children make up only 12 percent of the labor force and were only slightly more likely to leave the labor force than were women without young children. The exception? Women with young children who don’t hold college degrees—they constitute only 6 percent of the labor force but saw the biggest drop in employment. Their employment rate has fallen by almost eight percentage points since the pandemic started.
This suggests that women aren’t working for various reasons. For most families, several factors—child-care options, how much a given job will pay, and their partner’s employment prospects—determine whether they will decide to return to work. Rarely in economics does a single cause explain a phenomenon; policies often affect behavior on the margins. If you’re struggling to find good, affordable child care and you are being paid more to stay at home, that extra factor can tip the scales.
Indeed, several current policies seem to be discouraging women from returning to work.
Historically, bond yields have not been very good at predicting inflation.
In the last 70 years, bond yields rarely rose ahead of inflation, going up only after inflation takes hold. One study indicated that past inflation trends were a better predictor of bond rates than what future inflation turned out to be.
Does this mean bond traders are wrong? Not necessarily. It may just reflect that inflation is unpredictable and bond traders don’t know any more about the future than the rest of us. All they have is the past data and current prices to make their predictions, too. So when inflation suddenly spikes — as it has in the past — bond traders are as surprised as everyone else.
My colleague at Bloomberg writes we’ll have to pay teachers more to get them to return to work. Their pay has been stagnant for a decade. But their compensation has not been. A very large part of teachers’ compensation comes in the form of a massive risk-free asset—a defined benefit pension. The value of this pension increased as real interest rates fell. It not only took more resources for the states and municipalities to finance (assuming the pension funds were well funded—a big if) the pension when rates were low. The pension became more valuable.
So teachers really got large raises in the form of their more valuable pension. The problem is they don’t fully internalize how much more their pension is worth. Also, pensions are less valuable for young teachers who may change jobs one day. If we do want to increase teachers’ pay, we really need to reform the pensions. Reform would free up more money for salaries, and there’s evidence young teachers prefer more flexible compensation.
That probably won’t happen since the teachers’ union is very attached to its defined benefit plan. But you can’t have it all, even in this labor market.