on the macroeconomics of risk intolerance · on the macroeconomics of risk intolerance author:...

On the Macroeconomics of Risk Intolerance

Ricardo Caballero

MIT and NBER

BIS, Summer 2017

Caballero (MIT and NBER) Risk Intolerance BIS, Summer 2017 1 / 25

Background papers

1 Caballero, R.J., E. Farhi, and P.O. Gourinchas, “Rents, TechnicalChange, and Risk Premia. Accounting for Secular Trends in InterestRates, Returns on Capital, Earning Yields, and Factor Shares,” inAmerican Economic Review, Papers and Proceedings, 2017, 107(5):614-620

2 Caballero, R.J., E. Farhi, and P.O. Gourinchas, “The Safe AssetShortage Conundrum,” forthcoming in Journal of EconomicPerspectives, Vol 31(3), Summer 2017

3 Caballero, R.J., and A. Simsek, “A Risk-centric Model of DemandRecessions and Macroprudential Regulation,”MIT Mimeo, May 2017

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Real (Riskfree) Interest Rates (U.S.)

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016­6

­4

­2

0

2

4

6

8

10

12

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Real Return on Capital (U.S.)

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 20143.5

4

4.5

5

5.5

6

6.5

7

7.5

8

8.5

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Labor Share (U.S.)

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 20140.6

0.62

0.64

0.66

0.68

0.7

0.72

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Risk Intolerance

Note: unlevered premium

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Earnings Yield (S&P 500)

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016­0.02

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

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Equity Risk Premium (U.S.)

1980 1985 1990 1995 2000 2005 2010 20150

0.05

0.1

0.15

0.2

0.25

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Equity Risk Premium (Global)

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Risk Intolerance

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 20170

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

Important caveat: Evidence of reach-for-yield within asset classes(heterogeneity)

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The Safe Assets Shortage Perspective

Steady increase in demand for store of value and “safe”assets

Demographics, international reserves accumulation, regulation...

What is a safe asset?

Depends on time and context: Individual and collective fears andconcerns, on coordination and liquidity, and so on...Operational definition: A simple debt instrument that is expected topreserve its value during adverse systemic events

The supply of these assets is not keeping up with demand

The financial system reacted to that gap (financially engineered) andmasked the underlying trend for a while, but it didn’t end up well(micro vs macro safe assets)

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The Safe Assets Shortage Perspective

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The Safe Assets Shortage Perspective

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 20170

0.02

0.04

0.06

0.08

0.1

0.12

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Consequences

Early phases: Mostly “benign”

Overtly benign: Lower cost of capitalOvertly concerning: Global imbalances and the Greenspan conundrumCovertly dangerous: Financial engineering to manufacture safe tranchesfrom subprime inputs (... and partially held by levered institutions)

Post 2008: The Safety Trap

With downward rigidities in rates adjustment (ZLB, reversal rate, etc.),goods markets takes the hitA stubborn form of liquidity trap, less responsive to standard (generic)wealth boosting macro policies

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The Medium Term

Obviously there are cycles, waves of euphoria won’t go away, and soon.... but the secular forces seem robust

Moreover, this is a global, not a U.S. phenomenon

A country with an acute shortage of safe assets spreads its downwardpressure on rates all around

Incentives aside, this is mostly good news for the recipient country ifinterest rates are flexibleNot so, if against “ZLB”

We may well be in a recurrent global safety traps environment

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Scape Valves

The main market mechanism to restore equilibrium in a safety trap isan increase in the valuation of safe assets

Interest rate drop is the first response, but not much space thereNext is an appreciation of the currency in which these assets aredenominated, primarily USD – paradox of the reserve currency

Issuance of public debt

If asset producer economies grow less than asset demander economies,we get a modern “Triffl in dilemma"

Risk of fiscal fragility. In this environment the main concern is theappearance of credible substitutes (not too worrisome for the U.S.... atthe moment)

The value of the new safe debt created is distinct from the use of thesefunds (cheaply funded fiscal expansion). QE swapping risky for safeassets does it too (while Operation Twist doesn’t)Public good dimension of safe asset issuance

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Scape Valves

Private substitutes.

Endogenous risk reduction via technology/sector selection and liabilitymanagementFinancial system (to the extent that it doesn’t consume too many safeassets in the process). Needs public insurance overlay (micro vs macroinsurance)

Reducing the (net) demand for safe assets

International reserves

EM: Self-insurance. Partially replace with multilateral insurancearrangementsDM: QE makes sense when absorbing risk, otherwise it can becounterproductiveRegulatory framework

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A Macroeconomic Framework for the Times (Risk-centric)

A productive capacity (and its expansion) generates output and risks,both of which need to be absorbed by economic agentsIn principle, we could have output- and risk-gapsIn most macro (unlike finance) modeling the emphasis is on theformer

Often the risk side is ignored (log-linearizations)Or it remains in the background (discount factor)

Main “big picture” goal of paper with Alp Simsek: To provide amacro model to study both gaps jointly, but inverting the hierarchy

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What do we do?

AD/AS:

Aggregate supply (potential output): Stochastic endogenous growthmodel with investment costs and (implicit) NK-structureAggregate demand: It may become an additional constraint toproducersInterest rate has downward rigidity (ZLB or others)

Two shocks: productivity (diffusion) and ERP (Poisson)Heterogenous beliefs (about ERP shocks) and speculationPolicy: r-policy, FG, macroprudential

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What do we find?

Cyclical:

In the absence of r -friction: Productivity shocks only affect growth,while ERP shocks are absorbed one-for-one by r−adjustmentWith r ZLB:

when (implied) vol spikes, asset prices drop to restore equilibrium inrisk markets, and drag down aggregate demand,...which drags downasset prices, and so onoptimism (about exit from high vol state) is key to limit the fall in ADwith heterogeneous beliefs, share of wealth owned by optimists is a keystate variablespeculation is destabilizing (economy is effectively extrapolative)volatility rises endogenously and feeds back into asset prices andaggregate demand

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Policy:

Interest rate policy is highly effective while it lasts

it controls the Sharpe ratio, leaving asset prices to equilibrate thegoods market

Forward Guidance is also effective, but its robustness to deviationsfrom "RE" drops with pessimismMacroprudential policy makes everyone better off (evaluated undertheir own beliefs, or belief-neutral criterion)

Goal is to provide additional insurance to high valuation investors tointernalize aggregate demand externalitiesIt is naturally procyclical as the negative effect on AD can be offsetwith r -policy during the boom but not during deep recessions

Volatility stabilization measures are also powerful

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The Basic Mechanism

Goods Markets Eq

(Ak) η = ρQk + ι(Q)k

Monetary Policy

Q ≤ Q∗, r ft ,s ≥ 0, with complementary slackness

Risk Markets Eq.

σs =ρ+ g(Qs ) + λs

(1− Qs

Q∗

)− r fs

σs

Speculation leads to sharper drops in RM; Interest rate policy, FG,macropru

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Final Remarks

The world economy experienced a prolong period of“risk-intolerance,”which is likely to remain around the(macroeconomic) corner

Risk-intolerance has strained the safe-assets markets.

The natural market solutions to the problem are not encouraging(appreciations, financial instability,...)There is a need for policy support in the creation and use of safe assets

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Final Remarks

High frequency macroeconomics is also affected by this environment

Strong feedbacks between risk-markets, volatility, and the output-gap

The key tension is that asset prices have the dual role of equilibratingfinancial markets and supporting aggregate demand

Interest rate policy works by taking over the role of equilibratingfinancial markets, which then leaves asset prices free to balance thegoods marketsAt the ZLB the dual role problem reemerges and asset prices are drivenprimarily by financial markets considerations...

triggering a perverse feedback between asset prices and ADwhich can only be stopped by hope (optimism about recovery)

(Procyclical) Macroprudential regulation reduces the gap between theasset prices that equilibrate the financial and goods markets at theZLB... by keeping high valuation investors well capitalized

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