Rogoff: The $200 Trillion Question

Kenneth Rogoff looks at the risks from unexpected changes in macroeconomic volatility:

The $200 Trillion Question, by Kenneth Rogoff, Project Syndicate: Perhaps the most remarkable trend in global macroeconomics over the past two decades has been the stunning drop in the volatility of output growth. In the United States, for example, quarterly output volatility has fallen by more than half since the mid-1980’s. Obviously, moderation in output movements did not occur everywhere simultaneously. ... But by now, the decline has become nearly universal, with huge implications for global asset markets.

Indeed, the main question for 2007 is whether macroeconomic volatility will continue to decline, fueling another spectacular year for markets and housing, or start to rise again, perhaps due to growing geopolitical tensions. I lean slightly toward the optimistic scenario, but investors and policymakers alike need to understand the ramifications of a return to more normal volatility levels.

Investors, especially, need to recognize that even if broader positive trends in globalization and technological progress continue, a rise in macroeconomic volatility could still produce a massive fall in asset prices. Indeed, the massive equity and housing price increases of the past dozen or so years probably owe as much to greater macroeconomic stability as to any other factor. As output and consumption become more stable, investors do not demand as large a risk premium. The lower the price of risk, the higher the price of risky assets.

Consider this. If you agree with the many pundits who say stock prices have gone too high, and are much more likely to fall than to rise further, you may be right—but not if macroeconomic risk continues to drain from the system. ...

Of course, ... [s]tocks are risky, depressions can happen, and it is dangerous to extrapolate the past to the future. If prices rise simply because investors decide that there is no longer any risk, then prices will collapse all the more precipitously if investors collectively change their minds.

This brings us to the $200 trillion question (roughly the value of global money and asset markets, including housing): What could cause macroeconomic volatility to start rising? Don’t look to central banks; most are likely to manage the near-term risks to inflation and growth reasonably well. Hedge funds could throw a scare. The Germans tried to use their leadership in the G8 to achieve greater transparency in hedge funds, but they were beaten back by the US and Great Britain.

To my mind, though, the greatest risk is geopolitical instability. By and large, China has been a far more constructive counterpart to the US than the former Soviet Union ever was. But, given huge income disparities. China’s leaders still face enormous challenges in maintaining domestic stability, and continuing quiescence cannot be taken for granted. At the same time, there are at least a half-dozen other global hot spots – some might be tempted to include the US Senate – that could trigger a major breakdown in world trade.

In short, if the macroeconomic moderation that dominated 2006 continues into 2007, look for further asset price inflation... But if a major flare-up causes investors to lose confidence in low volatility, the bottom could fall out from under equity and housing prices. In that case, do investors and policymakers have a plan B?

Comments

[anne]

These last 5 years have marked the fastest such period of international growth since 1945, and international asset values have grown in turn. The growth through can be marked the last 10 years and extends before 2003 through international economic and financial crises ranging from Tailand to Argentina to a severe bear market in information technology and selected growth stocks to an American recession. Nonetheless, for all the volatility in asset prices before 2003, international asset prices have grown markedly these 10 years. Valuations are high, and the question for investors is how to be protective in portfolio building no matter volatility levels.

[elvis]

the question for investors is how to be protective in portfolio building no matter volatility levels.

Ok, ok, I got the question, but I missed the answer part.

oh, and by the way, the total worth of the world is $200 trillion? So, if Iraq cost us $2 trillion, that would be 1% of the entire known universe's assets. spoooky.

Of course, we'll be getting a good return on that investment, right? It's not like we're just handing out cash hand over fist to Kellogg Brown and Root for a whole lot of nothing, right?

1% of the whole world's assets should buy us a whole lot of good will and loooove. The kind of peace of mind that bullets can't buy. Is that Jefferson Airplane I hear? Oh, my mistake, just another not-so-smart bomb, missing insurgents and generating ill-will.

Why didn't we send the troops into the poor areas of the world, bringing medicine, shelter and handing out bundles of cash? What makes bloodshed so much more palatable than peace?

Why do evangelicals want the 10 commandments installed in public places--and not the sermon on the mount?

I just re-read it and...it's not the Republican platform. But it's kind of catchy.

[anne]

Well, I have been and am thinking. Though I love this market period, the question of what caution means becomes trickier as asset prices in general rise. Of course, bond indexes are always an answer even when bonds seem relatively pricey. David Swensen, who is always worth paying attention to, is suggesting as much as 30% in inflation protected bonds, or expressly the Vanguard inflation protected securities fund.

[spencer]

Right now we are seeing a significant increase in the I/S ratio in many sectors of the economy -- for the last 3 months the overall, the manufacturing, the wholesale and the retail I/S ratios have each increased.

In the old days this would have been a major warning of problems ahead in the economy. But now hardly anyone pays any attention to it because they expect business to quickly correct the problem before it becomes significant.

What we have now is that improved information technology allows firsm to catch mistakes and take corrective actions much more quickly then in the old days. So now we have mini-cycles rather the the massive overshoots and corrective recession of an earlier era.

[spencer]

I have developed a behavioral PE equation for the stock market that makes one of the variables the percent of the time the market has been in a bear market over the last twenty years. Prior to WW -II the stock market was in a bear market almost 50% of the time -- and I have data on this back to 1870. In the 1950s the ratio fell to about 25% so by 1958 the market had fully adjusted to the idea that the four year cylcle with stock down only 25% of the time had been built into market valuations. This accounted for the secular rise in the stock market PE from 1949 to 1960. The four year cycle remained the norm until the late 1980s-early 1990s when it started rising again. By the late 1990s stocks had only been in a bear market some 11% over the prior 20 years and this shift in risks accounted for much of the 1990s rise in the market PE. The market pe is now within one standard error of what this behavior model says it should be.

I published an article on this several years ago in business economics.

The dow 36,000 publishers had the right idea, they just massively overestimated the impact of this trend.

[yartrebo]

The most likely source of volatility, both in the past and in the future, is the herd mentality of people. So long as a significant fraction of people buy because others are buying and sell because others are selling, booms and busts will happen.

[anne]

Spencer's observation which bears repeating has long struck me as right. The American economy became notably more flexible or adaptable through the 1980s, western Europe, Australia and Canada seem to have followed. Japan puzzles me always, but beyond or even with the terrible bear stock and real estate markets in Japan the continually sluggish or deflating economy was not nearly as draining on the Japanese middle class as might have been expected. I am also increasingly impressed with the way in which the German economy is gaining.

[yan]

One could argue that the decreased volatility is at least partly due to increased geopolitical and economic stability from such factors as:

1) End of the Cold War reducing the risk of major military conflicts, as well as the integration of former communist states into the global financial system
2) Globalization further synchronizing developed world business cycles but also adding robustness due to the scale of the integrated economy
3) The role of the Euro and an ECB in stabilizing regional foreign exchange and interest rate volatility

This does not mean that risk never returns but these have been some of the stabilizing trends since 1990. Some of the same trends have also been the drivers of economic growth along with technological diffusion, with some of the technologies that drove the late 90s boom in the developed world still trickling down into other economies (e.g continued rapid growth of mobile telephony in many developing markets).

[James Killus]

A bond, or any other form of debt is the promise of a later money transfer. Such assets, in and of themselves are not "productive" assets; they just promise to transfer money.

A "bubble" occurs when there are more promises outstanding than there are productive assets backing them up. I do wish that there was more attention paid to the nature of productive assets than the promises to move what is produced by those assets. I've yet to see what I considered to be a good discussuion of what housing "produces" for example.

[ECONOMISTA NON GRATA]

The Rich Stand Accused
By Louis-Gilles Francoeur
Le Devoir

http://www.truthout.org/docs_2006/010807G.shtml

Good stuff...

Econolicious

[slink]

elvis
its the "meek"
that
"shall inherit the earth"

not the bleak

so smile with god's grace
while we operate on your .....

[slink]

it occurs to me reading herr rogoff
perhaps if we take the entire period between 1945 and today
we see bands of varying
economic turbulence
culminating in an ever growing tranquility
much
like the eye of a hurricane

[yan]

James: "Such assets, in and of themselves are not "productive" assets; they just promise to transfer money."

Every asset promises a transfer of money (future income) and is not intrinsically "productive". Agricultural land is a productive asset to the extent that there are consumers to purchase the food that is produced. Manufacturing capacity is a productive asset to the extent that there are consumers for the manufactured goods. Both of these only produce future income as long as final demand for their output exists. Bonds are a productive asset to the extent that the debtor can produce an income stream for the bondholder. Perhaps owning a bond is one step removed from owning the actual productive assets but it is in effect a pass-through to some form of economic production.

The value of housing as an asset is dependent upon the final demand for shelter. Future income is a stream or rent payments, which are ultimately based on the future wages of the occupant. Home ownership simply bypasses the relationship between landlord and tenant in favor of the bank based mortgage. Now the mortgage lender holds a bond for the future wage earnings of the borrower, until the mortgage is paid.

[anne]

Housing produces jobs, darn good jobs, as does commercial real estate. Housing produces places to live; commercial real estate to work. Housing is an investment and the Vanguard real estate investment trust index has been a terrific portfolio addition and diversifier from the beginning.

[Movie Guy]

Kenneth Rogoff - Perhaps the most remarkable trend in global macroeconomics over the past two decades has been the stunning drop in the volatility of output growth. In the United States, for example, quarterly output volatility has fallen by more than half since the mid-1980’s.

While I certainly agree with Ken's general point, this IMF chart doesn't make light of the principal shocks that we have suffered during the past three decades.

The drop in volatility in economic output growth since 1980 can be attributed in large part to noted improvements in business practices and application of available multiple technologies, chief among them technologies allowing for better tracking and demand supply decisions related to inventory-to-sales (I/S) of nondurable and durable goods, minimizing nonproductive inventory stockages. Technology gains also improved transportation efficiencies, further enhancing domestic and international factors of transportation delivery times and costs that also drive on site retail, wholesale, and component supplied inventory levels. As reduced tariffs have led to the shift of production offshore from many industrialized developed nations, a principal factor in such decisions are the declining international transportation costs for sea freight (particularly since 1990) and air freight and trends in average tariff rates as evidenced here. The net results have included reduced production costs and an approximate 30 percent decline in the inventory-to-sales ratio of durable goods.

The sharp decline in the volatility of U.S. economic output growth is discussed further in two Federal Reserve papers (among many other sources' publications and documents), here and here, though neither paper acknowledges the critical role of improved transportation efficiencies or reduced tariffs allowing for higher levels of offshore production, including the significant concentrations of goods production in China, and growing back office/sales/support services provided by sources located in India.

[Movie Guy]

Kenneth Rogoff - Obviously, moderation in output movements did not occur everywhere simultaneously. Volatility in Asia began to fall only after the financial crisis of the late 1990’s. In Japan and Latin America, volatility dropped in a meaningful way only in the current decade. But by now, the decline has become nearly universal, with huge implications for global asset markets.

According to the IMF in 2005, the volatility of output growth in emerging market and developing countries, and industrial countries has declined markedly over the past decades, but it remains considerably higher in emerging market and developing countries. Note these charts - here, here, and here.

Another measure of noting the improvements in reduced volatility may be this chart of comparisons between the periods of 1970–86 and 1987–2003.

[Movie Guy]

Kenneth Rogoff - This brings us to the $200 trillion question (roughly the value of global money and asset markets, including housing): What could cause macroeconomic volatility to start rising? Don’t look to central banks; most are likely to manage the near-term risks to inflation and growth reasonably well. Hedge funds could throw a scare. The Germans tried to use their leadership in the G8 to achieve greater transparency in hedge funds, but they were beaten back by the US and Great Britain.

I suggest that individuals pay attention to increases in the prices of base metals and crude oil. I would monitor the growing demand for base metals in particular as discussed in this chapter of the IMF report, 2006 World Economic Outlook.

Other considerations are outlined in the IMF reports, 2005 World Economic Outlook and 2006 World Economic Outlook, from Ken's old stomping ground.

[john c. halasz]

According to The CIA, world gross product was $43.07 trillion in 2005. ($60.63 tillion PPP). $200 trillion in assets outstanding is a long horizon of future claims on current production, ~4.65 years. The question is who owns those claims, i.e., what is their distribution and what effects would that distribution have on the composition and level of future consumption demand.

It may well be that improvements and extensions of business organization have smoothed production flows and reduced transaction volatilities. And certainly developments in IT have enabled and promoted transformations of business organization, raising productivity efficiencies, increasing product differentiation, improving inventory controls, lowering search costs in transactions and investments, increasing the capacity to model and calculate alternatives in predictions and decisions, etc. More specifically, IT has directly increased the productivity and flexibility, while lowering the cost, of capital equipment, hence increased the substitutability of capital equipment for labor. Yet, at the same time, those same developments have increased the power of business organizations, i.e. capital, over the very markets and labor supplies that they have expanded.

No doubt, lowered market volatility would generally lower interest rates, which would increase the liquidity available to bid up assets, even as incentives for ordinary savings and constraints on current consumption are lowered. But that results in an awful lot of people betting on the continuation of the same trend, to the near exclusion of the viability of opposite bets. So many people betting on the impossibility of a perfect storm is less a matter of crowd psychology than a collective forgetting of "natural" constraints.

"All reification is forgetting."

[James Killus]

yan,
It is the "steps removed" part that I am interested in, plus the possibility of double counting, which is always inherent in the lending of money (hence reserve requirements for banks).

Nevertheless, there are various sorts of hidden assumptions inherent in the situation that Rogoff is touching. Transfer promises like debts are counted; I don't see that tax and pension liabilities are counted equally. If "pass throughs" are fine, then future taxes are as important as private and public debt service.

It may also be noted that the analysis only includes labor that goes through the labor market. Or carries the interesting conclusion that natural resources are made more valuable by being depleted (which raises their price). I understand that this is a general criticism of anything that tries to quantify "wealth," but I'm feeling critical lately.

As for housing, housing does much more than provide shelter. Indeed "location, location, location" implies as much. Housing also provides access, to jobs, schools, social services, etc., as well as the aesthetic/psychic pleasure of ownership (without which a Picasso is also worthless). It is this sort of analysis that I never see; housing is usually just dismissed as "shelter," as you have done.

[evagrius]

ECONOMISTA NON GRATA;

Herve Kempf is one of those Foley type economist, you know, the ones who argue that isolating economics from the rest of human life and activity perpetuates Adam's fallacy.

[Winslow R.]

Yan wrote:"Every asset promises a transfer of money (future income) and is not intrinsically "productive"."

Financial assets have this 'promise'.

"Agricultural land is a productive asset to the extent that there are consumers to purchase the food that is produced. Manufacturing capacity is a productive asset to the extent that there are consumers for the manufactured goods. Both of these only produce future income as long as final demand for their output exists.

Nonfinancial assets lack the 'promise'.

"Bonds are a productive asset to the extent that the debtor can produce an income stream for the bondholder."

The creation of a bond creates negative (loan) and positive (deposit) financial wealth which net to zero. No net 'real' wealth is created in 'bondmaking'. You need to understand that loans are not 'reserve constrained' as any shortfall can be borrowed from the Fed window.

In practice, the connection between reserve requirements and money supply is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits such as CDs, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.

http://en.wikipedia.org/wiki/Reserve_requirement

Capital ratio is more effective in limiting bank loan creation but only so far as banks are unwilling to 'sell' or 'securitize' their loan portfolios which just shifts loans from the bank to nonbank sector.

"Perhaps owning a bond is one step removed from owning the actual productive assets but it is in effect a pass-through to some form of economic production. "

A bond attaches nonfinancial/financial assets with a 'promise' - breaking the 'promise' can force bankruptcy which legally exchanges the bond for the nonfinancial asset.

[Alex Grey]

This is a very good article. One point is that increase in asset prices themselves lead to a decline in volatility if the increases are correlated. What seemingly has led to a near universal increase in asset prices and a collapse of risk premia? One argument is that the flood of liquidity into markets has raised asset prices and lowered volatility. While there has been subsantial growth in asset prices this has been accompanied by a substantial growth in credit. One back-of-the envelope cacluation suggests that total credit in the US economy relative to GDP has increased from 3.7 times in 1978 to about 8 times (the original estimate for 1978 is from Goldsmith (1986) Comparative National Balance Sheets; has anyone seen an official update of this?). This flood of liquidity itself though is based on rising asset prices. For example, increases in house prices because of a flood of liquidity into the housing market increases the equity of existing homeowners which alllows a further increase in borrowing.

The link between rising liquidity and deceased volatility in asset markets raises the issue of what happens when the flow of liquidity to markets ceases. This is most likely to be driven by a change in the upward price trends in the asset markets to which the liquidity is being directed, as in the housing example above. The result is that a change in the price trend will begin to reverse the flow of liquidity to a market causing an increase in volatility which itself will reduce the flow of leveraged investments in markets.

[Alex Grey]

PS.

I am a great fan of Hyman Minsky and his theory of financial innovation may explain the decline in volatility and the consequent sustained rises in asset markets. Financial innovation results in more borrowing being levered from a given rise in asset prices. If that increased borrowed capital flows back into the selfsame market which is entirely reasonable, it will generate a broader increase in prices in that market. In other words upswings in asset markets become both more sustained as well as price increases becoming more pervasive because of financial innovation. The effect of financial innovation is therefore further magnified by its impact on reducing asset price volatility. However if the more sustained rises in asset markets that we have witnessed are driven by financial innovation, the endgame cannot be pretty.

[James Killus]

Winslow R., that was enlightening.