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Brad DeLong: Insuring Against the Rising Tide of Global Risk
Brad Delong “wonders how investors should attempt to insure against the lowest tail of the economic-political distribution”:
Fearless Financial Markets, by J. Bradford DeLong, Project Syndicate: A number of thoughtful observers – like Citigroup’s Robert Rubin, Harvard’s Larry Summers, and The Financial Times’ Martin Wolf – have expressed puzzlement in recent months about financial markets’ perceptions of risk. While markets have judged today’s world … to have low risk when viewed in historical perspective, geopolitical risks in fact appear to be large. …
But if an investor today did wish to insure against geopolitical catastrophe, how would he or she do so? In the generation before World War I, the safe assets were thought to be the debt of governments tied to the gold standard, which supposedly offered protection against the inflationary populist viruses that afflicted countries like Mexico, France, or the United States. But investors in British government debt faced huge losses when Britain’s commitment to World War I produced inflation, and investors in Czarist bonds papered their bathrooms with them after the October Revolution.
After the inflations of World War I, a prudent investor might have thought gold … an attractive asset. But gold is stagnant, while capital is productive. In any case, American gold holders found their wealth involuntarily transformed into paper dollars by the Roosevelt administration at the nadir of the Great Depression. Following World War II, investments in the United States seemed safer than any alternative. But, in the 1970’s, investors in American stocks and long-term bonds lost half their principal, and even investors in short-term American debt were down by 20 percent in real terms…
Investors fearing geopolitical catastrophe might cope to some degree by raising their consumption spending. But there is a limit to this option. Those who fear geopolitical catastrophe will sell assets … only if there are other, safer assets that they see that they can buy. As Harvard’s Robert Barro has recently pointed out, fear of a general or unpredictable catastrophe … will not affect relative asset prices, because investors have no motive to sell or buy any particular asset.
According to Barro, the consequences of enhanced fear of a general or unpredictable catastrophe depend on how it affects the global pool of savings. … If people are risk-averse enough that increased fear of the future causes them to save more, rising global uncertainty will raise bond and stock prices, and lower interest rates and dividend and earnings yields. …
This may be the situation that the world financial system is in now. The principal fear, at least in the circles in which I move, is of a sudden unwinding of “global imbalances”: a rapid and destabilizing end to America’s very large trade deficit and to Asia’s very large trade surplus.
In such a global financial crisis, if the Federal Reserve accommodates inflation and accelerates devaluation in order to prevent collapsing employment in formerly foreign capital-financed sectors…, American debt will be among the worst affected assets. But if the Fed refuses to accommodate inflation produced by a dollar collapse and accepts a depression in the belief that the long-run benefits of maintaining its credibility as a guarantor of price stability will come before we are all dead, American equities will suffer. …
Don’t get me wrong: somewhat more than half my brain agrees with Rubin, Summers, Wolf, and company. The principal risk I see today is that being borne by investors in dollar-denominated debt – and I don’t believe they are charging a fair price for what they are doing. But a quarter of my brain wonders how investors should attempt to insure against the lowest tail of the economic-political distribution, and that quarter of my brain cannot see which way somebody hoping to insure against that risk should jump.
Posted by Mark Thoma on Monday, March 5, 2007 at 12:12 AM in Economics, Financial System
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