Risk as the Bedrock of Economic Activity
I've been led to believe that there is not much truth to the idea that skyscrapers are clustered in midtown and downtown because the bedrock is near the surface in those places, and deep in between. (Here, in PDF, is what seems to be the relevant paper by Jason Barr and Jeffrey Cohen.)
But let's use bedrock as a metaphor anyway. I want to think a bit about macroeconomics. As always, my ideas are not remotely original. My basic claim is that macroeconomic cycles can be thought of as expressions of the collective risk-bearing capacity of the economy. In support of this, I'll use a metaphor in which every expenditure on physical assets or labor in the economy rests on the bedrock of a financial asset, which exists by virtue of the willingness of some economic actor to hold her wealth in the form of that financial asset. This willingness to hold financial assets is an expression of willingness to bear risk. So ultimately a society's risk-bearing capacity supports its economic activity, the way bedrock supports skyscrapers. We will observe prosperous economies in those places where risk-bearing capacity is strong and easily accessible. And fluctuations in risk-bearing capacity explain macroeconomic cycles.
Risk is ubiquitous in a capitalist economy. And risk is traded in the market like other things—this is most obvious in the case of insurance, but it's also true in the financial markets overall. In general, economic activity depends on some person or entity being willing to bear risk at an affordable price. (I'll give some examples below to flesh this idea out.) There are a variety of reasons that the risk-bearing capacity of an economy might fluctuate. An unexpected loss could call into question the accuracy of the models used to measure risk, leading to an increase in perceived riskiness (this could be an overreaction, or it could be that perceived riskiness was too low previously—or both!). A large loss, even if consistent with pre-existing models, reduces wealth and in doing so eliminates risk-bearing capacity. Also, there can be large spillovers, so that as one person withdraws his risk-bearing capacity from the market, the overall risk for the economy goes up.
First, let's explore what risk means. I think for our purposes risk should be understood as the possibility of loss of wealth (or some close substitute for wealth). To be a risk-bearer, you have to have wealth in one form or another, so that you have something to lose. (However, one form of wealth is anticipated future earnings, so a penniless person can take risks.) We are not including activities that are risky but that aren't economic in nature. Every time you use Tinder or Grindr you risk a broken heart, but that is not what we are talking about today. We are mostly concerned with voluntary (and therefore compensated) risk-taking. That is, we are asking what holders of wealth demand in exchange for risking that wealth. (As a side note, the existence of casinos shows that some people are willing to bear risk for negative compensation—they are willing to pay someone else to let them take risks, whereas in the financial markets they could get paid to take risks. Let's ignore that puzzle for now.)
Note what this means, if I am right: society's risk-bearing capacity is a function of its wealth (since you have to have wealth to take risks), society's economic activity is a function of its risk-bearing capacity (as I will explain below), and a society's wealth is a function of its economic activity. This means that economies will be subject to virtuous circles on the way up and vicious circles on the way down. Or another way of looking at it is that there is a multiplier effect. An exogenous increase of n units of wealth ultimately leads to an extra nm units of wealth, where m is greater than 1. This is because the initial increase in wealth also increases risk-bearing capacity, and that spurs a further increase in wealth. The same multiplier would apply in the case of an exogenous destruction of wealth. (Note that the multiplier depends on how the marginal unit of wealth is invested, not the average unit. We'll return to this.)
What do I mean when I talk about risk-bearing capacity and its relationship to economic activity? Imagine a farmer with limited wealth. Some of his land is used for chickens and cows, and some of his land is forested. Currently he uses the forested land for firewood, but this is a relatively low-value use of the land. He would like to cut down a section of the forest and plant an orchard. However, the area is prone to hailstorms in the summer. The forest trees are basically impervious to hail, but fruit trees could lose their crop of fruit if a hailstorm strikes at the wrong time. The farmer's estimate is that hailstorms will be infrequent enough that the expected value of the orchard is positive (in financial terms, its good years will more than make up for the years in which the fruit is lost). However, if the farmer borrows money to finance the orchard, a hailstorm or two at the wrong time could render him insolvent, and the farmer isn't willing to risk losing his farm. So the farmer doesn't build the orchard.
But then an insurance agent comes to the farm and offers to write a policy that would compensate the farmer for any losses caused by a hailstorm. What will the farmer do? Well, it depends on the premium. If the premium is low enough, the expected profits will be worth whatever risk remains in the project, and the farmer will invest in the orchard. The farmer will pay the insurance premium, he will pay to clear an area of land, he will pay for fruit trees, and he will pay to have them planted. (If he does some of the work himself, he is effectively paying himself to do the work.) Therefore we observe increased economic activity, and greater social wealth, once the insurance company makes its risk-bearing capacity available to the farmer. (Of course, if the insurance company were to reduce its risks elsewhere, we would have to net that out. But let's just assume this insurance company is entering a new line of business, and neither it nor its investors compensate by reducing risk elsewhere.)
The same logic applies to any business venture. We can think of each business venture as a "black box" that requires inputs of money at time t0 and possibly at other times, and that spits out money at various future times tx, ty, and so forth. Each venture will use money to employ real resources—machines, raw materials, labor, real estate, etc. That employment of resources is what we call economic activity, and it reduces unemployment and generates wealth for the suppliers of those inputs. For a potential venture to be undertaken, someone must be willing to risk the cost of the real resources that it will consume. The level of risk depends on the reliability of the future payments the venture will generate.
Risk can be allocated in many different ways. Imagine a business venture that is financed by issuing securities. (In other words, the business sells shares of stock or bonds to generate money up front, and then in the future it makes principal and interest payments on the bonds, and it may pay dividends on the stock.) The business venture could finance itself with lots of equity (stock) and a modest amount of debt (bonds). In that case, the business would issue lots of fairly safe stock (low probability of bankruptcy) and a modest amount of very safe debt (again, low probability of bankruptcy). Alternatively, the business could finance itself with a modest amount of equity and lots of debt. In that case, the business would issue a small amount of risky stock (risky because the probability of bankruptcy is much higher) and a large amount of risky debt (risky for the same reason). Note that the second approach isn't necessarily riskier overall—stock is generally riskier than debt, so increasing the portion of debt financing and decreasing the portion of equity financing may offset the increased riskiness of both. There isn't a right or wrong answer here, it just depends on what investors have more taste for. (There may be externalities—a highly leveraged business may impose a higher risk of layoffs on its workers, and it may not fully compensate them for it—but let's ignore that for now.) If it proves economical to do so, the business could buy an insurance policy, so that its investors don't bear the full risk of the enterprise. Equivalently, the business could use swaps or futures to hedge some of its risks—again, this means that some of its risk is being borne by non-investors.
Now, not all potential business ventures will be financed, and so some will never happen. It depends on whether there is some combination of financing and hedging/insurance that makes the numbers work. As more and more people are willing and able to bear risk (that is, willing to buy stocks and bonds, or invest in insurance companies), more and more business projects become feasible. Willingness to hold financial assets creates a bedrock, and on that bedrock business ventures spring up. As economic activity increases, people get richer, and more wealth is available to finance projects.
However, it's important to recognize that the same amount of wealth can bear different amounts of risk and support different amounts of economic activity. Let's say you have $100. You can hold that wealth in the form of a bank deposit, where it incurs almost no risk, but where it also supports relatively little economic activity. You can hold your $100 in the form of a corporate bond, in which case it incurs a bit more risk and probably supports a bit more economic activity. You can invest $100 in a single stock, which is very risky. You can invest $100 in a stock index mutual fund, which is risky, but less risky than the single stock. The collective risk-bearing capacity of a society's wealth depends on exactly what form that wealth is held in.
That last example, the mutual fund, is very important. A mutual fund is generally less risky than investing in a single issuer. That's because the risks of the individual components of the index offset to some extent (we are assuming their correlation is less than 1—if not, an index is really no less risky than its components). But that risk reduction is "free." An economy can fund the exact same projects with equity financing raised through index funds as it can with equity financing raised by selling a different stock to each investor, but the index funds are less risky for each individual investor. As capitalism develops "technologies" to spread risk in this way, it increases the amount of economic activity that can be supported by a given level of risk-taking. It's like increasing the height of buildings that can be supported by a given amount of bedrock.
Now we can see why a recession is sometimes cast in terms of a glut of demand for safe assets (this is also sometimes called a savings glut). For a given level of wealth, more economic activity can be supported if people are willing to hold that wealth in the form of risky financial assets such as stocks. On the other hand, if people shift their holdings toward safe assets, this will reduce the economic activity that can be supported for a given level of wealth. In all likelihood, it will also be accompanied by a collapse in asset prices that reduces wealth, and so not only can society support less economic activity for a given level of wealth, the level of wealth is also reduced, increasing the magnitude of the economic downturn. Projects that were feasible before the crash are no longer feasible, and so unemployment increases and resources languish unused. (A reduction in risk-bearing capacity destroys wealth in at least two ways. First, it reduces economic activity and increases unemployment, making people poorer. Second, the mechanism by which stock prices reflect a higher "price" for risk-bearing is by dropping in value until their expected return is sufficient to induce investors to hold them. This collapse in stock prices destroys a lot of financial wealth.)
This framework can also explain why monetary and fiscal stimulus can be effective. In general, long-term bonds are riskier than cash. When it wants to stimulate the economy, the central bank buys long-term bonds, so that the public holds more cash and the central bank holds more long-term bonds. In essence this means the central bank is increasing the risk of its portfolio, thus supporting more economic activity. (Another way to look at it is that the central bank is taking risk off the public's hands, inducing investors to look for risk elsewhere.) However, even long-term government bonds are relatively safe, so there is a limit on how much traction the central bank can get, unless it is willing to invest in risky private-sector assets. There are a variety of reasons this might be a bad idea, although the Federal Reserve did invest in some privately issued securities during the financial crisis (and it still holds a large portfolio of them).
But fiscal stimulus is not limited in this way. The government can spend money directly on projects while issuing debt. These are obviously public sector projects, not privately funded projects, but that makes no difference to the people and resources employed. The public badly wants government debt because it is the safest asset. So deficit-financed expenditures soak up the money that people want to invest in safe assets and use it to employ society's resources, increasing economic activity. Government debt financing is a technology that transforms investment in low-risk financial instruments (government bonds) into lots of economic activity, much more activity than could be supported by safe private-sector assets. (The reason we don't use this technology in ordinary times is that we might question whether government-directed economic activity generates as much social welfare as would an equivalent amount of private sector economic activity. If government projects are really worthwhile, they should be undertaken no matter what the macroeconomic conditions. But during a recession, even relatively low-yield government projects can make everyone better off.)
This is obviously far from a complete story of macroeconomic fluctuations. But it seems coherent and satisfying. I will probably try to piece it together with other models to create a kind of mental framework I can use to think about macroeconomics.
But let's use bedrock as a metaphor anyway. I want to think a bit about macroeconomics. As always, my ideas are not remotely original. My basic claim is that macroeconomic cycles can be thought of as expressions of the collective risk-bearing capacity of the economy. In support of this, I'll use a metaphor in which every expenditure on physical assets or labor in the economy rests on the bedrock of a financial asset, which exists by virtue of the willingness of some economic actor to hold her wealth in the form of that financial asset. This willingness to hold financial assets is an expression of willingness to bear risk. So ultimately a society's risk-bearing capacity supports its economic activity, the way bedrock supports skyscrapers. We will observe prosperous economies in those places where risk-bearing capacity is strong and easily accessible. And fluctuations in risk-bearing capacity explain macroeconomic cycles.
Risk is ubiquitous in a capitalist economy. And risk is traded in the market like other things—this is most obvious in the case of insurance, but it's also true in the financial markets overall. In general, economic activity depends on some person or entity being willing to bear risk at an affordable price. (I'll give some examples below to flesh this idea out.) There are a variety of reasons that the risk-bearing capacity of an economy might fluctuate. An unexpected loss could call into question the accuracy of the models used to measure risk, leading to an increase in perceived riskiness (this could be an overreaction, or it could be that perceived riskiness was too low previously—or both!). A large loss, even if consistent with pre-existing models, reduces wealth and in doing so eliminates risk-bearing capacity. Also, there can be large spillovers, so that as one person withdraws his risk-bearing capacity from the market, the overall risk for the economy goes up.
First, let's explore what risk means. I think for our purposes risk should be understood as the possibility of loss of wealth (or some close substitute for wealth). To be a risk-bearer, you have to have wealth in one form or another, so that you have something to lose. (However, one form of wealth is anticipated future earnings, so a penniless person can take risks.) We are not including activities that are risky but that aren't economic in nature. Every time you use Tinder or Grindr you risk a broken heart, but that is not what we are talking about today. We are mostly concerned with voluntary (and therefore compensated) risk-taking. That is, we are asking what holders of wealth demand in exchange for risking that wealth. (As a side note, the existence of casinos shows that some people are willing to bear risk for negative compensation—they are willing to pay someone else to let them take risks, whereas in the financial markets they could get paid to take risks. Let's ignore that puzzle for now.)
Note what this means, if I am right: society's risk-bearing capacity is a function of its wealth (since you have to have wealth to take risks), society's economic activity is a function of its risk-bearing capacity (as I will explain below), and a society's wealth is a function of its economic activity. This means that economies will be subject to virtuous circles on the way up and vicious circles on the way down. Or another way of looking at it is that there is a multiplier effect. An exogenous increase of n units of wealth ultimately leads to an extra nm units of wealth, where m is greater than 1. This is because the initial increase in wealth also increases risk-bearing capacity, and that spurs a further increase in wealth. The same multiplier would apply in the case of an exogenous destruction of wealth. (Note that the multiplier depends on how the marginal unit of wealth is invested, not the average unit. We'll return to this.)
What do I mean when I talk about risk-bearing capacity and its relationship to economic activity? Imagine a farmer with limited wealth. Some of his land is used for chickens and cows, and some of his land is forested. Currently he uses the forested land for firewood, but this is a relatively low-value use of the land. He would like to cut down a section of the forest and plant an orchard. However, the area is prone to hailstorms in the summer. The forest trees are basically impervious to hail, but fruit trees could lose their crop of fruit if a hailstorm strikes at the wrong time. The farmer's estimate is that hailstorms will be infrequent enough that the expected value of the orchard is positive (in financial terms, its good years will more than make up for the years in which the fruit is lost). However, if the farmer borrows money to finance the orchard, a hailstorm or two at the wrong time could render him insolvent, and the farmer isn't willing to risk losing his farm. So the farmer doesn't build the orchard.
But then an insurance agent comes to the farm and offers to write a policy that would compensate the farmer for any losses caused by a hailstorm. What will the farmer do? Well, it depends on the premium. If the premium is low enough, the expected profits will be worth whatever risk remains in the project, and the farmer will invest in the orchard. The farmer will pay the insurance premium, he will pay to clear an area of land, he will pay for fruit trees, and he will pay to have them planted. (If he does some of the work himself, he is effectively paying himself to do the work.) Therefore we observe increased economic activity, and greater social wealth, once the insurance company makes its risk-bearing capacity available to the farmer. (Of course, if the insurance company were to reduce its risks elsewhere, we would have to net that out. But let's just assume this insurance company is entering a new line of business, and neither it nor its investors compensate by reducing risk elsewhere.)
The same logic applies to any business venture. We can think of each business venture as a "black box" that requires inputs of money at time t0 and possibly at other times, and that spits out money at various future times tx, ty, and so forth. Each venture will use money to employ real resources—machines, raw materials, labor, real estate, etc. That employment of resources is what we call economic activity, and it reduces unemployment and generates wealth for the suppliers of those inputs. For a potential venture to be undertaken, someone must be willing to risk the cost of the real resources that it will consume. The level of risk depends on the reliability of the future payments the venture will generate.
Risk can be allocated in many different ways. Imagine a business venture that is financed by issuing securities. (In other words, the business sells shares of stock or bonds to generate money up front, and then in the future it makes principal and interest payments on the bonds, and it may pay dividends on the stock.) The business venture could finance itself with lots of equity (stock) and a modest amount of debt (bonds). In that case, the business would issue lots of fairly safe stock (low probability of bankruptcy) and a modest amount of very safe debt (again, low probability of bankruptcy). Alternatively, the business could finance itself with a modest amount of equity and lots of debt. In that case, the business would issue a small amount of risky stock (risky because the probability of bankruptcy is much higher) and a large amount of risky debt (risky for the same reason). Note that the second approach isn't necessarily riskier overall—stock is generally riskier than debt, so increasing the portion of debt financing and decreasing the portion of equity financing may offset the increased riskiness of both. There isn't a right or wrong answer here, it just depends on what investors have more taste for. (There may be externalities—a highly leveraged business may impose a higher risk of layoffs on its workers, and it may not fully compensate them for it—but let's ignore that for now.) If it proves economical to do so, the business could buy an insurance policy, so that its investors don't bear the full risk of the enterprise. Equivalently, the business could use swaps or futures to hedge some of its risks—again, this means that some of its risk is being borne by non-investors.
Now, not all potential business ventures will be financed, and so some will never happen. It depends on whether there is some combination of financing and hedging/insurance that makes the numbers work. As more and more people are willing and able to bear risk (that is, willing to buy stocks and bonds, or invest in insurance companies), more and more business projects become feasible. Willingness to hold financial assets creates a bedrock, and on that bedrock business ventures spring up. As economic activity increases, people get richer, and more wealth is available to finance projects.
However, it's important to recognize that the same amount of wealth can bear different amounts of risk and support different amounts of economic activity. Let's say you have $100. You can hold that wealth in the form of a bank deposit, where it incurs almost no risk, but where it also supports relatively little economic activity. You can hold your $100 in the form of a corporate bond, in which case it incurs a bit more risk and probably supports a bit more economic activity. You can invest $100 in a single stock, which is very risky. You can invest $100 in a stock index mutual fund, which is risky, but less risky than the single stock. The collective risk-bearing capacity of a society's wealth depends on exactly what form that wealth is held in.
That last example, the mutual fund, is very important. A mutual fund is generally less risky than investing in a single issuer. That's because the risks of the individual components of the index offset to some extent (we are assuming their correlation is less than 1—if not, an index is really no less risky than its components). But that risk reduction is "free." An economy can fund the exact same projects with equity financing raised through index funds as it can with equity financing raised by selling a different stock to each investor, but the index funds are less risky for each individual investor. As capitalism develops "technologies" to spread risk in this way, it increases the amount of economic activity that can be supported by a given level of risk-taking. It's like increasing the height of buildings that can be supported by a given amount of bedrock.
Now we can see why a recession is sometimes cast in terms of a glut of demand for safe assets (this is also sometimes called a savings glut). For a given level of wealth, more economic activity can be supported if people are willing to hold that wealth in the form of risky financial assets such as stocks. On the other hand, if people shift their holdings toward safe assets, this will reduce the economic activity that can be supported for a given level of wealth. In all likelihood, it will also be accompanied by a collapse in asset prices that reduces wealth, and so not only can society support less economic activity for a given level of wealth, the level of wealth is also reduced, increasing the magnitude of the economic downturn. Projects that were feasible before the crash are no longer feasible, and so unemployment increases and resources languish unused. (A reduction in risk-bearing capacity destroys wealth in at least two ways. First, it reduces economic activity and increases unemployment, making people poorer. Second, the mechanism by which stock prices reflect a higher "price" for risk-bearing is by dropping in value until their expected return is sufficient to induce investors to hold them. This collapse in stock prices destroys a lot of financial wealth.)
This framework can also explain why monetary and fiscal stimulus can be effective. In general, long-term bonds are riskier than cash. When it wants to stimulate the economy, the central bank buys long-term bonds, so that the public holds more cash and the central bank holds more long-term bonds. In essence this means the central bank is increasing the risk of its portfolio, thus supporting more economic activity. (Another way to look at it is that the central bank is taking risk off the public's hands, inducing investors to look for risk elsewhere.) However, even long-term government bonds are relatively safe, so there is a limit on how much traction the central bank can get, unless it is willing to invest in risky private-sector assets. There are a variety of reasons this might be a bad idea, although the Federal Reserve did invest in some privately issued securities during the financial crisis (and it still holds a large portfolio of them).
But fiscal stimulus is not limited in this way. The government can spend money directly on projects while issuing debt. These are obviously public sector projects, not privately funded projects, but that makes no difference to the people and resources employed. The public badly wants government debt because it is the safest asset. So deficit-financed expenditures soak up the money that people want to invest in safe assets and use it to employ society's resources, increasing economic activity. Government debt financing is a technology that transforms investment in low-risk financial instruments (government bonds) into lots of economic activity, much more activity than could be supported by safe private-sector assets. (The reason we don't use this technology in ordinary times is that we might question whether government-directed economic activity generates as much social welfare as would an equivalent amount of private sector economic activity. If government projects are really worthwhile, they should be undertaken no matter what the macroeconomic conditions. But during a recession, even relatively low-yield government projects can make everyone better off.)
This is obviously far from a complete story of macroeconomic fluctuations. But it seems coherent and satisfying. I will probably try to piece it together with other models to create a kind of mental framework I can use to think about macroeconomics.
posted by James | 4:54 PM
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