Many who attended grade school during the Cold War will remember what
they were instructed to do in the event of a nuclear attack. When the
siren wailed, US students were told, one should “duck and cover.”
Apparently, squatting under your desk with your arms covering your head
would save you from nuclear annihilation. If only it were so.
To recall this absurd advice is also to appreciate the current angst now
being felt in Japan. Several times in recent weeks, cellphone texts
(today’s sirens) have informed the public that the faint streak in the
sky overhead is an intercontinental ballistic missile launched by a
nuclear-armed 33-year-old dictator with impulse control issues.
This is a manmade threat to the world order that Atlantic-hugging
policymakers and pundits, buffered by a continent and a large ocean to
their west, may not fully appreciate. But the threat posed by North
Korea’s Kim Jong-un has had a significant effect on global financial
markets in recent months.
Simply and discouragingly put, sabre-rattling on the Korean Peninsula
has increased the risk of direct conflict with the North, which would
shatter the relationship between China and the US. Any such conflict
would involve massive loss of life and trigger a large regional, perhaps
global, contraction in economic activity.
The theory of “rare disaster risk” has progressed considerably in recent
years, owing to the work of the Harvard economist Robert Barro. The
core insight is that no one can rule out the occurrence of an Old
Testament-style event – war, famine, pestilence, or societal collapse.
Such disruptions to a settled way of life slash output, consumption, and
human welfare. Because they do not happen often, they are far removed
from the smooth centre of the probability distribution from which
baseline scenarios are drawn.
The experience of the Great Recession tells us what to expect from
financial markets when output plummets: as inflation tumbles, so do
nominal and real (inflation-protected) yields on Treasury bills. The
yield curve flattens because owning a long-term term claim on a
safe-haven asset is valuable insurance. As yields on Treasury securities
fall, other spreads widen relative to them.
In the current context, geopolitical tensions create the remote
possibility of a disaster – the odds of which shift daily – that would
make everyone much worse off. We claim no special insight into the mind
of Kim Jong-un, but knowing that there is an unknowable helps to make
sense of current asset prices. In such circumstances, risk-averse
investors, especially those more directly in harm’s way along Asia’s
Pacific Rim, will want to insure against an adverse event by taking
advantage of the expected financial-market effects now. Nominal, real,
and inflation-break-even Treasury rates are lower than the cyclical
position of the economy warrants, owing to investors’ perception of
acyclical and atypical risk.
In a recent speech, Gertjan Vlieghe, a member of the Bank of England’s
Monetary Policy Committee, pointed in the same direction. He explained
that when future consumption prospects are misshapen relative to the
tried-and-true bell curve, so that there seems to be a higher chance of
bad outcomes, the market-clearing (or “equilibrium”) real interest rate
falls relative to its history.
The growing perception of rare disaster risk has three implications.
First, low interest rates do not necessarily indicate that advanced
economies are mired in a low-growth trap as a consequence of adverse
demographic trends and slow productivity growth. Rather, they tell us
that competition for safe assets has heated up.
Second, this is no counsel for government to ramp up spending. The
near-term cost of financing deficits is low because households are
worried that the possible “seven lean years” will be very lean, indeed.
If citizens are storing up for the worst case, are their leaders – even
officials concerned about the cyclical management of aggregate demand –
justified in throwing caution to the wind?
And, third, low policy interest rates in the advanced economies are not
necessarily evidence of ample accommodation by the monetary authorities.
This is because monetary-policy ease is measured in terms of the
difference between the actual rate and the equilibrium rate. The current
low policy rates maintained by the US Federal Reserve, the European
Central Bank, and the Bank of Japan may not look so low if the
equilibrium rate is actually low.
The idea of rare disaster risk complements other explanations for the
current low level of real rates globally. Perhaps the risk of a remote
catastrophe is what created the “global saving glut” that former Federal
Reserve Chair Ben Bernanke warned about in 2005. And, if government
officials are worried about future conflict, they may have greater
incentive to push real interest rates lower through “financial
repression,” so that they have sufficient budget space to prepare.
These, however, are explanations of longer-term trends. Recognising the
existence of the global savings glut helps us to understand the 15 years
after the Asian financial crisis of 1998. Financial repression makes
sense of the experience after wars or on other occasions when government
debt piles up. Rare disaster risk is most likely a contributing factor
in such episodes, and it may be even more relevant for explaining
short-term dynamics in financial markets when missiles fly. – Project
Syndicate
* Carmen Reinhart is Professor of the International Financial System at
Harvard University’s Kennedy School of Government. Vincent Reinhart is
Chief Economist for Standish Mellon Asset Management.
Kang Kyung-wha