The fear factor in today’s interest rates

Many who attended grade school during the Cold War will remember whatthey were instructed to do in the event of a nuclear attack. When thesiren wailed, US students were told, one should “duck and cover.”Apparently, squatting under your desk with your arms covering your headwould save you from nuclear annihilation. If only it were so.To recall this absurd advice is also to appreciate the current angst nowbeing felt in Japan. Several times in recent weeks, cellphone texts(today’s sirens) have informed the public that the faint streak in thesky overhead is an intercontinental ballistic missile launched by anuclear-armed 33-year-old dictator with impulse control issues.This is a manmade threat to the world order that Atlantic-huggingpolicymakers and pundits, buffered by a continent and a large ocean totheir west, may not fully appreciate. But the threat posed by NorthKorea’s Kim Jong-un has had a significant effect on global financialmarkets in recent months.Simply and discouragingly put, sabre-rattling on the Korean Peninsulahas increased the risk of direct conflict with the North, which wouldshatter the relationship between China and the US. Any such conflictwould involve massive loss of life and trigger a large regional, perhapsglobal, contraction in economic activity.The theory of “rare disaster risk” has progressed considerably in recentyears, owing to the work of the Harvard economist Robert Barro. Thecore insight is that no one can rule out the occurrence of an OldTestament-style event – war, famine, pestilence, or societal collapse.Such disruptions to a settled way of life slash output, consumption, andhuman welfare. Because they do not happen often, they are far removedfrom the smooth centre of the probability distribution from whichbaseline scenarios are drawn.The experience of the Great Recession tells us what to expect fromfinancial markets when output plummets: as inflation tumbles, so donominal and real (inflation-protected) yields on Treasury bills. Theyield curve flattens because owning a long-term term claim on asafe-haven asset is valuable insurance. As yields on Treasury securitiesfall, other spreads widen relative to them.In the current context, geopolitical tensions create the remotepossibility of a disaster – the odds of which shift daily – that wouldmake everyone much worse off. We claim no special insight into the mindof Kim Jong-un, but knowing that there is an unknowable helps to makesense of current asset prices. In such circumstances, risk-averseinvestors, especially those more directly in harm’s way along Asia’sPacific Rim, will want to insure against an adverse event by takingadvantage of the expected financial-market effects now. Nominal, real,and inflation-break-even Treasury rates are lower than the cyclicalposition of the economy warrants, owing to investors’ perception ofacyclical and atypical risk.In a recent speech, Gertjan Vlieghe, a member of the Bank of England’sMonetary Policy Committee, pointed in the same direction. He explainedthat when future consumption prospects are misshapen relative to thetried-and-true bell curve, so that there seems to be a higher chance ofbad outcomes, the market-clearing (or “equilibrium”) real interest ratefalls relative to its history.The growing perception of rare disaster risk has three implications.First, low interest rates do not necessarily indicate that advancedeconomies are mired in a low-growth trap as a consequence of adversedemographic trends and slow productivity growth. Rather, they tell usthat competition for safe assets has heated up.Second, this is no counsel for government to ramp up spending. Thenear-term cost of financing deficits is low because households areworried that the possible “seven lean years” will be very lean, indeed.If citizens are storing up for the worst case, are their leaders – evenofficials 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 notnecessarily evidence of ample accommodation by the monetary authorities.This is because monetary-policy ease is measured in terms of thedifference between the actual rate and the equilibrium rate. The currentlow policy rates maintained by the US Federal Reserve, the EuropeanCentral Bank, and the Bank of Japan may not look so low if theequilibrium rate is actually low.The idea of rare disaster risk complements other explanations for thecurrent low level of real rates globally. Perhaps the risk of a remotecatastrophe is what created the “global saving glut” that former FederalReserve Chair Ben Bernanke warned about in 2005. And, if governmentofficials are worried about future conflict, they may have greaterincentive to push real interest rates lower through “financialrepression,” so that they have sufficient budget space to prepare.These, however, are explanations of longer-term trends. Recognising theexistence of the global savings glut helps us to understand the 15 yearsafter the Asian financial crisis of 1998. Financial repression makessense of the experience after wars or on other occasions when governmentdebt piles up. Rare disaster risk is most likely a contributing factorin such episodes, and it may be even more relevant for explainingshort-term dynamics in financial markets when missiles fly. – ProjectSyndicate* Carmen Reinhart is Professor of the International Financial System atHarvard University’s Kennedy School of Government. Vincent Reinhart isChief Economist for Standish Mellon Asset Management.