Probability theory maintains that, over time, random outcomes tend to coalesce around long-term averages; in other words, the “mean” becomes the most likely occurrence. Conversely, the probability associated with extreme outcomes tends to be negligible. Walking down any street, one is more likely to meet people of average height than meet someone who is 7 feet tall.
Mathematical models that form the foundation of probability theory work well with a large number of observations collected over a lengthy period. In finance, probability concepts manifest in the widely held notion of “mean reversion.” An asset that is overvalued should, over time, decline to a long-term average, either as compared with other assets or against itself historically. An asset that is undervalued should, over time, rise until it too converges on a long term average.
The financial crisis of 2008 was supposed to be an extremely unlikely event, at least according to probability models. Given the fact that the stock market experienced a major decline in 2002, the probability of another bear market in the same decade was assumed to be remote. Yet, that’s not what occurred. The “higher than expected” negative outcomes in the past decade have led to criticism of the probability models that govern much of how global finance is conducted.
The markets have also adjusted by assuming that extreme outcomes are no longer remote possibilities. Investors have sought protection against unpredictable market implosions and spikes in volatility. New financial products now exist to capture increases in volatility associated with random events. Yet the market seems equally divided as to which extreme outcome should be feared. There are those that remain convinced that excessive monetary stimulus will result in a hyperinflationary period similar to the experience of the Weimar Republic in the 1920s. Others argue the opposite: i.e., the world needs to guard against a protracted period of pernicious deflation similar to that experienced by Japan since the early 1990s. The most prominent advocate for protecting against deflation is the Federal Reserve.
Politically, there has also been a similar global shift away from the middle and toward extremes. In Europe, as described by one prominent economist, there is a clash between those suffering from “bailout fatigue” and those suffering from “austerity fatigue.” Similar to the 1930s, it is likely the financial crisis will lead certain economies to shift away from free market principles. This would end a nearly three-decade migration toward a common middle ground of market-based policies.
In the United States, the Federal Reserve has received intense and unrelenting criticism from many that believe our central bank has done too much in the way of monetary stimulus. They claim that the Fed’s actions will inevitably lead to a collapse in the dollar and hyperinflation. At the same time, progressive economists have written scathing attacks against the Fed for doing too little. They argue that global deflation is imminent, and the Fed should do more to promote job creation. It is highly unlikely one would find many market participants that currently occupy a middle ground: i.e., confidence in a “Goldilocks Fed” that has done the right amount of stimulus.
In an application of “mean reversion,” there does seem to be one area of consensus in the market—interest rates will eventually rise. It is a matter of “when, not if.” The timing of such movements in rates remains largely under the control of the Fed. However, from a policy standpoint, the Fed has indicated that a reversal of their zero interest rate policy will not be considered until 2014. This would seem to suggest that the Fed has assigned a much higher probability to deflation than to inflation. However, the Fed’s actions also reflect, in part, a policy of financial repression.
Financial repression, an ominous sounding term, refers to a type of monetary policy focused on debt restructuring through artificial suppression of market interest rates. It has been practiced by many nations, including the United States following World War II, to gradually pay down excessive public debt. Financial repression would manifest in the following manner: a) explicit or implicit caps on interest rates; b) debt servicing costs that decline despite massive increases in the amount of public debt, and c) sharp declines in real interest rates.
Following World War II, the U.S. implemented Regulation Q, a policy that remained in effect until the Reagan Administration. Regulation Q essentially determined the level of interest rates banks could assign to loans and deposits. While the Fed’s current policy is not as explicit as Reg Q, there is nevertheless an implicit rate cap in effect until 2014. Moreover, in reaction to the Fed’s policy stance, real interest rates are now negative (i.e., nominal interest rates less inflation) for Treasury maturities beyond 5 years. Two of the conditions of financial repression have thus been satisfied.
With respect to the final condition of financial repression, consider the following: outstanding “net external” federal debt exploded in size from $2.5 trillion in 1990 to $10.1 trillion as of June 30, 2011. Yet the net interest cost on this debt has fallen from a peak of $331 billion in 1996 to the current level of $216 billion. Thus, despite a four-fold increase in the amount of debt, actual interest costs to service that debt have fallen by 35 percent.
Another way of interpreting this development is that it has become considerably cheaper for our government to finance its operations, with the average interest cost declining from 12 percent in 1990 to the current level near 2 percent (or 83 percent reduction). Investors have become increasingly more willing to accept a lower yield on their loans to the Federal government. This willingness is evident despite the fact that the creditworthiness of the US has deteriorated since 1990. The net effect, however, is beneficial to our Treasury in the sense that it costs less to service an increasingly large debt burden.
Whether intentional or not, it seems pretty clear from these trends that monetary policy was designed, in part, to effect lower debt service costs while allowing the government to borrow ever greater sums from the public. This is the crux of financial repression as the policy assists borrowers at the expense of savers. Wealth is transferred through the transmission mechanism of negative “real” interest rates. Given the need to pay down debt and the Fed’s stated intentions, it’s highly likely that bond yields remain at punitively low levels for the next several years. Investors should “follow the lead of the Fed” and refinance outstanding debt wherever possible.
Policy should seek to establish a balance between growth and fiscal prudence while maintaining a focus on the long-term. A faster growing economy would liberate the Fed to abandon financial repression earlier than currently expected. However, fiscal profligacy increases the probability, however slight, that investors will demand a premium for financing our deficits. It is nevertheless likely that the most probable outcome of our policy actions, despite all the various arguments to the contrary, lies somewhere in the middle.
Article originally appeared in CityScope® magazine, June 2012.