The Discount Rate Mismatch
Posted: 19 Apr 2010 12:36 PM PDT
. . . or, how finance is like quantum mechanics.
This guest post is contributed by StatsGuy, an occasional commenter and contributor to this blog.
Many pundits like to discuss the issue of Maturities Mismatch – that banks borrow short (at low interest), lend long (at higher interest), take the profit and (allegedly) absorb the risk. We often hear talk about how the Maturities Mismatch is integrally linked to liquidity risk – the sometimes self-fulfilling threat of bank runs – which the FDIC is designed to fight. Rarely if ever do we see anyone making the connection to the Discount Rate Mismatch . . . In fact you’ve probably never even heard of it, and neither have I.
What is the Discount Rate Mismatch?
It is the difference between the risk-free return on investment that investors demand, and the risk-free return on investment that can be generated by real world investments. And by investors, I do not just mean individual retail investors or hedge funds. I also mean retirement accounts and state pension funds as well, which rely on massive 8% projected returns in order to avoid officially recognizing massive fiscal gaps between their obligations and funding requirements.
It has been well documented that the existence of these gaps implicitly forces state and municipal retirement agencies to engage in risky investments to hit target asset appreciation goals. This strategy sometimes works. And, sometimes, it does not – as Orange County well remembers.
What drives the Discount Rate Mismatch?
Many things drive it – including behavioral and cultural factors that deter savings and encourage short term time horizons – but it’s worth noting that it’s built into modern institutions. Recently, I helped assemble a couple business plans, and was (again) reminded of the fact that standard net-present-value calculations use a 5% or 6% discount rate. That’s a real rate (which translates into a 7%-8% nominal rate given typical 2% inflation assumptions).
What does this mean? Even after controlling for inflation, getting $100 next year is worth only $94 this year, and the value of $100 in thirty years (controlling for inflation) is a mere $15.6 dollars today. Of course, these calculations extend beyond money. The value of 100 megawatts of electricity in 30 years is only 15.6 megawatts today. The value of 100 lives lost in 30 years (holding age constant) is equal to only 15.6 lives today. Wow. Future life is cheap!
Yet that leaves a conundrum – with such dramatic needs for long term investments, how is it that my savings account is paying essentially 0% interest?
How does the Discount Rate Mismatch relate to Maturities Mismatch?
Let’s imagine a society where everyone demands 6% real returns before committing money to an investment, but society really needs some long term investments – things like the Hoover dam or the Golden Gate Bridge that pay out over 80 years. Let’s say these investments are truly risk free, that there’s a lot of money sitting in bank accounts unused, and that the broader economy has lots of unused productive capacity (e.g. low capacity utilization). Why is it unused? Because many people, given a choice between an illiquid investment with 3% real return and holding liquid cash, would rather hold liquid cash. That liquidity offers insurance against unforeseen needs (like losing a job, or a health expense). But if that cash sits in bank deposits, it takes a lot of money out of circulation, and that can cause problems with things like the price level. That’s where the banks come in.
If I were to ask you where the money in your savings deposit account is, you might say at the bank. That is not quite right. In truth, your money is in several places simultaneously. In this sense, finance is like quantum mechanics. Money is like Schrodinger’s cat – you never know where it is until you actually observe it. (And if everyone tries to observe their money at the same time, that’s called a bank run.)
But how can money be in multiple places at the same time? Simple – because you think you have the money, the bank agrees, and so does everyone else – and since everyone believes it, it’s true. The money you deposit is lent out, then deposited by borrowers, then lent out again – many times over until it eventually sits in vault cash or on deposit with the reserve or in your pocket. We called this fractional reserve banking, and there used to be a limit on how far this cycle could go (the reserve ratio), but this limit was rendered worthless by technological innovations like sweeping, and Bernanke recently hinted at getting rid of it altogether.
By pooling deposits and making loans, banks “borrow” from deposits at 0% and lend it for 3%, thus they make a profit even though the social discount rate (the rate a retail investor would charge for giving up their liquidity for a long period of time) is 6%. That’s because banks care primarily about the spread (sometimes known as the yield curve). Recently, the yield curve was as sharp as it’s ever been.
By engaging in inter-temporal arbitrage, banks allow society to continue to make investments even during periods of high discount rates – at least for a time. Banks essentially create temporary money to make investments without savings. So long as money is continually created, savings are not necessary to sustain investment – credit supplants savings. Citizens don’t need to buy municipal bonds or pay taxes to support public infrastructure – the banks can.
To the uneducated masses, replacing savings with credit may sound a bit frightening, but economists can demonstrate – mathematically – that this credit-based money system is far more efficient than injecting money through the crude process of “printing” and government spending. That’s because endogenous money creation is decentralized – anyone with an opportunity and willingness to take risks (and collateral) can (theoretically) get credit to fund an investment. This, presumably, is why Larry Summers is so infatuated with the credit system, and why Obama argues that credit – not money – is the lifeblood of a modern economy.
Astute readers have probably sensed some danger in the system described above. For example:
Doesn’t credit dependency to sustain investment give banks a lot of power?
If credit creation by banks is replacing cash printing by government, doesn’t this have distributional consequences?
Isn’t credit fueled, leveraged investment rather unstable?
Doesn’t this system punish cash-based savers? If banks no longer have a reserve requirement, then why should they pay anything for deposits? (Hint – they don’t.)
Doesn’t all of this mean that the only real limit on lending right now is capital-asset ratios, and willingness to absorb risk? What if weak regulation and financial innovation allow evasion of capital-asset ratios, and banks are not adequately pricing risk for any number of reasons (TBTF, agency problems, bad math, etc.)?
Yes, well, those are all valid concerns. But if there’s ONE THING we should have learned in the past 18 months, it’s that we the people are a lot less courageous when we’re facing unemployment, impoverished retirement, and foreclosure. It’s easy to curse Goldman Sachs and the credit-breathing financial dragon of Wall-Street, but what would we do without them when most people would rather consume or hold liquid cash than make investments in the future? Consider:
The huge level of debt means that if nominal GDP growth fails to hit targets, the system may collapse spectacularly.
The Discount Rate Mismatch problem is real – without relying on credit, how do we fix it?
Without the certainty of anticipated consumption, what will drive new investment? With the savings glut in countries like Japan, what will sustain global demand if the US decides to start saving more?
If our under-funded pension and retirement funds can’t hit their 8% returns, how do they meet obligations (especially when those obligations are indexed to inflation but not indexed to life expectancy or medical costs)? How do we cover the federal debt if tax revenues fall?
Make no mistake – until we solve the latter set of problems, we are stuck with the credit based system. Banks know this too, and they hope very much that we lack the political will to do what is necessary to fix our structural problems. That’s why any talk of financial reform rings hollow unless it’s accompanied by serious proposals to fix the discount rate mismatch problem and deal with unfunded obligations.
But maybe – if we’re lucky – we’ll get a modern day Pecora who will haul Lloyd Blankfein to the witness stand, and taunt him till he breaks. Imagine, for a moment, Mr. Blankfein losing his cool while ranting in Jack Nicholson’s voice . . .
“You want the truth? You can’t handle the truth. Son, we live in a country with an investment gap. And that gap needs to be filled by men with money. Who’s gonna do it? You? You, Middle Class Consumer? Goldman Sachs has a greater responsibility than you can possibly fathom. You weep for Lehman and you curse derivatives. You have that luxury. You have the luxury of not knowing what we know: that Lehman’s death, while tragic, probably saved the financial system. And that Goldman’s existence, while grotesque and incomprehensible to you, saves pension funds. You don’t want the truth. Because deep down, in places you don’t talk about at parties, you want us to fill that investment gap. You need us to fill that gap.
“We use words like credit default swaps, collateralized debt obligation, and securitization… We use these words as the backbone of a life spent investing in something. You use ‘em as a punchline. We have neither the time nor the inclination to explain ourselves to a commoner who rises and sleeps under the blanket of the very credit we provide, and then questions the manner in which we provide it! We’d rather you just said thank you and paid your taxes on time. Otherwise, we suggest you get an account and start trading. Either way, we don’t give a damn what you think you’re entitled to!”
As with any great villain, what makes Goldman Sachs so compelling is that their vision of the world is not entirely without a twisted kernel of truth.