Glenn Stevens: Risk and the macroeconomy
Address by Mr Glenn Stevens, Deputy Governor of the Reserve Bank of Australia, to the 2006
Securities & Derivatives Industry Association conference, Melbourne, 27 May 2006.
* * *
I am pleased to be here in Melbourne to take part in your conference.
There seems no better issue to discuss with a group of securities and derivatives professionals than
risk and its pricing. This is quite topical since, as you would be well aware, the extent of additional
return paid to investors to take on risk seems to have been unusually low in recent years.
There are several questions that naturally arise, and which I would like to address.
First, how does the recent period compare historically? Compensation for risk is low compared with
the 1980s and 1990s, but what can we learn from a longer-run comparison?
Second, to what extent can it be claimed that the underlying economic outcomes, which presumably
have a major bearing on investors' perceptions of risk, are less "risky" or volatile than they used to be?
Third, what are the odds that this apparently benign environment will persist? What factors might
prompt a change?
What is risk?
To begin, it is perhaps important to be clear what we mean by "risk", and how it differs from
"uncertainty", a distinction first made by Frank Knight1 in 1921.
He wrote:
"The practical difference between the two categories, risk and uncertainty, is that in the
former the distribution of the outcome in a group of instances is known (either through
calculation a priori or from statistics of past experience), while in the case of uncertainty this
is not true, the reason being in general that it is impossible to form a group of instances,
because the situation dealt with is in a high degree unique."
Risk can be priced, on the assumption that the probabilities in the future will be those inferred from the
past. In Peter Bernstein's2 excellent book Against the Gods, the early development of thinking about
risk is presented as arising from the study of games of pure chance - where the odds are precisely
calculable. The classic response to the chance-like characteristics of life is insurance. Actuaries draw
up tables of life expectancy for a population based on historical experience, and insurance companies,
with reasonable confidence, price policies. The probability and likely cost of certain other events -
fires, car accidents, etc. - is sufficiently calculable that, over time, risk can be priced.
In the case of uncertainty, we don't or can't know the parameters of the distribution. Events that have
no known parallel in recent history, where there is no basis for determining expected frequency or
impact, will not easily be amenable to pricing. An avian flu pandemic, for example, could result in a
frequency and severity of illnesses and a number of deaths that is outside any recent historical
experience, with important implications for life and health insurance providers.
In fact, many economic and financial processes produce outcomes that do not come from any known
statistical distribution, because the human interactions which drive them are not like the turn of a
roulette wheel or throw of a dice. In such a world, quantification and formal management of risk can go
only so far; there will always be some possibilities that simply can't be priced.
These issues are quite important, and will intrude into our discussion later on. But for now, let me turn
to what the quantitative evidence can offer us.
Risk Pricing
The place to start is with the level of long-term rates on highly rated sovereign debt. Given that the
likelihood of default by such countries is remote, what is being priced here, essentially, is the rate and
variability of future inflation. For those of us whose economics awareness dates from some time in the
1970s or later, it certainly seems that long-term interest rates globally have in recent years been
unusually low. In the United States, 10-year Treasury note yields were below 5 per cent over several
years, which stands out compared with the history of the preceding few decades. Furthermore, it is
historically unusual for these rates to have been low and pretty steady at a time when the Fed is
raising short-term rates. That this would coincide with a sizeable US budget deficit, and a US current
account deficit of unprecedented magnitude, was certainly not anticipated by any observer I can recall.
It was labelled a "conundrum"3, and "an intriguing financial phenomenon"4 by successive Fed
chairmen.
Long-term interest rates in other major centres - Japan and Europe - have been even lower than US
rates. As recently as 2003, Japan's rates were the lowest on record anywhere that we could find over
several centuries. These yields too have risen somewhat from those levels, but remain very low by
standards of the past couple of decades.
Because sovereign yields in major countries have been low, so have those for most private borrowers
and many emerging-market sovereign borrowers in capital markets. But there has also been
considerable compression in risk spreads for both corporate and emerging-market sovereign debt,
which takes them back to levels that were observed in the mid 1990s. Many observers have a feeling
of discomfort about all this - since, on some previous occasions, spreads this low quickly gave way to
much higher pricing for risk in the face of some event, like the Asian crisis, the LTCM episode or the
global downturn of 2000-01. All too often, risk has - in hindsight - been underestimated in good times
and overestimated in bad times.
Bond Spreads
To US government bonds, duration matched
Bps Bps
Emerging markets
sovereign
1200 1200
US corporate 'junk'
(B-rated)
900 900
600 600
300 300
US corporate
BBB-rated
0 0
1996 1998 2000 2002 2004 2006
Sources: Bloomberg; RBA; Thomson Financial
Against the backdrop of the past century, on the other hand, recent levels of long-term US interest
rates do not look especially low; they look quite within the range of historical experience, especially
experience when inflation was low. The 1970s and 1980s look more like the outlying period. Nor have
spreads, for US corporate debt at least, been all that low when viewed from this longer perspective.
There were lengthy periods in the mid part of the 20th century when spreads were as low as or lower
than they are today.
US Corporate and Government Bond Yields
Monthly
% %
15 15
BAA
12 12
AAA
9 9
A
AA
6 6
Treasuries
3 3
0 0
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Sources: Global Financial Data; Moody's
US Corporate Bond Spreads
Rolling 3-month average
Bps Bps
750 750
BAA
600 600
450 450
A
300 300
AA
150 150
AAA
0 0
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Sources: Global Financial Data; Moody's
It is more difficult to get consistent data for emerging market yields and spreads over history. But a
study released a few years ago by the IMF suggested that, on average, emerging market spreads in
the 1990s were much higher - twice as high or more - as in the period of globalisation and free capital
flows leading up to World War I.5
Now it could immediately be objected that the world of today is a vastly different place from that of
these historical episodes, so that any comparison is not valid. During World War II and up to 1951, US
bond rates were effectively pegged by the Fed under the monetary procedures then in place. Hence,
the bond market was not really a market.6 The US corporate debt market was not so regulated but it
was a vastly reduced market in size in this period, after the extremely high rates of default in the
period of the Great Depression.7 The peak number of US corporate borrowers rated by Moody's in the
mid 1920s was not surpassed until 1997.8 So while those bonds that were in the market from the end
of World War II until the early 1970s paid quite low spreads, it is not clear to what extent this provides
a reasonable basis for comparison with the larger and more active market of today.
On the other hand, it is a natural human tendency to think that the world we face is unprecedented in
its risk and complexity compared with the past, when it probably is not.9 It has to be said as well that
the 1970s and 1980s were also, historically, rather an unusual period. This era saw a major outbreak
of price inflation, which had hitherto been seen only during wars. Inflation was not only high, but highly
variable, and policy-makers struggled to formulate an effective response. This was extremely
disruptive for fixed-income markets, and for financial asset pricing generally. Nominal yields rose to
unheard of levels.10 The business cycle downturns of this period seemed to be much more damaging
than earlier post-World War II recessions. In general, it was a period of considerable macroeconomic
instability.
That instability has subsided considerably since then, as I shall show in a moment. But the echoes of
the 1970s and 1980s - an intellectually formative period for most of us here - took a long time to fade;
just as nominal interest rates took time to recognise rising inflation, they took time to recognise what
was clearly, in hindsight, a fundamental regime shift in inflation which occurred in most countries in the
mid 1980s.
So in assessing the level of interest rates or spreads for reasonableness, it can be difficult to find a
period of history that can serve as a neutral basis for comparison. While the mid 20th century might not
be ideal as a benchmark, the 1970s and 1980s are surely quite unsatisfactory. Perhaps the safest
conclusion is that no historical period can be assumed unambiguously to be a good benchmark for
pricing. Each period is different and we need to make efforts to understand the forces at work in
economies and financial markets at the time.
Economic variability
That brings me to the second set of questions: is there any evidence, at a macroeconomic level, that
economies are less volatile than they were in the past?
The answer is clearly yes. A host of studies have documented a decline in the variability of GDP
growth not only in the United States but also in a number of developed economies, even though there
are still periodic recessions.11
7
One authoritative study found that one-tenth of investment grade and over one-third of speculative grade corporate
borrowers defaulted between the end of 1931 and the end of 1935. See W. Braddock Hickman (1958), Corporate Bond
Quality and Investor
Experience, Princeton University Press for National Bureau of Economic Research.
8
David T. Hamilton, Praveen Varma, Sharon Ou and Richard Cantor (2006), 'Default and Recovery Rates of Corporate Bond
Issuers, 1920-2005', Moody's Investors Service.
9
Is the world a more risky place today than it was 50 or 60 years ago? I am not sure that it is. We can point to the threat of
terrorism, the impact of globalisation on various business models, avian flu and so on. But without wishing to downplay the
importance of those factors, the earlier era included World War II, the Korean and Vietnam wars, the broader cold war with
its threat of nuclear conflict, and intense political uncertainty and risk in various countries. In late-1940s Australia, for
example, the Federal Government sought to nationalise the banking system - presumably a source of considerable risk for
the owners of the time. There were also major technology changes in that era, which would have destabilised some
important existing business models. For example, the development of air transport, and its acceleration (literally) with the
development of the jet aircraft in the 1950s, would have changed the outlook for railroads and ocean travel dramatically.
The advent of transistors was, by the 1960s, transforming the electronics sector long before the PC or the flat-panel screen
arrived. Arguably the world was no less "risky", or more precisely, a no less uncertain place in those days.
10
Bernstein writes (op cit, pp. 334-335): "In the early 1970s, long-term interest rates rose above 5 per cent for the first time
since the Civil War and have dared to remain above 5 per cent ever since". This was written in 1996. Long-term US rates
have, of course, subsequently traded as "low" as below 4 per cent and are currently about 5 per cent. This territory
presumably looks much more familiar to people who remember the 1950s and 1960s.
11
See http://www.kc.frb.org/publicat/econrev/PDF/3q05summ.pdf
http://www.federalreserve.gov/pubs/feds/2005/200554/200554pap.pdf
http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=5413
http://www.phil.frb.org/files/wps/2003/wp03-22.pdf
http://www.nber.org/papers/w12079.pdf
BIS Review 49/2006
Much of this literature has tended to compare the period since the mid 1980s with the preceding
couple of decades. But in fact, for the US at least, a decline had been under way long before then.
Work conducted by one of my RBA colleagues, John Simon,12 documents a long-term trend decline in
US output volatility dating from the early 1950s, which was interrupted by the 1970s' and early 1980s'
instability.
Variability of Real GDP*
United States OECD Australia
Average Standard Average Standard Average Standard
growth deviation growth deviation growth deviation
% % pts % % pts % % pts
1951-69 4.0 2.55 n.a. n.a. 4.5 2.37
1970-85 3.0 2.76 3.2# 1.91# 3.1 2.01
1986-2005 3.1 1.26 2.8 0.90 3.4 1.53
1996-2005 3.3 1.27 2.7 0.78 3.7 0.94
* Based on annual data
#
Data are for 1971-85
Variability of Core CPI Inflation*
United States OECD Australia
Average Standard Average Standard Average Standard
rate deviation rate deviation rate deviation
1958-69 2.5 1.67 n.a. n.a. n.a. n.a.
1970-85 6.7 2.91 10.1# 1.92# 8.7 3.16
1986-2005 3.0 1.08 4.9 2.18 3.6 2.25
1996-2005 2.2 0.43 3.2 1.10 2.4 0.46
* Based on December quarter on December quarter data
#
Data is 1978-85
An even more remarkable feature of the past 15 years is the trend decline in both the rate of inflation
and the variability of inflation. The average rate of inflation since the mid 1990s in the US has been
about one-third of what it was in the period 1970-85, while the volatility of inflation has fallen to about
one-seventh of its previous value. Quite similar results have been observed in Australia. For the
OECD group, the trend is similar though less pronounced.
These trends are surely of great importance for financial pricing. There will always be individual
businesses that fail because of technological obsolescence, flawed strategies and so on -
idiosyncratic risk remains. That is why the list of firms in the Dow Jones 30 or the ASX top 50 is rather
different today from a decade or two ago.13 But insofar as the probability of default usually rises
sharply in a business cycle downturn, it must matter that the size of year-to-year fluctuations in
economic activity is half what it once was. And the value of re-attaining virtual price stability around the
world, dramatically reducing one source of uncertainty over the future value of nominal claims, should
not be underestimated. High and variable inflation is a powerful deterrent to people parting with their
money for long periods. To the extent that the term premium in long-term interest rates reflects
compensation for both the level and the volatility of expected future inflation, one could expect those
premia to be reduced if we have returned to a world of near price stability. An alternative way to make
the same point is to note that a more stable world means less variation in policy interest rates, which
presumably reduces premia built into longer-term rates to compensate for expected future variability in
short rates.
That having been said, the evidence for this greater macroeconomic stability producing less volatile
returns to equity or bond investors to date is mixed. Volatility in returns to equity holders, measured by
rolling standard deviations of quarterly accumulation index returns, displays pronounced cycles. But
there is little obvious tendency for equity returns volatility in the US or Australia to be systematically
lower since the early 1990s (though for Australia it was lower than the peak levels of the mid 1970s).
Volatility in bond returns tended to remain reasonably high in the US in this period, notwithstanding the
improvement in inflation stability.14 If this indicates continuing volatility in subjective discount rates, it
may have limited the extent to which volatility of equity returns could fall.15 Were macroeconomic
stability to continue, it is conceivable that long-term interest rates might also become more stable; that
would presumably carry some implications for equity (and other asset) valuations. But whether that
occurs or not remains to be seen. Indeed at present we seem, if anything, to be seeing something of a
pick-up in short-term volatility in many asset classes.
Volatility of Stock Market Returns
Rolling 3-year standard deviation of monthly returns
% %
United States
15 15
12 12
Australia
9 9
6 6
3 3
0 0
1910 1930 1950 1970 1990 2010
Sources: Global Financial Data; RBA
Volatility of 10-year Government Bond Returns
Rolling 3-year standard deviation of monthly returns
% %
10 10
Australia
8 8
6 6
United States
4 4
2 2
0 0
1910 1930 1950 1970 1990 2010
Sources: Global Financial Data; RBA
The evidence for enhanced stability for emerging markets is not so easy to come by. But it could be
said, I think, that the fundamental position of a number of emerging-market countries has improved
since the late 1990s. They have increased growth and greatly reduced inflation. The median credit
rating of the countries in the JPMorgan EMBI has risen by two notches. Recent work by the IMF
suggests that such factors can account for part, though not all, of the decline in spreads in recent
years.16 Of course, the fact that this has been a period of quite stable economic outcomes and low
yields in developed countries, hence prompting a search for yield elsewhere, has been a big
advantage to emerging-market borrowers. But a number of these countries do seem to have been
using the benign conditions to strengthen their financial resilience. One of the periodic tests of that
resilience appears to be under way at present.
Key Indicators for Emerging Markets*
1995 2000 2005
GDP Growth (%) 2.7 3.8 4.1
Inflation (%) 21.4 7.0 4.1
S&P Credit Rating BB+ BB+ BBB
* Median values for group of countries in JPMorgan EMBI Global
World Economic Outlook
Sources: Bloomberg, IMF
This very brief look at some of the key facts cannot claim to be a comprehensive analysis.
Nonetheless, a marked improvement in macroeconomic conditions in many countries - not just lower
volatility of growth, but also a vast reduction in inflation and inflation variability - after the upheavals of
the 1970s and early 1980s would seem to have been an important factor conditioning financial pricing
for "risk" over recent years. That this might show up in yields and spreads, which look a bit more like
they were in the 1950s and 1960s, and less like they were in the 1970s and 1980s, is not that
surprising. We cannot be sure, of course, whether the extent of the change has been appropriate, but
we can at least see some logic for its direction.
Can it last?
The final question, then, is whether this apparently benign state of affairs can persist.
In particular, given that long-term yields and spreads have recently been at levels seen for lengthy
periods after World War II through until the 1960s, is it possible that the prospective environment for
capitalist economies is actually like it was during that period? The post-war era was a period when
there were still business cycles, but there was a long-asting and pretty robust secular expansion in
economic activity and global trade, with relatively little instability. Granted, in Europe and Japan there
was the rebuilding and "catch-up" after wartime devastation, which no longer needs to occur. But in its
place is catch-up by China, India and a range of smaller economies which are engaging in the
international economic and financial system. The openness of that system, if we are able to maintain
it, arguably offers as much scope for strong growth accompanied by price stability as did the post-war
world.
Or is it the case that people are underestimating the likelihood of less stable times in the future? Is
there, just around the corner, some event that will usher in a period of instability, triggering a
wholesale reappraisal of economic and financial prospects, and hence appetite for risk? In that
scenario, some of the financial exposures that were taken on in a mood of optimism over the past
several years could be unwound, possibly quite disruptively.
One's answer to such questions hinges to a considerable extent on what one thinks was behind the
enhanced stability of the past decade and a half. Better macroeconomic policies, better
microeconomic policies, globalisation, technological advance, good luck - all of these can plausibly be
argued to have played a role. People can make their own assessments of the likelihood of a continued
role for such factors (presumably one should not rely much on luck!).17
The truth, however, is that our capacity to predict even the near-term future is limited. Grappling with
the question of whether we are in a new epoch - and pricing accordingly - is an even bigger ask.
Following World War II, the main fear among the economics fraternity in many countries was of
another depression and deflation akin to the 1930s, as the demand provided by defence expenditures
tailed off and military personnel re-entered the civilian labour force.18 In fact, partly as a result of that
policy preoccupation, the economy expanded strongly through the 1950s and 1960s, and it was
inflation, not deflation, that ultimately turned out to be the problem - a problem which then took quite
some time (in Australia's case, two decades) to sort out.
That should, if nothing else, make us cautious about long-term prediction. But the end of the long
post-war boom also highlights something else. We can see now that during that period, businesses,
wage earners, industrial tribunals and policy-makers gradually adapted their behaviour as they came
to assume that the long expansion could continue indefinitely. As they did, they sowed the very seeds
of the expansion's demise. The oil price rises of the mid 1970s were a shock, but the other problems
on the supply side of market economies had been developing for some time.
And that, perhaps, points to the relevant question to pose at present. It is possible that the world is in
for another period of stability like the 1950s and 1960s. But even if it is, even if some of the "risks" of
economic life, insofar as we can quantify them, are actually lower, or can be better managed, people
will adjust to that. So the question is: might not the behaviour of borrowers, lenders, investors and
price setters, in response to perceived lower risk, itself work to increase the probability of instability in
future?
This, of course, is the question posed about the tendency of households in some countries (including
Australia) to take on much more debt. In enjoying - rationally, based on lengthening experience - the
opportunities afforded by a more stable macroeconomic environment and a more complete and liquid
set of capital markets, are they in the process gradually impairing the very resilience to economic
shocks which helped to produce the stability in the first place? It is not saying anything new to note
that this is a significant source of uncertainty for policy-makers: there is no historical dataset to draw
on in estimating how households might respond to a macroeconomic downturn under conditions of
much higher leverage. Nor, for lenders, could historical rates of default on mortgages be assumed to
be a good guide to the future, since that dataset is derived from an era of different behaviour. It cannot
be assumed that future outcomes will be drawn from the same distribution.
Questions could well extend - once again - to some corporate entities before much longer, given the
re-emergence of leveraged buy-outs, which leave the cash-flow positions of the corporations more
precariously balanced. At least here there is, admittedly, more historical experience as a guide to likely
subsequent behaviour.
Of perhaps more immediate relevance, considerable sums of money have been risked over recent
years in various manifestations of the search for yield, which depended on a degree of stability and
predictability in global short-term interest rates that was unlikely - even with a more stable
macroeconomy - to last for a long time. While I believe central banks will continue to control inflation
over the years ahead, this does require short-term rates to move: they cannot stay low and steady
permanently. Market action around the world over recent weeks reflects, in part, some adjustment to
previous assumptions about the likely degree of short-term rate variation in major countries which
were overly sanguine.
There are also some challenging questions associated with the very rapid growth seen in credit
derivative markets in recent years. Generally speaking, this should be promoting the more efficient
pricing of credit risk and helping to shift it away from its intrinsic origin in businesses and their bankers
to a broader set of holders who really want it. From the perspective of economic and financial stability,
such a trend is to be welcomed. But even leaving aside the question of whether some investors know
what they are actually getting into, the amount of leverage that can be embedded in such products is a
potential source of trouble. There is also considerable uncertainty about whether, under conditions of
stress, liquidity in these markets will be such as to allow risk-holders to manage their positions.
I have made it almost to the end of my presentation without mentioning "global imbalances". It is time
they received a mention, though not in the way you probably would expect. While there are some risks
posed by the possibility of disorderly changes to interest rates, exchange rates, American
consumption patterns and so on, I think the biggest risk stemming from the imbalances is of another
kind. It is that the wrong conclusions will be drawn, based on partial or simply wrong analysis, with the
result that structural problems in various countries will not be addressed, and/or that protectionism will
flourish, under the guise of attempts to affect bilateral "imbalances". That would undermine the global
openness that has helped to produce the enhanced stability we have been enjoying.
Conclusion
It is frustrating that we cannot offer a definitive assessment of the adequacy or otherwise of pricing for
risk. Taking a long historical perspective, it is not unreasonable to claim that risk - at least aggregate
economic variability - really is lower, in some important dimensions, than it was 10 or 20 years ago.
Certainly the 1970s and early 1980s - a period which deeply affected financial markets for a very long
time - were themselves unusual and not a good benchmark for judging pricing. Yet notwithstanding
this evidence, experienced hands almost invariably have an uneasy feeling about developments. In
part, that unease reflects a conviction that the business cycle (and the cycle of greed and fear in
markets) has not gone away. But it also reflects a recognition that behavioural changes are occurring,
in response to the environment we face, which could elevate risks or create new ones. At some point,
the financial structure emerging as a result of this behaviour will be tested. But exactly when the bell
might ring to signify a new phase of the game, and what event might be the catalyst, we cannot say. In
other words, life remains uncertain.
That is a good reason why, as my US colleague, Tim Geithner,19 suggested recently, thoughtful
managers will surely be using the good times to strengthen resilience, and will be wary of the "late
cycle" tendency for risk management and credit standards to become lax. Even if the future is pretty
stable, there will still be a business cycle. Some occasional counter-cyclical behaviour gives us the
best chance of continuing the stable, steady conditions - and good returns for investors - that markets
seem so confidently to expect.