Trying to get a sense of household risk preferences
December 8, 2011 Leave a comment
According to one common view, monetary policy works by influencing household (and to a lesser extent business) preferences for investing, saving, borrowing, and spending. Bernanke’s stated justification for quantitative easing was that he could stimulate the economy by getting people to move money from their checking accounts into the stock market and from their money-market funds into car dealerships.
Risk preferences are not determined solely, or even primarily, by monetary policy. When times are good and you are confident in the future, you put more of your savings in long-duration, risky, illiquid assets like equities and housing. When times are bad, cash is king. Using data from the flow of funds, we can see how American households’ risk preferences have changed over time. The crisis has caused many people to retrench and solidify their balance sheets, yet it turns out that there could be a long way to go.
I consider deposits and money-market funds to be safe and liquid. Other household assets (stocks, houses, cars, bonds, mutual funds) are illiquid and risky. This chart shows how risk appetite has changed over time, with a higher number corresponding to greater risk aversion:
Risk appetite increased steadily from the early 1980s until 2000. This corresponds with one of the biggest bull markets in financial assets ever. It also coincides with the collapse of household savings rates and the explosion of private indebtedness. After the IT investment bubble of the 1990s burst, households began to retrench. However, this process was undone by the housing bubble and the restoration of the stock market to its prior nominal highs. When the most recent crisis hit, risk aversion rose sharply and has not really decreased since.
One could make a good case that money-market funds are also illiquid and risky because they are not insured by the FDIC and involve short-term loans to highly-leveraged financial institutions, including risky investment banks. However, the government was willing to guarantee the entire market in 2008 (for better or for worse) and I have no reason to believe they will not do so again.
For the sake of argument, this is what the same chart looks like if you count money-market funds as risky assets:
The basic story stays the same, although the 1970s look different because deposits payed interest rates that were capped by regulations while the yields on money-market funds floated with the market. In fact, money-market funds were created to exploit this loophole.
What are the implications for monetary policy?
One view is that the households are now in a state of irrational panic and need to be forced back into risk-taking by the government whether they like it or not. This was best expressed by Larry Summers:
The central irony of financial crisis is that while it is caused by too much confidence, borrowing and lending, and spending, it is only resolved by increases in confidence, borrowing and lending, and spending. Unless and until this is done other policies, no matter how apparently appealing or effective in normal times, will be futile at best.
If you believe this—and if you believe that the central bank knows how to manipulate the investment, saving, and spending choices of hundreds of millions of Americans—then the Fed is currently not doing enough to fulfill its mandate.
Of course, there is no reason to think that the Fed is capable of forcing people to take on more risk even if that were desirable. After all, the Fed has already lowered interest rates about as low as they can go, and not just at the short end. While the first round of quantitative easing stemmed the initial panic and brought risk premiums back to their (unjustifiable?) pre-crisis levels, the second round has been largely ineffective.
An alternative view is that the risk aversion caused by the crisis should be welcomed. For decades, American balance sheets became distorted and fragile, possibly due in part to misguided government policies. Rather than forcibly restore the unsustainable status quo by inflating a new bubble—as it did in response to the end of the IT investment boom of the 1990s—the Fed ought to trust households to responsibly rebuild their finances. It is not as if risk aversion is especially high relative to history.
To be honest, I do not feel completely comfortable picking a side on this one. Whichever position makes most sense to you, hopefully this helped provide a little extra context.