John Cochrane is an economist, specializing in financial economics and macroeconomics. He is the Rose-Marie and Jack Anderson Senior Fellow at the Hoover Institution. He has previously been a Professor of finance at the University of Chicago Booth School of Business and before that, at the Department of Economics. He also writes the Grumpy Economist blog.
Today's conversation is an extremely enlightened and highly detailed one, that you may want to return to, in order to accrue all of its value. We host John Cochrane, an economist specializing in financial economics and macroeconomics. John has a popular blog and podcast called The Grumpy Economist and also hosts the GoodFellows Podcast. He is a Rose-Marie and Jack Anderson Senior Fellow at the Hoover Institution and a senior fellow at Stanford Institute for Economic Policy Research, and was a Professor at the Booth School of Business at the University of Chicago. In this fascinating chat, John shares so much of his expertise, going in-depth on the subjects that we and our audience are constantly exploring and excited about. We discuss long-horizon stocks, market inefficiency and return predictability, classic portfolio theory, risk-less assets, and performance evaluation. John also shares his perspectives on the future of centralized finances, digital and cryptocurrencies, and where the business of financial advice is headed. So for all this and more from a leader in his field, be sure to join us for this great episode of the Rational Reminder.
Key Points From This Episode:
Breaking down the basics of why stock prices go up and looking at the market as a whole. [0:02:05.8]
The information contained in valuation ratios about long-horizon stock returns. [0:04:25.3]
Market inefficiency and return predictability; unpacking the opinions on the correlation. [0:07:17.8]
What the research on available information and market timing tells us about predictability. [0:12:59.6]
Under-appreciating risk and asking important questions about dividend growth in the future. [0:18:46.5]
The huge impact that predictability can have on classic portfolio theory. [0:22:36.2]
Volatility aversion and communicating important concepts across divides. [0:28:11.7]
John explains the risk-less asset for the long-term investor. [0:30:12.6]
Using the example of bonds to get to grips with performance evaluation. [0:36:26.8]
Unpacking the roots of wealth inequality and the best perspectives for understanding it. [0:40:30.4]
Misguided thoughts about the market and the usefulness of keeping general equilibrium in mind. [0:44:14.1]
Market portfolios and the zero-sum game; hedging state variable risk. [0:52:40.5]
Decisions about the ability to bear the value risk premium and allocation. [0:58:10.7]
John's thoughts on the future of financial advice. [1:01:27.8]
Describing the fiscal theory of the price level and its predictions about inflation. [1:06:03.6]
Cryptocurrencies and value maintenance; John's perspective. [1:13:12.8]
Assessing the longevity of traditional or centralized finance. [1:19:15.4]
John's own definition of success in the different areas of his life. [01:22:06.1]
Read The Transcript:
Is the volatility and valuation ratios like dividends to price due to changes in discount rates or changes in expected cash flows?
Well, you asked a good question there. So why do prices change? This is one about facts, not about opinions. There's a lot of study. I'm going to try to summarize 30 years of research in two sentences here. Why does the stock price go up? Big question. Now there's two possibilities. One is the stock price goes up, because everybody understands that the future dividends, the future cash flows, the price is, that there's more money coming later on, but there's another possibility, which is the price goes up, and I'm being careful here about the cause word, that the price will come back down again. In other words, so if we look at this through a present value formula, the price is up corresponding to a lower discount rate, not to a higher set of future cash flows, but I want to give, really the empirical work establishes the fact, but not the causality.
And you also said ratio. So prices go up when dividends go up and prices go up when earnings go up, we know that, but does price relative to current earnings go up? Does that mean that future earnings are going to be even higher than current earnings? And for the market as a whole, the answer is pretty much no, that higher prices relative to current earnings correspond to lower returns in the future. So I take a view, I work on economic models where the causality is lower risk premiums, lower expected returns cause the price to go up, but the facts are consistent with fads and fallacies and bubbles, if you'd like, that the higher prices are the cause and the lower future returns are the effect, but it's not overstated. It is for the market as a whole, and current relative to current earnings, individual stocks have a lot of that feature. So a lot of high prices relative to whatever you want are a reflection of or associated with lower returns going forwards, but less so than the market as a whole. So there's more evidence for individual stocks that higher prices relative to current earnings means that earnings will grow in the future. So I hope I didn't go on too long, but you asked a big question.
No, no, not at all. That was great. Now what information do valuation ratios contain about long horizon stock returns?
Thanks for emphasizing that, which I put in a lot of academic caution there, but not quite enough. This is a long horizon phenomenon. And therefore one that is not, you're not going to start a hedge fund based on what we know about the academic return predictability, cash flow non predictability. So the stock market as a whole, when prices are high relative to earnings, that sets you up for years, decades of slightly lower returns than you'd otherwise see, but we can't predict that in the next six months that the bubble will burst or whatever you want to call it and returns will be lower. It's a business cycle phenomenon. There's a business cycle phenomenon, and then on top of that, a decade long phenomenon. So I'm going to change, not really answering your question because I'm going to change it a little bit. The information that is in valuation ratios about returns is about long horizon returns, not about something actionable or ready to start your high frequency trading fund based on it.
Okay. Now you mentioned the word predictability. So long horizon returns are predictable. And you also mentioned the difference between return predictability and cashflow predictability. What does return predictability tell us about cashflow predictability?
Yeah, this is a lovely, we don't know much in economics and in financial economics, but we know budget constraints and things that have to add up. And often, just the fact that things have to add up is a great deal of wisdom. So if the price is higher than current earnings or dividends, just mechanically, one of two things has got to happen. The price has got to come down or the dividends have got to go up, but one those two is going to happen. So that tells you something about the future. Just mechanically, if prices are higher than current dividends or current earnings, we can forecast that earnings dividends are going to go up or returns are going to be low. So those two things are two sides of a coin. And it's kind of funny because even academics tend to fall into the trap of saying, "Well, returns, aren't really predictable, but also no one can predict dividend growth."
Well, those two things cannot coexist. If one is predictable, the other isn't. If the other is not predictable, the one must be predictable. So those two things add up and then that's one of the things I've emphasized in my own work. Looking at both sides of the coin can really help you to understand the phenomenon. If you think returns or cash flows are not predictable, that means returns must be predictable. If you think returns are not predictable, that means cash flows must be predictable. So each tells you a lot about the other, but kind of in a, it gives you a deeper insight if you will.
So does return predictability imply that markets are inefficient?
Well that depends who you ask. If you ask Bob Shiller, it's the nail in the coffin. If you ask Gene Fama, "No, you got to be kidding. Read my 1970 paper that said the paper defining efficient markets, that said no, return predictability doesn't mean markets are inefficient."
So let's think about a world that seems to be sort of the world we're in where high prices relative to earnings correspond to low returns going forward. Low prices relative to earnings correspond to higher returns going forward. Well you say, "Whoa, trading strategy. Let's go." Markets are inefficient. I can make money off of everyone else being down, but then let's look out the window. What's going on at a time, say of low prices relative to dividends and earnings? The last big moment like that was December, 2008. What's going on? Is there a reason that everybody else out there is not buying stocks despite high expected returns, despite the chance that this is the buying opportunity of a lifetime. There's still risk, but things look pretty good for returns going forward when everybody else is in a panic and yeah, everyone else is in a panic and probably for good reasons, they are very risk averse.
You're in the middle of a recession. It's quite reasonable for someone to say, "Yeah, I understand that stocks are low, but my business is going bankrupt. They just came to repossess the dog. I can't take any extra risk right now." I talked to some people like running the University of Chicago endowment who were selling at the moment who expressed exactly that view. We understand that this is a buying opportunity, but it could go and get worse before it gets better and we just can't take the risk right now. So it is quite, there is a theory, there's sort of the kinds of theories I've worked on in which nothing that says that the expected return on stock should be constant over time, especially in an economy where there are recessions, pandemics, technological innovations, technological busts. It's perfectly sensible that we live in an economy where the interest rate, which you can see, and the risk premium that people demand varies over time.
And if that's the case, then markets will efficiently have predictable returns just as they are perfectly efficient with... the real interest rate varies over time. Nobody says that's an inefficiency. Well, the expected return on stocks, the risk premium can vary over time. Now, proving that is hard. Proving anything's hard. There's also a story that it's just fads and bubbles and everyone else is dumb. And if you could only be smarter than them, you'd do well, but so return predictability does not prove markets are inefficient, nor does it prove that markets are efficient, but there is a perfectly efficient, and notice where the return predictability peaks in. It peaks in over business cycle and longer horizons. It is associated with business cycles. Stocks are cheap, high expected returns in bad times. They are expensive, low expected returns in good times.
So it's just the kind to predictability that you would think would come out of a normally functioning economy. If stocks were predictable that Monday, Wednesday, and Friday, you knew they'd go down, Tuesday, Thursday, you know they'd go up and there's nothing else going on, then boy, it would be a lot harder just to reconcile that with efficiency. Also, it is a small, in some sense, it's small, in some sense, it's big, very hard to trade. You have to sit on things for a business cycle. You have to buy when everyone else is selling. And then by the way, doesn't mean there's no portfolio advice out of this. So I think we're all stuck in portfolio advice, in looking for inefficiencies, looking for, "Oh, I'm the smart one and everyone else is dumb.", although everyone else thinks they're the smart one and you're dumb.
That's like one zillionth of the reason to actually trade and do something and have a financial industry. So if it's December, 2009 and you're a tenured professor and you know you are inured from any risk and your house is paid for, then you maybe should be trading. You should be taking on the risk that other people want to sell. If you are an endowment that looks at it and said, "We're an endowment that sits through the long, that only cares about the long run." But in reality, you just understood that if the stock market goes down anymore, you got to close down the university. Well then maybe, even though it's a buying opportunity, you should be selling. So just I think we're way too focused on inefficiencies as the only reason, the only thing to think about, chasing alpha, as opposed to all the other reasons to invest and to change your investments.
So does that imply that if somebody has the risk capacity to do so, they could look for higher expected returning parts of the market or countries or what would it be?
Absolutely. You know, look for the reasons somebody else is selling. Look in yourself to see, "Well, maybe if someone else is selling, maybe there's a reason you should be selling too.", but if you can understand there's a reason I should be buying and there's a reason someone else is selling, that is a perfectly respectable reason for trade, even in the Gene Fama approved efficient markets, the fancy word is investor heterogeneity, there's the fancy word for it. So viewing markets as a big sort of insurance market, where some people earn a premium by taking on risks that others don't want to take is a perfectly valid way of thinking about the world.
Okay. Now Goyal and Welch, and again, Gibson, Marsh and Stanton redid their research in 2013 with global data going back to 1900. They show that investors with access only to available information at the time would not have been able to profitably time the market, which is a little bit different than I think what we were just talking about. What does their finding tell us about predictability?
Yeah, that it's a long run phenomenon and that it is not... just because expected returns vary over time doesn't mean that there's some easy profit strategy, which I think enhances the view. If this were bubbles, fads, irrationalities, people being dumb, then you who are smart should be able to take advantage of it.
Oh, interesting, yeah.
Here's a phenomenon that's pretty big, but that Goyal and Welch just showed us that it takes a long time. The parameters are uncertain in real time. Unless you have 1,000 years of data, you can't really take much advantage of it. To me, that enhances the view that this is a rational, efficient market phenomenon, not something that is a puzzle because people could easily take advantage of it. Now it's quite possible that returns are predictable, but you don't know exactly whether today is a good day or a bad day.
And I think that there's always the chance that as Irving Fisher famously said in 1929, stocks were on a permanently higher plateau. So even though I write about this stuff and believe it deeply, I don't actively try to market time either because we could be in a period of higher price earnings ratio for a long, long, long, long time. And the parameter could have drifted and so on and so forth. So I think they point to this very interesting possibility. Returns vary over time, but not in such a way that you can make a lot of money out of it.
So something that we've been thinking about a lot recently is related to this. What should you use for an expected return for financial planning purposes? Should it be related to valuation ratios or should it be the long run average?
You should use risk management. I think there is a tendency to survey the expected return forecast and say, "Aha, the expected return forecast is 4.23%." So we will plan on for the next 50 years, we'll lock in. We can spend 4.23% of our portfolio. That's probably not such a wise idea. This is a number that is subject to great uncertainty. The historical average is pretty darn good. Now it depends when you take your beginning and end sample, but your numbers in the 5%, 6%, 7%, 8%. Now, one way I like to think about this is did your grandfather or great-grandfather know in 1945, that stocks were going to earn on average 8% more than bonds, and he put it all into bonds, which is what my grandfather did even though he was a stockbroker, wonderful man.
I have to work for a living for a reason. No, nobody knew this was going to happen. In 1945, all the worthy economists were saying secular stagnation. And the idea that we would have 50 years of the greatest economic growth ever seen, with zeros in front of it, is arguably a surprise. And with it, the stock market returns. Valuation ratios were much lower than, and it kind of do seem to be permanently higher down. A lot of the observed return, this is a great Gene Fama and Ken French paper. A lot of the observed return from 1945 until now comes with the price to earning ratio rising. And if that price to earning ratio rises permanently, which is good reasons to think it is permanently higher price is relative to earnings, back in 1945 to own stocks, you had to clip, you had to actually have physical shares and put them in a safe deposit box. Normal people didn't own stocks.
Now we have 401(k) plans and index funds, so stock ownership is much more wide. So why history is not a well, the future may not be like the past, our economic growth is now kind of stuck in sclerosis and everything out of Washington seems to tell me, we're going to be having the next 50 years are not going to see the 3.5%, 4% growth that the last 50, 60 years do, unless these guys wake up and just recognize that economic growth is the challenge, not all the other stuff they're looking at. So you got to kind of take your best guess. And most academics now are saying maybe in the four percent-ish range, but that's as much of a guess in an echo chamber as anything else is.
There is this equity premium puzzle. It's been very hard for a long time to come up with economic models that justify 5%, 6% and 7% stock premium over bonds. And after you've tossed a puzzle, now, economists are pretty good about this stuff. It's a puzzle, our models don't work. This is the Mehra Prescott equity premium puzzle. And you spend 30 years trying to make better models, say, "Oh, the world's right, but our models are wrong." Economists are pretty good about that. Well, here we are 30, 40 years later, and the models still don't generate 5%, 6%, 7% regular premium of stocks of bonds. The risk is just not that big in stocks. There is risk in stocks, but this looks too good to be true. Well, maybe the models were right after all and going forwards were more in the 3%, 4% that the model's constrained to get. So that's what we know about it, which is not much. And that's why I always say, number one, don't pay taxes. You don't have to. Number two, risk managements, it might be good, might be bad. Number three, my best guess is in the 3% or 4% range, but I don't know anymore than anybody else.
So I take away from that, John, that your grandfather didn't appreciate the return that was on the horizon. Am I overstating that from you? I understand that people today might be underappreciating the risk that they're looking at.
Yeah. So I don't want to say anything. My grandfather's a wonderful guy, with typical family skill at market timing. He started out as a stock broker in the summer of 1929. And the subsequent years were a searing very difficult time for him and everybody else around. That he personally was not willing to jump in in 1945, I think is understandable. And that was the consensus as economic opinion. We're right back to the Great Depression is what all of the good teamsies and worthies were saying in 1945. So going forward, yes, risks are long run risks, I think are more than people think, which is it's got to be, if you want to justify even, if bonds are paying 1.6% and you want to justify stocks paying anything more than 1.7%, you need some sense of long run risk. So those risks do add up over the long run.
And the primary part of the long run risk is not the valuation risk, I think. Price dividend ratios can vary. And that's kind of the short, if you want to call a decade a short run risk, you might have to sell at a time that prices are really low, like in the middle of another Great Depression, relative to dividends. But the big question is what is dividend growth going to be like for the next 30, 40, 50 years for the return? Because the return is dividend growth plus change in the price dividend ratio roughly. Well, leaving the change in the price dividend ratio alone, which is kind of the speculation, the valuation risk, the dividend growth risk is there. So do you think economic growth is baked in at 2% a year, which is already that's two percentage points down from the post World War II era. That's bad for returns and how much risk do you think there is in those long run growth rates?
I think there is actually more risk in those long run growth rates than people say. The end of Pax Americana, the decline of America is not going to be good for economic growth and for the stock market, if that happens. And certainly, risk means things that we aren't expecting to happen, but that could happen. And so the risks of our government falling apart, our political system falling apart, climate change is nothing compared to, I would think that kind of risk. Historically, worse have been bad. So now, we're back on valuation risk, but if China invades Taiwan and we do nothing about it, I would look for a decline in the stock market. So yeah, there has to be risk out there and it's less longer horizons than shorter horizons. So risk is better borne by people with long horizon strategies, but you don't get that return in return for nothing.
And you get that return for bearing risk and you also get returns for thinking it is true that if you can think about things better than the other person, you're going to make money. Markets reward people who are better to outthink everybody else. So if you got a better idea on the long run future of the American or world economy than I do, a better understanding of the sources of risk premium than I do, you're going to make money. So markets reward you for taking risk and for processing information. So when we say markets are efficient, it just means that it's a very competitive market for processing information, but the people who do it better than other people, even though it's only half of them as well as people who get lucky can make a tremendous amount of money. That's what we're here for.
We're going to come back to that, being smart as a source of investor heterogeneity. But before we get there, I want to come back to predictability for a second. Classic portfolio theory assumes that markets are IID, independent and identically distributed. How much predictability change classic portfolio theory?
A lot. Now, classic portfolio theory, you only have to go to Merton 1972, I think to see in theory how predictability should change portfolio theory. So it's interesting that the theory here was two decades ahead of the fact. So in principle, predictability means that horizon effects are there. So stocks are a bit like bonds. When prices are low, they do kind of come back in the same way if a bond price goes down, you know that the yield went up and that the expected return went up. So if you're a long horizon investor, you invest in long term bonds, even though long term bonds have a lot of price risk in them. Well, stocks are a bit like bonds. So that stock risk though, it's there is. If you're long term enough and can wait for price dividend ratios to come back, you're bearing only the dividend growth risk, not the dividend growth risk and the price relative to dividends risk.
So predictability tells you that people with longer horizons can afford to take that risk better than people with shorter horizons. Now there's also, predictability is also in the cross section. I'm sure we're going to get the factor sooner or later, but factors are about the same phenomenon cross-sectionally. The value effect is stocks with higher prices have lower returns and growth stocks, stocks with lower prices have higher returns. So there's something about the different risks of those things that some people are better able to take and other people are less able to take. So it does open up all sorts of things to different kinds of risk taking are available to different people, because the returns are predictable, which is the same thing as high prices don't always mean not higher dividends.
You touched on the answer to this question, but I want to ask it explicitly because I think it's important. How do time varying discount rates change the way that investors should think about the mark to market of variations in their portfolio value?
Thanks. And I hope I get to plug a paper. I just wrote a paper on this exact question, but yeah, let's take, I think the bond example I think is an excellent one and this hit me like a ton of bricks when John Campbell came and gave his paper on long term bond investing in Chicago, which is also a brilliant paper, but take the example of a bond. You're a long term investor and you've decided we're investing for 30 years from now, you buy a 30 year bond. Now that's locked in. In 30 years, it's a government bond. Let's make it an index bond, 30 year index bond. It's ready to pay off on the day you retire 30 years from now. That is a risk free investment for your purpose. And then a month from now, the Fed wakes up or decides to do what it's going to do sooner or later and raises interest rates and the value of your bond plummets.
And your spouse comes in and says, "What the heck did you do? You just lost our retirement money." Well, the answer is no, you didn't. Even though the mark to market value plummeted, you know that the lower price means a higher return and it's going to come back and the bond is still perfectly safe for that investment purpose. Now, if your purpose was you were buying a bond because you needed to park money for a month because the new car was going to come in in a month, well, now that is a very risky investment. Long horizon time varying expected returns, which is what's happening in the bond case means that the mark to market value doesn't necessarily tell you the new risks to that final payoff and stocks are no, they're not, they're a little bit like bonds in this way is actually true what Wall Street said for a long time and academics were suspicious of, that long term investors can afford to wait out temporary price declines.
And we went, "You guys didn't get the news, did you?" Well, they were sort of right. There is this element of temporary price declines that bounce back in long horizon return predictability. So this is a deep point for accounting too. Accounting took on the market to market revolution in the 1970s. Mark to market is beautiful if returns are independent over time and stocks of random walks because today's price tells you everything you need to know about future value. Well, now today's price doesn't tell you everything you need to know about future value. That's okay if you mark to market. So in our hypothetical example, but 30 years from now, if you and your spouse sat down and marked to market both the asset and the liability, if you said, "Oh well, yes but honey, that RV that I'm planning to buy 30 years from now when I retire, the present value of that just fell exactly as much as the investment fell."
We're fine. If your spouse would accept that, then you'd be in good shape. But of course, accountants, no one's willing, people are willing to mark to market marketable stuff, but no one likes to mark to market unmarketable stuff. And so that really profoundly changes how accounting, that explains a lot of the sort of crazy accounting rules of stuff that you do mark to market and stuff that you don't mark to market and so forth. So yeah, now that doesn't mean silence market to market accounting. That means understand what it's telling you and what it's not telling you.
I'm curious how you explain all of this as someone who may be averse to volatility in that portfolio.
Well, let's go, I love my bond example because it's so clear. So let's suppose that you and your wife have decided on this 30 year plan, you've bought a long term bond. How do you explain to your wife we're fine? Now, one way to explain it might be just tear up the statements. Let's not look, and in fact, I see a lot of that. Why do universities seem to love investments that nobody can value? Private equity, venture capital, real estate, stuff where they get to make up the numbers? Well, it doesn't get marked to market and people don't freak out about temporary price declines.
But I think that's very inefficient considering the fees that all those people charge for the simple act of tearing up the statements. There's an advantage to public equity. There's big advantages to traded equity. And you're on a deep question. How do we explain things better to people is something that I think finance professors should do a better job of. I think that the Merton portfolio advice just didn't get taken for 40 years, still isn't taken. When you look at how institutions make portfolios and you look at the portfolio theory in every academic textbook, including my own, they're radically different, but we just have not communicated well how to think about this stuff. I'm not in my typical fashion when I don't want to answer a question I'm going around in circles.
It's not an easy question to answer. It maybe ends up being our job as the one dealing with end investors to help figure it out, or at least help communicate it.
Yeah, but I think back with, this is part of what that essay I refer to is trying to get at. If we professors listened more to end investors, we might be able to ask the theory in better ways.
You mentioned that John Campbell paper, that was important for you. Can you talk about that? What is the riskless asset for the long term investor? And why was that enlightening to you when you first heard about it?
Okay, so what's the riskless asset? You're going to tell me it's T-bills, overnight federal funds. No, for a long term investor, the riskless asset is an indexed perpetuity, the longest tip you can get. I wish the Treasury would issue perpetuities for all sorts of reasons. But in the meantime, in the riskless asset, something that gives you a real coupon every year, same amount forever. That's the risk. If you're going to live forever or you and your children that you want to give money to, or your foundation, whatever, going to live forever. Something that gives a steady inflation index check every month forever. That is the riskless asset. It's kind of mind bending, right? I mean, you're so used to risk the vertical access to the graph is treasury bills or bank accounts or something like that. But that's one period thinking. We're not going to live one period. We're going to live forever, or you and your estate are going to live forever.
And an indexed annuity, if you want to go for a lifetime is the riskless asset. If you're managing an endowment, then you are planning for forever, so that's the index perpetuity and funny kind of finance retro regression. Those are hard to buy. You can buy tips, but tips have a horrible tax treatment. They're horribly complicated. And you go into any financial advisor and say, "I think I'm going to live a long time, but let's start my portfolio with some riskless investment." They're not going to guide you to a tips fund is probably the best thing you can have now. And in the 19th century, read your Jane Austen novels, the 19th century, people understood this. Queen Victoria financed, it wasn't Queen Victoria at the time, but she paid them off. The UK financed the Napoleonic wars issuing perpetuities under the gold standard. And those were rolled over for the entire 19th century. Everybody understood perpetuities that paid off under the gold standard in real terms were the safe asset, and that you ignore fluctuations in their market price, that in fact, short term debt was a risky asset because their interest rate could go up or down. So all of those country houses, the Downton Abbeys, the core of their investments were index perpetuities. And we seem to have lost that little piece of wisdom, but there is a fun theorem for finance to enliven your listeners' day.
Oh, that's so good. I bet you, the perpetuities were not marked to market though. Maybe that's why they were able to hang onto them.
Well, you know you could sell them. So there was a mark to market. There was a market, it was English government debt, which it started like 140% of GDP at the end of the Napoleonic war. So they had a big government debt and an active market for that government debt and the prices went up and down.
Interesting, okay. Maybe, it's because they didn't have online accounts to log into then.
Well, yeah, that's a good point. Or maybe because they understood. It's not a deep psychology once you get it. We are holding this for the coupons. We're not holding this as a speculative investment to buy. And if you are, then it is quite risky. But if your investment objective is, "I inherited a ton of money from the Lord Earl Count of Brandywine, whatever. And my job is to keep Downton Abbey going and pass that on to my kids, then what I want out of my investment is a steady monthly check." And people got that.
It really is obvious when you say it like that. How does that payoff perspective, the cash flow perspective, how does that change the approach to managing risk? Because it's kind of not volatility anymore. So how do you manage risk in this payoff focused portfolio?
Yeah. So that was now here, I'm sort of making up words for papers that haven't been written yet, but it does seem like a good psychology for real investors is to think not so much about the one period risk in return. This month, how much will we make, and not if the world were IID, then thinking about one period returns bakes in everything you need to know about the long run. And the world is still a lot more IID than most advisors think. So let's not, investment advisors are here, if classic efficient markets was here, I'm moving us here. But the speed of meaner version of stock prices is much slower than most people think.
And the temporary component is, but at least we move a little bit in this direction, but yeah, thinking about your investment objective in terms of what is, I think we ought to think about not what rate of return do you want and rate of return risk you're willing to take, but your fundamental investment objective is typically, "I want a stream of checks and I want this." Most people, "I want a stream of checks to start coming when I turn 65 or 70 or choose to retire. And I want that stream of checks to go on. And then I want a lump sum so that a stream of checks keep paying my no good children and grandchildren in their careers as social influencers or whatever it is that they're going to do in their life."
Whilst people made money the old fashioned way, they started a business, they're not following. Anyway, jokes aside, if you start thinking about the stream, now that stream of checks, you don't, and then I, the advisor go, "Okay, well, we can bake in for you right now that you can have a real 2,250 a month by putting in a fresh lien in perpetuities.", or if you're willing to take some risks about what those checks look like maybe they're going to be 5,000 a month if you'll take some risk, but maybe they're only 2,000 a month, that's I think a useful way to start thinking about the portfolio problem rather than what's your one year risk and return objectives.
When I fill out the forms on investment advisors or I look at the forms, I have no idea how to answer those. What's your investment objective conservation growth? What's your risk thought? I have no idea how to answer those questions. Make me some money, buddy. Don't lose any along the way.
So how does this whole framework change performance evaluation?
Well, yeah, I think again, the bond example is the clearest example and the challenge, we know that stocks are a little bit like bonds, so let's understand the bond example and then think about how to make it. I don't really have the answers, but I think that's the right question. So how would you do, let's go back to the bond, you're a long term investor, and you've invested in this long term bond for its long term value. How do you think about performance evaluation?
Well, thinking about evaluating your manager based on one month or one quarterly return, an alpha would be insane, because if it's a bond fund and if the manager lost a little more money, then aside from default risk, then he is going to make it more coming back again. So indexing a bond manager, with bonds, we know all of it is time varying expected returns. The entire reason the price went down is the expected return went back up again, plus default risk, which we'll take on in a minute. But if it's just duration risk, then saying, "Well, your alpha's down because you're down 7% of the lean, the bond index is only on 5%." That's nuts because how much of that 7% is going to bounce back is the central question now.
So how do you do it right? It gets harder. We have to think about modeling that long run objective and how well your manager has gotten you to a long run objective. I can do it in fancy stuff with a model. So I can take my model of expected returns and I can say, "Well, the price went down. But given that the price went down, I have a model of how expected returns are higher so we can shoot that model forward and we can see how did you earn, did you lose too much? So are we we off track for get heading back up the hill or did you lose a little bit, but actually, expected returns are so great that we're going to end up better than we thought?" I kind of want to update where we are relative to that long run objective. That takes modeling and modeling, as Goyal and Welch pointed out is uncertain and it takes risk management. What are the chances of doing it? That's conceptually how you would do it? How would you do it in practice? How would you believe that model? That's another question.
Does the payoff perspective require dividend paying stocks?
Well, all stocks pay dividends eventually if you count the dividends correctly, that's why I was careful to say earnings. And I mean, corporate profits eventually are paid out to shareholders. Many stocks now, most stocks do not pay. Listen, so thank you for, I've been saying the word dividends, but dividends, proper in good data like the crisp data, I put in a plug for my former employer, good data includes not just official corporate dividends, but for example, if we sell the company and you get cash, that cash payout is a payment to investors. So eventually, all of those profits end up in the pockets of investors and we just got to think about how and not just measure dividends. And that's the profit. Individual stocks for statistical analysis, those payments tend to be lumpy. They're doing a lot more repurchases now and how do you account for repurchases is a headache.
It's a great thing to do because it gets cash out of the company and gives you the option of do you want to realize the capital gain now, or do you want to realize the capital gain later? But it certainly makes the individual company stuff harder to do. So yes, everything applies to stocks that don't pay dividends because if you have a stock, that's not going to pay dividends ever. That's like Bitcoin. And the fundamental value of that is zero. So every stock, you are holding it because of the dividends, eventually of some payments from the corporation to the investor. And if there are none of those ever, this stock is worthless, get rid of it right now. So you definitely have to think about what those payments are going to be and when they're going to come and how they're going to come.
What does the payoff perspective tell us about wealth inequality?
The payoff perspective, let me kind of, I'm not sure about the payoff perspective, but certainly the time varying expected return perspective. This is the point I've made in a bunch of blog posts. And recently my colleague Hanno Lustig wrote it up in a really nice paper with some co-authors. I'm not mentioning co-authors here and that's because it's a blog. So my apologies to co-authors who haven't been mentioned.
We'll link to the papers that you're mentioning.
Okay, fine. Thank you. So let's just take a simple example. So interest rates have gone down a lot. Interest rates in the 1990s were in the 5% and 6% real range. And now they're in the zero, the negative real range. And if you do one over R to discount long run cash flows, negative interest rates cause a real problem here. So lower interest rates make the same cash flow much more valuable.
And that is I think a major part of the observed wealth inequality. Wealth inequality at mark to market values is staggeringly greater than income inequality and income inequality is staggeringly greater than consumption inequality. Bill Gates lived a very nice, well until he got divorced, he lived a very nice life involving multiple mansions and cars and jet planes and so forth. But the amount of his consumption relative to yours is tiny relative to the amount of his value of Microsoft stock. So where did that wealth inequality come from? Much of it came from higher market prices, which in turn, came from lower interest rates. And when interest rates are very low, it's back to, it's the same as the long term bond question. If interest rates go very, very far, suppose you bought that long term bond, which buys you $2,000 a month and interest rates go down to zero.
The long term bond explodes in value, but it's still paying you $2,000 a month. The same wealth when interest rates go down, when expected returns go down, when price earnings ratios go very high. You need much more wealth in order to buy the same consumption. So absolutely no change in consumption inequality becomes a huge change in wealth inequality when interest rates go down, when prices go up, because expected returns go down and that's a lot of what's happened. A lot of the billionaires are billionaires in terms of the market value of their securities at very low interest rates at very high PE ratios, but good luck to them selling it all at once, but nobody wants to sell it all at once. You want to use that to support your lifestyle and your philanthropy and whatever else you're sporting, and when prices are high, when interest rates are low, it supports the same old stream it ever did. So it's really the much lower interest rates and lower equity premiums that we live in are producing a mark to market wealth inequality that is not at all indicative of the underlying consumption inequality.
Fascinating. Prices have changed, but prices don't predict cash flows. So how much has actually changed?
Yeah. It's like houses in San Francisco, I suppose well until San Francisco started falling apart. How about houses in Palo Alto? If you want to suppose you got in Palo Alto in the 1980s and you bought a house at $400,000, it's now worth 5 million. Are you rich? No. If you want to keep living in Palo Alto, it costs, the new house you want to buy costs 5 million, just like that house you sold. So it doesn't do you any good whatsoever. You're still in sort of value of housing services, you're still living in the same old house you always were. And that is true of stocks and bonds and lots of other things as well.
I want to shift to another concept that you had in your most recent paper. I don't know if it's the most recent, but the portfolios for long term investors paper. The concept of general equilibrium. So the average investor holds the market portfolio. They have to, but most investors are not the average investor. So if someone's sitting down thinking about how they should be different from the market, what are the important sources of heterogeneity that they should be thinking about?
Before we get to what are the most important sources, let me repeat your question at great length, because I think there's a deep insight there. Most people thinking about the market think only, "Well, do I want a buyer or do I want to sell? Do I think the price is going up or the price is going down? Is this a risk I want to take and I don't want to take?" It was very hard question to answer, but you should, anytime someone wants to sell you something, you should ask yourself, what does he know that I don't know? Why is he selling? Now most people think he's selling because of moron and I'm smarter than he is, but he thinks he's the smart one and you're the moron. So one of you is wrong. This is the theorem. One of you is wrong.
So how do you get around that conundrum? And so you mentioned it very quickly, but let me just take a deep breath. The average investor holds the market portfolio. The average investor must hold the market portfolio. That's just the definition. The average is the average. All the children can't be above average as Garrison Keillor famously said. Well, he said the opposite and it was a joke. Now that means if you look honestly in the mirror and say, "I'm not any smarter than average. I don't have any better than average ability to hold risks or analyze the economy." Then you should hold the market portfolio. And in fact, anything but holding the market portfolio is a zero sum game. So investing in general is a wonderful thing to do because it's not a zero sum game.
If you invest in the stock market, if you take your savings and invest in the stock market, you don't make money at somebody else's. This is the big fault of the left because they don't understand capitalism is not a zero sum game. It's a positive sum game, but doing anything different from the market portfolio is a zero sum game. The only way you can do better is if somebody else does worse. So this is, I wanted to restate your question, because that's such an important insight and it's very hard for investors, especially institutional context to sit down and say, well, let's just throw it in total market portfolio. Find the lowest fees we can. No, we have to think. We have to adjust. No. In fact, by just holding the market, you protect yourself against being the dumb guy. Many models of trading have the informed investor and the liquidity investor.
Well, don't be the liquidity investor. Don't be the mark, as I think I said in the article, if you're having a dinner with lions, make sure that you are at the table, not on the menu. Somebody's on the menu. Make sure it's not you. Well, holding the market portfolio is a great defense against being the dumb guy. So that was your question. Now let's get to your answer. Why shouldn't everybody hold the market portfolio? Well, there's plenty of reasons not to hold the market portfolio. And here's where I think general equilibrium thinking comes into mind. When you walk into the grocery store, you don't have to think about the general equilibrium. I'm in Palo Alto, the market for arugula. You just say, well, do I like arugula? What does it cost? Let's buy it. But in financial markets, the expected returns, the risks are not very clear.
So I think if you can go into the market understanding, "Oh arugula's 2.59 a pound. Everybody else thinks it contributes to climate change. I don't, there's a reason why it might be cheap." That gives you encouragement, that you're actually getting a deal. So understanding what the equilibrium of the market is, who's buying, who's selling and why the market might reward you for doing something I think is a useful discipline for investing. Now, finally, I think I'll answer your question. Why should you, with this great insight, do something different from everybody else? Well, you might be genuinely smarter than everybody else. You might be genuinely better informed than other people. Good luck to you on that one. You certainly might have a different ability to take risk. So you might want to be an insurance company and simply say, "Well, the average investor is somebody who has started a business and made a lot of money in it, but they still own a business."
So if they're doing their jobs right, they're thinking hard about integrating their business risk and their portfolio risk. So in a time when the average person like December 2009 or March, I guess March 2009 was the all time buying opportunity that I didn't take. And I can tell you guys didn't take either because you're still working for a living or whatever, but if you can spot that everybody else is, they are really worried about the risk to their business. And so they're dumping, even though they understand it's probably a good time to buy. But you're a tenured professor or you're retired, you can afford to take a risk that you understand other people want to get rid of. You're probably going to get paid a premium to do it. Actually March, 1934, if you can go back and if you can get a time machine, go back to March, 1934. That was the all time bottom of the Great Depression.
That was the greatest single month in stock returns ever. And so you want to buy February, 1934, go back and tell great grandfather to buy because, and there was the depths of the Great Depression and you're still taking risk. There was a good chance that America turned fascist and socialist and communist in the middle of the Great Depression. There was a good chance that we lost World War II. There's all sorts of risks there, but it feels like a good bet. So I think the best one is if you can identify your ability to take risk as different from other people, that justifies buying. And most importantly, now here's where I get a little fluffy, which stocks do you buy? Value stocks, growth stocks, momentum stocks, which industries do you invest in?
How do you avoid the good stock versus good company fallacy? I think if you could understand what risks are in different categories of stocks, who is buying them, who is better served to taking them, I think that is probably the great, the market timing happens slowly, but the sector allocation, the style allocation, that's something that you can do at different times. I think understanding your risk bearing capacity relative to various sector styles and factors would be really good way to think about that. I don't have good answers about that. No one has good answers about that. The one I would say is don't invest in your own company and don't invest in your own industry, which is one of the biggest mistakes people make. They load up on their own company. Even the geniuses at long term capital management have borrowed money to invest in their own company.
Come on guys, you don't want to do that. That is just multiplying risks. So we can start, always start with don't pay too many taxes and risk management. Those are completely free. You don't need to chase alpha for that. It's not a zero sum game. And one of the aspects of risk management is even though everybody thinks their own industry is the industry of the future, even the coal people for thought that, keeping enough money out of the wonderful rewards of your own industry and your own company, so that if things go bad, you can survive is that's a classic example of this kind of thinking about heterogeneity even if your company is a great company, and if you think it's a great return opportunity, it might not work out. The FTC could decide that you're a monopoly and destroy it, or the SEC could decide you contribute too much to climate change and destroy it. So even if you think it's a great opportunity, you should be investing less in it than the average person because you are exposed to that risk. And if we could make that case more generally for factor risks, I think we would've a much better framework for understanding who should invest in factor risks and who shouldn't.
You make the point in your paper that deviating from the market portfolio is a zero sum game from a financial perspective. But you're very explicit about that. Not from all the other stuff you were just talking about, where if you're hedging state variable risk, then it's not a zero sum game.
You read that paper better than any student of mine ever read a paper in an assignment for class. So congratulations. Yeah, that's the sense in which, so insurance is a zero sum game in a financial perspective, right? Because you know that the premium you're paying is the insurance company's making a profit. So you are paying more premium than the expected value of your losses. You buy insurance. Why? Because in the state of nature that you come home and there's a big crater where your house used to be, then guess what? A check shows up. So it's a zero sum financial, but not zero sum, to use fancy words weighted by marginal utility. It's still a valuable product because the check comes at a time that is very useful to you and writing insurance is risky. It's a zero sum game too, plus profits and fees and so forth. But writing somebody else, insurance is financially profitable for the same.
Those people are willing to pay more than it's worth. So that's why we engage in this zero sum transaction, because it's not zero sum weighted by how hungry you are for money. And that's where risk, that's why I think risk analysis is where you start with, you should start with thinking about portfolios. What are the events that I really can afford to lose money in and I'm willing to say I'm willing to give up some on average to make sure that I'm not poor in those events, well the event that my house burned down there. There's a good one to start with. How about the event that my company goes bankrupt? Let's think about, let's set up your stock portfolio so that in the event that your company goes bankrupt, you are not completely gone. How about the event that the U.S. economy has another huge pandemic? Well, if you're retired already on a fixed income, yeah you can afford to take some of that risk. If you're starting a company that might not do well in the next pandemic, well, then you need to think about your ability to take that kind of risk.
Wow. So interesting. So practically speaking, how does an investor hedge their outside income? Do we know enough to reliably execute on this kind of customization given I guess the higher cost to do it?
You tell that I'm real good at posing questions for other people to answer and not really good on the practical answers. This has been, in my old age, I'm sort of putting all my research ideas out as essays and saying, "You guys figure it out.", but I didn't touch on some of the obvious ways. If you own a business, you should not be investing in that business or industries, things that will be hurt by that business. A certain risk analysis of the business itself would be a useful thing to think about. If your business, classic is oil price risk. So if your business is really going to be hurt by a spike in oil prices, then you might want to buy a lot of oil futures so that if oil goes up, you get a financial payoff just at the time that your business is doing badly.
You might want your business to hedge that risk as well. So there's places to start. Now, the problem is that the things that academics have found generate premiums in the stock market like value until well, apparently value's not doing so well lately. Momentum has always been a thorn in our sides. These other factors kind of come and go. So we're having our own little replication crisis about whether any of this stuff was real or not, but the factor risks have been much harder to tie to economic fundamentals and therefore to give much of economic advice about who should, and shouldn't be digging. Industry though, is the major factors in the industry, they're not price factors, which is what's wonderful. Academics, we still stuck in spending all of our time chasing alpha for the last remaining mean variance investor and finding a factor portfolio that generates alpha relative to the S&P 500.
Well, we just described a world in which nobody cares about that. So why are we spending all our time doing that? Industry portfolio is a great example. They're really strong factors. Industries tend to move together, but investing in particular industries doesn't really seem to generate much alpha, but nonetheless, so industry portfolios are a great place to start our risk management exercise, because it's free. You don't lose any alpha for underweighting an industry. So weight all your industries according, oh put in a pitch, looks like a lot of people are shunning ESG unpopular industries. That ought to generate a positive alpha for the politically unfavorable industries. Although of course there's always the chance that Washington chimes in and destroys those industries. But when you could find a mass of people selling for a reason that is clearly related to their preferences about society and feeling good and doing good, if you have different preferences about what I don't want to argue for immoral investing, but if you have different views about what's important for society and the planet and so forth going forward, then the large mass of people and advisors and shareholder voting services who are piling into this game presents profit opportunity. So there's a factor risk we can make sense of.
That makes a lot of sense for the unpriced risks. What about the price risks? You mentioned the value factor. So if someone's sitting down deciding how to allocate their portfolio, how does someone decide if they are able to bear the value risk premium?
Well, there used to be a good answer for this back when there was value risk, which I still want, I mean it's done badly in the last 10 years. And in some sense value, that means when they said it was a risk, not a perpetual alpha, they were right. There's a risk it doesn't do well. Certainly when you look at the value stocks, it correlates very much with things that feel like risk. So this was back in the days when there was a reliable value premium. I'll tell you my story for the value premium and who should invest in it. I would start my MBA class on the value stocks by saying value premium, look, isn't this wonderful? We'll look at this wonderful alpha. Let's all invest. And they say, "Yeah, let's all invest."
Then I would get out a list of what the value stocks were. And you would see railroads, you would see Sears Roebuck. You would see company after company on the verge, in old dying industries on the verge of bankruptcy or very low price, just churning out, steel mills churning out earnings at a very low price, no growth opportunities, no sexiness, very little trading, no information content in these industries, whereas the opposite of course is the Googles or the Yahoos, all the sexy ones. And then I'd say, "Okay, who wants to buy these stocks?" And you got to be kidding. I'm not buying that junk over there. I'm buying the sexy stuff over here. You say, "Well, there's a value premium." Looking at it gives you some sense. There was a strong economic difference between the value stocks and the growth stocks. So you could tell a story about people not holding the value stocks.
We tried to tell a story, and actually, the fact that value stocks did badly in the last recession, it was a big puzzle in the '90s that value stocks didn't seem to do badly in recessions. So why are people who are afraid of recessions not buying value stocks? Well, they've started to do badly in recessions. So they're kind of coming back as an economic risk factor in that sense. There's another, we haven't really talked about the view of stock markets as a information, a trading mechanism, and there's the Bitcoin element of stock market valuation is real and is economically true. People do "overpay" for stocks when there's a lot of information and new technology and enormous opportunities and so forth. So another reason if you view stocks, if you view the economic general equilibrium function stocks that way, that's another reason to stay away from, you certainly want to stay away from GameStop.
So anything that's involved in a short squeeze, huge trading to, well, to some extent there's some GameStop involved in Tesla as well, and so if you're a long run investor, that's another argument. If you're not an informed investor, not somebody who's playing the trading game, then there's no reason to hold stocks, a lot of whose valuation is involved in the trading game. So that's another economic reason one might want to hold value stocks. I'm making it up here. This is more and more topics for future research that I wish I could persuade graduate students to pay more attention to.
So you alluded to this earlier, but can you expand on where you see the role of financial advice going forward?
Well, financial industry is it's really, it's a marketing industry, 100%. You're taking generic ingredients off the shelf, putting them in a bottle, putting a label on them and charging, if you can, 100 basis points. So far be it from me to forecast how people will continue to market such, to do such marketing. I did have some thoughts about where it could go. It's kind of funny that we in the efficient market space have been decrying how silly high fee active management is for 50 years now. And there's some inroads of indexing, but it's not going away. So they must be providing something other than just making you feel good by you spend 1% off the top. You spend all of Elizabeth Warren's wealth tax and more voluntarily off the top so that somebody can violate all the theorems of markets for you. Why are you doing that?
But there must be some economic question. And I did try in this essay to say look, there are valuable economic functions. It is true. I talked about how do you hedge yourself against risk of your own business or industry? If you're a very high net worth individual, good, competent investment banks can work this out for you. You may even be subject to, you're not allowed to sell your own company stock. They can get you a rate of return swap or offsetting option position that will help you. That's high tech portfolio advice that's worth the price. And I do think more generally, the stuff we've talked about is hard. I don't know how to do it. How do you take an average investor who's maybe a business owner with a $10 million business and figure out what are the economic risks you're exposed to in your business, how we set up your portfolio so that your portfolio doesn't tank at the same time your business is tanked and your portfolio sets up this payout focused approach for your own retirement and that of your kids.
That's hard. We've just spent an hour talking about which factors correspond to which economic risks and how do different horizons, that's hard. I don't know how to do that, but that's all stuff that is not chasing alpha. So it's typically sold as come to us, we're smarter than the other guy. We'll give you this magic alpha, but we know half the people selling that are wrong. And we know from empirical studies that active management does not generate alpha. So that's hopeless, but look at all the other stuff, all the hard things me talking about, give me a business with $100 million and a bunch of quants and a good marketing staff, I ought to be able to make some progress on these hard issues and not just be a blogger spouting opinions on a podcast to say nothing of decent tax advice.
I'm still astounded how frequently professional advisors charging fees will recommend that people take short term capital gains. Guys, number one, never take a short term capital gain. Why would you pay ordinary income on this investment? They don't even think about tax strategies. So there's an example of it's perhaps zero sum to society, but it's not zero sum to you and the advisor. Extremely complicated tax code is something that professional advice in portfolio handling ought to be able to help. So those are examples of, I think there are good services to say nothing of just the record keeping part of it. That's not worth the whole percent off the top, but certainly all this heterogeneity, horizon risk management approach is that strikes me as something financial management could and perhaps they are in ways that I don't really appreciate. And that just people like the marketing of alpha and we're smarter than the other guy. But in fact, they are helping to tailor portfolios. Anyway, that's what makes sense.
It was implied in your answer earlier about the zero sum portion of what you can do and the non-zero sum portion, that makes sense as an answer, that the part that's not zero sum to the individual, it would make sense to be getting advice on that piece as opposed to be.
Yeah, which is, is this investment right for you? Now when the advisor says, "This is a great investment, everyone should buy it." Now we're back into magic alpha land. And a good question I suggested for when the investment advisor says, "Well, you really ought to be buying value stocks." You should ask, "Okay, who are you advising to buy growth stocks and short value stocks?" And if the answer is nobody, this is golden opportunity, you're back into alpha land.
A party favorite. Could you, and this is something that from what I gather from reading your research is you've been working on this for quite a while and think about it a lot. You got an 800 page PDF on your website that people are free to peruse as I tried to, but I got lost pretty quickly. Could you describe the fiscal theory and how it changes monetary theory?
Yeah, it's a very simple, but I think profound, I wouldn't take 800 pages to do what really could be done in about three, but to answer criticisms. That part is, it should ring true to your asset pricing imperialism. When we think of the price of a stock, where do we start? Well, we start with the value of the stock is the present discounted value of the dividends or earnings company. So how do we think of the value of the U.S. dollar? Well, why don't we start with it's the president discounted value of the stream of fiscal surpluses, which pay off the dollar and all U.S. government debt. So the dollar is just a form of U.S. government debt, especially these days. Cash is kind of a historical anachronism, but reserves pay interest at the Fed. They are just overnight U.S. government debt. So just throw all government debt in what determines the nominal value of government debt.
Well, how about the present value of surpluses? When you look at the same equation holds for stocks as for government debt. The value of government debt is the value of the fiscal surpluses that retire. That statement should not make you feel very comfortable about current affairs, by the way. So that's a fiscal theory and it's a beautiful theory, but it makes it interesting to contrast in all the other ways that people currently think about inflation, that inflation is entirely about too much money chasing too few goods that the Federal Reserve controls inflation, not by controlling the amount of government debt or the likelihood of its repayment, but by controlling how much of the debt is in reserves and how much of the debt is in one month treasury bills, that somehow the split between different kinds of debt is crucial to the price. Fiscal theory says it's kind of in big terms. What really matters is the overall quantity of debt and people's guesses about how likely it is to be repaid. So that's a simple theory, but then how does it compare to classic theories? How do you begin to think about events? How do you begin to think about policy? That's what takes 800 pages.
Yeah, okay, okay, okay. You were on Tyler Cowen's podcast and he asked you what fiscal theory predicts about inflation, and you said, theories make conditional predictions only. So I wanted to ask what does the fiscal theory conditionally predict about inflation in the current environment?
So let me explain. I'm very reluctant to say I think the stock market going up are going down, or I think inflation's going up or going down. I think what I meant by conditional economics in general is better at if you do X, the world will change in Y direction rather than here's what's going to happen. And so, the fiscal theory says fundamentally that inflation comes from the total amount of government debt relative to people's faith that the government will sooner or later raise taxes or cut spending and raise taxes in a way that doesn't destroy, I mean doesn't destroy the economy, raise tax revenues, which really means reform our tax system to generate more revenue at less economic damage in perfectly easy, obvious ways or reform its spending to not be drunken sailor spending. It's sooner or later bond holders will get paid back.
People are remarkably patient with the U.S. government on this issue because I think they figure that America will once again do the right thing after we've tried everything else. So right now, bond holders are willing to lend money to the U.S. government at astonishingly low interest rates, despite no clear picture of how or when that debt's going to get paid back. Inflation comes when people lose their faith. Now that's a hard thing to predict. It has a lot of the mechanics of a run. Our government rolls over short term debt. So really, people start dumping government debt today, not when they think there's going to be a fiscal problem five or 10 years from now. They start dumping debt today when they think somebody else won't be here next year in order to lend the government new money to pay me back. That's how we do stuff in the U.S.
So there's a lot of, that's why it's so hard to predict when this event happens, but it certainly points to that the danger we face right now is that danger of that kind of generalized loss of faith, that the U.S. government is good for its debts. And I want to get out before the other guy gets out. So it points to a scenario, inflation just kind of zooming out of control, even though the Fed is making all sorts of soothing speeches and even though the Treasury is making all sorts of soothing speeches, and that's an inflation that's much, there's not much the fed can do about it. If you're the governor of the Central Bank of Argentina and people are abandoning your government debt and your currency, you can make all sorts of great speeches about our future policy and our framework and our tools and so forth.
Peso's going to go down. So I do think it paints a picture of a fiscally driven inflation and the Fed has less power. I think the Fed does have substantial power, even under the fiscal theory. And so conventional monetary policy can work, but there's this fiscal thing that threatens us sort of in the way an earthquake threatens California. I can't tell you when it's going to happen, but I can tell you we're sitting on an earthquake fault.
Did breakeven rates tell us anything? Like they're pretty low right now, does that mean we expect low inflation?
Those markets do not expect inflation in the near future. But remember my sermon about risk management, nobody expects the Spanish inquisition. Nobody expects a bank run and nobody expects inflation. And you look at breakeven rates in the 1970s. You just, well, there weren't breakeven rates because we didn't have tips, but you look at long term bond rates, long term bonds did not see any of the waves of inflation in the 1970s coming. They did not see any of the waves of less inflation coming. And they certainly did not see that the 1980s was going to be a victory over inflation. Bond yields went up and long term bond yields stayed up throughout the decade of the 1970s and the '80s, which you could think of, one way of thinking of this is people weren't sure this one was going to work. So they certainly did not see that it was going to work. So that financial markets don't see this coming just tells you, that reinforces that inflation has the same kind of random walkie tendencies that stocks have for the same kind of very good reasons. If we knew that inflation was going to go up next year and you're running a business, what do you do? You raise your prices right now. And so we get inflation right now.
So I just told you why inflation's unpredictable for exactly, if you knew the stock market was going to go up next year, what do you do? Buy. And then the stock market would go up right now. So there's every reason to think that it's a risk, not a foreseeable event.
So we have to ask you about crypto. Do you think digital currencies like Bitcoin will maintain their value in the long run?
No. Long run, long run, long run. I can go against you for a long time. I'm very interested by digital currency. I'm very interested in new technology from an electronic point of view and zero new technology from a financial or economic point of view. So Bitcoin kind of reinvented gold. We sort of know how gold works with one crucial problem relative to gold, that it's easy to make substitutes. So the demand for Bitcoin is the demand for anonymous transactions, which is a polite way of saying who's using Bitcoin these days, but should Bitcoin get overpriced?
There's like 15 other ones. So there's nothing. Bitcoin was smart. There's rules against creating a Bitcoin, but there's no rules against creating another Bitcoin or forwarding Bitcoin or something of that sort. So I can't see how Bitcoin itself will maintain its value in the long run. And it's been kind of fun to watch the crypto space rediscover the theory of money and the theory of banking. The next thing is, oh, I guess we need Stablecoins. So that was invented in about 1760. It's called a bank, where we promise a fixed value redemption and we have some assets out there, except running a bank is much more fun if your reserves are less than the amount that you issue, because then you make a lot more money. So we have sort of backed, sort of Stablecoins that are open to the same runs that were open back then.
I think we're going to go to a digital dollar of some sort. I think there is a long run issue that will stick with us, not the value of Bitcoin. We need electronic transactions and I've been arguing that the Fed and Treasury should get their acts together and do for electronic money what they did in the 19th century for notes. We used to have bank notes. The government did not issue currency. Only banks issued currency, and there was always runs and crashes. So the late 19th century, the government said, "End of this guys, you may not issue currency. We're going to issue all the currency." We haven't seen a run on a dollar bill since. So we need a electronic currency furnished by the government, or at least to allow narrow banks to emerge. The Fed is on a war against narrow banks, because they threaten the profits of real banks.
But to allow companies that are just payment system companies who offer you a deposit that's 100% backed. If we had that, we would never have a financial crisis again. And it's only the profits that the current banks keeping us in the way of having a financial system that never has a crash again. But the core of that is either opening up reserves to companies that are just payment companies and offer you digital dollars. And they don't, so Bitcoin is about decentral ledger versus central ledger and so forth. I don't want to get into that. Actually central ledger is just much more efficient so electronic money does not have to be a cryptocurrency, a decentralized ledger. In fact, it's much more efficient if we just have a central ledger.
The problem that is causing this to stick in the throats of every central bank, one is maintaining the profits of the existing banking system. The other big one is anonymity. Cash is anonymous and we're kind of at a nice equilibrium with cash where you can use it for all the things you want to stay private about, including a certain amount of avoiding the kinds of taxes and regulations that would bring the economy to a halt. If we monitor all taxes, if we monitor all payments, every undocumented immigrant, 11 million people is out of a job and in the streets right now. So there's a reason we tolerate cash. But the problem with anonymity on a digital scale is you have ransomware, you have North Korea, you have all the people we want to do sanctions with and allowing people enough anonymity and privacy to keep a democracy going, but not to make a crime and tax evasion just go through the roof is really where they are stuck.
And there's ways to get out of that stuck. But they have to be willing to tolerate some stuff they don't want to tolerate. But anyway, so definitely I want to say digital payments are coming and have to be coming. They are not likely to be cryptocurrencies because decentralized ledgers are just so inefficient. They're likely to be something like narrow banks, which in other words, electronic transactions that are not funneled through a banking system and loans and all the rest of it until the great sovereign debt crisis happens. I mean, Bitcoin is, what is the question to which Bitcoin is the answer? Part of that is how do I get money into Venezuela and out of the U.S. and how do I do ransomware? But part of the genuine question, it was kind of a libertarian dream of how do we provide a money in the state of the world where the U.S. sovereign debt has exploded.
Nobody trusts government debt anymore. The banking system is completely exploded, yet somehow the internet still works. It's the famous Ron Paul portfolio. It's the guns and beans and ammo portfolio. It's very inefficient as a transactions mean, but it was designed to be a replacement currency. Now, a replacement for government provided unit of account, not just government provided currency, we know how to do that. We make a narrow bank. We make a currency that promises to pay in dollars or assets that are in dollars. But how do you provide something that is a separate unit of account? That's an interesting question. I haven't worked on it a lot because I hope that the U.S. will not go into the kind of sovereign debt crisis that unseats the U.S. dollar from the core of all financial system. But that's the other interesting thing that Bitcoin sort of offers, but it's so kludgy. It's kind of like holding gold bars in your basement at the moment. Not very useful until that world comes.
You touched on this. So I don't know if we need to go too much more into detail because you kind of already answered the question, but Cam Harvey's got a book coming out about DeFi, decentralized finance. Do you think traditional finance is in trouble or is centralized finance going to continue to be the thing?
Cam's a good friend, buddy and always a creative guy. Haven't read his book yet.
It's not out yet. I guess you could have gotten a draft, yeah.
I could have gotten a draft if I had asked. Now it depends on what we mean by traditional. Traditional banking is steadily being undermined, so like loan origination has already moved out of traditional banks. Part of reason it's being undermined is because it's regulated to death. And so innovation to get around regulation is often good and often disastrous. You want innovation to be around providing better products to customers. The innovations involved in some of the stuff that fell apart in 2008 were getting around existing bad regulations, but they proved to be just as fragile themselves. So there's a strong force for getting around traditional banking is awful and inefficient. The fact that we're still paying 3% to 4% fees to make simple transactions is a scandal, but there's a lot of regulation keeping that in place.
So the possibilities of modern financial and computational technology to make financial products much better and incidentally incredibly safer is certainly there. Imagine a world where you pay for your coffee by swiping your phone and instantly selling, not for three day settlement, instantly selling a share of an S&P index fund. That is a very exciting world for payments and a similar world where your loans don't come from a bank, but you know what you actually need a traditional bank for is less and less these days. So the opportunities are there to do really exciting things in finance. Will the regulators let us? Notice how many new banks have come in place in the last 10 years, practically none.
Very interesting. All right, we've just got a couple more questions for you here, John. Gene Fama is your father-in-law. If you guys are sitting around the table at a holiday dinner on financial economics, keep it to that. Is there anything that you guys disagree about?
Oh yeah, lots of stuff although I always learn from Gene, so we tend not to fight that much. We tend to keep finance in the office and other stuff at home.
That makes sense. That makes sense.
But I'm not going to tell you.
My last question.
Well, actually I thought this, you wrote this. No, I'm not going to tell you.
Come on.
Gene is a great guy. And if you disagree with Gene Fama, you should read the paper again.
It's funny. So our last question, John and our listener favorite, how do you define success in your life?
Oh, we're here for the pursuit of happiness, right? I define success as well, my pursuit of happiness is related to productivity. I feel better when I'm producing ideas and people pay attention to them and I try to be a good person, a good father, colleague, husband, companion, friend and participant in various institutions. I think one gains great satisfaction from trying to live at an ethical, straight arrow life. That's something I learned from Gene Fama a long time ago. If it feels icky, don't do it. So what else is there to say?
Great answer and a great way to end. Yep, phenomenal interview John. Thanks for your time so much. You shared lots of great ideas here today and we really appreciate it. Thank you.
Thank you guys.
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'Portfolios for Long-Term Investors' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3790823
'A Fiscal Theory of Monetary Policy with Partially-Repaid Long-Term Debt' — https://www.johnhcochrane.com/research-all/a-fiscal-theory-of-monetary-policy-with-partially-repaid-long-term-debt?rq=fiscal%20theory
Ken French 'Current Research Returns' — https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html