The Economic Costs of Fear

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– The S&P stock index now yields a 7% real (inflation-adjusted)return. By contrast, the annual real interest rate on the five-year UnitedStates Treasury Inflation-Protected Security (TIPS) is -1.02%. Yes, there is a“minus” sign in front of that: if you buy the five-year TIPS, each year overthe next five years the US Treasury will pay you in interest the past year’sconsumer inflation rate minus 1.02%. Even the annual real interest rate on the30-year TIPS is only 0.63% – and you run a large risk that its value willdecline at some point over the next generation, implying a big loss if you needto sell it before maturity.

So, imagine that you invest $10,000 in the S&P index. This year, yourshare of the profits made by those companies will be $700. Now, imagine that,of that total, the companies pay out $250 in dividends (which you reinvest tobuy more stock) and retain $450 in earnings to reinvest in their businesses. Ifthe companies’ managers do their job, that reinvestment will boost the value ofyour shares to $10,450. Add to that the $250 of newly-bought shares, and nextyear the portfolio will be worth $10,700 – more if stock-market valuationsrise, and less if they fall.

In fact, over any past period long enough for waves of optimism andpessimism to cancel each other out, the average earnings yield on the S&Pindex has been a good guide to the return on the portfolio. So, if you invest$10,000 in the S&P for the next five years, you can reasonably expect (withenormous upside and downside risks) to make about 7% per year, leaving you witha compounded profit in inflation-adjusteddollars of $4,191. If you invest $10,000 in the five-year TIPS, you canconfidently expect a five-year loss of $510.

That is an extraordinary gap in the returns that you can reasonablyexpect. It naturally raises the question: why aren’t people moving their moneyfrom TIPS (and US Treasury bonds and other safe assets) to stocks (and otherrelatively risky assets)?

People have different reasons. And many people’s thinking is not terriblycoherent. But there appear to be two main explanations.

First, many people are uncertain that current conditions will continue.Most economists forecast the world a year from now to look a lot like the worldtoday, with unemployment and profit margins about the same, wages and prices onaverage about 1.5% higher, total production up roughly 2%, and risks on boththe upside and the downside. But many investors see a substantial chance of2008 and 2009 redux, whether triggered by afull-fledged euro crisis or by some black swanthat we do not yet see, and fear that, unlike in 2008 and 2009, governmentswould lack the power and will to cushion theeconomic impact.

These investors do not view the 7% annual return on stocks as an averageexpectation, with downside risks counterbalanced by upside opportunities.Rather, they see a good-scenario outcome that only the foolhardywould trust.

Second, many people do see the 7% return on stocks as a reasonableexpectation, and would jump at the chance to grab it – plus the opportunity ofsurprises on the upside – but they do not think that they can afford to run thedownside risks. Indeed, the world seems a much more risky place than it seemedfive or ten years ago. The burden of existing debts is high, and investors’ keygoal is loss-avoidance, not profit-seeking.

Both reasons reflect a massive failure of our economic institutions. Thefirst reason betrays a lack of trust that governments can and will do the jobthat they learned how to do in the Great Depression: keep the flow of spendingstable so that big depressions with long-lasting, double-digit unemployment donot recur. The second reveals the financial industry’s failure adequately tomobilize society’s risk-bearing capacity for the service of enterprise.

As individuals, we appear to view a gamble that has a roughly 50% chanceof doubling our wealth and a roughly 50% chance of halving it as worthy ofconsideration – not a no-brainer, but not out of the question, either. Well-functioningfinancial markets would mobilize that risk-bearing capacity and put it to use for the benefit of all, so thatpeople who did not think that they could run the risks of stock ownership couldlay that risk off onto others for a reasonable fee.

As an economist, I find this state of affairs frustrating. We know, or atleast we ought to know, how to build political institutions that accept themission of macroeconomic stabilization, and how to build financial institutionsto mobilize risk-bearing capacity and spread risk. Yet, to a remarkable degree,we have failed to do so.

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关键词：Economic econom costs Econo fear contrast interest annual return

The S&Pstock index now yields a 7% real (inflation-adjusted) return. By contrast, theannual real interest rate on the five-year United States TreasuryInflation-Protected Security (TIPS) is -1.02%.So, if you invest $10,000 in the S&P for the nextfive years, you can reasonably expect (with enormous upside and downside risks)to make about 7% per year, leaving you with a compoundedprofit in inflation-adjusted dollars of $4,191. If you invest $10,000 in thefive-year TIPS, you can confidently expect a five-year loss of $510.
It naturally raises the question: why aren’t peoplemoving their money from TIPS (and US Treasury bonds and other safe assets) tostocks (and other relatively risky assets)?
First, many people are uncertain that currentconditions will continue.

These investors do not view the 7% annual return on stocks as an averageexpectation, with downside risks counterbalanced by upside opportunities.Rather, they see a good-scenario outcome that only the foolhardywould trust.

Second, many people do see the 7% return onstocks as a reasonable expectation, and would jump at the chance to grab it –plus the opportunity of surprises on the upside – but they do not think thatthey can afford to run the downside risks.investors’ key goal is loss-avoidance, notprofit-seeking.

Both reasons reflect a massive failure of our economic institutions. Thefirst reason betrays a lack of trust that governments can and will do the jobthat they learned how to do in the Great Depression: keep the flow of spendingstable so that big depressions with long-lasting, double-digit unemployment donot recur. The second reveals the financial industry’s failure adequately tomobilize society’s risk-bearing capacity for the service of enterprise.