Investment Externalities and Investors' Search for Yield
Many people have rules upon which they lead their lives and conduct their behavior; in fact, one could argue that most people would subscribe to this some way or the other. My readers should immediately be assured that I am not in the process of morphing Alpha.Sources into some kind of quasi philosophical column; nor would I dare embark on an account of the specific rules I live by myself. However, one very simple rule which I have found quite useful is what I have chosen to dub the "one paper a week" rule. Quite simply and given the almost extreme amount of interesting punditry being served up by econblogs I have had to submit myself to the rule that at least one academic paper should be read each week alongside the almost endless (and much enjoyable) reading of more analytical and commentary nature.
Most of the times these papers don't make it above the fold at Alpha.Sources (although they may well make to Beta.Sources). However, this week I stumbled upon a paper which may in fact be of interest to others.
This note presents a simple model that nests the “excess liquidity” and “savings glut” hypotheses of the debate on the recent asset price boom. It clarifies the notion of investors’ ‘search for yield’ and shows how financial frictions influence asset price dynamics.
Yep, I know; not the most clarifying of abstracts but don't be fooled. The key for me is consequently the attempt (or desire) to link the three concepts of excess liquidity, savings glut and the idea of investors' search for yield. In my opinion this must be one of the most fundamental endeavors in the context of understanding the global economy. In my own work on the global economy (e.g. here and here) I have consistently been trying to link these three concepts not least in the context of global demographics. The authors of the present study don't mention demographics as such, although one could argue that the inclusion of the savings glut hypothesis as originally conceived by Ben Bernanke implicitly incorporates some variant of a global life cycle analysis. The omission of demographics and in particular the life cycle perspective with which the excess liquidity and yield hunger concepts can be conceptualized is important. Yet, ultimately I don't think it demotes the conclusions of this small working paper.
More to the point the authors present their work as follows (link to Blanchard added by me):
We present a simple model, inspired by Blanchard (1981) and Krugman (1991), that nests the “excess liquidity” and “savings glut” hypotheses of the current debate on the global asset market boom. Our paper clarifies the notion of a
search for yield and shows how financial frictions affecting the ability of agents to make markets for risky securities might influence asset price dynamics. Our analysis also demonstrates how asset prices driven by investors’ “ search for yield” could have negative consequences for financial stability.
The key for me in the context of this study is the specification of the gamma coefficient (see pp 4-5) which denotes positive network externalities. The idea is simple and instructive. If gamma equals 0 the value of the asset is equal to the fundamental value but if gamma is larger than one the investment in an asset will have positive network externalities thus inciting increased investment in that asset (see Plantin and Shin (2007) and Brunnermeier and Pedersen (2007)). As with all equilibrium models the operationalization is a gross simplification. Basically, the authors restrict investors to two choices; one is to invest in a high yielding asset and one is to invest in the low yielding asset. I won't go into the derivation of the steady state here but the conclusion that emerges is quite interesting (not least in the context of my before mentioned paper on carry trade). Basically, there are two possible steady state equilibria in the model.
The first is that all investors move into the high yielding asset and the second that none of the investors invest their 'initial endowment.' More interestingly, the authors show how the equilibrium depends on the strength of gamma (i.e. the positive network externality effects). More specifically, it means that if inflows are expected to increase into the high yield asset investors will exhibit a herd like behaviour. This strikes me as very close to the dynamics of the carry trade I try to account for in my paper on carry trading currencies.
The positive externalities (e.g. in the spot currency markets) can consequently be operationalized through the idea that as investors move into carry trades the impetus for piggy backing is large. Remember here that as carry trading activity increases the funding assets (low yielders) will have a tendency to depreciate relative to the high yielding assets. In fact, in reality it should increase in the movement of funds which suggests that this gamma coefficient is not stable over different values of t (i.e. if we take a multi period perspective). The idea would simply be that that as the size of global liquidity moves into carry trades (i.e. exploiting yield differentials) the pressure on the low yielding assets will intensify.
However, and by investigating daily returns, I also show in my paper how such 'externalities' can be prone to significant volatility. In fact, it is very easy to see that the idea of a stable equilibrium here is not "viable" since it seems as if the "search for yield" while fundamental in the long term (I will accept that it may then be an equilibrium in the long run as all investors go for high yield) is also prone to a very sensitive on/off switch pending on the risk sentiment in the market.
Now, as my readers, with a more than passing interest in such matters, can see the plot thickens. What we have on our hands here on the basis of monsieurs Gai and Trivedi is thus an entry point into a fundamental discussion of what it means that investors go for yield in the global economy, whether such investment behaviour is stable and what it means for the global economy. Two important conclusions can thus be derived from this study.
- The first is simply the need to look at the concepts of excess liquidity, global savings glut, and investors' search for yield. As I will argue in the context of the second point I also think that global life cycle perspective is needed here and thus that demographics be included. One could obviously argue that the savings glut hypothesis represents this view but I am more ambitious than as such. One crucial question to ask would be the question of what it actually means to be 'old' in a macroeconomic context? Specifically, I am talking about old in an absolute sense and the important point that the global economies all may be converging towards this same point.
- Secondly we have the idea of externalities of investment behavior which is hardly a new conception in the modern annals of finance. First of all, I should note that I like the model presented in the paper by Gai and Trivedi and I do think that the model may stick if subjected to a real life experiment. However, as I have tried to articulate above the distinction between short term unstable equilibria and a long term equilibrium in which all investors ultimately (have to) go for yield is important. More importantly though is the point I have been elaborating before (here and here) in the context of the externalities of investors' long term search for yield. Another way to operationalize the externalities in this regard would then be to ask what it actually means that the world is growing older in an absolute sense. As I have noted before one way to conceptualize this would be to invoke the inter temporal current account and thus how economies will tend to crowd in one end of the spectrum as a result of ageing; i.e. everybody wants to be export dependent. My feeling is that the externalities presented in the present study could be expanded to cover the obvious externalities that would arise as economies (and by derivative investors, e.g. in the form of pension funds) are forced to live off of their accumulated savings (i.e. the rolling external surplus).
The work goes on ... but the economic concept of externalities (positive as well as negative) should definitely be explored more thoroughly in this specific context.
List of References (as noted above)
Blanchard, O (1981), Output, the stock market and interest rates, American Economic Review, 71, 132-143.
Brunnermeier, M and L Pedersen (2007), Market liquidity and funding liquidity, mimeo, Princeton University.
Krugman, P (1991), History versus expectations, Quarterly Journal of Economics, 106, 651-667.
Shin, H S (2005), Liquidity and twin crises, Economic Notes, 34(3), 257-277.