September 2019. GrowthPolicy’s Devjani Roy interviewed John Y. Campbell, Morton L. and Carole S. Olshan Professor of Economics at Harvard University, on the current investing environment, asset pricing, stock market lessons from India, and solutions for financial crises. | Read more interviews like this one.
GrowthPolicy.org. One of your renowned contributions to the field of asset pricing theory is the stochastic discount factor model. Would you tell our readers why this model is both significant and different from the various extant financial models of time-and-risk related discounting?
John Campbell: The stochastic discount factor approach is a unified framework for thinking about asset pricing. It gives economists a common language in which we can express different views of the economic forces driving asset markets. Any specific model in which there are no arbitrage opportunities—that is, no ways to get money with no risk and no initial investment—can be expressed in the language of the stochastic discount factor or “SDF.” I did not invent the SDF approach but I have used it extensively in my work. One of the things I have always emphasized is that the rewards for taking risk in asset markets seem to vary over time. As a specific example, the equity premium (the expected excess return on stocks over safe money market investments) was much higher in the recession of the early 1980s, and again during the global financial crisis in late 2008, than it was in a boom time such as the year 2000. To explain this one needs a model in which the volatility of the SDF varies over time. At each point in time and in each possible state of nature, the SDF is proportional to the marginal utility of wealth for investors—that is, the value investors place on an extra dollar. So the question becomes, why is this marginal utility more volatile in recessions than in booms? In a 1999 paper I wrote with John Cochrane, we argued that this is because investors have habits: components of consumption that they are used to having and that they are completely unwilling to adjust. Only spending above the level of habit or “surplus consumption” delivers utility. In a model like this, shocks to spending are much more consequential when consumption is close to habit, as in a recession, than when people have a large cushion of surplus consumption, as in a boom. Thus, investors become more cautious and demand a higher equity premium in a recession.
GrowthPolicy.org. In May this year, you spoke on the topic of “Long-Term Investing in a Nonstationary World” at the NBER Long-Term Asset Management Conference. Some might say multiple macroeconomic indicators show that we are, quite literally, in a “non-stationary world.” For instance: Since January 2018, Purchasing Managers’ Indices have been falling in every major economy with the exception of India; economies in the Eurozone have been slowing down; and the future of Brexit currently has Britain teetering on an economic precipice. I have two questions: Do you believe we are heading towards a global recession? Second, how should conservative investors “read” the current investing environment?
John Campbell: There are certainly downside risks to global output. Some of these come from policy itself, as countries with populist governments undermine the global rules-based economic system with policies that increase trade barriers. More generally, populism makes businesses uncertain about the framework that they must operate in, and accordingly reluctant to invest. Even if policy does not start a recession, it is hard to have faith that populist governments will know how to respond effectively to any downturn that does occur. As Michael Gove in Britain memorably put it, “the British people are tired of experts,” and economists are losing influence on fiscal policy. While we still have a competent generation of central bankers, populist leaders are likely to appoint less competent successors so monetary policymakers also may become less effective. Even when central bankers are competent, they now have fewer tools at their disposal than was the case ten years ago. Nominal interest rates are much lower, so there is less room to cut them; and after the political backlash to the actions taken in the global financial crisis, central banks now have less discretion to stabilize the financial system. Despite all these downside risks, we are not yet in a recession and investors remain willing to take many types of financial risks. The way I read today’s markets is that many risk premia such as term spreads and credit spreads are unusually low. The equity premium seems to be close to historical average levels, however, which means that stock market investing remains attractive. I suggest that even conservative investors should continue to hold stocks, perhaps overweighting low-volatility, low-beta stocks as a way to reduce risk while giving up surprisingly little average return.
GrowthPolicy.org. In a recent research paper, “Do the Rich Get Richer in the Stock Market? Evidence from India,” you studied returns from wealth held in equity accounts in India. India’s economic trajectory since 1947 has been somewhat sui generis: a period of socialist planning based on the Soviet model, followed by the current period of pro-business, market deregulation based on the Western liberal democratic model. What lessons may we extrapolate from India apropos of patterns in global wealth inequality?
John Campbell: The broad trend of increasing wealth inequality is similar in India to many other countries. Indeed, there was a worldwide shift from regulation and relatively high income taxation in the early postwar period to deregulation and lower taxation in the last 40 years. The shift was more dramatic in India than in developed countries, but it was even more extreme in China than in India. The paper I wrote on India focused on a narrow question, which is the effect of stock market investing on wealth inequality. If wealthy people are able to earn higher returns in financial markets than poorer people, then this will drive up wealth inequality as “the rich get richer”—a point emphasized by Thomas Piketty in Chapter 12 of his famous book Capital in the Twenty-First Century. There are various channels by which the rich may get richer in financial markets. Piketty emphasizes that wealthy people have access to investment vehicles such as hedge funds and private equity, which poorer people cannot invest in. I think that a more important effect is that wealthy people are willing to take more risk and are more likely to participate in the stock market—behavior I and my coauthors have documented in research using Swedish data. Beyond this, even within the set of stock market investors it may be that larger investors do better. My research shows that larger investors earn average simple returns that are comparable to or even slightly lower than those of smaller investors. However, they get these average returns with lower risk because they diversify more effectively. This in turn means that on average their wealth grows faster, worsening wealth inequality. The lesson for policymakers is that it is important to create financial markets that are as far as possible a level playing field for small and large investors. Above all, this means encouraging the creation of cheap, well-diversified investment vehicles such as indexed mutual funds. Mutual funds were not widely used in India until recently, and this undermined the benefits of stock market participation for small investors.
GrowthPolicy.org. In January 2019, 3,554 economists, including yourself, were signatories to a landmark unified statement on carbon dividends. The statement is constructed on five pillars, all based on a carbon tax. Proposals for climate change policies have become a part of the ongoing, rather contentious political conversation, based especially around the upcoming U.S. Presidential election. In what ways can carbon-pricing instruments, whether in the form of carbon taxes, cap-and-trade mechanisms, or others, respond to voter concerns and the biases embedded in public perceptions? Second, do you hold the opinion that carbon taxes constitute the only policy instrument at our disposal or are there other solutions you see as an economist?
John Campbell: For some time now there has been a broad consensus among economists that carbon pricing is an effective way to harness the energy of capitalism to address the very real problem of climate change. Carbon taxes are a particularly simple way to set prices that incentivize consumers to shift away from carbon-intensive products, and firms to shift away from carbon-intensive production methods. Unfortunately, politicians and the public have not shared economists’ enthusiasm for carbon taxes. One reason for this is that carbon tax proposals have not always been clear enough on what will happen to the revenue raised. If revenue is returned to the public in the form of lump-sum carbon dividends, then people with lower-than-average carbon footprints will gain from carbon taxation. If the public can be made to understand this, then I hope that opposition to carbon taxes can be weakened—even though those with high carbon footprints will still lose from the policy and may remain opposed to it. A second problem with carbon taxation is the possibility that it can be evaded by importing carbon-intensive products from other countries. This problem can be handled by border adjustments, which I believe are vital both for the effectiveness of a carbon tax and for its political acceptability. While carbon taxation can be extremely effective, it is certainly not the only instrument of public policy that is available. The government also has an important role in promoting basic research into low-carbon energy sources, and in lowering regulatory barriers to the use of clean energy. Most experts feel that nuclear power is an important part of the solution, but nuclear power plants have become uneconomic to build in the U.S. largely because of regulation and one-plant-at-a-time design that does not realize economies of scale. Public policy should certainly try to address these problems. Finally, while economists naturally focus on technical aspects of policy, there is also a role for government in mobilizing public opinion and encouraging a sense that carbon reduction is a moral imperative. While it is easy to mock the utopian language of the “Green New Deal” proposal, it is at least a serious effort at political mobilization—which, if successful, will enhance the political viability of technocratic responses to climate change.
Growthpolicy.org. How should we prevent the next financial crisis?
John Campbell: A precondition for a financial crisis is that risky assets are concentrated on the books of specialized investors who have borrowed to hold them. When asset values fall, these leveraged investors enter financial distress and must act quickly to restore their financial position. They may engage in disorderly “fire sales” which lower asset prices further and worsen the crisis. To prevent this downward spiral, policy can act at various stages. Most obviously, leverage can be regulated through capital requirements. Considerable progress has been made in raising capital requirements during the last ten years, although there remains concern that large banks are vulnerable as indicated by the continuing high volatility of their stock returns. A danger here is that this approach may simply shift risky assets from the books of tightly regulated institutions to the books of less-regulated institutions sometimes known as “shadow banks.” Capital regulation needs to be broadly applied to be effective. Once a crisis starts, policy can help by requiring recapitalization of distressed institutions through equity issuance rather than through asset sales. It can also help by providing information about financial institutions’ soundness to the marketplace, for example through stress tests. At the most basic level of financial system design, policymakers should consider ways to limit the need for leverage in the first place. If risks are broadly distributed, then there is less need for leverage to finance risky asset holdings. And if the demand for short-term safe assets by households can be largely met by the public sector, there will be less demand for potentially problematic short-term debt issued by the private sector. Finally, we should avoid creating unnecessary endogenous risks. Refinanceable fixed-rate mortgages are problematic in part because borrowers do not know how to handle their option to refinance and so their mortgage prepayment behavior is hard to predict. In effect, the mortgage system creates an artificial risk that the financial sector must then manage. Simplicity and transparency should be guiding principles of financial system design.