In a recent course (AFM 424) we were asked to write an essay  about why the financial markets are so disconnected from the fundamentals of the real economy. This led me to explore various economic theories that attempt to explain today’s situation.

Many theories have been proposed by economists below are a few of them:

  • Debt Overhang (Kenneth Rogoff)
  • Global Savings Glut (Ben Bernanke)
  • Liquidity Trap (Paul Krugman)
  • Secular Stagnation (Larry Summers)
  • Safety Trap (Emanuel Farhi)

I will discuss the last two theories as they are relevant to financial markets (others are equally relevant too), and best non-technical explanations are available for them.

Secular Stagnation

The theory of secular stagnation suggests that there is an excess of savings over investment in the economy. There are many factors that explain why savings have increased and investment has come down. Savings have increased as a result of income inequality, increased length of retirement, and uncertainty with respect to the future. Lower investment is driven by slower growth in labour force, cheaper capital goods, and tighter credit controls as a result of regulation.

The increase in the amount of savings has led to an increase in demand for financial assets. Further, falling interest rates due to central bank intervention have forced the investors to turn to riskier assets like stocks in search for higher yields . There are not enough assets in the market due to a shortfall in investment, which has led to an unprecedented inflation in asset prices not warranted by the fundamental factors of the real economy. This has caused a sort of stagnation across the economy moreover, the long term forecast also pegs the US benchmark rate no more than 3% implying that the stagnation is here to stay.

The Safety Trap

Emanuel Farhi of Harvard University has put forth another explanation for the current economic phenomena. He calls it the Safety Trap. According to Farhi the increase in propensity to save has increased the demand of ‘safe’ assets. The situation is exacerbated by destruction of a large class of such assets (think synthetic CDOs) which has driven the prices of many such assets through the roof and yields downwards. What Farhi argues is that as interest rates approach the zero-lower-bound (ZLB) yields on the assets cannot fall further, and the prices are still going up this creates another equilibrating mechanism through a fall in output in other words a recession. Such a recession would force the interest rates upwards and the market will clear.

Both of the theories suggest a low growth economy at best. Highly inflated financial asset prices are a common theme in all the above ideas. This analysis suggest caution against a bubble in asset prices, which are bound to correct with time. I hope this makes some sense and drives curiosity to probe further. I have included a bibliography of sorts of articles, videos, and books that will help you explore these ideas further.

References:

1 http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/

2 https://m.youtube.com/watch?v=N2AH8HMpEnM

3 https://m.youtube.com/watch?v=xvmhkng-MmM

4 http://scholar.harvard.edu/files/farhi/files/safetytrap011117_ef.pdf

5 The Age of Stagnation by Satyajit Das (https://goo.gl/ImfRX5)

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