Fearless Financial Markets

A number of thoughtful observers – like Citigroup’s Robert Rubin, Harvard’s Larry Summers, and The Financial Times’s Martin Wolf – have expressed puzzlement in recent months about financial markets’ perceptions of risk. While markets have judged today’s world – especially the dollar and securities linked to it – to have low risk when viewed in historical perspective, geopolitical risks in fact appear to be large. Wolf, for example, argues that financial markets have adopted a head-in-the-sand focus on the “long run of small gains,” ignoring the “occasional calamity” in advance, while losses will be attributed after the fact to “unforeseeable bad luck.”

But if an investor today did wish to insure against geopolitical catastrophe, how would he or she do so? In the generation before World War I, the safe assets were thought to be the debt of governments tied to the gold standard, which supposedly offered protection against the inflationary populist viruses that afflicted countries like Mexico, France, or the United States. But investors in British government debt faced huge losses when Britain’s commitment to World War I produced inflation, and investors in Czarist bonds papered their bathrooms with them after the October Revolution.

After the inflations of World War I, a prudent investor might have thought gold – easily assessable, portable, and real – an attractive asset. But gold is stagnant, while capital is productive. In any case, American gold holders found their wealth involuntarily transformed into paper dollars by the Roosevelt administration at the nadir of the Great Depression. Following World War II, investments in the US seemed safer than any alternative. But, in the 1970’s, investors in American stocks and long-term bonds lost half their principal, and even investors in short-term American debt were down by 20% in real terms by the end of the decade.

Investors fearing geopolitical catastrophe might cope to some degree by raising their consumption spending. But there is a limit to this option. Those who fear geopolitical catastrophe will sell assets, putting downward pressure on their value, only if there are other, safer assets that they see that they can buy. As Harvard’s Robert Barro has recently pointed out, fear of a general or unpredictable catastrophe – even one that spares a subset of assets that cannot be specified in advance – will not affect relative asset prices, because investors have no motive to sell or buy any particular asset.