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In this month’s edition of Research Roundup, we summarize four academic papers touching on topics ranging from behavioral finance to macroeconomics, and from an informed prediction about the future path of interest rates to speculation about the introduction of a Federal Reserve-sponsored digital currency.

If you believe that wealthy buy less insurance because they can live without it,  that financial crisis are brought on by “black swans,” that governments can’t issue digital currency, or that Boomer decumulation will soften the economy, you may find surprises here. These studies aim to put conventional wisdom—or perhaps just straw men, depending on your views—to the test.

Why the wealthy buy more insurance than expected

In theory, wealthier people should buy less insurance, because they can afford to set aside enough savings to “self-insure” against all kinds of risks, large and small, and thereby cut out the costs of the middleman—the life insurance or property/casualty insurance company.  Those risk might include a fender bender, a roof crushed by a storm-felled tree, a “root canal” procedure or—in the case of annuities—outliving their savings. The rich can also afford a high deductible on their insurance policies, thereby keeping their premiums lower.

But research by a team at the University of North Carolina-Chapel Hill shows that “the wealthier have better life and property insurance coverage… This puzzling correlation persists in individual fixed-effects models estimated using 2,500,000 person-month observations,” write Camelia M. Kuhnen, a professor of finance, and Michael J. Gropper, a doctoral candidate in finance, in “Wealth and Insurance Choices: Evidence from US Households” (NBER Working Paper 29069, July 2021).

“Whether we measure wealth by the value of financial assets, or by the value of the homes individuals own, we find that life insurance coverage as well as property insurance coverage increase with wealth, controlling for the value of the insured asset. We estimate that a $1 increase in financial wealth leads to an increase of 68 cents in a person’s term life insurance coverage limit, and to an increase of $2.25 in the coverage limit of their homeowners insurance policy.”

In their study, the two looked at possible causes and effects of this phenomenon. It’s not because the wealthy are pessimistic or risk-averse; optimism about longevity is correlated with higher wealth and higher ownership of term life insurance. “It is possible that the less wealthy do not trust financial products or institutions as much as their better-off counterparts, and thus do not purchase products like insurance. It is also possible that insurance products are being advertised more to those who are wealthier.”

It may simply be that the wealthy have more risk exposures, more wealth to protect, or are better able to afford the expense of insurance.   

‘Black swans’ are the shadows cast by excessive credit 

Financial crises do not appear randomly without warning, regardless of what the “black swan” theories say. “Irrational exuberance” and “animal spirits” don’t explain them either. Instead, new research shows that they typically follow the over-creation of private-sector debt—not public debt.

“Crises are predictable with growth in credit and elevated asset prices playing an especially important role,” write Amir Sufi of the University of Chicago and Alan M. Taylor of the University of California-Davis in “Financial Crises: A Survey” (NBER Working Paper 29155, August 2021). “An understanding of financial crises requires an investigation into the booms that precede them.”

“The unconditional probability of a crisis is 2.5% (one in 40 years)…  However, when the credit growth variable rises one standard deviation (s.d.) above its mean, the expected crisis probability almost doubles to 5% (one in 20 years), and at two s.d. above the mean the expected crisis probability is near 10% (one in 10 years).”

Causes of excessive lending cited in the paper:

Deregulation. Financial “liberalization, by opening a gate, enables other fundamental economic forces in the local or global economy to play out, creating the possibility of new or more elastic financial flows (intermediate claims, or leverage) relative to existing investment opportunities.”

Income inequality. “The rise in top income shares since the 1980s has been associated with a saving glut of the rich. Furthermore, this saving glut of the rich has financed a large rise in household and government debt.”

Low interest rates. “The credit booms that predict financial crises are associated with a low cost of debt, and a low cost of risky debt in particular… Crises are preceded by unusually low and falling credit spreads between higher and lower grade bonds. Riskier firms are able to finance themselves at a relatively lower cost during the credit booms that precede financial crises.”

The bottom line is that we should be able to see financial crises coming. “The empirical evidence rejects the view that financial crises should be viewed as random events. Instead, they are predictable,” Sufi and Taylor write. “Credit growth and asset price growth are key factors that predict financial crises, and these two factors have significant forecasting power.”   

‘Central Bank Digital Currency’ could be coming our way

Central Bank Digital Currencies (CBDCs) are digital or electronic versions of the liabilities (aka IOUs or money) issued by central banks. In most countries, CBDCs are still hypothetical. But China already has a “digital renminbi” and the Bahamas have a “Bahamian Sand Dollar.”

In a speech last March, Fed chairman Jay Powell said, “Experiments with central bank digital currencies (CBDCs) are being conducted at the Board of Governors, as well as complementary efforts by the Federal Reserve Bank of Boston in collaboration with researchers at MIT.”

CBDCs would allow ordinary Americans to have accounts at the Federal Reserve, as commercial banks do. By eliminating, or partly eliminating the middleman (banks) in the daily settlement of transfers between banks at the Fed, CBDC could make the payments process instant and cheaper for Americans. Banks may view it as a threat.

In a new paper, economic historian Michael Bordo of Rutgers University argues in favor of the development of CDBCs in the US. He calls the digitalization of money as momentous a turning  point as the appearance of central banks in the 17th century, the shift from gold and silver coins to  paper money in the 18th and 19th centuries, and the emergence of central bank monopolies over money in the 19th and 20th centuries.

In “Central Bank Digital Currency in Historical Perspective: Another Crossroad in Monetary History” (NBER Working Paper 29171, August 2021), Bordo claims a CBDC in the US would improve the efficiency of the monetary/financial system; neutralize competition from other virtual currencies that could threaten US monetary sovereignty; allow the Fed to set monetary policy by adjusting the interest paid on CBDC accounts, and “revolutionize international payments in the way that the first Atlantic cable did for capital flows and international payments in 1866.”

On the other hand, Federal Reserve board of governors member Christopher Waller said on August 5 that he is “skeptical” of the need for a CBDC in the US. His comments at a meeting of the American Enterprise Institute have been posted at the Federal Reserve’s website.

“Government interventions into the economy should come only to address significant market failures,” Waller wrote. “The competition of a Fed CBDC could disintermediate commercial banks and threaten a division of labor in the financial system that works well. And, as cybersecurity concerns mount, a CBDC could become a new target for those threats.”

Boomer decumulation won’t push interest rates higher

Demographic change, including the aging of populations in many countries, is expected to affect global financial conditions in the future. Economists have posed the question: If retirement saving by the Baby Boom generation led to historically low interest rates, will interest rates rise as Baby Boomers spend down their savings?

In “Demographics, Wealth, and Global Imbalances in the Twenty-First Century” (NBER Working Paper 29161, August 2021) four economists argue that it will not. “Our model predicts that population aging will increase wealth-to-GDP ratios, lower asset returns, and widen global imbalances through the twenty-first century. These conclusions extend to a richer model in which bequests, individual savings, and the tax-and-transfer system all respond to demographic change,” wrote Adrien Auclert and Frederic Martenet of Stanford, Hannes Malmberg of the University of Minnesota and Matthew Rognlie of Northwestern University.

“There will be no great demographic reversal: through the 21st century, population aging will continue to push down global rates of return, with our central estimate being -123 basis points, and push up global wealth-to-GDP, with our central estimate being a 10% increase, or 47 percentage points in levels.”

The study focused on expected changes in the wealth-to-GDP level in 25 countries. In the US, for instance, the total accumulated wealth of the population (including the current market value of financial assets) is about $126 trillion, or about five times the annual Gross Domestic Product ($22.7 trillion in mid-2021, annualized). Rich countries have high wealth-to-GDP ratios; poor countries have low ones. Hong Kong boasts the world’s highest wealth-to-GDP ratio, at 8.4. 

Observers have predicted “that aging will raise interest rates, decrease standards of living by impairing capital accumulation, or exert inflationary pressure as the number of consumers increases relative to the number of producers. These predictions are not borne out in our analysis,” the authors said.

© 2021 RIJ Publishing LLC. All rights reserved.

The “gold standard” died 50 years ago this week. I witnessed the execution, in a sense, and I’ve spent a fair amount of time since then trying to understand what happened, why, and how well it explains today’s economy.     

The date was August 16, 1971. The scene was a provincial bank in France. I had pedaled north from Fontainebleau that morning, following the Seine to Paris. At the outskirts of Melun, I leaned my bike with its saddlebags against a stone wall outside the bank and walked inside. 

The teller seemed flustered, even panicky. Richard Nixon had taken dollar “off gold” the day before; she wasn’t sure how many francs to exchange for my $20 travelers check. Eventually, calmer, she gave me about four francs per dollar—the usual rate. I countersigned my check, pocketed the money and left.

“Bretton Woods,” and the eponymous financial treaty that the US had just broken, didn’t mean anything to me at the time. I had just spent ten picaresque weeks in southern Europe on a budget of about $10 a day, vaguely aware of why everything was so cheap. The future—the oil crisis and the “stagflationary” 70s—was still over the horizon.

A whistle-stop in New Hampshire

Mount Washington Hotel

Bretton Woods is a section of Carroll, New Hampshire, and the home of the still elegant Mount Washington Hotel. That’s where, in July 1944, to escape the swelter of Washington, DC, for the cool White Mountains, the world’s finance ministers met to replace an international monetary system whose perverse incentives helped cause two world wars in 30 years.

Or, rather, the ministers came to rubber-stamp the new dollar-based regime, designed mainly by the Roosevelt administration. Given America’s economic strength and the fragility of Britain’s empire near the end of World War II, America was in a position to replace England as the world’s economic leader and the dollar to replace the pound as the world’s “reserve” currency.

The dollar became a proxy for gold and a benchmark for all other currencies. Under the Bretton Woods agreement, the US (with 55% of the world’s yellow bullion) was the only country that would exchange its money for gold on demand from foreign central banks. Dollars, backed by about $25 billion in gold, would and did help finance the economic recovery of a war-whacked world.

The boom—including the Baby Boom—lasted through the mid-1960s. By then, deep-pocketed Uncle Sam eventually spread so many dollars around the world (via wars and imports) that it couldn’t afford to keep releasing ounces of gold for only $35—at least, not without cutting spending on Vietnam, raising interest rates, cutting imports, clamping controls on domestic wages and prices, and throwing the US economy into recession. With his eye on re-election in 1972, Nixon threw the gold standard under the bus instead of the US economy.

In his 1981 book, The Money Lenders, Anthony Sampson summarized the financial sea-change:

“The supremacy of American bankers was already questioned by the end of the sixties, as the balance of financial power was shifting. The world’s confidence in the dollar, which lay at the basis of the Bretton Woods agreement, was undermined by the Vietnam War. The long boom of the West was faltering, with too much capacity and too little employment. The pound was devalued in 1968 followed by other currencies, which in turn undermined the strength of the dollar. American manufacturers were losing out against Europe and Japan; Japanese cars were beginning to roll into America. The United States showed a [trade] deficit for the first time since 1893.” US gold reserves stabilized after slipping to about $10 billion in 1968, but the antagonism between the gold standard and the expansion of US spending was set.

“The Nixon administration tried to hold up the dollar but by 1971… they ‘had either lost or abandoned any semblance of control of the situation’; and they finally decided to force devaluation on the others. The western finance ministers at the Smithsonian Institution in Washington legitimized what the market had already decided, and devalued the dollar against gold… By March 1973 Nixon gave up the attempt to fix the dollar to gold. All western currencies floated up and down freely. The Bretton Woods system had virtually collapsed (p. 118-119).”

That collapse has been well-described and explained in several non-technical books: Closing the Gold Window, by Joanne Gowa; The Way the World Works, by Jude Wanniski, The Fate of the Dollar, by my late uncle Martin Mayer, among others. The most recent may be Kenneth D. Garbade’s 2021 book, After the Accord, an academic history of the Federal Reserve from 1951 to 1979. For events leading up to the Bretton Woods agreement, see Ben Steil’s The Battle of Bretton Woods (2013.)

Garbade, an economist and former senior vice president at the New York Fed, writes that Arthur Burns, who in 1970 succeeded Fed chairman William McChesney Martin (the chair since 1951 and the man who compared the Fed to a “chaperone who has ordered the punch bowl removed just when the party was really warming up”), satisfied Nixon’s demand for lower interest rates to stimulate the economy.   

“The decline of rates reversed the flow of gold [to the US Treasury] and exacerbated a cascading series of problems that culminated in Nixon’s decision to close the Treasury’s gold window on August 15, 1971, putting an end to United States gold sales to foreign central banks at $35 an ounce. Within two years, the Bretton Woods system of fixed exchange rates was gone as well, replaced with floating rates.”

Red lights, very cheap

At the time, Europe was still a bargain, especially if you were a young bicyclist or backpacker in southern Europe with no need for things that required money, like fancy dining, lodging or transportation. (Prices in the US in 1971 were roughly 10% of today’s level—the minimum hourly wage was $1.60—but most of Europe was an order of magnitude cheaper.)

From left: Federal Reserve chairman Arthur Burns, Treasury Secretary John Connally and President Richard Nixon.

My biggest single expense that summer was airfare from New York ($250, round-trip). A Peugeot UO-8 10-speed bicycle cost $115. At the very lowest end of the tourist economy, you got very little but you paid nothing for it. The price of a cot, among three or four other cots, in a spare bedroom in an Italian family’s apartment near the Rome train station: 800 lira or $1.

And so forth. A night at the only lodging house (with a staff of one, offering linen but no other amenities) in Arvi, on the southern coast of Crete: 20 drachma or about 60¢. In Holland, a cold green bottle of Heineken with ham-and-cheese on a dinner roll cost less than $1. In Amsterdam’s stoner cafés and even its famous red-light district, 20 guilders or $6 could go a long way.

How do today’s prices compare? Finding out would require a breadth and depth of research that I’m no longer prepared to do. For my purposes here, the more pressing question is, How did the end of Bretton Woods and the gold standard impact the world’s economy?

A 40-year bull market begins

In How the World Works, Wanniski describes how it led to a decade of stagflation—inflation plus low growth. By unmooring the dollar from gold while lowering interest rates and stimulating the economy for political reasons, Nixon added to the inflation that had already been underway. Then a series of hefty political and economic dominos began to fall.

Wanniski, a “supply-side” journalist who championed economist Arthur Laffer’s famous “curve,” noted that inflation drove American’s salaries into higher tax brackets and reduced their spending power, leading to the famous “stagflation” of the 1970s. But more fatal geo-political other-shoes soon dropped.

Precipitously, the oil producers of the Middle East, to offset the falling value of dollars, raised the price of oil, which was fixed in dollars. That event was followed by the oil shortages of 1973, the “Yom Kippur War” between the Arabs and Israelis, Nixon’s resignation from the presidency, and then the recession of 1974-1975, when the Dow dropped to 619 (3264, adjusted for inflation).

On an inflation-adjusted basis, the Dow fell from the present equivalent of about 8000 in 1966 to 2252 in 1982—bottoming out after two or three years during which Fed chair Paul Volcker stopped accommodating the banks’ needs for reserves and allowed the fed funds rate—which today stands at only 0.25%—to climb to 20%.

Gold’s atomic structure

That’s when the post-Bretton Woods fever seemed to break. From that point—the climax of perhaps the greatest stock- or bond-buying opportunity in financial history—the prices of securities began climbing and, with a couple of significant but transitory interruptions, ascended to today’s alpine heights. Many people remember the 1970s as a gloomy time; Warren Buffett probably doesn’t. He scooped up blue-chip bargains.

But it was also the start of the era of widening economic inequality in the US (between those who own a lot of securities and those who don’t), the exponential accumulation of US deficits and debt (the value of outstanding Treasury debt rose to $28 trillion in 2021 from $1.2 trillion at the end of 1982), and the appearance of large trade deficits. Once a major exporter, the US has been the world’s biggest importer for more than 40 years. Once the world’s largest creditor, the US is now the world’s largest debtor.

That makes for a lot of historical dots, and there’s no limit to the number of ways you could connect them. One residual question: How has the dollar managed to remain the reserve currency even after so many trillions of them have been put in circulation worldwide? 

We shouldn’t mourn the end of the gold standard. As Keynes noted, digging gold out of the earth, exchanging it for paper at a central bank, and re-burying it in Fort Knox or in a vault under the Federal Reserve Bank of New York never made sense. In any case, there isn’t nearly enough gold in the world to finance today’s global economy. And that’s not the worst aspect of it.

Countless Aztecs, Incas and Africans were enslaved or slaughtered for gold. In the 1940s, Europeans were killed for the crowns and fillings in their teeth. Toxins still bleed from old gold adits in Colorado. Cyanide-laced pools stagnate beside new gold mines all over the world. All because of gold’s intrinsic value: its perfect atomic structure, which makes it ideal for conducting electricity and for making jewelry that never loses its lustre.  

© 2021 RIJ Publishing LLC. All rights reserved.