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Macro Markets and Financial
Security
Stefano Athanasoulis, Robert Shiller, and Eric van Wincoop
oday, people have a rich set of investment options, ranging from low-risk money market instruments to high-risk growth stocks. They can choose to invest in mutual funds, hedge funds, and pension plans. They can hedge themselves with options and other derivatives while investing both at home and across the globe. Plenty of opportunities are available for diversifying their portfolios and avoiding excess exposure to sectoral or geographic risk. Nonetheless, there is good reason to believe that most people’s wealth is not well diversified. For example, although investors can diversify through equity markets, corporate profits account for less than 10 percent of national income. That figure suggests that about 90 percent of an average person’s income is sensitive to sectoral, occupational, and geographic uncertainty.
Shiller (1993) has proposed a new set of markets that could in theory provide much better diversification opportunities. These so-called macro markets would be large international markets trading, in the form of futures contracts, long-term claims on major components of incomes shared by a large number of people or organiza- tions. For example, in a macro market for the United States, an investor could buy a claim on the U.S. national income and then receive, for as long as the claim is held, dividends equal to a specified fraction of U.S. national income. Such a claim is comparable to a share in a corpo- ration, except that the dividend would equal a share of national income rather than a share of corporate profits. Such markets might exist for entire countries— the United States, Japan, and Brazil—or for regions— such as the European Union and North America. Even a market for claims on the combined incomes of the entire world could be formed. Prices would rise and fall in these markets as new information about national, regional, or global economies became available, just as
T
Stefano Athanasoulis is a visiting assistant professor at Yale University. Robert Shiller is the Stanley B. Resor Professor of Economics at Yale University. Eric van Wincoop is a senior economist at the Federal Reserve Bank of New York.
prices rise and fall in the stock market as new information about corporate profits is revealed. The potential future importance of these markets is supported by the most basic principle of finance— diversification. People could use macro markets to hedge their own national income risks and to invest in the rest of the world. This investment strategy would reduce income growth uncertainty and lead to a more secure financial future. We address several questions in this paper. First, how could macro markets be useful to the average person? Second, how large are the potential benefits from diver- sification if these markets were to be introduced and used optimally? Third, can existing financial markets achieve a similar degree of diversification when used opti- mally? Fourth, why don’t these markets already exist?
H OW WOULD I NVESTORS USE
M ACRO M ARKETS?
The basic idea behind macro markets is a simple one. Consider the case of claims on national income. If macro markets existed for every country of the world, people could take short positions in their country’s market, thereby hedging their own country’s risk, and long posi- tions in the markets of all other countries in proportion to each country’s size, thereby completely hedging them- selves. The short positions in their home country would exactly offset the long positions that they hold by virtue of living there, and the long positions in the world would mean that they were completely diversified. If everyone hedged risk in this way, it would all add up, that is, for every long in every country there would be a short, and demand would equal supply in each macro market. The dividends paid on the securities for each country would be paid by the people who live in that country and hold short positions. By definition, these people can always make the payments because they are earning the national income upon which the dividends are drawn. Taking such positions in these markets is the best way for an individual to achieve diversification. After hedging, everyone earns a share of global income. It would be impossible for individuals to lower their risks any further.
It is impossible for everyone to diversify away uncertainty about global income, because total income earned across all individuals equals global income itself.
RETAIL I NSTITUTIONS
Of course, most people are not accustomed to hedging. Thus, it would probably be unrealistic to expect the aver- age person to hedge through macro markets without the assistance of intermediaries. Most people are familiar with insurance, and they readily buy insurance against other risks. Retail institutions, such as pension funds or insur- ance companies, could offer people contracts to hedge their aggregate income risk. These insurance companies and pension funds would trade in macro markets to sell off the risk incurred by writing the contracts in retail markets. These institutional investors would be hedging, much as institutions now hedge in stock index futures markets.
AN AVERAGE I NVESTOR
We will now give an example of how these markets and retail institutions could serve the individual investor. Con- sider a person who earns income from wages and from returns on financial assets (such as stocks and bonds). The individual cares about the uncertainty of the future value of his or her total wealth , which is the sum of the future value of financial assets and the future value of ‘‘human capital.’’ The value of human capital is equal to the present value of the stream of future wages earned by the individual. The value of the person’s wealth can thus be written as , where PDV is present discounted value, represents the annual dividends and interest earned from financial assets, and W is wages plus noncorporate business income. Even if the individual were well diversified in the equity and bond markets, he or she would still be exposed to uncertainty associated with wages earned. Because wages plus noncorporate profits are at least nine times as great as corporate profits (in national income accounts), the largest component of wealth remains undiversified. Let us further assume that the wealth of the indi- vidual is ‘‘average’’—the value of the individual’s financial
Wealth = PDV ( Π) + PDV W ( ) Π
about foreign stock returns than domestic investors. Asymmetric information is one of the most common explanations for the lack of observed international diver- sification in equity and bond markets. In macro markets, which are tied to aggregate incomes, asymmetric infor- mation is much less of a concern. Japanese investors are not likely to predict Japanese GDP growth rates more accurately than U.S. investors because the information needed to make such predictions is publicly available. The diversification strategy outlined above is different from the type of diversification most investors are accustomed to. Most individual stock market investors diversify by investing their money in a wide basket of assets. With macro markets, diversification is achieved instead through a hedging contract.
P RICING IN M ACRO M ARKETS
So far we have left two issues unaddressed. First, the insti- tutional investors that offer the hedging contract we just described will themselves be exposed to risk when offering the instrument. Second, we have yet to explain why the price of the contract will be zero. To understand how insti- tutional investors will lay off the risk and what factors determine prices, we describe in more detail the macro markets on which the hedging instruments are based. These markets trade perpetual claims on a GDP index. Trade can take place either over the counter or on an exchange like the Chicago Board of Trade. Existing theoretical research has laid out exactly what will determine prices in markets like these.^2 As with any asset, the price of a claim on a country’s per capita GDP depends on two factors—expected payoff and risk. The expected payoff is the expected present discounted value of future per capita GDP. Risk is measured by the covariance between the present discounted value of a coun- try’s per capita GDP and the present discounted value of the world’s GDP. First consider a simple example in a symmetric world. Two countries have an equal number of residents. Assume that expected future per capita GDP is the same in both markets. If we also assume that the variance of the present discounted value of GDP is the same for both
countries, then the covariance with the world claim will be identical for the two countries. Claims on the per capita GDP of both countries therefore will have the same price. Let us say for the sake of simplicity that the only traders in these markets are pension funds, and let N be the size of the population in both markets. Domestic pension funds will sell 12 ---^ N perpetual claims on domestic
per capita GDP and buy perpetual claims on foreign per capita GDP. Because these claims have the same price, the net cost will be zero. Foreign pension funds take the other side of the market. The per capita gross domestic product of the world, , equals , where is foreign per capita GDP. Through their operations in the macro markets, domestic pension funds have effectively purchased N perpetual claims on
. Because the pension funds also sell N per- petual claims on to domestic individuals through the hedging instrument, domestic pension funds break even. The same is true for the foreign pension funds. The two countries have effectively agreed to swap a claim on half of each other’s GDP. Under this arrangement, there is no cost or ‘‘insurance premium’’ to reducing risks. After risk sharing, the residents of both countries will hold claims on half the domestic country’s per capita GDP plus half the foreign country’s per capita GDP, which together add up to world per capita GDP. Residents’ expected aver- age income is the same as it was before, but the variability of income is lower. So far everything in the example is very symmetric. Now suppose that the domestic country is much larger than the foreign country: its population N is a hundred times that of the foreign country. Accordingly, the covariance between
12 --- N
GDP W^12 --- GDP +^12 ---^ GDP ∗
GDP ∗
GDP W – GDP
GDP W – GDP
Because people’s exposure to national income risk differs, limiting trade in claims on a country’s national income to the residents of that particular country would be beneficial.
domestic GDP and world GDP will be higher than the cova- riance between foreign GDP and world GDP, even if the variance of per capita GDP in both countries is the same. The price of a perpetual claim on the foreign country’s per capita GDP will therefore be lower than the price of a claim on the domestic country’s per capita GDP. If the prices of claims on the per capita GDP of both countries were still equal—as they were when both countries had the same population—then people in the larger country would want to swap half their income for half the per capita income of the people in the smaller country. But there are not enough people in the smaller country to take the other side of these transactions. There- fore, the price of a perpetual claim on the foreign country’s per capita GDP will be higher than the price of a claim on the domestic country’s per capita GDP. Consequently, the people in the larger country will be discouraged from demanding so many claims on the foreign country, and market clearing can take place. In more technical terms, a claim on domestic per capita GDP can be exchanged for claims on world per capita GDP, with. Through trade in macro markets, domestic pension funds will buy N claims on (with a net price of zero) and sell those claims as hedging instruments to domestic individu- als. After the hedge, domestic residents have a perpetual claim on times per capita world GDP. Foreign pen- sion funds will take the other side of the market by selling N claims on , which is equivalent to buying (the foreign population) claims on
. Here. Foreign pension funds will sell these claims as hedging instruments to foreign individuals, who will then own a perpetual claim on times per capita world GDP. The higher price of a claim on the foreign country’s output leads to larger claims on world per capita GDP by foreign residents after risk sharing. In the example above, we have assumed for sim- plicity that all individuals within a country have the same exposure to their country’s national income risk. In reality, some individual’s income is more sensitive to national growth rates than other people’s income. The optimal hedge
α α < 1
α ( GDP (^) W ) – GDP
α
α ( GDP (^) W ) – GDP N ⁄ 100 β GDP (^) W – ( GDP )∗ β = 101 – 100 α > 1
β
position that an investor takes through pension funds or insurance companies depends on his or her exposure to national risk. Because people’s exposure to national income risk differs, limiting trade in claims on a country’s national income to the residents of that particular country would be beneficial. Although this limitation would eliminate inter- national risk sharing, it would allow individuals to share their exposures to national income risk. Ultimately, through the appropriate retail institutions, those individuals with high exposure to national income risk could sell perpetual claims indexed to national income to those individuals with low exposure to national income risk.
THE P OTENTIAL R ISK -S HARING B ENEFITS
Individuals are exposed to many types of aggregate risk. The most common risks are specific to a sector (occupational risk), to an age cohort (demographic risk), or to a geographic area in which someone works (geographic risk). For example, an auto worker is subject to auto industry risk. A decline in demand for automobiles will affect the entire industry. Geographic risk can be linked to a specific neighborhood or to a whole continent. To measure the potential diversification benefits of macro markets, we restrict our analysis to national income risk, abstracting from other types of aggregate risk. Because we limit our- selves to national risk, the measure of hedgeable aggregate income risk derived in this section is lower than the level achievable through aggregate income markets generally. Because individuals cannot diversify away global income growth uncertainty, we focus on country-specific growth, that is, the difference between a country’s growth rate and the world growth rate. As explained in the pre- vious section, macro markets allow individuals to eliminate the country-specific component of their income growth uncertainty. We now quantify the size of this uncertainty. 3
A R EGRESSION MODEL OF COUNTRY-SPECIFIC
GROWTH UNCERTAINTY
To identify country-specific growth uncertainty, we esti- mate the following regression for each horizon s : g (^) i t t , , + s – g (^) tw , t + s =λ′ s z (^) it – z wt ^ + u (^) i t t , , + s.
Standard deviation
Chart 2 Growth Uncertainty in the Set of Forty-Nine Countries
Horizon (years) Source: Authors’ calculations. Notes: The chart shows the standard deviation of the unpredictable compo- nent of the difference between the per capita GDP growth of a representative country and that of the world. The full information set used to predict growth consists of thirteen variables (see text). The information set of three variables consists of the log of per capita GDP, the fertility rate, and the investment rate.
0
Informationset of three variables
5 10 15 20 25 30 35
Full information set
Probability
Chart 3 Per Capita GDP: Best Performing Country versus Worst Performing Country Forty-Nine Countries
Horizon (years) Source: Authors’ calculations. Notes: The chart shows the probability that the per capita GDP of the best performing country will unexpectedly double, triple, quadruple, or quintuple relative to that of the worst performing country. These probabilities depend on the growth horizon.
0
5 10 15 20 25 30 35
Doubles (^) Triples
Quadruples
Quintuples
To get a better sense of the amount of uncertainty involved here, we perform a simple experiment. We take 10,000 draws from the distribution of residual risk for each country, 7 assuming that the draws are independent across countries and that each country’s standard devia- tion of residual risk is the same. For the set of forty-nine countries, we use the results to compute the probability that per capita GDP of the best performing country will unexpectedly double, triple, quadruple, or quintuple rel- ative to that of the worst performing country over the specified time horizon. The results are shown in Chart 3. The probability that the best performing country’s per capita GDP doubles or triples relative to that of the worst performing country is practically 100 percent at the thirty-five-year horizon. The probability that the best performing country’s per capita GDP quadruples or quin- tuples relative to that of the worst performing country is 81 percent and 44 percent, respectively. These results are striking. They suggest that, after controlling for the growth that had already been expected, per capita GDP of the best performing country is likely to rise by a factor of five relative to that of the worst performing country! Even at the short ten-year horizon, the probability that
the per capita GDP of the best performing country would unexpectedly double relative to the per capita GDP of the worst performing country is 84 percent. For the set of OECD countries, we report the proba- bility that the per capita GDP for the best performing country rises by 30 percent, 50 percent, 70 percent, or 100 percent relative to that of the worst performing country (Chart 4). At a thirty-five-year horizon, the probabilities are 99.99 percent, 99.9 percent, 61 percent, and 13 percent, respectively. Although less spectacular, these numbers are still significant. Indeed, the best performing country’s per capita GDP is likely to rise by 70 percent relative to the worst performing country’s over a period of thirty-five years. Because these figures only consider the very extremes, that is, the worst compared with the best per- forming countries, we also compute the probability that the unweighted average per capita GDP of the seven best performing countries doubles, triples, quadruples, or quin- tuples relative to the unweighted average of per capita GDP of the seven worst performing countries. For the set of forty-nine countries, at the thirty-five-year horizon the probabilities are 99.9 percent, 89.4 percent, 29 percent, and 3 percent, respectively. These results suggest that, contrary
Probability
Chart 4 Per Capita GDP: Best Performing Country versus Worst Performing Country OECD Countries
Horizon (years) Source: Authors’ calculations. Notes: The chart shows the probability that the per capita GDP of the best performing country will unexpectedly rise by 30 percent, 50 percent, 70 percent, or 100 percent relative to that of the worst performing country. These probabilities depend on the growth horizon.
0
5 10 15 20 25 30 35
30% (^) 50%
70%
100%
to expectation, the per capita GDP of the seven best performing countries as a group is likely to triple relative to that of the seven worst performing countries over thirty- five years. For the set of OECD countries, we find a proba- bility of 88 percent that the unweighted average of per capita GDP of the three top-performing countries in the sample rises by 50 percent relative to that of the three worst performers. Note that in both of these cases we look at the best performing one-seventh and worst performing one-seventh of the countries in our sample. To illustrate further that these numbers are not unrealistic, Chart 5 shows the expected deviation from world growth in 1955 for the thirty-five-year period 1955- (according to the information set of three variables) com- pared with the actual deviation from world growth over the same period. For the set of forty-nine countries, the best performing countries relative to the expectation in 1955 were Thailand and Japan. Several African and South American countries were the worst performers. Note that Thailand was expected to grow slightly less than Uruguay in 1955. In fact, however, Thailand’s per capita GDP rose by a factor of 5.1 relative to that of Uruguay! Per capita GDP of the worst performing country in the sample,
Nicaragua, dropped 22 percent over the period 1955-90. Some countries that are not in our sample performed even worse. Extreme cases include Nigeria, whose real per capita GDP declined 59 percent from 1976 to 1990, and Guyana, whose real per capita GDP dropped 59 percent from 1976 to
- For the world’s poorest countries, hedging national income risks may truly be a matter of life and death for some citizens. In these countries, declines in national income have seriously harmed the quality of health care, nutrition, environmental protection, and law enforcement. These results might leave the impression that only nations in Africa, South America, and East Asia are subject to large income shocks. Although these countries have experienced the most dramatic changes in per capita GDP during the past several decades, what matters today is uncer- tainty about future income. It is quite possible that over the next fifty years the biggest income surprises will come from other parts of the world. Large gains from risk sharing are therefore not necessarily limited to the set of countries that have faced the largest income shocks in recent years. We see from Chart 5 that in our sample of OECD countries the best performing countries were Japan and Canada. In 1955, based on various indicators such as low investment, low school enrollment, high per capita income, and low recent growth rates, Canada was not expected to grow as fast as the average OECD country. Nonetheless, its growth rate turned out to be almost average. The worst performing countries were Greece, the United Kingdom, and New Zealand. Japan’s per capita GDP grew 80 percent more than that of Greece, even though the two countries’ expected growth rates were very similar in 1955. These results are suggestive of the significant uncertainty of relative performance among OECD countries. Of course, we caution against taking the results for individual countries too literally. The figures are somewhat sensitive to the precise information set and the countries considered. Nonetheless, this exercise provides a good sense of the degree of diversifiable uncertainty of future income. Although our sample ends in 1990, a very recent and large growth surprise surfaced in Ireland. Ireland’s economy stagnated during the first half of the 1980s. In 1987, its per capita GDP was 63 percent of Britain’s. But
correlated with the return of a claim on the present discounted value of aggregate income. This is the case when the return on human capital is highly correlated with the return on domestic financial assets. Consider an average individual whose current wealth consists of $900,000 in nontraded assets. Nontraded assets include both human capital and noncorporate business assets, but, for simplicity, here we will simply refer to both as human capital. An additional $100,000 of the individual’s wealth is in financial assets, including pension funds. Now assume that the return on domestic financial capital is perfectly correlated with the return on domestic human capital. The individual can then achieve full diversifica- tion as follows. First, if the financial return has the same standard deviation as the human capital return, selling short domestic financial assets by $900,000 eliminates all domestic risk. After that, $1 million is invested globally ($100,000 of financial wealth plus the $900,000 of revenue from selling short domestic assets). The correlation between the return on human capital and financial capital, however, is much smaller than one. Bottazzi, Pesenti, and van Wincoop (1996) compute this correlation using data for the years 1970- for OECD countries. The return on human capital is defined as the innovation in the present discounted value of wages divided by the current value of human capital.^9 The innovation is computed using the results from a vector autoregressive process for the wage rate and the profit rate or for the wage rate and a broad measure of return on domestic financial capital. A trend is extracted from both the wage rate and the profit rate. Three measures of the return on domestic financial capital are used: the profit rate (profits divided by the capital stock); the present discounted value of the profit rate, again using the results from the vector autoregressive process; and the weighted average of returns on stocks, long-term bonds, and short-term deposits (a broad measure of financial returns). Across countries, the average of the estimated correlation between the return on human capital and financial capital for the three measures is 0.26, -0.34, and -0.43, respectively—the correlations are all much smaller than one.
It is important to note that these correlations are based on wages and profits after extracting a trend. A common stochastic growth trend is likely to exist across countries.^10 Because such a common trend represents global risk, it cannot be shared among countries. Therefore, con- trolling for such a trend is appropriate for our purposes. It is useful to note, however, that the negative correlation
for two of the measures is not inconsistent with a positive correlation between the ‘‘raw’’ returns on human capital and domestic assets. An improvement in global technol- ogy raises both profits and wages. There are many possible explanations for the absence of a strong positive correlation. First, shocks to the bargaining power of labor or a change in government can significantly affect the income distribution. Second, if wages are less flexible than prices, positive demand shocks will affect real wages and profits asymmetrically. Third, standard trade theory predicts that the wage rate and return to capital move in opposite directions in response to terms of trade shocks (Stolper-Samuelson). An important question that we do not address is how much of the country-specific income growth uncer- tainty documented in the preceding section can be shared through existing financial markets. No research has yet been done to address that question. Nonetheless, the low correlations between the return on human capital and financial assets reported above suggest that macro markets have an important role to play in the diversification of aggregate income growth uncertainty, a role that existing financial markets cannot completely fill. Macro markets would also allow individuals to invest in firms and companies that are not traded publicly. Stock indexes only include companies after they have become successful. But productivity growth is influenced
Macro markets would also allow individuals to invest in firms and companies that are not traded publicly.
by private firms and start-ups at least as much as by public companies. Thus, investment in stock indexes cannot capture the growth of these smaller companies. For an individual who wants to invest in a country because the fundamentals of the country are strong, buying a share of GDP would be more appropriate than buying a stock index.
WHY D ON ’T M ACRO M ARKETS E XIST?
If the potential benefits of aggregate income markets are so large, and the underlying risk management concepts are apparently so simple, why have they not already developed in the private sector? Surely, significant commissions could be earned if a large demand for these securities developed. Surely, there ought to be some niche for these securities somewhere in the world. And yet there is no evidence that markets like these have ever existed. In principle, macro markets would not be difficult to introduce. In 1997, the U.S. Treasury introduced inflation-indexed bonds. The only essential difference is that in macro markets the coupons would be indexed to a measure of aggregate income rather than to the consumer price index (CPI). It is important, therefore, to try and understand what barriers stand in the way of the creation of macro markets.
N OT SO O BVIOUS
The first thing to note is that while the concept of risk management is very basic, the idea of markets that share income risks is not so obvious as to occur immediately to most people. The idea of markets in aggregate incomes is like other important inventions in the history of technol- ogy that have seemed extremely simple after they were implemented—simple, that is, from the vantage point of people viewing the final invention and not the idea that preceded it. For example, rejecting a proposal for invest- ment in radio technology in the 1920s, David Sarnoff’s Associates wrote, ‘‘The wireless music box has no imagin- able commercial value. Who would pay for a message sent to nobody in particular?’’ Between 1939 and 1944, more than twenty companies rejected the idea of Chester Carlson, inventor of the Xerox machine, to copy a document on plain paper. Although the idea was considered useless at
the time, today Rank Xerox Corporation earns annual reve- nues of about $1 billion, and it is hard to imagine life without the machine. Establishing markets for long-term claims on flows of income aggregates is no more obvious than other recent financial innovations. Even the concept of national income itself is a relatively new invention that has been perfected over many years. Developed earlier in this century by Kuznets (1937), Stone (1947), and others, the concept of national income as we know it did not become widely accepted until after World War II. Similarly, many risk management institutions that are now commonplace have gotten off to slow starts. For example, markets in foreign currency swaps—which now account for about half the gross turnover in the
foreign exchange market—did not develop until the early 1980s. A futures market in stock price indexes also did not develop until 1982. An even more recent innovation is the creation of indexed bonds. Economists have been pointing out the dangers of long-term nominal contracting for more than a hundred years, and yet in the United States long-term debt has been almost exclusively nominal. Indexed federal government debt did not exist in the United States until 1997, and it still only accounts for less than 1 percent of the federal debt. 11 Brainard and Dolbaer (1971) have long pointed out the advantages of creating contracts that allow people to share occupational income risks, but serious discussion of such contracts has only just begun.
P OTENTIAL FOR FAILURE
Not only do market innovations take a long time to start, they also often fail. Those who contemplate taking the
Establishing markets for long-term claims on flows of income aggregates is no more obvious than other recent financial innovations.
dividend announcements and not the price, no one would know the amount of volatility present in stock prices. 13
T HE IMPORTANCE OF P UBLIC DEBATE
AND L EADERSHIP
One reason aggregate income markets do not exist is that there has been very little public debate about the potential goals of such markets. Kennickell, Starr-McCluer, and Sundén (1996) find that friends and relatives are the most important source of financial advice. Others’ actions clearly provide an important signal for most people. Thus, a broad consensus on the value of macro markets among financial advisors, writers, commentators, lawyers, regulators, and lawmakers is very important if risk management contracts are to be sold to the public. Historical evidence suggests that professional leadership is an important factor in mak- ing risk management institutions a success. Consider, for example, disability risk insurance. In the early part of this century, private disability insurance was available but the public showed little interest in it. Only through the work of economists—notably John R. Commons, a cofounder of the American Economic Association—did the state- government institution of Worker’s Compensation become established in the United States in all but six states by
- 14 Since then, disability insurance has become com- mon among private employers as well. Today, disability insurance is a well-established institution that is not exclusively governmental, even though relatively little disability insurance is sold directly to individuals by insurance companies.
A P UBLIC GOODS P ROBLEM
Another reason why these securities may not exist is that market innovators typically capture a very small fraction of the benefits and almost all of the costs of introducing a new market. Financial instruments or ways of doing business usually cannot be patented. Evidence indicates that when a firm successfully issues a new financial product, a competi- tor typically introduces a similar product within a period of less than two or three months. 15 At the same time, the introduction of aggregate income assets requires substan- tial initial investments from the innovator, including data
collection, publicizing the product, experimenting with different types of contracts, and educating the public on how to use these markets.
MEASUREMENT P ROBLEMS
What these contracts should cash-settle on is a serious issue that poses significant measurement problems. Per capita income measures can change based on shifting demo- graphics alone. One solution may be to keep track of the incomes of a large group of individuals. Changes in quality are also notoriously hard to measure. Beyond such measure- ment issues is the question of how to deal with revisions. Shiller (1993) advances the theory of index numbers to address these questions. He proposes several kinds of chain indexes that are relatively robust to revision problems, and adjustments to national income measures could be made
along these lines. Attempts to generate labor income indexes that are less sensitive to the changing composi- tion of the labor force are reported in Shiller and Schneider (1998). The standardization of the indexes is essential to creating liquidity in these markets. A related problem is that governments collect most of the data to compute these indexes. If countries sell short claims on their own income, which they should do for the purpose of risk sharing, governments have an incentive to under- report GDP. It is not immediately clear how to resolve the problem of underreporting, although similar problems have not stopped the development of markets in indexed bonds and CPI futures.
P ROBLEMS OF E NFORCEMENT
Enforceability may also be a significant obstacle. In the for- mation of macro markets, contract designers need to avoid
Historical evidence suggests that professional leadership is an important factor in making risk management institutions a success.
incentives for investors to renege on contracts. Consider the hedging instruments discussed earlier, which yield an annual payoff of. Domestic residents buy such securities from pension funds to eliminate their expo- sure to country-specific aggregate risk. But when per capita output in their own country unexpectedly grows faster than per capita world output, they lose on the contract. In order to guarantee their ability to pay, domestic residents must put up margin. These margin calls can be very large because the expected present discounted value of a coun- try’s per capita GDP can fluctuate widely. The amount of margin required shrinks as the margin is adjusted more fre- quently because at shorter time intervals the uncertainty about asset price changes is smaller. Nonetheless, as we saw in October 1987 and October 1997, sometimes very large asset price changes are observed even over very short periods of time. High levels of margin may push individuals who do not have sufficient liquid assets out of the market. One advantage of arranging these contracts through pension funds is that the money already invested in the fund can be applied as margin. Very young investors—whose pension accounts are still small—may not be able to fully diversify against aggregate income risk. This problem gradually improves as an investor gets older. Most middle-aged people have accumulated sufficient wealth to take full advantage of the option to hedge aggregate risk. But as an investor gets older, the horizon for hedging becomes shorter and the benefits from risk sharing decrease.
M ACRO M ARKET B UBBLES
An additional problem is that the price of the macro securities may be even more volatile than the underlying fundamentals. Asset price bubbles cannot be ruled out. An asset price bubble occurs when increasing optimism causes investors to bid up prices to unsustainable levels, eventu- ally resulting in a bursting of the bubble and a sudden crash. By some accounts, bubbles are caused in part by individuals who overreact to past positive returns and flock into a bull market. Investors who enter the market because of excessive optimism typically choose to depart once they find that their optimism is unfounded and can cause a market to crash.
GDP W – GDP
Stock market crashes have sometimes had signifi- cant repercussions on economic performance. The world- wide stock market crash of 1929, for example, appears to have triggered a public sense of great uncertainty and a desire to postpone expenditures until the economic outlook grew clearer (see Romer [1990]). This reaction may have been a factor in bringing on the Great Depression. The consequences of such price swings in macro markets, and safety measures to protect against such shocks, need to be considered and addressed.
P ORTFOLIO MANAGEMENT P ROBLEMS
Finally, we would like to address a very practical question. Given the uncertainties surrounding a person’s future income, future employment, and future career develop- ments, how will he or she know what positions to take in these markets? In our earlier example, we assumed that the
individual’s wages are equal to the per capita wage rate plus an idiosyncratic component unrelated to aggregate risk. But in reality, some people’s income is more exposed to the national business cycle than others’. This exposure depends on the location of someone’s work as well as the sector in which he or she works. In general, the optimal positions in the aggregate income markets depend on how much one’s future income is correlated with measures of aggregate income over long-term horizons. Depending on the sector and location of someone’s work, information about long- term income fluctuations can be obtained from historical data. But what happens when someone moves to another part of the country or to another sector, or when someone changes careers altogether? Of course, every person’s career has a significant idiosyncratic component. What is really needed, however, is a good estimate of the aggregate component of a person’s future income that takes into
In the end, almost all people are sensitive to the growth performance of the aggregate economy, no matter where or in what sector they work.
36 FRBNY E CONOMIC P OLICY R EVIEW / A PRIL 1999 A PPENDIX
We use two sets of countries in the regression analysis—a set of forty-nine countries and a smaller set of twenty-one OECD countries. The forty-nine countries are Kenya, Mauritius, Uganda, Canada, Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Trinidad and Tobago, the United States, Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, Venezuela, India, Japan, Pakistan, the Philippines, Sri Lanka, Thailand, Austria, Belgium,
Cyprus, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Turkey, the United Kingdom, Australia, and New Zealand. The twenty-one OECD countries are Canada, the United States, Japan, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Turkey, the United Kingdom, Australia, and New Zealand.
A PPENDIX : TWO SETS OF COUNTRIES
ENDNOTES
N OTES FRBNY E CONOMIC P OLICY R EVIEW / A PRIL 1999 37
The authors thank Phil Strahan and two anonymous referees for many useful comments and suggestions.
- See Kang and Stulz (1997), French and Poterba (1991), and Tesar and Werner (1994, 1997).
- See Shiller and Athanasoulis (1995) and Athanasoulis and Shiller (1997); for related work, see also Demange and Laroque (1995) and Allen and Gale (1994).
- The country-specific growth uncertainty can also be transformed into a measure of welfare gains from international risk sharing. See Athanasoulis and van Wincoop (1999) and van Wincoop (1994, 1996, 1999).
- See Athanasoulis and van Wincoop (1997) for details on the estimation procedure. For each horizon s , we use data for all non- overlapping intervals with that length, starting with the most recent interval ending in 1990.
- See Barro and Sala-i-Martin (1995) and Levine and Renelt (1992).
- We experimented with additional variables: political instability; terms of trade growth over the past five years; percentage of primary, secondary, and higher education attained; the most recent one-year and five-year growth rates of private consumption; and the investment rate averaged over the past five years. None of these variables improved predictive power substantially.
- The residual risk is based on the three variables that have the most predictive power.
- See The Economist , May 17-23, 1997, pp. 21-4, for a discussion of Ireland’s recent growth.
- The wage rate is the average real wage per employee using national data on employee compensation divided by the number of employees and the consumer price index.
- Plenty of evidence suggests that technological convergence occurs across industrialized countries, leading to a common stochastic growth trend.
- See Shiller (1997) for a discussion of public resistance to indexation.
- Similar markets were reintroduced twice in the late 1980s. However, each time they were eventually shut down by the government.
- This problem is not insurmountable. Initial public offerings face the same problem.
- See Moss (1995).
- See Tufano (1992).
- Shiller and Athanasoulis (1995) find that a U.S.-Japan swap of national incomes may be the best single contract to recommend, with a U.S.-Europe swap being important as well. Athanasoulis and Shiller (1997) find that an important market to develop early would be a market for the entire world, a market that would trade claims on the aggregated incomes of all countries.
REFERENCES ( Continued )
N OTES FRBNY E CONOMIC P OLICY R EVIEW / A PRIL 1999 39
Tufano, P. 1992. “‘Financial Innovation and First Mover Advantage.” JOURNAL OF APPLIED C ORPORATE FINANCE 5: 83-7.
van Wincoop, E. 1994. “Welfare Gains from International Risksharing.” JOURNAL OF MONETARY E CONOMICS 34, no. 2 (October): 175-200.
———. 1996. “A Multi-Country Real Business Cycle Model with Heterogeneous Agents.” S CANDINAVIAN JOURNAL OF E CONOMICS 98, no. 2: 233-51.
———. 1999. “How Big Are the Potential Welfare Gains from International Risksharing?” J OURNAL OF I NTERNATIONAL E CONOMICS 47, no. 1: 109-35.
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