The $200 Trillion Question

Kenneth Rogoff
Kenneth Rogoff
Kenneth Rogoff Thomas D. Cabot Professor of Public Policy and Professor of Economics - Harvard University, Former Brookings Expert

January 8, 2007

Perhaps the most remarkable trend in global macroeconomics over the past two decades has been the stunning drop in the volatility of economic growth. In America, for example, quarterly output volatility has fallen by more than half since the mid-1980s. Obviously, moderation in output movements did not occur everywhere simultaneously. Volatility in Asia began to fall only after the financial crisis of the late 1990s. In Japan and Latin America, volatility dropped in a meaningful way only in the current decade. But by now, the decline has become nearly universal, with huge implications for global asset markets.

Indeed, the main question for 2007 is whether macroeconomic volatility will continue to decline, fueling another spectacular year for markets and housing, or start to rise again, perhaps due to growing geopolitical tensions. I lean slightly toward the optimistic scenario, but investors and policy makers alike need to understand the ramifications of a return to more normal volatility levels.

Investors, especially, need to recognize that even if broader positive trends in globalization and technological progress continue, a rise in macroeconomic volatility could still produce a massive fall in asset prices. Indeed, the massive equity and housing price increases of the past dozen or so years probably owe as much to greater macroeconomic stability as to any other factor. As output and consumption become more stable, investors do not demand as large a risk premium. The lower the price of risk, the higher the price of risky assets.

Consider this. If you agree with the many pundits who say stock prices have gone too high, and are much more likely to fall than to rise further, you may be right — but not if macroeconomic risk continues to drain from the system. At the end of 2000, at the height of the Internet stock boom and just before the 2001 crash, the economists James Glassman and Kevin Hassett published the book “Dow 36,000.” At the time, the Dow Jones industrial average of American stocks was trading at around 11,000, so the book’s premise seemed outrageous. Certainly the timing was bad: Global stock prices began to collapse a few months later, and it took years for them to fully recover.

But Messrs. Glassman and Hassett did have a point. Their admittedly crude analysis shows why, if volatility continues to fall in 2007, prices of stocks and other assets can still go a lot higher. They asked how investors would price stocks if they expected historical average returns to continue, while also deciding that the risk was essentially zero. That may sound extreme, but some scholars, such as the 2004 Nobel laureate Ed Prescott, have shown that, historically, holding a large diversified portfolio of stocks long enough is generally a far better investment than ultra safe U.S. Treasury bonds. A back-of-the-envelope calculation shows that with the risk premium removed, stock prices could easily triple from existing levels, with price/dividend ratios soaring to over 200, compared to historical averages of between 40 and 50. Of course, there is a big hole in the “Dow 36,000” logic. Stocks are risky, depressions can happen, and it is dangerous to extrapolate the past to the future. If prices rise simply because investors decide that there is no longer any risk, then prices will collapse all the more precipitously if investors collectively change their minds.

This brings us to the $200 trillion question, roughly the value of global money and asset markets, including housing: What could cause macroeconomic volatility to start rising? Don’t look to central banks. Most are likely to manage the near-term risks to inflation and growth reasonably well. Hedge funds could throw a scare. The Germans tried to use their leadership in the G8 to achieve greater transparency in hedge funds, but they were beaten back by America and Great Britain.

To my mind, though, the greatest risk is geopolitical instability. By and large, China has been a far more constructive counterpart to America than the Soviet Union ever was. But, given huge income disparities within China, its leaders still face enormous challenges in maintaining domestic stability, and continuing quiescence cannot be taken for granted. At the same time, there are at least a half-dozen other global hot spots — some might be tempted to include the Senate — that could trigger a major breakdown in world trade.

In short, if the macroeconomic moderation that dominated 2006 continues into 2007, look for further asset price inflation, but don’t hold your breath for the Dow to hit 36,000. But if a major flare-up causes investors to lose confidence in low volatility, the bottom could fall out from under equity and housing prices. In that case, do investors and policy makers have a plan B?