Ten years after the 2008 financial crisis, there is much hand-wringing over whether we’ve already forgotten the lessons of the Great Recession.
Former Federal Reserve Chief Ben Bernanke and former Treasury Secretaries Henry Paulson and Timothy Geithner all recently warned that the US’s fast-rising debt and rollbacks to protections put in place post-recession threaten to lead the country back into trouble. And with US stocks last week hitting an all-time high on the way toward setting the record for longest-ever bull market, concerns have grown of an equity bubble fueled by cheap money.
But before you convert all your money into gold, consider this counterpoint from Finance Professor Laura Veldkamp: Interest rates on safe assets have remained persistently low over the past decade, arguably because the recession has fundamentally reshaped the way we think about financial crises. Her new working paper, “The Tail that Keeps the Riskless Rate Low,” co-authored with Julian Kozlowski and Venky Venkateswaran of New York University, argues that this ingrained risk perception will continue to dampen interest rates for at least another decade.
“Knowing that a crisis is possible influences risk assessment for many years to come,” the professors write in the paper, which is under revision with the Journal of Political Economy.
Veldkamp, who recently joined Columbia Business School, offers an analogy to explain the current financial risk environment. Imagine you’re rolling a die. You’ve seen the numbers one, two, three, four, five, and six — so you determine it’s a six-sided die. Then one day you roll a seven — which was the Great Recession.
“Something we thought wasn’t in the realm of possibility just materialized,” Veldkamp says. “Long after anything that triggered the financial crisis had passed, the knowledge that this was possible created an extra fear, extra risk aversion, extra amount of caution in people’s behavior that may persist for a generation.”
This heightened sensitivity to risk is why investors have preferred safer assets ever since the market crash, in the same way that if someone’s house burns down they’re likely to become extra cautious with fire prevention safety. In economics, this idea is called “tail risk,” or the chance that something with low probability might happen. Crises “fatten the tails,” meaning that they raise the perceived risk of a repeat crisis.
As an example of how the post-crisis tail risk remains high, Veldkamp and her colleagues focused on the interest rates of safe assets. When investors see a higher risk of crisis, they are more likely to seek a safe asset such as a US Treasury security, which leads to greater demand and thus a lower interest rate on it. So-called risk-free rates fell after 2007 and have remained abnormally low when compared to trends over the past 70 years, which the authors attribute to changes in the value of safety and liquidity.
To explain this persistently high “tail risk,” Veldkamp and her colleagues developed a mathematical model that accounts for this post-crisis change and predicts that the increased tail risk will be associated with a 1.45 percent drop in interest rates on government bonds in the long run. Two decades after the 2007-2008 crisis, according to their model, interest rates would still be 1 percent lower than they would otherwise be, owing simply to perceived risk of another crisis.
“Extreme events, like the recent crisis, are rare and therefore, lead to significant belief changes (and through them, aggregate variables like riskless rates) that outlast the events themselves,” the authors write. “…Rare event beliefs are more persistent because rare event data is scarce. It takes many observations without a rare event to convince an observer that the event is much more rare than they thought.”
Behind all the math in Veldkamp’s model is a simple idea, which is illustrated by a story from her classroom. Veldkamp has taught macro global economy for 15 years, and until 2008 her students didn’t want to study the Great Depression or learn about bank runs because it was “old history” and developed economies had supposedly solved those problems. Then the subprime mortgage meltdown turned into an international banking crisis with the collapse of Lehman Brothers.
“After 2008,” says Veldkamp, “I got a couple of emails from former students saying, ‘I didn’t think it was worth learning, but then I saw a bank run and I understood what it was. I saw it happening.’”
“There were events that people didn’t think were possible,” she says. “And then we saw them happen.”
About the researcher
Laura Veldkamp is a Professor of Finance at Columbia University's Graduate School of Business and a co-editor of the Journal of Economic Theory...Read more.