Evidence that the publisher Hay House thought that in 2006 people would be interested in “reaching for yield.” (No recommendation intended.) 

Many readers have misunderstood the following passage in my recent post “Contra John Taylor” about the effects of interest rates on risk-taking. I was responding to John Taylor’s following argument:

The Fed’s current zero interest-rate policy also creates incentives for otherwise risk-averse investors—retirees, pension funds—to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income.

What I wrote in response was this:

I can’t make sense of this statement without interpreting it as a behavioral economics statement about some combination of investor ignorance and irrationality and fraudulent schemes that prey on that ignorance and irrationality. The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality.

What I did not say clearly enough is that I have no problem believing that, indeed, investor ignorance and irrationality and schemes that prey on that ignorance and irrationality do indeed cause people to take on more risk as a result of low interest rates than they otherwise would. This is a genuine cost to the Fed stimulating the economy with low interest rates. But– especially once we figure out the details–it has much bigger implications for financial regulation than for monetary policy. I wanted to object to  John Taylor’s using “reaching for yield” to criticize current monetary policy without discussing the implications “reaching for yield” has for financial regulation. Regulation has serious costs, but so does tight monetary policy in the current environment. So either we need to live with the costs of “reaching for yield” or we need to consider the costs and benefits of various remedies. Let me add more investor education to the list of potential remedies. So as alternatives to living with the costs of “reaching for yield” we need to consider  

• tighter monetary policy;
• appropriate financial regulation;
• more investor education.

To me, it seems clear that tighter monetary policy is the worst of these three options–not only because that would have a high change of causing another recession, but also because the effectiveness of tighter monetary policy in helping investors make better decisions is likely to be quite small. I would love to go with the third option of more investor education, but the costs of that option will only be manageable if effective educational interventions short of having everyone get a degree in finance can be found. That is not easy. (I am making no claim that a degree in finance would do the trick as an educational intervention, only that we would need something that is effective and costs less than having all investors get a degree in finance.)

I am serious in thinking it is important to develop formal models of “reaching for yield.” Let me give that explicitly as advice to Ph.D. students looking for dissertation topics. Here is tgmoe: 

A while back I replied to a blog on dissertation topics suggesting I was interested in topics in finance, but I never got around to providing detail. I will do so now. I am interested in the mutual fund industry and how individual households make investment decisions. The evolution of planned sponsors and other institutional investors in this environment is also intriguing and has significantly altered the manner in which households invest. Any thoughts would be greatly appreciated. Thanks, Todd

Answer: To me, modeling “reaching for yield” and testing your model and other models against data on individual investor decisions seems like a great topic for your research. I just storified a Twitter conversation that might be helpful. Here is the link:

Reaching for Yield.

In addition, let me suggest the following idea. Suppose someone wants to commit financial fraud–think Bernie Madoff. In a way that might itself be irrational, in the real world, low interest rates seem to be associated with investors expecting a low percentage of the value of an investment being paid back each year. If expectations for the percentage of the value of an investment that is paid back each year are low, it is much easier to hide financial fraud. By contrast, if after a few years start-up period, if people expect substantial dividends or other payments paid out, then it is harder to hide financial fraud. Another to put it is that in a Ponzi scheme, the rate at which one must find additional investors to defraud is lower when people don’t expect fast payback. In some models, the rate of expected payback is the real interest rate, but it is possible that in the world, it is  closer to the nominal interest rate. In any case, the details of the path over time at which investors expect to be paid back matters a lot for how long a fraudulent scheme can last. And the level of interest rates is likely to affect the payback path required by investors. 

A couple of final thoughts.  

1. If “reaching for yield” when interest rates are low is a strong enough phenomenon, it should show up as a reduction in risk premia. But even if lower interest rates raised risk premia, it is quite possible that many individual investors could be taking on more risk as a result of low interest rates. In other words, the response of investors to low interest rates could vary a lot, and it is worth worrying about a maladaptive response to low interest rates by any substantial subgroup of investors, even if other investors react appropriately. 
2. It is a much bigger step to say they are taking on too much risk, than just to say that they are taking on more risk as a result of low interest rates.

Update: Karl Smith just wrote a very interesting post asking the question, as I did in some of my tweets in Reaching for Yield:

By ‘Reaching for Yield,’ Do You Mean 'Demand Curves Slope Downwards’?“

This is an important challenge to those arguing that low interest rates cause people to make mistakes in their decisions about which assets to invest in. Much of the evidence people point to when they talk about "reaching for yield” could be about perfectly rational responses to an increase in the risk premium. This rational response needs to be carefully distinguished from any claim that people are doing too much reaching for yield when interest rates fall–my point 2 just above. I may be more sympathetic than Karl to the idea that at least some people respond in maladaptive ways to low interest rates–enough to worry about. But the evidence is too thin to know how much of an issue this is once the rational response to higher risk premia is separated out.  

Let me explain a bit better what a fall in the safe interest rate does. Suppose there is some benchmark level of risk for which the expected average rate of return is unaffected. Then a reduction in the safe interest rate

1. increases the reward to bearing risk, since the expected average rate of return of the benchmark level of risk is now further above the (now lowered) safe interest rate, and
2. for anyone who chooses a level of risk below the benchmark level of risk, the expected average rate of return for their assets will be lower than before.  

The second consequence should be no surprise: in general, reductions in interest rates are a relief for borrowers but painful for savers. The pain for savers of lower interest rates is a topic for other posts. The issue for this  post is only if that pain drives some savers to make serious mistakes in their asset choices.