William J. Bernstein
The Societal Risk Premium
Financial economists like to talk about the risk-free rate: basically, the time value of money sitting in a perfectly safe vehicle. From an historical perspective per se, the very use of the term is fascinating. After all, it implies a society that is strong and stable enough to support a risk-free investment. Living in what is likely the most secure political, social, and economic environment ever seen on the planet, we take the existence of a "risk-free investment" for granted. But this is not always the case.
We have forgotten that our nation’s early political and financial prospects were far from certain. The global investor in 1790 would have been hard pressed to pick out the U.S. as an up and coming success story. At its birth, America was a financial basket case. And its history over the next century hardly inspired confidence, with an unstable banking structure, rampant speculation, and a civil war. The 19th century culminated in the near bankruptcy of the U.S. Treasury, narrowly averted only through the organizational talents of J.P. Morgan.
Even England’s political security has not been a sure thing during the past two centuries. Twice in this period—the Napoleonic Wars and early World War II, England's very existence was threatened. It is a commonplace that during times of turmoil, interest rates rise; economic historian Richard Sylla has said that a plot of rates over time is a sort of national "fever chart." This is true, in fact, of all rates of return—the "risk-free" rate, the interest rates of less-secure investments and, of course, equity returns.
The High Risk Environment of the Middle Ages
The capital markets are far older than most investors realize. Even before money first appeared in the form of small pellets of silver 5,000 years ago, there have been credit markets. For tens of thousands of years of prehistory, loans of grain and cattle were made at interest—a bushel or calf lent in winter would be repaid twice over at harvest time; such practices are still widespread in primitive societies. (When gold and silver first appeared as money, they were valued according to head of cattle, and not the other way around.)
The earliest loans were short-term—enough to tide the farmer over until the harvest or to support the merchant until his ship returned with goods to sell in the marketplace. In many places in the world, agricultural loans are still the most common form of credit extended. But gradually larger businesses and, finally, governments began demanding loans, and their needs were often long-term. Loan durations increased, and in many cases became infinite: that is, the principal was never returned. Such loans were known as "annuities"; wealthy citizens were often forced to purchase them. This is distinct from the modern insurance company annuity, in which payments cease with the death of the owner. Medieval annuities usually did not expire, but were handed down and traded among succeeding generations of investors. Modern investors, who live with endemic inflation, have trouble relating to this concept. But in the hard-money world before 1914, inflation was not high on the average investor’s list of concerns.
The European annuity which arose in the Middle Ages—Venetian prestiti, French rentes, and finally the English consol—is a thing of beauty from a financial economic perspective because its value is so easily calculated: it is simply the interest payment divided by the prevailing rate. For example, an annuity paying £100 per year at an interest rate of 5% is worth £2,000 (£100/0.05 = £2,000). Thus, the value of an annuity is precisely inversely related to the interest rate.
The history of pre-Renaissance and Renaissance Europe was of constant warfare, with continuously shifting alliances and borders. The one constant over many centuries was the rivalry between Venice and Genoa, both commercial and military. In the 12th century, Venice began requiring huge amounts of capital to finance its wars. It solved this problem with forced loans from wealthy citizens, called "prestiti," which carried a rate of only 5%. Since prevailing rates were much higher, the purchase of a prestiti at a 5% rate constituted a kind of tax. But the Venetian treasury did allow owners to sell their prestiti to others. Naturally, the prestiti sold at substantial discounts to their face value—initially at about 75% of par. (In other words, its actual yield was about 6.7%.) For the first time in the history of capital returns, we are now able to examine the element of risk. Prestiti soon became the favored vehicle for investment and speculation among Venetian noblemen and were even held abroad.
Unfortunately, the Venetian treasury did not pay quite all of the interest on these securities, but economic historians believe that most of the interest was remitted to the owners. Even so, the total return to secondary-market purchasers was in the 6% to 8% range. Since long-term inflation was not a worry at that time, this represents a fairly healthy rate of return. A fast look at the below graph shows that owners risked the loss of large chunks of principal. For example, in the tranquil year of 1375, prices reached a high of 92½. But just two years later, after a devastating war with Genoa, interest payments were temporarily suspended and vast amounts of new prestiti were levied, driving prices as low as 19—a temporary loss of principal value of about 80%. It was partially mitigated, however, by the 5% annual interest payments made during the period. Even though Venice’s fortunes soon reversed, this financial catastrophe shook investor confidence for more than a century, and prices did not recover until the debt was refinanced in 1482. Courtesy of Homer and Sylla’s A History of Interest Rates, I’ve plotted the market price of the 5% prestiti in the 14th and 15th centuries:
Even taking these stumbles into account, investors in medieval and Renaissance Europe earned healthy returns on their capital. But these rewards were bought by shouldering risk, red in tooth and claw. Later investors in Europe and America also have experienced similar high inflation-adjusted returns. Even in the modern world, where there is return, there also lurks risk.
Certainly, such investment disasters had occurred in earlier civilizations, but the bear market in the 14th century Venetian bond market is the first reasonably detailed record we have of a real financial crash. It was by no means the last.
Consider the average prices of prestiti in three different years:
The key concept is that buying when prices are low is always a very scary proposition. The low prices that produce high future returns are not possible without catastrophe and risk. In 1381, things looked bleak for La Serenessima: interest payments on presititi had been suspended, vast new amounts of them were being issued, and the Genoans were poised just outside the harbor entrance. Venetians brave enough to purchase prestiti at depressed prices in 1381 earned spectacular rates of return; conversely, had the history of Venice been placid, prestiti prices would have remained high, and returns low, given the inverse relationship between price and yield.
England in the 19th Century and Beyond
Let’s fast forward a few centuries to the English capital markets. They allow for the first time direct comparisons between high-quality short-term (bill) and long-term (bond and consol) rates, when the Bank of England began operations in 1694 and immediately began to dominate the English credit markets. In 1749, the Chancellor of the Exchequer, Henry Pelham, consolidated all of the Bank’s long-term obligations. These consolidated obligations later became known as the famous "consols." They were annuities, just like the prestiti, never yielding up their principal. They still trade today, more than two and a half centuries later. The consols, like the prestiti, provide historians with an unbroken record of bond pricing and rates over the centuries.
The rates for bills (and bank deposits) and bonds (consols) in 19th century England are shown below:
The modern investor would predict that bills would carry a lower interest than consols, since bills were not exposed to interest rate (i.e., inflation) risk. But for most of the period, short-term rates were actually higher than long-term rates. This occurred for two reasons. First, as we’ve already discussed, sustained high inflation only became a scourge in the 20th century. And second, wealthy Englishmen valued the consols’ steady income stream. The return on bills was quite variable, and a nobleman desirous of a constant standard of living would find the uncertainty in the bill rate highly inconvenient. As you can see, the interest rate on short-term bills was much more uncertain than for consols. Thus, the investor in bills demanded a higher return for the more uncertain payout. This graph also shows something far more important: the gradual decrease in interest rates as England’s society stabilized and came to dominate the globe. In 1897 the consol yield hit a low of 2.21%, which has not been seen since. This identifies the high-water mark of the British Empire just as well as any political or military event.
The tradeoff between the variability of bill payouts and the interest-rate risk of consols (and their modern reincarnation as long-term bonds) reverses during the 20th century. With the abandonment of the gold standard after World War I and the consequent inflationary explosion, the modern investor usually demands a higher return from long-term bonds and annuities than from bills. In recent years, in the developed nations, short-term rates have almost always been lower than long-term rates, since investors need to be rewarded for the higher interest-rate risk of bonds, due to the risk of serious damage from inflation.
The history of English interest rates reinforces the notion that with return comes risk. Anarchy and destruction lapped upon Britain’s very shores between 1789 and 1814. Investing in such a treacherous milieu demanded high returns and they were forthcoming—a 5.5% perpetual rate (remember, no inflation) with the otherwise ultra-safe consols. On the other hand, the Englishman in the late Victorian era lived in what seemed at the time to be the height of stability and permanence. With such safety comes low returns. But history played a cruel trick on John Bull after 1900, with low stock and bond returns being the least of his troubles.
Most recently, this relationship of return vs. perceived risk was validated by Campbell Harvey and his colleagues at Duke, who found that stock market returns correlate quite nicely with the degree of perceived economic risk. It cannot be any other way—the most reliable way of earning high returns is to buy at low prices. And the only way of getting low prices is with economic, political, or military turmoil.
The lesson here for the modern investor is obvious. Today, many are encouraged by the apparent economic vigor and safety of the post cold-war world. And, yet, both the logic of the markets and history show us that when the sun shines the brightest, investment returns are the lowest. This is as it should be: stability and prosperity imply high asset prices, which result in low future returns. Conversely, the highest returns are obtained by shouldering prudent risk when things look the bleakest. The worst case scenario occurs when the world suddenly goes from seeming stability to something far worse, as occurred just before the lights went out in 1914. The recent very high stock returns in the U.S. would not have been possible without the chaos of the 19th century and the prolonged fall in prices that occurred in the wake of the Great Depression. Conversely, the current placid economic, political, and social environment has resulted in very high stock prices; this likely presages relatively low future returns, and with it, the increased possibility of market catastrophe.
Don’t count this possibility out. Consider the following quote from John Maynard Keynes in The Economic Consequences of the Peace:
The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide, to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could dispatch his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable. The projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion, which were to play the serpent to this paradise, were little more than the amusements of his daily newspaper, and appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice.
In short, the New World Order circa 1912. If we get a happier ending this time around, it will have to be at the cost of much lower equity returns—a cheap price, indeed, for avoiding the horrors of the last century.
Copyright © 2001, William J. Bernstein. All rights reserved.
The right to download, store and/or output any material on this Web site is granted for viewing use only. Material may not be reproduced in any form without the express written permission of William J. Bernstein. Reproduction or editing by any means, mechanical or electronic, in whole or in part, without the express written permission of William J. Bernstein is strictly prohibited. Please read the disclaimer.