Normally, I’m too much of a rational economist to spend long periods of time in a casino—I just can’t get past the idea of a negative expected return. But several days ago while in Las Vegas for an academic conference, I decided to drop a few chips on the roulette table. Impulsively, I put the entire amount on number 33, recalling the jersey worn by Grant Hill, my favorite basketball player while I was in school at Duke University. Amazingly, the little silver ball came to rest on that very number and my loose change paid out 35 times the original bet!
Somewhat perversely, one of my greater insights of the week came at the roulette table rather than from one of the academic talks. Now, I certainly am not the first observer to draw parallels between investing and gambling in a casino. But the common comparison is to investing in the stock market. Instead, I’d like to discuss how the sovereign debt markets can resemble playing against the house.
At a casino, the house sets the rules and governs the payouts. They have decided that my winning bet pays 35-to-1 (giving me about a –5% expected return), instead of a fair rate of 37-to-1 (which would provide a 0% expected return). And the rules of the game can change. In Monte Carlo, roulette wheels have only a single green zero, while the Las Vegas casinos have added a green double-zero. The subtle impact is to slightly reduce the probability of any single number hitting, though the payout remains constant at 35-to-1, thus boosting the casino’s expected profits (and increasing my expected losses). A small change to the rules of the game tilts the profits more heavily in the casino’s favor.
One of the crucial differences between investing in sovereign debt issues instead of investing in, say, corporate bonds or stocks is that you are, in a sense, playing against the house rather than against other market participants. For example, when a corporation issues a bond, the capital markets establish the appropriate yield on the bonds. The individual company can do very little to influence the coupon or yield on their bonds. And, to the extent the market functions well, the company will pay an appropriate cost of capital and the purchasers of its bonds will receive a free and fair market return for bearing the risk associated with that bond.
In order to set fair prices, efficient markets require market participants that are not constrained and base their buying and selling decisions on a balance of risk and return. The presence of large non-economic participants that have no regard for a return to risk destroys one of the core assumptions underlying efficient capital markets. Like it or not, governments have the power (and with increasingly high debt burdens, increasing motivation!) to create non-economic regulations and incentives that tilt the rules of the game in their favor. Massive amounts of quantitative easing around the globe are examples of this behavior. In the United States, the Federal Reserve implemented “Operation Twist” with the stated goal of lowering the yields on long-term government bonds: Their expressed intent was to push prices away from an efficient market outcome. Their motivation may be a noble one, to stoke the engines of the U.S. economy and provide impetus for job creation. The pernicious side effect, however, is to reduce the profits to investors and increase the profits to the “house”—a transfer of wealth from savers and into the hand of borrowers—chief among them the U.S. Treasury.