In the late 19th century, Lev Nikolayevich Tolstoy popularly known as Leo Tolstoy wrote a novel called Anna Karenina. It is a story that revolves around an adulterous affair of Anna Karenina and Count Vronsky, a young bachelor and the first line of the novel I “Happy families are all alike; every unhappy family is unhappy in its own way”. While the novel addresses myriad themes that traverses the constructive and destructive interference of ripples in the lake of family dynamics, its first line lends itself as a lens which has been used to explore disparate fields of study from a different perspective: Jared Diamond, in his book Guns, Germs and Steel used it to explain the variability I the trends of animal domestication on Earth, researchers at Oregon State University and University of Washington-Bothell have used it to study the response of microbiomes to perturbations and some researchers have also used it as the basis to understand what drives progress in modern science. Such diverse applicability of the principle allows us to explore its applicability to other events shaping our world. From the veritable smorgasbord of events provided to us by the world we live in, this article would use the principle to contextualize and understand the current state of the global bond market.
As the symphony of the Anna Karenina principle resonates amongst the above examples, the undertone dictates that while “unhappy” individuals can be unhappy for different reasons, all “happy” individuals are very similar in their characteristics. Here, the essential idea is that it is possible to achieve a successful endeavor only if a multitude of factors obtain a favorable and desirable posture. If one of these factors becomes unfavorable, the enterprise rapidly accelerates towards failure. In the book Guns, Germs and Steel for example, the author argued that in order to successfully domesticate a particular species it is important for several factors to be favorable in tandem such as but not limited to ease of providing fodder, efficient breeding in captivity, benign temperament, functioning social hierarchy. Think of why humans have been able to domesticate horses but not zebras. Now that we have familiarized ourselves with our “lens”, let’s analyze the “picture”.
While the aim of this article is not to provide a tour de force of the current state of the bond market and its potential implications for a global recession, it is important to familiarize ourselves with the certain terms that would help us understand the reason for the worries of the cognoscenti of the bond markets and subsequently put into perspective the Anna Karenina Principle. Let’s start with understanding what bonds are. Basically, a bond is a loan given by “us to them” wherein the “us” stands for the individuals that owns the bond and the “them” stands for the borrower that issues the bond. Whenever we have to purchase a major commodity and don’t have the finances to do so, we take a loan from a bank and agree to pay a certain interest rate over a certain period of time.
Now if you own a company or run a government agency that builds bridges or roads, you would require much more money than an average bank can provide. Therefore, in order to raise money for your project, you would issue a bond stating the principal of the loan to be paid to the individual, and the timeframe for the payment. Thus, in this case, you are giving a loan to the company and a group of such investors assume the role of lenders for the particular project by owning the bonds issued by the company. The quality of the bond is governed by two primary factors- the credit rating of the issuer and the time of maturity. The higher the credit rating, the risk of the issuer defaulting is lower and longer the time of maturity for the bond, (usually) higher the interest rate. The higher rate in the latter factor is because an investor investing in a bond for 20 years is committing his wealth for a greater period of time and therefore exposing himself to a greater risk of default against an investor who invests for say 5 years. But what happens when the usual starts pivoting towards the unusual? Let’s find out.
In countries like the United States of America, the bond market is suffering from an inverted yield curve problem which means that the interest on bonds held for a shorter time are higher than the ones held for a longer time. This is paradoxical to the “usual” because as explained earlier, the investor is expected to receive a higher interest rate on a long-term bond due to higher risk of default. A similar trend has been observed in Europe wherein in countries like Germany negative interest rates exist from 3-month bonds to 10-year bonds. In Switzerland, bond yields have gone negative for bonds held for even 50 years. This means that if an investor buys a bond and holds on to it until its maturity, he will make a definite loss. The reason for the existence of this inverted curve problem is because people are so anxious about the near-future that they are willing to invest in safer, long term investments at the expense of receiving almost no interest in return. For a cohort of economic experts, this anxiousness has manifested into worries since an inverted yield curve is usually a harbinger of a recession. After all, the yield curve has been inverted before every recession since 1955 in the US, albeit months or years before the recession hits. While economists agree that we have not yet reached the stage of dealing with the “r-word”, it remains a worrying concern whether we will reach there or more worryingly how soon we would reach it.
These worries are exacerbated by the limited amount of ammunition that we have in case a recession hits. When a recession hits, people are hesitant on taking loans and prefer saving what they already have. This reduces the amount of money being pumped into the financial system. In this situation, the chief financial institution like the Federal Reserve in the United States reduce the interest rate so that taking loans can become more economical and people are lured into borrowing more money which in turns (in theory) pumps money into the economy. In financial lingo, lowering the interest rate during recession is called quantitative easing; something that was extensively implemented by the United States during the 2008 financial crisis until the interest rates literally hit 0%. Now the problem in the current financial market is that interest rates across the world are already low which leaves little scope of further reducing them in case a recession hit. The interest rates in America are already low (around 2%) compared to the world and the Federal Reserve in July further cut them for the first time in over a decade. Following this decision India, Thailand, Brazil, Peru and some other countries followed suit. While the interest rates in India are around 6% thus leaving more scope for cuts if necessary, the concerns surrounding the economic slump being faced by the country still persist.
Now that we have understood the picture, let’s use the “lens” of the Anne Karenina principle to analyze it. As noted earlier, the response of major financial institutions has been to cut interest rates due to their fear of recession or maybe because “Uncle Sam” fears so. To the uninitiated, a cursory glance at this decision would indicate that cutting interest rate is the primary way to address the situation. However, if we contextualize the Anna Karenina principle it helps us understand how different countries are “unhappy” in their own way. In other words, to reach a state of “happiness” (economic stability) a multitude of factors have to be rectified that are hidden under the veneer of anxiousness and uncertainty. In the case of Germany when we hear about their GDP shrinking by 0.1% and the problem of the inverted yield curve, the layman would be quick to conclude a direct causation between them failing to recognize other factors contributing to the situation: challenges to the automobile industry due to stricter emission standards in Europe and elsewhere leading to a fall in business, impact on its exports due to the US-China trade war with Germany being an export based economy and US and China being its major trading partners, the repercussions of a Brexit deal on its manufacturing sector and supply line and so on. Knowing the situation in Germany, if an uninformed individual looks at the economic situation in India, which has been facing an economic slowdown and sluggish GDP growth, he would be quick to assert
“Oh, we might be facing the same problem! US-China trade war is going on and the Central Bank has cut interest rates so we must have problem with exports and also an inverted yield curve!”
However, neither of them is true. India does not have an inverted yield curve (yet) and US-China trade war doesn’t affect us in the same way since India is not an export-based economy. Armed with the Anne Karenina Principle, we can now recognize that our “unhappiness” should be attributed to disparate set of factors such as lack of rural demand for fast moving consumer goods which has seen companies like Hindustan Lever and Dabur to cut their growth by half as compared to last year, rapidly shrinking labor force and so on. Therefore, while trying to understand the path to economic sustainability and trying to achieve our “happy” state, we need to be cognizant of the potential interplay of number of factors which need to be addressed.
To conclude, you might be wondering “But what’s the point of all this? What do I do with all this knowledge? I’m sure the finance people know what they are doing”. While I have absolutely no standing to comment on the competency of the economic decision makers, m response to those questions would be to consider this article, at the minimum, to introduce you to a different perspective of analyzing any difficult or complicated situation: by using the Anna Karenina principle. Also, I hope that the article contributed towards confronting the innate hesitance we have when being confronted with economic jargon because we consider the field to be too esoteric and only for the experts. Now, even if cannot lend your ear to an economic discussion, you can at least lend your perspective.
Views expressed are solely those of the author.
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About the Author
Aditya Tamar is a final year Electronics and Communications Engineering student at SRM IST, Kattankulathur, Tamil Nadu. He has had an excellent academic record throughout his schooling and has been actively involved in a number of co-curricular and extracurricular activities. Aditya aspires to be an Astrophysicist, and when he is not getting sucked into solving fundamental questions related to Black Holes (pun intended) and Galaxies, he actively takes part in Model UN Conferences and Debates. Furthermore, he is an avid football fan, with his allegiance currently being split between his favourite player and his favourite club. Aditya has always had a penchant for world politics and in his articles, you can expect cogency in analysis and research.