By Karl Smith, Contributor Miles Kimball noted a few days ago that the common place notion that investors take on silly investments when yields are low is hard to square with standard economic theory. 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. He got lots of push back, but I think the most useful comes from Alison Schrager For pension funds there is. Their accounting and funding rules give them every incentive to do just that If we think of “investor” not as market participant looking to maximize risk adjusted return but as household or group of households looking to exchange consumption now for consumption later then we have an easy interpretation for “Reaching for Yield” If the marginal return on capital falls below the discounted ratio of marginal utilities between periods then we are away from an optimum and there several ways to get back: Increase the marginal return on capital. That is, decrease investment and allow depreciation to drive up the marginal return. We see this quite normally during a recession. Decrease the marginal utility of current consumption. That is, save less and spend more. Arguably we regularly see this during recessions, though its hard to tell because our theory of recessions suggests that wanting to save more is the precipitating event that causes this disequilbrium in the first place. Importantly, however, in a balance sheet recession there may be explicit constraints on agent’s ability to consume more. Increase the marginal utility of future consumption. You might think this is just another way of saying “save less” as doing so would decrease future consumption and drive up its marginal utility. However, ex ante we have another way to do the same thing: accept a worse risk/reward tradeoff. Ex post your marginal utility of consumption will depend on the amount you saved and the average real rate of return on that savings. Ex ante, however, you faced with a distribution of future consumption possibilities. Increasing the variance of that distribution lowers the  expected future utility of consumption and hence raises the expected future marginal utility of consumption. Thus, if the marginal-return-to-capital is fixed in the short run, and balance sheet constraints causes net-savings to be fixed in the short run then to restore equilibrium you should take on more risk in an effort to drive up the future marginal utility of consumption. A less technical explanation might go like this: Life: I see, it says here that your plan is to “Live Like a Boss”, spend 98% of all your resources on jet-skis and gold plated rims and then invest the other 2% in making smartphones. Humanity: Yep. Life: So what are you going to do to produce food and shelter let alone your “Boss Lifestyle” in the future Humanity: Don’t worry. We are making an app for that. Life: Right. I am just going to go ahead and stamp ‘NO’ on this application. You’ll be saving 10%. Humanity: What! That sucks. Well can I at least invest the entire 10% in smartphones. Life: Uh no. You’ll have to find something else. Humanity: Everything else sucks! You’re just not being fair. Life: I’ve been told that before. Humanity: Screw it then. If I can’t invest the whole 10% in smartphones then I am investing the other 8% in a Rocketship to go to Mars. Life: Your past attempts at sending ships to Mars have been less than exemplary. Perhaps, you should reconsider. Humanity: Whatever. If its not a smartphone then its crap. I might as well go all in on the Rocketship, it sure beats your lame-o “food and shelter” plan. Life: I can’t imagine how you ended up in this mess   And, there you have “Reaching For Yield”, or alternatively a Rocketship.
Source: FULL ARTICLE at Forbes Latest