Rational Animals

I like this piece from Martin since it is reasonably parsimonious in the way it uses rational forsight.

The question remains “How rational do agents have to be in order to incorporate the output increases observed in the 1990s into the price of bonds being traded in the 1970s?” Do the agents need to have a demographic model like the one presented in this paper in order to anticipate the change in output? The answer is no. Individual agents simply looks forward to their own path of lifetime labor income. The agents in the model know their life time working hours and realize that their highest output years are yet to come. They realize that in the future their own household output per person will rise (their children becoming adults). Therefore, each agent wishes to borrow against these future increases in wealth. Unfortunately for them, the shock that they face turns out to be aggregate — their cohort goes to the bond market with them and interest rates rise. This is simply the flip side of why interest rates are low now.

Assett Transfers Over Time.

Robert Martin Says:

When the size of the working age population is temporarily high as it is now, output is temporarily high and households wish to transfer assets to the future. Because ability to do so is limited2 , there is upward pressure on real asset prices — house prices rise, interest rates fall.3 The increase in house prices occurs now despite the certain knowledge that once the baby boomers retire real house prices will fall.

Any individual agent can transfer output over long periods of time by trading long lived bonds. Thirty year bonds exist and exhibit fairly liquid markets. However, to undo the effects in the model real output must be physically transferred from today to the future. As the demographic shocks discussed in this paper occur over 30 to 50 year intervals, it is difficult to think of a real asset capable of making this transformation. Think of real capital and assume it depreciates at a mere 5 percent per year. Almost 80 percent of the capital is consumed by depreciation over the 30 year period. On a discounted basis over 95 percent of the capital is eroded.It is in this sense, that the ability to transfer assets to the future is limited.

This is the core of the problem.