The pizza is shrinking
The Luxembourg School of Finance has engaged Professor Rajnish Mehra, a renowned expert from the United States in asset pricing, pension systems and social security. He will hold the Deutsche Bank Chair and teach PhD students, as well as executives from the financial center. LFF talked to him about his area of research and the potential impact of his findings on the local pension system.
LFF: What will be your main research areas in Luxembourg?
RM: I have a well-articulated ongoing research agenda, which I will continue to pursue. One research interest is focused on changes in demography and its implications for asset pricing and pension systems. If you look at human history, people typically died within five years before or after retirement, so the large retired population overhang that we currently observe was never an issue. This has changed. With the baby boom generation retiring, this issue will be front and center in national politics and policies ... it will impact the solvency of pension systems, how assets are priced, immigration legislation and will be of particular relevance to Europe, where birth rates are low and immigration restricted.
Neoclassical economic theory predicts that capital should flow from developed countries to developing countries, if demographics were not an issue. However, look at China and India, both developing countries, and Norway and the United States both developed countries: capital is flowing out of China and Norway and flowing into the United States and India. This can, in large part be explained the relative changes in the capital labour ratio and the concomitant changes in the marginal productivity of capital. With China’s one-child policy, on average, when two people leave the workforce, one person replaces them. In the absence of rural urban migration, the capital to labour ratio will increase leading to a reduction of the marginal productivity of capital, making domestic investments relatively less attractive. We are faced with a similar issue in Norway, which historically has had low rates of immigration and low birth rates. India on the other hand is the beneficiary of a failed policy – it vigorously promoted birth control, but was largely unsuccessful in implementing it at the grass roots level. As a result, India has a demographic skew towards youth. In the United States, immigration policy has been one of its strengths, in that they have constantly replenished their young population with talented people from all over the world.
I’m also interested in the role of intangible capital – branding, technical knowledge, and organizational capital - in valuing stock markets. Look at a country like India, where, for the first time in history we see a developing country transform itself to a largely service economy from an agricultural economy – skipping the manufacturing phase. Its transition from an agricultural to a service based economy has resulted in a lot of intangible capital, which is not fully reflected in the price earning ratios of its publicly traded firms.
Another research interest is my work on financial intermediation and its role in explaining the difference in returns between different asset classes - for instance the large premium to holding equity rather than a government bond. Researchers have been trying to explain these empirical observations (The Equity Premium Puzzle) for the last thirty years. Only recently, has academia started to look at intermediation costs as part of the explanation of the equity premium puzzle. Given that financial intermediation is a non-trivial component of GDP, this is a promising development. Our findings suggest that about a third of the premium can be attributed to intermediation costs.
LFF: The pension system in Luxembourg is an issue, because of a generous social security system and many people taking early retirement. Could your work be an inspiration for the government?
RM: My work has policy implications and broad application to managing Social
Security, among the other critical choices we make as a society. At the end of the day, things have to add up - the budgets have to be balanced. Governments need to make a distinction between nominal and real growth. We can always print money, although now, being part of the European Monetary Union, you cannot print money on your own! To grow, a country has to be productive. Some people (the working population) make the pizza, however, the entire population eats the pizza! The proportion of people who are not working and are eating the pizza is increasing. We will either have to increase the tax on the people making the pizza (a bad idea), reduce benefits or make people work longer. Somewhere things will have to give. Society has to decide how to set incentives optimally. If you create incentives and encourage people to retire in their mid fifties – and don’t we all wish that were true! - they will - but then fewer people will work to produce food, clothing, medicine and the Porsches! The pizza will shrink. It’s a fine balance how a society sets the incentives between work and leisure. If we all think that the country is wealthy (in nominal terms) and we no longer need to work, that’s a recipe for a disaster in the making.
LFF: How will you adapt your areas of research to shaping the Luxembourg financial center?
RM: Luxembourg is a high cost economy. It’s not positioned to compete on routine services like check clearing. Luxembourg’s differential advantage is to offer unique, innovative, structured financial products – to compete on quality. To do that, you need an excellent educational system, where cutting-edge research is created and disseminated. All the major financial centers, London, New York, Hong Kong and Singapore have heavily invested in financial education. They all have strong academic ties with world-class universities. Cutting edge theory and practice go hand in hand. Together with Christian Wolff and my colleagues at the LSF and Ernst-Wilhelm Contzen at Deutsche Bank, we look forward to enhancing the synergies between the LSF and the Luxembourg financial community.
LFF: Where do you see the future of the Luxembourg financial center?
RM: Among Luxembourg’s many strengths are its stable political and judicial systems. Money doesn’t flow into a country where it is likely to be expropriated. You need a stable political system, a good juridical system and reasonable taxation; you don’t want excessive regulation. As long as these policies continue, the future looks promising. If you over regulate what happens? The British debated legislation to tax hedge funds. What happened? Several hedge funds relocated to Zug (Switzerland). Here, in Luxembourg, the climate is investment friendly, and conducive to technological and financial innovation.
LFF: What is your perception of Luxembourg? Were you familiar with the country before you came here?
RM: Students in the U.S in the early 70’s had figured out that the most economical way to travel in Europe was to take Icelandic Air to Luxembourg and many of my friends were always headed there! As an Indian passport holder, getting visas was difficult (I guess they thought we were potential refugees!). I figured out that once you had a Benelux visa, Germany and France and everyone else were happy to give you a visa as well. The Luxembourg consulate graciously offered us a cup of tea every time we went there and then stamped the Benelux visa. On a nostalgic note, I remember listening to Radio Luxembourg – which had wonderful pop music. My early impressions of Luxembourgish welcome, warmth and hospitality have only been reinforced on all my subsequent visits. EK