Certainty Equivalence

With Euro deposit rates close to zero and heading into negative territory the economic concept of certainty equivalence will come to the fore. First some definitions: Certainty is a conviction about which there is no doubt. Equivalence is the condition of being equal in value or worth. The certainty equivalent is an economic term describing the guaranteed amount of money that a consumer would view as equal to a risky asset. When, soon, deposit rates start to lose money how will consumers calculate certainty equivalence? How will they determine the value of risky assets and how will they evaluate risk-free equivalents?

Traditionally, investments pay a so-called risk-premium over deposit rates to compensate consumers for the possibility that they may lose money. If a consumer has a choice between a “guaranteed” return paying 1% and a risky-asset paying 5%, and chooses the former – the payoff is the certainty equivalent. In other words, the certainty equivalent is the return consumers receive to make them indifferent to the uncertainty.  But how will consumers behave when the above numbers are represented as, say, -1% and +4%? How much more of a risk-premium would have to be on offer to persuade consumers to abandon negative deposit rates? MMPI does not have definitive answers but it does have some sound suggestions. The authorities, on the other hand, are only beginning to wake up to the notion of a potential consumer revolution.

The certainty equivalent approach fully recognises risk and consumers do take this into account when making financial decisions – maybe oftentimes unconsciously. Utility is an economic term describing the total satisfaction received from consuming a good or service – in this case the investment return. Expected utility tries to measure the total satisfaction of the aggregate economy under any number of given circumstances. The response of consumers in these situations is vitally important to understand because it will directly influence the demand and, therefore, the price.

Rational expectations have helped economists calculate certainty equivalence and risk-premiums over many years; and the resulting investment models have stood the test of time even when deposit rates were in double digits. But none of the modelling expected negative interest rates – and, so, the likely behaviour of consumers to being charged for deposits is completely unknown.

Uncertainty is the one condition that the investment market despises most of all. It can tolerate, and adjust for, any type of news – even extremes like political upheavals; terrorist attacks, cyber security beaches or unexpectedly good news – but it cannot handle uncertainty.

Uncertainty is not merely the antonym of certainty it expresses a position of imperfection, unknown information and fear of undesired consequences. Insecurity has the potential to upset even the strongest-held beliefs. The absolute conviction that deposit accounts will forever pay reasonable returns and can be relied upon to repay 100% of the invested capital requires radical rethinking. The pre-eminence of certainty equivalence also needs re-evaluation. Consumers have it tough. It’s about to get even tougher.