Archive
The Quintillion-Dollar Coin
I was going to write a technical column today about how the sensitivity of bonds (and consequently, lots of other asset prices) to interest rates increases as interest rates decline, and discuss the implications for equity investors nowadays as interest rates head back up. That article will have to wait another week. Today, I want to just quickly dispense with a really silly idea that keeps making the rounds every time there is a standoff on the debt ceiling, pushed by the same guys who think Modern Monetary Theory (MMT) will work (even though we just tried it, and it didn’t).
The idea is that, thanks to a law passed back in the 1990s, the Treasury has the right to issue a platinum coin of any denomination. Ergo, it could produce a $1 Trillion coin, deposit it at the Federal Reserve (who does not have the option to not accept legal tender, Secretary Janet Yellen’s recently-voiced concerns notwithstanding), and continue to pay the government’s bills. Why? One well-traveled and entertaining simpleton started explaining the reasoning for doing this by saying “there’s this silly, anachronistic and ineffectual law on the books called the Debt Ceiling…”
If we started doing really really silly, not to mention stupid, things to get around every law that we thought was silly and anachronistic, legislators would be busy 24 hours a day, 7 days a week. (And, obviously, the law isn’t “ineffectual”; if it was then we wouldn’t need to get around it.)
I am continually amazed by how durable the really stupid ideas are. For instance, the notion that the government is lying about inflation to the tune of 6% per year is an idea that never seems to die even though you can show with basic math that it can’t possibly be the case. So, let’s dispense with this one even though I am sure I will have to keep slaying this dragon when it inevitably comes back from the dead.
A useful tool of logic that’s handy when you are trying to smoke out a dumb idea is to ask, “If that works, why don’t we do lots more of it?” Let’s not try to figure out why a $1 Trillion coin is a bad idea. Let’s try to figure out why a $1 Quintillion coin (a million trillions) is a bad idea.
After all, if we are going to mint a coin anyway, it doesn’t cost much more to stamp “Quinti” than it does to stamp “Tri”. And if the Treasury minted a Quintillion-dollar coin and deposited it at the Fed, it would be much more significant. With that balance, the Treasury could pay off all outstanding debt, fully fund Medicare and Social Security, and cancel all taxes basically forever while also dramatically increasing services! Why isn’t that a better idea? I spit on your Trillion-dollar coin.
Naturally, that would be a terrible idea and it’s now obvious why. I can think of several reasons, but I’ll leave most of them for other people to highlight in the comments. The immediate one is that by paying off all federal debt, increasing spending and decreasing taxes to zero, the money supply would increase immensely and immediately. As we saw quite recently, the result that rapidly follows is much higher inflation. Much much higher inflation. I will see your 8% and raise you 800%. Yes, to some extent that would depend on the Congress deciding to do that spending and cut those taxes – but do you doubt that would happen? And the Treasury offering to buy back all of the outstanding bonds wouldn’t need Congressional authorization. That’s trillions in money being suddenly returned to bondholders, which puts it back in circulation.
A trillion here, a trillion there, and pretty soon you’d be talking real money.
Inflation is a Tax
We all have heard it said before: “inflation is a tax.” It seems that when most people say it, they seem to mean that it’s painful, like a tax is. That both inflation and taxes hurt the little guy, more than the big guy. That the other political party is responsible for bad things, and these are both bad things, so they imply the same thing: vote for me!
When Milton Friedman said it, he meant inflation is a tax.
We recently have seen in an uncommonly explicit way just what this means. It isn’t something vague but an actual tax. It takes money from you, but it doesn’t stop there – it transfers that money to government coffers. I thought of this recently when I saw a headline about how government receipts were breaking records. The headline seemed to think this was great news, but I am a taxpayer so my natural reaction was: dang it. Indeed, receipts at all levels of government are way up for a bunch of reasons. Incomes are higher, so income taxes are higher. Corporate earnings are higher, so corporate taxes are higher. Retail prices are higher, so sales tax collections are higher. And real estate prices are higher, so real estate taxes are higher. To the extent that these things are higher because of higher real activity, it isn’t a bad thing – but at least part of the increase in receipts is due to inflation. Buy the same item today as you did last year and the price is going to be roughly 8-9% higher on average, which means that your sales tax will also be 8-9% higher. If your restaurant bill is 10% higher this year; so is the tax…and the tip, which is income. So it shouldn’t be a terrible surprise that overall federal receipts over the last twelve months are up. By about 27%, actually, compared to the twelve months ended in March 2021.
To be sure, the 12 months ended in March 2021 included a lot of the shutdown, although you can see in the chart that the shutdown didn’t really hurt receipts that much. But to make a better comparison: the first three months of 2022, compared to the first three months of 2021, federal receipts were +18.8%. It’s good to be the king, in inflationary times. At least until the rabble figures out where their money is going.
How much of the overall increase in tax collections is inflation? Over a long period of time, most of it although you are correct in your visceral sense that the pound of flesh has become more like 2.5 pounds of flesh over time.
The chart above shows rolling 12-month tax receipts, indexed to 12/31/1980. The red line is nominal receipts; the blue line is taxes adjusted for inflation. Since 1980, taxes have still gone up about 150% in real terms, about 2.25% per year. That’s not far from what the real growth rate of the economy has been, although to be fair about 22% of that is since the beginning of 2021.
[As an aside: if the “inflation truthers” are right about inflation really being about 5-6% higher per year than the government admits to, since the early 1980s, then either tax burdens have been going dramatically lower in real terms or the government is also lying about government receipts which must actually be orders of magnitude higher. You see how absurd this argument gets?]
So the government gets more revenue when you produce more, but it also gets more just because prices go up. Inflation is a tax.
While it isn’t directly illustrated in the charts above, this is one way that inflation contributes to inequality. It takes more from the less-well-off than it does from the well-heeled. Inflation is not only a tax – it is also a very regressive tax.
The Political Temptation Posed by “Price Gouging”
The arc of explanations about the rise in inflation and the end of the disinflationary era was foreordained:
- There’s no inflation.
- What you’re calling inflation is just a series of one-offs.
- This is just a ‘transitory’ phenomenon, a one-off at the broad economy level, and will soon fade.
- “It’s actually okay.” (NY Times: Inflation Could Stay High Next Year, and That’s OK)
- It’s greedy manufacturers and vendors that are price-gouging. Where is my pitchfork?
In the current arc, we are already easing past level 3, as “transitory” is starting to be stretched a bit to “well, not past 2022” (Former Fed Chair Ben Bernanke opined yesterday at an online event that inflation would “moderate” in 2022). And we’ve seen signs of #4, and even some #5. The blame game is heating up, and with an Administration under pressure for its handling of…well, everything…I suspect we will move sooner rather than later into the full-blown level 5, complete with price controls in some industries and possibly economy-wide. Yes, there’s a very clear lesson from history that price controls don’t work to restrain inflation, but (a) today’s politicians don’t seem to really know much history, and (b) price controls need not be about restraining inflation – for some, it’s worth the political points.
Since it’s a term we will hear more of, I thought I’d try and put a little more structure around the accusation of “price gouging.” It is an easy term to throw around, but what does it mean?
Developed economies are still mostly free markets, in that buyers and sellers are given wide latitude to negotiate on price and quantity. In certain markets, where there are limitations on competition (electric utilities being a classic example) or vast differences in negotiating power or information (health insurance?) there are limits on the terms of trade but for the most part, if you want to buy an apple from the apple vendor you can strike whatever deal suits you both. In a free market, either the buyer or the seller can choose not to transact at the proffered price; ergo, economists assume that if a transaction occurs then both buyer and seller made themselves better off or at least not worse off. Unlike many economist assumptions, this one doesn’t seem like a bad one, at least in most cases.
If the price is “too high” for the buyer, then the buyer can complain but the buyer can always choose to not transact. So there’s only two senses in which “price gouging” might mean something:
- The price is egregiously high because the seller knows you really have no alternative, as the buyer, other than to buy. If there is a mandate to buy insurance or lose your liberty, but no cap on the price of insurance, then the insurance provider can charge any price it wants. This is infrequent. Arguably, in the aftermath of hurricanes it might apply to building materials, but even in that case I would argue #2 below is a more-accurate sense of the word.
- The price is, in some sense, “unfair.”
What is “unfair?” We do, as social animals, have some innate sense of fairness. A classic result from “the ultimatum game,” where one person is endowed with money that he/she chooses unilaterally how to split with a second person who can in turn accept the split or reject it (in which case both parties get nothing) is that under experimental conditions splits that are worse than 70:30 tend to be rejected by the responding party – in other words, the respondent would rather get zero than 30%, if it feels “unfair.” It is in that context that “price-gouging” accusations could be related to “anchored” inflation expectations. If a vendor is charging a very high price, but the buyer expects price changes to be large, volatile, and generally not in the buyer’s favor, then an accusation of “price gouging” is less likely than if the buyer expects price changes to be low and random. So, it might be that accusations of price gouging simply means that the buyers have not adjusted to a new inflation/pricing paradigm, and perceive the price increases as unfair even if they are objectively fair.
If that’s the case, then the buyer is going to lose in cases where the higher prices are a result of changes in the supply/demand balance. Higher prices are how limited supply gets rationed among the buyers – it is a feature, not a bug, of the capitalist system. In the case where a surge in demand (caused by, say, massive government transfers to consumers) causes stock-outs and rising prices, then accusations of price gouging are just sour grapes. Rising prices in this case are simply normal inflation happening in an environment that has not adapted to normal inflation again. (Listen to the Inflation Guy Podcast, episode 2, where I point out that “supply chain problems” is exactly what inflation caused by too much money looks like.)
Nevertheless, where the “price gouging” accusation is code for “this feels unfair,” it is a terrific opportunity for a political lever. Politicians will feel that they can make people happy by instituting price controls, and blaming the wealthy industrialist, even though economics and history tell us that this isn’t the right answer. But it is a siren song, and I think that we are very likely to start hearing this more and more.
Once price controls are instituted, what follows is that the stock market craters (since the difference between input costs and consumer prices is some part profit), a black market develops in the restricted goods and services, and many products get impossible to acquire or rationed by a lengthening waitlist rather than by price.
Can you really control prices in the Internet age? It hardly matters. Politicians don’t really care about controlling prices after all; they merely want to appear as if they’re on the side of the voters. Bashing suppliers is one easy way to do that. I don’t think it will be long now. Keep the torches and pitchforks at the ready.
Drug Prices and Most-Favored-Nation Clauses: Considerations
A potentially important development in the market for pharmaceuticals – and in the pricing of the 1.6% of the Consumer Price Index that Medicinal Drugs represents – is the President’s move towards a “most-favored-nation” clause in the pricing of pharmaceuticals. The concept of a favored-nations clause is not new, although this is the first time it has been applied broadly to the pharmaceutical industry. In the investment management industry, it is not uncommon for very large investors (state pension funds, for example) to demand such a clause in their investment management agreements. Essentially, what such a clause does is guarantee to the customer that no other customer will get better pricing.[1] In the context of pharmaceuticals, the “problem” that the President is addressing is the fact that Americans buying a drug will often pay many times what a customer in another country will pay the pharmaceutical company for that same drug.
The optics are terrific for the President, but the economics not as much so. The argument is that demanding such a clause will force pharmaceutical companies to lower prices for American consumers drastically, to something approximating the price of those same products purchased abroad. The reality, though, is not so clear.
This is a story about price elasticity of demand. As I do often, I pause here and give thanks that I studied economics at a university that had a fantastic econ faculty. Economics is a great field of study, because done right it teaches a person to ask the right questions rather than jumping to what seems to be the apparent answer. (Incidentally, I feel the same way about Street research: done right, the value of that research is in guiding the questions, rather than handing us the answers.)
So let’s start at the ‘free market’ version of the pharmaceutical company’s profit-maximization problem. Let’s start by assuming that the marginal cost of production of a little pill is close to zero, or at least that it’s no different for the pill sold in one country versus the pill sold in another country. Then, the firm’s profit-maximizing linear programming problem is to maximize, independently for each country, the price where the marginal revenue is essentially zero – where in order to sell additional units, the price must be lowered enough that selling those additional units costs more in lost profit on the other units than it does on the incremental units. (If I sell 10 units at $10, and in order to sell the 11th unit I have to lower the price to $9, then I go from $100 in revenue to $99 in revenue and so if I am a profit-maximizer I won’t do this).
This point will be different in each country, and depends on the demand elasticity for that drug in that country. If the demand for a drug is very elastic, then that market will tend to clear at a lower price since each incremental decline in price will produce a relatively large increase in incremental quantity demanded. On the other hand, if the demand for the drug is very inelastic, then that market will tend to clear at a higher price since each additional increase in price will result in the loss of relatively few units of quantity sold. Now, every country and every drug will have different price elasticities. A lifestyle drug like the little blue pill will face fairly elastic demand in a Third World country, while a malarial drug probably does not.[2]
As an aside, one of the things which creates a more-elastic demand curve is the availability of substitutes. So, if the FDA makes it more difficult for a new statin drug to be approved than does the equivalent agency in Italy, then demand for a particular statin drug (all else equal) will be more elastic in Italy, where it faces more competition, than in the US. If you want lower prices, promote competition. But back to our story:
Now the Trump Administration adds a constraint to the drug company’s linear programming problem, such that the maximization is now joint; the problems are no longer independent maximization problems but the company must find the price that maximizes revenue across all markets collectively. If the free market has found a perfect and efficient equilibrium, then any such constraint must lower the value of the revenue stream to the drug company because if it did not, then it implies the company would already have be operating at that single-price solution. Constrained solutions can never be more valuable than unconstrained solutions, if both are in equilibrium.
What the drug company most assuredly will not do, though, is immediately lower the price to the American consumer to the lowest price charged to any other country. What it will do instead is take the highest price, and then add the incremental market that has the most inelastic demand, and see how much total revenue will increase if they have to lower the universal price to induce demand in that market. Note that this outcome may lower the price in the high-priced country, but it will also raise the price in the low-priced country. Since the lower-priced countries probably have more-elastic demand than the high-priced country…which is suggested by the fact that they had lower prices when they were being separately optimized…it is easy to imagine a scenario where the drug company ends up only supplying the high-priced country because the large increases in price for other countries essentially eliminate that demand. And that outcome, or indeed as I said any constrained outcome, is likely to be bad for the drug company. But what it will almost certainly not do is cause drug prices in the USA to drop 70%, or a massive decline in the Medicinal Drugs portion of CPI.
It may cause a decline in US drug prices, but that is not as certain as it appears. If the optimal strategy is to supply the drug only in the United States, then prices need not change at all (the US would then be the Most Favored Nation because it’s the only customer). In fact, the drug company might need to increase prices in the US. That happens because when you allow price discrimination, any customer who pays more than the variable cost of the product (which we assume here is close to zero) contributes something to the fixed overhead of the company;[3] therefore, a company that understands cost accounting will sometimes sell a product below the total cost per unit as long as it is above the variable cost per unit. When a US company, then, sells a pill to Norway at a really low price but above the cost of production, it defrays some of its overhead. If a most-favored-nation clause prevents a company from doing this, it will need to raise the price of the product in its remaining markets in order to cover the overhead that is not being covered any longer by those customers.
OK, so that’s just one iteration. I suspect that most pharmaceutical companies will end up lowering prices a little bit in the US and in other countries where prices are similar, and only selling them in countries that now pay a very low price to the extent that those foreign countries and/or international charities subsidize those purchases. But then we get into the financial and legal engineering part of this: what happens if Pfizer now licenses the formula for a particular drug to an Indian company that is legally distinct and doesn’t sell to the United States? Does the licensing agreement also fall under the MFN clause? What if Pfizer spins off its South American operations, sharing the intellectual property with its spinoff? For that matter, it might be the case that for some drugs, it is optimal to sell it everywhere in the world except the US, because the value of the unconstrained-non-US portion of the business is greater than the constrained-US portion of the business.
Now wouldn’t that be a kick in the head, to see pharmaceutical companies leave the US and refuse to sell to the US consumer because it makes them subject to the MFN clause? In the end, it seems to me that this is a great political gesture but it will be very difficult to get the results the President and his team wants.
[1] As an aside, in investment management this has caused the universe of strategies available to institutions demanding this clause to be reduced, hurting their investors. There are many circumstances in which an investment manager will offer outstanding, and sometimes outlandish, terms to investors who are the first in a new strategy, or who are low-touch easy/sophisticated customers, etc; a later entry by a large, high-maintenance customer may not be economic under the same terms.
[2] I am not at all an expert on how drug price elasticity behaves in this riot of market/product combinations, so readers who are should give me a break! I’m just illustrating a point.
[3] Cleverly called “variable contribution.”
And Now Their Watch is Ended
At one time, fiscal deficits mattered. There was a time when the bond market was anthropomorphized as a deficit-loathing scold who would push interest rates higher if asked to absorb too much new debt from the federal government. The ‘bond vigilantes’ were never an actual group, but as a whole (it was thought) the market would punish fiscal recklessness.
Of course, any article mentioning the bond vigilantes must include the classic account by Bob Woodward, describing how then-President Bill Clinton reacted to being told that running too-large deficits would cause interest rates to rise and tank the economy: “Clinton’s face turned red with anger and disbelief. ‘You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of ****** bond traders?’”
Truth be told, this was always a bit of a crock in the big scheme of things. Although the bond market occasionally threw a tantrum when Big Government programs were announced, the bond traders have always been there when the actual paper hit the street. The chart below shows 10-year yields versus the rolling 12-month federal deficit. Far from being deficit scolds, bond market investors have always behaved more as if bonds were Giffen goods (whose price gets higher when there is more supply, and lower when there is less supply, in the opposite manner from ‘normal’ microeconomic dynamics). I guess so long as we are doing a walk down economic history lane, we could also say that the bond market followed a financial version of Say’s law: that supply creates its own demand…
Well, if ever there was a time for the market to get concerned about deficits, now is surely it. While the Fed continues to buy massive quantities of paper (to “ensure the smooth functioning of the markets”, as it surely does since if they were not buying such quantities the adjustment may be anything but smooth), there is still an enormous amount of Treasury debt in private hands. And it all yields far less than the rate of inflation. Clearly, these private investors are not alarmed by the three-trillion-dollar deficit, nor of the effect that the Fed buying a large chunk of it could have on the price level.
If investors are not alarmed by a $3T deficit – and, aside from market action being so benign, consider whether you’ve read any such alarm in the financial press – then it’s probably fair to say that there isn’t a deficit amount that would alarm them. Always before, if the market absorbed an extra-large deficit there was always at least the concern that it might choke on all that paper. Or, if it didn’t, that surely we were at the upper level of what could be absorbed. I don’t sense anything like the unease we’ve seen in prior deficit spikes. And that’s what alarms me. Because, as I tell my kids: a rule without enforcement means there isn’t a rule. Investors are not putting any limitation on the federal balance; ergo there is no limit.
Well, perhaps by itself that’s not a big deal. Heck, maybe deficits really don’t matter. But what bothers me is that the risk to that possibility is one-sided. If deficits don’t matter, then no biggie. But if they do matter, and the bond vigilantes are dead so that there is no push-back, no enforcement of that rule, then it follows that the only speed limit that will be enforced is when the car hits the tree. That is, if there is no alarm that causes the market to discipline the government spenders before there’s a crack-up, then eventually there will be a crack-up with 100% probability (again, assuming that deficits do matter at some level, and maybe they don’t).
While the vigilantes kept watch, there was scant worry that a government auction would fail. Although, as I’ve pointed out, the vigilantes weren’t macro-enforcers there were sometimes micro-aggressions: sudden interest rate adjustments where yields would jump 100bps in six weeks, say. This doesn’t happen any longer. So, while there’s plenty of money floating about right now to buy this zero-yielding debt, the larger the bond market gets the more of that money it will be sucking up. Unless, that is, the amount of money expands faster than the amount of debt (so that the debt shrinks in real terms), which is another way to say that the price level rises sharply. In that case, in order to keep the markets “orderly” the Federal Reserve will have to take more and more of that zero-yielding debt out of the market, replacing it with cash. It’s easy to see how that could spiral out of control quickly, as well.
I am not sure how close we are to such a crack-up. It could be years away; it could be weeks. But without the bond vigilantes, there’s no law in this town at all.
Half-Mast Isn’t Half Bad
As I watch the stock market, implausibly, rise to levels no one expected so soon after the crash, I am also sickened by the cheerleading from those whose fortunes – not to mention egos – are wrapped up in the level at which the Dow trades. Stock market fetishism always fascinates me as much as it repels me. Although my experience as a trader (and a short-term options trader, at that) would seem to suggest otherwise, my makeup is as a long-term investor. I want to buy value, and the mathematics of investing for me is that I want (a) high intrinsic value at (b) a low price. While people who are buy-and-hold investors of a certain age clearly benefit from higher prices, young investors clearly benefit from lower prices since they’re going to be net buyers for a long time. And the price at which you acquire intrinsic value matters. So does the price at which you sell, but not until you sell.
So to me, there’s nothing great about a price that’s high relative to intrinsic value, unless I am preparing to sell. In a broader sense, the idea that we should cheer for higher prices (as opposed to higher intrinsic values) is not only unseemly, but destructive and I’ll explain why in a minute. I will note that the fascination with watching prices ticking every second goes back a long ways: you can read in Reminiscences of a Stock Operator about the bucket shops of the early 1900s where speculators would watch and trade the stock market tape. The general increase in investor twitchiness and short-termism that has accompanied the growth of financial news TV, online investing, and the development of ETFs to trade broad market exposures intraday certainly adds numbers to the cheerleading crowd. But it isn’t new. Depressing, but not new.
The most fascinating example of this belief in the (non-intuitive, to me) connection between the value of the stock market and the value of ‘Merica was presented to me in the aftermath of 9/11. When we first trudged back to lower Manhattan, there were people handing out these cards:
Fight Osama! Buy Cisco! I never did see the connection, and it seemed to me at the time either delusional (the terrorists win if my investment in Lucent goes down) or nakedly self-serving. Certainly the way I feel about my country has nothing to do with where I’m able to buy or sell eBay today. And actually, they really weren’t coming for our 401(k)s, they were coming for our lives. But I digress.
The point I actually want to make is that when the Fed works to stabilize market prices, they’re having a negative effect by destabilizing economic variables. An analogy from manufacturing might be an entry point to this explanation: a truism in manufacturing is that you can stabilize inventory, or you can stabilize production, but you can’t stabilize both (unless your customers are accommodating and provide very smooth demand). If you want to stabilize inventory levels, then you need to produce more when business is high and less when business is low, so you’re on the production roller-coaster. If you want to keep production level, then inventory will be low when business is high and high when business is low, so you’re on the inventory roller-coaster. Only if business itself is stable – which is rare – can you do both.
A similar thing happens in capital markets. You can stabilize the cost of capital, but then you destabilize growth rates. Or you can stabilize growth rates, and the cost of capital (stock and bond prices) will fluctuate. This is true unless you can do away with the business cycle. If you choose, as the Fed has in recent years, to try and stabilize market prices at very high levels (stabilizing the cost of capital at very low levels), then when underlying activity is strong you’ll get a ton of speculative investment in capacity, new ventures that depend on the availability of cheap capital, and strong growth. And then when economic activity heads lower, you’ll find that lots of businesses go bust and the recession is deeper. In fact, it’s not just the speculative businesses that go bust, but the overbuilding in the expansion can cause even prudent enterprises to have more difficulties in the downturn.
The Fed’s historical response to this has been to let the speculative activity happen when the cost of capital is held too low, but not let companies go bust when economic activity wanes…so they lower the cost of capital even further.
I’m obviously not the first person to point out that the Fed’s constant intervention has deleterious effects and tends to increase the amplitude of boom and bust. And, for what it’s worth, I’m not blaming the current recession on the Fed. Clearly, the proximate cause of this recession was COVID-19 and the global economic shutdown. What made it worse was that the Fed, by holding down the cost of capital, had previously precipitated the development and preserved the success of many more speculative enterprises. And the fetishism about stock prices, and about how important it is to have lots of money “working for you” in the stock market, is also one of the reason that people don’t save enough.
Of course, right now is probably not the time for the Fed and Congress to pull back and let huge numbers of people and companies go bankrupt. There’s a case to be made for the sort of government response we are having in this episode, in which personal income is being replaced by money creation while workers are ordered to stay home. There will be a piper to pay for that policy – a loss of price stability which is a consequence of trying to preserve output stability, but a consequence that it’s arguably acceptable to pay. Afterwards, though, I hope that central banks can start to let natural rhythms replace the autocratic ones. I am not hugely optimistic on that score, but one place to start is this: stop lowering the bar for central banks to intervene in markets. Stop targeting equity prices and interest rates. It’s okay to let the Dow trade at half-mast, and the bull will come back without the Fed’s help.
In fact, if we don’t keep trying to artificially increase the length of the mast, the Dow might never need to trade down to half-mast in the first place. Certainly, intrinsic values don’t retrace 50% in a recession!
I Dream of GINI – Is Inequality a Function of Longevity?
Before I get into a distinctly non-inflation thought, I want to add another non-inflation thought and offer my congratulations to the UK on the occasion of her independence. Congratulations for throwing off the oppressive yoke of her Continental overlords. We did that once, and it worked out really well. I heartily believe that every society should refresh its independence at least every thousand years or so. So good job, mates! Sorry about that Rugby World Cup, but after all this was more important.
I should also point out that the sky does not seem to be falling in the UK, or elsewhere for that matter for any reason related to Brexit. I should also point out that I told you so.
Now, on an wholly different topic – inequality. I had a thought a few days ago and after mulling it for a bit I concluded that there might be something useful in the concept so I thought I would share it. I first discussed it briefly with an eminent retired economist of my acquaintance, and he thought the proposition was intriguing, so here goes…
There has been a lot of teeth-grinding and navel-gazing about the idea that societal inequality seems to be growing worse over time. One way to measure this is with the GINI Coefficient, which ranges from 0 (everyone in society shares income, or wealth, depending on what is measured, equally) to 100 (one household gets all the income for the society). The calculation of the coefficient isn’t important for my purposes, nor is dwelling on its imperfections. Clearly it is an imperfect measure, but for my musing it suffices. The GINI coefficient has been rising steadily for some time in the US, and in most other countries in fact.
But consider this: does the fact that lifespans are also lengthening have anything to do with the growing measurement of inequality? After all, the longer someone is in the workforce the higher we would expect their income to be and, assuming any savings discipline at all the more wealth we would expect them to have. If the average lifespan is 50, then the oldest in society have less time to accumulate than if the average lifespan is 80. (Hey, look at all the billionaires. None of them are spring chickens.) Moreover, when a wealthy old person dies their wealth gets distributed and diluted, rather than remaining concentrated – the Vanderbilts and Carnegies are not as wealthy now as they were in the 1800s. So my hypothesis is that while I don’t claim this explains all of the apparent increase in inequality, I suspect it explains part of it.
Further, I wonder if the increased concentration of corporate value and power in larger and larger megacorporations might also be related to the relatively longer lifespans of corporations – the diminished frequency with which companies are broken up by antitrust crusaders or corporate raiders, or allowed to go bust (see GM et. al. in the Global Financial Crisis) allows them to accumulate “value” over longer and longer periods of time. I’m not talking market cap – Tesla, Facebook, Amazon, etc are all worth far more in the market than their actual economic heft. But a lot of the big banks might fall into this category today – heck, big finance companies on both sides: e.g. Blackrock! In short, I wonder if a lot of the problems with corporate ‘greed’ that Bernie Sanders and his ilk decry could be solved by the simple expedient of making the system more capitalist rather than less. Break them all up!
Of course, I wouldn’t argue for killing people at their retirement parties, so the same solution doesn’t exactly apply. But here, too, there might be merit in an alternate prescription that is essentially the opposite of the socialist path. Rather than trying to suck up all of a millionaire’s wealth when he/she dies, preventing him/her from passing along wealth to another generation, give more incentives for distributing wealth earlier. Give larger deductions for charitable contributions, larger gift exemptions, and so on. Distribute earlier and the concentration at the top won’t be as large.
One final point, and that is about inflation. Greater inflation also tends to cause wealth to concentrate more at the top since the wealthy tend to own more real property and consume a smaller proportion of their incomes. And autocratic regimes tend towards higher inflation. So I suppose what I am saying (and I didn’t know I was going to say this when I started to write this column) is that the prescription for less inequality is to have more creative destruction and for society to lean more towards freedom and capitalism than towards government intervention and socialism. I might even argue that this country’s lurch away from true capitalism, especially since the Global Financial Crisis, is a key reason that income and wealth has become less well-distributed. (And, as I wrap up with that statement, I do one more Google search and discover that others have already made some of these points. See this article for some historical perspective of inequality under non-capitalist regimes).
Discuss.
P.S. I feel like I ought to give some credit here to my teenage son, Andy, whose flirtations with questions of inequality has caused me to ruminate on these issues more than I might otherwise have done. Keep on questioning, son!
Profits and Health Care: A Beneficial Connection
I usually try to avoid political commentary in this space, because it has become so personal to so many people. If I point out that a particular program of the “left” is smart, or cleverly put together, then half of my readership is annoyed; if I point out the same about the right, then half of my readership is angry. It doesn’t really make sense to waste article space except on those occasions when a policy has a clear effect on inflation over time, such as when the structure of the ACA made it clear that it would put upward pressure on inflation (as I pointed out in 2013) or in response to someone else’s flawed analysis of a policy, as I did last year when I tackled the San Francisco Fed for their weak argument about how the ACA would hold down inflation because the government would demand lower prices. Actually, there is no policy I have written about more than the ACA over the years – but again, this was economic commentary and not political commentary.
This article will be short, but different in that I am writing it to express frustration with the absolute lack of intellectual clarity on the part of the Republicans in making a particular argument that immediately impacts the debate over health care but also extends far into other policies. And, because the argument is simple, direct, and has tremendous empirical support, I couldn’t restrain myself. I expect this article will not be picked up and syndicated in its usual channels since it isn’t directly about economics or markets, but it needed to be said.
I’ve been stewing about this topic since Tuesday (March 14th), when I happened to catch part of the daily White House press briefing. Press Secretary Sean Spicer was asked a question about the President’s health care proposal, and tap danced away from the question:
Q Thanks, Sean. You mentioned the call with the CEO of Anthem Health. Can you tell me what this proposal of the President means for health insurance companies? Will their profits go up or down under the President’s proposal?
SPICER: Well, I don’t think that’s been the focus of the President’s proposal. It’s not about them, it’s about patients. But I think what it means for them is that they finally get to create more choice and more plans and allow people to choose a plan that fits them. Right now, they don’t have that choice. And, frankly, in more and more markets, companies like Anthem, UnitedHealth, Signa are pulling out — Aetna — because they don’t have the choice and because of the government mandate. I think what we want to do is allow competition and choice to exist so that they can offer more options for the American people.
Q But will those companies make more money under the President’s plan or less?
SPICER: I don’t know the answer to that. That’s not been the focus of what we’re doing now. And at the end of the day, right now they’re pulling out of market after market, leaving the American people with fewer and fewer choices. So right now it’s not a question of — from the last I checked, I think many of them were doing pretty well, but it’s the American people and its patients that are losing under the current system. So I think that there’s a way you can do a little of both.
Spicer’s response was the usual drivel that the Republicans have adopted when they run in fear from any question that includes the word “profits.” To summarize, the question was basically, “you’re doing this to throw a sop to fat-cat insurance companies, aren’t you?” and the answer was “we don’t think about that. No idea. Profits? Who said anything about profits? It’s about patients and choice. And, if anyone gets more profits, it wasn’t on purpose and we didn’t have anything to do with it.”
But this was actually a softball question, and the answer ought to have been something like this:
Q But will those companies make more money under the President’s plan or less?
BIZARRO SPICER: Well, I hope so. After all, the insurance companies want every person in America to have health care – which is the same thing that we want – because the more people they sell their product to, the more money they can make. The insurance companies want to sell insurance to every person in the U.S. The insurance companies also want costs to be lower, and constantly strive to lower the cost of care, because the lower that costs are, the more profit they can make in the short run. But they don’t want lower costs at the expense of health – clearly, the best outcome for their profits is that most people covered by insurance are healthy and so don’t require the insurance they’ve paid for. So, if we just get out of the way and let companies strive for better profits, we are likely to get more coverage, lower costs, and a healthier population, and that is the goal of the President’s plan.
The reason we don’t already have these things is that laws we have previously passed don’t allow insurance companies to offer certain plans, to certain people, which both sides want but which politicians think are “unfair” for one reason or another. Trying to create a certain preconceived Utopian outcome while limiting profits of insurance companies is what caused this mess in the first place.
If you want to beautify gardens in this city, does it make sense to limit the amount of money that gardeners can make? If you did, you would find fewer gardens got tended, and gardeners would not strive to make improvements that they didn’t get paid for. We can see this clearly with gardeners. Why is it so hard to understand with the companies that tend to the nation’s health? Next question.
For some reason, Republicans think that saying “profits are good” is the same thing as saying “greed is good” and leads to caricatures of conservatives as cigar-smoking industrialists. But while at some level it is the desire for a better material outcome – which I suppose is greed, but aren’t there degrees of greed? – that drives the desire for profit, we cannot dismiss the power of self-interest as a motive force that has the effect of improving societal outcomes. “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest,” after all.
Of course, Republicans must also remember that profit without competition is a different animal. If an insurance company creates an innovation that lowers medical care costs, but does not face competitive pressure, then the benefit of the innovation accrues to the company alone. There is no pressure in such circumstances for the company to lower the price to the customer. But consider what happened to air fares after the deregulation of 1978, or to the cost of telephone service when the AT&T monopoly was broken up in 1984, as competition was allowed and even encouraged. Competition, and the more brutal the better, is what causes companies to strive for an edge through innovation, and it’s also what causes the benefit of that edge to eventually be accrued by the end customer. The government didn’t invent cell phones. Motorola did, in order to try and gain an edge against AT&T,[1] but until the telephone monopoly was broken up there were no commercial versions of the cell phone. The first cell phones cost $10,000 in 1983, about $25,000 in today’s dollars, but now they are ubiquitous and cost about 2% as much in real terms. But this didn’t happen because of a government program to drive down the cost of cell phones. It was the profit motive, combined with competition. All that government did was create the conditions that allowed innovation and competition to happen. And wouldn’t we like health care to be as ubiquitous and cheap as cell phones are?
This is not a hard thing to get right. It isn’t hard for people to understand. But for some reason, it seems incredibly hard for politicians to believe.
Note that nothing I have written here should be construed as an opinion about the President’s health care plan, which I have not read. My remarks are only meant to reflect on the utter inability of Republicans to properly convey the reasons that a different approach – one where the government’s involvement is lessened, rather than increased – would make more sense.
[1] The first cell phone call was made by the inventor, Martin Cooper at Motorola, who called his competition with it: the head of the cellular program at AT&T. According to him, he said “Joel, I’m calling you from a cellular phone, a real cellular phone, a handheld, portable, real cellular phone” and he said it got really quiet on the other end of the line.
Not So Fast on the Trump Bull Market
**NOTE – please see the announcement at the end of this article, regarding a series of free webinars that begins next Monday.**
Whatever else the election of Donald Trump to be President of the United States has meant, it has meant a lot of excitement in precincts that worry about inflation. This is usually attributed, among the chattering classes, to the faster growth expected if Mr. Trump’s expressed preference for tax cuts and spending increases obtains. However, since growth doesn’t cause inflation that isn’t the part of a Trump Presidency that concerns me with respect to a continuing rise in inflation.
In our latest Quarterly Inflation Outlook, I wrote a short piece on the significance of the de-globalization movement for inflation. That is an area where, if the President-Elect delivers on his promises, a lot of damage could be done in the growth/inflation tradeoff. I have written before about how a big part of the reason for the generous growth/inflation tradeoff of the 1990s was the rapid globalization of many industries following the end of the Cold War. Deutsche Bank recently produced a research piece (I don’t recall whether it had anything to do with inflation, weirdly) that contained the following chart (Source: as cited).
This chart is the “smoking gun” that supports this version of events, in terms of why the inflation dynamic shifted in the early 1990s. Free trade helped to restrain prices in certain goods (apparel is a great example – prices are essentially unchanged over the last 25 years), by allowing the possibility of significant cost savings on production.
The flip side of a cost savings on production, though, is a loss of domestic manufacturing jobs; it is this loss that Mr. Trump took productive advantage of. If Mr. Trump moves to increase tariffs and other barriers to trade, and to reverse some of the globalization trend that has driven lower prices for the last quarter-century, it is potentially very negative news for inflation. While there was some evidence that the globalization dividend was beginning to get ‘tapped out’ as all of the low-hanging fruit had been harvested – and such a development would cause inflation to be higher than otherwise it would have been – I had not expected the possibility of a reversal of the globalization dividend except as a possible and minor side-effect of tensions with Russia over the Ukraine, or the effect the Syrian refugee problem could have on open borders. The election of Mr. Trump, however, creates the very real possibility that the reversal of this dividend might be a direct consequence of conscious policy choices.
I don’t think that’s the main reason that people are worried about inflation, though. Today, one contributor is the news that OPEC actually agreed to cut production, in January, and that some non-OPEC producers agreed to an additional cut. U.S. shale oil producers are clicking their heels in delight, because oil prices were already high enough that production was increasing again and they are more than happy to take more market share back. Oil prices are up about 15% since the announcement.
But that’s near-term, and I don’t expect the oil rally has legs much beyond current levels. Breakevens have been rallying, though, for weeks. Some of it isn’t related to Trump at all but to other initiatives. One correspondent of mine, who owns an office-cleaning business, sent me this note today:
“Think of you often lately as I’m on the front line out here of the “instant” 25% increase in min wage. Voters decided to move min wage out here from 8.05 to $10 jan 1. Anyone close to 10/hr is looking for a big raise. You want to talk about fast dollars, hand a janitor a 25% pay bump and watch the money move. Big inflation numbers pending from the southwest. I’m passing some through but market is understandably reacting slower than the legislation.”
Those increases will definitely increase measured inflation further, though by a lot less than it increases my friend’s costs. Again, it’s an arrow pointing the wrong way for inflation. And, really, there aren’t many pointing the right way. M2 growth continues to accelerate; it is now at 7.8% y/y. That is too fast for price stability, especially as rates rise.
All of these arrows add up to substantial moves in inflation breakevens. 10-year breaks are up 55bps since September and 30bps since the election. Ten-year inflation expectations as measured more accurately by inflation swaps are now at 2.33%. Almost all of that rise has been in expectations for core inflation. The oft-watched 5y5y forward inflation (which takes us away from that part of the curve which is most impacted by energy movements) is above 2.5% again and, while still below the “normal” 2.75%-3.25% range, is at 2-year highs (see Chart, source Bloomberg).
So what is an investor to do – other than to study, which there is an excellent opportunity to do for the next three Mondays with a series of educational webinars I am conducting (see details below)? There are a few good answers. At 0.46%, 10-year TIPS still represent a poor real return but a guaranteed positive 1/2% real return beats what is available from many risky assets right now. Commodities remain cheap, although less so. You can invest in a company that specializes in inflation, if you are an accredited investor: Enduring Investments is raising a small amount of money for the management company in a 506(c) offering and is still taking subscriptions. Unfortunately, it is difficult to own inflation expectations directly – and in any event, the easy money there has been made.
What you don’t want to do if you are worried about inflation is own stocks as a “hedge.” Multiples move inversely with inflation.
Unlike prior equity market rallies, I understand this one. It is plausible to me that a very business-friendly President, who cuts corporate and personal taxes and reduces regulatory burdens, might be good for corporate earnings and even for the economic growth rate (although the bad things coming on trade will blunt some of that). But before getting too ebullient about the potential for higher corporate earnings, consider this: if Trump is business-friendly, then surely the opposite must be said about President Obama who did essentially the reverse. But what happened to equities? They tripled over his eight years (perhaps they “only” doubled, depending on when you measure from). That’s because lower interest rates and the Fed’s removal of safe securities in search of a stimulus from the “portfolio balance channel” caused equity multiples to expand drastically. So, valuations went from low, to extremely high. Multiples matter a lot, and right now even if you think corporate earnings over the next four years might be stronger than over the last four you still have to confront the fact that multiples are more likely to move in reverse. In short: if stocks could triple under Obama, there is no reason on earth they can’t halve under a “business-friendly” President. That’s not a prediction. (But here is one: equities four years from now will be no more than 20% higher than they are now, and might well be lower.)
Also, remember Ronald Reagan? He who created the great bull market of the 1980s? Well, stocks rallied in the November he was elected, too. The S&P closed November 1980 at 140.52. Over the next 20 months, the index lost 24%. It wasn’t until almost 1983 before Reagan had a bull market on his hands.
An administrative announcement about upcoming (free!) webinars:
On consecutive Mondays spanning December 5, December 12, and December 19 at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.
Each of these webinars is financially sponsored by Enduring Investments.
Britain Survived the Blitz and Will Survive Brexit
So I see today that former Fed Chairman Alan Greenspan says this is the worst crisis he has seen. Bigger than the 1987 Crash? Bigger than Long Term Capital? Bigger than the internet bubble collapse? Bigger than the Lehman (et. al.) collapse? Really?
As humans, we tend to have short memories and (ridiculously) short planning horizons. Greenspan, especially in his apparent dotage, has a shorter memory even than he had previously – maybe this is convenient given his record. I don’t want to comment on his planning horizon as that would seem uncharitable.
Why is Brexit bad? The trade arrangements and treaties do not suddenly become invalid simply because the UK has voted to throw off the shackles of her overlords and return to being governed by the same rules they’ve been governed by basically since the Magna Carta. But Jim Bianco crystallized the issue for me this week. He pointed out that while Brussels could let this be a mostly painless transition, it has every incentive to make it as painful as possible. In Jim’s words, “if it isn’t painful then hands shoot up all over Europe to be the next to leave.” That’s an astute political observation, and I think he’s right. The EU will work hard to punish Britain for having the temerity to demand sovereignty.
But Britain survived the Blitz; they will survive Brexit.
Indeed, Britain will survive longer than the Euro. The sun is beginning to set on that experiment. The first cracks happened a few years ago with Greece, but the implausibility of a union of political and economic interests when the national interests diverge was a problem from the first Maastricht vote. Who is next? Will it be Greece, Spain, Italy, or maybe France where the anti-EU sentiment is higher even than it is in the UK? The only questions now are the timing of the exits (is it months, or years?) and the order of the exits.
As I said, as humans we not only have short memories but short planning horizons. From a horizon of 5 or 10 years, is it going to turn out that Brexit was a total disaster, leading to a drastically different standard of living in the UK? I can’t imagine that is the case – the 2008 crisis has had an effect on lifestyles, but only because of the scale and scope of central bank policy errors. In Iceland, which addressed the imbalances head-on, life recovered surprisingly quickly.
These are all political questions. The financial questions are in some sense more fascinating, and moreover feed our tendency to focus on the short term.
A lot of money was wagered over the last few weeks on what was a 52-48 proposition the whole way. The betting markets were skewed because of assumptions about how undecideds would break, but it was never far from a tossup in actual polling (and now perhaps we will return to taking polling with the grain of salt it is usually served with). Markets are reacting modestly violently today – at this writing, the US stock market is only -2.5% or so, which is hardly a calamity, but bourses in Europe are in considerably worse shape of course – and this should maybe be surprising with a 52-48 outcome. I like to use the Kelly Criterion framework as a useful way to think about how much to tilt investments given a particular set of circumstances.
Kelly says that your bet size should depend on your edge (the chance of winning) and your odds (the payoff, given success or failure). Going into this vote, betting on Remain had a narrow edge (52-48) and awful odds (if Remain won, the payoff was pretty small since it was mostly priced in). Kelly would say this means you should have a very small bet on, if you want to bet that outcome. If you want to bet the Leave outcome, your edge was negative but your odds were much better, so perhaps somewhat larger of a bet on Brexit than on Bremain was warranted. But that’s not the way the money flowed, evidently.
Not to worry: this morning Janet Yellen said (with the market down 2.5%) that the Fed stood ready to add liquidity if needed. After 2.5%? In 1995 she would have had to come out and say that every week or two. A 2.5% decline takes us back to last week’s lows. Oh, the humanity!
Just stop. The purpose of markets is to move risk from people who have it to people who want it. If, all of a sudden, lots of people seem to have too much risk and to want less, then perhaps it is because they were encouraged into taking too much risk, or encouraged to think of the risk as being less than it was. I wonder how that happened? Oh, right: that’s what the Fed called the “portfolio balance channel” – by removing less-risky assets, they forced investors to hold more-risky assets since those assets now constitute a larger portion of the float. In my opinion (and this will not happen soon), central banks might consider letting markets allocate risk between the people who want it and the people who don’t want it, at fair prices. Just a suggestion.
One final point to be made today. I have seen people draw comparisons between this episode and other historical episodes. This is refreshing, since it reflects at least some thoughtful attempt to remember history. Not all of these are apt or useful comparisons; I saw one that this is the “Archduke Ferdinand” moment of this generation and that’s just nuts. Europe is not a military powderkeg at the moment and war in Europe is not about to begin. But, to the extent that trade barriers begin to rise again, the idea that this may be a “Smoot-Hawley” moment is worth consideration. The Smoot-Hawley tariff is generally thought to have added the “Great” to the phrase “Great Depression.” I think that’s probably overstating the importance of this event – especially if everybody decides to respect Britons’ decision and try to continue trade as usual – but it’s the right idea. What I want to point out is that while rising tariffs tend to produce lower growth and lower potential growth, they also tend to produce higher inflation. The fall of the Berlin Wall and the opening of Eastern Europe is one big reason that inflation outcomes over the last few decades have been lower than we would have expected for the amount of money growth we have had. The US has gone from producing all of its own apparel to producing almost none, for example, and this is a disinflationary influence. What would happen to apparel prices if the US changed its mind and started producing it all domestically again? Give that some thought, and realize that’s the protectionist part of the Brexit argument.
We can cheer for a victory for independence and freedom, while continuing to fight against any tendency towards economic isolationism. But I worry about the latter. It will mean higher inflation going forward, even if the doomsayers are right and we also get lower growth from Brexit and the knock-on effects of Brexit.
