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The Twin Deficits – One Out of Two IS Bad
From time to time on this blog, I circle back to the question of the balance of deficits. In my mind, as our economy goes through whatever the “Trump Transition” is, the biggest risk to the bond markets is not from some fear about whether the Treasury will default or whether the US dollar will cease to be the world’s currency of choice for reserves (neither of which I think is going to happen any time soon) but that large secular changes in the balances of savings and dollar demand could lead to outsized moves in interest rates.
First, let me remind you that the deficits are all intertwined. When the US Federal Government runs a deficit and borrows money, they have to get it from people/entities that have saved that money. One place that the government bond salesmen know they can turn to is non-US investors, who are in possession of those dollars because the US runs a large trade deficit with most other countries. When we run a trade deficit, it means we are importing more stuff than we are exporting or, equivalently, we are exporting more dollars than we are importing. Those dollars are pretty useless except to buy things that are dollar-denominated. By construction, we know that the new owners of dollars aren’t buying goods, because if they did there wouldn’t be a deficit; the main other thing they buy are securities or real property.
So if you don’t want other countries buying US stocks, buildings, and farmland, run a big trade surplus and they won’t have the dollars to do it.
It’s a good thing they have all of those dollars, because the Federal government needs them! The federal deficit needs to be funded by those foreign dollars, or by domestic savings (banks, individuals, companies, e.g.), or by the central bank buying up those bonds. And that’s pretty much it. Over time, the trade balance plus the budget balance plus the central bank balance plus private savings equals zero, more or less. During COVID, the massive expansion of the federal deficit was only possible because the Fed bought about the same number of bonds as the government sold. Had they not, interest rates would have risen precipitously because private savers would have had to be induced to put those dollars into bonds.
(Or, the government would give incentives for banks to hold more govvies, say by exempting them from the SLR. Not that such a thing would ever happen!)
Let’s pivot this then back to the Trump Transition. The stated goal of the Administration was to lower the trade deficit a lot, lower the budget deficit a lot, and lower interest rates. That all makes sense and is internally consistent. It could happen that way, if all of it happens that way.
What if, though, the President’s team makes more progress on one front than on the other? Early returns on the tariff front seem to imply that the US will face a smaller trade deficit going forward. Now, the latest spike higher (smaller deficit) here is at least partly and maybe mostly due to a ‘payback’ of the pre-tariff front-running that led to massive deficits in the prior three months. But it should not surprise us that increasing tariffs should cause the trade deficit to decline. That is, after all, sort of the point.
If we concede that the trade deficit is actually heading back towards some better semblance of balance, then that’s plank 1 of the Trump agenda. That will supply fewer dollars to cover the federal budget deficit, though. As long as the federal budget gets into something closer to balance…
That was the promise of DOGE, and of the revenues from tariffs. The latter will indeed be yuge, and will help balancing the budget. Or it would, if we weren’t about to run an even bigger deficit with the Big Beautiful Bill soon passing into law. The trailing-twelve-month budget deficit is just less than $2 trillion, which was a number we never even sniffed prior to COVID. So that’s the demand for savings: the feds look like they’re going to keep on spending more than they take in.
Unlike during COVID, too, the Fed is now letting its balance sheet shrink. No help there.
Now, there is also a movement in Congress to pass legislation preventing the Fed from paying interest on the reserves that banks hold at the Fed. For decades, the way the Fed managed the money supply was to adjust the quantity of reserves, which rationed credit and caused the price of credit (interest rates) to move as well. But it was the rationing of credit, not changing the price, that affected the money supply. Beginning with the Global Financial Crisis, the Fed flooded extra reserves into the system, forcibly deleveraging banks (look at that chart above again) – but, since that would also crush bank earnings, they started paying interest on reserves (IOR). Since, if banks were not being paid to hold reserves, they would hold as little as they could, the Fed had to pay interest or the excess of reserves in the overnight market would cause interest rates to always be zero. So the Fed started to manage the price of credit, rather than its quantity. The central bank fully intends to always hold way more in securities and therefore force way more reserves into the banks, going forward – but has gradually been reducing its portfolio securities. As I said, no help there.
If Congress succeeds in preventing the payment of IOR – and the politics on this looks good since the Fed now runs operating deficits, so that it is basically paying banks interest with taxpayer dollars (see chart below…Fed remits to the Treasury have dried up completely), then as I said above banks will try to hold fewer reserves and overnight interest rates will drop as banks compete to lend their excess reserves at anything above zero, unless (a) the fed increases the reserves banks are required to hold (really unlikely) or (b) the fed makes reserves scarce so some banks will have to buy them and some will sell them (the old way) (also really unlikely). In neither case does the Fed expand the balance sheet as a first intention, so unless we get another crisis the expansion of the Fed balance sheet is unlikely in my view.
So that leaves private savings. If the trade deficit declines and the budget balance doesn’t move significantly towards balance, then interest rates will have to rise, potentially a lot. I think the President’s stated plan makes very good economic sense. I just wonder if it’s going to be derailed by the desire to keep the Federal spend going.
A Price-Linked USD
Let me introduce you, for those who aren’t already acquainted, to the Unidad de Fomento.
The Unidad de Fomento (UF) is an almost-unique currency in the world.[1] It was established in 1967 by Chile as a non-circulating currency – I will get to that in a minute – and has survived a period of hyperinflation and a rebasing of the circulating Chilean currency from Escudos to Chilean Pesos in 1975. That is an amazing testimony.
What is unique about the UF is that it is directly indexed to the price level. The value of the UF increases (or in theory decreases) every day with the inflation index. This means that unlike the actual circulating currency, the UF maintains its purchasing power over time. If you could buy a physical UF, it would be like buying a 1967 Chilean peso. As long as you hold it, you will be able to buy exactly as much actual stuff as you could have in 1967, or for that matter last year. If you put enough UF in your pocket to buy an empanada when the price of an empanada was 1,000 pesos, then when you take it out of your pocket you should still be able to buy an empanada no matter what the price of an empanada is today.[2]
Every day, what is changing is the exchange rate between 1967 pesos and ‘today’ pesos, and the only part of that which is changing is the price level. That is, after all, exactly what a price level means. It means snapshotting the value of this basket of goods and services in, say, 1983 (as for the CPI) and then telling you what roughly the same basket of goods and services (allowing for changes in the consumption basket over time) would cost today. So the NSA CPI today at 314.54 means that if the consumption basket cost $100 in 1983, today the same basket would cost $314.54. Except that if we had a UF for the dollar, we would simply say the basket cost 100 UF$ in 1983 and 100 UF$ in 2024. That’s powerful.
I noted that the Chilean UF is a non-circulating currency. Then what good is it if you can’t actually buy goods and services with it?
The purpose of the UF was to facilitate contracts and wage agreements in a period of inflation uncertainty. When the future price level is unknown, negotiating longer-term agreements becomes more difficult. Consider a labor union negotiating a multi-year labor contract. The union, who is contracting to provide labor at certain future prices, will want larger increases to protect itself from the possibility that those future wages are eroded by higher-than-expected inflation. Management, on the other hand, wants lower increases because agreeing to larger increases if inflation is lower than expected will make its cost structure less competitive. For a short-term contract, the risk on both sides is low. But the longer the term of the contract, the more the risks grow for both sides and the harder it will be to reach an agreement. Where this manifests is that in low and stable inflation regimes, contracts tend to have longer tenors; in high and unstable inflation regimes, contracts tend to have very short tenors or to be completely untenable.
This is the problem that UF solves. The parties to a negotiation no longer have to protect their nominal wages and prices. They have offsetting risks to inflation, so they agree to real wage increases or price escalations by negotiating not in Chilean Pesos but in UF. Then, as time passes, those agreed-upon UF amounts are translated at the then-current exchange rate between UF and Chilean Pesos – reflecting the change in the price level that has actually occurred.
There are many salutatory effects to this. Suddenly, the need to get ahead of wage and price increases and negotiate larger increases to protect against inflation vanishes – and, with it, the feedback loop where higher wages induce higher prices, which in turn induce higher wages. (As I’ve discussed previously here, that doesn’t necessarily accelerate inflation, but it makes inflation much stickier going down than it is going up.)
Why am I mentioning this?
We do not have anything like this in the United States at this point. We have CPI, and companies do negotiate contracts on the basis of CPI. Longer-term construction contracts, such as for power plants or airplanes, often have escalators tied to particular price indices. Frankly, the ability to base a contract on a non-circulating currency is not itself something that is necessary in the USA today[3] although in 1967 in Chile it was. However it has escaped no one’s notice that over time, our currency is a medium of exchange but becomes less and less a good store of value when inflation moves away from the zero bound. Obviously, there are investment products which help address this issue but to the extent that there are any cash balances, higher inflation implies higher monetary velocity partly because the money itself becomes a worse and worse store of value.
One solution to this would be inflation-linked savings accounts, which don’t exist (although I’ve tried to convince people to do that!) Another solution would be to have a currency – a circulating currency – which you could hold which would keep up with inflation. Such a currency would be superior to USD, because it would be USD preserving the purchasing power of the base year.
Why don’t we have such a thing? Well, the US has a monopoly on issuance of its currency, and every time they issue more it is a pure gain to the government, called seigniorage. But that’s not really the reason, because the government would also earn seigniorage on “USDUF.” The real reason is that the USD is a successful fiat currency because, and only because, everyone believes that everyone else will accept it as worth $1. Any new currency, if unbacked, would have to generate trust anew that everyone else would accept the USDUF-USD exchange rate to be equal to the price level. Unless the US government guaranteed that exchange rate by freely exchanging dollars for USDUF on demand, there is no guarantee that USDUF would trade at the appropriate level.
I don’t see the government doing this any time soon. But it really should.
[1] In 2001, Bolivia established a similar currency, the Unidad de Fomento Vivienda, which is based on the same mechanism but is not as widely used as the Chilean UF due to the latter’s long head start.
[2] I am taking some liberties for the sake of illustration. Obviously some goods keep up with the price index, some run ahead and some fall behind…it’s really only true that the value of the UF is constant in terms of the overall consumption basket, not each specific item.
[3] …although having historical financial statements and financial projections in real terms instead of nominal terms, using real discount rates instead of nominal rates, would make a ton of sense and you can show that corporate finance in real space is more efficient and more sensible if there’s any volatility in inflation.
You Cannot Inflate the Debt Away
There is a popular meme that the government has an incentive to inflate, because the same debt is worth less in real terms at a higher price level. If inflation is high enough, then the government (it is said) can make the debt go away. Inflation is, after all, a tax; doesn’t it then follow that if the government increases that tax quite a bit then it can get itself out of hock in real terms?
It turns out that this is difficult to do, at least over a range of ‘normal’ inflation rates. The reason is that it is hard to get the debt to go away fast enough when the market adjusts interest rates to reflect the level of inflation. I want to try and illustrate the general idea here. I’ve looked at this before, so I know the answer, but I’ve never put this in a blog post before.
First, let’s start with the current distribution of debt for the US. The chart below is from Bloomberg, showing how many trillions of Treasury bill/note/bond maturities will happen every year. For a host of reasons, prime among them being incompetence, the US did not take advantage of the artificially ultra-low interest rate environment to extend maturities. That makes inflating the debt away even more difficult.
The average interest rate on US debt is 3.21%, about double what it was in early 2022 and the highest it has been since 2009 (and there is a lot more debt outstanding now than there was then, thanks to a decade and a half of massive deficits designed to save the world). Having a lot of debt mature every few years is a great way to increase the sensitivity of your interest expense, and therefore deficit, to short-term inflation and interest rate fluctuations. That’s not feature, it’s a bug!
Starting from the distribution above, let’s model how the debt would grow over time using a couple of simple assumptions and then tweaking those assumptions. We will start with this: assume that the maturing debt, plus the annual Treasury deficit, is rolled into new debt distributed 1/30th to each year. We will assume a 4% inflation rate, and an interest rate of 1% over the inflation rate. Because we are spreading out the maturities, we are explicitly extending the maturity of the debt. The more rapidly the average interest rate reacts to the current interest rate, the harder it is to inflate the debt away. If we started with that 3.22% interest rate and rolled the debt as I have just described, here is how the average nominal interest rate evolves over the next 25 years.
I should note that I am also assuming that the deficit is initially $1 Trillion, and grows by the rate of inflation every year. So, in year 0 it is $1T; in year 1 it is 1.04T, which is the same amount in real terms. Note that this implies that discretionary spending is decreasing rapidly. In year 0, the Treasury would pay interest of about $876 billion ($27.2 trillion in debt * 3.22% interest rate). In year 1, the average interest rate rises to 3.80% and the deficit is $1T larger, so the interest paid rises to $1072 billion. Since we assumed that the overall deficit increased by only $40bln, the implication is that discretionary spending fell $156bln ($1072 – $876 – $40). So, the notion that the deficit grows only equally with inflation is not realistic. But even using such magical thinking, the total debt rises from $27.2T to $72.5T over 25 years. The real debt (remember, we’re inflating it away!) stays basically steady at $27.2T in today’s dollars.
So constant inflation actually doesn’t do it. It’s even worse than the picture suggests, as I said. If we instead assume the nominal debt increases by the change in the interest outlays – which means discretionary spending still decreases, but only in real terms – then that chart looks distinctly uglier. The nominal debt in 25 years with these assumptions gets to $294T, and the real debt steadily climbs over $100T.
We can see that this is just not going to work unless we decrease discretionary spending. Again, we’re just trying to figure out if there is some way to inflate ourselves out of this mess. So let’s go back to the assumption that the deficit only rises pari passu with inflation, but now let’s get rocking on inflation and increase it 1% every year, from 4% to 30% over the next quarter-century. Assuming that investors still demand a positive 1% real rate on all new debt, we get this picture.
We finally make some headway on the debt! Because so much of it is short-term, though, it takes a good 6-7 years before we see a lot of progress on the real debt because we’re just rolling it over at higher rates too quickly.
By the way, I neglected to mention that Medicare is an off-balance-sheet ‘debt’ that we can’t outgrow in this fashion. And it’s a big item. It is impossible to inflate away Medicare.
Now, most people who suggest that we can inflate our way out of debt do not imagine a steadily-accelerating inflation rate forever. That’s not what we would call a ‘re-electable outcome’. So let’s instead assume that we spike inflation for two years to 10%, and then drop it back to 4%. You can look at the chart below and see that once again this doesn’t work because the debt is turning over too quickly. There is a quick, small benefit to the real debt, but then it levels off again.
Unless you can spike inflation to, say, 100% for a year or two and then put it right back down to the prior level, you really need accelerating inflation because you need the principal amount of the outstanding debt to fall in real terms more than the interest payments are accumulating. If you can have inflation a bit above the average interest rate on the debt, then you’ll make headway but since the interest rate responds you have to keep doing this for a while. And remember, we are assuming that the government outside of interest payments is steadily shrinking in real terms.
What about if we balanced the budget? Well, then obviously the real debt will tend to decline over time, although more and more of the budget becomes interest payments.
So far, we can find no realistic way to inflate our way out of debt, other than moving toward hyperinflation (and the faster, the better). And even with these simulations, I am making a very unrealistic assumption about how the deficit evolves when the interest costs of the debt blow up. Hyperinflation, with a balanced budget, is what you need. Good luck with that. The only way that happens is if the dollar collapses and no one will lend us any more money anyway. And there is no one in government today, I feel confident in asserting, who thinks that outcome is a decent tradeoff in order to get out from under the mountainous debt. At least…let’s hope not.
Have a better idea? Let’s hear it!
Beware the Price Controller
Late last year, I was asked on a podcast what one fear I had for 2023 that was out-of-consensus and not expected by markets, but a non-zero probability which if it came to pass would have a huge impact. I said ‘wage and price controls.’ In August of 2022 I had actually done a podcast of my own called “Bad Idea of the Year – Wage and Price Controls.” My fear wasn’t entirely academic, because there had been several obvious “running up the flagpole” articles by not-well-respected economists, in the Washington Post and NY Times, and comments by various policymakers all trying to sell the idea that price controls actually had worked historically.
That’s absolutely wrong, a perversion of history, and no one with any actual sense believes that price controls make any economic sense. But they might make, for some people, political sense (I’d flagged this a year prior to that, in August 2021, in this blog) and that’s what scared me.
For most of this year, blessedly, such dumb talk wasn’t heard. Until today, that is, when the Biden Administration announced that if they think prices are too high for patented medicines, they’ll seize the patents and license the medicines to third parties to make them instead. No, I’m not kidding. The government claims that their rights, under a 1980 law designed to make sure that drugs co-funded by the government would not sit in a patent library but rather be used, include the right to seize the property if they don’t like the price being charged.
There is very little chance of this policy actually coming into effect, since the legislative intent of the original law is clear, but if the ‘right’ judge hears the case then it might have to be appealed to the Supreme Court. At that level, it seems clear based on my understanding of Civics 101 that the Fifth and Fourteenth Amendments should prohibit the unlawful seizure of private property and the government wouldn’t be permitted to reallocate patent rights…but, on the other hand, historical precedent seems to allow the government to dictate the price charged if they don’t like it. That historical precedent, of course, is the history of wage and price controls. Which, as I’ve noted, was a historical disaster every time it was tried.
For what it is worth, file the chart below as away as a reference point for what constitutes “price gouging” in this Administration. The y/y change in the CPI for Prescription Drugs is at the nosebleed level of 3.14% y/y. For those of you keeping score at home, that is lower than the level of Core CPI (4.0% y/y). Prescription drug inflation hasn’t been above core inflation by any meaningful amount since 2014-2017.
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!
