The Capital Letter

The Capital Letter: Week of August 24

Federal Reserve Chairman Jerome Powell speaks to reporters during a news conference in Washington, D.C., March 3, 2020. (Kevin Lamarque/Reuters)
Changes at the Federal Reserve, ‘Stakeholder Capitalism,’ Economic Nationalism, and more.

It is beginning to seem as if I can begin this letter the same way every Friday: “Another week has passed in our strange sort of stasis, with no real movement on another stimulus package.”

Well, yes.

Nevertheless, in the financial world we did see a landmark — maybe — with the announcement of a change of policy by Federal Reserve chairman Jerome Powell.

In essence, Powell said that the Fed would be prepared to see inflation run higher, and unemployment run lower, than in the past. It is important to note that this change of course is not solely the product of the COVID-19 era, although events since early March will undoubtedly have reinforced the Fed to take the new stance that it has: Its review began early last year. What appears to have triggered it was a bleak assessment of what, a decade after the financial crisis, the “new normal” has turned out to be.


Since January 2012, the median estimate of potential growth from FOMC participants has fallen from 2.5 percent to 1.8 percent. . . . Some slowing in growth relative to earlier decades was to be expected, reflecting slowing population growth and the aging of the population. More troubling has been the decline in productivity growth, which is the primary driver of improving living standards over time.

While we could argue about how great the significance of population growth (at least so far as GDP per capita is concerned) might be — minimal, in my view; we are living in an age of automation, not 1950 — the Fed nevertheless is right that something is not working as it once did.

As to what that might be, take a look at a series of papers from the St. Louis Fed from last year, and, in particular this passage:

What caused the missing recovery after the Financial Crisis? In Part 1 of this three-part series, I argued that tail risk increased after the Great Recession; that is, the perceived probability that a large negative shock to the economy would occur increased after the 2007-09 recession. In this Part 2 essay, I discuss how this increase in tail risk can help us understand the missing recovery.

Think about a firm making risky investment choices. To determine how much to invest, the firm takes into account the upfront cost of investment, as well as the expected return of the project and its associated risks. The return of the project depends not only on the actions of the firm, but also on the overall performance of the macro­economy and its associated risks. Therefore, investment is inherently risky and depends on outcomes that are not under the control of the individual firm. Hence, the firm has to forecast both what will happen to the aggregate economy and how those events will affect its investments.

Before the Great Recession, the probability of a tail event on the overall economy was very small. Hence, the probability of an abnormally low return on investment projects was also very small. This small probability of tail risk led firms to make large investments, ultimately generating economic growth until 2008.

After the Great Recession, however, the probability of abnormally low returns increased substantially. This change in tail risk implies investments are more prone to abnormally low returns. Consequently, investors reassessed their investment plans and decided to cut investment. As a result, economic growth is lower now than before the Financial Crisis.

In short, before making investments, companies are going to require a rather higher potential return than before the crisis thanks to a heightened perception of risk. And memories of the financial crisis are taking a long time to fade.

Now ask yourself what the experience of the pandemic has taught companies. To be sure, they can reduce their exposure, in the most literal sense, to the risk that humans are vulnerable to disease — thus the accelerated investment in automation that we appear to have seen in the last few months — but they have received a powerful reminder, first of the risk of pandemic, and, in many ways more dangerously still, of the risk (certainty?) that government will botch the response.

In the run-up to March, we saw a series of failures by the CDC and the FDA as well as a remarkable degree of insouciance by the political class at all levels and on all sides: Incompetence was truly bipartisan. Worst, underreaction was followed by overreaction, with lockdowns being pursued for a length and of a severity that showed no understanding for the concepts of risk and reward. Companies have now learned that their businesses can be shut down at will. That is not a lesson that will be quickly forgotten. Throw in a long period of civil unrest, and it’s hard to imagine that “animal spirits” (in Keynes’s phrase) will be easy to restore, at least to the extent that is needed.

And that is before we consider the effect of the tax changes that a possible Biden administration might bring in, not to speak of the value destruction that a Green New Deal would bring in its wake.

Under the circumstances, I’m not convinced that the Fed’s new willingness to see inflation run above 2 percent for a while (and the implications that that will have for interest rates) will have much effect on growth, however handy it might be for the stock market.

The Fed’s new, more nuanced approach to unemployment (basically a further walk away from old Phillips Curve orthodoxies) reflects a welcome understanding of the lessons of the last ten years. To quote Powell, “a robust job market can be sustained without causing an outbreak of inflation.” That is true, but that reflects the reality that the new robust is not the old robust. While we were seeing truly encouraging improvement in the jobs market in the year or so before the pandemic, relatively subdued wage increases would suggest a deeper weakness in the labor market that cannot be just put down to lower rates of unionization in the private sector. If I had to guess, increasing automation is no small part of that equation, and that trend is not going into reverse.

“It is hard to overstate the benefits of sustaining a strong labor market, “said Powell. It was “a key national goal that will require a range of policies in addition to supportive monetary policy.”

I wonder what they will be. I wonder what they can be.

Over at Capital Matters, I steeled myself to take another look at stakeholder capitalism and, well:

“Stakeholder capitalism” is by its very nature political, whoever is cheering it on. In effect, its advocates are insisting that corporate money and power should be conscripted to force through a social and political agenda — without the bother of going through the ballot box.

Of course, companies often try to influence politics. K Street would not be what it was if they did not. Nor, for that matter, would numerous political campaign chests. But corporations working in the interest of their shareholders to engage with the democratic process is one thing. Hijacking a company’s resources in a manner designed to bypass it is quite another. Stakeholder capitalism not only trashes the property rights of the shareholder, it is also an attack on democracy.

And it is more insidious than the peril envisaged by Milton Friedman in “The Social Responsibility of Business is to Increase its Profits,” an article he wrote for the (very different) New York Times Magazine of half a century ago. In that piece, Friedman was clearly concentrating on the danger of socialism, a danger that, in one shape or another, has not gone away, but has, at least, the merit of being opposed to free enterprise in a fashion so obvious that even the [Business Roundtable] could not miss it.

Corporatism is a trickier challenge. It has taken different forms over the years — some more benign than others — but all of these forms are based on the belief that society should be organized by and for its principal interest groups — let’s call them “stakeholders” —  intermediated by, and ultimately subordinate to, the state. The individual doesn’t get a look-in, but to the managements of large corporations (the latter would count as one of those interest groups), it is an opportunity (and thus a temptation) as well as a threat. After all, much of the power that is being taken from shareholders will end up with those to whom they unwisely entrusted their funds.

Our chart guru, Joe Sullivan, analyzed the likely effects of Seattle’s plans to cut back its police force (spoiler: not good).

Alex Muresianu took aim at economic nationalism on both left and right:

Trump and Biden are finding some common ground. Recently the president again justified his moniker of “Tariff Man” by reinstating taxes on Canadian aluminum. Meanwhile, former vice president Joe Biden has released his Made in America plan, a set of policies intended to strengthen domestic manufacturing. Both candidates are claiming to be the real champion of the American workers — advocating government action to protect them from foreign competition.

Yet, this economic nationalism advocated by both men will really just weaken the U.S. economy.

Meanwhile, looking quite some way to our south, Antonella Marty demonstrated how a toxic mix of autarkic economic nationalism, peculiarly toxic corporatism, and manipulative populism can wreck a country for a long, long time:

Argentina did everything backwards. We were a developed, rich country that, after years of populism, has ended up underdeveloped.

The prosperous Argentina of the 19th century, one of the richest countries in the world, owed much of its early success to the ideas of Juan Bautista Alberdi, the political philosopher who was hugely influential in the drafting of the 1853 Constitution, a constitution based on the ideas underpinning the Constitution of the United States of America. We did well as a country when we bet on good ideas, when we bet on the rule of law and the free market, and when we bet on opening ourselves to the world.

With an economy based on the export of agricultural products — notably mutton, wool, beef, and cereals — Argentina, “the granary of the world,” rapidly became very rich, as a glance at some of Buenos Aires’s turn-of-the-century architecture shows. Much of this growth, and not only in the agricultural sector, was driven by foreign investment in the country. But the mid-1940s arrival into power of Juan Domingo Perón and his ideology, Peronism –which is usually simply described as populist but is better seen as a variant of fascism — effectively put an end to that. Peronism drove Argentina into poverty and became the basis of a political system which is still in place today.

One of the features of Capital Matters is our willingness to recognize that there can be sharp disagreements on the right and center-right over economic policy — and to use it as a platform where those differences can be aired, and maybe even hashed out.

I may worry about the impact of automation on jobs and Alex Muresianu is concerned by economic nationalism, but Nicholas Phillips set out a different view on both topics in “The Jobs Can Come Back.”

An extract:

We should start by rethinking trade policy: what the Senate Finance Committee once described as “the orphan of U.S. foreign policy.” For a long time, the dominant view was that trade deficits didn’t matter — if other countries want to subsidize their exports with taxpayer money so they become cheaper for American consumers, that sounds like a free lunch. But if that keeps happening in every industry, American industry will find it impossible to compete, and suddenly America won’t have anything to trade for those imported goods — except debt and assets. That’s what a trade deficit is: mortgaging your future productive capacity so that you can consume more than you currently produce.

Trade policy should therefore start from the premise that unreciprocated free trade — an open U.S. market for foreign imports but closed foreign markets for U.S. exports — is the worst-case scenario over the long term. These are the conditions that cause American producers to lose market share. Our trade policy should identify strategic industries — sectors such as robotics, aerospace, telecom, and others, along with industries important for national security — and do everything we can to win market access for them abroad while keeping American producers healthy at home.

This might sound elementary, but that’s not how American trade policy has worked. Instead, we historically gave away market access, believing that low consumer prices were their own reward. Economist Ian Fletcher summarized the problem in his 2011 book Free Trade Doesn’t Work: “Having disarmed ourselves by throwing open our markets, we desperately need to disarm everyone else by forcing their markets open too. But we try to do this after having thrown away our principal leverage: access to our own market.” From 1820 to the dawn of World War II, America built its industrial juggernaut with average weighted tariffs of 20 percent. Today, they’re 2.85 percent . . .

Some might protest that the very idea of a national trade strategy smacks of planning — the dreaded “picking winners and losers” that free-trade doctrine is designed to avoid. But having no strategy doesn’t mean the market will pick winners, it means that Chinese policy will. Free trade with China means allowing their prices — distorted by subsidies and currency manipulation — to shape our own market, where American firms will struggle to compete without the benefit of an industrial policy of our own.

On the other hand, Mike Watson focused on the threat to manufacturing jobs should Biden be elected:

One of [Biden’s] signature goals is to make the United States “lead the world in manufacturing electric vehicles.” By issuing rebates to trade in old gas-powered cars for new ones, building hundreds of thousands of electric charging stations across the country, and converting the federal government’s fleet to electric vehicles, Biden expects to create 1 million jobs. He will be disappointed.

Last fall, the United Auto Workers — which has endorsed Biden — went on strike, in part because of the danger posed by the electric vehicles Biden is now promoting. Tens of thousands of autoworkers around the world lost their jobs in 2019 as their companies retooled for building electric cars. Biden’s spending plans could help offset those costs, but not the far greater danger that workers will face once the new production lines are operating.

Electric vehicles will gut autoworkers’ and mechanics’ unions by driving their members out of work. Electric drive trains consist of a mere fraction of the parts of their gas-powered equivalents, and the vehicles are much easier to assemble. Ford estimates that electric cars will require 30 percent less labor in their auto plants, and other industry projections are even more drastic. Fewer moving parts mean fewer repairs too, threatening mechanics’ livelihoods, and charging cars at home will drive gas stations out of business. By putting the government’s weight behind electric vehicles, Biden will make those jobs disappear even faster.

He also plans to turn the U.S. into a green-energy leader by building more wind turbines and solar panels domestically and making the power grid carbon-free by 2035. These changes will further erode manufacturing.

Indeed they will.

Christos Makridis and Patrick McLaughlin highlighted the economic benefits brought by the Trump administration’s attack on overregulation:

In original calculations using Bureau of Economics data and QuantGov, a machine-learning and policy-analysis tool developed by Mercatus Center researchers, we found that the industries that saw the greatest declines in regulatory restrictions enjoyed the greatest growth in compensation per worker. Specifically, we put together data on 70 industry sub-sectors. In addition to finding that the 2017–19 decline in regulatory restrictions came at a time when real compensation per worker grew by 3 percent, we found that each 1-percentage point decline in regulatory restrictions from 2017 to 2019 came with a 0.05-percentage-point increase in real-compensation growth per worker.

Is that big or small? Here’s another way to think about it: The Trump administration’s regulatory reforms have arguably accounted for roughly one-tenth of the overall growth in compensation per worker we saw over these years. Given that income grows for many reasons, ranging from technological progress to competitive forces, anything with a sizable, measurable impact is a big deal.

Brad Polumbo returned to the bleak topic of taxation, specifically wealth taxes. He’s not a fan:

“Wealth is accumulated savings, which is needed for investment,” Cato Institute economist Chris Edwards explains. “The fortunes of the richest Americans are mainly socially beneficial business assets that create jobs and income, not private consumption assets. Raising taxes on wealth would boomerang against average workers by undermining their productivity and wage growth.”

This isn’t just a theoretical downside of wealth taxes. A mountain of research shows that they don’t work. The latest evidence comes courtesy of two Rice University economists, who in a new paper studied the effects of something along the lines of Warren’s proposals: a tax of 2 percent on household wealth above $50 million and 6 percent on household wealth of $1 billion or higher.

The economists found that such a wealth tax would cause a 2.7 percent decrease in the size of the economy over the next 50 years. That may sound relatively small, but it translates to trillions of dollars in American wealth that would never get created. They further found that a wealth tax would destroy 1.8 million jobs. It’s not hard to see why. If you make your country’s policies hostile to the wealthy and successful, they’ll take their wealth — and their businesses — elsewhere. They’ll also adapt their behavior and spending decisions domestically to avoid the tax. So, it’s no surprise that the Rice paper also concluded the average household’s income would drop by roughly $2,500 as a result of this supposedly “progressive” tax’s implementation.

The road to hell is also paved with bad intentions.

Finally, we produced the Capital Note (our “daily” — well, Monday-Thursday anyway). Topics covered included: “Shut up,” the “socially responsible” investor explained, autonomous trucks, Trader Joe’s and COVID-19, motels and COVID-19, lockdowns, small companies financing problems, the Democrats’ acceptance of nuclear power, short sellers, the greening of the Fed, financial repression, taxation, Chinese banks, and Soviet gold.

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