The Capital Letter

The Capital Letter: Week of September 14

People attend a performance by the Vienna Philharmonic Orchestra as COVID-19 flares across Europe in Vienna, Austria, September 18, 2020. (Lisi Niesner/Reuters)
Coronavirus back to Europe, Debating the Fed, the economy we lost, and more.

As I have been writing for several weeks now, it seems 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.”

And to repeat something else I wrote seven days ago — the greater the disruption that will arise out of the failure to pass another stimulus package now, the greater the reckoning that will come later (and don’t get me wrong: I don’t underestimate for a moment the problems that will be caused by all the debt that is being created).

As Rachel Bade and Erica Werner, writing in the Washington Post, observe, the latest move by the president — moving closer to what the Democrats want — presents Speaker Pelosi with a dilemma:

Now the California Democrat faces a crucial decision: Does she try to negotiate an agreement with a White House that suddenly seems ready to deal or continue to hold her ground and make Trump, facing his own election woes, swallow the sweeping $2.2 trillion bill she has long demanded?

Then again, as reported on Bloomberg:

“This used to be the White House versus Pelosi up until about now — now the president’s coming in and saying we can maybe go to $1.5 trillion,” Senate Finance Chairman Chuck Grassley said Thursday in a Bloomberg TV interview. “He better be careful of that because I don’t think that will get through the United States Senate.”

So, who knows?

The good (if unrelated) news is that agreement on a spending bill appears to be drawing closer: A government shutdown at this point would not be helpful to anyone.

As I write (10:55 a.m.), it looks as if the markets might eke out a win for the week, but the midweek tantrum was an uncomfortable reminder of how much now depends on the Fed.

The Financial Times:

The US central bank showed little hesitation in wading into the market during the pandemic panic in March, and investors took comfort from knowing that the Fed and its chairman Jay Powell had their back. But this week they were frustrated by his reluctance to promise more specific actions.

Equities sold off sharply during Mr Powell’s press conference on Wednesday, and again on Thursday. Although the Fed pledged it would not raise interest rates until inflation had outstripped its 2 per cent target — which is likely to be years away — no new guidance came on how it might adapt its balance sheet policy to generate that inflation and aid the US economic recovery.

“That was something the market was hoping to get more clarity on and they failed to deliver it,” said Michael Kushma, chief investment officer of global fixed income at Morgan Stanley Investment Management.

I suppose there are times when a junkie needs “more clarity” from his supplier.

On a brighter note, there are those who argue that the sell-off in the FAANGs (seen by some investors as quasi-defensives) is in fact a sign of greater underlying optimism in the market.

Looking a little further ahead, November still casts its shadow. We’ve discussed this before on Capital Matters and I wrote a broader article on this topic here, but it’s not a worry that has gone away.

From the Wall Street Journal yesterday:

Investors piled back into corporate debt as hopes of an economic recovery grew. The only cloud on the horizon now, based on options markets, is the presidential election.

The rally in credit markets has been helped by companies repairing their balance sheets and ensuring they have plenty of cash. By some measures, the extra income demanded by investors to hold corporate bonds instead of government debt—known as the spread—has fallen to near record lows.

But in options markets, there is unusually high demand for hedges against a credit market selloff in November, when the election takes place, according to analysts. This can be seen in the cost of buying protection against big moves in U.S. investment-grade credit using options on the most liquid credit index, the CDX.

Back in the real world, the unemployment data continued to improve, although there is — understatement — a long way to go, but the growth in retail sales fell short of expectations, although the recovery in this area has been more sustained than expected.

Meanwhile, keep an eye on news such as this coming across the Atlantic.

CNBC:

A dramatic rise in new coronavirus cases in Europe has been characterized as a “wake up call” by the World Health Organisation’s top official in Europe.

“We have a very serious situation unfolding before us,” WHO’s regional director for Europe, Hans Kluge, said Thursday in a press briefing on the epidemiological situation in the region. “Weekly cases have now exceeded those reported when the pandemic first peaked in Europe in March.”

He said that, last week, the region’s weekly tally exceeded 300,000 patients.

“More than half of European countries have reported a greater-than-10% increase in cases in the past two weeks. Of those, seven countries have seen newly reported cases increase more than two-fold in the same period,” he added.

While the initial lockdowns can be easily justified as a precautionary measure designed to ensure that hospitals were not overrun, it’s becoming increasingly difficult not to suspect that their prolongation has been (or was) nothing more than an exercise in kicking the can down the road, a common enough weakness among policymakers these days.

The markets may have been disappointed in the Fed in the middle of this week, but opening up for Capital Matters on Monday, Douglas Carr got his disappointment in first, adopting a different, and rather more erudite, line of argument, and concluding as follows:

On top of the risk of whether the Fed meets its target, there is risk in its pursuit. To spur 2 percent inflation, the Fed must maintain interest rates below normal for an extended period — as long as 20 years, in one Fed study. The Fed desires higher inflation so it has more latitude to cut interest rates in a downturn, but the contradiction of lowering rates more than higher inflation can boost them is exemplified by the coronavirus crisis. To gain 0.25 percent of inflation the Fed maintained interest rates 1.00 percent below normal, thus hampering its crisis response.

The Fed has sophisticated models underlying its 2 percent goal, but it must look at reality too. The prestigious Bank for International Settlements, the central bank for central bankers, has found that for OECD countries “there is a significant negative correlation between inflation and income growth during rather long periods.”

Between the Great Financial Crisis and the current one, the U.S. was growing above what most economists believe is its long-term potential. Inflation averaged 1.6 percent. That performance is as good as can be, given ongoing U.S. stagnation. The Fed’s framework was not the problem. The 20-year-old target is unlikely to be reached consistently and should change to reflect today’s U.S. economy. Stubborn persistence at 2 percent threatens America’s purchasing power and financial stability. Since the coronavirus crisis, the U.S. dollar has fallen 7 percent. Bank assets have grown 10 percent over last year, the fastest rate since the Great Financial Crisis. Both movements are likely short-term effects of the current crisis, but they bear watching for potential negative long-term impact.

Writing later in the week, Ramesh Ponnuru’s criticism of the central bank took a different tack:

The Fed issued a statement that it would “aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent.”

But it also released a summary of economic projections by its board members and bank presidents. They expect PCE inflation to run below 2 in 2020, 2021, and 2022, and to hit it in 2023. There’s no hint of above-2-percent inflation in the projections.

Whether above-2-percent inflation is desirable is a debatable question. But if you say your goal is to hit a 2 percent average and that you don’t expect to hit it, then you’re saying you don’t expect to be successful. In which case, if your goal is important, you might want to adjust your plans until you think you will be.

James Broughel argued for regulatory reform as a way of boosting the economy without boosting the deficit:

Recently, Robert Hahn and I reviewed studies published in the peer-reviewed academic literature that rely on these indices to explore the extent to which regulations affect economic growth or productivity (which is a proxy for growth). Virtually every study in our sample pointed in the same direction: Regulation that restricts entry into an industry or imposes anti-competitive restrictions on product or labor markets has a negative impact on growth. This held true across a variety of countries, industries, and time periods, and across studies employing a variety of methodologies and statistical techniques. . . .

As this year’s recession begins to fade, regulatory reform is an obvious choice for those who want to juice the economy without blowing a hole in the budget. President Trump has already made cutting red tape a priority of his administration. But according to some measures, there has actually been a modest increase in the overall amount of federal regulation during Trump’s tenure. Trump has effectively managed to turn off the regulatory spigot, such that the flow of new regulations has slowed from a geyser to a drip. But the stock of thousands of preexisting rules still on the books is still a big problem for the economy . . . .

The coronavirus has wrought havoc on the American economy, but some of the sluggish growth we are experiencing is man-made. While the worst of the virus and the economic devastation that has accompanied it are hopefully behind us, that doesn’t mean we should sit idly by. There is much that can still be done without pushing the federal government further into the red. In that sense, regulatory reform is a can’t-lose proposition.

Daniel Griswold welcomed (with caveats) Edward Goldberg’s Why Globalization Works for America:

Goldberg’s main task is to remind us of all the benefits of U.S. engagement in the global economy. Imports mean lower prices and more choice for American families, especially lower-income households that spend a higher share of their budgets on tradeable goods such as food, footwear, and clothing. Trade opens new markets for U.S. producers that can ramp up production to meet global demand, such as General Motors, Apple, and Boeing. And foreign investment means good-paying jobs for American workers at foreign-owned factories, such as the Mercedes, Hyundai, Honda, and Toyota plants in Alabama that employ 57,000 workers.

On manufacturing and job displacement, the author makes the important point that technology and automation are transforming the workplace. Today’s measure of wealth is no longer fixed assets such as steel mills; it’s human capital — skilled workers creating new products and adding value primarily in the service sector. Because of automation, manufacturing employment is falling as a share of the workforce around the world, including China.

The author throws a cold dose of realism on the pledge by both Democrats and Republicans to bring back millions of manufacturing jobs: “These jobs are not coming back simply because they no longer exist,” he writes. “The high-paying industrial jobs that comprised a major part of the postwar American workforce are no longer central to the economic growth of a modern knowledge-based economy.”

Quite how we are going to cope with automation on the scale that it is now advancing remains, of course a mystery.

Mike Watson also took a look at trade, arguing that the U.S. should avoid reacting to its dependence on China by bringing everything back home:

Although reshoring some manufacturing with direct national-security implications is prudent, bringing back all production would be a costly mistake. American workers tend to be very productive, in part because they are better educated and use more advanced technology than their peers, and they expect to be paid accordingly. Using expensive labor for goods that do not require it would make Americans poorer and undermine Trump’s other priorities. He has boasted about his attempts to cut prescription-drug prices. Does he really want to undo that by moving all pharmaceutical manufacturing back to the United States?

Fortunately, there are other ways to meet his goals. The trade ministers of Australia, India, and Japan recently pledged to cooperate on making their supply chains more resilient. Although they will reshore some factories, they will also build in other countries to reduce their vulnerability to local disruptions. Tokyo, for example, is subsidizing companies that move from China to not only Japan, but also to India, Bangladesh, and other designated countries.

Joining with these allies and partners makes economic and strategic sense. Many of China’s neighbors prefer the security environment the United States has created, but China’s economic clout gives Beijing tremendous leverage. Ensuring that countries in the Indo-Pacific have other, better sources of trade and investment will reduce China’s influence in a region as consequential to the 21st century as Europe was to the 20th. Wealthier partners can also play a bigger role in their own defense, which would allow the United States to shoulder less of the load.

It could bring other economic advantages as well. Because the United States produces relatively fewer consumer goods, many believe that American manufacturing output has declined. This is not true (American manufacturing still accounts for roughly the same share of the U.S. economy as it did at the end of World War II), but our high-tech companies and skilled workforce now specialize in complex, expensive products such as aircraft and the machine tools that other factories use to produce cheaper wares. As companies move their production lines out of China, they will need new factories and new tools. The imminent wave of reshoring is a golden opportunity for machine-tool exporters, and the United States should take advantage of this opportunity by joining with its partners and allies to build a stronger and better supply network. The administration should make sure that American industry gets opportunities to sell goods in exchange for its expertise and financing.

Ed Conard ran into media bias and pushed back with a few — well, more than a few — facts:

The clear message throughout the segment was that inequality has reached its highest level in 50 years. But the Congressional Budget Office’s (CBO) latest measure of income inequality after taxes and transfers shows income inequality was lower in 2016 than it was in 2007. And CBO expects it to remain lower than 2007 through the farthest point of its forecast — 2021. Perhaps CBO’s 2016 estimate is out of date, but poverty has declined since 2016, even during the pandemic.

You would think from popular reports that inequality has soared, despite the fact that consumption inequality, the inequality that matters most, has barely risen since the 1960s. Pre-tax income inequality has risen, but, after taxes, it likely hasn’t risen nearly as much as Piketty and Saez’s highly politicized and often-cited pre-tax measures indicate. Unbeknown to most, the CBO estimates that the share of pre-tax wages earned by the top one percent and top ten percent have not risen since the late 1990s . . .

Christopher Barnard wrote about developments in nuclear energy:

Last week, the future of nuclear energy got an immense boost. U.S. officials greenlit America’s first-ever commercial small modular reactor, to be constructed in eastern Idaho by a company called NuScale Power. The first will be built by 2029, with eleven more to follow by 2030.

Nuclear energy already provides 20 percent of American energy production, representing 60 percent of all clean energy in this country. Yet nuclear energy has stalled for several decades now, having fallen by 9 percent in terms of global energy generation since 2006. Of the 60 plants in operation in the United States, nine have already announced that they are closing, 16 are “at risk” of closure, and five are already gone. Together, this represents 15 percent of all carbon-free energy production in America.

Yet NuScale Power’s recently approved design marks a landmark achievement for the future of nuclear energy: the move towards smaller, more high-tech nuclear reactors — a type dominated by private-sector competition. These small modular reactors (SMRs) represent a real chance for energy innovation in the United States, and an opportunity to lead the world. As we increasingly seek to move away from fossil fuels and toward carbon-free forms of energy, SMRs will play a crucial role. We simply cannot rely on renewables such as solar and wind energy alone yet, meaning that competitive, new-generation reactors can fill that gap and reverse the trend of nuclear decline.

And, sticking with energy, Jon Miltimore noted Kamala Harris’s about-face on fracking:

“There’s no question I’m in favor of banning fracking,” said Harris, citing environmental concerns. “This is something I’ve taken on in California. I have a history of working on this issue.”

Harris has since reversed course.

In a recent interview with CNN correspondent Dana Bash, the Democratic nominee for vice president said she supports Joe Biden’s official position on fracking, which would freeze out new fracking permits but not ban the practice altogether.

“Joe is saying, one, those are good-paying jobs in places like Pennsylvania,” Harris said, before adding that Biden also supports renewable-energy alternatives.

It’s no accident that Harris mentioned Pennsylvania, and not just because the state has 20 electoral votes and is currently considered a tossup by RealClearPolitics.

Natural gas produced by fracking has been instrumental in the revitalization of the Keystone State’s economy. It has become to Pennsylvania what cheese is to Wisconsin, corn to Iowa, and oranges to Florida . . .

George Selgin argued that “a misguided attempt to save money caused Congress and the U.S. Treasury to come up with a plan for rescuing Main Street that now seems like the equivalent of dispatching a dinghy to the sinking Titanic”:

When it was hatched back in March, the government’s plan seemed like a bargain. Instead of sending CARES Act dollars directly to struggling businesses, Congress gave the U.S. Treasury $454 billion, which it could in turn use to support the Federal Reserve’s emergency lending. According to Secretary of the Treasury Stephen Mnuchin, the Fed might “lever up” its Treasury funding to as much as $4 trillion in emergency credit.

How could Congress resist such a deal? The Fed’s Main Street facilities alone were expected to turn $75 billion in CARES funding into $600 billion — over twelve times as much — in aid to small and mid-size businesses. Congress wasn’t going to send a dinghy to the Titanic. It was going to send a big lifeboat, while only paying for a dinghy.

Alas, a dinghy is what showed up — and a tiny one at that. Of hundreds of thousands of firms, the Main Street program was meant to serve, only 120 or so have borrowed just $1.4 billion from it. At that rate, it would take over 70 years for the program to reach its $600 billion capacity. Instead of “levering up” its Congressional funding, Fed has levered it down — way down.

What went wrong? In a word: risk. Business lending is always risky. In bad times, it’s much riskier. Lending during the current crisis, to firms that can’t “secure adequate credit accommodations from other banking institutions,” is, in Tour de France lingo, hors catégorie — “beyond category.” And the longer the crisis lasts, the further beyond it gets.

The government understood that Main Street lending would be risky. What it failed to appreciate is just how allergic the Fed is to losing money. In designing its Main Street facilities, the Fed erred on the side of extreme caution. It chose lending terms that disqualified many businesses outright, while discouraging far more from bothering to apply. It also made commercial lenders keep a 5 percent stake in their Main Street loans. That encouraged them to watch out who they lent to. Alas, it also convinced most potential lenders, including almost all the big banks, to not participate at all. Of some 11,000 banks, credit unions, and S&Ls that might have signed up, only 575 did.

The government should have seen this coming. The Fed’s reluctance to lose money is in its DNA . . .

Steve Hanke launched his monthly review of the countries with the highest inflation rates. To qualify for inclusion on “Hanke’s Inflation Dashboard,” a distinction that no country should want, its annual inflation rate must exceed 25 percent per year. In addition to using a methodology, based on purchasing power parity (PPP), to come up with more accurate data than are generally available, Dr. Hanke will discuss what is going on with one of the casualties in his ER. On this occasion it was Turkey:

Even though Turkey is at the bottom of Hanke’s Inflation Dashboard, I have chosen to highlight it this month. Why? When there are economic troubles, such as currency crises and accelerating inflation, they often move leaders to engage in foreign adventures. Indeed, these are often used to distract people from their economic travails and move them to rally around the flag. As President Recep Tayyip Erdogan ramps up Ankara’s operations in the Eastern Mediterranean’s dangerous power game, it will pay to keep an eye on the course of Turkey’s PPP-determined inflation rate.

On a nostalgic note, looking back to the prelapsarian world before COVID-19, Robert Verbruggen remembered “the economy we lost”:

The official statistics — including a whopping 6.8 percent increase in the median household income between 2018 and 2019, even after adjusting for inflation — seem too good to believe, because they are. But the fully adjusted numbers still tell a fundamentally positive story. Before COVID, life in America was gradually but tangibly improving, no matter how much we liked to complain about everything.

The adjusted numbers, for instance, still show about 4 percent growth in the median household income, from about $66,000 to a record high of $68,500, which represents an improvement on weaker growth the preceding two years. What’s more, the gains were widely shared, with more than 3 percent growth across pretty much the entire income spectrum.

Jerry Bowyer returned to the ESG wars, writing in defense of a proposed new rule from the Department of Labor that “shifts the burden of proof onto pension trustees to show that ‘socially responsible’ Environmental, Social, Governance (ESG) factors actually benefit retirees before pension assets can be put into them.”

The horror!

The debate over lockdowns is sometimes presented as if it were between clear-eyed #scientists on one side and callous folk who only care about money on the other. Nothing could be further from the truth. The decision to put in place lockdowns involves (or should involve) a continuing balancing of their risks and their rewards — which evolve over time — as well as an awareness that the choice is rather more complicated than lives vs. dollars. The collateral damage caused by the lockdowns has been immense and has extended far beyond “just” the economy, and even that damage will be greater than is often assumed.

Eric Hanushek and Ludger Woessmann examined school closures and found:

The economic future of the current cohort of K–12 students has been compromised by the school closures that occurred in spring 2020. If schools miraculously returned immediately to their 2019 performance, these students can on average expect some 3 percent lower income over their entire lifetimes. More distressingly, nobody believes that the reopening policies currently in motion will actually get students back soon to the learning pace of the past.

While the precise learning losses are not yet known, estimates suggest that the students in grades one through twelve affected by the closures might have already lost the equivalent of one-third of a year of schooling. Unless schools actually get better than they were in 2019, existing research indicates this will lead to permanently lower future earnings . . .

Finally, we produced the Capital Note (our “daily” — well, Monday-Thursday, -Thursday, anyway). Topics covered included: Complacency about the country’s growing debt load, the dangers of the “lockdown reflex”, the consequences of lockdowns, the (exaggerated) death of the office, Wall Street bets, Germany’s China trap, Nvidia, Argentina’s currency crunch, Amazon’s air force, the slowing pace of innovation, the Fed’s forward guidance, convertible arbitrage and the importance of property rights.

To sign up for the Capital Letter, follow this link.

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