Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: The war on Google, the Fed worries about what ultra-low interest rates might mean, the Biden liquidation, automation, a unicorn stumbles, and a case study in regulatory bungling.
Bashing the Google-Bashers (And Rightly So)
As (I hope) I made clear in this space on Tuesday, I have my doubts (understatement) about the legal action that the Department of Justice has launched against Google. We’ll have to see what discovery discovers, but the DOJ’s arguments about competition seem unconvincing, and the lawsuit has opened a dangerous door through which a future less market-friendly administration may charge.
Even worse, and shamefully for an administration that claims to put America first, this case is going to help those in Brussels who have weaponized antitrust against U.S. high-tech for reasons that have next to nothing to do with competition and a lot to do with sour grapes — and, yes, anti-Americanism too.
It’s well worth checking out what the CEI’s Ryan Young has to say about this case in a piece for Capital Matters today. Please do take the time to read the whole thing, but here’s an extract:
While the DOJ and most state attorneys general have been investigating Google for some time, many DOJ lawyers did not believe they had yet built up a solid case, and opposed Barr’s rushed pre-election timing. The New York Times reported in September that some staffers refused to sign onto the complaint. Some even left the case over their objections.
Google provides default search engine and web browser for most smartphones. As the complaint notes, “Google pays billions of dollars each year to distributors — including popular-device manufacturers such as Apple, LG, Motorola, and Samsung,” as well as to wireless carriers and browser companies. The exact payments aren’t known, but Apple alone likely receives between $8 billion to $12 billion from Google annually.
This default status is a powerful — and, DOJ argues, illegal — way for Google to exclude competitors.
The trouble with the Justice Department’s case is what I call the dozen keystrokes argument. It is not difficult to type DuckDuckGo.com or Bing.com into your browser. Just as Microsoft found out with Internet Explorer and then Edge, being the default is no guarantee of dominance. You still need consumers to prefer your product for them to use it.
And:
The classic legal test of monopoly power is whether a company can raise prices while restricting output. Online ad prices went down by more than half from 2009–19, and Google was a major reason why. Meanwhile, prices for print advertisements — which compete with Google for advertising dollars — rose, and in some cases doubled.
Monopolists do not cut prices. They raise prices while slashing output, because they have the market power to get away with it.
Meanwhile, Bloomberg’s editorial board slips in the stiletto:
The rationale for embarking on this project is far from clear.
However, its writers are surely correct when they argue that politics has played a big part in this decision. That is appalling, but it’s not shocking. As the Trump administration’s co-belligerents in the EU are already reminding us, antitrust is an unhealthily politicized area of the law (in many cases, it’s also a form of central planning, but that’s a discussion for another time). This case may be no exception.
Bloomberg:
From the start, the government’s public explanations have varied widely. Attorney General William Barr said in June that he was concerned about the suppression of conservative viewpoints online. Other officials have mused about biased search-engine results or dominant advertising technology. Trump himself justified the probe because tech companies “discriminate against me.”
Big tech clearly tilts strongly to the left. Equally, as we have seen recently, there are obvious examples of remarkable bias in the way in which it “moderates” content, but the fact remains that Silicon Valley has opened up platforms for alternative speech in a way that would have been unimaginable a couple of decades ago. In an age when much of the mainstream media is in ideological lockstep, that opening grows ever more valuable.
Those on the right who want (one way or another) to see that moderating function taken over by lawyers, the state or both, will not like the results. If you don’t believe me, check out Germany’s catchily-named (Gesetz zur Verbesserung der Rechtsdurchsetzung in sozialen Netzwerken) social media law, or there are plenty of other examples to choose from.
But back to Bloomberg:
In the end, the government focused its case on the agreements that Google has signed with phone makers and wireless carriers to promote its search business. On the face of it, the case is questionable: All the relevant agreements were the result of competitive bidding, users face only the slightest of hurdles if they wish to switch to other services, and even the world’s most ardent Bing enthusiasts must admit that Google has made a great product with immense consumer benefits.
“The world’s most ardent Bing enthusiasts.”
Well played, Bloomberg writers, well played.
But back to them:
[R]ecent hostility to big technology firms is not confined to the current administration. Earlier this month, the majority staff of a House subcommittee released a 449-page report that took a similarly expansive view of big tech’s depredations and proposed antitrust enforcement as the appropriate remedy. In addition to alleging anti-competitive conduct, it accused the big four companies of committing or accommodating many other misdeeds — disinformation, privacy violations, hate speech, technology addiction, political influence, impertinent emails — and concluded that these too reveal a systemic weakness in current antitrust policy.
The problem is that these are not mainly competition issues, and competition law is the wrong instrument for addressing them. Re-engineering it for that purpose is a recipe for the kind of incoherent and politicized antitrust doctrine that prevailed in the U.S. for decades before courts adopted the relatively clear and narrow standard of avoiding harm to consumers.
Untroubled by such doubts, the report contemplated radical change. It wondered whether the firms should, in effect, be broken up. It entertained the idea of “overriding” no fewer than six Supreme Court rulings. It proposed that all acquisitions by dominant firms be “presumed anticompetitive,” thereby undermining due process and empowering regulators over the courts. It suggested Congress consider amending or shredding decades worth of law and precedent, and aimed to enable an explosion of litigation.
Before the war on big tech goes any further, it’s worth remembering that these companies have given the U.S. and the world innumerable products and tools and services that would’ve been unimaginable even two decades ago. They’ve been a boon to small businesses, a huge benefit to consumers and an engine for the American economy. Not least, they’ve made the past seven months of Covid-19 restrictions bearable. There isn’t a government in the world that wouldn’t have given anything to see one of these firms, let alone all four, start up and succeed within its jurisdiction.
Concerns about the market power or political influence that these companies wield certainly shouldn’t be dismissed. But reformers need to be mindful of what’s at stake, and in less of a hurry to extend antitrust enforcement beyond its proper scope. For the past 50 years, U.S. antitrust doctrine has successfully protected both consumers and competition, thereby advancing innovation and economic growth. America’s success in technology is itself a proof of this approach. It shouldn’t be discarded lightly.
Quite.
The Fed Starts to Wonder
Meanwhile, here is an interesting straw in the wind from earlier this week.
Senior Federal Reserve officials are calling for tougher financial regulation to prevent the US central bank’s low interest-rate policies from giving rise to excessive risk-taking and asset bubbles in the markets.
The push reflects concerns that the Fed’s ultra-loose monetary policy for struggling families and businesses risks becoming a double-edge sword, encouraging behaviour detrimental to economic recovery and creating pressure for additional bailouts.
It also highlights fears at the Fed that the financial system remains vulnerable to new shocks, despite massive central bank intervention this year to stabilise markets and the economy during the pandemic.
Eric Rosengren, president of the Federal Reserve Bank of Boston, told the Financial Times that the Fed lacked sufficient tools to “stop firms and households” from taking on “excessive leverage” and called for a “rethink” on “financial stability” issues in the US.
“If you want to follow a monetary policy . . . that applies low interest rates for a long time, you want robust financial supervisory authority in order to be able to restrict the amount of excessive risk-taking occurring at the same time,” he said. “[Otherwise] you’re much more likely to get into a situation where the interest rates can be low for long but be counterproductive.”
Excessive risk-taking by banks in one of the usual senses of that notion is, I think, not too likely. I doubt if they are about to embark on a lending binge (please do not screenshot that sentence), but the risks (which will, directly or indirectly, affect the banking sector) that will inevitably pile up in this financial and economic environment are likely to be a result of the way that asset prices are being bid up due to the collapse in interest rates. Quite how regulators can regulate effectively against that remains unclear.
They will try, doubtless, but it’s worth remembering that regulation has a way of backfiring in ways that regulators have a way of failing to anticipate (for an examination of this take a look at Jeffrey Friedman’s analysis from 2009 of the causes of the financial crisis, which is featured in today’s Random Walk below.)
Meanwhile, consider this from the Financial Times (my emphasis added):
The central bank has also capped dividend payments and banned stock buybacks at the largest banks to the end of the year, though Ms Brainard — a possible Treasury secretary in a Biden administration — argued that this did not go far enough and a full dividend ban was warranted.
And yet (via The Wall Street Journal):
New research from the Federal Reserve Bank of New York released Monday said that when banks pull back on paying dividends, it increases their power to provide credit. “Dividends are an important factor in determining whether the U.S. banking industry would have sufficient capacity to absorb losses and expand lending,” the report written by Madeline Finnegan, Sarah Ngo Hamerling, Beverly Hirtle, Anna Kovner, Stephan Luck and Matthew Plosser said.
Hmmm . . .
Around the Web
The Biden Liquidation.
Investment bankers keen to win lucrative assignments have a new pitch for U.S. corporate owners: hire us to sell your company now or pay at least twice as much in taxes if Democratic presidential candidate Joe Biden has his way.
Biden has proposed raising the capital gains tax rate from 20% to 39.6% for those making over $1 million. He would also increase the corporate income tax rate from 21% to 28%.
Biden would have to win the presidency and his Democratic Party would have to gain control of the Senate and keep control of the House of Representatives in the Nov. 3 election for his tax proposals to become law. While far from certain, this prospect has been seized on by bankers hungry for new business.
Biden has proposed raising the capital gains tax rate from 20% to 39.6% for those making over $1 million. He would also increase the corporate income tax rate from 21% to 28%.
Biden would have to win the presidency and his Democratic Party would have to gain control of the Senate and keep control of the House of Representatives in the Nov. 3 election for his tax proposals to become law. While far from certain, this prospect has been seized on by bankers hungry for new business.
The investment bankers’ pitch is geared toward individuals and families, as well as private equity firms, who control companies and can decide when to sell them. It also targets company founders, who may only sell one business in their lifetime, making it the most important transaction of their lives.
The strategy appears to be working. Sales of privately held U.S. companies totaled a record $253 billion in the third quarter, up fivefold from the second quarter and up 51% from the third quarter of 2019, according to financial data provider Dealogic. This is despite the COVID-19 pandemic suppressing corporate valuations in some sectors.
I wonder if anything like that could be echoed in the stock market.
Unicorn down?
Renrenche was one of China’s hottest tech unicorns backed by investors including Goldman Sachs Group Inc. and Tencent Holdings Ltd. Now the car website could sell itself for a little over $1,000.
The Beijing-based startup — which had a pre-money valuation of $1.4 billion in a financing round just two years ago — has a preliminary plan to sell its major assets to 58.com Inc. for HK$10,000 ($1,290), according to people familiar with the matter. China’s online classified ad leader will take over Renrenche’s Hong Kong entity, while offering at least $4 million in loans to its mainland operations, said the people, asking not to be identified because the transaction is private. The parties have yet to finalize the deal and may not proceed with it, the people said.
A representative for Renrenche declined to comment but said the contents of an emailed query sent to the company was inaccurate, without elaborating.
The (job) Terminator.
Half of all work tasks will be handled by machines by 2025 in a shift likely to worsen inequality, a World Economic Forum report has forecast.
The think tank said a “robot revolution” would create 97 million jobs worldwide but destroy almost as many, leaving some communities at risk.
Routine or manual jobs in administration and data processing were most at threat of automation, WEF said.
I suspect that that tally of 97 million will be optimistic, on both sides of the equation, but time will tell. It’s also worth noting that the effect of automation is not only going to be a reduction in the number of jobs, but a reduction in the pay that goes with those jobs that remain.
The World Economic Forum (“Davos”) cannot stop being what it is, and the last bit of the next sentence seems . . . optimistic.
But it said new jobs would emerge in care, big data and the green economy.
Given the scope of the value destruction that the construction of a green economy will leave in its wake, the idea that it will create many, if any new net jobs, well . . .
Random Walk
In the Capital Note’s second “story” today, I touched on the subject of regulation backfiring.
In that context Jeffrey Friedman’s masterly analysis of the real causes of the financial crisis is well worth reading. The title is something of a spoiler: A Crisis of Politics, not Economics: Complexity, Ignorance and Policy Failure.
This is not a short read and it’s occasionally on the technical side, but it’s well worth your time. And it’s not without its pleasures, as Friedman dissects myth after myth and, by the end, assembles a narrative rather more subtle and considerably more inconvenient than the crude morality play conjured up in the wake of the reckoning of late in the last decade.
No one extract does Friedman’s work justice, but with the Fed apparently contemplating more regulation on the banks to head off, amongst other matters, some of the problems that may be brewing in the current ultra-low interest rate environment, perhaps this segment of Friedman’s cautionary tale is worth singling out:
The Basel accord, reached in 1988, was subsequently adopted by the governments of all the advanced economies, including the United States, and governed the minimum capital ratios of commercial banks until the Basel II accord was phased in, beginning in 2006.
According to the Basel I rules, an adequately capitalized commercial bank must maintain 8 percent capital against its assets. This capital is intended as security for assets, such as loans, that might default.
Capital minima like these are as old as deposit insurance. What was new with the Basel accords was that they linked the required capital to differences in risk among different types of asset. Thus, a government bond was judged to have zero risk of default, meaning that a bank needed to hold no capital against it under the Basel I rules. At the other end of the spectrum, commercial loans were given a 100-percent risk weight, requiring 8 percent capital: For every $100 in commercial loans, a bank had to have $8 in capital. Mortgages fell exactly in the middle, with a risk weight of 50 percent. Thus, a bank had to maintain $4 of capital against every $100 in mortgages that it originated: $100 x .08 x .50 = $4.00
However, the Basel rules assigned a risk weight of a mere 20 percent to securities issued by government-sponsored entities, which were interpreted in the United States to include Fannie Mae and Freddie Mac. Thus, a bank would have to maintain only $1.60 of capital against $100 of such securities: $100 x .08 x .20 = $1.60. A bank that originated a $100 mortgage, sold it to Fannie or Freddie for securitization, and then bought it back as part of a mortgage-backed security would reduce the amount of capital it needed from $4 to $1.60. Since $1.60 is 40 percent of $4, such transactions would increase the bank’s leverage—its borrowing and lending power, and thus its potential profitability—by 60 percent. Nor would it matter what type of mortgage the bank originated: It would get the same minimum capital reduction by transforming a mortgage into part of a mortgage-backed security regardless of whether the mortgagor had put down 20 percent or nothing at all, and regardless of how well documented or how low the mortgagor’s income might be. Any mortgage that a GSE would securitize was, under the Basel rules, profitable for American banks to originate—and profitable for them to buy back as part of a security. Thus, the low risk weight that the American regulators attached to GSE securities provides an explanation for why commercial banks found it profitable to originate nonprime and subprime mortgages.
The homeownership-expansion mandates imposed on the GSEs by HUD starting in 1994 made them eager to buy nonprime and subprime mortgages, and thus made it profitable for mortgage originators to sell their loans to the GSEs for securitization. But perhaps more importantly, the regulations also made it profitable for commercial banks to buy back the mortgage-backed securities created by the GSEs. Unlike other investors, who merely received income from mortgage-backed bonds, banks also received a 60-percent increase in their potential earnings on the mortgage portion of their assets. Acharya and Richardson…[show] that banks held $852 billion of “agency”-issued mortgage-backed securities (from Fannie Mae, Freddie Mac, and Ginnie Mae), or 24 percent of all such securities that were not held by the two GSEs themselves.
However, that still leaves us with the question of why private securitizers, such as Bear Stearns, became so heavily involved in subprime securitization after 2002, and why so many of their mortgage-backed securities—not just those issued by the GSEs—found their way into the portfolios of commercial banks. Here, too, according to the Acharya Richardson and Jablecki-Machaj papers, the answer may lie in the Basel rules.
Put another way, a regulatory structure designed to reduce risk-taking actually incentivized it. What’s more, those perverse incentives were made even more dangerous (as Friedman demonstrates elsewhere) by the fact that other regulations worked in a way that ended up understating the degree of risk involved.
Somehow, I don’t think those lessons have been learned as well as they should have been.
— A.S.
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