The Capital Letter

A Broken Market and ‘Rational’ Bubbles

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At the time of writing (1 p.m.), it looks as if the S&P will be up on the week, just one of a series of bubbles continuing on their merry way, even if Bitcoin has rather let the side down of late. Bitcoin is a separate case that warrants separate discussion, but what distinguishes the bubbles in the equity and bond markets is the way in which they are a rational response to a broken market.

And “broken” is the right word.

The Financial Times has seen a copy of a letter written by Seth Klarman to his clients. Klarman is a legendary value investor, and value investors have not had a great time recently, not least because notions of value have been hopelessly muddled by the Fed’s interventions in the market. It is possible to make the case that those interventions were justified, particularly in March (and I would make it). However, judging by the FT report, I do not think Klarman would agree (“Mr Klarman criticised the Federal Reserve for slashing rates and flooding the financial system with money since the onset of the coronavirus pandemic”), but it is hard to argue with him about this:

The biggest problem with these unprecedented and sustained government and central bank interventions is that risks to capital become masked even as they mount.

Or this:

The Fed’s policies and programmes “have directly contributed to exceptionally benign market conditions where nearly everything is bid up while downside volatility is truncated”, he added. “The market’s usual role in price discovery has effectively been suspended.”

When price discovery is blocked, trouble tends to follow. One of the many reasons for the disaster that engulfed the euro zone a decade ago was that the decision to replace a whole set of national currencies with one single currency seriously weakened the market’s ability to price country risk. If, say, well, Greece, had been pursuing reckless policies, this would previously have very quickly been picked up in the currency markets as the drachma came under pressure. And as a result, the markets would have been much more likely to put an accurate price on Greek risk. But with the drachma swapped for the euro, that warning signal was extinguished (between 2001–2007, the average spread between the yield on German and Greek ten-year government bonds was 27 basis points — 27!). Unhappiness ensued.

Somewhat similarly, by distorting the debt market in the way that it has, the Fed has (for now) destroyed the role that interest rates ought to play in signaling and thus pricing risk.

Instead:

Mr Klarman said investors were now in a constant hunt for yield that was driving them to riskier corners of the market, including investment-grade corporate debt, private credit or junk bonds.

And there is another problem. If (fights break out) the value of a stock should be linked to the discounted value of the forecast future cash flows generated by a company, then ultra-low interest rates can justify a massive increase in the present value of those cash flows and thus the share price.

Low interest rates have made projected cash flows more valuable, [Klarman] said, a point many investors have unwisely used to justify valuations on companies that sit far above historic norms.

“The more distant the eventual pay-off, the more the present value rises,” he wrote. “When it comes to the value of cash flows, the vast and limitless future, yet to unfold, has gained considerable ground on the more firmly anchored present.”

The difficulty is that, for as long as the market is being distorted in the way that it is, what would normally be irrational investing is rational. The signs of an investment bubble (or bubbles) are all there, from the rise of SPACs (blank-check companies) to the surge in participation of retail investors (the latter doubtless helped by the combination of being stuck at home and the sheer ease of investment in the Internet age) to electric vehicle mania. But quite what, other than an abrupt change of direction from the Fed, will change that is not easy to say.

Then again, at moments such as this I cannot help remembering the wise words of Nathan Rothschild — “I never invest at the bottom, and I always sell too soon”– advice that is good for almost any investment market, but, perhaps, for bubbles in particular.

Meanwhile, take a look at this piece, also in the Financial Times, on inflation by Jeremy Siegel, which, given my own expectations of a sharp rise in (conventional) inflation after the Fed’s Lehman-era interventions, I found of more than a little interest.

Siegel explains how the money created by the Fed at that time ended up in banks’ reserves and stayed there. Little of it was lent out, and inflation remained in its cage.

Following the crisis, interest rates collapsed. The Fed started paying interest on reserves, and regulators imposed liquidity requirements that could be satisfied with these reserves. The banks easily absorbed the extra reserves created by the Fed and quantitative easing led to only a modest increase in lending.

I would add that the post-crisis economy was also one in which animal spirits were notably absent — and absent for a long time — thus suppressing the demand for credit, despite low interest rates.

But back to Siegel, who turns his attention to where the money has gone (and is going) this time around (my emphasis added):

The money created by the Fed is not going only into excess reserves of the banking system. It is going directly into the bank accounts of individuals and firms through the US Paycheck Protection Program, stimulus cheques, and grants to state and local governments.

In the mid-1970s, I was a young assistant professor at the University of Chicago during the final years of Professor Milton Friedman’s distinguished career. I remember him telling me that aggressive expansion of the reserve base is a powerful force, and would have saved us from the Great Depression of the 1930s. But if expansion of reserves actually reaches saving and checking accounts of the private sector, such Fed action is many times more powerful.

I certainly do not expect hyperinflation, or even high single-digit inflation. But I do believe that inflation will run well above the Fed’s 2 per cent target, and will do so for several years . . .

It is inevitable that bond rates will rise, and rise far more than now envisioned by the Fed and most forecasters.

That, as Siegel observes, is “not good for bondholders.”

It is also not tremendous news for taxpayers either. For rising interest rates on what is now an enormous pile of debt could be very expensive indeed (which, incidentally, is why the government should be issuing very long-dated bonds), and that brings me back to Seth Klarman:

The Fed’s drastic measures have helped to boost economic activity and rescue ailing businesses, Mr Klarman said. “But they have also kindled two dangerous ideas: that fiscal deficits don’t matter, and that no matter how much debt is outstanding, we can effortlessly, safely, and reliably pile on more.”

Is that the ghost of Nathan Rothschild I see just across from my desk? I think he has something he wants to tell me.

Capital Matters began the week with our latest Supply & Demand, in which Casey Mulligan highlighted just one way in which Obamacare has not lived up to expectations:

Last week the [Trump] White House released data showing that one of the major taxes in the 2010 Affordable Care Act (ACA) turned out to be a big lie.

When Congress was debating the ACA, the experts told us that consumers must be forced to buy health insurance or else they would sign up only when they were sick. Anyone who did not comply must be disciplined for the greater good, they said. The 111th Congress embraced this conclusion when it passed the ACA. The law included an “individual mandate” forcing everyone to buy health insurance and an “employer mandate” forcing employers to sell health insurance to their workers. Individuals or employers who disobeyed would pay hefty tax penalties.

The Congressional Budget Office advised Congress that those two tax penalties would yield fiscal benefits offsetting some of the bill’s costs. In reality, and unique in the history of taxation, the two tax penalties ended up costing the government money . . .

Steve Hanke released the annual league table for those countries on his inflation dashboard (not a place where any country should want to be: to qualify for entry, required ending the year with an annual inflation rate of 25 percent or more). The “winner” came as no real surprise:

Venezuela tops the list of inflators once again. Indeed, it has been in a state of hyperinflation since late 2016. To qualify for that dubious distinction, a country’s inflation rate must be greater than 50 percent per month for at least 30 consecutive days. The only other country experiencing hyperinflation is Lebanon. Lebanon’s became the 62nd episode of hyperinflation in history this past July and is the only MENA country where inflation has ever crossed this threshold. Zimbabwe, while not going through hyperinflation at present, currently holds down the world’s second-highest annual inflation spot. But the country is no stranger to hyperinflation. In November 2008, it experienced the second highest hyperinflation in history, when prices were doubling every 24.7 hours. If that wasn’t bad enough, Zimbabwe experienced a second hyperinflation in October 2017, when the monthly increase in prices hit 185 percent.

Brad Polumbo was unimpressed by President Biden’s proposal for a nationwide minimum wage of $15 per hour:

Even in the best of times, raising the wage floor for so many workers to a level that nearly approximates the median wage would be a drastic shock for businesses and the labor market. Employers would respond to such an artificial price hike, like anyone would, by reducing the quantity of labor they demand. (Put another way, they would hire fewer people, something made even easier by ever more widespread automation.) In a 2019 survey, the nonpartisan Congressional Budget Office estimated that a minimum-wage increase to $15 by 2025 would lead to 1.3 million fewer jobs nationwide.

Suffice it to say, right now is not the best of times.

Alex Muresianu explained how a tax change from 1986 had hurt (and still hurts) American manufacturing:

Persistent problems with the tax code led to the demand for additional systemic reform in the mid-1980s, which ultimately culminated in the passage of the 1986 tax reform. The debate over whether to lower the corporate-tax rate or maintain ACRS was central to the debate. As Jeffery Birnbaum, author of Showdown at Gucci Gulch: Lawmakers, Lobbyists, and the Unlikely Success of Tax Reform, wrote on the 20th anniversary of the bill’s passage, “light” industries such as wholesalers preferred a lower rate, while the heavy industries preferred to keep accelerated depreciation. In the end, the light industries won.

TRA86 reduced the corporate-income-tax rate from 46 percent to 34 percent but extended the depreciation schedules for several types of assets. The act increased the depreciation periods for numerous types of equipment, from industrial machinery to cars, aircraft, and railway parts, from five years to seven years, and did away with the provisions allowing companies to deduct a larger share of the costs in earlier years. However, the biggest increase came for structures. Commercial structures (whether office buildings, warehouses, or industrial centers) had to be deducted over 31.5 years, instead of over 19. Similarly, residential structures had to be deducted over 27.5 years instead of the preceding 19.

Norman Ture, an architect of the 1981 tax cuts, referred to 1986 reform as “the Deindustrialization Act of 1986” the year after its passage. After TRA86, investment in most asset classes underperformed expectations. And in 1993, to add insult to injury, the depreciation schedules for commercial structures were increased to 39 years. Since then, there have been several temporary measures granting what’s called “bonus depreciation” to allow companies to deduct some investments faster (most usually equipment and machinery), the most recent example of which was included in 2017’s Tax Cuts and Jobs Act.

So far, most empirical analyses of these past temporary reforms have shown they increased investment, as well as productivity and wages. These changes should be made permanent . . .

Kevin Williamson agreed with Alex’s criticism of the 1986 changes:

To Alex’s very interesting “Capital Matters” column on corporate-tax-depreciation reform — and don’t roll your eyes; it is an interesting subject, if you let it be — I would add only this: Tax schedules pushing 30 or 40 years might (might) have made sense in some earlier, slower-moving capitalist era, but, in our time, businesses undergo major reorganizations much more frequently, and few of them are making 39-year plans for any asset. It is possible that almost none of the equipment Tesla is purchasing today to manufacture automobiles will be in use a decade hence . . .

The tax rules are, as Alex shows, a hairier problem for firms that make big investments in physical equipment, factories, etc., than they are for, say, software companies that mostly need office space and personnel. The tax rules are not the only reason U.S. manufacturers have not seen the kind of growth that tech and finance have seen, but improving them would improve the overall business climate, which is in the interest of manufacturers — and everybody else.

I was surprised (but not really) that China’s Xi would be addressing a “virtual” Davos next week:

Under the circumstances then, it might seem odd to be hosting Xi (even in the context of a discussion on Asia’s role in the recovery). After all, 2020 saw China’s military adventurism extend to the Indian border, and the regime has also brutally extinguished most of what remains of Hong Kong’s autonomy, effectively tearing up an international treaty to do so — disappointing behavior for a country allegedly so committed to the global legal order. And then there is the little matter of what has now become the genocide of the Uyghurs. It might have been hoped that the WEF would at least draw the line at that, but apparently not.

Anthony and Mark Mills demonstrated, using the example of the COVID-19 vaccines, the importance of “foundational” research:

After decades of being told it takes years to produce new drugs, we’ve now been spoiled by the magicians in pharma who invented multiple COVID-19 vaccines in mere months. Policy-makers and pundits will expect no less from technology in the future. And not just for diseases, but for all manner of societal challenges, from cancer to climate change.

Unfortunately, such high expectations for the pace of technological innovation may seduce some policy-makers into overlooking a key lesson from this medical feat. History shows that “overnight successes” in technology are often the result of decades of scientific research. If we want more such successes, we’ll need more scientific discoveries, too.

There’s no better example of this than the story of the COVID-19 vaccines.

On May 15, 2020, the government launched Operation Warp Speed, a public-private partnership focused on accelerating development, manufacture, and distribution of COVID-19 vaccines. Who could have guessed back then that the biggest obstacle to success would be the logistics of distribution, rather than the alchemy of invention? On December 11, 2020, the FDA approved the first vaccine, created by Pfizer, based on a new technology that utilizes “messenger RNA” (mRNA). Another from Moderna soon followed — an impressive timeline. But the story really began in April 1960 . . .

Veronique de Rugy paid tribute to the late Jerry Ellig:

It is with great sadness that I learned of the passing of my friend and former colleague Jerry Ellig. For those who didn’t know him, Jerry was one of the absolute best regulatory study experts we have ever had. His spent his entire profession studying an issue that is incredibly important and yet often neglected by economists and scholars.

A few years ago, his expertise was put into practice when he was named chief economist at the Federal Communications Commission. Under the chairmanship of Ajit Pai, Jerry and his team freed us from the net-neutrality rules, among other things.

Alexander Salter argued that the Fed does not set interest rates:

Among my ambitious New Year’s resolutions, the most difficult is my commitment to kill the oft-repeated claim that the Federal Reserve sets interest rates.

Wait, what? It is a basic truism of financial journalism that the Fed determines rates from on high. From the Wall Street Journal to the New York Times, central-bank control over interest rates is so thoroughly accepted that it’s hard even to think about things any other way.

Alas, it just isn’t true. Things have admittedly gotten more complicated since the 2007-8 financial crisis. With the switch from a corridor system to a floor system, the federal funds rate waned and the rate paid on excess reserves waxed in importance. Yet even now, the claim that the Fed sets interest rates obscures more than it illuminates. Let’s explore this, step by step . . .

Not a man who is afraid of controversy.

Isaac Schorr looked at a chart and decided it wasn’t a road map for the GOP:

As you can see, most swing voters are in the upper-left quadrant, meaning they had relatively conservative opinions on social issues, and relatively liberal ones on economic questions. This, we’re told, is why the GOP must be remade in Donald Trump’s image. That is, the image of candidate Trump, who promised not to reform entitlements and floated the idea of a universal health-care plan, not President Trump, whose greatest legislative achievement was a tax cut and whose reelection battle cry was “America will never be a socialist nation.” In any case, there are a few problems with the dead consensus crowd’s use of this single chart to dance on that consensus’s grave.

For example:

Markets mostly work. It’s easy to forget that, given that this simple and self-evident point is never made by Democratic Party, and is increasingly ignored by some in the GOP, but the United States is the most prosperous nation in the history of the world because of its mostly capitalist system. All around the world, the evidence is staring us in the face: North vs. South Korea, Republic vs. People’s Republic of China, Florida and Texas vs. New York and California. If the GOP abandons its generally pro-market outlook, there will be no pro-market argument being made, save for by some half-naked man on a stage at the Libertarian Party convention warning about the impending toaster-license mandate. Again, this shouldn’t preclude us from debate and reform of the party platform on specific issues — our economic relationship with the Chinese Communist Party, for example — but it should dissuade us from abandoning fusionism altogether.

David Harsanyi maintained that contrary to what he said on the campaign trail, Biden does want to end fracking:

We know Joe Biden wants to end fracking not only because his campaign literature promised to achieve “a 100 percent clean energy economy and net-zero emissions” in a few decades but because he explicitly asserted as much on numerous occasions.

When CNN’s Dana Bash asked Biden during a Democratic primary debate: “Would there be any place for fossil fuels including coal and fracking in a Biden administration?” Biden responded, “No, we would work it out. We would make sure it’s eliminated.” When Bernie Sanders said, “I’m talking about stopping fracking, as soon as we possibly can,” Biden replied, “No more, no new fracking.”

In an exchange in New Hampshire during the primary, a voter asked the then-presidential candidate: “But like, what about, say, stopping fracking?” Biden answered: “Yes.”

Yet, when the Trump campaign ran an ad featuring a woman saying, “If Joe Biden’s elected, he’ll end fracking. . . . That would be the end of my job and thousands of others,” the Associated PressWashington PostFactcheck.org, and many other outlets, threw up a bunch of red herrings to mitigate the damage that this position would cause among independents in places such as Pennsylvania.

Anyway, on his very first day on the job, Biden did what he had promised, using executive power to limit fracking to the best of his ability, stopping construction of the Keystone XL pipeline in which natural gas would flow, establishing a bunch of new fracking regulations on public lands, and reinstating the pseudoscientist anti-fracking, “Interagency Working Group on the Social Cost of Greenhouse Gases.”

In a Forbes article, “Did Biden Break Campaign Promise On Fracking? No—And Here’s Why,” Rachel Sandler makes the acutely irrelevant observation that “the president does not even have the power to ban fracking nationally.” Biden, you see, is only banning the fracking he can ban. Which is tantamount to arguing that Donald Trump never supported a wall on the Southern border because he didn’t have the power to unilaterally build it . . .

Zachary Evans heard from Scott Moe, the premier of Saskatchewan, about Biden’s revocation of construction permits for the Keystone XL pipeline (spoiler: he’s not impressed):

“It’s a wonder to me why it’s not moving forward,” Moe told National Review. “We’d ask that both our national leaders engage on this project as well as on future projects so that we can keep being competitive and move forward as an integrated, competitive, and strong North American economy.”

Moe’s comments came just before Biden and Canadian Prime Minister Justin Trudeau were scheduled to speak on Friday, in Biden’s first call to a foreign leader. Trudeau commented that he was “disappointed” in Biden’s decision to cancel construction.

According to Moe, the project’s cancelation would lead to the loss of “tens of thousands” of jobs both in Canada and the U.S . . .

Moe emphasized that the pipeline itself is unique in that it runs on net-zero carbon emissions, and TC Energy has stated the pipeline will be powered entirely by renewable energy by 2030. Additionally, energy producers in the west side of Saskatchewan have been able to reduce greenhouse gas emissions in each barrel of oil that they drill.

“In this particular area…the greenhouse gas emissions in each barrel of oil have been reduced by 50 percent,” Moe said. “That is a comparatively sustainable energy that is going into the Keystone XL pipeline, down to the Gulf Coast . . . ultimately offsetting the need for a much dirtier energy source coming in from Venezuela or one of the OPEC nations.”

Oh.

Finally, we produced the Capital Note (our “daily” — well, Monday-Thursday, anyway).  Topics covered included: Biden’s economic plan, Yellen’s debt dilemma, deficits in a zero-interest-rate world, the death tax’s (possible) new scythe, vaccines and the EU’s lethal central-planning fail, Merkel/Brezhnev, credit-market Jenga, lost Bitcoin/found Keynes, Yellen’s first Senate hearing, Biden’s inauguration, Europe’s small-loan buildup, a look back at the Plaza Accord, climate follies, minimum-wage follies, “robber baron” myths, Crocs’ pandemic surge, and COVID-19’s long-term economic scarring.

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