Historically, bond yields have not been very good at predicting inflation.
In the last 70 years, bond yields rarely rose ahead of inflation, going up only after inflation takes hold. One study indicated that past inflation trends were a better predictor of bond rates than what future inflation turned out to be.
Does this mean bond traders are wrong? Not necessarily. It may just reflect that inflation is unpredictable and bond traders don’t know any more about the future than the rest of us. All they have is the past data and current prices to make their predictions, too. So when inflation suddenly spikes — as it has in the past — bond traders are as surprised as everyone else.
My colleague at Bloomberg writes we’ll have to pay teachers more to get them to return to work. Their pay has been stagnant for a decade. But their compensation has not been. A very large part of teachers’ compensation comes in the form of a massive risk-free asset—a defined benefit pension. The value of this pension increased as real interest rates fell. It not only took more resources for the states and municipalities to finance (assuming the pension funds were well funded—a big if) the pension when rates were low. The pension became more valuable.
So teachers really got large raises in the form of their more valuable pension. The problem is they don’t fully internalize how much more their pension is worth. Also, pensions are less valuable for young teachers who may change jobs one day. If we do want to increase teachers’ pay, we really need to reform the pensions. Reform would free up more money for salaries, and there’s evidence young teachers prefer more flexible compensation.
That probably won’t happen since the teachers’ union is very attached to its defined benefit plan. But you can’t have it all, even in this labor market.
Is it just me or are people obsessed with tax compliance lately? I suppose it is part of this fantasy that high earners and corporations have enough money to pay for all our new spending – we just have to force them to pay up.
You know what might be simpler than jacking up taxes and doubling the size of a government agency? A broader base and simplified tax system that doesn’t leave so much room for getting out of paying taxes. Take the idea of a global minimum corporate tax. Sounds sensible enough; after all, you can’t increase the corporate tax rate too much because it is so easy to send profits overseas where taxes are lower.
But anyone who studied public finance can tell you there’s the tax rate and there’s the tax base. Generally, it is better to have a broader base and a lower rate. You get more revenue that way, and it causes fewer distortions and enhances transparency. Maybe we can convince OECD countries to set a higher corporate rate, but that creates a new race to the bottom to degrade the base. Countries will compete to offer more loopholes and deductions. And that seems worse to me.
And applying the higher capital gains rate to top earners, who tend to be wealthy, creates bigger distortions because these taxpayers have many tools to avoid the tax. For example, when you inherit assets subject to estate taxes, the capital gains tax that you pay is based on when the asset was transferred to you, instead of when it was bought. This is known as a step-up in basis. Doubling the tax rate makes this provision much more attractive, and word is that the Biden plan nixes it. High earners can find other ways to get around this tax with the right advice. Certain asset classes, such as investment real estate, offer a chance to lower liability. We may also see more high-net-worth investors move further into the murky world of private equity, where values are easier to distort.
There are better ways to collect investment-income revenue. Getting rid of step-up in basis is a start; the administration could also take on the myriad loopholes that favor different asset classes. But these approaches don’t offer the stick-it-to-the rich satisfaction of doubling the rate on investment income—even if we all wind up paying for it.
We can see evidence of the market distortions that government subsidies cause in the market capitalization of electric-car maker Tesla—currently about $650 billion, or more than five times that of General Electric. Tesla benefits from many subsidies already, and the Biden infrastructure plan aims to divert even more to the electric-car industry. And by increasing the corporate tax rate to pay for part of these subsidies, the Biden plan will further distort the market by making the unsubsidized private sector even less attractive to investors.
The pandemic forced many businesses to adopt new technologies that could boostproductivity for decades. Productivity gains don’t always come so fast. It took more than 100 years for the steam engine, a transformative technology, to show up in productivity estimates, for example. The pandemic’s acceleration of this process of technological adoption means that we could be poised for a big burst of follow-on growth and innovation. But government interventions on the scale of the Covid stimulus and infrastructure bill threaten to divert these energies into less productive investments.
True, the added government spending will provide short-term benefits to workers in the form of new jobs building roads, bridges, and airports or retrofitting buildings with green technology. But using industrial policy to create jobs can also generate long-term risks for those workers, by steering them away from gaining the skills and experience the market may need in the future. Research has shown that workers for the Depression-era Works Progress Administration were less likely to take higher-paying private-sector jobs when they became available because they preferred the security of a government guarantee. In the long term, that can lead to wage stagnation and a population less competitive in the global market.
It is a miracle anyone ever listens to us. Honestly, sometimes they shouldn’t. Other than the theory of comparative advantage, I can’t think of any correct economic insights that defy common sense. Economists, or experts in any field, are meant to offer a framework to weigh costs and benefits, help us see risks, and understand how the economy and people respond to shocks and policy. This helps people make choices that are right for them. If someone is pushing something totally counterintuitive, whether in economics or public health, we should be skeptical.
The same goes for debt. I heard someone say MMT has become an accepted theory – that is simply not true. And there is nothing new here. If you look at the history of debt cycles and financial crisis, they often featured some convoluted justification for why taking on tons of leverage isn’t so risky after all because this time was different – we are so much more clever now. Guess what, you might use some big words that tell you otherwise, but debt is always risky. Sure, some of the time it works out and juices higher growth, but when it doesn’t, things get really nasty.
And this is why our semi-annual time changes need to end. It disrupts coordination, which is the whole point of keeping time. Most of the world does not observe DST. And countries that do adopt it do so on different days.
This means for a few weeks each year there is total time chaos. People on the East Coast can’t remember if Europe is five or six hours ahead anymore. It wreaks havoc on the airline industry, costing them hundreds of millions of dollars a year in non-pandemic times. JP Morgan estimates consumer spending drops 3.5% every year we return to Standard Time. There are also more heart attacks, strokes, car accidents, and depression.
Perhaps most damaging, however, has been the idea arising in the last few years that people simply can’t be trusted to make sensible risk assessments—that they must be guided or even manipulated into making smarter choices. The idea that we need to be “tricked” into good behavior was pervasive throughout the pandemic. First, we were told masks weren’t effective, in what turned out to be an attempt to protect supplies for health-care workers. Last spring, we were told that coming into contact with others in just about any environment was unsafe, despite data showing the risk of outdoor transmission was very low. Over the holidays, rather than telling people that they should reduce their risks at holiday gatherings by taking steps like getting a test beforehand, public-health officials said that we should all just stay home, because tests can’t guarantee safety. Even today, the FDA refuses to approve cheap, at-home rapid tests without a prescription because the government doesn’t trust individuals to assess risks based on good, albeit imperfect, information.
The worst, most consequential failure in risk communication concerns the current vaccine rollout. The media constantly instruct us that, even weeks after receiving the second shot, it’s still not safe to socialize without masks. President Biden and Anthony Fauci have warned that we may not be able to resume “normal” life for another year. Fauci recently counseled against vaccinated people eating in indoor restaurants or playing mahjong together. Public-health officials today gave the green light for vaccinated people to gather together—but only after weeks of confusing and contradictory guidance.
I expect some big institutional changes to be coming our way soon. One favorite debate, at least according to the editorial page of the Financial Times, is the trade-off between efficiency and resilience. Buying all your goods from China, including PPE, may be efficient—but if you have a global pandemic, then it means that you’re not so resilient. Or, if you live in Texas, cheap energy is great when you blast your air-conditioning every August when it’s 110 degrees outside, but if there’s a crazy cold snap and your power gets shut off, you see that your system is actually not that resilient at all.
We already see the Biden administration taking on resiliency, as he is trying to revive domestic manufacturing. And we can expect some soul searching in Texas as well. But I’m not convinced that we’ll get the big overhaul, because the problem with resiliency is that it can be extremely expensive, and once we forget about the shock, we don’t want to pay for it anymore. It’s expensive if you define resiliency as the ability to seamlessly handle a once-in-a-lifetime tail risk that you never saw coming. People like cheap power and goods, and those things help the economy grow.
The big misunderstanding here is that, though structural changes are certainly persistent and less responsive to policy, they are not permanent. Conditions are always changing. Productivity transforms economies, and so do shifting age structures and demographics. Foreigners are already losing their appetite for U.S. debt; much of it is now bought by the Fed or by banks required to hold it for regulatory reasons. Thus prices may not be as revealing as we think.
And we can’t be sure that debt monetization won’t unleash inflation or higher interest rates. The Fed buys bonds from the banks and credits them with reserves. Eventually banks may want to spend their reserves, and the Fed will need to sell some bonds—which could increase interest rates, or increase inflation, or both. The world could also discover a new safe asset, like German stocks. For many years, gold was considered the only safe asset, and it was unimaginable that a fiat currency could be safe.
Structural changes happen more often and much faster than people realize. We could come out of the pandemic in a new regime of less trade and more reliance on tech that could change debt and price dynamics in ways that we don’t yet understand.
When economists like Larry Summers and Olivier Blanchard, who normally support more spending, balked at the size of the Biden stimulus plan, supporters of the plan said there was no reason to worry. Clearly markets are not worried about inflation or sustainable debt, just look at low bond prices and modest inflation expectations. They argue if markets aren’t worried, maybe none of us should be.
But we are in uncharted territory. The Debt-to-GDP ratio grew exponentially last year to once unthinkable levels, at least for a time of without a major military conflict.1 Piling on another $1.9 trillion (and possibly more later this year) risks higher rates in the future. The more leverage you carry, the less room you have to spend on the next disaster.
So why aren’t markets more worried? Perhaps because for the time being there are not better, safer alternatives. Also, the government has a captive buyer of its debt in the Federal Reserve, whose holdings of US government debt also reached unprecedented levels last year. Debt enthusiasts dismiss worries of an overheating economy by pointing out the Fed could raise rates and stop inflation if it takes off. But that would involve the Fed selling some of its debt and putting even more bonds on the markets, only this time there won’t be a single captive buyer.
But the whole thing is being framed in an odd way—i.e., that the individual retail investor is rising up against the big, bad hedge funds. This is a compelling narrative, and that’s why it’s all anyone is talking about. And I suppose that could be the takeaway after a single day of trading. But making money in markets requires knowing when to get out (or having power friends who will lend you money when you need it), and I worry about some people betting money they don’t have without realizing the risks that they’re taking on. Taking down a hedge fund is only fun when you make money at it, and we don’t know whether these day traders care so much about taking down big whales until they actually lose money while doing so. And these funds have much deeper pockets and access to a lot more capital. It’s sad to say, but the game is rigged in their favor. So, as satisfying as it may be in the short run, I don’t see it ending well.
It feels like all of these discussions about risk, class, and fairness are dancing around the real question here, a question few will dare to ask: Should retail investors be able to buy individual stocks? Or should we only be able to buy mutual funds?
Investing in individual stocks is risky, and most people would be better off owning an index fund. If they did, they’d make more money on average and face less risk at the same time. Day-trading options are even riskier. So is shorting. My mentor, Robert Merton, has likened owning an individual stock to buying a single piece of car—it’s pretty useless, especially if you don’t know what you are doing. After all, a security’s value is largely about how it contributes to your entire portfolio as a whole.