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The True Cost of Low Rates

From Barron’s Stephanie Pomboy: A Grim Outlook for the Economy, Stocks by Leslie Norton

In the past rates that were too high were the trigger (for a financial crisis). Not this time. No. 1, we have basically bankrupted corporate and state and local pensions by having rates at these repressive levels. If you lay on top of that a decline in equity prices, there will be a scramble to plug holes in pensions. Obviously if a state or local government has to divert funds to plugging its pension, it won’t build more roads. The corporate sector has the luxury of kicking the can down the road, and because their spending has been on buybacks, not plants and equipment, the economy would suffer less. For S&P 1500 companies, the pension deficit is roughly $560 billion, but for state and local governments, it’s $1.2 trillion. According to the Center for Retirement Research, if you used a more conservative discount rate, the unfunded liability would go to $4 trillion.

No. 2, you’re pushing consumers to the brink as they try to save enough for retirement at zero rates. You’re already seeing a reluctant return to credit-card usage, a clear sign of distress—they are charging what they previously paid with cash. The credit-card delinquency rate is picking up.

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Stifling Inflation and Productivity

From The Reasons Behind the Obama Non-Recovery by Robert Barro in The Wall Street Journal

The main U.S. policy used to counter the Great Recession was increased government transfer payments. Federal social benefits to persons as a ratio to GDP went from 8.7% in 2007 to 11.7% in 2010, then fell to 10.9% in 2015. The main increases applied to Medicaid, Medicare, Social Security (including disability) and food stamps, whereas unemployment insurance first rose then fell. Unfortunately, increased transfer payments do not promote productivity growth.

The 2007-08 financial crisis was also followed by vast monetary expansion involving increases in the balance sheets of the Federal Reserve and other central banks. The Fed’s expansion featured a dramatic rise in excess reserves, used to fund increased holdings of Treasury bonds and mortgage-backed securities. Remarkably, the strong monetary growth came without inflation.

The absence of inflation is surprising but may have occurred because weak opportunities for private investment motivated banks and other institutions to hold the Fed’s added obligations despite the negative real interest rates paid. In this scenario, the key factor is the flight to quality stimulated by the heightened perceived risk in private investment.

HKO

High monetary growth without inflation happened because:

  1. High friction costs stifled investment. Included is the accumulation and addition of regulations and the uncertainty; every increase in regulation and taxation is followed by calls for more.
  2. The combination of low interest rates and higher friction costs meant that the prudent use of the cheap money was stock buy back rather than increases in productive investment. Misguided corporate incentives that pay for increased shareholder value rather than higher productivity or better return on assets (as opposed to equity) exacerbated this trend.
  3. Low velocity of money. Related to the above, individuals reduced debt and curtailed both consumption and investment.  The individuals still have some control.

 

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Known and Unknown Risks

Henry3

No government policy can remove the risk of investment; the best they can do is not add to the risks by adding uncertainty to the environment.

The reason that strangers from all over the country will congregate to a blackjack table at a casino is not to avoid risk.  They seek risk, but every player seated at the table knows the rules and the rules never change. Actually they seek reward, but are more than willing to accept the risk that rides with it.

They know that if the dealer is showing a six and the player shows a ten, then the prudent risk is to double down.  If the player draws a nine and the dealer draws a five and a queen, the player loses.  That is a risk the player willingly accepts.

But if the player displays 19 and the dealer ends up with 19 and instead of calling a draw takes your money because the rules changed this morning, then this table and the casino will start to empty.

We are more than willing to take a risk when the rules are fixed, but are not willing to do so when the rules are either a) not known or understood or b) constantly changing.

Taxes and regulations are friction costs that decrease the return on investment and therefore make marginal investments less prudent.  Higher friction costs reduce incentives to invest  but this is limited  as long as they are stable and known.  We can still make prudent investment decisions if we know in advance what the costs are.

But when we do not know what the rules are, if they are constantly changing, and if every elected fool keeps harping on their desire to increase friction costs further, then the rules are never known or trusted and investment is stifled far more than from the mere friction costs the government imposes.

“You did not build that” is a clear signal that you do not deserve the fruits of your investment and are therefore obligated to return more of your profits to the government.  “The rich need to pay their fair share” is the echo of Occupy Wall Street that seeks further confiscation of investment returns.

Because of this added uncertainty from the bully pulpits, even a drop in friction costs may not create the incentive it normally would if investors have no confidence that it will last.  The tax cuts of George Bush had an expiration date.  This muted their effect especially as the deadline approached and the Democrats took control of Congress.  Nobody had faith they would be renewed.

And because of this uncertainty there is a preference for liquidity.  Investors prefer a vehicle they can turn to cash quickly; preferable for about $9 and a click on their computer.  Systemic uncertainty is a drag on housing prices, and is compounded by the collapse in housing prices in recent memory.  It is also a drag on starting a business which can be even more difficult to sell.

The stock market increase is driven by a number of forces; the liquidity preference, regulations which favor larger public companies, low interest rates which is fueling stock buybacks, and the absence of better investment alternatives.  Unfortunately, the one driver that is missing is increasing productivity and the main reason is that the systemic uncertainty and the friction costs has stifled the capital investment that drives long term wage and economic growth.

The Keynesian demand stimulation of cheap money has not stimulated production and investments in productivity. The stimulus of cheap money is perhaps offset by the increase in systemic uncertainty and other friction costs.  The left blames the depth of the 2008 financial collapse and refers to the claim of Reinhart and Rogoff from This Time It’s Different that such severe financially centered corrections are slower to recover.  But perhaps they are slower to recover because the same polices are enacted that do not work.

And they offer for consideration that we may entering a structural change that is unable to match the productivity gains of previous eras. This is the theme of Robert Gordon’s The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War . It seems that periods of stagnation create demands for explanations that avoid the accountability of the policies enacted to address the problem.

Still, there is a point to be made that we may be in the throes of a structural shift, but these transitions are never understood until they are well established.  The desire and pretense of intellectuals and policy elites to manage them does not clarify or illuminate them.  If we are in the midst of such structural changes then central policies will more likely serve only to obscure and delay the efforts of the economy to adjust.

Perhaps instead of Reinhart and Rogoff and Gordon, the elite should meditate on the messages in Matt Ridley’s The Evolution of Everything where spontaneous order is explored or Deidre McCloskey’s Bourgeois Equality which explores the underlying cultural principles of ethics and virtues in their role that led to the stellar economic growth we have experienced in the last few hundred years.

Instead of explaining why growth eludes us we should examine the effects of the policies we have enacted and better understand what worked before.

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The Home Ownership Myth

houseofcards

from The Wall Street Journal, The Housing Non Crisis

The home ownership rate is a largely meaningless statistic that has more to do with politics than economics. For starters, it promotes the myth that owning a home is the key to middle-class savings and a driver of economic prosperity.

The home ownership rate becomes destructive to the larger economy when it is used to misallocate resources to housing from other parts of the economy. Government policy heavily subsidizes housing via the mortgage-interest tax deduction, the low down-payment rules of the Federal Housing Administration, and the taxpayer mortgage guarantees of Fannie Mae and Freddie Mac.

When these subsidies were supercharged by the Federal Reserve’s negative interest rate policies in the early and mid-2000s, they created the housing bubble. Those policies misdirected capital away from what might have been more productive economic uses. And in the end they created an unsustainable boom that ultimately took down the entire U.S. economy.

Our concern is that politicians will use the falling home ownership rate to once again ease standards for credit and down payments. Hedge funds and their pals in Congress are already lobbying to restore Fannie and Freddie to their former grandeur as purveyors of private profit but taxpayer risk, and the clamor will grow.

Americans should buy or rent for shelter as they see fit. Politicians should keep their eye on the biggest American problem, which as John Cochrane writes nearby is the historically slow rate of economic growth. The home ownership rate is a false prophet.

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A Thousand Course Smorgasboard

from The Clinton Plan’s Growth Deficit by John Cochrane in The Wall Street Journal

The rest of Mrs. Clinton’s economic agenda is a thousand-course smorgasbord of government expansions, with the same deficiencies. A random sample: Higher taxes on capital gains and corporations. New taxes on financial transactions. A corporate exit tax. Paid leave. Free college. A higher minimum wage. More federal training programs. Tax credits for apprenticeships and profit-sharing programs. A “new markets” credit. Rural business investment cooperatives. The Paycheck Fairness Act. “Make it in America Partnerships.” And on and on.

Moreover, much of it is merely aspiration, without (yet) concrete action: “Restore collective bargaining rights.” “Strengthen overtime rules.” “Make quality affordable childcare a reality.” “Ensure that the jobs of the future in caregiving and services are good-paying jobs.” “Break down barriers to make affordable housing and homeownership possible for hard working families.” And on and on and on.

The “plan” offers neither a strategy for enactment, nor thought about why these are problems in the first place. Yes, it’s hard to find quality affordable childcare. Why? Could licensing, zoning, teachers unions, minimum wages, ObamaCare mandates, employee time rules, taxes, immigration restrictions and the like have something to do with it? Apparently, every problem in America occurs because the president did not “fight” hard enough for new programs and against the dark forces that oppose progress. Like a hyperactive overachiever approaching a mock-U.N. debate, Mrs. Clinton seems to trust that the opposition will wilt from the sheer volume, detail and righteousness of her proposals.