Renovating the Fed

Source: Federal Reserve Board of Governors

Source: Federal Reserve Board of Governors

Source: Federal Reserve Board of Governors

Source: Bloomberg

Taming the masters of the tech universe

Examining the macroeconomic impact of the world’s most valuable companies

Martin Wolf




Eight of the world’s most highly valued companies are technology businesses. The combined market capitalisation of these companies is $4.7tn. That is 30 per cent of the combined market capitalisation of the other 92 companies in the world’s 100 most valuable firms. Of these eight companies, five (Apple, Alphabet, Microsoft, Amazon and Facebook) are from the US, two are Chinese (Alibaba and Tencent) and one is South Korean (Samsung). The most highly valued European tech company, SAP, is the world’s 60th most valued company.

Today’s valuations might be excessive. The market’s relative rankings might also turn out to be wrong. Moreover, the businesses in which these companies are engaged are all different in important respects. Nevertheless, the rise to prominence of these technology groups has to be telling us something important (see charts).

What then are the questions raised by these remarkable numbers? I will not respond by considering the economics of the digital economy itself (interesting and important though this is), except to the extent that it could reshape the wider economy and society. Nor do I focus on the benefits brought by the collapse in the costs of generating and distributing information itself. I focus below on seven wider challenges.




First, what are the implications of the remarkable US dominance? Thus, while five of the 10 most valuable US companies are technology companies, not one of the most valuable European companies is. Indeed, the most valuable European company is Royal Dutch Shell. Yet Exxon, its more highly valued US counterpart, is only the eighth most valuable US company.

The optimistic view might be that what matters is the ability to take advantage of what US or Chinese technology groups create. The pessimistic view is that if one’s economy is not in the technology game, it is not in the economic games of the future at all. I suspect that the latter view may be correct.

Second, what are the economics of these extraordinary valuations? The answer must be monopoly. As of September 30, the book value of Apple’s equity was $134bn, while its market valuation was close to $900bn. The difference has to reflect the expectation of enduring “super-normal” profits. This may not be the product of malign behaviour, but of innovation and economies of scale and scope, including the network externalities that lock in customers. Yet only monopoly could deliver such super-normal profits.




Third, how should we think about competition policy for businesses that benefit from such powerful monopoly positions? A question is whether these positions are temporary — as the great Austrian economist, Joseph Schumpeter, with his idea of “creative destruction”, would argue — or lasting. This suggests a host of responses, but one at least seems straightforward.

Schumpeter would argue that new entries are a necessary condition for eroding such temporary monopolies. If so, the technology giants should be strongly deterred from buying up their potential competitors. That must be anti-competitive.

Fourth, what might be the macroeconomic impact of such companies? Apple’s accounts are, again, fascinating. Apple’s total assets were $375bn on September 30, but with fixed assets a mere $34bn. The value of Apple’s long-term investments was almost six times that of its fixed assets. Its net income in the year to September 30 was also more than 40 per cent higher than its total fixed assets. This company evidently has no profitable way to invest its huge profits in its business. It is now an investment fund attached to an innovation machine and so a black hole for aggregate demand. The idea that a lower corporate tax rate would raise investment in such businesses is ludicrous.




Fifth, how should such a business be taxed? One aspect of the answer to this question is that a well-designed corporate tax would fall on monopoly rent. A way to do this would be via expensing of investment, together with a higher, not lower, corporation tax than at present.

Another and equally important aspect is recognising that territorial taxes are inescapably defective in taxing global technology companies, since the location of their production is so hard to define. The inability to tax technology companies in a way that matches taxation of territorial competitors creates a huge economic distortion.

Sixth, how should we think about the impact of the technology giants on media? Media are not just a business, but a vital element in a free and democratic society. Here Google and Facebook are currently the main players. In 2017, these two businesses are expected to receive 63 per cent of all US digital advertising revenue, itself a rising share of the total. Yet these enormously profitable businesses are parasitic on the investments in collecting information made by others.

At the limit, they will become highly efficient disseminators of non-information. This links to a further point: they can, as we now know, be used by people of ill will for the deliberate dissemination of dangerous falsehoods. These facts raise huge issues.





Finally, the activities in which the technology industry is now engaged — what Andrew McAfee and Erik Brynjolfsson call “machine, platform, crowd” — are going to have a huge impact on our labour markets and, if artificial intelligence continues to advance, on our very place in the world.

What are the implications? They are that our futures are too important to be left to the mercies of the technology industry alone. It has done magical things. Yet nobody elected it master of the universe. Policymakers must get an intellectual grip on what is happening. The time to begin such an effort is now.

McKinsey: Automation may wipe out 1/3 of America’s workforce by 2030

By Steve LeVine

• Up to 30% of the hours worked globally may be automated by 2030.

• The transition compares to the U.S. shift from a largely agricultural to an industrial-services economy in the early 1900s forward. But this time, it's not young people leaving farms, but mid-career workers who need new skills. "There are few precedents in which societies have successfully retrained such large numbers of people," the report says, and that is the key question: how do you retrain people in their 30s, 40s and 50s for entirely new professions?

• Just as they are now, wages may still not be sufficient for a middle-class standard of living. But "a healthy consumer class is essential for both economic growth and social stability," the report says. The U.S. should therefore consider income supplement programs, to establish a bottom-line standard of living.

• Whether the transition to a far more automated society goes smoothly rests almost entirely "on the choices we make," Chui said. For example, wages can be exacerbated or improved. Chui recommended "more investment in infrastructure, and that those workers be paid a middle wage."

Bitcoin is a faith-based financial asset for a populist era

The cryptocurrency is a barometer of the politics shaping our times, says Miles Johnson

Miles Johnson
.

The most dedicated of bitcoin supporters see their survival of previous crashes in its value as a point of pride © Bloomberg


As the price of bitcoin hit $10,000, the cryptocurrency’s supporters took to Twitter last week to boast of their triumph. “You, a Wall St trader: spent years in school learning the minutia of finance, 10 years of 100-hour work weeks, never see your family, super excited about your 10 per cent returns this year,” one enthusiast wrote. “Me: a Bitcoiner: read some books, s*** posted on Twitter, ate some steaks, enjoying 900 per cent returns.”
 
This trolling social media comment perfectly captures the mutual disdain between professional financiers, who have mostly watched bitcoin’s rise with a mixture of puzzlement and horror, and the hardcore of true believers who view owning cryptocurrencies as a disruptive act of financial iconoclasm.
 
Those who are trying to explain bitcoin’s popularity and behaviour through the spectacles of mainstream finance are committing a simple analytical error: they are attempting to apply fact-based analysis to an asset that is impervious to it.
 
Bitcoin is a faith-based financial asset for a populist era.
 
Speculative manias have occurred throughout history. The study of bubbles has greater value in informing us about the state of the societies in which they occurred than any lasting financial lesson. The Tulip bubble in the Netherlands occurred during the Dutch Golden Age, when the country was the world’s leading economic and social power, and the ability of an investment to defy gravity was easy to believe.
 
Bitcoin’s price is not being driven by anything resembling conventional financial logic, but in part by the same forces that have delivered the political shocks of the past two years. Like populist politics, belief in cryptocurrencies and “trustless networks” have chimed with a collapse in confidence in traditional forms of authority and a disdain for experts. Unwavering belief in bitcoin’s story is powered by the crowd-fuelled authority of the internet.
 
Financial professionals who fail to comprehend why someone would risk their wealth investing in bitcoin when it appears to them so obviously to be a bubble can be compared with the political analysts who believed it was impossible the UK would vote to leave the EU.
 
The global financial crisis severely discredited the banking system. In the world of investment there has been a breakdown in confidence that expert professional investors and advisers know what they are doing. The rise of passive investment is occurring at a time of criticism of years of excessive fees and poor performance of the mutual funds that millions are relying on to fund their retirement.

When an expert such as Jamie Dimon, the head of the largest bank in the US, warns that bitcoin is dangerous, crypto true believers regard such warnings with the same disdain directed at experts ahead of the UK referendum.

Like bitter political spats on Twitter, any criticism of bitcoin is greeted by this cohort as inherently corrupt in its motivations, while any alternative opinions are used as evidence that merely confirms existing beliefs.

Sceptical financial professionals appear to similarly underestimate what can be seen as a millenarianism devotion that inures them to the conventional psychology of investment: the fear of losing money.

The most dedicated of bitcoin supporters — those who refer to themselves as HODL-ers, or those who will hold on whatever happens to the price — see their survival of previous crashes in its value as a point of pride. The devout hold the value and future of bitcoin is a matter of faith, a Manichean battle between believers and sceptics.

To this most extreme acolyte there is noble glory in the act of owning bitcoin, even if it results in a debilitating loss.

Vast amounts of attention will inevitably be devoted to the wild swings in the value of bitcoin in the coming weeks.

Decades from now — whether bitcoin still exists or not — it may be that its significance is seen less as a financial asset and more as a speculative barometer of the political forces that are shaping our times.


Miles Johnson is the FT’s capital markets editor

Central Banks in the Dock

BARRY EICHENGREEN




LONDON – On November 11, 1997, the Bank of England took a big step toward independence, courtesy of the second reading in the House of Commons of a bill amending the Bank Act of 1946. The bill gave legislative affirmation to the decision, taken by then-Chancellor of the Exchequer Gordon Brown, to free central bank operations from governmental control. This was a landmark event for an institution that had been under the yoke of government for a half-century. It symbolized how the need for central bank independence had become conventional wisdom.

Now, however, this wisdom is being questioned, and not just in the United Kingdom. So long as inflation was the real and present danger, it made sense to delegate monetary policy to conservative central bankers insulated from pressure to finance government budget deficits. Today, in contrast, the problem is the opposite, namely the inability of central banks to raise inflation to target levels.

To achieve this, it is necessary for monetary and fiscal policymakers to work together, including by allowing the central bank, in extremis, to monetize budget deficits. But when it comes to cooperating with the fiscal authorities, central bank independence is a hindrance, not a help.

Independence was also easier to defend when central bankers’ task was limited to keeping inflation low and stable. Given this narrow remit, the distributional consequences of central banks’ decisions were limited. It was easier, moreover, to explain how a central bank’s policy instruments were linked to its politically mandated targets.

But after the global financial crisis highlighted the dangers of consigning monetary and fiscal policy to separate silos, central banks acquired additional responsibilities. Deciding whether or not to rescue a specific financial institution, whether to ensure systemic stability or for other reasons, has visible consequences for individual investors.

The same is true of unconventional interventions in markets for corporate bonds and mortgage-backed securities. Not surprisingly, the notion of independence for central banks that visibly aided specific financial institutions – and this at a time when society as a whole was under unprecedented economic stress – quickly became politically toxic.

Independence is even more problematic in an age when the cross-border spillovers of national monetary policies have become powerful. Those spillovers make it important for central banks to take into account the impact of their policies on foreign countries and the global system. But the pursuit of global objectives is difficult, bordering on the impossible, when central banks function under the kind of narrow, domestically focused mandates that independence requires.

Today, central banks are under attack for all of these reasons: for missing their inflation targets, for failing to maintain financial stability, for failing to restore stability in transparent ways, and for not adequately taking into account the global repercussions of their policies.

Dissatisfied by their performance, politicians are seeking to reassert control.

Thus, we see the Bank of Italy attacked for its handling of the country’s banking crisis. We hear the Bank of England criticized for voicing worries about the macroeconomic repercussions of Brexit. We encounter speculation that US President Donald Trump is intent on packing the Federal Reserve Board with politically compliant appointees.

But compromising central bank independence in order to enhance political accountability would be to throw the baby out with the bathwater. Monetary policy is complex and technical.

Returning control to politicians is no more prudent than handing them the keys to a country’s nuclear power plants.

Some will say that the way for central banks to ensure their independence is to abandon macroprudential and microprudential policies and foreswear unconventional interventions in securities markets. But a key lesson of the crisis is that macroeconomic and financial policies are closely intertwined, and that their coordination is most effective when the two tasks are housed in the same institution, if run by separate committees. Given the prevailing low level of interest rates, moreover, it is all but certain, come another crisis, that unconventional policies will be back.

What central banks can do to head off threats to their independence is become more transparent. They can announce the votes of individual board members on all policy-relevant matters and release minutes without undue delay. They can hold more press conferences and be less platitudinous in explaining their policies. They can avoid pontificating on questions remote from their mandates.

They can acknowledge the right of politicians to define the goals the central bank is tasked with achieving.

And to shape the views of those politicians, they can better explain why cooperation with fiscal authorities and foreign central banks is in the public interest. They can publish more detailed financial accounts, including on their individual security transactions and counterparties.

Above all, they can avoid intervening in parliamentary politics, as the European Central Bank did when it hastened the fall of Silvio Berlusconi’s government in Italy in 2011. Then they can keep their heads down and hope for the best.




Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is Hall of Mirrors:The Great Depression, the Great Recession, and the Uses – and Misuses – of History.

Who Killed The Bull Market?

by: The Heisenberg

- "Bull markets do not die of old age."

- Ok, so what kills them?

- And if killing a bull market and/or an economic expansion is a crime, who's the culprit?
 

As regular readers know, I am no fan of amorphous market aphorisms. 

 

Here's a good rule of thumb: If it would be right at home in a market-themed tear-off desk calendar, it's probably not very useful for you as an investor.

 

Nebulous statements like "the market can remain irrational longer than you can remain solvent" are great as punchlines or as something you would use as the last slide in a Powerpoint presentation delivered during an undergraduate finance seminar, but their universality serves to render them meaningless for making actual decisions about real money.

 

Take the "irrational/solvent" aphorism for example (because that's one that people trot out all of the time in an ill-fated effort to say something ostensibly profound). That statement is meaningless. Of course the market can "remain irrational longer than you can stay solvent."

And I say "of course" because the opposite of that statement could never be true. When would it ever be the case that the market could not remain irrational longer than you can stay solvent?

The only way that would be possible is if you were an immortal with unlimited funds. And even then it would probably be a stalemate because assuming your immortality doesn't apply in cases where the actual world ends, there's a scenario in which the market remains irrational while you remain solvent right up until a comet hits the Earth at which point the standoff between the market's irrationality and your solvency becomes immaterial by virtue of the fact that both the market and you have ceased to exist.
 

See what I mean? It's meaningless by virtue of being self-evident. And most other market aphorisms are of a similar carácter.

 

Ok, so that brings me to the following quote from Goldman's latest "Top of Mind" piece. In that piece, there's an interview with Omega's Steve Einhorn and here's what Steve said when asked what could derail the bull market:

Neither economic expansions nor equity bull markets in the US die of old age.

That's another amorphous market aphorism that gets bandied about all the time and I'm not a fan of it.

 

Of course economic expansions and equity bull markets don't "die of old age." Neither do people. It's everything that goes along with being "old" that kills people and the same goes for economic expansions and bull markets. Again, there is no sense in which the opposite of that aphorism would ever make sense. Imagine, for instance, that you woke up on Monday, turned on CNBC, and heard this: "The U.S. economy careened into recession and global stocks plunged 10% overnight because both the expansion and the rally were deemed too old according to economists and traders." That doesn't make any sense, and so by extension, that aphorism is useless.

 

Now to be fair, there is a certain sense in which things that are self-evident are useful. After all, we can't dismiss things that are by definition true, because at the end of the day, we're all out to discover the truth. But there's no utility in parroting the self-evident. That doesn't get us anywhere. Self-evident statements are nice as reminders when our thinking has become detached from reality and that thinking is materially impacting our lives, but that's about as far as it goes. So for instance, if you keep buying OTM puts in anticipation of a market crash and after two years of doing that and seeing them expire worthless you are having trouble buying food and paying the electric bill, well then, you might benefit from an amorphous aphorism about market irrationality outlasting your solvency or about how bull markets do not come with expiration dates. But outside of that, these oft-repeated nuggets of market "wisdom" are largely useless.

 

So the reason I bring that up is because in the interview mentioned above, Einhorn embarks on a quest to explain that why the current expansion and bull market have not yet manifested themselves in the type of "symptoms" (if you will) that would normally precede death. As noted above, it's everything that goes along with being "old" that kills people and the same goes for economic expansions and bull markets.

Steve looks for (and ultimately finds) evidence to support the contention that we are not in fact late cycle (as many people claim) but rather mid-cycle. So you can think of this as something akin to a 97-year-old getting a physical and the doctor concluding that while 97 is indeed a nominally high number, physically speaking there are no signs that death is imminent. The things that go along with being old which eventually kill people have not as yet caught up to the person.

 

Einhorn does an admirable job in this regard. Here's what he says about the expansion:

There is an almost unending number of metrics that suggest we are more mid-cycle than late-cycle in economic activity. The GDP gap, which measures output versus potential, has — almost without exception — been above zero and declining before we entered a recession during the last 40 or 50 years; today, it is below zero and rising.  

The share of cyclical components of GDP — consumer durables, residential investment, capital spending — is typically above average late in an economic expansion, but today it is below average. The Conference Board’s leading economic indicator composite is typically declining year-over-year six to nine months before the beginning of a recession, whereas it is currently up. The unemployment rate is typically up year-over-year late in the economic cycle, but it is now down. Inflation usually accelerates late in the cycle, but today it is moderating. Real money supply growth typically sinks late in the cycle, but it is now stable-to-growing. The fed funds rate is typically above Fed estimates of the neutral funds rate when we are late in the cycle, but today the funds rate is probably less than half of the neutral rate. The yield curve typically has a flat-to-negative slope late in an economic expansion, but currently the slope is positive. And credit spreads, which normally widen prior to the end of an expansion, are tight and stable-to-narrowing. I have more examples, but I think those are enough to indicate that we are nowhere near a recession, that the probability of a recession anytime soon is quite low, and that mid-cycle characterizes the current economy better than late-cycle.

And here's what he says about valuations:

Equity valuations are not at all stretched given the low level of interest rates. Today, the S&P 500 (SPY) earnings yield is 5.5% while the 10-year Treasury yield (TLT) is less than 2.5%. This is a very wide spread relative to history. Further, the composite yield of the S&P 500 — dividend yield plus buyback yield — is very high relative to bond interest rates. So it is nearly impossible to suggest that the S&P multiple is extended relative to rates on Treasury bonds, investment grade bonds, or high yield bonds. Of course, absolute measures of value such as market-cap-to-GDP, price-to-sales, or the Shiller price-to-earnings ratio are all at the very upper end of their historical ranges. But importantly, there is virtually no correlation between such measures and S&P 500 returns one, two, or even three years out. So it’s not relevant to an investor to say absolute measures are extended. Finally, valuation by itself does not end bull markets.

 

Ok, so all of that is great and there's no question that these are the types of arguments we need when it comes to having serious discussions about whether the cycle is about to turn and/or about whether a correction in risk assets is just around the corner.

 

And the reason I say that is because a cursory look at the current state of affairs overwhelmingly suggests that we are teetering on the edge in terms of pushing the historical limits on both the length of the expansion and on the scope of the bull market:

 

(Goldman)

 

 

Cursory looks are just that - cursory. A cursory examination allows us to get a general sense of the current state of affairs. Once we have a general idea of the situation, we can then determine who has the burden of proof. Clearly, the burden of proof when it comes to predictions about the current expansion and the rally lies with those who say that one or both will continue. That might seem counterintuitive, but it's not. The very use of the term "cycle" implies that a downturn is inevitable.

 

The very idea of a bull market implies that there is some state of affairs that exists which is not a bull market. And so, when expansions and bull markets reach historical extremes in terms of length and scope, it is incumbent upon those who contend that history is not a good guide to explain why.

The same thing is true in the opposite direction. During contractions and prolonged bear markets, there comes a point at which anyone who is still bearish must explain why history is wrong to suggest that the economy will turn around and/or that stocks will not simply go to zero.

 

In this scenario, you cannot fall back on aphorisms. "Expansions and bull markets do not die of old age" doesn't work, because as noted above, that's self-evident. Assuming everyone realizes it's self-evident and thus not worth assailing in defense of a bearish position, the bears must be arguing something else - namely that while old age itself doesn't kill expansions and bull markets, the things that accompany old age do.

 

But let me save you some trouble. Getting into a metrics arms race with market veterans is an exercise in abject futility. For one thing, metrics are in many cases vulnerable to tedious critiques about the extent to which they are more or less meaningful "this time" than "last time." And on top of that, one person's list of purportedly definitive metrics is going to be different from another person's list. So that argument ends up devolving into something akin to a debate about who the top five NBA players of all time are. Everyone has a claim on being "right."

 

The better way to critique Einhorn's assessment is to point out the obvious: his arguments about the expansion and about valuations are contingent and relative, respectively. In short: his assessment depends to a large degree upon inflation remaining anchored and relatedly, upon central banks remaining gun-shy. He readily acknowledges this as follows:

Neither economic expansions nor equity bull markets in the US die of old age; they are murdered by the Fed.

That effectively relegates all of the points enumerated in the first two excerpts cited above to also-ran status. It doesn't mean they aren't useful and it sure doesn't mean I can refute them all (I can't), it just means they are secondary and thus will be largely immaterial in the event the Fed's hand is forced.

Consider these excerpts from the same interview:

It’s certainly a unique cycle, for several reasons [one of which is that] inflation has been much tamer than in other expansions. 

The start of bear markets in the US — almost without exception — has historically required five conditions that we have put on a “bear market checklist.” And none of these conditions are present today, nor do I expect them anytime soon. The first item on the list is problematic wage and consumer price inflation, by which I mean inflation that would likely illicit an aggressive response from the Fed. I would put problematic wage inflation at about 3.5% to 3.75% year-over-year and problematic core consumer inflation at around 2.5% year-over-year, or maybe a touch higher.

And see there it is: everyone keeps coming back to the same point. Namely that all of this hinges on inflation never showing up. But everything central banks have done since the crisis has ostensibly been in the service of creating inflation. Further, the fiscal agenda in the U.S. (if it ever gets implemented) is geared towards reflation.

 

The snail's pace of policy normalization in the U.S. (and especially in Europe and Japan, with the latter having not even begun to tighten) has in large part been justified by the fact that inflation has yet to materialize in the way you might expect it to given how long accommodation has remained in place. Recall this from Albert Edwards' latest:

Indeed throughout this cycle wage inflation has been the dog that failed to bark.  

The risk is that the market is hugely vulnerable if it hears a distant bark, let alone feels its bite.

The longer this goes on (i.e., the longer inflationary policies are pursued without inflation actually showing up), the greater the risk that everyone is missing something. Here's Edwards one more time:

The nightmare scenario for equities would be if US wage inflation flickers back to life and investors not only decide that they are too far behind the Fed dots, but they also decide that the Fed itself is behind the tightening curve.

In that event, everything goes out the window. All bets are off. Because we've never been here before. This experiment in monetary policy is unprecedented.

 

What seems to be at least partly lost on everyone parroting the "expansions and bull markets don't die of old age, they are murdered by the Fed" line is that if what you've seen in the past in that regard can be accurately described as "murder," well then, what you're going to see this time around will be an outright "massacre".

 

Finally, allow me to pose a question in closing: what happens if inflation "starts to bark" at the same time that fiscal policy finally loosens and the post-crisis regulatory regime is dismantled?

 

Here's a hint (follow the red line from the lower left quadrant to the upper right)...