Tag: finance

“The financialization of the nonfinancial corporation”

One common narrative attached to the murky term financialization is that nonfinancial corporations have, in effect, turned themselves into banks or hedge funds — they have replaced investment in means of production with ownership of financial assets. Financial profits, in this story, have increasingly substituted for profits from making and selling stuff. I’m not sure where this idea originates — the epidemiology points toward my own homeland of UMass-Amherst — but it’s become almost accepted wisdom in left economics.

I’ve been skeptical of this story for a while, partly because it conflicts with my own vision of financialization as something done to nonfinancial corporations rather than by them — a point I’ll return to at the end of the post — and partly because I’ve never seen good evidence for it. On the cashflow side, it’s true there is a rise in interest income from the 1960s through the 1980s. But, as discussed in the previous post, this is outweighed by a rise in interest payments; it reflects a general rise in interest rates rather than a reorientation of corporate activity; and has subsequently been reversed. On the balance sheet side, there is indeed a secular rise in “financial” assets, but this is all in what the financial accounts call “unidentified” assets, which I’ve always suspected is mostly goodwill and equity in subsidiaries rather than anything we would normally think of as financial assets.

Now courtesy of Nathan Tankus, here is an excellent paper by Joel Rabinovitch that makes this case much more thoroughly than I’d been able to.

The paper starts by distinguishing two broad stories of financialization: shareholder value orientation and acquisition of financial assets. In the first story, financialization means that corporations are increasingly oriented toward the wishes or interests of shareholders and other financial claimants. The second story is the one we are interested in here. Rabinovitch’s paper doesn’t directly engage with the shareholder-value story, but it implicitly strengthens it by criticizing the financial-assets one.

The targets of the paper include some of my smartest friends. So I’ll be interested to see what they say in response to it.

The critical questions are:  Have nonfinancial corporations’ holdings of financial assets really increased, relative to total assets? And, has their financial income risen relative to total income?

The answers in turn depend on two subsidiary issues. On the first question, we need to decide what is represented by the “other unidentified assets” category in the Financial Accounts, which is responsible for essentially all of the apparent rise in financial assets. And on the income side, we need to consistently compare the full set of financial flows to their nonfinancial equivalents. Rabinovitch argues, convincingly in my view, that looking at financial income in isolation is not give a meaningful picture.

On the face of it, the asset and income pictures look quite different. In the official accounts, financial assets of nonfinancial corporations have increased from 40% of nonfinancial assets to 120% between 1946 and 2015. Financial income, on the other hand, is only 2.5% of total income and shows no long-term increase. This should already make us skeptical that the increase in “financial” assets represents income-generating assets in the usual sense.

Rabinovitch then explores this is detail by combining the financial accounts with the IRS statistics of income (SOI) and the Compustat database. Each of these has strengths and weaknesses — Compustat provides firm-level data, but is limited to large, publicly-traded corporations and consolidates domestic and overseas operations; SOI gives detailed breakdowns of income sources for all forms of legal organization broken down by size, but it doesn’t include any balance-sheet variables, so it can’t be used to answer the asset questions.

iI the financial accounts, the majority of the increase in identified financial assets is FDI stock. As Rabinovitch notes, “it’s dubious to directly consider FDI as a financial asset if we take into account that it implies lasting interest with the intention to exercise control over the enterprise.” The largest part of the overall increase in financial assets, however, is in the residual “other unidentified assets” line of the financial accounts. The fact that there is no increase in income associated with these assets is already a reason to doubt that they are financial assets in the usual sense. Compustat data, while not strictly comparable, suggests that the majority of this is intangibles. The most important intangible is goodwill, which is simply the accounting term of the excess of an acquisition price over the book value of the acquired company. Importantly, goodwill is not depreciated but only written off through impairment. Another large portion is equity in unconsolidated subsidiaries; this accounts for a disproportionate share of the increase thanks to a change in accounting rules that required corporations to begin accounting for it explicitly. Other important intangibles include patents, copyrights, licenses, etc. These are not financial assets; rather they are assets or pseudo-assets acquired, like real investment, in order to carry out a company’s productive activities on an extended scale.

These are all aggregate numbers; perhaps the financialization story holds up better for the biggest firms? Rabinovich discusses this too. Both Compustat and SOI allow us to separate firms by size. As it turns out, the largest firms do have a greater proportion of financial income than the smaller ones. But even for the largest 0.05% of corporations, financial income is still only 3.5% or total income, and net financial income is still negative. As he reasonably concludes, “even for the biggest nonfinancial corporations, financialization must not be understood as mimicking financial corporations.”

What do we make of all this?

First, the view of financialization as nonfinancial businesses acquiring financial assets for income in placer of real investment, is widely held on the left. After my Jacobin interview came out, for example, several people promptly informed me that I was missing this important fact. So if the evidence does not in fact support it, that is worth knowing. Or at least, future statements of the hypothesis will be stronger if they respond to the points made here.

Second, the fact that “financial” assets in fact mostly consist of goodwill, interest in unconsolidated subsidiaries, and foreign investment is interesting in its own right, not just as negative criticism of the  financialization story. It a sign of the importance of ownership claims as a means of control over production— both as the substantive content of balance sheet positions and as a core part of corporate activity.

Third, the larger importance of the story is to the question of whether nonfinancial corporations and their managers should be seen mainly as participants in, or victims of, financialization. Conversely, is finance itself a distinct social actor? In a world in which the largest nonfinancial corporations have effectively turned themselves into hedge funds, it would not make much sense to talk about a conflict between productive capital and financial capital, or to imagine them as two distinct sets of people. But in a world like the one described here, or in my previous post, where the main nexus between nonfinancial corporations and finance is payments from the former to the latter, it may indeed make sense to think of them as distinct actors, of conflicts between them, and of intervening politically  on one side or the other.

Finally, to me, this paper is a model of  how to do empirical work in economics. Through some historical process I’d like to understand better, economists have become obsessed with regression, to the point that in academic economics it’s become synonymous with empirics. Regression analysis starts from the idea that the data we observe is a random draw from some underlying data generating process in which a variable of interest is a function of one or more other variables. The goal of the regression is to recover the parameters of that function by observing independent or exogenous variation in the variables. But for most macroeconomic questions, we are dealing with historical processes where our goal is to understand what actually happened, and where the hypothesis of some underlying data-generating process from which historical data is drawn randomly, is neither realistic nor useful. On the other hand, the economy is not a black box; we always have some idea of the mechanism linking macroeconomic variables. So we don’t need to evaluate our hypotheses by asking how probable the it would be to draw the distribution we observe from some hypothetical random process; we can, and generally should, ask instead whether the historical pattern is consistent with the mechanism. Furthermore, regression analysis is generally focused on the qualitative question of whether variation in one variable can be said to cause variation in a second one; but in historical macroeconomics we are generally interested in how much of the variation in some outcome is due to various causes. So a regression approach, it seems to me, is basically unsuited to the questions addressed here. This paper, it seems to me, is a model of what one should do instead.

Some Interviews

One new one, and two older ones I should have posted here a while ago.

The new one is with Seth Ackerman at Jacobin. Its starting point is a new article (co-authored with Arjun Jayadev and Enno Schroeder) I have coming out in Development and Change. But it’s also a continuation of the argument I made in my earlier Jacobin piece on the socialization of finance [*], and in my talk at this year’s Left Forum. (I still hope to get a transcript of that one at some point.)

The older two are both in response to my “What Recovery?” report for the Roosevelt Institute. This one, with David Beckworth at the Mercatus Institute, was a wide-ranging conversation that touched on a lot of topics beside the immediate question of whether we should regard the US economy as having reached full employment or potential output. This one, with Joe Weisenthal and his colleagues at “What Did You Miss” on Bloomberg, was much briefer but still managed to cover a lot of ground.

Supposedly there’s also an interview with me coming out in Der Standard, an Austrian newspaper, but I’m not sure when it will appear.

If you’re reading this blog, you’ll probably find these interviews interesting.

[*] Incidentally, my preferred title was that: The Socialization of Finance. I understand why the editors changed it to the catchier imperative form, but what I liked about my original was that it could refer both to something done to finance, and something done by finance.

Capital Mobility as Trojan Horse

In my Jacobin piece on finance, I observed in passing that financial commitments across borders — what’s sometimes called capital mobility — enforce the logic of markets on national governments. This disciplining role has been on vivid display in the euro area over the past few years. Here, courtesy of yesterday’s Financial Times, is a great example of the obverse: If a state does want to resist liberal “reforms”, it needs to limit financial flows across the border.

The headline in the online edition spells it right out:

Renminbi stalls on road to being a global currency. New capital controls lead to doubt, especially over hopes of forcing economic reform.

The print edition is wordier but even clearer:

Renminbi reaches its high water mark. Fresh capital controls cast doubt over the push to increase the global use of its global currency. But what does that mean for the Chinese policymakers who saw it as a ‘Trojan horse’ to force through economic reform?

The whole article is fascinating. On the substance it’s really quite good — anyone who teaches international finance or open-economy macroeconomics should bookmark it to share with students. Along with the political-economy question I’m interested in here, it touches on almost all the most important points you’d want to make about what determines exchange rates. [1]

The article’s starting point is that for most of the past decade, international use of the Chinese renminbi (Rmb) has been steadily increasing. Some people even saw a future rival to the dollar. For most of the period, the renminbi was appreciating against the dollar, and the Chinese government was loosening restrictions on cross-border financial transactions. But recently those trends have reversed:

The share of China’s foreign trade settled in its own currency has shrunk from 26 per cent to 16 per cent over the past year while renminbi deposits in Hong Kong — the currency’s largest offshore centre — are down 30 per cent from a 2014 peak of Rmb1tn. Foreign ownership of Chinese domestic financial assets peaked at Rmb4.6tn in May 2015; it now stands at just Rmb3.3tn. In terms of turnover on global foreign exchange markets, the renminbi is only the world’s eighth most-traded currency — squeezed between the Swiss franc and Swedish krona — barely changed from ninth position in 2013.

What appeared to be structural drivers supporting greater international use of the Chinese currency now appear more like opportunism and speculation.

Large financial outflows — including capital flight by Chinese wealthholders and currency speculators reversing their bets — have led the renminbi to lose 10 percent of its value against the dollar over the past year or so. The Chinese central bank (the People’s Bank of China, or PBoC) has had to use a substantial part of its dollar reserves to keep the renminbi from depreciating even further.

… the PBoC remains active in the foreign exchange market as buyer and seller. Over the past 18 months, this has mostly meant selling dollars from foreign exchange reserves to counteract the depreciation pressure weighing on the renminbi.

This strategy has been expensive, contributing to a decline in reserves from $4tn in June 2014 to $3.1tn at the end of November. Defenders of the PBoC believe such aggressive action to curb depreciation has been worth the price because it prevented panic selling by global investors. Critics counter that costly forex intervention has merely delayed an inevitable exchange-rate adjustment.

For years, the IMF, US Treasury and other outside experts have urged China to embrace a floating exchange rate. In theory, such a step should eliminate the need to tighten capital controls or to spend precious foreign reserves on propping up the exchange rate. Instead, the currency would weaken until inflows and outflows balance.

In the age of Trump, it’s worth stressing this point: The Chinese central bank has been intervening to make the renminbi stronger, not weaker — to keep Chinese goods relatively expensive, not cheap. This has been true for a while, actually, although you can still find prominent liberals complaining about China boosting its exports through “currency manipulation”.  Also, as the article notes, the Washington Consensus line has been that China should end foreign-exchange interventions and abolish capital controls, allowing the renminbi to depreciate even further.

For most countries, continuing to spend down reserves would be the only alternative to uncontrolled depreciation. But China, unlike most countries, has maintained effective controls over cross-border financial flows, so it has another option: limiting the ability of households and businesses to trade renminbi claims for dollar ones.

The State Administration of Foreign Exchange, the regulator, last week said it would continue to encourage outbound investment deals that support the country’s efforts to transform its economy… But the agency said it would apply tighter scrutiny to acquisitions of real estate, hotels, Hollywood studios and sport teams.

That will probably mean fewer food-additive tycoons buying second-tier UK football clubs. It also suggests a crackdown on fake trade invoices, Hong Kong insurance purchases and gambling losses in Macau — all channels used to spirit money out of China. …

“They are trying to squeeze out all the low quality or suspicious or fraudulent outbound investment. But they have also made it clear they support genuine high-quality investment,” says Mr Qu.

These moves come on top of other limits on financial outflows. This passage highlights a couple additional points. First, effective controls on financial flows require controls on cross-border transactions in general. Second, there’s no sharp line between macro policy aimed at the exchange rate or other monetary aggregates, and micro-interventions aimed at channeling credit in particular directions.

Now to the political economy point:

China’s recent moves to tighten approvals for foreign acquisitions by Chinese companies, as well as other transactions that require selling renminbi for foreign currency, cast further doubt on China’s commitment to currency internationalisation.

“There is a fundamental conflict between preserving stability and allowing the freedom and flexibility required of a global currency,” says Brad Setser, senior fellow at the Council on Foreign Relations and a former US Treasury official. “Now that the cost is becoming clear, Chinese policymakers may be realising they are not willing to do what it takes to maintain a global currency. Capital controls certainly set back the cause of renminbi internationalisation but they may well be the appropriate step given the outflow pressures.”

As a topic for banking conferences and think-tank seminars, renminbi internationalisation could not be beaten. It offered a way to express dissatisfaction with the US dollar-dominated monetary system, as laid bare by the 2008 financial crisis, while signalling an eagerness to do business with China’s large, fast-growing economy.

For China’s reform-minded central bank, however, renminbi internationalisation … offered something else: a Trojan horse that could be used to persuade Communist party leaders in Beijing and financial elites to accept reforms that were, in reality, more important for China’s domestic financial system than for the renminbi’s international status. Since 2010, when the internationalisation drive began, many of those reforms have been adopted…

This is the dynamic we’ve seen over and over. Real or imagined pressure from the outside — from international creditors , institutions like the IMF, “the markets” in general — is needed to push through a liberal agenda that would not be accepted on its own merits. This is true in China, with its multiple competing power centers and effective if disorganized popular protests, just as it is for countries with more formally democratic political systems. What’s unusual about China’s case is that the “reform” side may no longer be winning.

What’s  unusual about this article is that it’s spelled out so clearly. “Trojan horse”: Their words, not mine.

The article continues:

The totem of currency internationalisation also served as justification for China’s moves over the past half-decade to open up its domestic financial markets to foreign investment, a process known as capital account liberalisation, that has been crucial to the global push of the renminbi. If foreign investors are to hold large quantities of China’s currency, they must have access to a deep and diverse pool of renminbi assets — and the peace of mind of knowing that they are free to sell those assets and convert proceeds back into their home currency as needed.

Again, thinking of classroom use, this is a nice illustration of liquidity preference.

Until last week, regulators had also steadily loosened approval requirements for foreign direct investment, in to and out of the country.  But those reforms occurred at a time when capital inflows and outflows were roughly balanced, which meant that liberalisation did not create strong pressure on the exchange rate. Now, the situation is very different. Beijing faces a stark choice. Either row back on freeing up capital flows — as it has already begun to do this year — or relinquish control of the exchange rate and accept a hefty devaluation.

We used to talk about a trilemma: A country cannot simultaneously peg its currency, set interest rates at the level required by the domestic economy, and allow free financial flows across its borders. At most you can manage two of the three. But it’s becoming clear that for most countries it’s  more of a dilemma: If you allow free capital mobility, you can’t control either the exchange rate or domestic credit conditions. International financial shifts are so large, and so unpredictable, that for most central banks they’ll overwhelm anything that can be done with conventional tools.

And when you accept free capital mobility, with its dubious rewards, it’s not just control over interest rates and exchange rates you’re giving up. In the absence of  controls over international financial flows, the whole range of economic policy — of public decisions in general — is potentially subject to the veto of finance. If you need foreign wealth-owners to voluntarily hold your assets, the only way to keep them happy — so goes the approved catechism — is to adopt the full range of market-friendly reforms. The FT again:

Economists argue that the fate of renminbi internationalisation ultimately depends on far-reaching economic reforms rather than short-term responses to rising capital outflows.

The list of course starts with privatization of state-owned companies and continues with deregulating finance.

“When you reimpose capital controls after having rolled them back, it can sometimes have a perverse effect,” says Mr Prasad… “What they need to do is something much harder — actually to get started on the broader reform agenda and show that they are serious about it. Right now the sense is that there is very little happening on other reforms.”

This is what it comes down to: If China is going to reach the grail of international-currency status, it is going to have to focus on the “reform” agenda dictated by financial markets — it’s going to have to earn their trust and prove it is “serious.” What exactly are the benefits of that status for China? It’s far from clear. (Of course it’s an attractive prospect for Chinese individuals who own lots of renminbi-denominated assets.) But it doesn’t matter as long as it serves as a seemingly objective basis for continued liberalization, which otherwise might face serious resistance.

“The question is which is to be the master — that’s all.”

 

 

[1] It doesn’t, of course, mention uncovered interest parity, the idea that interest rate differences between currencies exactly offset expected exchange rate changes. This doctrine dominates textbook discussion of exchange rate movements but plays no role in any real-life discussion of them.

At Jacobin: Socializing Finance

(Cross-posted from Jacobin. A shorter version appears in the Fall 2016 print issue.)

 

At its most basic level, finance is simply bookkeeping — a record of money obligations and commitments. But finance is also a form of planning – a set of institutions for allocating claims on the social product.

The fusion of these two logically distinct functions – bookkeeping and planning – is as old as capitalism, and has troubled the bourgeois conscience for almost as long. The creation of purchasing power through bank loans is hard to square with the central ideological claim about capitalism, that market prices offer a neutral measure of some preexisting material reality. The manifest failure of capitalism to conform to ideas of how this natural system should behave, is blamed on the ability of banks (abetted by the state) to drive market prices away from their true values. Somehow separating these two functions of the banking system –  bookkeeping and planning –  is the central thread running through 250 years of monetary reform proposals by bourgeois economists, populists and cranks. We can trace it from David Hume, who believed a “perfect circulation” was one where gold alone were used for payments, and who doubted whether bank loans should be permitted at all; to the 19th century advocates of a strict gold standard or the real bills doctrine, two competing rules that were supposed to restore automaticity to the creation of bank credit; to Proudhon’s proposals for giving money an objective basis in labor time; to Wicksell’s prescient fears of the instability of an unregulated system of bank money; to the oft-revived proposals for 100%-reserve banking; to Milton Friedman’s proposals for a strict money-supply growth rule; to today’s orthodoxy that dreams of a central bank following an inviolable “policy rule” that reproduces the “natural interest rate.” What these all have in common is that they seek to restore objectivity to the money system, to legislate into existence the real values that are supposed to lie behind money prices. They seek to compel money to actually be what it is imagined to be in ideology: an objective measure of value that reflects the real value of commodities, free of the human judgements of bankers and politicians.

*

Socialists reject this fantasy. We know that the development of capitalism has from the beginning been a process of “financialization” – of extension of money claims on human activity, and of representation of the social world in terms of money payments and commitments. We know that there was no precapitalist world of production and exchange on which money and then credit were later superimposed: Networks of money claims are the substrate on which commodity production has grown and been organized.  And we know that the social surplus under capitalism is not allocated by “markets,” despite the fairy tales of economists.  It is allocated by banks and other financial institutions, whose activities are not ultimately coordinated by markets either, but by planners of one sort or another.

However decentralized in theory, market production is in fact organized through a highly centralized financial system. And where something like competitive markets do exist, it is usually thanks to extensive state management, from anti-trust laws to all the elaborate machinery set up by the ACA to prop up a rickety market for private health insurance. As both Marx and Keynes recognized, the tendency of capitalism is to develop more social, collective forms of production, enlarging the domain of conscious planning and diminishing the zone of the market. (A point also understood by some smarter, more historically minded liberal economists today.) The preservation of the form of markets becomes an increasingly utopian project, requiring more and more active intervention by government. Think of the enormous public financing, investment, regulation required for our “private” provision of housing, education, transportation, etc.

In  world where production is guided by conscious planning — public or private — it makes no sense to think of  money values as reflecting the objective outcome of markets, or of financial claims as simply a record of “real’’ flows of income and expenditure. But the “illusion of the real,” as Perry Mehrling somewhere calls it, is very hard to resist. We must constantly remind ourselves that market values have never been, and can never be, an objective measure of human needs and possibilities. We must remember that values measured in money – prices and quantities, production and consumption – have no existence independent of the market transactions that give them quantitative form. We must recognize the truth that Keynes – unlike so many bourgeois economists – clearly stated: a quantitative comparison between disparate use-values is possible only when they actually come into market exchange, and only on the terms given by the concrete form of that exchange. It is meaningless to compare  economic quantities over widely separated periods of time, or in countries at very different levels of development. On such questions only qualitative, more or less subjective judgements can be made.

It follows that socialism cannot be described in terms of the quantity of commodities produced, or the distribution of them. Socialism is liberation from the commodity form. It is defined not by the disposition of things but by the condition of human beings. It is the progressive extension of the domain of human freedom, of that part of our lives governed by love and reason.

There are many critics of finance who see it as the enemy of a more humane or authentic capitalism. They may be managerial reformers (Veblen’s “Soviet of engineers”) who oppose finance as a parasite on productive enterprises; populists who hate finance as the destroyer of their own small capitals; or sincere believers in market competition who see finance as a collector of illegitimate rents. On a practical level there is much common ground between these positions and a socialist program. But we can’t accept the idea of finance as a distortion of some true market values that are natural, objective, or fair.

Finance should be seen as a moment in the capitalist process, integral to it but with two contradictory faces. On the one hand, it is finance (as a concrete institution) that generates and enforces the money claims against social persons of all kinds — human beings, firms, nations — that extend and maintain the logic of commodity production. (Student loans reinforce the discipline of wage labor, sovereign debt upholds the international division of labor.)

Yet on the other hand, the financial system is also where conscious planning takes its most fully developed form under capitalism. Banks are, in Schumpeter’s phrase, the private equivalent of Gosplan, the Soviet planning agency. Their lending decisions determine what new projects will get a share of society’s resources, and suspend — or enforce — the “judgement of the market” on money-losing enterprises. A socialist program must respond to both these faces of finance.  We oppose the power of finance if we want to progressively reduce the extent to which human life is organized around the accumulation of money. We embrace the planning already inherent in finance because we want to expand the domain of conscious choice, and reduce the domain of blind necessity. “It is a work of culture — not unlike the draining of the Zuider Zee.”

*

The development of finance reveals the progressive displacement of market coordination by planning. Capitalism means production for profit; but in concrete reality profit criteria are always subordinate to financial criteria. The judgement of the market has force only insofar as it is executed by finance. The world is full of businesses whose revenues exceed their costs, but are forced to scale back or shut down because of the financial claims against them. The world is full of businesses that operate for years, or indefinitely, with costs in excess of their revenues, thanks to their access to finance. And the institutions that make these financing decisions do so based on their own subjective judgement, constrained ultimately not by some objective criteria of value, but by the terms set by the central bank.

There is a basic contradiction between the principles of competition and finance. Competition is imagined as a form of natural selection: Firms that make profits reinvest them and thus grow, while firms that make losses can’t invest and must shrink and eventually disappear. This is supposed to be a great advantage of markets.

But the whole point of finance is to break this link between profits yesterday and investment today. The surplus paid out as dividends and interest is available for investment anywhere in the economy, not just where it was generated. Conversely, entrepreneurs can undertake new projects that have never been profitable in the past, if they can convince someone to bankroll them. Competition looks backward: The resources you have today depend on how you’ve performed in the past. Finance looks forward: The resources you have today depend on how you’re expect (by someone!) to perform in the future. So, contrary to the idea of firms rising and falling through natural selection, finance’s darlings — from Amazon to Uber and the whole unicorn herd — can invest and grow indefinitely without ever showing a profit. This is also supposed to be a great advantage of markets.

In the frictionless world imagined by economists, the supercession of markets by finance is already carried to its limit. Firms do not control or depend on their own surplus. All surplus is allocated centrally, by financial markets. All funds for investment comes from financial markets and all profits immediately return in money form to these markets. This has two contradictory implications. On the one hand, it eliminates  any awareness of the firm as a social organism, of the activity the firm carries out to reproduce itself, of its pursuit of ends other than maximum profit for its “owners”. The firm, in effect, is born new each day by the grace of those financing it.

But by the same token, the logic of profit maximization loses its objective basis. The quasi-evolutionary process of competition – in which successful firms grow and unsuccessful ones decline and die  – ceases to operate if the firm’s own profits are no longer its source of investment finance, but both instead flow into a common pool. In this world, which firms grow and which shrink depends on the decisions of the financial planners who allocate capital between them. Needless to say it makes no difference if we move competition “one level up” – money managers also borrow and issue shares.

The contradiction between market production and socialized finance becomes more acute as the pools of finance themselves combine or become more homogenous. This was a key point for turn-of-the-last-century Marxists like Hilferding (and Lenin), but it’s also behind the recent fuss in the business press over the rise of index funds. These funds hold all shares of all corporations listed on a given stock index; unlike actively managed funds they make no effort to pick winners, but hold shares in multiple competing firms. Per one recent study, “The probability that two randomly selected firms in the same industry from the S&P 1500 have a common shareholder with at least 5% stakes in both firms increased from less than 20% in 1999 to around 90% in 2014.”

The problem is obvious: If corporations work for their shareholders, then why would they compete against each other if their shares are held by the same funds? Naturally, one proposed solution is more state intervention to preserve the form of markets, by limiting or disfavoring stock ownership via broad funds. Another, and perhaps more logical, response is: If we are already trusting corporate managers to be faithful agents of the rentier class as a whole, why not take the next step and make them agents of society in general?

And in any case the terms on which the financial system directs capital are ultimately set by the central bank. Its decisions — monetary policy in the narrow sense, but also the terms on which financial institutions are regulated, and rescued in crises – determine not only the overall pace of credit expansion but the criteria of profitability itself. This is acutely evident in crises, but it’s implicit in routine monetary policy as well. Unless lower interest rates turn some previously unprofitable projects into profitable ones, how are they supposed to work?

At the same time, the legitimacy of the capitalist system — the ideological justification of its obvious injustice and waste —  comes from the idea that economic outcomes are determined by “the market,” not by anyone’s choice. So the planning has to be kept out of site. Central bankers themselves are quite aware of this aspect of their role. In the early 1980s, when the Fed was changing the main instrument it used for monetary policy, officials there were concerned that their choice preserve the fiction that interest rates were being set by the markets. As Fed Governor Wayne Angell put it, it was essential to choose a technique that would “have the camouflage of market forces at work.”

Mainstream economics textbooks explicitly describe the long-term trajectory of capitalist economies in terms of an ideal planner, who is setting output and prices for all eternity in order to maximize the general wellbeing. The contradiction between this macro vision and the ideology of market competition is papered over by the assumption that over the long run this path is the same as the “natural” one that would obtain in a perfect competitive market system without money or banks. Outside of the academy, it’s harder to sustain faith that the planners at the central bank are infallibly picking the outcomes the market should have arrived at on its own. Central banks’ critics on the right — and many on the left — understand clearly that central banks are engaged in active planning, but see it as inherently illegitimate. Their belief in “natural” market outcomes goes with fantasies of a return to some monetary standard independent of human judgement – gold or bitcoin.

Socialists, who see through central bankers’ facade of neutral expertise and recognize their close association with private finance, may be tempted by similar ideas. But the path toward socialism runs the other way. We don’t seek to organize human life on an objective grid of market values, free of the distorting influence of finance and central banks. We seek rather to bring this already-existing conscious planning into the light, to make it into a terrain of politics, and to direct it toward meeting human needs rather than reinforcing relations of domination. In short: the socialization of finance.

*

in the U.S. context, this analysis suggests a transitional program perhaps along the following lines.

Decommodify money. While there is no way to separate money and markets from finance, that does not mean that the routine functions of the monetary system must be a source of private profit. Shifting responsibility for the basic monetary plumbing of the system to public or quasi-public bodies is a non-reformist reform – it addresses some of the directly visible abuse and instability of the existing monetary system while pointing the way toward more profound transformations. In particular, this could involve:

 1. A public payments system. In the not too distant past, if I wanted to give you some money and you wanted to give me a good or service, we didn’t have to pay a third party for permission to make the trade. But as electronic payments have replaced cash, routine payments have become a source of profit. Interchanges and the rest of the routine plumbing of the payments system should be a public monopoly, just as currency is.

 2. Postal banking. Banking services should similarly be provided through post offices, as in many other countries. Routine transactions accounts (check and saving) are a service that can be straightforwardly provided by the state.

 3. Public credit ratings, both for bonds and for individuals. As information that, to perform its function, must be widely available, credit ratings are a natural object for public provision even within the overarching logic of capitalism. This is also a challenge to the coercive, disciplinary function increasingly performed by private credit ratings in the US.

 4. Public housing finance. Mortgages for owner-occupied housing are another area where a patina of market transactions is laid over a system that is already substantively public. The 30-year mortgage market is entirely a creation of regulation, it is maintained by public market-makers, and public bodies are largely and increasingly the ultimate lenders. Socialists have no interest in the cultivation of a hothouse petty bourgeoisie through home ownership; but as long as the state does so, we demand that it be openly and directly rather than disguised as private transactions.

 5. Public retirement insurance. Providing for old age is the other area, along with housing, where the state does the most to foster what Gerald Davis calls the “capital fiction” – the conception of one’s relationship to society in terms of asset ownership. But here, unlike home ownership, social provision in the guise of financial claims has failed even on its own narrow terms. Many working-class households in the US and other rich countries do own their own houses, but only a tiny fraction can meet their subsistence needs in old age out of private saving. At the same time, public retirement systems are much more fully developed than public provision of housing. This suggests a program of eliminating existing programs to encourage private retirement saving, and greatly expanding Social Security and similar social insurance systems.

Repress finance. It’s not the job of socialists to keep the big casino running smoothly. But as long as private financial institutions exist, we cannot avoid the question of how to regulate them. Historically financial regulation has sometimes taken the form of “financial repression,” in which the types of assets held by financial institutions are substantially dictated by the state. This allows credit to be directed more effectively to socially useful investment. It also allows policymakers to hold market interest rates down, which — especially in the context of higher inflation — diminishes both the burden of debt and the power of creditors. The exiting deregulated financial system already has very articulate critics; there’s no need to duplicate their work with a detailed reform proposal. But we can lay out some broad principles:

1. If it isn’t permitted, it’s forbidden. Effective regulation has always depended on enumerating specific functions for specific institutions, and prohibiting anything else. Otherwise it’s too easy to bypass with something that is formally different but substantively equivalent. And whether or not central banks are going to continue with their role as the main managers of aggregate demand —  increasingly questioned by those inside the citadel as well as by outsiders — they also need this kind of regulation to effectively control the flow of credit.

2. Protect functions, not institutions. The political power of finance comes from ability to threaten routine social bookkeeping, and the security of small property owners. (“If we don’t bail out the banks, the ATMs will shut down! What about your 401(k)?”) As long as private financial institutions perform socially necessary functions, policy should focus on preserving those functions themselves, and not the institutions that perform them. This means that interventions should be as close as possible to the nonfinancial end-user, and not on the games banks play among themselves. For example: deposit insurance.

3. Require large holdings of public debt. The threat of the “bond vigilantes” against the US federal government has  been wildly exaggerated, as was demonstrated for instance by the debt-ceiling farce and downgrade of 2012. But for smaller governments – including state and local governments in the US – bond markets are not so easily ignored. And large holdings of pubic debt also reduce the frequency and severity of the periodic financial crises which are, perversely, one of the main ways in which finance’s social power is maintained.

4. Control overall debt levels with lower interest rates and higher inflation. Household leverage in the US has risen dramatically over the past 30 years; some believe that this is because debt was needed to raise living standards of living in the face of stagnant or declining real incomes. But this isn’t the case; slower income growth has simply meant slower growth in consumption. Rather, the main cause of rising household debt over the past 30 years has been the combination of low inflation and continuing high interest rates for households. Conversely, the most effective way to reduce the burden of debt – for households, and also for governments – is to hold interest rates down while allowing inflation to rise.

As a corollary to financial repression, we can reject any moral claims on behalf of interest income as such. There is no right to exercise a claim on the labor of others  through ownership of financial assets. To the extent that the private provision of socially necessary services like insurance and pensions is undermined by low interest rates, that is an argument for moving these services to the public sector, not for increasing the claims of rentiers.

Democratize central banks. Central banks have always been central planners. Choices about interest rates, and the terms on which financial institutions will be regulated and rescued, inevitably condition the profitability and the direction as well as level of productive activity. This role has been concealed behind an ideology that imagines the central bank behaving automatically, according to a rule that somehow reproduces the “natural” behavior of markets.

Central banks’ own actions since 2008 have left this ideology in tatters. The immediate response to the crisis have forced central banks to intervene more directly in credit markets, buying a wider range of assets and even replacing private financial institutions to lend directly to nonfinancial businesses. Since then, the failure of conventional monetary policy has forced central banks to inch unwillingly toward a broader range of interventions, directly channeling credit to selected borrowers. This turn to “credit policy” represents an admission – grudging, but forced by events – that the anarchy of competition is unable to coordinate production. Central banks cannot, as the textbooks imagine, stabilize the capitalists system by turning a single knob labeled “money supply” or “interest rate.” They must substitute their own judgement for market outcomes in a broad and growing range of asset and credit markets.

The challenge now is to politicize central banks — to make them the object of public debate and popular pressure.  In Europe, the national central banks – which still perform their old functions, despite the common misperception that the ECB is now the central bank of Europe – will be a central terrain of struggle for the next left government that seeks to break with austerity and liberalism. In the US, we can dispense for good with the idea that monetary policy is a domain of technocratic expertise, and bring into the open its program of keeping unemployment high in order to restrain wage growth and workers’ power. As a positive program, we might demand that the Fed aggressively using its existing legal authority to purchase municipal debt, depriving rentiers of their power over financially constrained local governments as in Detroit and Puerto Rico, and more broadly blunting the power of “the bond markets” as a constraint on popular politics at the state and local level. More broadly, central banks should be held responsible for actively directing credit to socially useful ends.

Disempower shareholders. Really existing capitalism consists of narrow streams of market transactions flowing between vast regions of non-market coordination. A core function of finance is to act as the weapon in the hands of the capitalist class to enforce the logic of value on these non-market structures. The claims of shareholders over nonfinancial businesses, and bondholders over national governments, ensure that all these domains of human activity remain subordinate to the logic of accumulation. We want to see stronger defenses against these claims – not because we have any faith in productive capitalists or national bourgeoisies, but because they occupy the space in which politics is possible.

Specifically we should stand with corporations against shareholders. The corporation, as Marx long ago noted, is “the abolition of the capitalist mode of production within the capitalist mode of production itself.” Within the corporation, activity is coordinated through plans, not markets; and the orientation of this activity is toward the production of a particular use-value rather than money as such. “The tendency of big enterprise,” Keynes wrote, “is to socialize itself.” The fundamental political function of finance is to keep this tendency in check. Without the threat of takeovers and the pressure of shareholder activists, the corporation becomes a space where workers and other stakeholders can contest control over production and the surplus it generates – a possibility that capitalist never lose sight of.

Needless to say, this does not imply any attachment to the particular individuals at the top of the corporate hierarchy, who today are most often actual or aspiring rentiers  without any organic connection to the production process. Rather, it’s a recognition of the value of the corporation as a social organism; as a space structured by relationships of trust and loyalty, and by intrinsic motivation and “professional conscience”; and as the site of consciously planned production of use-values.

The role of finance with respect to the modern corporation is not to provide it with resources for investment, but to ensure that its conditional orientation toward production as an end in itself is ultimately subordinate to the accumulation of money. Resisting this pressure is no substitute for other struggles, over the labor process and the division of resources and authority within the corporation. (History gives many examples of production of use values as an end in itself, which is carried out under conditions as coercive and alienated as under production for profit.) But resisting the pressure of finance creates more space for those struggles, and for the evolution of socialism within the corporate form.

Close borders to money (and open them to people). Just as shareholder power enforces the logic of accumulation on corporations, capital mobility does the same to states. In the universities, we hear about the supposed efficiency  of unrestrained capital flows, but in the political realm we hear more their power to “discipline” national governments. The threat of capital flight and balance of payments crises protects the logic of accumulation against incursions by national governments.

States can be vehicles for conscious control of the economy only insofar as financial claims across borders are limited. In a world where capital flows are large and unrestricted, the concrete activity of production and reproduction must constantly adjust itself to the changing whims of foreign investors. This is incompatible with any strategy for  development of the forces of production at the national level; every successful case of late industrialization has depended on the conscious direction of credit through the national banking system. More than that, the requirement that real activity accommodate cross-border financial flows is  incompatible even with the stable reproduction of capitalism in the periphery. We have learned this lesson many times in Latin America and elsewhere in the South, and are now learning it again in Europe.

So a socialist program on finance should include support for efforts of national governments to delink from the global economy, and to maintain or regain control over their financial systems. Today, such efforts are often connected to a politics of racism, nativism and xenophobia which we must uncompromisingly reject. But it is possible to move toward a world in which national borders pose no barrier to people and ideas, but limit the movement of goods and are impassible barriers to private financial claims.

In the US and other rich countries, it’s also important to oppose any use of the authority – legal or otherwise – of our own states to enforce financial claims against weaker states. Argentina and Greece, to take two recent examples, were not forced to accept the terms of their creditors by the actions of dispersed private individuals through financial markets, but respectively by the actions of Judge Griesa of the US Second Circuit and Trichet and Draghi of the ECB. For peripheral states to foster development and serve as vehicle for popular politics, they must insulate themselves from international financial markets. But the power of those markets comes ultimately from the gunboats — figurative or literal — by which private financial claims are enforced.

With respect to the strong states themselves, the markets have no hold except over the imagination. As we’ve seen repeatedly in recent years — most dramatically in the debt-limit vaudeville of 2011-2013 — there are no “bond vigilantes”; the terms on which governments borrow are fully determined by their own monetary authority. All that’s needed to break the bond market’s power here is to recognize that it’s already powerless.

In short, we should reject the idea of finance as an intrusion on a preexisting market order. We should resist the power of finance as an enforcer of the logic of accumulation. And we should reclaim as a site of democratic politics the social planning already carried out through finance.

Links for October 6

More methodenstreit. I finally read the Romer piece on the trouble with macro. Some good stuff in there. I’m glad to see someone of his stature making the  point that the Solow residual is simply the part of output growth that is not explained by a production function. It has no business being dressed up as “total factor productivity” and treated as a real thing in the world. Probably the most interesting part of the piece was the discussion of identification, though I’m not sure how much it supports his larger argument about macro.  The impossibility of extracting causal relationships from statistical data would seem to strengthen the argument for sticking with strong theoretical priors. And I found it a bit odd that his modus ponens for reality-based macro was accepting that the Fed brought down output and (eventually) inflation in the early 1980s by reducing the money supply — the mechanisms and efficacy of conventional monetary policy are not exactly settled questions. (Funnily enough, Krugman’s companion piece makes just the opposite accusation of orthodoxy — that they assumed an increase in the money supply would raise inflation.) Unlike Brian Romanchuk, I think Romer has some real insights into the methodology of economics. There’s also of course some broadsides against the policy  views of various rightwing economists. I’m sympathetic to both parts but not sure they don’t add up to less than their sum.

David Glasner’s interesting comment on Romer makes in passing a point that’s bugged me for years — that you can’t talk about transitions from one intertemporal equilibrium to another, there’s only the one. Or equivalently, you can’t have a model with rational expectations and then talk about what happens if there’s a “shock.” To say there is a shock in one period, is just to say that expectations in the previous period were wrong. Glasner:

the Lucas Critique applies even to micro-founded models, those models being strictly valid only in equilibrium settings and being unable to predict the adjustment of economies in the transition between equilibrium states. All models are subject to the Lucas Critique.

Here’s another take on the state of macro, from the estimable Marc Lavoie. I have to admit, I don’t care for way it’s framed around “the crisis”. It’s not like DSGE models were any more useful before 2008.

Steve Keen has his own view of where macro should go. I almost gave up on reading this piece, given Forbes’ decision to ban on adblockers (Ghostery reports 48 different trackers in their “ad-light” site) and to split the article up over six pages. But I persevered and … I’m afraid I don’t see any value in what Keen proposes. Perhaps I’ll leave it at that. Roger Farmer doesn’t see the value either.

In my opinion, the way forward, certainly for people like me — or, dear reader, like you — who have zero influence on the direction of the economics profession, is to forget about finding the right model for “the economy” in the abstract, and focus more on quantitative description of concrete historical developments. I expressed this opinion in a bunch of tweets, storified here.

 

The Gosplan of capitalism. Schumpeter described banks as capitalism’s equivalent of the Soviet planning agency — a bank loan can be thought of as an order allocating part of society’s collective resources to a particular project.  This applies even more to the central banks that set the overall terms of bank lending, but this conscious direction of the economy has been hidden behind layers of ideological obfuscation about the natural rate, policy rules and so on. As DeLong says, central banks are central planners that dare not speak their name. This silence is getting harder to maintain, though. Every day there seems to be a new news story about central banks intervening in some new credit market or administering some new price. Via Ben Bernanke, here is the Bank of Japan announcing it will start targeting the yield of 10-year Japanese government bonds, instead of limiting itself to the very short end where central banks have traditionally operated. (Although as he notes, they “muddle the message somewhat” by also announcing quantities of bonds to be purchased.)  Bernanke adds:

there is a U.S. precedent for the BOJ’s new strategy: The Federal Reserve targeted long-term yields during and immediately after World War II, in an effort to hold down the costs of war finance.

And in the FT, here is the Bank of England announcing it will begin buying corporate bonds, an unambiguous step toward direct allocation of credit:

The bank will conduct three “reverse auctions” this week, each aimed at buying the bonds from particular sectors. Tuesday’s auction focuses on utilities and industries. Individual companies include automaker Rolls-Royce, oil major Royal Dutch Shell and utilities such as Thames Water.

 

Inflation or socialism. That interventions taken in the heat of a crisis to stabilize financial markets can end up being steps toward “a more or less comprehensive socialization of investment,” may be more visible to libertarians, who are inclined to see central banks as a kind of socialism already. At any rate, Scott Sumner has been making some provocative posts lately about a choice between “inflation or socialism”. Personally I don’t have much use for NGDP targeting — Sumner’s idée fixe — or the analysis that underlies it, but I do think he is onto something important here. To translate the argument into Keynes’ terms, the problem is that the minimum return acceptable to wealth owners may be, under current conditions, too high to justify the level of investment consistent with the minimum level of growth and employment acceptable to the rest of society. Bridging this gap requires the state to increasingly take responsibility for investment, either directly or via credit policy. That’s the socialism horn of the dilemma. Or you can get inflation, which, in effect, forces wealthholders to accept a lower return; or put it more positively, as Sumner does, makes it more attractive to hold wealth in forms that finance productive investment.  The only hitch is that the wealthy — or at least their political representatives — seem to hate inflation even more than they hate socialism.

 

The corporate superorganism.  One more for the “finance-as-socialism” files. Here’s an interesting working paper from Jose Azar on the rise of cross-ownership of US corporations, thanks in part to index funds and other passive investment vehicles.

The probability that two randomly selected firms in the same industry from the S&P 1500 have a common shareholder with at least 5% stakes in both firms increased from less than 20% in 1999Q4 to around 90% in 2014Q4 (Figure 1).1 Thus, while there has been some degree of overlap for many decades, and overlap started increasing around 2000, the ubiquity of common ownership of large blocks of stock is a relatively recent phenomenon. The increase in common ownership coincided with the period of fastest growth in corporate profits and the fastest decline in the labor share since the end of World War II…

A common element of theories of the firm boundaries is that … either firms are separately owned, or they combine. In stock market economies, however, the forces of portfolio diversification lead to … blurring firm boundaries… In the limit, when all shareholders hold market portfolios, the ownership of the firms becomes exactly identical. From the point of view of the shareholders, these firms should act “in unison” to maximize the same objective function… In this situation the firms have in some sense become branches of a larger corporate superorganism.

The same assumptions that generate the “efficiency” of market outcomes imply that public ownership could be just as efficient — or more so in the case of monopolies.

The present paper provides a precise efficiency rationale for … consumer and employee representation at firms… Consumer and employee representation can reduce the markdown of wages relative to the marginal product of labor and therefore bring the economy closer to a competitive outcome. Moreover, this provides an efficiency rationale for wealth inequality reduction –reducing inequality makes control, ownership, consumption, and labor supply more aligned… In the limit, when agents are homogeneous and all firms are commonly owned, … stakeholder representation leads to a Pareto efficient outcome … even though there is no competition in the economy.

As Azar notes, cross-ownership of firms was a major concern for progressives in the early 20th century, expressed through things like the Pujo committee. But cross-ownership also has been a central theme of Marxists like Hilferding and Lenin. Azar’s “corporate superorganism” is basically Hilferding’s finance capital, with index funds playing the role of big banks. The logic runs the same way today as 100 years ago. If production is already organized as a collective enterprise run by professional managers in the interest of the capitalist class as a whole, why can’t it just as easily be managed in a broader social interest?

 

Global pivot? Gavyn Davies suggests that there has been a global turn toward more expansionary fiscal policy, with the average rich country fiscal balances shifting about 1.5 points toward deficit between 2013 and 2016. As he says,

This seems an obvious path at a time when governments can finance public investment programmes at less than zero real rates of interest. Even those who believe that government programmes tend to be inefficient and wasteful would have a hard time arguing that the real returns on public transport, housing, health and education are actually negative.

I don’t know about that last bit, though — they don’t seem to find it that hard.

 

Taylor rule toy. The Atlanta Fed has a cool new gadget that lets you calculate the interest rate under various versions of the Taylor Rule. It will definitely be useful in the classroom. Besides the obvious pedagogical value, it also dramatizes a larger point — that macroeconomic variables like “inflation” aren’t objects simply existing in the world, but depend on all kinds of non-obvious choices about measurement and definition.

 

The new royalists. DeLong summarizes the current debates about monetary policy:

1. Do we accept economic performance that all of our predecessors would have characterized as grossly subpar—having assigned the Federal Reserve and other independent central banks a mission and then kept from them the policy tools they need to successfully accomplish it?

2. Do we return the task of managing the business cycle to the political branches of government—so that they don’t just occasionally joggle the elbows of the technocratic professionals but actually take on a co-leading or a leading role?

3. Or do we extend the Federal Reserve’s toolkit in a structured way to give it the tools it needs?

This is a useful framework, as is the discussion that precedes it. But what jumped out to me is how he reflexively rejects option two. When it comes to the core questions of economic policy — growth, employment, the competing claims of labor and capital — the democratically accountable, branches of government must play no role. This is all the more striking given his frank assessment of the performance of the technocrats who have been running the show for the past 30 years: “they—or, rather, we, for I am certainly one of the mainstream economists in the roughly consensus—were very, tragically, dismally and grossly wrong.”

I think the idea that monetary policy is a matter of neutral, technical expertise was always a dodge, a cover for class interests. The cover has gotten threadbare in the past decade, as the range and visibility of central bank interventions has grown. But it’s striking how many people still seem to believe in a kind of constitutional monarchy when it comes to central banks. They can see people who call for epistocracy — rule by knowers — rather than democracy as slightly sinister clowns (which they are). And they can simultaneously see central bank independence as essential to good government, without feeling any cognitive dissonance.

 

Did extending unemployment insurance reduce employment? Arin Dube, Ethan Kaplan, Chris Boone and Lucas Goodman have a new paper on “Unemployment Insurance Generosity and Aggregate Employment.” From the abstract:

We estimate the impact of unemployment insurance (UI) extensions on aggregate employment during the Great Recession. Using a border discontinuity design, we compare employment dynamics in border counties of states with longer maximum UI benefit duration to contiguous counties in states with shorter durations between 2007 and 2014. … We find no statistically significant impact of increasing unemployment insurance generosity on aggregate employment. … Our point estimates vary in sign, but are uniformly small in magnitude and most are estimated with sufficient precision to rule out substantial impacts of the policy…. We can reject negative impacts on the employment-to-population ratio … in excess of 0.5 percentage points from the policy expansion.

Media advisory with synopsis is here.

 

On other blogs, other wonders

Larry Summers: Low laborforce participation is mainly about weak demand, not demographics or other supply-side factors.

Nancy Folbre on Greg Mankiw’s claims that the one percent deserves whatever it gets.

At Crooked Timber, John Quiggin makes some familiar — but correct and important! — points about privatization of public services.

In the Baffler, Sam Kriss has some fun with the new atheists. I hadn’t encountered Kierkegaard’s parable of the madman who tells everyone who will listen “the world is round!” but it fits perfectly.

A valuable article in the Washington Post on cobalt mining in Africa. Tracing out commodity chains is something we really need more of.

Buzzfeed on Blue Apron. The reality of the robot future is often, as here, just that production has been reorganized to make workers less visible.

At Vox, Rachelle Sampson has a piece on corporate short-termism. Supports my sense that this is an area where there may be space to move left in a Clinton administration.

Sven Beckert has edited a new collection of essays on the relationship between slavery and the development of American capitalism. Should be worth looking at — his Empire of Cotton is magnificent.

At Dissent, here’s an interesting review of Jefferson Cowie’s and Robert Gordon’s very different but complementary books on the decline of American growth.

Links for March 14

A few things elsewhere on the web, relevant to recent conversations here.

1. Michael Reich and his colleagues at the Berkeley Center for Labor Research have a new report out on the impacts of a $15 minimum wage in New York. It does something I wish all studies of the minimum wage and employment would do: It explicitly decomposes the employment impact into labor productivity, price, demand and labor share effects. Besides being useful for policy, this links nicely to the macro discussion of alternative Phillips curves.

2. I like Susan Schroeder’s idea of creating a public credit-rating agency. It’s always interesting how the need to deal with immediate crises and dysfunctions creates pressure to socialize various aspects of the financial system. The most dramatic recent example was back in the fall of 2008, when the Fed began lending directly to anyone who needed to roll over commercial paper; but you can think of lots of examples, including QE itself, which involves the central bank taking over part of banks’ core function of maturity transformation.

3. On the subject of big business’s tendency to socialize itself, I should have linked earlier to Noah Smith’s discussion of “new industrialism” (including my work for the Roosevelt Institute) as the next big thing in economic policy. Eric Ries’ proposal for creating a new, nontransferable form of stock ownership reminded me of this bit from Keynes: “The spectacle of modern investment markets has sometimes moved me towards the conclusion that  the purchase of an investment [should be] permanent and indissoluble, like marriage, except by reason of death or other grave cause… For this would force the investor to direct his mind to the long-term prospects and to those only.”

4. In comments to my recent post on the balance of payments, Ramanan points to a post of his, making the same point, more clearly than I managed to. Also worth reading is the old BIS report he links to, which explicitly distinguishes between autonomous and accommodative financial flows. Kostas Kalaveras also had a very nice post on this topic a while ago, noting that in Europe TARGET2 balances function as a buffer allowing private financial flows and current account balances to move independently from each other.

5. I’m teaching intermediate macroeconomics here at John Jay, as I do most semesters, and I’ve put some new notes I’m using up on the teaching page of this website. It’s probably mostly of interest to people who teach this stuff themselves, but I did want to call attention to the varieties of business cycles handout, which is somewhat relevant to current debates. It’s also an example of how I try to teach macro — focus on causal relationships between observable aggregates, rather than formal models based on equilibrium conditions.

“The Money Has to Go Somewhere” – 1

A common response to concerns about high payouts and the short-term orientation of financial markets is that money paid out to shareholders will just be reinvested elsewhere.

Some defenders of the current American financial system claim this as one of its major virtues — investment decisions are made by participants in financial markets, rather than managers at existing firms. In the words of Michael Jensen, an important early theorist of the shareholder revolution,

Wall Street can allocate capital among competing businesses and monitor and discipline management more effectively than the CEO and headquarters staff of the typical diversified company. [Private equity fund] KKR’s New York offices … are direct substitutes for corporate headquarters in Akron or Peoria.

But while private equity funds do indeed replace exiting management at corporations they buy shares in, this form of active investment is very much the minority. The vast majority of “investment” by private shareholders does not directly contribute any funding to the companies being invested in. Rather, it involves the purchase of existing assets from other owners of financial assets.

Suppose a wealthy investor receives $1 million from increased dividends on shares they own. Now ask: what do they do? Their liquidity has increased. So has their net wealth, since the higher dividends are unlikely to reduce the market value of the shares and may well increase them. The natural use of this additional liquidity and wealth is to purchase more shares. (If the shares are owned indirectly, through a mutual fund or similar entity, this reinvestment happens automatically). But this purchases of additional shares does not provide any funding for the companies “invested” in, it simply bids up the prices of existing shares and increases the liquidity of the sellers. Those sellers in turn may purchase more shares or other financial assets, bidding up their prices and passing the liquidity to their sellers; and so on.

Of course, this process does not continue indefinitely; at each stage people may respond to their increased wealth by increasing their cash holdings, or by increasing their consumption; and each transaction involves some payments to the financial industry. Eventually, the full payout will leak out through these three channels, and share prices will stop rising. In the end, the full $1 million will be absorbed by the higher consumption and cash holdings induced by the higher share prices, and by the financial-sector incomes generated by the transactions.

Now, not every share purchase involves an existing share. But the vast majority do. In 2014, there were $90 billion of new shares issued through IPOs on American markets — an exceptionally high number.  By comparison, daily transactions on the main US stock markets average around $300 billion. Given around 260 trading days in a year, this implies that only one trade in a thousand on an American stock exchange involves the purchase of a newly issued share. And that is not counting the many “stock market” transactions other than outright share purchases (closed-end mutual funds, derivative contracts, etc.) all of which allow income from shareholder payouts to be reinvested and none of which provide any new funding for businesses.

External financing for businesses is much more likely to take the form of debt than new shares. But here, again, we can’t assume that there is any direct link between shareholder payouts and funding for other firms. Corporate bonds are issue by the same established corporations that are making the payouts. Meanwhile, smaller and younger firms, both listed and unlisted, are dependent on bank loans. And the fundamental fact about modern banks is that their lending is in no way dependent on prior saving. There is no way for higher payouts to increase the volume of bank lending. Banks’ funding costs are closely tied to the short-term interest rate set by the Federal Reserve, while their willingness to lend depends on the expected riskiness of the loan; there is no way for increased payouts to increase the availability of bank loans.

New bonds, on the other hand, do need to be purchase by wealthowners, and it is possible that the market liquidity created by high payouts has helped hold down longer interest rates. But many other factors — especially the beliefs of market participants about the future path of interest rates — also affect these rates, so is hard to see any direct link between payouts by some corporations and increased bond financing for others. Nor do new bonds necessarily finance investment. Indeed, since the mid-1980s corporate borrowing has been more tightly correlated with shareholder payouts than with investment. So if payouts do spill over into the bond market, to a large extent they are simply financing themselves.

Defenders of the financial status quo suggest that it’s wrong to accuse the markets as a whole of short-termism, since for every established company being pressured to increase payouts, there is a startup getting funded despite even when any profits are years away. I certainly wouldn’t deny that financial markets do often fund startups and other small- financially-constrained firms; and these firms do sometimes undertake socially useful investment that established corporations for whatever reason do not. And in principle, shareholder payouts can support this kind of funding both directly, as shareowners put money into venture capital funds, IPOs, etc.; and indirectly, as higher share prices make it easier to raise funds through new offerings. But the optimistic view of shareholder payouts not sustainable once we look at the magnitudes involved. It is mathematically impossible for the additional funds directed to new firms, to offset what they drain from established ones.

Again, IPOs in 2014 raised a record $90 billion for newly listed firms. (Over the past ten years, the average annual funds raised by IPOs was $45 billion.) Secondary offerings by listed firms totaled $180 billion, but some large fraction of these involved stock-option exercise by executives rather than new funding for the corporation. Prior to an IPO, the most important non-bank source of external funding for new companies is venture capital funds. In 2014, VC funds invested approximately $50 billion, but only $30 billion of this represented new commitments by investors; the remaining $20 billion came from the funds’ own retained profits. (And there is some double-counting between VC commitments and IPOs, since one of the main functions of IPOs today is to cash out earlier investors.) Net commitments to private equity funds might come to another $200 billion, but very little of this represents funding for the businesses they invest in — private equity specializes, rather, in buying control of corporations from existing shareholders. All told, flows of money from investors to businesses through these channels was probably less than $100 billion.

Meanwhile, total shareholder payouts in 2014 were over $1.2 trillion. So at best less than one dollar in ten flowing out of publicly-traded corporations went to fund some startup. And this assumes that shareholder payouts are the only source of funds for IPOs and venture capital; but of course people also invest in these out of labor income (salaries are a significant fraction of even the highest incomes in the US) and other sources. So the real fraction of payouts flowing to startups must be much less. There simply isn’t enough room in the limited financial pipelines flowing into new businesses, to accommodate the immense gusher of cash coming from established ones. Apple alone paid out $56 billion to shareholders last year, or nearly twice total commitments to VC funds. Intel, Oracle, IBM, Cisco and AT&T together paid out another $70 billion. [1] It’s hard to understand why, if finance is able to identify such wonderful investment opportunities for its cash, the management at these successful technology companies is unable to. You would have to have a profound faith in the unicorn hunters at Andreesen Horowitz to believe that the $1 billion they invested last year will produce more social value than $10 or $20 or $50 billion invested by established companies — or an equally profound pessimism about the abilities of professional managers. If this is what people like James Surowiecki really believe, they should not be writing about the dynamism of American financial markets, but about whatever pathology they believe has crippled the ability of mangers at existing corporations to identify viable investment projects.

 

[1] These numbers are taken from the Compustat database of filings by publicly traded corporations.

Reallocation Continued: Profits, Payouts, Investment and Borrowing

In a previous post, I pointed out that if capital means real investment, then the place where capital is going these days is fossil fuels, not the industries we usually think of as high tech. I want to build on that now by looking at some other financial flows across these same sectors.

As I discussed in the previous post, any analysis of investment and profits has to deal with the problem of R&D, and IP-related spending in general. If we want to be consistent with the national accounts and, arguably, economic theory, we should add R&D to investment, and therefore also to cashflow from operations. (It’s obvious why you have to do this, right?) But if we want to be consistent with the accounting principles followed by individual businesses, we must treat R&D as a current expense. For many purposes, it doesn’t end up making a big difference, but sometimes it does.

Below, I show the four major sources and uses of funds for three subsets of corporations. The flows are: cashflow from operations — that is, profits plus depreciation, plus R&D if that is counted in investment; profits; investment, possibly including R&D; and net borrowing. The  universes are publicly traded corporations: first all of them; second the high tech sector, defined as in the previous post, and third fossil fuels, also as defined previously. Here I am using the broad measure of investment, including R&D, and the corresponding measure of cashflow from operations. At the end of the post, I show the same figures using the narrow measure of investment, and with profits as well as cashflow.

all_broad

For the corporate sector as a whole, we have the familiar story. Over the past twenty-five years annual shareholder payouts (dividends plus share repurchases) have approximately  doubled, rising from around 3 percent of sales in the 1950s, 60s and 70s to around 6 percent today. Payouts have also become more variable, with periods of high and low payouts corresponding with high and low borrowing. (This correlation between payouts and borrowing is also clearly visible across firms since the 1990s, but not previously, as discussed here.) There’s also a strong upward trend in cashflow from operations, especially in the last two expansions, rising from about 10 percent of sales in the 1970s to 15 percent today. Investment spending, however, shows no trend; since 1960, it’s stayed around 10 percent of sales. The result is an unprecedented gap between corporate earnings and and investment.

Here’s one way of looking at this. Recall that, if these were the only cashflows into and out of the corporate sector, then cash from operations plus net borrowing (the two sources) would have to equal investment plus payouts (the two uses). In the real world, of course, there are other important flows, including mergers and acquisitions, net acquisition of financial assets, and foreign investment flows. But there’s still a sense in which the upper gap in the figure is the mirror image or complement of the lower gap. The excess of cash from operations over investment shows that corporate sector’s real activities are a net source of cash, while the excess of payouts over borrowing suggests that its financial activities are a net use of cash.

Focusing on the relationship between cashflow and investment suggests a story with three periods rather than two. Between roughly 1950 and 1970, the corporate sector generated significantly more cash than it required for expansion, leaving a surplus to be paid out through the financial system in one form or another. (While payouts were low compared with today, borrowing was also quite low, leaving a substantial net flow to owners of financial assets.) Between 1970 and 1985 or so, the combination of higher investment and weaker cashflow meant that, in the aggregate all the funds generated within the corporate sector were being used there, with no net surplus available for financial claimants. This is the situation that provoked the “revolt of the rentiers.” Finally, from the 1990s and especially after 2000, we see the successful outcome of the revolt.

This is obviously a simplified and speculative story. It’s important to look at what’s going on across firms and not just at aggregates. It’s also important to look at various flows I’ve ignored here;  cashflow ideally should be gross, rather than net, of interest and taxes, and those two flows along with net foreign investment, net acquisition of financial assets, and cash M&A spending, should be explicitly included. But this is a start.

Now, let’s see how things look in the tech sector. Compared with publicly-traded corporations as a whole, these are high-profit and high-invewtment industries. (At least when R&D is included in investment — without it, things look different.) It’s not surprising that high levels of these two flows would go together — firms with higher fixed costs will only be viable if they generate larger cashflows to cover them.

tech_broad

But what stands out in this picture is how the trends in the corporate sector as a whole are even more visible in the tech industries. The gap between cashflow and investment is always positive here, and it grows dramatically larger after 1990. In 2014, cashflow from operations averaged 30 percent of sales in these industries, and reported profits averaged 12 percent of sales — more than double the figures for publicly traded corporations as a whole. So to an even greater extent than corporations in general, the tech industries have increasingly been net sources of funds to the financial system, not net users of funds from it. Payouts in the tech industries have also increased even faster than for publicly traded corporations in general. Before 1985, shareholder payouts in the tech industries averaged 3.5 percent of sales, very close to the average for all corporations. But over the past decade, tech payouts have averaged  full 10 percent of annual sales, compared with just a bit over 5 percent for publicly-traded corporations as a whole.

In 2014, there were 15 corporations listed on US stock markets with total shareholder payouts of $10 billion or more, as shown in the table below. Ten of the 15 were tech companies, by the definition used here. Computer hardware and software are often held out as industries in which US capitalism, with its garish inequality and fierce protections of property rights, is especially successful at fostering innovation. So it’s striking that the leading firms in these industries are not recipients of funds from financial markets, but instead pay the biggest tributes to the lords of finance.

Dividends Repurchases Total Payouts
APPLE INC 11,215 45,000 56,215
EXXON MOBIL CORP 11,568 13,183 24,751
IBM 4,265 13,679 17,944
INTEL CORP 4,409 10,792 15,201
ROYAL DUTCH SHELL PLC 11,843 3,328 15,171
JOHNSON & JOHNSON 7,768 7,124 14,892
NOVARTIS AG 6,810 6,915 13,725
CISCO SYSTEMS INC 3,758 9,843 13,601
MERCK & CO 5,156 7,703 12,859
CHEVRON CORP 7,928 4,412 12,340
PFIZER INC 6,691 5,000 11,691
AT&T INC 9,629 1,617 11,246
BP PLC 5,852 4,589 10,441
ORACLE CORP 2,255 8,087 10,342
GENERAL ELECTRIC CO 8,949 1,218 10,167

2014. Values in millions of dollars. Tech firms in bold.

It’s hard to argue that Apple and Merck represent mature industries without significant growth prospects. And note that, apart from GE  (which is not listed in the  the high-tech sector as defined here, but perhaps should be), all the other members of the $10 billion club are in the fast-growing oil industry. It’s hard to shake the feeling that what distinguishes high-payout corporations is not the absence of investment opportunities, but rather the presence of large monopoly rents.

Finally, let’s quickly look at the fossil-fuel industries. Up through the 1980s, the picture here is not too different from publicly-traded corporations in general, though with more variability — the collapse in fossil-fuel earnings and dividends in the 1970s is especially striking. But it’s interesting that, despite very high payouts in several big oil companies, there has been no increase in payouts for the sector in general. And in the most recent oil and gas boom, new investment has been running ahead of internal cashflow, making the sector a net recipient of funds from financial markets. (This trend seems to have intensified recently, as falling profits in the sector have not (yet) been accompanied with falling investment.)  So the capital-reallocation story has some prima facie plausibility as applied to the oil and gas boom.

oil_broad

In the next, and final, post in this series, I’ll try to explain why I don’t think it makes sense to think of shareholder payouts as a form of capital reallocation. My argument has two parts. First, I think these claims often rest on an implicit loanable-funds framework that is logically flawed. There is not a fixed stock of savings available for investment; rather, changes in investment result in changes in income that necessarily produce the required (dis)saving. So if payouts in one company boost investment in another, it cannot be by releasing real resources, but only by relieving liquidity constraints. And that’s the second part of my argument: While it is possible for higher payouts to result in greater liquidity, it is hard to see any plausible liquidity channel by which more than a small fraction of today’s payouts could be translated into higher investment elsewhere.

Finally, here are the same graphs as above but with investment counted as it is businesses’ own financial statements, with R&D spending counted as current costs. The most notable difference is the strong downward trend in tech-sector investment when R&D is excluded.

all_narrowtech_narrowoil_narrow

 

 

 

 

Is Capital Being Reallocated to High-Tech Industries?

Readers of this blog are familiar with the “short-termism” position: Because of the rise in shareholder power, the marginal use of funds for many corporations is no longer fixed investment, but increased payouts in the form of dividends and sharebuybacks. We’re already seeing some backlash against this view; I expect we’ll be seeing lots more.

The claim on the other side is that increased payouts from established corporations are nothing to worry about, because they increase the funds available to newer firms and sectors. We are trying to explore the evidence on this empirically. In a previous post, I asked if the shareholder revolution had been followed by an increase in the share of smaller, newer firms. I concluded that it didn’t look like it. Now, in this post and the following one, we’ll look at things by industry.

In that earlier post, I focused on publicly traded corporations. I know some people don’t like this — new companies, after all, aren’t going to be publicly traded. Of course in an ideal world we would not limit this kind of analysis to public traded firms. But for the moment, this is where the data is; by their nature, publicly traded corporations are much more transparent than other kinds of businesses, so for a lot of questions that’s where you have to go. (Maybe one day I’ll get funding to purchase access to firm-level financial data for nontraded firms; but even then I doubt it would be possible to do the sort of historical analysis I’m interested in.) Anyway, it seems unlikely that the behavior of privately held corporations is radically different from publicly traded one; I have a hard time imagining a set of institutions that reliably channel funds to smaller, newer firms but stop working entirely as soon as they are listed on a stock market. And I’m getting a bit impatient with people who seem to use the possibility that things might look totally different in the part of the economy that’s hard to see, as an excuse for ignoring what’s happening in the parts we do see.

Besides, the magnitudes don’t work. Publicly traded corporations continue to account for the bulk of economic activity in the US. For example, we can compare the total assets of the nonfinancial corporate sector, including closely held corporations, with the total assets of publicly traded firms listed in the Compustat database. Over the past decade, the latter number is consistently around 90 percent of the former. Other comparisons will give somewhat different values, but no matter how you measure, the majority of corporations in the US are going to be publicly traded. Anyway, for better or worse, I’m again looking at publicly-traded firms here.

In the simplest version of the capital-reallocation story, payouts from old, declining industries are, thanks to the magic of the capital markets, used to fund investment in new, technology-intensive industries. So the obvious question is, has there in fact been a shift in investment from the old smokestack industries to the newer high-tech ones?

One problem is defining investment. The accounting rules followed by American businesses generally allow an expense to be capitalized only when it is associated with a tangible asset. R&D spending, in particular, must be treated as a current cost. The BEA, however, has since 2013 treated R&D spending, along with other forms of intellectual property production, as a form of investment. R&D does have investment-like properties; arguably it’s the most relevant form of investment for some technology-intensive sectors. But the problem with redefining investment this way is that it creates inconsistencies with the data reported by individual companies, and with other aggregate data. For one thing, if R&D is capitalized rather than expensed, then profits have to be increased by the same amount. And then some assumptions have to be made about the depreciation rate of intellectual property, resulting in a pseudo asset in the aggregate statistics that is not reported on any company’s books. I’m not sure what the best solution is. [1]

Fortunately, companies do report R&D as a separate component of expenses, so it is possible to use either definition of investment with firm-level data from Compustat. The following figure shows the share of total corporate investment, under each definition, of a group of six high-tech industries: drugs; computers; communications equipment; medical equipment; scientific equipment other electronic goods; and software and data processing. [2]

hitech

As you can see, R&D spending is very important for these industries; for the past 20 years, it has consistently exceed investment spending as traditionally defined. Using the older, narrow definition, these industries account for no greater share of investment in the US than they did 50 years ago; with R&D included, their share of total investment has more than doubled. But both measures show the high-tech share of investment peaking in the late 1990s; for the past 15 years, it has steadily declined.

Obviously, this doesn’t tell us anything about why investment has stalled in these industries since the end of the tech boom. But it does at least suggest some problems with a simple story in which financial markets reallocate capital from old industries to newer ones.

The next figure breaks out the industries within the high-tech group. Here we’re looking at the broad measure of investment, which incudes R&D.

techsectors

As you can see, the decline in high-tech investment is consistent across the high-tech sectors. While the exact timing varies, in the 1980s and 1990s all of these sectors saw a rising share of investment; in the past 15 years, none have. [3]  So we can safely say: In the universe of publicly traded corporations, the sectors we think would benefit from reallocation of capital were indeed investing heavily in the decades before 2000; but since then, they have not been. The decline in investment spending in the pharmaceutical industry — which, again, includes R&D spending on new drugs — is especially striking.

Where has investment been growing, then? Here:

hitech_oil

The red lines show broad and narrow investment for oil and gas and related industries — SICs 101-138, 291-299, and 492. Either way you measure investment, the increase over the past 15 years has dwarfed that in any other industry. Note that oil and gas, unlike the high-tech industries, is less R&D-intensive than the corporate sector as a whole. Looking only at plant and equipment, fossil fuels account for 40 percent of total corporate investment; by this measure, in some recent years, investment here has exceeded that of all manufacturing together. With R&D included, by contrast, fossil fuels account for “only” a third of US investment.

In the next post, I’ll look at the other key financial flows — cashflow from operations, shareholder payouts, and borrowing — for the tech industries, compared with corporations in general. As we’ll see, while at one point payouts were lower in these industries than elsewhere, over the past 15 years they have increased even faster than for publicly traded corporations as a whole. In the meantime:

Very few of the people talking about the dynamic way American financial markets reallocate capital have, I suspect, a clear idea of the actual reallocation that is taking place. Save for another time the question of whether this huge growth in fossil fuel extraction is a good thing for the United States or the world. (Spoiler: It’s very bad.) I think it’s hard to argue with a straight face that shareholder payouts at Apple or GE are what’s funding fracking in North Dakota.

 

[1] This seems to be part of a larger phenomenon of the official statistical agencies being pulled into the orbit of economic theory and away from business accounting practices. It seems to me that allowing the official statistics to drift away from the statistics actually used by households and businesses creates all kinds of problems.

[2] Specifically, it is SICs 83, 357, 366, 367, 382, 384, and 737. I took this specific definition from Brown, Fazzari and Petersen. It seems to be standard in the literature.

[3] Since you are probably wondering: About two-thirds of that spike in software investment around 1970 is IBM, with Xerox and Unisys accounting for most of the rest.

Mixed Messages from The Fed and the Bond Markets

It’s conventional opinion that the Fed will begin to raise its policy rate by the end of 2015, and continue raising rates for the next couple years. In the FT, Larry Summers argues that this will be a mistake. And he observes that bond markets don’t seem to share the conventional wisdom: “Long term bond markets are telling us that real interest rates are expected to be close to zero in the industrialised world over the next decade.”

The Summers column inspired me to take a look at bond prices and flesh out this observation. It is straightforward to calculate how much the value of a bond change in response to a change in interest rates. So by looking at the current yields on bonds of different maturities, we can see what expectations of future rate changes are consistent with profit-maximizing behavior in bond markets. [1]

The following changes shows the yields of Treasury bonds of various maturities, and the capital loss for each bond from a one-point rise in yield over the next year. (All values are in percentage points.)

Maturity Yield as of July 2015 Value Change from 1-Point Rise
30 year 3.07 -17.1
20 year 2.77 -13.9
10 year 2.32 -8.4
5 year 1.63 -4.6
1 year 0.30 -0.0

So if the 30-year rate rises by one point over the next year, someone who just bought a 30-year bond will suffer a 17 percent capital loss.

It’s clear from these numbers that Summers is right. If, over the next couple of years, interest rates were to “normalize” to their mid-90s levels (about 3 points higher than today), long bonds would lose half their value. Obviously, no one would hold bonds at today’s yields if they thought there was an appreciable chance of that happening.

We can be more precise. For any pair of bonds, the ratio of the difference in yields to the difference in capital losses from a rate increase, is a measure of the probability assigned by market participants to that increase. For example, purchasing a 20-year bond rather than a 30-year bond means giving up 0.3 percentage points of yield over the next year, in return for losing only 14 percent rather than 17 percent if there’s a general 1-point increase in rates. Whether that looks like a good or bad tradeoff will depend on how you think rates are likely to change.

For any pair of bonds, we can calculate the change in interest rates (across the whole yield curve) that would keep the overall return just equal between them. Using the average yields for July, we get:

30-year vs 20-year: +0.094%

30-year vs. 10-year: +0.086%

30-year vs. 5-year: +0.115%

20-year vs. 10-year +0.082%

20-year vs. 5 year: + 0.082%

Treasury bonds seem to be priced consistent with an expected tenth of a percent or so increase in interest rates over the next year.

In other words: If you buy a 30 year bond rather than a 20-year one, or a 20-year rather than 10-year, you will get a higher interest rate. But if it turns out that market rates rise by about 0.1 percentage points (10 basis points) over the next year, the greater capital losses on longer bonds will just balance their higher yields. So if you believe that interest rates in general will be about 10 basis points higher a year from now than they are now, you should be just indifferent between purchasing Treasuries of different maturities. If you expect a larger increase in rates, long bonds will look overpriced and you’ll want to sell them; if you expect a smaller increase in rates than this, or a decrease, then long bonds will look cheap to you and you’ll want to buy them. [2]

A couple of things to take from this.

First, there is the familiar Keynesian point about the liquidity trap. When long rates are low, even a modest increase implies very large capital losses for holders of long bonds. Fear of these losses can set a floor on long rates well above prevailing short rates. This, and not the zero lower bound per se, is the “liquidity trap” described in The General Theory.

Second,  compare the implied forecast of a tenth of a point increase in rates implied by today’s bond prices, to the forecasts in the FOMC dot plot. The median member of the FOMC expects an increase of more than half a point this year, 2 points by the end of 2016, and 3 points by the end of 2017. So policymakers at the Fed are predicting a pace of rate increases more than ten times faster than what seems to be incorporated into bond prices.

FOMC dotplot

If the whole rate structure moves in line with the FOMC forecasts, the next few years will see the biggest losses in bond markets since the 1970s. Yet investors are still holding bonds at what are historically very low yields. Evidently either bond market participants do not believe that Fed will do what it says it will, or they don’t believe that changes in policy rate will have any noticeable effect on longer rates.

And note: The belief that long rates unlikely to change much, may itself prevent them from changing much. Remember, for a 30-year bond currently yielding 3 percent, a one point change in the prevailing interest rate leads to a 17 point capital loss (or gain, in the case of a fall in rates). So if you have even a moderately strong belief that 3 percent is the most likely or “normal” yield for this bond, you will sell or buy quickly when rates depart much from this. Which will prevent such departures from happening, and validate beliefs about the normal rate. So we shouldn’t necessarily expect to see the whole rate structure moving up and down together. Rather, long rates will stay near a conventional level (or at least above a conventional floor) regardless of what happens to short rates.

This suggests that we shouldn’t really be thinking about a uniform shift in the rate structure. (Though it’s still worth analyzing that case as a baseline.) Rather, an increase in rates, if it happens, will most likely be confined to the short end. The structure of bond yields seems to fit this prediction. As noted above, the yield curve at longer maturities implies an expected rate increase on the order of 10 basis points (a tenth of a percentage point), the 10-year vs 5 year, 10 year vs 1 year, and 5 year vs 1 year bonds imply epected increases of 18, 24 and 29 basis points respectively. This is still much less than dot plot, but it is consistent with idea that bond markets expect any rate increase to be limited to shorter maturities.

In short: Current prices of long bonds imply that market participants are confident that rates will not rise substantially over the next few years. Conventional wisdom, shared by policymakers at the Fed, says that they will. The Fed is looking at a two point increase over the next year and half, while bond rates imply that it will take twenty years. So either Fed won’t do what it says it will, or it won’t affect long rates, or bondholders will get a very unpleasant surprise. The only way everyone can be right is if trnasmission from policy rate to long rates is very slow — which would make the policy rate an unsuitable tool for countercyclical policy.

This last point is something that has always puzzled me about standard accounts of monetary policy. The central bank is supposed to be offsetting cyclical fluctuations by altering the terms of loan contracts whose maturities are much longer than typical business cycle frequencies. Corporate bonds average about 10 years, home mortgages, home mortgages of course close to 30. (And housing seems to be the sector most sensitive to policy changes.) So either policy depends on systematically misleading market participants, to convince them that cyclical rate changes are permanent; or else monetary policy must work in some completely different way than the familiar interest rate channel.

 

 

[1] In the real world things are more complicated, both because the structure of expectations is more complex than a scalar expected rate change over the next period, and because bonds are priced for their liquidity as well as for their return.

[2] I should insist in passing, for my brothers and sisters in heterodoxy, that this sort of analysis does not depend in any way on “consumers” or “households” optimizing anything, or on rational expectations. We are talking about real markets composed of profit-seeking investors, who certainly hold some expectations about the future even if they are mistaken.