Kevin Warsh recently coauthored a piece in the WSJ suggesting that lower interest rates actually penalize business investment, contrary to common knowledge and mainstream theory. The specific argument itself is wrong, at least by itself. Even if lower interest rates did somehow encourage buybacks, that’s cash ultimately returned and theoretically invested where it’s most needed. Now this might not increase business investment, but that’s another argument entirely. Brad DeLong isn’t happy and Larry Summers agrees, though is open to any logic about why this might be the case. 

I’ve vaguely thought about this before, and think it’s worthwhile to think about the assumptions under which lower short term rates might reduce current investment. Even accepting this is most likely not the case, the process of figuring out how something might happen at least provides a set of empirical projects researchers might pursue in determining this question. To the extent these arguments are reasonable they also provide a useful counterpoint to conventional wisdom.

Note the point here isn’t to argue in favor of lower or higher rates – indeed answering this question has little bearing on that topic, without further assumption about the quality of the business investment itself. We’re also not trying to tell ad hoc stories – for example how, perhaps, low interest rates might signal uncertainty about the economy, reducing investment. Rather, the interesting if impertinent question is the existence of any obvious theme or set of incentives that create a world where interest rates are positively correlated with investment.

I have four suggestions.

True versus observed investment

The first point I would make is regardless of true investment, lower interest rates probably tend to positively bias the observed investment. This doesn’t move the ultimate question in one direction or the other, but raises questions about any data used to justify a particular position. My intuition behind this is simple – though possibly incorrect. Consider a firm that borrows from a bank to invest in what turns out to be a bad project. In theory managers learn about a loss and recognize it immediately. But in practice it’s hard to know when the economic fundamentals of an investment fail to match their invested value – that is fail to generate a positive return net of a capital charge (in this case the interest rate).

An obvious example to this effect might be Japanese banks that can delay recognition of economic loss simply because they can return the cost of capital to investors – who expected the project to work out – by rolling over inexpensive debt. Eventually, of course, all accounts must be settled and someone won’t be happy. You might think of this as an illusory double-counting mechanism that is particularly prevalent when the cost of doing nothing is low.

This requires nuance about the constitution of ‘business investment’. We must in some sense think about the true ex post value of the investment – otherwise it wouldn’t matter whether business investment meant cash spent on a cup of coffee or building a new tower. Of course this isn’t something we can know for sure in real time, but a simple effect of investment cycles that we should note when thinking about interest rates. The important point here is this won’t get out of hand in a world with high interest rates.

Agency dilemmas and a growing gap between volatility to manager and volatility to investor

Another story might involve agency problems between owners and managers. Investments are made in expected value – with some compensation for risk. Investors can diversify firm or project risk, whereas managers cannot. There is an enormous literature discussing and debating manager risk-aversion and its effect on investment though there is an important wedge when individual firms can commit to a limited number of projects, unable to diversify risk and thereby failing to invest in positive expected value projects that investors like.

Low interest rates affect this wedge. If the marginal project that becomes profitable at a slightly lower rate is one with high variance, individual firms may not be compelled to invest – despite every economic argument that the opportunity cost of holding money is now higher. This is particularly true when projects are not traded and limited to a small number of firms. (Do you know about various potential investments a Wisconsin waste management company might make to decrease the number of routes it has to make every morning and, if you did, would you have the capacity to purchase this investment and use it to the same effect?)

It might be – and I’m only theorizing potential assumptions, not claiming any to be practically true – that marginally profitable projects are increasingly risky for the individual firms that compete. But this wouldn’t be an outlandish claim, either. The discounted value of a project grows dramatically faster as interest rates fall. Small errors in judgement have larger feedback into economic calculations, amplifying the gap between investments that are made and should be made. There’s evidence to back this story. Where interest rate have fallen to zero, corporate executives still demand a 10% hurdle rate. Indeed lower interest rates change the opportunity cost for investors, not managers. This shouldn’t matter, but maybe agency dilemmas are significant.

This matters only because price changes manifest in both an income and substitution effect. If the income effect of lower interest rates, a smaller supply of investable capital, works as predicted at low interest rates, but the substitution effect is increasingly challenged by other factors, this change might reduce business investment.

Attenuation of relative debt preference

Also note the general agreement that the tax code privileges debt. There’s the explicit tax shield, along with various other interest deductions that bias towards lending more and borrowing more (with an indeterminate effect on price). Some of these are restricted to interest payments, excluding settling the principal. Lower interest rates would tend to reduce the debt bias. That is they might increase overall debt, but reduce the divergence vis-a-vis equity in a world where both are treated equally.

High leverage industries tend to be more capital-intensive, with large outlays for business investment. Airlines are a good example. If the relative bias changes with interest rates, and investors privilege industries that are typically equity-financed – again, keep in mind the distinction between change in bias and change in actual quantities – business investment might decrease.

Note this doesn’t reduce ex post returns – for example software firms have been able to produce remarkable returns without much invested capital. Indeed investing much in an industry that returns little isn’t always better than investing less in an industry with outstanding potential. This is a point of stipulation in the secular stagnation argument, and is potentially very true.

Permanent patience

Finally, I think we should distinguish between a dramatic fall in short-term rates to encourage investment in a recession to prolonged low rates because of a lower bound. Low rates now, and commitments to lower rates in the future where there isn’t an obvious ‘return to normal’, substantially decrease the urgency of any capital decision on the technical principle of ‘well, what else are you gonna do with your money’. This sort of flies in the face of what a discount rate even means, but your life period loss function for delayed investment will certainly be greater when the penalty from impatient investors is higher. Furthermore, if low interest rates are associated with comfortable liquidity conditions the cost of waiting may not be high.

Distinguish between the average investment (which may be amazing, and does not matter) and the marginal investment (which may be mediocre, and definitely matters). This patience and a slight risk aversion can’t be explained away by simply noting ex post fantastic investments that were risky and did turn out well, as much as noting that the incentive to make the many marginally profitable investments might be lower today for reasons outlined above.

None of this is to say that lower interest rates reduce investment, as much as to propose a pathway through which that argument might be made.

Some people argue that inflation causes high tax rates. In the obvious – and obviously correct – sense that taxes are progressive, resulting in bracket creep. But also in the more insidious sense that asset appreciation through inflation creates a nominal tax burden that must be paid out of a base of no real income. This is a point forwarded by the Tax Foundation, prominent economists, and just about every entry on the search entry “capital gains tax inflation”. These arguments all describe how inflation substantially increased the real tax burden between 1955 and 1990. Unfortunately, none of it is as straightforward as the writers make it out to be.

Let’s make a few assumptions. At the margin all taxes are proportional to value, that is no lump-sum levies. Assume there is no bracket creep, and that marginal government spending is restricted to transfer payments. The role of taxes in this world is, then, limited to assigning the distribution of income among various groups. The argument, then, is tantamount to claiming that the “inflation tax” perverts the tax system to skew post-tax income away from capitalists towards everyone else.

When you think of it this way, inflation doesn’t matter. If I own a security that appreciates $10 through inflation, generating a tax burden of $2 the natural reaction might be that the government is creating a real tax burden out of no nominal income. An “infinite” tax rate. Except inflation affects all future cash flows, including income from labor, which also increases in the state with inflation. If inflation affects most assets evenly over the long-run, not charging a tax on nominal gains would increase the relative distribution of income accruing to capital owners, necessarily at the expense of everyone else.

Another way to think of it is that the government has real liabilities – workers, indexed transfer payments, and material costs will all eventually rise with inflation – and to finance the larger nominal outlay it must also receive a larger nominal income from each group. To the extent taxes are levied as a percent of income this does not change the final distribution between capitalist and worker.

The truth of this simple claim can be noticed by taking the infinite tax argument to its logical conclusion. Suppose we have really high inflation for a while and taxed only real gains – out of concern for the Tax Foundation. If the stock of capital increased from $1 to $10, without any real gains, the capitalist faces no tax burden. Except everyone else – rentiers, workers, lenders – does face the nominal burden, and pay more in taxes. This naturally results in a capital subsidy.

One might argue that really we should tax only real gains on both capital and labor. This, of course, isn’t the argument that everyone cited above is making as they restrict the argument to an “infinite tax on capital” and believe there is something special about the nominal appreciation that makes capital different. Also note this would mean there was an “infinite tax” on labor, making the claim that there is some net inflation tax (i.e. change in distribution due to inflation) very likely false. More importantly – supposing the relative distance of various brackets were indexed – indexing real income on capital and labor is a really challenging strategy.

For one there’s a lot of error in these measurements, creating a political bias to understate inflation figures to juice tax revenue. It also assumes there is some measurable, true inflation ignoring the complex heterogeneity of various liability structures. Of course, ultimately, if we did figure out how to get around these problems and taxed everyone on t – 10 dollar values, the net distribution would change none at all since all income would be modulated by the same factor.

In reality, of course, some of the assumptions that led to this conclusion aren’t true. Inflation doesn’t affect everyone uniformly – at least not over any fixed period of time – and each individual has different preference for changing prices since the goods market may react more sensitively in one industry than the other, hurting some people more.

It might be worthwhile to study these assumptions, and figure out cases where higher inflation changes the distribution away from capitalists purely through the nominal tax rate. But the sort of work you saw from the Tax Foundation, apparently detailed, wonky, and evidence-oriented is misleading. It is either tautologically true saying absolutely nothing (inflation means bigger numbers) to certainly false (that inflation changes the net distribution without further assumption).

This isn’t particularly tricky to see, and is simply a consequence of efficient markets. If present value is the weighted sum of future cash flows, it makes no sense to argue that inflation affects the two sides of the equality any differently.

A few weeks ago I sent a good, also Indian friend of mine a text: “Indians kill it” – linking to a Financial Times article describing the ways in which Indian-Americans have become, by many counts, the most prosperous ethnic group in the country. And, objectively, Indians do “kill it”. Across an array of socioeconomic statistics, Indian success is basically unparalleled. Filipino, Taiwanese, and Chinese emigre are similarly prosperous among a subset of each of these indicators, leading to a cultural obsession among the chattering classes of, say, an “Asian Advantage”. (And this from an otherwise fantastic journalist who understands the deep cultural nuances that pervade American inequities.) This topic is a perennial subject in some corners of the country (and now we have a new book and coverage from a Narendra Modi visit to get back to where we left off).

Plenty of people have argued against this advantage and the contour of the criticism is usually something along the lines of “selection bias” or “why are all these countries so poor if their culture is so great”. Obviously selection bias by itself is both a weak and unilluminating claim (Mongolian Americans are poor, but surely selection must have played a role, there, too) So let me be clear upfront – you would need to be an idiot to argue that culture does not matter. Obviously something that governs the people you cherish, the skills you value, and the jobs you consider meaningful will affect income, education, and marriage. 

Let’s stipulate a few points so that we’re on the same page:

  1. Asians as a group are not really that economically successful. There’s a lot of variance within. Indians and Filipinos earn around $100,000. Koreans earn around $50,000. “Asians” as a category earn on average somewhere right in between. So if income, or something derivative like disproportionate representation in high-powered occupations, is your focus of concern, talking about the “Asian advantage” doesn’t make much sense. If cultural factors like marriage or educational attainment are your focus of concern, you’re missing the point (more below).
  2. There are four relevant, often interactive, factors:
    1. Cultural. Something innate about the values, behaviors, and norms within an ethnic group that generates superior socioeconomic outcomes.
    2. Structural. The ability to apply cultural values to great profit in countries with the right economic design (perhaps free markets, focus on cutthroat meritocracy, and a national comparative advantage in skill-biased industries).
    3. Institutional. A set of policy maneuvers that specifically biases emigre of a certain group, and specifically unreflective of productive gains from structural factors.
    4. Selective. Constraints in the home country and America resulting in the emigration of some elite subset, not indicative of any particular cultural superiority, as much as privileged upbringing.
  3. Successful Asian subpopulations are more likely to be foreign born. Only 75% of Asians are foreign born, compared to 90% of Indians. A majority of foreign born Asians don’t speak English whereas Indian emigre universally speak English.

Cultural, structural, and selective factors receive disproportionate coverage at the cost of attention towards very specific institutional policies that help certain groups. To make this point, it’s important to first note that Asian immigrants, when they first arrive, tend to fall in a category I can best describe as “privileged poor”. They are, in every real sense, dirt poor. Incomes or family wealth back home, to the extent it exists, is meaningless at US prices. They have very little economic or social security. Yet, they have none of the despondence prevalent among native groups with similar economic poverty. They are hopeful, and work hard to learn very marketable skills.

This deep economic fragility rarely coincides with such bright prospects among native groups, creating situations where someone is in grad school or working in a scientific profession with the same general security of a seasonal worker who can’t hold a steady job. This is strictly an institutional insecurity. Grad students are often on scholarships that have strict requirements of academic performance, and early-stage workers have their entire residency and career tied to the whims of a single employer.

So yes, the very likely threat of getting kicked out of the country because you want to change jobs, can’t afford permanent residence, or let your grades fall a little too far is, astonishingly, going make you work really hard and save a lot of money. What’s not clear whether the slight improvement in educational attainment and savings rate is worth the forced insecurity that necessitates it. It’s pretty well documented that low-income scholarship kids tend to work harder than their well-heeled peers at state-colleges. I don’t see any New Yorker writers pondering about the cultural advantages of lower-class Americans from middle Appalachia. This is pretty basic economics.

New immigrants also have weaker social networks to fall back on in times of stress, and there’s almost no existing property or wealth to help. Divorce tends to be easier when parents, friends, and a large community of neighbors can help with the process and when there’s less doubt about future citizenship prospects. Divorce rates in rural India are low. This is a sign of many things, but superior cultural attitudes is not one. Tangentially, at least among new Indian immigrants many marriages are at least quasi-arranged. The entire setup results in a more stable situation, though not necessarily a more desirable one.

Of course institutional factors go further still, especially for the few Asian ethnic groups that dramatically outperform their white counterparts. If there is a certain occupation, a certain trade association that regulates that occupation, a small quota for immigrants from a certain country that is, perhaps, really large and employers within this industry, for argument’s sake, want the most valuable people to fill their allocated spots then, well, it’s not exactly surprising that a disproportionate number of immigrants from said country will be employed in this industry, and earn astonishingly high wages. Filling in the blanks of the right occupation and country here are left as an exercise for the reader.

This gets to the problem of the entire argument. Very smart people want to argue that there’s something we can learn from successful immigrant group, and that “we” [white Americans] can emulate certain patterns and norms, as if White culture is some monolithic entity. This argument tends to be completely divorced from the economic constraints that require certain behaviors. It’s somewhat like arguing requiring drivers to have a trident attached to the steering wheel creates safer roads and is therefore a reasonable policy choice.

But it also assumes culture is something we can construct and modify. The reality is one is simply not going to achieve extreme marriage stability without penalizing divorce with some social or financial stigma. Liberals should accept this – are blacks culturally inferior because they have extremely low marital stability? Conservatives should accept this – do you buy the Douthat argument that the Ivy League elite prescribe a fake sense of sexual and social liberation while holding themselves to a relatively strict code of social conduct?

This is all on top of the fact that there’s basically no obvious evidence for cultural drivers of success at the extremes. Bangladeshi and Pakistani Americans aren’t doing that well (earning a little below and a little above the White median respectively). Nor are British Indians, where Indians are 50% more likely to fall under the poverty line than white natives. Of course Indians have a much longer emigration history to the UK (and, therefore, are less disproportionately foreign-born) and tend to be less educated. This says everything about selection and nothing about culture. Surely structural factors might come into play, and the “smart money” seems to be at (there’s something special about Asians and the way America operates).

But this can hardly excuse the absurd difference in income between various South Asian groups. One might suspect religion is a key differentiating factor, but this ignores that a) many of the important religious differences should be moderated in educated groups that move abroad, but come from similar cultural histories and that b) 51% of Indian Americans claim Hindu heritage compared to almost 80% of Indian natives.

Occam’s razor suggests a simple explanation. India has well over 1 billion people, and the American visa quota system does not proportionately allocate new visas by population of emigrant country. Therefore, even if the distribution of immigrants is independent of country and culture, the limited number of Indians that come will always be more successful.

And then we have the case of Taiwanese or Filipino immigrants. The former is really too small a group to consider, and the latter benefits, again, from huge institutional benefits remnant of America’s little imperial experiment. In fact the AMA openly admits that Filipinos have a disproportionately easy time coming receiving licenses in the US due to American influence of the Filipino educational system.

This basically boils down to a heterogenous group of people who have some similar characteristics – focus on education, family, hard work, high savings rate, etc. – and a surprising dispersion in economic outcomes, especially given the universal focus on things the American cultural elite consider important for upward mobility. The important outliers can be characterized as oddities not emerging from any cultural superiority or the structural ability to capitalize on the meritocratic, skill-biased American market as much as very specific policy incentives and peculiarities that coerce an outcome, almost to the point of tautology given a basic acceptance of supply and demand.

People keep writing books on the topic. Asian parents love talking about the importance of hard work and one of the few things Amy Chua gets right in her book on the topic of Asian success is that they do, indeed, foster a superiority complex.

Perhaps it’s time for white Americans to do the same. They seem to have accomplished economic parity with a large subset of Asians who work much harder, save more diligently, and embrace every aspect of their lives with greater discipline and deliberation. None of this is to praise or criticize any cultural traits as much as to get people to move on to more interesting, more meaningful, and more actionable items of debate.

Comparing income and educational attainment and whatever other factor that magazine editors fancy is a futile procedure. Indian and Filipino Americans have a mid-career household salary rivaling graduates of Ivy League universities. To the extent we are talking about arbitrary measures of socioeconomic success, wouldn’t it be a little absurd to use that statistic – devoid of any further context – to claim that this group is more successful than a group that the same people would define as ultimate socioeconomic success?

Of course, this entire exercise is the pointless result of cherry-picked statistics. Indian household income is high, but per capita income falls below that of many northern European immigrants. Chinese, Korean, Japanese, and pretty much every other Asian group falls well, well below even the American average. European immigrants have greater financial security almost by definition of their country of birth. They also have a much easier time, given arbitrary quota privileges, getting visas and residency. And so single-income households are more common. Does anyone want to write an article about the cultural disadvantages of soccer moms in upper-middle class America?

Nor does this entire have much respect for a mean-variance tradeoff. Indians and Filipinos, for all their incredible success in upper-middle class occupations, are not particularly well-represented in elite politics, finance, media, entertainment, sports, or journalism. Jews, for example, are poorer on average but more likely to have incomes above $100,000 (and certainly much more likely to have incomes above $1,000,000). But they’re also much more likely to earn less than $30,000.

So these things really are complex. The conversation, as I’ve written before, is devoid of facts and consideration of obvious, but boring explanations. This may have to do with the fact that its primary participants seem to be Asians who love talking about how successful their model is (have you read Chua’s atrocious writing on the subject?) and elite media observers who for some reason have a keen interest in engineering a certain cultural pattern as a salve the problems middle America faces.

Yet for all this hubbub, American kids have always sucked at the PISA test, divorce frequently, have noticeably poor savings habits, and yet always succeed at the highest levels of innovation, technology, and finance. Astonishingly, children of educated, caring, devoted parents with a foreign government that deeply subsidized scientific education of this privileged lot seem to do better than children of unnecessarily incarcerated crack dealers and single-mothers who receive barely enough welfare to put food on the table. Can we please kill this culture zombie, or at least induce it into a coma until these obviously more important institutional factors are fixed?

A lot of smart people got upset that John Paulson, the guy who made a fortune betting against subprime mortgages and probably lost it all on gold, gave $400 million for Harvard to start an engineering school. The arguments were standard – Harvard is an obscenely wealthy school that by and large caters to kids from obscenely privileged backgrounds. Surely the marginal value of $400 million dollars – indeed, $400 million dollars that’s not evening being spent – would be much higher in the hands of African children.

Except that’s exactly why it’s one of the best gifts to society. The many defenses (and there were many) that focused on research and technology investment miss the point. They’re correct, but that’s not where the money is (so to speak). Let’s talk about why we respect investors like Warren Buffet. Buffet puts in a lot of capital to identify companies that are undervalued and need money, provides operational support to bring them to their potential, and makes a profit. In the process, of course, society as a whole is ever so slightly better off, with that capital producing superior societal returns than the next best opportunity (the opportunity cost, or discount rate).

This doesn’t always happen. Investors are wrong. But for the good ones this is how it basically works. But imagine if Buffet reinvested the returns, and promised to keep reinvesting them forever.

That’s basically what the Harvard Company is. Sure there’s a payout, on the order of 5%, to bankroll the universities operations, but it’s principal (and returns beyond the necessary payout) are permanent.

Go back to what investment is. Before money. When A does work for B, in return he gets some claim on B’s future work. Now since C owes B some work, B asks C to settle his debt with A who, instead, redirects C to D since D needs help building something better. Now A isn’t altruistic. Eventually he’ll reap the rewards of his patience. But imagine he never did that.

Of course, this line of reasoning isn’t anything new for economists. It’s why they advocate (at times with dubious reasoning) preferential taxation on capital gains.

But the argument here is so much more compelling. Ultimately, I’m going to spend my capital gains (economists just want to reward me for being patient). Even if I redeem it in 10,000 years, it doesn’t change the calculus (I’d just redeem a lot of capital). But on an infinite timeline – which is what Harvard’s endowment is – not only is Paulson’s gift financing Harvard’s operations (which do include research), he’s permanently financing millions of business activities around the country which have all been better than the alternative – the endowment beats the S&P500 on an annualized basis by about 3%.

None of this is to say giving to Harvard is superior philanthropy than buying bed nets for African children. But for one, it actually scales (an organization with an operating budget of $3 million isn’t exactly going to be able to absorb a $400 million gift). It doesn’t really meet the “most need” criteria, but the broad social good brought by financing superior businesses and ideas is intangibly valuable as well.

There are a lot of problems with the way university finances work. For one, the land they’re sitting on and the payout from the endowment they consume shouldn’t be tax free, for the reasons many critics cite. Education is a social good, but (for understandable reasons) Harvard’s enrollment is far outweighed by the capacity of Harvard’s enrollment (which the the value of the institution and hence its tax shield). Instead, Harvard should be required to pay taxes on the land it sits on, as well as the portion of the endowment it commits to its operating budget, with a deduction for every student it enrolls.

This isn’t ending the debate. But if we want to engage in the conversation of telling other people what to do with their money (and hey, it’s fun) let’s at least do it intelligently. I’d love to see the pros and cons of the value added to society from a permanent investment in its potential ideas compared to, say, furnishing Givewell ideas (taking into account scale, liquidity, general welfare, and distributive welfare). Let’s not make it about privileged Harvard kids and poor African babies.

It’s a common proposition that prevailing market valuations are unreflective of underlying fundamentals. Some say that we’re living through an outright bubble and are in for a correction, and others that markets will be lethargic and stagnant over the next few months, without much room to grow at historical rates.

On the other hand, extremely low interest rates – not just in Treasuries, but safe(r) assets in general – suggest anxiety about future growth. If growth potential really is so fantastic, it doesn’t make sense to crowd into risk-free assets that have almost no claim on that growth. One explanation could be a decline in the risk premium, which militates in favor of the “lethargic and stagnant” view – that we’ve rerated valuations with a lower discount rate, but shouldn’t expect exceptional growth.

A decline in the risk premium would suggest a host of projects that were otherwise unprofitable become feasible, resulting in increased business investment across the board. This may be the case (and we can’t examine the counterfactual) but, somehow, this doesn’t sit well with the prevalence of cash and highly liquid assets piling up on corporate balance sheets.

One simple (if unsatisfying) explanation might be that markets aren’t efficient. There are two types of inefficient. The sort that persists temporarily, and that is bidded away as investors and arbitrageurs profit on the discrepancy, and the sort for which there isn’t an obvious correcting mechanism. The latter, I would argue, is rarer but one can definitely contrive explanations that make sense of the situation.

A possibility that I find appealing stems from a simple principal-agent dilemma. The risk profile for high-level managers (who are – as a baseline – compensated extremely well) aggressively pursuing projects that become viable on the margin is asymmetric. If lots of cash is lost, the manager risks his job. If it succeeds, given that it is a marginal investment, the effect on his bonus would be minimal. The literature on CEO salaries outlines incredible bonuses as an incentive to take big risks – but big risks with big payoffs (and big losses), not necessarily those that are merely better than nothing.

There is some real evidence that this sort of managerial kerfuffle is real:

Importantly, the hurdle rates are often left unchanged for years, even when interest rates drop. A paper included in the latest Reserve Bank Bulletin reports that some hurdle rates have not changed in years.

They were set when interest rates were “far higher than they are today”.

The bank’s findings match those of a survey by Deloitte that found that two-thirds of corporations recalculate their hurdle rate less frequently than they recalculate their cost of capital. Nearly half change their hurdle rate “very rarely”.

Among the reasons businesses give are that changes to the rate might “send the wrong message to staff proposing projects”. Another reason is that changes in the hurdle rate “require board approval”.  Or that keeping the rate high protects against the type of economic uncertainty likely to be present when interest rates are low.

One could argue that this risk aversion should befall investors and managers. Unfortunately, high-level managers have a much less diversified implicit portfolio (including the returns from their labor) than investors, and cannot diversify the idiosyncratic risk that emerges from projects that are profitable on the margin (wherever EV is all the investor would care about).

This outlines at least one possible case of “persistent inefficiency”. You might even argue that inefficiency is cyclical – spare me a few moments of speculative rambling before we get to real data. In a sense the “market” is like a public good. We put into it by performing due diligence on stocks, commodities, and countries to arbitrage any mispricing and more efficiently allocate capital. We take from it by holding its value as a given and using models to infer useful information. Implicit volatility. Inflation expectations. Future price probability distributions.

There’s a tension between the two that becomes especially pronounced when one takes from one pond and puts it into another pond. If you’re a fundamental investor discounting future cash flows, you might take the forward Treasury curve as a starting point to measuring the WACC. (In fact, unless Janet Yellen tells you what she’s up to, you don’t have much of a choice but to take the forward yield curve as a given).

There is some “fundamental” work that goes into generating the forward curve which currently underprices the Fed’s dot plot. The market is telling you that certain economic and geopolitical gravities are conspiring against the Fed’s chosen choice of action – to increase interest rates. It’s come to this conclusion under the guidance of thousands of macro investors who have studied these forces to the extent they can.

Then your value investors are taking this work and applying it to their valuations of individual companies. If the market is wrong, and the Fed is right, the discounted value of S&P cash flows would be lower than valuations imply. But David Einhorn and George Soros do very different things and, in a vague sense, rely on each other for their fundamental work.

This doesn’t really solve our problem. If markets are underpricing the Fed because they think its optimistic about wage growth and international stability, this would be reflected in lower earnings for American companies and be a “short equities, long bonds” moment.

But maybe there isn’t a paradox. And maybe markets aren’t really overpricing anything. That, at least, is the theory I’d like to forward.

If, at a first pass, Price = Earnings/(Risk-free Rate + Risk Premium – Growth), then G_implied = D + RP – (E/P). To my surprise, the picture you get really isn’t that crazy.


The blue line is market implied earnings growth, and the red line is smoothed (realized) NGDP growth. I took a market risk premium of 4.5%. The two aren’t perfectly aligned for three key reasons:

  1. Primarily, the rough estimation I used is incorrect. We should discount by the forward curve instead of the spot rate. Today this would increase the implied growth rate but not meaningfully.
  2. Implied earnings growth is ex ante whereas NGDP growth is ex post. Markets aren’t always correct, there are always random, exogenous, and significant events (wars, draughts, etc.) that couldn’t be predicted before, after which the market corrects. This explains why the two series aren’t perfectly equal, but more in generally the same direction (after the information is released, the market revalues as necessary, changing the implied earnings growth).
  3. And implied earnings are a level above growth (of which profit is a component) because capital’s share of GDP is increasing (and profits, hence, grow faster than the economy itself).

Otherwise, as expected the two series track each other pretty well.

In the long-term, nominal earnings growth in the 4-5% range, or real growth in the 2-3% range does not seem absurd – especially if you believe an increasing share of the economy will accrue to capital owners. Those who argue that the Fed is keeping the market artificially inflated may want to look at how the curve shifts if the forward curve steepens a bit. We will likely be well into 2017 by the time interest rates are even 1%, and even a 1% increase in G_implied may not necessarily be absurd.

And that’s assuming the Fed’s decision isn’t endogenous to economic factors that influence earnings. Very likely, if the forward curve steepens, it is a result not of a negative supply shock (runaway inflation requiring an increase in interest rates, for example) as much as a positive demand shock, where better-than-expected global trade and growth result in an increase in earnings to maintain valuations at a higher interest rate.

This post was meant as a composite of a number of thoughts that I’ve been playing with recently, many of which deserve their own blog post. A particularly interesting tangent would consider the effect delayed IPOs and exclusion of public investors from lucrative returns has on this analysis. My initial guess is “not much”. While it is a deeply interesting, and important, trend, it doesn’t effect public valuations much. Most of Facebook and Uber’s returns might have been captured in the private market but the valuation is slash will be reflected in the public market. And that’s what we’re concerned about here, not returns specifically.

A constellation of seemingly contradictory events over the past five years – high unemployment, stagnant wages, anecdotal evidence of astounding technological growth, alleged robotization of everything, all ensconced in a grim uncertainty about the future – has brought about something incredible: prominent economists can now reasonably question the value of new technology.

This ranges from Martin Wolf’s generic essay questioning techno-optimists to a star-studded paper arguing that “under the right conditions, more supply produces […] less demand as the smart machines undermine their customer base”. Economists as prominent as Larry Summers and Paul Krugman have voiced their fears about robot-driven unemployment, and a general stagnation in living standards, if we don’t radically reassess our relationship with inequality and capital-driven growth.

I’m not here to necessarily disagree with any of these sentiments as much as explore their implications when taken to a logical conclusion. As a first pass, let’s start with a simple economy, consisting of capital owners and rentiers providing capital, high-skilled technology workers producing innovation, and low-skilled laborers producing commodity goods and services. Your production function in this world would look something like Y = A*F(K, B*G(K_r, L)) where F is of Cobb-Douglas form and G is any more general CES function, K is capital, L is labor, and K_r is innovation.

From one perspective, this is the crux of the problem. Go back to Piketty whose argument can be summarized as “when the capital stock increases by n%, the marginal return on capital decreases by less than n% and therefore K/Y increases”. Summers (in his review of the book) noted that no studies suggested that capital-labor elasticity, net of depreciation, was greater than 1. But once you have the slightly modified production function, what matters is the substitutability between K_r and L which, as I’ve written before, is governed as mu = 1 – 1/sigma where sigma is the classical elasticity of substitution between capital and labor, and mu is the robot-labor substitutability. As mu tends towards 1 (which, with improving technology, is not unreasonable) sigma grows without bound.

So we can stipulate that in the world of our robot overlords it isn’t unreasonable to expect that an unprecedented proportion of national output would accumulate to capital owners. But what does this say about living standards and employment? For one there will be a shift in employment among the unskilled laborers from highly substitutable commodities to services that benefit from human interaction (artisans coffeeshops, massage parlors, art vendors, street artists, and botanical gardeners for example).

And while there will be displacement within the unskilled population, they will – as a whole – very likely be much better than they were before. This statement isn’t the result of a careful empirical study as much as a reflection of certain fundamental, economic gravities. Let’s say robots replace workers in all manufactured goods and consumer durables production. The high standard of living in the United States isn’t derived from that employment itself as much as the collective result of that unemployment – a middle class that has multiple cars, microwaves, abundant food, television sets, carpets, furniture, and other staples of the modern home.

So the stagnationists need to further argue that the purchasing power for these products will somehow evaporate from the laboring masses. This is where it gets much harder. Because if millions of workers who once had the employment (and, therefore, the skills) to build said products and the products themselves clearly – within this population – there exists a supply and demand which, in equilibrium, creates prosperity for the masses.

As the largest consumer base in the world, this market also provides abundant profits (if at low margins) for the capitalists – the old fashioned kind who buy the old-school machines and factories necessary for the production of the goods thereof. So in this hypothetical world it will by definition be economically profitable for a capitalist to finance the sort of old-school capitalism that brought so much wealth to the middle-class. And this is as true globally as it is domestically (Chinese, assembly-line workers are  the victims of the sort of automation we’ve just described).

So here is a challenge for anyone who believes technology will result in both unemployment and a broad-based decline in living standards for the unskilled. Describe the precise mechanism in this world that will prevent the old equilibrium – that is both preferable both for the marginal capitalist and the working class as a whole – from reemerging. Or, if that isn’t your preferred interpretation of the economy, explain why supply or demand have somehow changed among this working class to make the question moot in the first case.

If you want an economic intuition for why this will be highly improbable, notice that this technology effectively means the marginal cost of production will fall to the commodity cost (which, itself when automated will, in the perpetual run, be the cost of recycling that unit of ore, or whatever). You would have to believe wages falling below this level at a mass-scale (something like a physical paralysis overcoming all that exist) for this explanation to remain reasonable.

This isn’t a model, it’s imprecise and unrigorous but is still a better interpretation of the world than some of the more formal models I’ve seen written on the subject. Take the Benzell, Kotlikoff, LaGarda, and Sachs paper which uses an OLG model with low and high tech workers to map certain equilibria in which technology decreases consumer purchasing power. Even if this is the best paper on the subject I’ve seen, the model is baked with not just incorrect assumptions but mechanics that are fundamentally divorced from the way technology operates. For example, mapping “code” as some sort of capital-like stock makes little sense. They stipulate that A_t = d * A_{t-1} z * H_{t-1} where A is the stock of code, d is the depreciation rate of code, z is the productivity of high skilled laborers and H is the quantity of high skilled laborers.

Expect code doesn’t depreciate it the way they model it as. The crux of the problem, they say, is:

Things change over time. As more durable code comes on line, the marginal productivity of code falls, making new code writers increasingly redundant.

Eventually the demand for code-writing high-tech workers is limited to those needed to cover the depreciation of legacy code, i.e., to retain, maintain, and update legacy code. The remaining high-tech workers find themselves working in the service sector. The upshot is that high-tech workers can end up potentially earning far less than in the initial steady state.

Their view of the world essentially requires one to believe that eventually we will have perfect code – code that never needs to be improved, rewritten, updated, redeployed, or debugged. There is some irony in 4 economists building such dramatic conclusions into their argument, but the problem here isn’t an assumption that code will eventually live on its own, updating itself, improving itself (presumably by using “machine learning”). It’s that what’s lacking from here is any imagination about what a world with perfect code would look like.

You would ave driverless cars moving everyone from point A to point B without a single accident. You might well have a revolutionized biotech industry that can run scalable tests virtually and suggest perfect medicine without any human work whatsoever. You might cure cancer and heart disease. You might identify markers of suicide and track and help those prone years before the fact.

Of course I’m just listing random, utopian ideas. None of these might happen, none of these might even be possible. The fact is we don’t know. If we knew it would already be here. This is why some startups work and others fail. And this is the problem with a lot of what Autor writes as well. To be able to divine the effect of technology on employment and have a say on the living standards thereof you need to make assumptions about what the world many years hence will look like. No one is capable of making these assumptions.

This is why Martin Wolf can write that the Roman can imagine the America of 1840 but neither of the two could imagine the America of 1940. Once you have technological growth, the logical conclusion is unknown. Economic models might have been contrived before, but they at least tried to abstract and understand dynamics that already existed, that we can fundamentally comprehend. You are kidding yourself if you think models that talk about code depreciation in a world where “the demand for code-writing high-tech workers is limited to those needed to cover the depreciation of legacy code, i.e., to retain, maintain, and update legacy code” are economics or science.

They are speculation at worst and thought-provoking philosophy at best. So file this talk about robot driven stagnation next to Nick Bostrom’s paper that we are all human simulations.

Let me end this with a rejoinder – that the technology-capital driven world will actually be freer, more equal, and more egalitarian than the one we live in today. Code and soft intellectual property in general is so much harder to restrain in the hands of the few than factories, machines and physical land (which, in the capitalist world is defended by the government’s monopoly on violence to anyone who threatens the sanctity of property). If you describe me a world where 3D printers replace workers, and magically one where these workers don’t have any of the fruits from the 3D printers, are you telling me the code that generated the item can really be locked up forever?

Technology monopolies, one might say. But, as I’ve argued before, many technology monopolies are actually contestable markets. Google makes a profit by advertising goods to the consumer, but it’s not clear what the consumer’s costs are. (This is something I would love to see debated and modeled in a more convincing and clarifying manner). If Google decided to charge even $500/yr for its search I would be happy to bet would be irrelevant in under 2 years.

The burden of proof on future technology seems to lie with those who believe growth will be more exclusive, rather than inclusive.

Interfluidity has an excellent post on Greece and I don’t wish to repeat what he’s written much more fluently than I could. But I want to use something he said as a segue into a deeper conversation about how we should think about Greece (and sovereign default in general):

I’ll end this ramble with a discussion of a fashionable view that in fact, the Greece crisis is not about the money at all, it is merely about creditors wresting political control from the concededly fucked up Greek state in order to make reforms in the long term interest of the Greek public. Anyone familiar with corporate finance ought to be immediately skeptical of this claim. A state cannot be liquidated. In bankruptcy terms, it must be reorganized. Corporate bankruptcy laws wisely limit the control rights of unconverted creditors during reorganizations, because creditors have no interest in maximizing the value of firm assets. Their claim to any upside is capped, their downside is large, they seek the fastest possible exit that makes them mostly whole. The incentives of impaired creditors are simply not well aligned with maximizing the long-term value of an enterprise.

There’s no getting around the fact that Greece needs debt relief. The IMF has made this clear in no uncertain terms. If the fundamental purpose of finance is to align asymmetric incentives in an efficient way, creating an environment of trust, and hence lending and development, the Greek dilemma is more than a failure of European integration. It’s a failure of finance itself.

Where Steve Randy Waldman channels his fury at the political failure of European authorities, Michael Pettis has an extraordinarily prescient essay – from February! – begging Europeans to pay attention to financial distress and poorly aligned incentives. You have two ways of doing this. You can either tell Greece that you won’t roll over its debt unless it engages in a series of politically unpalatable policies to secure your principal or you can recognize that success is shared and create a debt structure that reflects this mutual enterprise.

Quite simply, the Greek government should sell optionality on its prosperity. As much as countries are not corporations one of the purposes of Chapter 11 is to ensure that senior creditors do not force an inefficient liquidation on the entire corporate structure. For example, selling assets to meet financing requirements even if the company has a really good ten-year plan. Or, for example, forcing a degree of austerity that would wreck domestic agency to make your initial investments whole.

And whatever you think about fiscal policy, that’s exactly what this is. Whether you like Syriza or not, that is the democratically-elected government of Greece and hence its representative. And, therefore, by proposing a restructuring scheme that forces the other party into capital controls that asphyxiate domestic business you are partaking in precisely the form of liquidation that Chapter 11 seeks to avoid.

At least in the case of a distressed shipping company – or whatever – it’s possible to see why someone would want this. The number of senior creditors are small, the upside is capped, and the benefits to immediate liquidation are obvious. In the case of forcing Greece to make whole its current capital commitments the benefits are distributed across millions of European tax payers, the costs are concentrated among the Greeks, and that’s not even considering the spillovers of financial distress and turmoil generated by the plan.

And don’t kid yourself that the referendum changes things. A “no” vote only exacerbates the above and the “yes” vote seems to be the precise definition of “kicking the can”. As I’ve written before, if you eventually default (and Greece will, in some fashion or form, default) it will always have been better to default one day before after the fact.

Senior creditors are, when they cannot be made whole, given the option to buy equity (at what would be a discounted price relative to normal liquidity conditions). Some will sell these and write-off their losses, furnishing a lucrative industry in special situations investing. Regardless, creditors painfully recognize their losses, and move to align their incentives with the firm, gaining optionality in the process.

One obvious way to do this is to exchange a meaningful portion of the principal for GDP-indexed bonds. These have been discussed in detail elsewhere. It’s not clear that these are a bad idea, but it’s certainly not clear they’re a good idea, either – or the quickest and most obvious way to align European incentives. Argentina sold GDP-warrents in 2002 and investors were recognizing dramatic losses years after the fact (that’s not necessarily an indictment of the idea as much as that they are a straightforward salve). Not to mention Greece actually offered something like a GDP-bond in 2012 without any of the benefits proponents advocated (again, this might be an issue of magnitude but that’s not really the question).

Rather, Greece can sell calls on its export revenue. For one, this isn’t subject to the same measurement complexities that plague GDP (and when we’re talking billions of dollars in coupon payments, this matters). More importantly, exports are a much quicker and sensitive guide to adjustment performance than GDP, which can years to reflect structural improvements. Now the obvious flaw of export calls by themselves is that it’s not clear that the Greece government really cares about higher exports (even if its population does).

Here we can incorporate German sensibilities. Exports that fall below some benchmark on which the option is indexed incur a penalty in proportion to outstanding debt that would come out of a pool of “optional austerity” consisting of pensions, national assets, and defense spending. This would ensure that authorities engage in the sort of reforms – removing red tape, reallocating taxes, subsidizing the right things, and encouraging devaluation over unemployment – in a way that austerity resulting from failure would be predictable.

The final part is important. The IMF wants to give Greece a 20-year grace period before requiring any debt payments. What if we cut that in half, and indexed the coupon payments by an reverse exponential weighted average of net export performance over the next 10 years. This would allow Greece the freedom to implement policy that is responsible but not too responsible.

Maybe austerity is necessary and maybe it’s not. We can recognize the corruption of the Greek government without making a claim on how much austerity it needs. Michael Pettis has the key point:

The same process occurs within any economic entity, including a national economy. It is not an accident that in nearly every case in history in which countries have excessively high debt levels or have undergone debt crises, policymakers have never been able to keep their promise that, with forbearance from creditors and the implementation of the right reforms, the country can grow its way back into full solvency. Historical precedents are pretty clear on this point. Countries suffering from debt crises never regain growth until debt has been partially forgiven — explicitly or implicitly — and the uncertainty associated with its resolution has either been sharply reduced or eliminated.

And we shouldn’t expect Greece be any different. Without growth any Greek repayment schedule is doomed. Economically yes, but politically certainly. By opening a market determined pool of austerity as Greece misses its export (or other benchmark) targets, and offering the upside on any growth above that benchmark over the next 10 years, authorities will be forced to focus on a long-term economic salve. And, in this world, we let Greece grow and pay back what it can first, if that doesn’t work take a cut from its optional austerity pool, and if that doesn’t work let it default once and for all. And that’s basically what Eurocrats should have done decades ago.

Addendum: Tyler Cowen doesn’t agree with the Steve Randy Waldman post on what I think is weak reasoning. Germany is trying to maximize its return as senior creditor. In a Chapter 11 (not that this is the same, but follow the logic), the court’s responsibility is to maximize stakeholder value. To the extent this is more than a plain wealth transfer – that it will further depress demand in a region already rife with unemployment and poverty – further austerity does not meet the criterion. Sure, the German government has a responsibility to its taxpayers, but the per capita cost of a “stakeholder maximizing” agreement, I suspect, is not meaningfully important. (Yes, folks, the ECB’s monetary policy very likely had fiscal risks).

For Germans maybe it’s about setting precedent. For one, it really isn’t clear that Greek is strategically defaulting because it doesn’t feel like it (the austerity it has endured remains testament to its commitment to a European project). As IMF reports I’ve linked to before suggest, in most cases default isn’t costly precisely because markets don’t believe it sets some sort of precedent of irresponsibility.

Regardless, to the extent setting precedent is about the continuity of the European project, one can’t seriously argue that recent brinkmanship (on either side) has served greater service to further unity. Germany should allow this because there seems to be near-unanimous consensus that its preferred policy landscape is not maximizing the value of the European enterprise.

(On the criticism of American economists, he is right. Capital controls are a form of austerity – granted maybe an ideal form of austerity – requiring much short-term pain for potential long-term payoffs. It is easy to sit at Princeton and suggest that this is a good idea, when trade credit dries up and importers cannot purchase energy to turn on the lights it is quite a different matter).


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