Category Archives: Politics

Fiscal policy is next but it’s also unlikely to work

03 Sunday Feb 2019

Posted by in Monetary Policy, Politics, Uncategorized

≈ 1 Comment

Simon Wren-Lewis wrote an interesting article yesterday The Interest Rate Lower Bound Trap and the ideas that keep us there

Unfortunately, the ideas that keep us plugging pointlessly at monetary policy are not that dissimilar to the ideas which will push us into trying fiscal policy: both of them are based on using the old industrial model of labor and capital income distribution which is much less suitable in the digital age where technology takes center stage.

What particularly caught my attention was the 3rd paragraph and this very relevant question: “If these countries really did have a zero output gap, then why is inflation below target?” Which gets to the core of the issue about how technology has possibly substantially increased potential output.

Yet, our models do not fully capture that. Perhaps that is because we continue to put too much weight on capital and labor in the production function when clearly technology has marginalized them both, the evidence being in zero rates and flat wages.

Let’s take capital.

1) there is a large corporate capital surplus;

2) digital technology does not require so much capital;

3) consumer debt is maxed out.

All three of the above lead to low demand for credit meaning low interest rates regardless/independent of monetary policy.

So, after years of zero/negative/low rates (decades in Japan) it is finally obvious that the monetary transmission mechanism is now clogged (see above). Naturally, despite all the opposition, we are probably just a recession away to switching to fiscal policy.

But as labor’s turn comes, there is no guarantee and zero evidence (see, again, Japan) that fiscal policy would work as its transmission mechanism is probably also clogged. And the reason can be found in the fact that it is easier for corporates to switch from labor to technology in automating production.

A diversion.

That’s where the debate about technological unemployment comes in. And here I am in the camp believing that this time things are different because technology is more advanced and is taking away ‘IQ’ jobs in addition to just ‘brawn’. ‘EQ” jobs are humans’ last call of resistance but maybe not for too long.

Sure, no evidence of this for now but that’s because in the initial stages, with aggregate demand low, companies will choose to focus on cost reduction by using cheaper labor (taking advantage of the threat of automation keeping a lid on wages), than higher output/higher productivity using technology.

We’ve had jobless recoveries before but post GFC’08, we’ve had a ‘wageless’ recovery – plenty of jobs but anaemic wages. Neither is particularly good for aggregate demand as individual purchasing power barely increases.

The situation is even worse now as consumer debt to disposable income keeps rising (people now need two jobs to survive).

In the short run, we could potentially see a rise in wages as the labor pool gets gradually depleted, but the switch to automation would also be faster which would push unemployment up/wages back down. In the long run, technology substitution becomes inevitable as both its cost continues to decline and its capabilities to rise.

And, by the way, we are not helping, as apparently we are also getting dumber (see “Were the Victorians cleverer than us?” by M. Woodley et all).

Diversion ends.

So, the most obvious fiscal policy stimulus is infrastructure spending. That’s much easier to get voted in given the state of our roads and bridges, etc., and the fact that there are probably already too many people shuffling papers on desk jobs working for the government.

Infrastructure spending could be the most economically beneficial option but could also contribute the least to aggregate demand if it bypasses labor due to automation: awarding a billion $ contract to a company to renovate a bridge using mostly automated machinery is hardly going to increase labor’s purchasing power.

My feeling is fiscal policy will indeed soon become the default option. Sadly, not necessarily because it would work better overall for increasing aggregate demand but simply because it has become plain obvious that monetary policy is powerless.

Instead, we need to think ‘beyond the Overton Window’. The income transmission mechanism which we have adopted since the first industrial revolution, Work->Job->Income is broken. Monetary and fiscal policy thus become redundant. We need a new model more suitable for the digital age.

Share buybacks must be seen through the shareholder primacy doctrine

12 Sunday Aug 2018

Posted by in Equity, Politics

≈ Leave a comment

Tags

 

  • Buybacks are a direct and natural response to the shift in corporate management structure in the late 1970s which ushered in the period of ‘shareholder primacy’. It was Rule 10B-18 in 1982 which legitimized them.
  • Banning share buybacks without also changing the focus away from maximizing shareholder value will accomplish little because companies will simply find other ways to reach that objective.
  • The 1970s were a tumultuous period for the global economy with the two oil crises leading to stagflation and to enormous pressure on corporate profits. But the ground was set already in 1970 when M. Friedman published “The Social Responsibility of Business is to Increase Profits”.
  • In 1976 M. Jensen & W. Meckling published “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” which explored the idea of equity-based compensation for professional managers.
  • Finally, six years later Rule 10B-18 provided safe haven for companies to buyback their shares, allowing them another option to reward shareholders, in addition to dividends. The results were explosive.
  • Equity-based compensation rose from 0% of the median executive’s pay in 1980s to at least 60% in the 2000s; just in 1983, the aggregate amount of cash spent on share buybacks tripled and by 1985 it was 5 times higher than the average in the period 1972-1982.
  • With the incentive structure thus created in the 1980s, companies NOT doing buybacks would not be fulfilling their objective of maximizing shareholder value, notwithstanding that managers are also large shareholders.
  • Thus, banning buybacks makes no sense as it goes against the shareholder primacy doctrine unless, of course there is solid evidence that buybacks erode long-term shareholder value. So, therefore, the issue is not with buybacks but with the corporate management structure which has emerged since the 1980s.
  • Profit maximization and focus on shareholders has created extremely efficient companies boosting aggregate supply(AS), in many cases at the expense of aggregate demand(AD) at home, thus forcing those same companies to shift sales increasingly abroad.
  • It has also contributed to the concentration of both companies and shareholders, the former leading to the monopolization of US industries, the latter to US inequality->continuing with the shareholder primacy thus could indeed be damaging to corporate profits long terms once AD dries off even in EM.
  • I think it is difficult if not impossible to gauge the size of the effect of share buybacks on stocks prices or EPS, but there is no doubt that there is one: JPM, for ex. thinks effect on EPS growth is less than 10%, UBS thinks it is more than 30%.
  • Fed’s Z1 Flow of Funds reports a break-down of the major equity buyers each quarter: since 2008 corporates buying back their shares is absolutely dominant; the second biggest ‘buyer’, ETF, is three times smaller; pension funds and households net sold equities during that period.
  • The stock price of profitable companies like Apple should be rising on its own merit , but that does not negate the possibility that buybacks ‘juice up’ stock prices even higher than ‘justified’. It goes the other way too: with 22 consecutive quarters of declining revenues the stock price of IBM probably should  be lower -where would IBM stock price be if not for buybacks?
  • If we are adjusting R&D to GDP, we might as well adjust share repurchases to GDP as well (and yes, they are also at record high). Tech companies raising their R&D – that’s great – but if they did not do any buybacks, could they have raised it even more?
  • The recapitalization argument (shifting from equity to debt refinancing) is probably the most logical argument in favor of buybacks, if it was not for the agency conflict of interest (managers are equity holders) and the fact that they could have also boosted dividends instead.
  • The argument that giving money back to shareholders could boost wages and investment somewhere else (therefore, where is the problem?) – yes, it could – but as far as I am aware there is not much evidence of this.

The anomaly of an European UK

13 Saturday Jan 2018

Posted by in Politics

≈ 1 Comment

The foundations of the EU were laid after WW2 in an effort to put a stop, once for all, to the endless wars ravaging Europe throughout its history. Thus, the EU was primarily a political project. UK joined mostly for economic reasons.  No one should be surprised that the UK decided to finally exit when the economic benefits of staying in were largely overtaken by politics and its equivalent economic costs. What is astonishing is that the EU ‘allowed’ the UK to join on such terms (and even improve upon them) in the first place.

  1. Peace was a relatively infrequent occurrence in Europe which was instead constantly ruined by ‘internal’ wars and foreign occupations. One way to achieve peace was by unification. In the past, Europe was ‘united’ by empires: Roman, Byzantine, French, English…
  2. For example, under Pax Britannica (1815-1914, in Latin “British Peace”) England was the dominant power which ‘assured’ that the Great Powers co-operated rather than fought with each other.
  3. After the devastating effects of WW1, the calls for European unification again became strong. In fact, in the Congress of Aix-la-Chapelle of 1818, tsar Alexander (Emperor of Russia) suggested a permanent European union.
  4. Nothing happened. We had to go through another world war after which Churchill finally called for a ‘United States of Europe’ (1946). Three years later the first pan-European organization, The Council of Europe, was established.
  5. Despite the immediate plan behind its founding treaty (Treaty of Paris, establishing the European Coal and Steel Community, 1951), the EU was a political project first and economic second.
  6. UK eventually joined the European Economic Community in 1973 (after being rejected by Charles de Gaulle a decade earlier) mostly for economic reasons and never embraced fully the political angle.
  7. The election of Margaret Thatcher and the embrace of neo-liberal economic policies, which led to a resurgence of the UK economy, influenced the direction of European integration towards a more economic turn. The idea being that economics will eventually drive politics: “the invisible hand working, its wonders to perform”.
  8. UK was (reluctantly) ok with the free movement of labor (Treaty of Rome 1957) and welcomed the free movement of capital (Maastricht Treaty 1994). But, UK became increasingly unhappy with the free movement of people especially after the enlargement of 8 extra Eastern European countries (the Citizens’ Rights Directive, 2004)
  9. This discontent was exacerbated by the fact that UK decided to open its borders immediately to citizens of those countries, after the Directive came into force, while most other EU countries chose to implement a 7yr-grace period.
  10. The creation of the common currency, the EUR, in 1999 was a natural evolution of the political union but also a response to a number of currency crises, especially so the ERM II in 1992.
  11. The UK decided not to participate despite/because of the fact its currency suffered a lot during ERM II, confirming that it was in mostly for economic reasons. We can say in hindsight that this was the right choice given that the EU political process was far from complete.
  12. This became particularly obvious after the EU sovereign crisis (2012-13) when the continent suffered disproportionally due to its fiscal inflexibility, lack of common treasury and a proper re-distribution mechanism.
  13. While after the 2004 Directive, the UK was swamped by mostly Eastern Europe migrants (by its own choosing), after the EU crisis, migration increased also from the EU periphery and even from the core.
  14. It was at this time that UK media/government started a concentrated push to blame the EU for UK’s economic problems, again, notwithstanding that its own unnecessary austerity was causing most of it.
  15. It was a surreal situation: by choosing to keep its own currency, the UK was not subject to the fiscal straitjackets of the EU, yet it chose to do exactly that and blame the EU in the process.
  16. The Brexit vote came in light of these developments, and with the Treaty of Lisbon (2007) providing for the first time legally a way out of the EU, the procedure of UK exit has started.
  17. What is interesting is that there is a big disconnect between the UK’s position and the EU’s stand in the negotiations: economics vs politics->despite the UK joining for mostly economic reasons, it did, after all, ‘join’ a political union.
  18. What is astonishing here is the UK’s failure to see the political aspect of this (for ex. Northern Ireland issue) and focus primarily on trying to “buy itself out”. Equally, it will be EU’s give-in to strike an economic solution while disregarding the political message it sends.
  19. What is surprising is not that the UK has decided to leave the EU but that the EU has ‘allowed’ for this loophole to exist: if a country wants to enjoy the economic upside of a union shouldn’t also share the political responsibilities that come with it?
  20. In fact, after the 2015 deal between the UK and EU, the UK did acquire a special status within the union: something no other country had been able to achieve. Why did the EU let the UK in on mostly economic terms and why did it even improve on them later on?
  21. But can we blame the UK that it has gone in the Brexit negotiations process asking “to eat the cake and have it” given that this is exactly what the EU has allowed it to do for 40 years (single market, free trade, own currency, no EU fiscal straitjacket, no Schengen)?
  22. This should not distract from the fact that the political union is far from complete. However, economic commentators not only largely underestimate the political difficulties inherent in building its infrastructure…
  23. …but also disregard the history behind this whole project: the initial impetus for it, and the gradual process of adding, layer after layer, in some cases, unfortunately, only following a crisis.
  24. Brexit, however, is the first serious political crisis facing the EU. The future peace in Europe is dependent not on what UK does now, but on how Europe decides to proceed forward.
  25. The European ‘unions’ of the past (empires) were largely based on the idea of ‘colonialism’ – the center takes much more than it gives back. This could be the first European union which is based on common sharing.
  26. On the other hand, if history is any guide, the failure to complete this European integration can have drastically negative political consequences which will dwarf the economic difficulties present today.