Banking on the best case scenario
Banking on the best case scenario
So much wishful thinking on taxes, interest rates, and inflation
Hello,
Welcome to Known Unknowns, a newsletter that’s still old school because here, the Philips curve still matters and interest rate means revert to their long-term average.
The economy is still running hot
How about those employment numbers?! Despite high rates and falling inflation, unemployment is at 3.4%! Time to give up on the Philips curve? Not me: I’m too Phelpsian. The labor market just can’t be tamed because—once again—we are seeing that monetary policy is powerful. But not as powerful as we thought when it comes to bigger structural issues. Or—in English—consumers and the government are still spending and firms still want workers.
Some economists are already declaring victory: arguing that inflation is already where it needs to be and interest rates will soon follow. If true, it was the most immaculate of immaculate disinflations. Effectively, we had an economic boom and inflation and high rates have just gone away. Color me skeptical. Inflation is still high in services, which suggests it is still far from the Fed’s target. In the past, inflation has fallen and then returned, fell again, and returned again. It’s the risk and uncertainty from inflation that increases interest rates, not just the level. The fact that Canada has stopped issuing real bonds is not a good sign. Maybe inflation will go away and negative real rates are the future. But that is only one scenario: the best-case scenario, and who takes a leveraged bet on the best-case scenario? No self-respecting pension Geek.
True, I’ve been a debt and inflation hawk for a long time, even when both were considered cooky things to worry about. But this isn’t because I’m certain that we face a high inflation/high rates future: it is because I don’t know. Our economic choices are making us a lot less resilient to future shocks. And that worries me.
Even today there are signs of weakness. Inflation is still high—lower than it was before, but still higher than it used to be. Wage growth is slowing, but people are still spending. Hardship withdrawals from 401(k)s have risen, which means many households are burning through their savings. The fact households came out of the pandemic with so much money in the bank is a big part of the reason why the economy has been so robust. However, it is less so now.
Maybe we’ll get out of this unscathed, but the economy is now much more fragile to whatever the world holds.
Gen Z in the labor force
The labor market is weird. And—as I mentioned last week—it’s the same weird in every country. I dug in deeper last week for Bloomberg. I regularly hear two complaints from employers, which remind me of the old Woody Allen joke: "labor is terrible and there's so little of it.". Employees won’t come into the office and are working less—and that’s if you can hire them!
This may explain labor hoarding and firms not letting workers go. Why is the labor market so tight? There is less supply in some countries due to more retirement and less immigration. But other nations with labor shortages have seen an increase in participation. It seems a rise in demand from to the pandemic spending boom is the issue.
The question is, does this last? Workers have a lot of power in the labor market, which they are exercising. Even—especially—younger workers who have fewer skills. If it is demand-driven, someday demand will fall—or supply will adjust as we adopt more technological innovations and get our act together on immigration. Then, the power will shift, and workers will be in a bad spot.
So, being a bad or indifferent worker is probably not a good long-term career strategy. Especially when a robot may soon be capable of doing your white-collar job.
Fraud is all the rage
I’m fascinated by the Frank–JP Morgan story. What is it with young fraudsters emanating from the tech industry? Seems like there are so many of them. I suppose every generation has its share of people capable of fraud. But what is unique about the last 20 years is low-interest rates and a fetish for young founders in the tech industry.
Normally, a successful track record, ethical behavior, and experience are things investors want to see, since these make an investment much less risky. But when it comes to tech, such things are liabilities. This is the industry that is supposed to change the world, so ties to old ways of doing things only hold you back. This explains the ageism in tech (and the high demand for Botox). Never mind that young founders lack good track records, industry knowledge and business experience. In fact you are more likely to invest in a unicorn with a middle-aged founder.
I blame low interest rates. Because they skew risky decisions. I think we’ll look back on this era and think “Why did we give so much pension fund money to 25-year-olds?”
Wealth taxes
Last week, I linked to my debate about wealth taxes, which hasn’t stopped seven states from floating bills to increase taxes on wealth. This is still a terrible idea. It is the most inefficient of all taxes, which means more distortions and less growth. The rates that states are proposing (on top of federal capital gains taxes) reduce the return on risky investments to a hair above the risk-free rate. I think that could be a problem. It’s also curious that states like California and New York are also trying this, since they are already losing their biggest taxpayers. Why shove them out the door?
But even if they do, the logistics of collecting wealth taxes, especially at the state level, are a non-starter. I know it’s fashionable to say, “We’ll just hire more tax collectors!” But you could employ half of California and it would still be difficult to value a privately held company. Also, hiding wealth in opaque assets skews incentives and other nasty things.
Incidentally, I wonder what this would do to the venture capital industry. Its appeal as an asset class is claiming low volatility and high returns by being illiquid and opaque. But if you must pay a wealth tax on your investment—or on unrealized gains—individual investors would want the funds to claim a lower return to reduce their tax liability. What will that do to the entire private equity investment proposition? Or will only pension funds invest in private equity going forward?
I’m not sure that lawmakers have given it much thought. They just want to raise revenue and keep telling people “No one who makes less than $400,000 will have to pay for anything.” That is unrealistic: even if you could tax wealth.
In other news
I spoke to Chris Pope about healthcare and how we will pay for it.
SeLFIES are a thing in Brazil now!
Until next time, Pension Geeks!
Allison
Wealth tax: The time to tax wealth is with estate tax. Have a generous exclusion to help kick-start the next generation, pass on family farms and small business, etc. (all part of the "The American Dream") and then substantial tax (35%-50%) on the rest without non-charity loopholes to avoid it. Don't allow family trusts. A generous exclusion would be something like $10 million, indexed to inflation.
Fraud: The US has been writing the laws over the past several decades to make fraud difficult to prosecute, particularly require "intent" to be proven. If you avoid writing e-mails and texts telling co-workers that you are planning to commit fraud, it is difficult to prove. There has also been institutional hesitancy to even investigate it. So no fraud prosecutions came out of the 2000s housing debacle and subsequent financial crisis (Madoff actually turned himself in because his fund was collapsing under its own weight and there was no potential for it not to be fraud). They struggled to get Enron and Theranos prosecuted. Rich person tax fraud is rarely audited and prosecuted because the tax code is so complicated and then you have to show "intent". It is good to see that they are starting to go after some of the Covid PPP fraud. If people get investigated and prosecuted for fraud, there will be less of it.
Labor: Despite a reduction in labor force participation rates, the number of people employed in the US has quietly risen to all time highs. in the 2022 Q4. https://fred.stlouisfed.org/series/CE16OV
I think the bigger issue is that many US employers are reluctant to offer full-time work due to extra benefit costs. They are reluctantly raising hourly wages because competition for labor is forcing that. Labor participation rate is still down at late 1970s levels, so employers are still not making employment attractive enough to pull people from the sidelines.
The fact that employers are still complaining about labor shortages despite the greatest number of people employed in US history indicates that the economy is still "hot". I think 2023 is when labor costs, desire to maintain revenue despite rising labor costs, number of employed (I think more important statistic than unemployment rate), and interest rate costs to companies are going to be an intricate dance with economic, financial, and stock market implications.
“..debate about wealth taxes, which hasn’t stopped seven states from floating bills to increase taxes on wealth. This is still a terrible idea. It is the most inefficient of all taxes, which means more distortions and less growth. The rates that states are proposing (on top of federal capital gains taxes) reduce the return on risky investments to a hair above the risk-free rate.”
Could you please provide link where I might find detail as to your determination of the resultant risky investment returns?