Known Unknowns

Hello,

Welcome to Known Unknowns, a newsletter about risk in the economy, especially the risks we pose to ourselves.

Let’s Talk about Monetary Policy

In the last two weeks, both the ECB and the Fed cut rates. The ECB is even resuming quantitative easing, buying long-term bonds, while the Fed will just let its balance sheet grow naturally. To be honest, I am not sure any of it matters. If a trade war takes the global economy into a recession, a 25 or even 50 basis point rate cut isn’t doing to do much. It is probably just signaling that the Central Banks are on it.

Personally, I would have welcomed a neutral stance because it would be honest. At best, the most the Fed can do is fine-tune the economy. It can take the edge off a recession and shorten its duration or it can cause a recession with super-high rates, but that’s pretty much it.

Instead, the fashion these days is complex communication signals, the idea being we can trick the economy out of recession. I liked communication as a policy tool when it was direct, clear, and humble. It was good because it reduced uncertainty and risk.

Now it feels like central bankers are using communication to justify discretionary policies when they know they should be using rules. I am not a-rules-all-the-time kind of person. There is a time for discretionary policy, which can be a powerful tool to reduce the costs of a bad recession. But if you use discretionary policy all the time, especially under the belief you can keep the economy humming at full speed no matter what shocks you get, the tools don’t work so well when you need them.

A rate cut isn’t insurance, credibility is—and I worry that central bankers are claiming it when they don’t need it.

Vampire Policies: Bad Ideas That Just Won’t Die

True, much of policy is signaling, and that can be powerful. In these uncertain times, people want strong, new policies that bring change. The problem is we don’t know what to do, so we are resurrecting old ideas that were dead for a reason.

In the depths of the recession, Central Banks started buying long-dated bonds—even though it never worked before. Now everyone insists QE works, even if the evidence for that is still spotty. I think it was worthwhile during the recession because doing something—anything—could be justified, but as a standard tool? Eh, I’m not so sure. People might catch on that it doesn’t work, and where will we be during the next recession?

And now wealth taxes. I mean seriously. I thought we all agreed they create big distortions and are difficult to enforce. There are better, even more progressive, ways to tax. But it’s been a while, and people forgot how useless they are—so now they are excited about them.

Take this from the FT, which, based on Fatih Guven’s paper, claims wealth taxes are desirable because they reward more productive investments. The thinking goes if you have two entrepreneurs, one invests and earns 20% and the other earns 0%, capital income taxes punish the 20% guy more than the 0% guy. Fatih argues that, if we move to a wealth tax instead, we will reward productive investments more, or wealth taxes are better than capital income taxes. This all depends on getting rid of capital income taxes (good luck with that!). Taxing investments for under-performing is an interesting idea, sort of the opposite of what we do now.

But isn’t this just encouraging more risk because higher-risk investments generally offer higher returns? Is that wise? I don’t think it is. There is no shame in risk aversion.

The FT goes on to argue that wealth taxes are good because people who have had their money longer (heirs and old entrepreneurs) earn a lower return, will be taxed more, and reducing their wealth is a noble aim.

Is it true they earn a lower return? That sounds like an awfully bold assumption, and I am not sure why it would be true. Are they more risk averse? Is it because they are better diversified because they own more assets than just their start-up? Or do they just keep their money in cash to throw on the fire at Burning Man? The argument that old rich people and their heirs are bad (or just mediocre) investors is pervasive among wealth tax proponents. It also underlies calculations that wealth inequality is exploding. But I am not sure I’ve seen evidence this is true. Surely, someone has looked at this. It must be testable.

And, speaking of vampire bad policy ideas, now Bernie Sanders would like to institute national rent controls where landlords can only raise rents 3% a year. You might laugh, but I would have, too, if someone told me 15 years ago that Operation Twist and wealth taxes would become mainstream ideas.

I know macroeconomists don’t understand the macroeconomy, but sheesh!

More on Low-Long Term Interest Rates

I may be beating a dead horse here, but, like all pension nerds, nothing excites me more than the bond market. And after weeks of speculation that attempted to justify why bond holders can predict the future, I am reading some good, simple explanations of what may be going on.

Perhaps we don’t need more QE after all because so many market forces are already pushing long yields down. Rich Clarida thinks the yield curve is inverted because investors are searching for the yield they aren’t getting in Europe. Let’s give a warm welcome to John Cochrane who has joined the investors-just-want-more-duration club. And Tyler Cowen thinks low rates are because there’s a shortage of productive labor.

Index Funds Take Over

People got excited for a minute because the amount of money in index funds exceeded the money in active funds. There are concerns this could be a too much of a good thing because it gives BlackRock and Vanguard too much voting power, and it increases volatility (volatility was actually low, as indexing became a larger share of the market). Apparently, it also makes airfare more expensive than it should be.

These all sound like second or much higher (when it comes to the weird airfare argument) order concerns compared with the overwhelming benefit of low fees. The ultimate test of a new regime is how it responds to periods of extreme market turmoil, and we don’t know yet. But, even still, if you save 100+ basis points a year on fees for your investing life, that seems like a fair trade.

Besides, active management isn’t going anywhere. Institutional investors will never go passive. Pension fund managers and endowments have every incentive to claim they’ve found investments that beat the market. As long as they are a large share of assets, passive’s market share is limited. Active managers have more to fear from algos.

Just look at venture capital. Some are surprised VCs invested so much money in companies that will never earn a profit and have crazy CEOs. I am not. They get lots of their money from public pension plans who need illiquid, hard to value assets so they can justify their absurd return assumptions. We’ll all pay for those cheap Uber rides and WeWork rents one day. It just may come in the form of tax-payer-funded pension bailouts.

Yeah, active management and unprofitable companies aren’t going anywhere—yet.

In the meantime, Australia comes to terms with Super's short-comings.

Until next time, Pension Geeks (and friends)!

Allison