Photo by Jamie Street on Unsplash
Hello,
Welcome to Known Unknowns, a newsletter that is here to remind you that markets were always risky, and policymakers always messed up, but somehow things still got better.
Markets get nasty
The Fed giveth and the Fed taketh away. I realize this is a small consolation when you look at your statements (try not to), but some of the stock market gains in the last few years came from the Fed keeping rates way too low for too long. So, were they real gains to begin with? I suppose they were because if you are the sort of person who times the market (which you should not be), you could have seen what was going on in 2021 and thought, “Why are rates so negative when the economy is on fire? This will end badly.”
And if you had looked at history (not the popular revisionist take on 2009; go back further) you’d have seen that the Fed tends to come in too hard and too late, and we are doomed to learn nothing from past policy errors. And then you could have sold when markets were high. But that would have required timing Fed policy mistakes, which is never advisable.
The lesson here, that we will never learn, is you can’t spend and rate-cut your way into prosperity. I am a free market person. I think it is incredible that there is so much chaos—people wanting to buy or sell goods, services, and securities—and out of all that mess comes a price that brings order to the chaos. Prices are a force of nature.
But if you mess too much with things, you get the wrong price, and it can’t clear the market. Then you have more chaos, and that can be expensive. Of course, there is still scope for government policies. There are market failures, government insurance can be efficient and complete markets, and smoothing out the worst of the business cycle is desirable. But there are limits to what policymakers can do. You can’t make people feel better about the economy shutting down by sending them checks and artificially propping up the stock and housing markets; it will come back to bite you. The mess we are in is an own goal, it’s not a natural blip in the business cycle. It feels like we broke something, and I am not sure how we put it back together.
Another (better) consolation is, firms seem to be in decent shape going in, and some of the market gains reflected actual increases in value. I am optimistic it will recover.
Entrepreneurship can blossom anywhere
I reviewed Steve Case’s new book for the Wall Street Journal. It is about his travels around the country in a red coach bus trying to revive local entrepreneurship. It is something like Shark Tank meets American Idol. But instead of singing for a recording contract, hopefuls ask for venture funding.
I just said I am not sure how we put the economy back together. There is lots of talk about focusing on the supply side and an abundance economy. That is potentially great, but I fear it will just turn out to be industrial policy that further distorts the market. If we do build back better, we need to restore market dynamism and make healthy risk-taking available to everyone, no matter where they live. And Case, to his credit, is trying to do that.
So far, the tech boom has mainly benefited highly skilled people who live in big cities. Case thinks prosperity can reach entrepreneurs everywhere. And buried deep in his book is an almost Schumpeterian argument about phases of the innovation cycle. He thinks we are done with the growth-comes-from-Silicon-Valley phase. He says that we’ve reached the part where success comes from applying technology to local and industry knowledge. If true, maybe growth can come organically from entrepreneurs in Detroit.
I compared his tour to American Idol. And there is something there. Idol showed us that talent was everywhere, and you did not have to go to LA or Nashville to be discovered. A few years later it seemed you did not even need Idol; you could get famous in your basement with YouTube or TikTok. Maybe we are in a new phase of the tech transformation where successful entrepreneurship happens anywhere, too.
What did the pandemic change forever?
We did break some things during the last two years. The economy is still so weird. We are used to plenty, but now it takes a year to get a dishwasher, businesses can’t hire workers, and Advil is under lock and key at CVS.
Some of this will go back to normal. Supply chains will heal, or just morph into something equally effective. It seems that a big part of the problem is labor shortages. Some of that is due to the fact that our immigration system is still frozen. Hundreds of thousands of people are still waiting for visas. It is crazy that 50 migrants are getting so much attention when many of our problems could be helped if we just restored the legal immigration system we already have. Why are we not pressuring the administration to do that?
We will get it together eventually, and some things will get better. But I reckon a lot of what’s different is just an acceleration of long-running trends. And these things won’t return to normal. Rates and inflation may just be higher going forward. The market response to British tax cuts suggests market discipline may finally come for bond markets. (For the record, I think expansionary fiscal policy financed by deficits is a bad idea when inflation is raging. But many of the critics of the Truss tax cuts are totally OK with deficit-financed government spending—even in this environment. So don’t complain about austerity this time. The gist of the reforms is the kind of supply side policies we need and it’s better than massive spending and industrial policy).
But the most troubling change is the breakdown of our trust in institutions. Some of the distrust is deserved (prolonged school closures and politicization of everything) and some of it isn’t. In any case, functional, trustworthy institutions are critical to long-term prosperity. And I am not sure how we fix that.
In other news
I had a chat with the wonderful Beth Akers on the high cost of college and what we need to do about student debt.
Until next time, Pension Geeks!
Allison
I think many of these challenges are different faces of the same philosophical problem. especially in the US. Things have been getting progressively more reliant on more complex and less robust systems.
That came to a head in the supply chain in Covid where all of a sudden "just-in-time" became "no-idea-when-or-how-it will-get-here". All that cheap manufacturing in Asia that lead to rampant profit growth suddenly became something preventing sales. Government bail-outs to the rescue. Now we are on-shoring, which should lead to a more robust supply chain over the next decade.
The financial sector has become addicted to the Fed's crack cocaine of Fed puts whenever the markets had a hiccup. That works when inflation is largely non-existent. At 8% inflation, the Fed put has to vanish. These rallies are showing that the financial sector still thinks the Fed is in a Roadrunner-Coyote cartoon where the coyote immediately recovers from the disastrous accident he inflicted on himself. Meanwhile, Jerome Powell and other governors keep saying they are driving a convoy of 18-wheelers over the coyote inflation roadkill on the interstate to make sure it won't bounce back up. I don't think the bond and stock markets will get resolved until those conflicting market and economy images get resolved.
The current generation on Wall Street has been trained by the Fed since the late 80s to expect the Fed Chairman to kiss the boo-boo and make it better. The problem is that leads to Rube Goldberg financial theories for trades that create instability due to the false sense of security that the Fed imparts. The result has been two stock market crashes of over 40% over the past 22 years in 2000-2002 and 2008-2009. We are currently seeing the equivalent of one of those crashes in the bond market (14% one-year total return drop in bonds is similar to 40% in stocks) and we might still see the current 22% S&P 500 YTD loss turn into 40%+. If we have three stock market drops greater than 40% in 22 years, that would be the first time since the 1920-1938 time frame. Most market analyses are presented post-WW II because the markets got so much more sophisticated since then. We are showing that the current approaches are creating instabilities unseen since the New Deal was enacted and the 1870s to 1930s may be better market analogies.
Corporate profit margins have been above 10% post-tax for several years. Historically, the high end was 6%-8% post-tax. Companies have to do a lot of work to keep those profit margins elevated so high. Some if it is good management but some of it is Jack Welch style financial shuffling that eventually runs out of time and space. When that unstable corporate finance can't be sustained, lots of bad things happen that usually involve a cascade of workers losing jobs that then feeds back through the economy. We don't know how much of that is out there, but it is another non-robust complex Rube Goldberg device waiting to have a minor breakdown sonehere that brings it all to a stop.
The Fed pumped financial steroids back into the systems after the dot.com, GFC, and Covid crises. The intial response is very good, but they have a habit of keeping it going for an extra year or so causing complexity and instability to build. They don't have the humility to think that they don't really understand how ti may end up and so they think they can keep tinkering to maintain stability as it builds instability. There is an economic Nobel Prize sitting out there for whoever figures out how the central banks can figure out when they have passed the mid-point of the teeter-totter and their continued actions would cause it to flip down on the other side.
Do you think it’s really about a breakdown in trust in institutions? Isn’t it more that institutions are not serving the purpose they are expected to serve in competent ways?
For example, the public health establishment has seemed more interested in playing three-dimensional chess with public opinion in order to influence the behaviors that they want to see people engage in rather than, you know, just trying to protect the public health. You could make a similar point about lots of different institutions.
Also it seems that some institutions thrive more on satisfying some emotional need for some segment of the population or scoring points against a perceived opposition than they do on adhering to some sort of principle. See for example the ACLU. Also see many institutions on the right who’ve compromised a lot of principles they seemed once to have held to become Trump supporters.
I think the point is that the “breakdown in faith” is perhaps a rational response to the institutions not deserving any faith!