Programing note: I will be on vacation for the next few weeks. Known Unknowns will be back July 18.
Photo by Pablo Merchán Montes on Unsplash
Hello,
Welcome to Known Unknowns, a newsletter which offers a grand unified theory on our economy that centers on pension discount rates.
No more free lunch for you
For several years, something was clearly wrong in the tech industry—even crazy. Obviously terrible ideas got financing. And even start-ups with great ideas were able (even encouraged) to grow as large as possible without a credible plan to become profitable. That couldn’t last.
Why did we all participate in this collective delusion? To some extent, we all benefited. So long as the Ubers of the world were hungry for market share, we got every cheap service, like $20 rides to the airport. But there is no free lunch. Now that rates are up and labor costs are rising, we must pay market rates for all these subsidized services. This is on top of existing inflation. It is a drop in our standard of living, which is never good.
To make matters worse, we indirectly subsidized ourselves. For me, everything comes back to pensions (and when it comes to public sector pensions, it comes down to terrible accounting rules!), which is a factor here too. Public-sector pensions discount their liabilities using their expected return, which is crazy because it does not account for risk. That might not be terrible if pensions were only paid when investments pay off. But no. You need to pay pensions no matter what.
It also means the higher the “expected return,” the lower liabilities appear, the better funded pensions seem, and there is less need to increase taxes or worker salaries. But in a low-rate environment, it was hard to justify 7 or 8% returns. Enter private markets where your investments were tied up for years and impossible to value. So, you can just say your PE portfolio returned 15%, and no one will question it. And if one or two investments in that portfolio paid off in a big way, everyone was a winner, the VC portfolio manager, the firm founders, and the pension fund gets their 15%. And if it all goes badly, the taxpayer was on the hook, but far into the future, so that was not a big concern.
So, tech start-ups got cash and were highly encouraged to distinguish themselves as the next unicorn. And there was no better way to prove that than being a brand everyone uses and associates with the product, like Q-Tips. There was an incentive to dominate a market by offering the service for very little money, even if it meant the firm lost money. And no one seemed to question it. Personally, I always assumed this was the strategy.
Well, cut to high rates, inflation, and a labor shortage. Investors aren’t so tolerant of firms losing money, so pricing is increasing. The free lunch of $10 Uber rides is over.
In addition to my Bloomberg column, I discussed the end of cheap nice things with Josh Barro last week. Due to the construction next door, I recorded it from my closet. That seemed appropriate because we also discussed consumption behavior.
People hate to pay more for things, loss aversion, and all that. But I still think, on balance, we are better off. The tech revolution is making once luxury services more accessible for all, like personal training, car service, and even butlers. It is the next generation of the industrial revolution made consumer goods cheaper. The process is a little rocky, and some investments don’t make sense. So, as I pay more for Uber, I try to take a Schumpeterian attitude about the whole thing.
Turns out there is downside risk
The other shoe to drop from high rates is significant losses for investors in very risky portfolios. It is not too hard to make money in a bull market, and you can even out-perform the market if you bulk up on risk. People always mistake it for skill. However, as many people are learning, how you do in a down market and rising rate environment is the real test of an investment strategy.
It does seem people bulked up on risk in the last few years. Some 34% of Americans own individual stocks, 19% of those people started investing in them during the last 3 years, and 12% of households own crypto. These investors tend to be younger, earn less, and are more likely to be minorities.
In some ways, this is good that more people got into investing. We need more market participation. Risk is an integral part of wealth accumulation and lessening inequality. But this is a precarious way to invest, and they face big losses now. If that’s not bad enough, losses in a down market can scar new investors, and they may not invest in the future.
Inflation’s false choice
Is inflation entirely due to oil prices? I am seeing more people make that argument lately. “it’s all oil’s fault” is the new inflation is “transitory”. The argument then goes that contractionary monetary policy will inflict undue harm on the economy because it can’t make oil cheaper; it will only cause a recession.
First, high inflation is due to supply and demand—not just oil. Supply and demand feed off each other. This isn’t hard, and we have lots of data and expertise to back this up. I can’t believe people are actually arguing that the Fed should not raise rates when unemployment is 3.5%, and inflation is 8.6%. It is as if they were magically transported from 1969 to make us repeat all our monetary policy mistakes. Meanwhile it feels like Crypto enthusiasts were transported from 1880 so we can all relearn banking and currency.
Since then, we have learned quite a bit about monetary policy. One is that the inflation/recession choice is a false one. If we let inflation go, it does not just disappear. It gets worse and causes an even more severe recession. And we can say goodbye to any last shred of Fed credibility. That will make future monetary policy much harder and more costly. There is no choice between recession and inflation.
Speaking of, I went on Morning edition to talk about oil prices.
Until next time, Pension Geeks!
Allison
for good and bad, PE subsidized tech disrupted a number of indusries. The NYC taxi medallion market was one of them. A monopoly with restricted number of taxis suddenly got T-boned at the intersection by ride-sharing apps. Lots of debris will need to be cleaned up over the next few years in the wake of the tech crash, including disrupted industries that may have an opportunity to redeem themselves and become useful and fair again. The same opportunity created many of these new tech business in the wake of the dot.com crash 20 years ago. Very Schumpeterian on a 10-20 year rinse and repeat cycle.
https://documentedny.com/2021/11/23/taxi-cab-medallion-explained/