Monday, January 10, 2022

Investors Should Pay More Attention to Congress and the Courts (And Less to the Fed)

One of the goals for this blog is to get people, particularly investors, to understand the MMT economic framework and how it can help us make better, more informed decisions. But the MMT framework goes beyond just "money" in the conventional sense. We can adopt an MMT framing to better understand other financial assets.

Government Handouts

In her fantastic book The Code of Capital, Katharina Pistor argues persuasively that capital itself is a creature of law. The value for any asset, whether tangible (e.g. land or equipment) or intangible (e.g. patents) is derived from the State creating the property right which assigns ownership status to the asset's owner. The State also promises to enforce contracts. These facts are typically ignored or looked over in our modern discourse, but nevertheless are critical for what capitalists call "value creation." Any homeowner in the US had to purchase their house, which involved signing a contract and obtaining legal title to that property. What would happen if the government suddenly said it would no longer acknowledge and/or enforce that contract and title? What happens to your "equity?" Your equity has, quite literally, been cancelled and is now worthless. The property itself may provide utility, but without the State's legal recognition, you are no longer the owner. Libertarians and other "rugged individualist" types love to rail on "government handouts" without acknowledging they receive the ultimate handout in the form of the government's promise to protect the right to own property. Thus, similar to how the government's liabilities are the non-government's assets, the government creates economic value in the private sector by promising to use the full resources of the State to protect property rights and handle contract disputes. 

Sure, it is possible for someone to defend themselves from intruders without the government's help, but do we really want to live in a world where everyone has to defend their property themselves without the support of the State? That sounds extremely resource-intensive and wasteful, and would lead to anarchy and chaos. Centuries of common law innovations and subsequent improvement in living standards suggest we are better off with the State intervening. It's important for us to acknowledge and be grateful for the government's role in private sector value creation, and recognize we are better off as a result. WE LIVE IN A DEMOCRACY. THE GOVERNMENT WORKS FOR US.

Big Tech's Secret Sauce: Regulatory Arbitrage

So if capital is a creature of the State, then it makes sense for investment analysts to pay attention to how the State's laws are, and will, influence outcomes in capital markets. Think about it - if Congress extends or reduces the term period for a patent, that will significantly impact the financial results of the patent's owner. While the mega-cap tech stocks today are frequently referred to as the best, most innovative businesses, it's worth considering an alternative view: that their success has much more to do with their favored legal status and "regulatory capture" as opposed to any sort of merit-based reason. The fact that Facebook was allowed to corner the photo-sharing social media market when it acquired Instagram shows how the government's blessing (it could have blown the deal up citing antitrust concerns) created unimaginable economic value for FB's shareholders.

Not only that, but the Big Tech companies like Facebook and Google don't have to play by the same rules as traditional media companies. Section 230 of the Communications Decency Act gives special legal privileges to an "Interactive Computer Service" to be exempt from being treated as a publisher or speaker. Instead, they are merely treated as platforms which cannot be held accountable for the content that gets posted on their sites. They have maintained this status despite evidence they have their thumb on the scale of what content people do and don't see. Because they are exempt from tort liability, and don't have to pay for the content that gets created on their platforms, Facebook and Google can generate substantially large profits by selling advertisements at structurally higher margins than traditional media companies. This has nothing to do with them being "innovative." Indeed, when was the last time Facebook innovated anything? They can't even figure out how to make a compelling online dating product!

Google's business model has historically been to take already-existing IP, repackage it and sell it as their own. Google's original search algorithm, called PageRank, was effectively a filing system converted to digital code. The company's lawyers successfully argued that PageRank was deserving of a patent, which was a reach considering there doesn't seem to be anything novel about a filing method. Nonetheless, their lawyers won which allowed Google to monopolize online search; they hold over 90% market share to this day. Google Maps is possible because of GPS, which was created by the US government. Google Books involved taking books that were already available to the public, converting them to a digital form, and using them for commercial use.

And let's not forget the fact that the internet was created by the US government. Any "internet" company today, including Facebook, Google, and Amazon, owes their existence to Uncle Sam. Public services and investments create private wealth.

Wall Street's Fed Fetish

As we can see, the business outcomes of Facebook and Google are very much a function of the legal code. If we can understand how laws affect business outcomes, we can make better investment decisions.

Surprisingly, this type of analysis is not a topic of focus in the analyst community. Investment analysts are taught to analyze and project business operating results, and also understand the competitive dynamics of its industry. Logically, one would expect that investment analysts were experts and/or paid significant attention to Washington in its capacity to write and enforce laws. And yet, instead of focusing on Congress and the Courts, Wall Street traders obsess over a different public entity: the Fed.

I have been working in financial markets for over a decade, and am still flummoxed by Wall Street's obsession with the Fed. Traders on Wall Street obsess over the FOMC's meeting minutes and press conferences. Wall Street folklore is filled with stories about how traders used to gauge the size of former Fed Chair Alan Greenspan's briefcase to determine whether a rate cute was coming or not. The whole thing is a circus and is ridiculous, and yet Portfolio Managers are still the highest paid professionals on average in the US:

Mainstream economists will defend such practices as merely a result of a magical "invisible hand" guiding market participants to optimal resource allocation. But of course, this is all the "natural" state of things, nothing to do with arbitrary power structures.

Rate Hawks

The Fed is routinely railed by influential people on Wall Street and the press for its supposed role in creating "asset bubbles" and "interfering" in free markets, thereby distorting the market's "price discovery" mechanism. Jim Grant of the eponymous Grant's Interest Rate Observer is perhaps one of the most fervent critics of the Fed, and has even likened the Fed's "suppression of interest rates" as borderline criminal. For the record, I like Jim Grant and think he is a noble man who means well, and am a subscriber to his newsletter; I happen to disagree with several of his "macro" takes however. Grant's thesis is one that is widely shared on Wall Street, which is that the Fed's monetary policy decisions since the GFC have not only interfered with "natural" market pricing functions, but also created conditions for today's massive wealth inequality. This view is increasingly embraced by mainstream media outlets including the NY Times.

The theory goes as follows: financial assets generate cash flows for their owners, and are priced using a discount mechanism. Cash flows to be received in the future are discounted to the present using a discount rate. The Fed, through its monetary policy operations, sets the near-term discount rates for money and, by extension, asset prices. Generally speaking, lower discount rates increases the present value of those cash flows. By keeping rates "artificially suppressed," the Fed has supported wealth generation for those who are already wealthy and own financial assets, exacerbating wealth inequality.

Is there merit to Grant's point is that the Fed's policies hurts "savers," by denying them income they previously were able to generate risk-free? While this seems to be conventional wisdom on Wall Street, it is a false narrative. Grant seems to think the typical saver is an "ordinary working person." It's unclear why he believes this to be the case. Perhaps "savers" included working-class people when Mr. Grant grew up, however, median household incomes have been shrinking as a percent of aggregate income share for over fifty years. Income and wealth disparities have gotten so bad that, as published in a 2019 study by the Fed, 4 in 10 Americans didn't have sufficient funds to pay for an unexpected $400 expense. With so little net savings, ordinary working people are forced to become debtors instead of creditors. Indeed, as former Fed economist Claudia Sahm points out, the top 1% of households hold one-third of the nation's wealth whereas the bottom half hold merely 2%. Not only that, but the top 1% owes 5% of the nation's debt vs. the bottom half does one-third. As Sahm puts it:

"Wealthy people - those who have tons of savings and money to lend out - get hosed by low interest rates. Inflation is even worse. Who benefits from low rates and some moderate inflation? Main Street, especially anyone with debt."

Some MMT economists have argued that interest paid on government debt securities can be thought of like any other fiscal policy decision, and are in fact subsidies for the wealthy. This framing makes more sense than Grant's argument - you can't earn interest on government debt if you don't have the financial resources to purchase that debt in the first place, which in turn requires generating income in excess of costs. Rising living costs and declining incomes for workers makes it difficult, if not impossible, to accumulate savings, and turns the working class into debtors instead of creditors. Sahm and other MMT economists' make a compelling, data-driven case that low rates in fact ease debt burdens and thus help working class people. Jim Grant's evergreen call for the Fed to raise rates is attractive for wealthy people who are net creditors, NOT workers.

So the real reason that Wall Street obsesses over the Fed is because people on Wall Street are generally rich and part of the "creditor" class; they are biased towards higher interest rates because that helps them get richer. That said, what about the argument that low rates support asset prices?

USA vs. Europe vs. Japan

The main problem I have with this thesis is that other countries have also had very low, including negative, interest rates, and their stock and real estate markets have not experienced anything like the capital appreciation we've seen in the US over the last 20 years. As Nathan Tankus, head researcher for the Modern Money Network, writes (emphasis added):

"As economist JW Mason pointed out many years ago, the U.S. has more assets which see paper price increases because more of society’s wealth is converted into property which can be freely bought and sold. Countries like Germany have lower stock valuations because of worker representation and influence on companies and a higher proportion of renters. Those renters have strong legal protections for their tenancy which decreases measured real estate values."

When it comes to tech companies, Europe has been at the vanguard of consumer data protection with its GDPR program. The continent is not as friendly to business owners than in the US, and this is reflected in the legal code. We can also look at a country like Japan, which is notoriously shareholder un-friendly, and see that zero percent interest rates and QE have done little support Japanese asset prices, at least compared to the US.

Below is a 20yr comparison for US (S&P 500, blue), Europe (Euro Stoxx 600, black) and Japan (Nikkei 225, yellow) stock market returns for the period ended December 31, 2021:

That's not to say interest rates are completely irrelevant. Again citing Tankus:

"For one thing, capital gains come from falling interest rates, not low interest rates. Sustaining the same interest rate stance doesn’t have the effect of increasing capital gains, and certainly not to the extent that actually lowering interest rates does. This sort of capital gains happened in the 1980s when rates were falling from 20+% to “merely” 7% or so. Holding interest rates at the same level shouldn’t be conflated with this interest rate effect. Further, from an inequality point of view, the high returns provided by such high interest rates is as relevant as these capital gains. It's not hard to get rich when you are earning your principal back in just a few years."

Perhaps it's true the Fed created inequality when Paul Volcker took interest rates up north of 20% and caused a recession in the early 1980's. But the tech-driven, relentless US stock market gains over the last decade or so can be better understood as the result of the laws on the books, not because of an expansion of the Fed's balance sheet or "money printing."

So, stop obsessing over the Fed. The Fed is a creature of Congress, and doesn't have nearly the impact on financial outcomes that Congress and the Courts do.

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