Why aren't markets freaking out?

 From Paul Krugman

For those of us who follow economic policy in general and the Federal Reserve in particular, the past week has been shocking and terrifying. Donald Trump’s ongoing attempts to bully the Fed into large interest rate cuts have escalated into an attempt to fire Lisa Cook, a member of the Fed’s Board of Governors, over unsubstantiated claims that she committed financial fraud while still a college professor. Indeed, Trump claims that he has already fired her, although he has no legal right to do so.

Whatever happens, Trump’s campaign to take over monetary policy has shifted from a public pressure to personal intimidation of Fed officials: the attack on Cook signals that Trump and his people will try to ruin the life of anyone who stands in his way. There is now a substantial chance that the Fed’s independence, its ability to manage the nation’s monetary policy on an objective, technocratic basis rather than as an instrument of the president’s political interests and personal whims, will soon be gone.

So why aren’t markets freaking out? Nations in which central banks lose their independence sooner or later suffer high inflation, especially when they are taken over by autocrats who buy into crackpot economic doctrines. And Trump, who has been demanding large rate cuts because, he claims, the economy is running hot — which almost every economist would say is a reason to raise rates, not cut them — certainly fits that pattern. Yet although there have been small tremors in the bond and currency markets, there have been no significant upheavals in financial markets that reflect the severity of the situation we are in. Throughout this episode, the stock market has remained fairly flat and bond yields haven’t spiked.

Why not? Do financial markets doubt that Trump will get his way? Or do they reject mainstream economics and the clear examples of countries like Turkey and Argentina?

Neither. My read of economic and financial history is that market pricing almost never takes into account the possibility of huge, disruptive events, even when the strong possibility of such events should be obvious. The usual pattern, instead, is one of market complacency until the last possible moment. That is, markets act as if everything is normal until it’s blindingly obvious that it isn’t.

The inimitable Nathan Tankus summarizes this by saying that the market is not, as stylized economic models would have us believe, a mechanism that pools the knowledge and informed judgment of millions of investors. It is, instead, a “conventional wisdom processor.” That is, it reflects views that seem safe to hold because many other people hold them — and the crowd only abandons those views when they become blatantly unsustainable.

John Maynard Keynes said something similar in Chapter 12 of his General Theory of Employment, Interest and Money. Market investors, he argued, pay little attention to the question of what assets are truly worth. Instead, they worry mostly about the market value of those assets a few months in the future. In a memorable albeit sexist passage (it was 1936), he declared that:

"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view … we devote our intelligences to anticipating what average opinion expects the average opinion to be."

So if the conventional wisdom is that economic conditions will remain more or less normal despite highly abnormal policy, markets will remain calm until the illusion of normality becomes unsustainable. At that point market prices may “change violently.” The current technical term for this phenomenon is a “Wile E. Coyote moment” — the moment when the cartoon character, having run several steps off the edge of a cliff, looks down and realizes that there’s nothing supporting him. Only then, according to the laws of cartoon physics, does he fall.

You might ask why smart investors with long time horizons don’t foresee Wile E. Coyote moments and get very rich in the process. Some do. But for reasons that would take another long post to explain — maybe a primer one of these days — there never seem to be enough such investors to shake market complacency, no matter how unwarranted. It’s one thing to short a stock, but to short the entire market is a completely different beast.

Can I document these assertions? Let’s look at a couple of relatively recent examples of market complacency and myopia in the midst of clear signals of an oncoming crisis.

First, the subprime crisis of the 2000s. By 2005, at the latest, there were very good reasons to suspect that we were in the midst of a major housing bubble. Here’s a graph of one measure of housing overvaluation, the ratio of home prices to average rents: 

When home prices are very high compared with average rents, that indicates the likelihood of a bubble because, ultimately, the value of the house lies in its use as a place to live.

The shaded area starting in late 2007 is the Great Recession [GFC]. Now, one could try to rationalize the extremely high prices of houses relative to rents in 2006. But an honest assessment would at least have reflected the serious possibility — not the certainty — that there was a bubble in house prices during this period. It would also reflect the possibility of a flood of mortgage defaults when the bubble popped.

Yet ABX indices, a measure of perceived default risk on securities backed by subprime mortgages, didn’t show any serious decline until well into 2007, when the housing bubble had already been deflating for more than a year

Source: Bank for International Settlements

Another example of market complacency is the euro area crisis that began in 2009. By the mid 2000s it was already obvious that huge sums of money were flowing into southern European nations like Spain, where they were being used largely to finance highly speculative real estate investment — very much like the US sub-prime bubble.

Even if it was unclear that the flood of money would abruptly end -- a nasty “sudden stop” – the possibility of such a stop should have been reflected in bond yields.

Yet the spread between interest rates on Spanish and German bonds — a measure of the risk markets perceived that Spain would experience a crisis — stayed very low until the crisis was already underway:

So if you want to know why markets aren’t reacting to the risk of very bad policy if Trump takes over the Fed, you should know that major market reactions to that kind of risk are rare. In fact, I can’t come up with a single example.

All of which says, in turn, that the absence of a strong reaction to Trump’s assault on the Fed isn’t a sign that everything is OK. We are, in fact, looking at a policy disaster in the making. But markets probably won’t react strongly until the disaster is already upon us.

I sold all my personal holdings in early May, going into 100% cash.  (In my notional portfolio, I also went into cash, but reinvested later.  The reality is that clients want to enjoy the last of the any rise in the markets, and get angry if you underperform the share market, even if you eventually are right.  Understandable, but it leads to exactly the kind of market actions Krugman deplores.)

When I was still managing portfolios professionally, I sold 50% of our portfolios in early 2008, just before the GFC hit.  Mortgage default rates were already high.  If there was a recession, unemployment would rise, and defaults would explode.   At the first payrolls report in January 2008, for December 2007, employment fell (ironically revised away later!).  I was on holiday, and so was our dealer.  I went back into the office, I called him in from his holiday too, and we sold all our liquid stocks.

The perilous situation now is made even riskier by the dominance of AI stocks in the US share market.  AI may eventually make money, but the situation smells just like the dot-com boom of the early 2000s, which I also sat out.  Some internet companies did go on to eventually make big profits (Amazon!) but the market halved between 2000 and 2002.  The market cap of the top ten companies as a percentage of the total market cap is now at a record high.   7 of those companies are AI-related.  When the AI bubble bursts, the market will collapse, just like it did after the dot-com boom.

Will that happen tomorrow?  Who knows?  But it will happen.  It's only a matter of time.

DISCLAIMER:  I might be wrong.  That has happened from time to time before.

Why China can't bail out Russia

 From The Age. [Article written by Paul Krugman for The New York Times]

In deciding to invade Ukraine, Vladimir Putin clearly misjudged everything. He had an exaggerated view of his own nation’s military might; my description last week of Russia as a Potemkin superpower, with far less strength than meets the eye, looks even truer now. He vastly underrated Ukrainian morale and military prowess, and failed to anticipate the resolve of democratic governments — especially, although not only, the Biden administration, which, in case you haven’t noticed, has done a remarkable job on everything from arming Ukraine to rallying the West around financial sanctions.

I can’t add anything to the discussion of the war itself, although I will note that much of the commentary I’ve been reading says that Russian forces are regrouping and will resume large-scale advances in a day or two — and has been saying that, day after day, for more than a week.

What I think I can add, however, is some analysis of the effects of sanctions, and in particular an answer to one question I keep being asked: Can China, by offering itself as an alternative trading partner, bail out Putin’s economy?

No, it can’t.

Let’s talk first about the impact of those sanctions.

One thing the West conspicuously hasn’t done is try to block Russian sales of oil and gas — the country’s principal exports. Oh, the United States might ban imports of Russian oil, but this would be a symbolic gesture: Oil is traded on a global market, so this would just reshuffle trade a bit, and in any case US imports from Russia account for only about 5 per cent of Russian production.

The West has, however, largely cut off Russia’s access to the world banking system, which is a very big deal. Russian exporters may be able to get their stuff out of the country, but it’s now hard for them to get paid. Probably even more important, it’s hard for Russia to pay for imports — sorry, but you can’t carry out modern international trade with briefcases full of $US100 bills. In fact, even Russian trade that remains legally permitted seems to be drying up as Western companies that fear further restrictions and a political backlash engage in “self-sanctioning.”

How much does this matter? The Russian elite can live without Prada handbags, but Western pharmaceuticals are another matter. In any case, consumer goods are only about one-third of Russia’s imports. The rest are capital goods, intermediate goods — that is, components used in the production of other goods — and raw materials. These are things Russia needs to keep its economy running, and their absence may cause important sectors to grind to a halt. There are already suggestions, for example, that the cutoff of spare parts and servicing may quickly cripple Russia’s domestic aviation, a big problem in such a huge country.

But can China provide Putin with an economic lifeline? I’d say no, for four reasons.

First, China, despite being an economic powerhouse, isn’t in a position to supply some things Russia needs, like spare parts for Western-made airplanes and high-end semiconductor chips.

Second, while China itself isn’t joining in the sanctions, it is deeply integrated into the world economy. This means that Chinese banks and other businesses, like Western corporations, may engage in self-sanctioning — that is, they’ll be reluctant to deal with Russia for fear of a backlash from consumers and regulators in more important markets.

Third, China and Russia are very far apart geographically. Yes, they share a border. But most of Russia’s economy is west of the Urals, while most of China’s is near its east coast. Beijing is 3,500 miles from Moscow, and the only practical way to move stuff across that vast expanse is via a handful of train lines that are already overstressed.

Finally, a point I don’t think gets enough emphasis is the extreme difference in economic power between Russia and China.

Some politicians are warning about a possible “arc of autocracy” reminiscent of the World War II Axis — and given the atrocities underway, that’s not an outlandish comparison. But the partners in any such arc would be wildly unequal.

Putin may dream of restoring Soviet-era greatness, but China’s economy, which was roughly the same size as Russia’s 30 years ago, is now 10 times as large. For comparison, Germany’s gross domestic product was only 2 1/2 times Italy’s when the original Axis was formed.

So if you try to imagine the creation of some neofascist alliance — and again, that no longer sounds like extreme language — it would be one in which Russia would be very much the junior partner, indeed very nearly a Chinese client state. Presumably that’s not what Putin, with his imperial dreams, has in mind.

China, then, can’t insulate Russia from the consequences of the Ukraine invasion. It’s true that the economic squeeze on Russia would be even tighter if China joined the democratic world in punishing aggression. But that squeeze is looking very severe even without Chinese participation. Russia is going to pay a very high price, in money as well as blood, for Putin’s megalomania.

A person holds cash withdrawn from an ATM machine at a Sberbank branch. On February 24, the United States announced it was imposing sanctions on major Russian banks, including Sberbank and VTB in response to the special military operation in Ukraine.

Anton Novoderezhkin | TASS | Getty Images

Soaring US inequality

 From Paul Krugman

We have always been at war with Eastasia

Big Brother is Watching You--from George Orwell's 1984

From ClimateCrocks:

It’s hard to feel any sympathy for Trish Regan, the Fox News host who was fired after a rant in which she called the coronavirus “yet another attempt to impeach the president.” We may never know how many Fox viewers became gravely ill or died because they ignored social distancing in response to people like Regan, who told them that the pandemic was a politically motivated hoax. But the number was surely significant.

The twist in the Regan story, however, is that what she said wasn’t significantly different from what her whole network had been saying for weeks. Her career-killing mistake wasn’t saying something false and evil, it was her timing. She apparently missed the abrupt turn in the party line by a few hours.

For Regan’s rant came just after Fox and right-wing media in general suddenly changed their line from “the pandemic is a liberal hoax” to “everyone must unify behind our great leader in his heroic struggle against the Chinese virus.” And for some reason Regan didn’t get the memo.

Actually, Regan wasn’t the only person who didn’t get the memo. A number of people on the religious right are still sticking with the virus-as-hoax story, notably Jerry Falwell Jr., who defied public health experts by reopening Liberty University — and promptly created his own personal virus hot spot. But most leading figures on the right have swerved on command.

Needless to say, the mounting coronavirus death toll hasn’t produced any apologies from pundits who previously claimed that the virus was a hoax, let alone admissions that the terrible, horrible, no-good mainstream media were actually giving accurate information. Perhaps more surprisingly, as far as I know there haven’t been any howls of protest from Fox viewers, or Rush Limbaugh listeners, who are now being told something completely different from what they were hearing three weeks ago. Their trust in Fox, their disdain for The New York Times and The Washington Post, and, above all, their faith in Donald Trump are apparently unshaken.

The parallels with George Orwell’s “Nineteen Eighty-Four” are obvious. When Oceania suddenly shifts alliances, and its former ally Eastasia becomes an enemy, everyone knows what to believe: not only was the nation at war with Eastasia, it had always been at war with Eastasia. In Orwell’s vision, however, this mind-set was produced by a totalitarian state whose vigilant Thought Police stamp out any hint of independent thought. America isn’t a totalitarian state — not yet, anyway — yet there are tens of millions of American apparently willing to act and think as if the Thought Police were already up and running.

Orwell wrote a great essay a few years before “Nineteen Eighty-Four” titled “Looking Back on the Spanish War.” In it he wrote of his vision of a “nightmare world in which the Leader, or some ruling clique, controls not only the future but the past. If the Leader says of such and such an event, ‘It never happened’ — well, it never happened. If he says that two and two are five — well, two and two are five. This prospect frightens me much more than bombs.

Well, a lot of Americans evidently already live in that nightmare world. And that scares me more than Covid-19.
-----Paul Krugman

Apocalypse becomes the new normal

From Paul Krugman of the New York Times:

The past week’s images from Australia have been nightmarish: walls of flame, blood-red skies, residents huddled on beaches as they try to escape the inferno. The bush fires have been so intense that they have generated “fire tornadoes” powerful enough to flip over heavy trucks.

The thing is, Australia’s summer of fire is only the latest in a string of catastrophic weather events over the past year: unprecedented flooding in the Midwest, a heat wave in India that sent temperatures to 123 degrees, another heat wave that brought unheard-of temperatures to much of Europe.

And all of these catastrophes were related to climate change.

Notice that I said “related to” rather than “caused by” climate change. This is a distinction that has flummoxed many people over the years. Any individual weather event has multiple causes, which was one reason news reports used to avoid mentioning the possible role of climate change in natural disasters.

In recent years, however, climate scientists have tried to cut through this confusion by engaging in “extreme event attribution,” which focuses on probabilities: You can’t necessarily say that climate change caused a particular heat wave, but you can ask how much difference global warming made to the probability of that heat wave happening. And the answer, typically, is a lot: Climate change makes the kinds of extreme weather events we’ve been seeing much more likely.

And while there’s a lot of randomness in weather outcomes, that randomness actually makes climate change much more damaging in its early stages than most people realize. On our current trajectory, Florida as a whole will eventually be swallowed by the sea, but long before that happens, rising sea levels will make catastrophic storm surges commonplace. Much of India will eventually become uninhabitable, but killing heat waves and droughts will take a deadly toll well before that point is reached.

Put it this way: While it will take generations for the full consequences of climate change to play out, there will be many localized, temporary disasters along the way. Apocalypse will become the new normal — and that’s happening right in front of our eyes.

Attack of the Wall Street Snowflakes

NY Stock Exchange by Jeenah Moon for the New York Times

From Paul Krugman at The New York Times

Given all the recent focus on health policy, you might think that the medical-industrial complex would be heavily involved in the Democratic primary race, going all-out to block Elizabeth Warren. And a coalition of drug companies, insurers and hospitals is indeed running ads attacking “Medicare for all.”

But the health industry’s political role has been relatively muted so far. Partly this may reflect realism: Even if Warren becomes president, the chances of getting Medicare for all through Congress are small. It may also reflect the surprising openness of doctors to reform. While the American Medical Association still officially opposes single-payer, at a recent meeting, 47 percent of the delegates voted to drop that opposition.

No, the really intense backlash against Warren and progressive Democrats in general is coming from Wall Street. And while that opposition partly reflects self-interest, Wall Street’s Warren hatred has a level of virulence, sometimes crossing into hysteria, that goes beyond normal political calculation.

What’s behind that virulence?

First, let’s talk about the rational reasons Wall Street is worried about Warren. She is, of course, calling for major tax increases on the very wealthy, those with wealth exceeding $50 million, and the financial industry is strongly represented in that elite club. And since raising taxes on the wealthy is highly popular, it’s an idea a progressive president might actually be able to turn into real policy.

Warren is also a big believer in stricter financial regulation; the Consumer Financial Protection Bureau, which was highly effective until the Trump administration set about gutting it, was her brainchild.

So if you are a Wall Street billionaire, rational self-interest might well induce you to oppose Warren. Rationality does not, however, explain why a money manager like Leon Cooperman — who just two years ago settled a suit over insider trading for $5 million, although without admitting wrongdoing — would circulate an embarrassing, self-pitying open letter denouncing Warren for her failure to appreciate all the wonderful things billionaires like him do for society.

Nor does it explain why Cliff Asness, another money manager, would fly into a rage at Warren adviser Gabriel Zucman for using the term “revenue maximizing” — a standard piece of economic jargon — describing it as “disgustingly immoral.”

In any case, the point is that Wall Street billionaires, even more than billionaires in general, seem to be snowflakes, emotionally unable to handle criticism.

I’m not sure why that should be the case, but it may be that in their hearts they suspect that the critics have a point.

What, after all, does modern finance actually do for the economy? Unlike the robber barons of yore, today’s Wall Street tycoons don’t build anything tangible. They don’t even direct money to the people who actually are building the industries of the future. The vast expansion of credit in America after around 1980 basically involved a surge in consumer debt rather than new money for business investment.  [Contrast that with what Elon Musk is doing]

Moreover, there is growing evidence that when the financial sector gets too big it actually acts as a drag on the economy — and America is well past that point.

Now, human nature being what it is, people who secretly wonder whether they really deserve their wealth get especially angry when others express these doubts publicly. So it’s not surprising that people who couldn’t handle Obama’s mild, polite criticism are completely losing it over Warren.

[Read more here]

Trump pulls out

Source

There's been lots of commentary on Trump's withdrawal from the Paris climate agreement (how, for example, can an agreement be both 'non-binding' and 'draconian'?)  But of all the mountains of stuff I've read I think Paul Krugman's take is my favourite, so I'll just quote him:

The point is that while tackling climate change in the way envisaged by the Paris accord used to look like a hard engineering and economic problem, these days it looks fairly easy. We have almost all the technology we need, and can be quite confident of developing the rest. Obviously the transition to a low-emissions economy, the phasing out of fossil fuels, would take time, but that would be O.K. as long as the path was clear.

Why, then, are so many people on the right determined to block climate action, and even trying to sabotage the progress we’ve been making on new energy sources?

Don’t tell me that they’re honestly worried about the inherent uncertainty of climate projections. All long-term policy choices must be made in the face of an uncertain future (duh); there’s as much scientific consensus here as you’re ever likely to see on any issue. And in this case, uncertainty arguably strengthens the case for action, because the costs of getting it wrong are asymmetric: Do too much, and we’ve wasted some money; do too little, and we’ve doomed civilization.

Don’t tell me that it’s about coal miners. Anyone who really cared about those miners would be crusading to protect their health, disability and pension benefits, and trying to provide alternative employment opportunities — not pretending that environmental irresponsibility will somehow bring back jobs lost to strip mining and mountaintop removal.

While it isn’t about coal jobs, right-wing anti-environmentalism is in part about protecting the profits of the coal industry, which in 2016 gave 97 percent of its political contributions to Republicans.

As I said, however, these days the fight against climate action is largely driven by sheer spite.

Pay any attention to modern right-wing discourse — including op-ed articles by top Trump officials — and you find deep hostility to any notion that some problems require collective action beyond shooting people and blowing things up.

Beyond this, much of today’s right seems driven above all by animus toward liberals rather than specific issues. If liberals are for it, they’re against it. If liberals hate it, it’s good. Add to this the anti-intellectualism of the G.O.P. base, for whom scientific consensus on an issue is a minus, not a plus, with extra bonus points for undermining anything associated with President Barack Obama.

And if all this sounds too petty and vindictive to be the basis for momentous policy decisions, consider the character of the man in the White House. Need I say more?

[Read more here]

Atlas shrugged

Via Paul Krugman