Do the rich finance unproductive household debt?

A Chicago Booth school research review note (or article or brief) published in May talks of the research by Sufi, Mian and Straub on how the top 1% investment in Treasury bills, notes and bonds and deposits in financial institutions end up as household debt for the bottom 99% which is relatively and mostly unproductive. The paper is problematic because it is looking at at the wrong place for the causes. Both the phenomenon they describe – the wealthy ending up with too much wealth and hence cash to invest and the lower-income households taking on more debt – are traceable to a common factor. That is monetary policy of the Federal Reserve.

By training their guns on the top 1% – not that I have a particular problem with it – they are not holding the Federal Reserve accountable for perpetrating huge wealth and income inequality. 

Ultra-loose monetary policy through a combination of low interest rates and liquidity provision fuel asset markets. Rich hold assets and they are able to enhance the return on such asset holdings through leverage as well that low interest rates amply facilitate and amplify as well.

To the extent that extraordinarily loose monetary policies fuel a much greater rise in equity prices than in real estate prices, then monetary policy can boost the wealth of the top 1% or 10% compared to the rest of the 99% or 90% and that is what has been happening.

In fact, this was pointed out in a brief but useful essay in the BIS Quarterly Review of March 2016. The essay is titled, ‘Wealth inequality and monetary policy’. Some extracts:

While low interest rates and rising bond prices have had a negligible impact on wealth inequality, rising equity prices have been a key driver of inequality. A recovery in house prices has only partly offset this effect. Abstracting from general equilibrium effects on savings, borrowing and human wealth, this suggests that monetary policy may have added to inequality to the extent that it has boosted equity prices.

Considering the tails of the wealth distribution – not shown here – generally reinforces this picture. The share of securities holdings, equity in particular, tends to be even higher at the top 5% or 1% of the distribution. Conversely, housing accounts for a higher share in the lowest net wealth quintile, for which low net wealth is in many cases a reflection of high levels of mortgage debt. In a number of cases, net wealth is negative, suggesting that liabilities, in the form of mortgage, consumer and other debt, exceed assets.

Since 2010, high equity returns have been the main driver of faster growth of net wealth at the top of the distribution.

What is interesting is that this essay points out that even in Japan, which is one of the least unequal among advanced nations, ultra-loose monetary policy has played a part in fomenting a rise in equity prices and hence a rise in inequality. This is what footnote no. 16 of the essay says:

Frost and Saiki (2014) study the impact of unconventional monetary policy on income inequality in Japan in a vector autoregression (VAR) framework. Using household survey data, they find that quantitative easing widened income inequality, especially after 2008 when policy became more aggressive. They identify capital gains resulting from higher asset prices as the main driver.

Corporate businesses do not invest in productive assets in America. They used to do that a lot in other countries to save on costs. They engaged in share buyback and the managers paid themselves very well. Workers were laid off as production went offshore. Worker insecurity restrained wage growth. Workers made up for it through borrowings and mortgage debt thinking that the rising value of their homes would keep them safe and offset weak income growth.

Loans are fixed and legal obligations. Real estate prices can go up and down and hence low income households bore the brunt of the real estate crash of 2008. The cycle repeats.

To say that banks recycle the excess savings of the top 1% into unproductive debt for low-income households is to misunderstand how banks create assets. The authors have not taken into consideration BoE research published in 2014 and which is borne out by empirical research (Richard Werner) as well that banks do not wait for deposits to create assets. They create money and THEN create deposits, in its wake.

Banks engaging in real estate lending (what the authors call unproductive debt) is partly lazy banking. Real estate loans carry lower risk weight because they are collateralised (Alan Taylor, et al) and mortgage loans are easier to securitise and get off the books as well. Third and a weaker consideration is that real estate loans to lower income households also gets a relatively freer pass on politically correct considerations.

So, the paper rests on flimsy foundations or is empirically unfounded. The common problem is the excessive and prolonged reliance on monetary policy to drive long-run economic performance as opposed to using them as short-run business-cycle management (or, aggregate demand management) tools.

Second, the review states:

Mian, Straub, and Sufi lean toward the global savings glut theory. Mian and Sufi argue in 2018 research that a rapid flow of foreign funds into the US triggered a credit-supply expansion that boosted household debt, which they say was a major factor in igniting the financial crisis.

This too is problematic and faulty. There are proximate and seemingly logical causes and there are longer-term considerations. Foreign funds flowed to America because extremely low US interest rates caused a surge in the value of other currencies against the US dollar. The ‘too-much-too-quick’ appreciation met with natural and unsurprising resistance from other countries. They accumulated foreign exchange reserves and those reserves were deployed in US Treasury and agency debt, etc. Even in stocks. Again, the underlying cause and the proximate cause are different.

Third, the authors appear to have recycled stale and impractical solutions to the problems that they had identified. Given that the problem identification was wrong, naturally the solutions were superficial too:

Their proposed solutions involve taxation—either a more progressive tax system or a wealth tax—through which the government can finance spending and investment, or redistribution programs that benefit lower-income households. 

The review does well to point out, citing other researchers, the practical difficulties of implementing a wealth tax:

As of 1990, there were 12 countries in Europe taxing net wealth, but now that is down to Norway, Spain, and Switzerland. When France did away with its version in 2018, the prime minister said it had caused many millionaires to flee. 

That is why any proposal to tax the wealth of the rich has to come from the rich themselves as part of a broader social compact. But, that is the stuff of fantasy and dreams these days, for the most part.

The practical suggestion:

Research by Booth’s Eric Zwick and Princeton’s Owen Zidar suggests that reforms such as rolling back special deductions for pass-through businesses, which they say collectively generate more taxable income for the top 1 percent than do big C corporations, could be a key part of a tax plan that raises up to $5 trillion over the first decade of implementation. Pass-through businesses typically include medical and law practices and other types of consultancies.

This makes sense. I do remember reading about the magnitudes of these pass-through in ‘The Captured Economy’ by Brink Lindsey and Steven M. Teles. Perhaps, it is a relatively unheralded book. It offers specific solutions and backs up its assertions with data and evidence. In a way, it provides the all-important evidential backing for the assertion that capitalism needs to be saved from capitalists.

In conclusion, one can speculate on why academics, in general and for the most part, tend to give a free-pass to central bankers. But, it is, well, speculative. Further, to be fair, it is not just academics who give a freer pass to fellow academics. This piece by Daniel Moss in Bloomberg on the (subtle or not) policy shift by the European Central Bank is proof that the cosy network is bigger and wider.

Shareholder capitalism and consumer welfare

Dr. Sumita Kale drew my attention to the article on Big Tech and anti-trust in the Wall Street Journal by Greg Ip via the newsletter she gets from ‘’. The name rang a bell. I had met Charles Assissi in the annual Aavishkaar-Intellecap led Sankalp Forum in 2018 (I think). He was talking about it, then. Glad to see it up and running.

The article by Greg Ip was interesting. It is great discussion material in economics and in public policy classrooms. Perhaps, in business schools too.

I did not know that Robert Bork was the counterpart to Milton Friedman on shareholder capitalism. The latter argued that the mission of companies was only shareholder returns. Bork appeared to have argued that the only thing that would militate against size was consumer welfare. If that was not affected, then size did not matter. That is the view that most judges have taken since the 1980s. I am not convinced of that logic.

Equally, I am not convinced of Greg Ip’s argument that it is about democracy. Questioning bigness is not a political issue as he is making out to be. Stakeholders, if broadly defined, go beyond shareholders. Similarly, size goes beyond consumer welfare. Suppliers, workers, small entrepreneurs and start-ups are part of the economic system.

Andrew Haldane argued that ‘Theory of Moral sentiments’ was a book for the 21st century as much as ‘The Invisible Hand’ became a book for the 20th century.

This is part of the foreword he wrote for the report on economics education by the Post-Crash Economics Society at the University of Manchester:

It is time to rethink some of the basic building blocks of economics. And in this rethink we could do worse than return to Adam Smith. For just prior to the Wealth of Nations, Smith had produced a rather different book. It was called The Theory of Moral Sentiments and was published in 1759.
In it, Smith emphasizes cooperation, as distinct from competition, as a way of satisfying society’s needs. It places centre-stage concepts such as reciprocity and fairness, values rather than value.
If the Wealth of Nations was the book for the 20th century, the Theory of Moral Sentiments may be the book for the 21st.

Whether it is shareholder returns or stakeholder returns or small or big sizes, there is no capitalism without fairness. Every other argument is obfuscation.

The inequity of the tax system

Based on the headline of this post, it may be possible to make the case that it applies to India as well, esp. after the data for 2020-21 revealed that India’s indirect tax collection exceeded the direct tax collection and within the latter, personal income tax collection exceeded the corporate tax collection. But, analysing the Indian situation is for another occasion. Let us now stick to the United States of America where the inequity is more glaring, arguably.

I came across and read the full article by Anand Giridhardas in New York Times published on the 13th June 2021. The title of the article leaves nothing for imagination: ‘Warren Buffett and the Myth of the ‘Good Billionaire’.

Vinod Khosla tweeted in response:

Amazingly nonsensical views from someone who hasn’t done anything material except pontificate. They have no notion of how to help the have-nots. Anand should try moving to a socialist state. The current system needs radical updates not revolution. [Link]

Other useful reads:

  • The original Big Story in ProPublica on how much billionaires pay in taxes.
  • Another article (by the authors of the article in ‘ProPublica’) that explains their methodology used for the article in above.

We can set aside Anand G.’ rant. I listened to a 7-minute clip of his conversation with Arthur Laffer in the Mehdi Hasan show. It was way over the top. Since that was my ‘benchmark’, this NYT article of his comes across as far more gentlemanly. He was being overly dramatic and calling Laffer a criminal. Ridiculous. So many things had to come together to make his ideas become policies. Second, we don’t know what are the things that Laffer recommended and what the politicians cherry picked. Third, putting someone on the defensive and ‘shaming’ him is good theatre, no doubt, but not something that helps make the world better.

So, notwithstanding Anand Giridhardas, we can still think about the manner in which incomes and capital gains & dividends are taxed. I see three issues, at my level.

There needs to be a discussion on unrealised capital gains and dividends. Dividends are avoided and companies buy stocks back to avoid dividend tax. What if the tax policies take away that choice?

Second, even if we accept that only realised capital gains are to be taxed, why are they taxed at much lower rates than tax on wages?

The logic was that capital-starved countries needed to attract capital. Second, capital investments in productive assets is considered to have a higher multiplier on economic growth and employment. In labour-rich countries it creates an ethical dilemma. So, the tax system favours the scarce resource (capital) and ignores the one that the country has more of (labour). As a result, labour resources are not fully utilised because there are relatively fewer incentives to deploy labour. The third aspect is that, since the Great Plague, the global economy has revolved and evolved around capital-intensive technology. It started in the West. Through their intellectual and other forms of domination, including colonisation, it spread everywhere, even to countries that were labour-rich. The Great Plague shifted the paradigm and economies had to grow according to that paradigm. That is why labour-rich countries began to lag in the global prosperity and economic growth league tables since the beginning of the 19th century.

Third, even if we accept this logic (which, in addition to the above arguments, is also a reflection of who made those laws, their incomes and wealth status, etc., over time and across the world) of the primacy of capital, for the sake of argument and hence accept the conclusion that capital gains will be treated differently from regular labour income, then the question is one of defining short-term and long-term. Why should short-term be just one  year? In economics, anyone’s definition of short-term is not one year but a business cycle, i.e., minimum three years. Extending the definition of ‘short-term’ to 36 months from 12 months will earn more revenues.

Incidentally, the IRS Sheet on calculating capital gains taxes in America comes across as rather complicated. See here.

There needs to be a better discussion on the way historically governments have taxed wages and taxed capital.

Given that extremely low interest rates have fostered asset price gains and asset price gains are not taxed until realised while tax on wages continues to be taxed annually and at higher rates, it is fairly straightforward to conclude that monetary policy and liquidity have actively helped capital gains grow faster than otherwise.

Now, the Federal Reserve in America has decided that it would be more patient in raising interest rates when employment picks up, wages rise and inflation rises.

That is a partial movement in the direction of being less hostile to wage inflation as compared to asset price inflation. But, notice that this policy continues to keep the real cost of capital low (even lower) and boosts asset prices for some more time.

So, monetary policy has not stopped helping capital owners disproportionately so.

On top of this, regulatory and tax policies are being tweaked fairly slowly as political and social momentum in favour of a better balance in taxation on labour income and capital income is building up only slowly.

In America, the 2020 Presidential election began the process of moving that balance away from being extremely favourable towards capital income. But, the election result was not decisively in favour of a thorough overhaul of the tax system, for two reasons.

One, the other side that recommends a far stricter tax code on capital income argues like Anand Giridhardas does. So, it scares away a lot of people. It helps to polarise the discussion, no doubt. But, it stokes anger and division. Even centrists are scared since normal middle and upper income Americans benefit from stock market and property wealth gains too.

By gunning for revolution, protagonists like Anand G. forego evolutionary gains. In any case, the track record of revolutionary regimes is nothing to speak of, in this matter. They have left their lands penurious. That is because the balance of power is always with capital owners. They eventually prevail.

So, a shrill approach does not make for a more equitable society.

The second reason is that baby boomers are still substantial and still influential. Come 2024 elections, they may become less influential. Millennials and Generation Z would be numerically more. If, in the next three years and plus, their situation does not improve, they may become more assertive and even aggressive in their demands and in their approach towards the problem – both via policies and in the streets.

There is a fair number of capitalists in America who recognise the problem and are willing to pay their fair share. It makes practical and policy sense to co-opt them rather than to stigmatise them as Anand G. does. More than that, his approach to solving the problem at hand is guaranteed to yield almost nothing.

STCMA – 27th April 2021

I read this strongly worded article in FT on the ‘bogus’ claims (as per the FT authors) of Bitcoin being environmentally not-unfriendly. Clearly, as the FT authors pointed out, the folks who wrote such a report had a natural conflict of interest. They were heavily invested in Bitcoin. Bruno Maçães countered it here. He has a point that, over time, the energy consumption of Bitcoin would or could come down. Two, Bitcoin farms can be located near sources of renewable energy that have surplus energy to sell. All that is fair.

He also highlights the case of petrodollars. He is right. Petrodollars were earned by extracting and burning fossil fuels and they were re-invested in US assets, including Treasuries. Of course, that was that. Now, the world has changed. When the West changes its ways, it wants others to change their ways too. But, it does not acknowledge that it has been guilty of similar conduct and has profited from it, while it wants to shut others’ access to such profits now. Some see it as hypocritical, arbitrary and self-serving. There is something to be said for it.

Stephen Roach’ mea culpa does not come across as inauthentic or as disguised self-praise. He is writing about how he got his forecast of a double-dip recession in 2021 for America wrong. Of course, he proudly recalls some of the big calls he made. Nothing wrong with that.

On the topic of the booming consumer, here is the latest global consumer confidence dipstick by Ipsos Mori. Consumer confidence is booming. For macroeconomists, that is a boost to aggregate demand. 

You have to believe these stories. Bubbles are not inferred from valuations alone. But, from such stories as well. It is a bubble psychology that matters. Or, for that matter, the blog post by Matt Levine – I had covered it as a separate post a short while ago – on the business model of helping businesses to be set up to to defraud individual investors – these are tell-tale signs of an euphoric market.

On market psychology, check out Robin Wigglesworth’s long article on the bubble in US stocks vs. not-so-much in UK stocks. The Shiller P/E for US stocks at 37 times is not just shy of the peak reached during the dotcom era of 1996-2000. Tobias Levkovich of the Citigroup also has a cautionary tale to tell about investing at current levels. 

It is always interesting to read that investors cannot see obvious triggers for a correction, let alone a crash. Tobias mentions that their clients tell him that. But, what they don’t seem to get is that the trigger is never obvious, except in hindsight.

The header for the article leaves no one in doubt as to what NYT Editors think of the subject: ‘A global tipping point for reining in tech. has arrived.’ The article discusses the emerging thinking, regulatory actions and their successes in different parts of the world, against the technology giants. On this one, I hope NYT has got it right. 

Runaway residential real estate prices is bad news for conservatives

From the Politico (8th March 2021):

If there aren’t enough homes to meet that demand, though, the largest generation in the country won’t be able to start building equity, which will in turn delay other financial decisions. Despite making up over a third of the workforce, millennials own less than 6 percent of all U.S. wealth, according to Federal Reserve data.

The delays will have long-term societal impacts. Even before the pandemic struck, more than 1 in 5 millennials — 21.9 percent in 2019 — lived with their parents, up from 11.7 percent in 2001, according to a Zillow analysis of census data. Partially as a result, millennials are significantly behind previous generations in forming families. [Link]

I was reminded of an article I read months ago. It turns out, it was published on my 57th birthday in

young people are not becoming more conservative as they reach middle age, or at least are doing so very slowly, countering a historic trend which had much to do with social patterns that no longer exist.

Conservatism is heavily contingent on lifestyle. Among Americans, for example, marriage (and motherhood) is the single biggest factor determining how white women vote, the country’s marriage gap being far larger than its gender gap (although Donald Trump, being utterly repulsive to a lot of women, did narrow this).

Liberalism, with its focus on the individual and the individual’s limitless potential, has always been associated with singledom. Most of its founding philosophical fathers were childless men, including Locke, Mill, Spinoza, Bentham, Hume and Adam Smith. (Jean-Jacques Rousseau had five children but abandoned them all to the death sentence of orphanages.)

Marriage rates are affected by a number of cultural factors, especially religion, but the simple cost of having children is also an obvious problem. Children have become more expensive, and the biggest component is runaway housing costs; in the US there is a clear correlation between high house prices and support for the Democrats.

In Britain, Conservative economic policy was for many years to encourage rising house prices as a nest egg, but each increase in value, aided by our strict planning laws, was decreasing the number of future Tories. Now, highly-expensive London is a sea of red and it’s only a matter of time before that starts to spread into the Home Counties.

Left-wing parties win where land is expensive, and cities comprise the most expensive real estate of all, and they are everywhere more liberal than rural areas. [Link]

Supply chain disruptions and the threat of inflation

I have long held the view – and am still holding on to it – that a sustained pickup in general price levels (familiarly known as a higher inflation rate) requires acceleration in wage growth. Post-1980 policy framework basically embraced the Phillips curve and suppressed wage growth in order to suppress the inflation rate. It served a dual purpose. It held down the inflation rate and hence the cost of capital. It also meant holding back the power of labour vs. capital. To put it somewhat provocatively and more colourfully, it was about defeating Marx in the name of markets. That framework has remained in place for four decades.

Now, central banks are only trying to loosen a small plank of it. They want to let inflation rise without letting the cost of capital rise and they are confident that wage growth is not accelerating anytime soon.

Robin Wigglesworth in this long article for the FT on the ‘inflation bogeyman’ comes up with a good description of the forces that held the inflation rate down in the advanced world in the last four decades:

Inflation will mechanically accelerate in the coming months, simply given the base effects from last year’s coronavirus-blasted data. A spurt of post-lockdown spending could give it some extra juice in places. But labour markets are not exactly screaming that wage growth is going to be an issue, and the longer-term inflation outlook remains clouded by the same secular, powerful forces that have kept it contained for decades…..

… It was only the “heady cocktail” of post-second world war rebuilding, the birth of welfare states, the collapse of the Bretton Woods exchange rate system, trade unionisation, and an oil crisis that helped send inflation spiking in the 1970s, he said. It might re-emerge as a genuine, long-term threat, but that is likely to take decades to manifest itself, not months. 

[Parenthetically, I want to mention a couple of things:

(i) Robin Wigglesworth’s article has a nice graphic on ‘the largest market tail risk’ as perceived by market participants over the last ten years (2012-21). Check it out. My guess is that all the five tail risks identified between 2012 and 2017 are likely to come back this decade.

(ii) I must note here that you are better off saving time by not reading this article by Martin Wolf which had appeared a day before Robin Wigglesworth’s article. It is too long for too little insight.]

While that is a good stylistic description, are there signs that things are beginning to shift? Well, the evidence is in favour of this balance of power not shifting anytime soon. This short news-story in FT on the wage negotiations between IG Metall – the labour union that represents all manufacturing sector workers in Germany – proves that central bankers are right to be sanguine about the rate of inflation ‘not getting out of hand’ any time soon.

So, central banks are right about the latter – wages. Further, they will mostly succeed in holding back the cost of capital with their tsunami of bond purchases because they may not succeed in stoking inflation higher, much as they want to.

Regular visitors to the blog will be familiar with these arguments of mine. Pl. bear with me. But, what if I am wrong and the central banks succeed in stoking inflation, without wages accelerating and therefore, what if they fail in holding the cost of capital down?

Evidence contrary to the IG Metall story from Europe is emerging from the United States of America despite a record number of people still remaining unemployed. It is partly because of the unemployment cheques are generous. Hence, there are job openings and no takers. Ed Yardeni points out that the ratio of unemployed to job openings dropped to 0.81 in January. It jumped to 4.63 in April 2020. Hence, wage growth is somewhat on the brisker side. Into this milieu has come the new USD1.9 trillion stimulus package that has been passed. Its effect will be unfolding in the coming months.

So, could this combination of wage growth due to unexpected reasons, over-generous and superfluous fiscal stimulus supported by an ultra-accommodative monetary policy be a sure-fire recipe for inflation resurgence? The Federal Reserve might then experience the old Chinese proverb: “Be sure of what you want; you may get it.”

If they succeed in letting inflation rise and if they fail in holding down the cost of capital, then mayhem will follow in financial markets because too much of debt has been added to many balance sheets in the last fifteen years. Further, wage growth may follow as the higher cost of living will force workers to wake up from their slumber and start demanding their pound of flesh.

So, it is a high-risk, high-wire game for central banks. But, it may be a familiar world for commercial banks. They may like it as interest margins rise but before that, the pain of bad loans might strike first. Eventually for central banks since taming inflation does not impose any upper bound on interest rates as the lower bound does, when trying to generate inflation. But, none of this will be smooth. In fact, more likely tumultuous, painful and long drawn out.

How can this situation emerge? This is where we have to pay attention to climate risks. In fact, that might be the reason why central banks are beginning to keep an eye on climate change. Some are going a step further and are wanting to incorporate it into their policy framework. Climate change impact can be stagflationary. That is my first guess. So, how to react to it is a challenge for central banks.

Climate change has caused quite a few disruptions in short time. One was the Texas freeze that gutted chip production. Then, the drought in Taiwan. Third, the desert winds that caused a big container ship to run aground. It has since been freed. Clearly, climate change is emerging as a significant ‘facilitator’ of higher inflation. That is what I am now beginning to be alive to, notwithstanding the long-held view that a sustained acceleration in wages is a pre-condition for an equally sustained pick-up in inflation.

This long article in Wall Street Journal captures the chaos or mess in supply chain everywhere. The evidence assembled is compelling and persuasive. Of course, many of these might be ephemeral and may disappear. But, one does not get that impression. It depends on the investments made already. Not sure if the western business world did really invest in capacity building. Not much in America, for sure. The chart below captures the ‘non-residential fixed investment in equipment and software’ as a share of GDP. This is long-form for what is more commonly known as capital expenditure by businesses or, simply, capex.

I have taken the nominal quantities rather than real since they are subject to somewhat subjective quality adjustments. Since the 1980s, the ratio has been declining. The striking thing is the failure of the ratio to rise in the new millennium. The internet boom had bust and many an investment had gone sour. There was a recession that lasted about 3 to 4 quarters. Then, there was the Bush tax cuts. The Federal Reserve dropped the Federal funds rate to 1.0% by 2003 and held it there for a year. There was ample reason and avenue to invest afresh in ‘capex’. But, instead, we got a real estate investment boom that eventually went bust in 2007-08.

It was during this period that China had a massive investment boom and export-led growth. Post-2008, China continued in that vein. Even now, China’s investment share of GDP is quite high. So, excess capacity in productive sectors, if any, is to be found in China. But, with China adopting ‘dual circulation’, how much of this excess capacity will be available to the rest of the world and at what price is a different question to answer than it was in the heydays of globalisation before the global financial crisis of 2008.

Indeed, the freak weather related disruptions or accidents, apart from the pandemic-induced shutdowns and lockdowns, what has come into sharp focus in recent months or a year is the fragility of just-in-time inventory systems. Read this well-researched (good graphics, again) article in FT on the chip shortages faced by car-makers. They are not the biggest customers of the chipmakers. The first two spots belong to smartphone and PC (incl. laptop) makers. Work-from-home has caused a spurt in PC demand. Along with that, came the disruptions in Texas and Taiwan.

An interesting quote from the article is this:

“It’s unheard of for such incidents to happen all at the same time. The impact will be considerable,” said Akira Minamikawa, analyst at research firm Omdia. 

Three things came to my mind. One is my blog post few days ago on the brilliant or wicked scriptwriter from the heavens. The second is that such statements are more likely to occur than not going forward. Third, I wonder if such accidents are more likely harbingers of a pickup in inflation even before wage pressures kick in.

I shall end this article with the time-worn expression of op.-ed. writers: “Only time will tell.”

Bitcoin untethered – links

Andy Kessler tracks the rise of Bitcoin to Tether:

Tether’s creators might have manipulated bitcoin, a University of Texas paper suggests, by issuing tokens willy-nilly unbacked by real dollars and then buying bitcoin to jack up its price. (The company claims the research is flawed.) [Link]

This is the link to the original Univ. of Texas paper published first in 2018. The link did not open for me, however. I will be trying again. Having problems with SSRN tonight.

(2) Edward Chancellor appears to have thrown in the towel on Bitcoin, having called its top in 2017 correctly. [Link]

(3) This article in ‘Research Affiliates’, published barely two months ago, echoes the point made by Andy Kessler on the how Bitcoin was ‘tethered’:

Tether is currently being sued by some investors who allege that no one is actually buying USDT from Tether Limited, but are minting USDT out of thin air, bypassing the supposed one-to-one (USDT/USD) backing (Mizrahi, 2019). They further allege that agents for Tether then use USDT to buy Bitcoin (and select other cryptocurrencies in favor with Tether) on exchanges, such as Bitfinex and Binance, that offer trading on the BTC/USDT pair. This action pushes up the price of the BTC/USDT pair. Because USD/USDT trades at dollar parity, the price is arbitraged on exchanges that trade the BTC/USD pair. Tether’s agents can then sell the BTC for USD and deposit them into the Tether bank account in case of audit and Tether could claim the USD were always there. …

If the market manipulation story is true, then BTC is not in a bubble in the traditional sense (Arnott, Cornell, and Shepherd, 2018), but is in the midst of something that could be much worse. If Tether were to be shut down, and if, in fact, artificial demand from Tether was supporting the price, the losses from a BTC crash may not be recoverable. [Link]

(4) Jim O’ Neill writes for ‘Project Syndicate’:

The rising popularity of SPACs and cryptocurrencies seems to reflect not their own strengths but rather the excesses of the current moment, with its raging bull market in equities, ultra-low interest rates, and policy-driven rallies after a year of COVID-19 lockdowns. [Link]

Thoughts on SPAC

Let me start by saying that being anti-SPAC is not an unconventional or off-consensus view. It is perhaps becoming quite mainstream. Some of us – I include myself – would not have even minded being offered a shot at one of the SPACs for a small bet. Well, I cannot afford anything more than that. So, it could be a case of sour grapes. You decide.

First, I am not even sure how SEC in America could even allow something like SPAC or Blank-Cheque companies. The level of scrutiny that IPOs go through goes missing with SPAC. This long article in WSJ which is more of a profile article on Chamath Palihapitiya points out at least a couple of specific things that one cannot do with a IPO but are easily permitted in the case of SPAC:

A SPAC avoids many of the rules governing a traditional IPO by executing a reverse merger between a corporate shell that raised the money and a private company that takes both the cash and the shell’s stock listing. …

…. Unlike in a traditional IPO, executives and sponsors of SPAC transactions can make projections about the company’s future revenue and profits. Because such deals are structured as mergers, SPAC sponsors don’t have to worry about restrictions on talking openly about a business before its shares start trading.

Mr. Palihapitiya takes advantage of these loopholes. He talks his deals up on Twitter, which his lawyers then submit to the Securities and Exchange Commission to comply with stock-solicitation rules. Mr. Palihapitiya arranged with CNBC extended airtime on the days his deals were announced and went through slides from his investor presentation, according to people familiar with the matter. CNBC declined to comment. YouTube and Inc.’s Twitch have also approached him about moving his deal announcements to their live-video streaming services, some of the people said….

…. The Securities and Exchange Commission proposed new guidance in December for SPAC sponsors to provide more disclosure around their compensation arrangements. [Link]

Second, the incentives of the sponsors are out of alignment with that of the other shareholders. Of course, other shareholders, these days, do not seem to mind this asymmetry. Greed drives all.

The sponsors get to earn some extra 20% and also enjoy additional warrants. So, their incentive is aligned with finding a target acquisition to be taken public through this route. Second, they have no long-term incentive to ensure that the company so bought is going to deliver long-term returns/value to the investors. Of course, the reasonable justification for that is that no one cares about the long-term these days. Not even so-called non-political technocratic policymaker-elites in central banks…

But, in theory the incentive of SPAC promoters is similar to the incentives of executive in investment banks who packaged sub-prime mortgages into securities. They took their payoff as soon as the securitisation was completed. Not even when the securitised structure was wound up. So, what went into the securitised asset was of least concern to them. It did not matter if its loss-tolerance was very low or that it was leveraged multiple times over. That is why the biggest innovation that the Reserve Bank of India, under Dr. Y.V. Reddy, did was to change the incentive structure for securitised products.

The compensation was to be reckoned when those structures were safely wound up and not when they were structured. See here:

The RBI has issued guidelines on securitisation of standard assets in February 2006. The guidelines are applicable to banks and financial institutions, including nonbanking financial companies (NBFCs). These guidelines provide for a conservative treatment of securitisation exposures for capital adequacy purposes, especially in regard to the credit enhancement and liquidity facilities. The regulatory framework encourages greater participation by third parties with a view to ensure better governance in the structuring of special purpose vehicles (SPVs), the products, and the provision of support facilities. A unique feature of these guidelines, which may be at a variance with the accounting standards, is that any profits on sale of assets to the SPV are not allowed to be recognised immediately on sale but over the life of the pass through certificates issued by the SPV. We believe that these guidelines, as a package, have ensured an appropriate incentive mechanism for securitisation transactions. [Link]

Emphasis mine. This is an extract from a speech (‘Global Financial Turbulence and Financial Sector in India: A Practitioner’s Perspective’) that Dr. Y.V. Reddy delivered in March 2008. America did not do this before 2008. Now, again, SEC and the Federal Reserve are missing this trick with respect to the incentives that accrue to SPAC sponsors. So, some of us will be bitter about it – because we are missing out on easy-money and also because it is systemically risky. That is human nature for you!

Having written this, let me point out the exit of a sponsor – Chamath Palihapitiya – from Virgin Galactic. You can read the article in Bloomberg on why the SPAC party may be over (I don’t think so) and this article in ‘Business Insider’. Both could be behind paywalls. A shorter version of the article in ‘Business Insider’ is available here. One week is too long these days. Therefore, the article in Bloomberg was a product of its times, a week ago! Now, all is clear and it is back to ‘risk on’ in financial markets. SPACs are not going away anytime soon.

From ‘The Economist’ last month:

Their sudden popularity and the sheer variety of their size, scope and structure raise the question of which spacs are sensible and which show signs of mania. A financier in charge of a big investment bank’s spac business sees a clear bifurcation. There are plenty of good spacs with excellent management teams that can help turn mediocre companies into good ones. But the rest, perhaps a third to two-thirds, “don’t know the first thing about the businesses they are dealing with”.

That seems to be confirmed by a recent study by Michael Klausner and Emily Ruan of Stanford University and Michael Ohlrogge of New York University. The authors look at blank-cheque firms that made acquisitions between January 2019 and June 2020. They find that, in 25% of cases, the sponsor’s payout exceeded 12% of post-merger equity, compared with a median stake of 7.7%. [Link]

The above article does point out that the incentive of Bill Ackman, a SPAC-sponsor was aligned with that of his investors:

…. like Mr Ackman’s, which will issue him 6.7% of the shares in the merged firm only once investors earn a 20% return, are more sensibly structured, valuing it more handsomely than the rest. (Its share prices are trading at 50% above their ipo level.) 

Incidentally, the article talks about the valuation of electric cars. On that topic, readers should read this excellent report at on how not all electric vehicle makers will succeed and, hence, all of them commanding extremely high valuations is a case of market delusion.

The concluding line of the article in ‘The Economist’ is what it is:

Seen this way, the mania around SPACs is simply an expression of wider exuberance.

Of course, that will take us next to other expressions of the wider exuberance or delusion: Non-Fungible Tokens or Green Energy, Green Finance or ESG, etc.

All these ‘expressions of wider exuberance’ must be traced to central bank exuberance, of course.

The ‘Greensill’ canary in the coalmine

I understand the following:

(1) Greensill offers supply chain finance: pays off suppliers of a company at a discount. The original buyer is now a receivable with Greensill.

(2) Greensill packages these receivables (securitises) and these are invested into by funds like CS Supply Chain Finance Fund

(3) Greensill gets its receivables insured (credit insurance).

Insurance is now not being offered; or was being offered at more onerous terms. That has triggered the collapse of Greensill.

An Edit in Financial Times provides some useful conceptual backdrop:

The practice of a supplier selling on invoices to a middleman who takes over collecting payments from buyers, known as factoring, is long-entrenched. “Reverse” factoring, or supply chain financing, flips things round: a buyer — often a large business — agrees with its suppliers that they will be paid by an intermediary, so they receive payments more quickly but at a small discount. The business later pays the full sum to the finance provider.

Greensill is among those that have added a new spin to the practice, by arranging funding for companies not just through a bank it owns in Germany but by packaging supplier bills into bond-like investments that are sold to investors. In Greensill’s case, one of the biggest buyers has been Credit Suisse — which on Monday suspended $10bn of funds linked to assets that Greensill originated. Its founder, Lex Greensill, cultivated political contacts in the UK and his native Australia, and successfully pitched to bring his supply chain financing methods into public-sector contracts and procurement. [Link]

Greensill, on the face of it, offers supply chain finance to many different industries. But, what one does not know is the relationships between Greensill and all its debtor-companies. For example, were they all funded by Softbank? Was there a Softbank connection? Is Sanjay Gupta a big concentration risk for Greensill? Was there a Softbank connection there? Well Sanjay Gupta is a former Greensill shareholder himself!

But, loans to Sanjay Gupta are not the only warning signs of potential or possible wrongdoing. This story in WSJ on Softbank bailing out Katerra and Greensill cancelling/forgiving the loans extended to Katerra through the bank in Germany it owned does not smell good. The headline of this story tells the story already! It actually stinks quite badly from a distance. Too many inter-connected deals and conflicts of interest. As central banks create money out of thin air and in spades, it just finds it way into all the cesspools (only). It is incretdible that Softbank appears to be in the thick and thin of all of them.

This does sound quite like the sub-prime mortgage situation.

This could be the canary in the coalmine as the BNP Paribas Funds were, for the 2008 crisis. Let us see.

The fragility of democracy

On the fragility of democracy:

“Democracy is inherently fragile. We have an idea that it’s a very robust system. But democracies have existed for about 150 years. In this country, I think you could say that they existed from the second half of the of the 19th century — they are not the norm. Democracies were regarded in ancient times as inherently self-destructive ways of government. Because, said Aristotle, democracies naturally turn themselves into tyranny. Because the populace will always be a sucker for a demagogue who will turn himself into an absolute ruler…

“Now, it is quite remarkable that Aristotle’s gloomy predictions about the fate of democracies have been falsified by the experience of the West ever since the beginning of democracy. And I think one needs to ask why that is. In my view, the reason is this: Aristotle was basically right about the tendencies, but we have managed to avoid it by a shared political culture of restraint. And this culture of restraint, which because it depends on the collective mentality of our societies, is extremely fragile, quite easy to destroy and extremely difficult to recreate.”

I have not read Aristotle, let alone his views on democracy. But, what Lord Sumption says is that the dangers for democracy have been avoided by a shared culture of restraint (voluntary restraint).
That is a hypothesis. Not an assertion. It could be that it just took a little longer for Aristotle’s warnings to arrive (become a reality).
It could be that the natural post-WW II prosperity kept at bay all the divisive/dangerous tendencies. Plus, the revulsion at what happened before WW II ended must have been fresh in people’s minds. So, the power of unpleasant near-term memory kept dangerous tendencies at bay?
Over time, prosperity fades. It is no longer a low-hanging fruit. More importantly, the ‘other’ was vanquished by 1989-90. No external ‘other’ to focus one’s energies on. Internal divisions – historical and recent – augmented by elite greed take over.
In other words, Aristotle was not wrong but that it is always a matter of time?
Just putting forward a topic and set of hypotheses for discussion.