Streetwise Professor

August 30, 2015

Don’t Get Carried Away By Political Rhetoric on Carried Interest Taxation

Filed under: Economics,Politics — The Professor @ 7:12 pm

The tax treatment of “carried interest” for private equity and hedge fund general partners is something pretty much everyone loves to hate. Politicians particularly. Several major candidates, including Hillary, Sanders, and Trump, have said that they will scrap it.

Their argument is simple. Carried interest is taxed at the lower long run capital gains rate  (20 pct), instead of the rate for earned income (39.6 pct). Obviously unfair!  Private equity and hedge fund managers are greedy bastards who do nothing to earn their money! (Trump says they just push paper around.) They don’t deserve a break! Restore fairness to the tax code!

Tax professionals are largely against the treatment too, though their reasoning is a little more sophisticated. Carried interest is income properly attributable to labor or service provision, and is not a return on capital. It therefore should be taxed as labor income.

A little reflection shows that both arguments are simplistic. I can’t say 20 percent is the right rate, but I am highly confident that 39.6 percent is too high. And that’s because carried interest treatment does affect returns on capital, and this should be taken into consideration when figuring out the proper tax treatment. Capital taxes are a bad idea generally, and the effects of carried interest on returns to capital should be taken into consideration when deciding how heavily to tax it.

First, what is carried interest? Private equity and hedge funds typically have limited partners as investors, and general partners who manage. These entities employ incentive mechanisms. The general partners get a percentage (overwhelmingly 20 percent) of all gains over a benchmark, and get zero incentive comp if they fail to reach the benchmark. This is incentive compensation is carried interest, and is taxed as a long term capital gain.

So what would be the effect of increasing taxation on carried interest? Basic tax incidence analysis applies here. Tax incidence analysis basically shows that the costs of a tax are paid not just on whom it is levied (PE and hedge fund GPs in this instance), but are also paid in part by those who buy from or sell to the taxed entity.

There is a supply and demand for the services of PE and HF managers. Investors are willing to pay for managers because the managers can earn a higher return than the investors could earn by investing themselves. Like the demand for anything, the demand for management services is downward sloping: the lower the cost of managers, the more capital will be invested with them because at a lower cost PE and HF outperform more competing investments.

Since these industries are likely highly competitive, the supply curve of services reflects the marginal costs of managerial services. The supply is upward sloping, mainly because some managers are more efficient than others. To expand the industry requires some managers to expand beyond their efficient scale, and also requires the entry of new, less efficient (i.e., higher cost) managers.

Taxes imposed on managers increases their costs, and shifts up the supply curve of managerial services. As the supply curve moves up and to the left, its intersection with the demand curve moves up and to the left. At the new, post-tax equilibrium, less funds are under management (which is crucial), and the cost paid by investors is higher. Thus, some of the burden of the tax is borne by the investors. The rise in the price of managerial services is typically small rather than increase in the tax, however, meaning that managers’ after tax income declines. Thus, the burden of the tax is shared between investors and managers.

How the burden is split depends on how steep the supply and demand curves are. Only if the supply of managerial services is vertical (“perfectly inelastic”) will all of the burden of the tax fall on the PE and HF bastards. This occurs only if all managers are equally efficient, and all are willing to supply the same amount of services at any price. If the supply of their services is very flat (i.e., a small decline in the price of their services leads to a large decline in the quantity supplied), virtually all the burden of the tax is paid by investors.

Thus, like all taxes, the tax on carried interest drives a wedge between the price paid by consumers (investors in PE and HF, in this instance) and suppliers (PE and HF managers).

The fact that investors pay some of the tax means that the carried interest tax is in part a tax on capital, except in the edge case (perfectly flat supply of PE and HF management). This is true because investor returns are depressed by the higher pre-tax compensation that must be paid to managers. Further, note that except in the edge case, investment in PE and HFs will decline, and thus they have less capital to invest. Although things are complicated by the fact that capital may be diverted to other investments, it is likely that total investment goes down. This means that even if the services managers are providing are deemed “labor” or “services”,  taxing carried interest reduces returns on some capital, and likely leads to a reduction in overall investment.

Since there are strong economic arguments that capital should not be taxed, and certainly not taxed as high as labor income if it is taxed, this in turn implies that taxing carried interest exactly the same as earned income is not likely to be optimal. I don’t know what the tax rate should be, but is plain wrong to analyze carried interest as pure labor income. It impacts returns on capital and this needs to be considered when deciding the right tax rate.

There are some other considerations that bolster this conclusion. In particular, carried interest is like a call option on managerial performance: managers’ compensation increases with performance only once the “strike price” is exceeded. They underperform, they get no incentive comp.

Why choose this form of compensation? To align the incentives of managers and investors. High powered incentives expose managers to a lot of risk. They tend to be more risk averse than investors. In particular, investors shouldn’t care about idiosyncratic, diversifiable risk, but managers with incentive-based fees bear that idiosyncratic risk, and may be less well diversified. They will therefore tend to be more averse to that risk than investors: this creates a conflict of interest between investors and managers.

Option-like compensation mitigates this problem, because the value of options is increasing in risk (volatility). Thus option-like carried interests offsets managerial risk aversion, and tends to align the interests of managers and investors. It induces managers to invest in some higher risk projects that investors prefer because they offer higher average risk-adjusted returns.

Increasing taxes on carried interest reduces the after-tax payoff to the managerial option, but this effect is asymmetric: it only reduces payoffs when managers perform well, but doesn’t affect compensation when they perform badly. They have a weaker incentive to take risk because they get less of the upside, and have the same downside.

Put differently, the tax reduces the alignment of incentives between investors and managers. Managers will tend to make investments that are less risky than investors would like. Thus, increasing the tax on carried interest will tend to impact riskier investments disproportionately, and lead to underinvestment in them. In particular, investments with high idiosyncratic risks (which are likely to include many tech investments, for instance, whose performance depends on the success or failure of a technology, rather than the performance of the overall economy) are disproportionately punished.

(This can also be fit into the tax incidence analysis. With a higher tax rate, it is costlier to provide incentives to managers, and this drives down returns on capital, especially for high idiosyncratic risk investments.)

If the politicians and tax professionals are right about carried interest, raising the tax on it won’t reduce returns on capital and reduce investment, or divert investment away from risky but high average return projects. The foregoing analysis demonstrates that this is not correct. Tax incidence analysis, and a consideration of the effect of carried interest taxation on the incentive for managers to invest in high risk, high return projects that investors favor, show that raising this tax will reduce returns, reduce investment, and divert investment away from high risk projects.

And let’s remember why taxation on capital is harmful: it reduces wages. Less capital means lower productivity. Lower productivity means lower wages. So although the seen effect of higher capital taxation will be on the Gnomes of Greenwich, the unseen costs will be paid by those on whose behalf Hillary, Bernie, and Donald claim to be speaking. Funny how the middle class can get wet when the politicians try to soak the rich.

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August 28, 2015

Walter Russell Meade Saw Trump Coming, 15 Years Ago

Filed under: Economics,Politics — The Professor @ 9:30 pm

More than 15 years ago, Walter Russell Meade anticipated the emergence of Trump:

It is perversion rather than corruption that most troubles Jacksonians: the possibility that the powers of government will be turned from the natural and proper object of supporting the well-being of the majority toward oppressing the majority in the service of an economic or cultural elite—or, worse still, in the interests of powerful foreigners. Instead of trying, however ineptly, to serve the people, have the politicians turned the government against the people? Are they serving large commercial interests with malicious designs on the common good? Are they either by ineptitude or wickedness serving hostile foreign interests—giving all our industrial markets to the Japanese, or allowing communists to steal our secrets and hand them to the Chinese? Are they fecklessly frittering away huge sums of money on worthless foreign aid programs that transfer billions to corrupt foreign dictators?

Jacksonians tolerate a certain amount of government perversion, but when it becomes unbearable, they look to a popular hero to restore government to its proper functions. It was in this capacity that Andrew Jackson was elected to the presidency, and the role has since been reprised by any number of politicians on both the local and the national stages. Recent decades have seen Ronald Reagan master the role, and George Wallace, Ross Perot, Jesse Ventura and Pat Buchanan auditioning for it. The Jacksonian hero dares to say what the people feel and defies the entrenched elites. “I welcome their hatred”, said the aristocratic Franklin Roosevelt, in his role of tribune of the people. The hero may make mistakes, but he will command the unswerving loyalty of Jacksonian America so long as his heart is perceived to be in the right place. [Emphasis added.]

What is bizarre is that the sin of “giving our industrial markets to the Japanese” was somewhat dated by 1999, but Trump pounds on that theme today, when it is well past its sell date. Decades past. Just yesterday, in  Greenville, SC, he said something to the effect that “the Japanese are up here [holding his hand over his head] and we are down here [holding his hand by his knee].” Fact: Japanese per capita GDP is $36K, and US per capital GDP is exactly 50 percent higher, at $54K. But facts don’t matter. The image of Japanese domination (now accompanied by the image of Chinese domination) resonates intensely among Jacksonians.

But moving beyond that particular point, Meade clearly identified the role Trump is playing, and the audience-Jacksonians-to whom he is appealing.

One of the characteristics of Jacksonians that Meade identifies is their hostility to elites.  Angelo Codevilla makes a similar point, saying that Trump is channeling intense anger at the “Ruling Class.”

And truth be told, there is a lot to be hostile to and angry with. Viewed objectively, the term “elite” can only be used ironically in the America of 2015. There has never been such a sorry lot at the upper echelons of politics and culture in our nation’s history, except perhaps for the 1850s. The Jacksonian instinct to break out the pitchforks and torches and get the bastards is understandable.

But Trump is a fatally flawed vessel for this rebellion, in part because of he echoes so well the flawed beliefs of so many Jacksonians, notably the tribalism that gives rise to protectionism and indiscriminate hostility to all immigration. (And I say this as someone with decided Jacksonian impulses on foreign policy, and as someone descended in part from a quintessential Jacksonian family.)

But also in part-in large part-to Trump’s authoritarianism. Virtually every proposal he makes involves some sort of government intervention, such as the imposition of tariffs, a concerted effort to weaken the dollar, or mass deportation. Indeed, it is difficult to find any serious policy differences between Trump and avowed socialist Bernie Sanders.

What’s more, he promises a highly personalized government, in which he will exercise his personal executive authority to impose his policies. (A style pioneered by Andrew Jackson, notably.) He envisions his presidency as the application of the methods of the corporate CEO (who frequently exercises virtually untrammeled authority) to the governance of a nation that dwarfs even the largest company.

Even beyond the defects of his specific policy proposals, this personalization of process is the last thing we need right now. Obama has already taken us far down this road, and we need to retrace our steps, rather than hurtle even further forward on it. We are careening towards presidentialism, which has proved disastrous to both liberty and wealth wherever it has been implemented. (It is not for nothing that Trump sees a kindred spirit in Putin.)

It is ironic that many Tea Party people are ardent Trump fans, despite the fact that he represents the antithesis of the Constitution-worshipping, small-government rhetoric of the Tea Party. If Trump actually wins, these people will wake up with the biggest morning-after regret ever.

That said, I doubt that Trump can win the presidency, or even the nomination. But I temper my doubts because I never thought that he would make it this far. And even if he does not gain the nomination, he may do so much damage to the (already divided and dysfunctional) Republican Party that its electoral prospects may be doomed, even in a year when the presumptive Democratic Party nominee is a walking disaster who is at some risk of trading her orange pantsuits for orange prison garb, and the alternatives are an aging socialist loon and an aging lifelong pol with a well-earned reputation for buffoonery. (This is another illustration of the degraded condition of our purported elites.)

And Trump also brings out in stark relief the Republicans’ fundamental dilemma. They cannot win without the Jacksonians, but it is seriously questionable whether they can win with them, because they repel a large number of the swing voters who will decide the election. Reagan was able to bridge this gap, but the gap was much narrower 35 years ago. Reagan was arguably the only person that could have done it in the 1980s, but even he would almost certainly find it impossible today.

Trump today is polling at 20 percent or so of a party that may-may-account for 50 percent of the electorate. You can’t win with 10 percent, no matter how intense its support, especially if that very intensity alienates 10 percent (or more) of the voters.

This is particularly true if you look at the electoral map. The swing states that the Republicans need to win to regain the White House are the very ones that are most likely to be neuralgic to Trump and his angry band of Jacksonians.

So what will happen? In such discontented times making forecasts is even more difficult than usual, but I cannot identify plausible, positive scenarios. Trump and the Jacksonian faction he appeals to are a destructive force, even though the object of their anger and disdain largely deserves it.  Destructive because they are likely to perpetuate the misrule of the progressives, and destructive even in the (unlikely) event of victory, because Trump’s policies and presidentialism would just represent a different form of misrule.

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August 26, 2015

Donald Trump Can Only Aspire to Match Obama’s Economic Ignorance

Filed under: Climate Change,Economics,Energy,Politics,Regulation — The Professor @ 8:00 pm

Yesterday I said Trump and O’Reilly were in a cage match to determine the world champion of economic ignorance. There is another contender of course, the current occupant of the office to which Trump aspires. Actually, I would say that Obama is the undefeated reigning world champ, and that the O’Reilly-Trump set-to was merely to see who might contend for the title in the future.

Obama’s gobsmacking ignorance-served up with a heaping side of superciliousness-was on full display at the “Clean Energy Summit” in Las Vegas on Monday. Time is finite, and my energy is only intermittently renewable, so I can’t possibly deconstruct these vaporings in detail. So I will limit myself to a few high-level comments:

  1. Obama’s claims that his policies on renewable energy and carbon will make a meaningful impact on climate is a massive fraud that would land you or me in jail. Obama’s own EPA acknowledges that the policy will reduce global mean temperatures by an imperceptible and irrelevant .02 degrees by 2100. Farenheit? Celsius? Who cares? It matters not. It is rounding error on any scale.
  2. Obama’s mantra is all about the jobs that his renewables policies are creating and will create. Jobs are costs, not benefits.
  3. Further, Obama is clueless about the seen vs. unseen. To the extent that these policies raise the cost of electricity, they will have adverse consequences on wealth and income in consuming sectors, and in sectors that could produce electricity more efficiently, but for the subsidized competition from renewables.
  4. And yes, these policies will increase costs. Renewables are intermittent and diffuse and therefore require backup resources to ensure reliability; there is often a long distance between renewable sources and demand, meaning that new investments in icky transmission are required; and there is often a negative correlation between renewable production and electricity demand (e.g., the wind usually stops blowing when it’s really hot). Just look to Germany, with its Energiewende fiasco if you have any doubts. There is a strong correlation between electricity costs and fraction of electricity from renewables, and although this could be due in part to an endogeneity issue (those with more costly electricity sources utilize more renewables), this does not explain the entire effect.
  5. Obama and other boosters of renewables boast about falling costs of solar. Wind is conspicuously absent from this discussion, even though it represents the bulk of renewables generation. Further. Fine! When these inexorable efficiency gains make solar economical as a large-scale source of electricity, it will be able to compete without subsidy. This is no reason to subsidize now. This technical progress in solar argument is a non sequitur of the first magnitude.
  6. Obama and other boosters rave about capacity additions attributable to renewables. Well, due to the intermittence issue, capacity utilization is very low. It takes a lot more than 1MW of renewable capacity to replace 1MW of thermal or nuclear capacity. Indeed, if the wind ain’t blowing, all the windmills in the world can’t replace one conventional plant.
  7. Obama’s ignorance is on full display when he claims that conventional electricity generation was not characterized by “a lot of innovation.” This is just a crock. Compare heat rates of plants 20 years ago to those of today: in California, for instance, thermal efficiency has improved by 17 percent over the last 13 years. Heard of combined cycle, Barry? There has been considerable innovation in electricity generation. Well, not at the light switch plate, which is probably the extent of Barry’s familiarity with the electricity value chain.
  8. Obama mistakes opposing subsidies with being anti-free market. Welcome to bizarro world. And, as is his wont, he did so in an Alinskyite fashion, demonizing his opponents (the always handy Koch Brothers) in a very personal way.

I could go on, but that would be an S&M exhibition, and this is (usually!) a SFW site.

Suffice it to say that in Las Vegas Obama gave a demonstration that proves that when it comes to economic illiteracy, Trump can only aspire to fill Obama’s shows.

And yeah. Take a moment to absorb just what that means.

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August 25, 2015

Donald Trump: Leader of the Mercantilist Zombie Apocalypse

Filed under: China,Economics,Politics — The Professor @ 6:53 pm

Running the risk of serious brain damage, I watched Trump on O’Reilly last night. It was a cage match to determine the world champion of economic ignorance. I declare it a tie.

The “discussion” started out with China. O’Reilly asked Trump about China’s alleged devaluation policy. Except O’Reilly couldn’t pronounce “devalue”: he kept saying “devaluate.” But Trump took the bait and ranted (but I repeat myself) about how China has relentlessly devalued its currency over the years.

Except, of course, it hasn’t. It devalued years ago, but since the financial crisis it has pegged the yuan to the dollar, and only recently made two small devaluations.

Indeed, the yuan has been appreciating in recent years. Since 2011 the yuan has risen from about 6.8 to the dollar to 6.2 to the dollar, before dropping to 6.4 to the dollar as a result of the devaluations. It is arguable whether the yuan is undervalued or overvalued as a result of the peg, but that’s something completely different than devaluation. And it is just wrong to say, as Trump does, that China has been relentlessly devaluing its currency for years. If anything, indicators are that the currency has become overvalue of late: in particular, capital outflows signal overvaluation. Look at real estate markets in the Bay Area, Vancouver, Sydney, etc., or step into any luxury car showroom in the US, and you will see a lot of Chinese buyers. That’s a telling anecdote, but there is hard data to back that up.

What’s more, it’s not as if the US has been passive post-crisis. QE anyone? To ignore this is to ignore one elephant in the room, and criticizing the currency peg without mentioning QE has more than a little of the feel of “Mommy! No fair! Johnnie hit me back!”

Further, even if the Chinese have engaged in policies that keep their currency artificially low, the effect on the US is not unambiguously bad. Yes, some US industries and workers are harmed, but consumers overall would get a great boon, as we exchange overvalued paper for artificially cheap goods. It is not uniformly bad for US manufacturing either, as many of the “consumers” are manufacturers who can purchase cheaper inputs. This raises the derived demand for other inputs, including some labor.

The best part was where Trump repeated one of his common themes that American leadership is dumb (I don’t disagree) but that Chinese leadership is really smart. But then he went on to screech that the Chinese have created a huge bubble that is imploding, and threatens to bring down the US economy with it. But, if the Chinese leadership is so damn smart, why would they create a huge bubble, and then be incapable of preventing its bursting? And if we live in a zero sum world where China’s gain is America’s loss, wouldn’t a Chinese economic collapse be good for the US?

Another lowlight was the discussion of trade with Mexico, which is apparently also governed by those overqualified for Mensa. (Who knew?) He is furious at Nabisco for moving a plant from Chicago to Mexico. Presumably if elected president he will force the company to forego use of the “Ritz” brand (because that’s the name on a fancy-schmancy American hotel!) and preclude them from selling Oreos with a cream center in the US. Nope, just two dry chocolate biscuits, unsweetened, held together with a nail. Ford also came in for a bashing for moving assembly to Mexico.

Perhaps to give him more intellectual credit than he deserves, Trump is a died-in-the-wool mercantilist who believes trade is a zero sum game, and who favors protectionism and beggar-thy-neighbor currency policies. He talks like it is the late-80s, and Japan is still an economic juggernaut that will overwhelm the US, completely overlooking the fact that Japan’s crypto-mercantilist policies gifted it a 25 year long lost decade, and that neo-mercantilist China is on the brink of the same fate. If it is lucky.

Adam Smith is spinning in his grave.

But alas, mercantilism is a like a zombie. It has no brain, and has proven impossible to kill. Which means, I guess, that in Donald Trump, it has found its perfect advocate.

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August 24, 2015

I Knew Black Monday. Black Monday Was a Friend of Mine. This Was No Black Monday

Filed under: Economics,Financial crisis — The Professor @ 6:26 pm

Today the S&P500 dropped about 4 percent. A pretty big move, yes, but hardly a catastrophe. But to follow the financial media and Twitter, you’d think it was market Armageddon. It’s Monday, so of course everybody was screeching “Black Monday,” and (of course)^2, #blackmonday trended on Twitter.

Not even close.

I worked at an FCM in Chicago on Black Monday. Well I guess I still worked there. After a falling out with my boss, I submitted my resignation at 7AM on the October 19, 1987: so now you know the real cause of the Crash. But I was in the office, and had a ringside seat to an honest-to-God crash. People, please. Today wasn’t even close.

Today’s move was about a 3 sigma move. Black Monday, 1987, was a 20 sigma move. If the world was normal-which it ain’t, of course-a 20 sigma move should occur every several billion lives of the universe. Three sigma moves occur about once every five years. So in fact, we’re a little bit overdue.

In brief, there is no comparison.

Despite the decline in stock prices, there is still one raging bull market. In stupidity. Today’s market move triggered Pavlovian responses from both idiots and people who should know better.

Leading the idiot parade were Bernie Sanders and Donald Trump. (You’re shocked, I’m sure.) Both took to the express lane of stupidity, Twitter, to share with us their deep thoughts. Sanders reflexively blamed trade:

The results are in. Unfettered free trade has been a disaster for working Americans. It is high time we ended our disastrous trade policies.

Trump blamed China, and (apparently) US policy makers dancing to China’s tune:

Markets are crashing – all caused by poor planning and allowing China and Asia to dictate the agenda. This could get very messy! Vote Trump.

Yes, China has something to do with it, but (a) as noted above, today’s “crash” is small beer indeed, and (b) the sort of autarky that Trump fantasizes about would have made us far less wealthy than we are, resulting in stock prices (and other asset prices) far below than the level to which they “crashed” today.

And then there’s Zero Hedge, which wet itself repeatedly in excitement, all the while declaring that the era of DOOM! is upon us. Too bad for ZH that if there’s anybody who’s effed by recent developments, it’s ZH’s BFF Putin and Russia. (Ruble above 71, and Brent at a 42 handle today. Good times, Vlad!)

As for people who should know better, consider Mark Cuban:

Later, in an interview on CNBC’s “Fast Money,” Cuban said the historic moves in the market on Monday were not caused by normal trading.

“No one else that trades can move the market [by] hundreds of points in hundreds of seconds in either way,” Cuban said.

“What we saw today was like a three stooges market… that doesn’t happen from normal traders, that doesn’t happen from large funds taking positions or selling positions, that happens because algorithms watch everything that’s happening and everything that’s correlated to what’s happening in equities and they take action.

Cuban has an obsession with HFT, and today gave him an opportunity to spout off on it again, revealing his ignorance, and unreasoning hatred, of it. Days like today, and market movements like today (with big gaps) have occurred before anyone even thought of algos, before markets were computerized, and before Mark Cuban was born. Days like today occurred when prices were recorded on blackboards in chalk. Days like today occurred when the closest thing to HFT was the telegraph and the stock ticker. Regardless of the technology, markets do things like they did today.

Everybody should just give it a rest. Days like today happen with some regularity. No reason to panic. Indeed, it should be a source of some comfort that the impetus for the selloff was events in China, rather than (as in 2008) the impending implosion of the US banking sector.

And do yourself a favor. Turn off the TV, and just look at Twitter so that you can mock the likes of Trump and Sanders. The signal-to-noise ratio is asymptotically approaching zero. When you really need to panic, you’ll know.

 

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August 23, 2015

China’s Michael Jackson Moment Has Arrived

Filed under: China,Economics,Politics — The Professor @ 7:05 pm

About 6 years ago, reflecting on China’s massive stimulus effort in the aftermath of the crisis, I referred to the country as the “Michael Jackson economy,” sustained by artificial stimulants, and extending the analogy, predicted it would not end well. In the years since, Chinese economic statistics have performed according to plan with metronomic regularity, but all of the distortions inherent in an investment-driven, credit-financed boom only accumulated. Throughout this period, China interfered in markets, by the manipulation of crucial prices, notably interest rates and the exchange rate, and the implementation of measures to direct capital to favored sectors and firms.

Signs of resource misallocation have abounded most notably in the form of massive overcapacity in myriad industries (e.g., steel), the construction of vacant cities, and a relentless rise in debt-to-GDP that is approaching the stratospheric levels attained by Japan before its crash in the early 1990s.

It was inevitable that this was not sustainable. But although Chinese authorities indicated at some level they understood this, and talked about transitioning away from the credit, export and investment-driven growth model towards a consumption-driven one, political economy considerations that tend to favor established interests, and no doubt a deep fear about their inability to maintain control and social peace during a transition, kept them from kicking the old habits. And now it appears that the Michael Jackson-esque denouement is nigh.

All signs are of an impending economic crisis in China. The recent stock market decline is one symptom (but mainly a symptom), as are other economic data. But the surest sign is the panic evidenced by truly gargantuan stimulus measures (totaling around $2 trillion, or four plus TARPs, according to Christopher Balding’s figuring) and the recent decision to devalue the yuan.

The real slowdown is an especial concern because of the Rube Goldberg nature of the Chinese financial system, and the massive amounts of debt that has accumulated since 2009. The government is using a variety of measures to take the associated risk on its balance sheet (although it is using indirect means to conceal this fact), but even the government balance sheet is not bottomless. In such a debt-dominated and opaque financial system, a full-blown financial crisis that would greatly exacerbate the real slowdown is quite possible.

There are a couple of lessons here that need to be emphasized. The first is the dubious value of GDP as a measure of economic performance, especially in an investment-driven, highly managed economy. Investment is a cost incurred in the expectation of realizing a greater benefit in the future: it is not a benefit  in itself. In an economy where price signals and incentives are deeply distorted by financial repression, capital controls, and crucially a high-powered incentive system that ties remuneration and promotion of government officials to GDP targets, there will be massive malinvestment. With this malinvestment, future returns will be small and negative, and often insufficient to service the debt used to finance it.

When the investment is made it looks great in the GDP figures. But in an economy where investment accounts for upwards of 50 percent of GDP, the destruction of value caused by the malinvestment is staggeringly large.

The GDP-linked high powered incentive system is likely especially pernicious. Investment decisions should be forward looking, but the incentive system drives officials to make “investments” based on their current cost, not the expectation of their future returns.  Big investment (cost!) today means big GDP today means life is good for the cadres. This is beyond perverse.*

Another lesson is that no one should be surprised. Logic and experience lead to the same conclusion. Economic logic teaches that distortions of prices and top-down resource allocation mechanisms destroy wealth rather than create it. Experience, from extreme cases like the USSR to less extreme ones like Japan, illustrate vividly the hard reckoning that a managed system must eventually face.

I am only surprised that people are surprised. Even though logic and experience should have led people to question the Chinese “miracle,” and to doubt rather than tout its GDP figures, for years Smart People** have marveled at Chinese economic performance and sang paeans to its wise government steersmen. They were mesmerized by GDP figures, and confused costs with benefits. But just as it was inevitable that Michael Jackson’s dependence on artificial means would eventually result in a health crisis, it was inevitable that China’s dependence on artificial stimulants and distortionary interventions driven by political agendas and warped incentives wold result in an economic crisis.

And there are mounting signs that that moment has arrived. Perhaps it will result in a serious crisis. Perhaps it will result in multiple lost decades (a la Japan). But one way or another, forecasts of future Chinese economic dominance are going to look quite embarrassing.

* This is a different issue than whether Chinese officials routinely falsify economic data. Given the high powered incentives at the lower and middle levels of the governing hierarchy, and the need for the government to demonstrate its alleged economic competence at the upper levels, the incentives to falsify data are acute.

** H/T @soncharm, of Rhymes With Cars and Girls.

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August 22, 2015

Political Correctness and Building Social Strife in Europe–and America

Filed under: History,Politics — The Professor @ 7:13 pm

About a month back I wrote about my experiences in Sweden. As if to illustrate my point about the Swedes’ attempt to flee from their historic identity and current cultural realities, horrific events occurred on 10 August. An Eritrean refugee who had just been denied asylum in Sweden went into an Ikea, grabbed two knives from the shelf, and proceeded to butcher two shoppers, a woman and her son. Some reports indicate that one of the victims had been beheaded.

Swedish officialdom immediately shrouded the events and the perpetrator in a veil of secrecy. Tellingly, the name of the assailant has not been released. There is only one reason to have done this: to prevent revelation that the assailant was not just an immigrant, but a Muslim one. But, of course, this attempt was futile because any sentient being can infer immediately the reality from the very fact that the Swedish authorities attempted to suppress the reality. Meaning that the authorities did not succeed in their object, and in the bargain proved themselves to be craven and afraid to recognize that their immigrant community harbors a terrorist threat. As if everyday Swedes are blind to this reality. Further meaning that the authorities insult the intelligence of the citizenry, increasing the alienation of large segments of the population from the elite.

Swedish officials compounded the insult by ostentatiously rushing police to protect refugee centers, insinuating that native Swedes were prone to indiscriminate violence against immigrants.

This behavior is precisely why, to the shock of the Swedish establishment, that a far right nativist party now leads the polls in the country. The suppression by the elite of frank discussion of matters such as the integration of immigrants into society, the failure to deal with potential terrorist threats emanating from the immigrant population, and the creation of protected classes inevitably pushes people towards the fringes, and strengthens  those whom the elite despises most. This problem is particularly acute in Europe, where mechanisms of conformity and social control are more pronounced than in the US. But the US is not immune. Indeed, the appalling success of Donald Trump here is the result of the same dynamic.

As if another illustration were needed, consider the events on the Amsterdam-Paris train yesterday. A Moroccan with terrorist connections who was known to authorities in three European countries, and who had been to Syria, boarded the train in Brussels, armed with an AK-47, an automatic pistol, and boxcutters. As he emerged from the bathroom intent on mayhem, three Americans, including two enlisted servicemen on vacation, rushed him, forced him to the floor, and disarmed him. When he was down, a 62 year old Brit jumped on to keep him down.

But for the actions of three brave Americans, there would be dozens of dead Euros.

The train crew, if you have to know, took cover, barricading themselves in a safe room on the train. One French actor did suffer injuries while breaking the glass on the alarm.

Consider the reaction of French officialdom:

The motives behind the attack were not immediately known, although a spokesman for the interior minister said: ‘It is too early to speak of a terrorist link’

As the Swedes show, it is always too early. No doubt the French will attempt to put this issue behind them quickly, so they can get back to truly pressing matters. Such as the existential threat from Uber.

And the strains are about to get worse, as a metastasizing refugee crisis in southern Europe is about to spill over into rich Europe, most notably Germany, which is already experiencing a backlash.

Suppressing discussion of uncomfortable and thorny issues can buy social peace. For a while. But shutting off all outlets for civil discussion of controversial matters just causes the buildup of latent pressures that eventually cannot be contained, leading to a potentially calamitous disruption of social harmony. Allowing a little strife now can avoid a lot of strife in the future. But the Euros (and increasingly the US) have chosen the opposite course.

As long as the Euros keep denying they have an Islamist terrorism problem, they will have an Islamist terrorism problem. And their denial is creating another problem: a rise of the reactionary right.

 

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August 18, 2015

Vladimir Putin: At Sea in More Ways Than One

Filed under: Energy,Politics,Russia — The Professor @ 7:12 pm

Putin went for a dive in a submersible of the Crimean coast today. He was apparently in search of the Russian economy, and the ruble, but the sub couldn’t quite make it that far down.

As people get older, they tend to repeat the same behavior even after it has become self-parodying: they run out of new ideas and cling to old ones that used to work. This is especially true for people who are at a loss for what to do, because they are presented with insoluble problems.

Vladimir Putin is a perfect illustration of this. Even though his acts of derring do have become the target of world-wide satire, did the submarine thing again. (I thought he would actually go to Kherson, and claim to stumble a cross a relic of Vladimir the Great, but he went with the glass bottom boat again.) Perhaps smarting from previous criticism of his scuba dive in which he claimed to have found a (planted) amphora, today he asserted that the sea bottom was strewn with them.

Putin is at sea in more ways than one. He faces a dire economic situation. His old standby-various energy powerplays-has been undermined by declining demand growth and the development of new supplies. He is in a quagmire in Donbas. He has no idea how to address any of these problems, and indeed, everything he tries seems to turn out badly.

So he goes to the well one more time, and looks even more delusional than usual. It’s the kind of thing that people who are out of ideas do.

It’s also hilarious that the man who bans Dutch cheese and Dutch flowers*, and stymies the investigation of the shutdown of airliner with dozens of Dutch citizens aboard, went on his dive in a Dutch-built vessel.

I guess he didn’t trust a Russian one. Given that it’s August, that’s probably wise.

To round out the comedy, Putin communicated with Medvedev by radio. Poor Dmitry, always the sidekick who never gets to do the fun stuff.

* The Dutch flowers are allegedly infested with California thrips. Dutch flowers and American bugs! Obviously a Nato plot!

 

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August 17, 2015

The Chronicles of Hillary, Book the Third: Felon or Cipher?

Filed under: Politics — The Professor @ 8:54 pm

The Hillary email travesty becomes more of a travesty by the day.

Hillary keeps repeating her mantra: none of the email was marked as classified when she received or sent it.

Yes, she thinks you are that stupid. Or maybe she is that stupid, and doesn’t recognize the difference between a sufficient condition and a necessary one. Keeping information marked as classified on her private server would be sufficient to violate the law. But it’s not necessary. The relevant statute defines classified information of the United States as:

information originated, owned, or possessed by the United States Government concerning the national defense or foreign relations of the United States that has been determined pursuant to law or Executive order to require protection against unauthorized disclosure in the interests of national security [emphasis added].

Hillary was Secretary of State, the officer of the government responsible for the “foreign relations of the United States,” and who dealt with national defense issues as part of that job. So, if Hillary wrote anything in an email pertaining to her job that would have damaged the United States had it been disclosed, or received any email pertaining to her job that would have damaged the United States had it been disclosed, she violated the law.

So Hillary’s defense would have to be: “All I did as Secretary of State–or at least, all I did via email–was discuss frivolous matters that would not have mattered in the least had they been disclosed.” In other words, she was a total cipher as SoS whose electronic correspondence (sent and received) was utterly trivial and required no protection against unauthorized disclosure. Not some of it. All of it.

Well Okay then! Who am I to disagree that Hillary was a cipher?

But if that’s her defense, why the extreme measures to prevent disclosure of this information? Why protect the banal and irrelevant? Why have a private server in the first place? Why fight tooth and nail to delay and impede turning over even paper copies of the allegedly trivial email? And most tellingly: why wipe the server clean? The latter act particularly suggests guilt.

All of these questions answer themselves. It was impossible for her to perform her official duties without keeping information that required protection against unauthorized disclosure on her precious server.

The wiping of the server raises another serious issue. It seriously impedes, and perhaps makes impossible, any forensic examination of the server to determine whether it had been hacked.

It’s also worth noting that apparently Hillary’s server utilized a spam service that opened, decrypted, and read every email to make sure it wasn’t spam. (Heaven forfend Hillary get unsolicited ads for yoga pants!) Well, what if her spam service was hacked? Just how many potential holes were in her email system, anyways?

Further, it now appears that the classification designations had been illegally removed from things sent to Hillary. Very sensitive things, including information related to satellite intelligence/national technical means. As an aside, Jonathan Pollard spent decades in prison for revealing information related to intelligence satellite capabilities.

The legal violations are self-evident.

The appalling lack of judgment is also evident. But it’s important to note that she is not just guilty of lack of judgment as the term is usually used, to indicate thoughtlessness, carelessness, or negligence. She made the conscious judgment to place her own selfish interests above those of the country. It’s not so much bad judgment, as malign judgment.

One wonders how long this can go on. There are two mechanisms for terminating her political career, as is only just and necessary. The first is political: voters will realize that she is unfit for any office, let alone the presidency. The second is legal: the Justice Department will prosecute her.

I have my doubts that either mechanism is sure-fire. The second is particularly interesting. Obama does not like Hillary: his Svengali, Valerie Jarrett, positively hates her. Will he let her twist in the wind for a while and then let a prosecution proceed? Or will he decide that the blowback from a war with the notoriously vicious Clinton machine (a) could distract him during his last year in office, and detract from his precious legacy, and (b) increase the odds that the even more hated Republicans could take the presidency, and undo some of his actions.

I can see it both ways, but think it more likely that Obama will stay the Justice Department: taking her on would be an extremely risky move. I therefore think that the more promising mechanism is a political judgment by the American people that Hillary is categorically unfit for the presidency. Promising, but not inevitable. Intense partisanship, combined with the fact that the Republican party is currently a mess and being ripped apart by whatever the hell Trump is doing, could mean that despite her manifest flaws as a person and a politician, Hillary could become the next president.

 

 

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August 15, 2015

Is Elon Musk’s Flim-Flam Beginning to Unravel?

Filed under: Climate Change,Economics,Energy,Politics — The Professor @ 7:03 pm

I’ve long been an Elon Musk skeptic.  He struck me as Harold Hill-esque con man, and an aspiring cult leader.

Izabella Kaminska at FT Alphaville has come to the same conclusion. (I appreciate her giving extended play to my posts on Musk, and for pointing out that I’ve “never bought the hype.”) Her last sentence says it all, in a rhetorically questioning kind of way: “Who was it again that said “the bigger the lie, the more it will be believed”?”

Exactly.

There are some major cracks beginning to show in the Musk facade. The most telling is the fact that one Musk entity-SolarCity-sold $165 million in bonds (that are backed by the cash flows from SCTY’s solar installations) to another Musk entity, SpaceX (which just experienced an embarrassing spacecraft malfunction.) When money is taken out of the left pocket to put into the right pocket, eyebrows should be raised. Especially when the explanation is this lame:

So why is SpaceX buying these up? According to SolarCity’s Vice President of Financial Products, Tim Newell, the answer is “very straight forward.” The bonds offered SpaceX an attractive rate of return for a one-year investment compared to other investment options out there. SpaceX carriers a fair amount of cash at times, noted Newell, and the company wanted to put that cash to work in the short term with a high degree of reliability

Sure. If it’s offering such a great rate of return, why isn’t anyone else buying it? And why does it have to offer a better rate than “other investment options out there”? A more plausible story is that the bonds weren’t selling, or that they would only sell at yields Musk didn’t want to pay, so  he had to use one of his companies to prop up another. Those kinds of shell games can only last so long.

Moreover, some executives have left, most recently the head of service, who is taking a leave of absence. This follows the departure of the CFO (announced in June).

Then there is the recent Tesla earnings report, which showed that despite the massive subsidies it has received, it still can’t earn a GAAP profit and, and is burning cash at a hellacious rate, $565 billion million* in the last quarter alone. Further the company revealed that it almost certainly will miss its sales target of 55,000, perhaps by as much as 10 percent. The introduction of the Model X is being pushed back yet again. The company had been counting on China for future growth. Performance there had been disappointing, and China’s current economic troubles (which include a huge automobile inventory overhang) make it an unlikely future savior.

But Musk responded in his typical supercilious fashion:

Rather sanctimoniously, the carmaker said that it would prioritise “a great product” over quarterly numbers. Investors have probably understood that by now. Just in case of doubt, Mr Musk followed up on the earnings call with: “We don’t want to set high expectations . . . Winning needs to feel like winning.”

Just a suggestion: channeling one’s inner Charlie Sheen is probably not a good idea.

There is also a medium-to-long term risk for Tesla, and a deliciously ironic one (though it is somewhat hedged by SolarCity). Specifically, Musk is a anthropomorphic anthropogenic climate change true believer who touts electric automobiles as a way of combatting it. The EPA’s recent proposed regulation of CO2 is also targeted at climate change. Though by its own admission will do virtually nothing to ameliorate temperature increases, the regulation will make electricity much more expensive: that’s a certainty. Estimates are in the range of 10-20 percent. That makes electric cars that much less attractive. Higher energy costs will also reduce income, leading to lower demand for Tesla vehicles, but will also reduce the demand for petroleum, which will lead to lower gasoline prices which will also negatively impact demand for Teslas: the EPA regulation will therefore cause both income and substitution effects that are harmful to Tesla (though again SolarCity will benefit from the EPA plan). Meaning that one green dream will cannibalize another.

For those who see Tesla as more of a battery company than a car company, higher electricity prices hurt the storage battery business too.

But no doubt Elon will turn his attention to doing what he does best: importuning the government to subsidize him. I lay heavy odds that we will see an effort to increase or extend subsidies to electric vehicles with the specific purpose of offsetting the effect of EPA regulations on the sales of electric cars. Just watch. If the markets are becoming less enamored with Elon, there are still plenty of suckers for his shtick in government.

*Thanks to commenter Highgamma for catching this.

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