Uneasy Money

David Beckworth has a recent post about the Trump stock-market rally. Just before the election I had a post in which I pointed out that the stock market seemed to be dreading the prospect of a Trump victory, based on the strong positive correlation between movements in the dollar value of the Mexican peso and the S&P 500, though, in response to a comment by one of my readers, I did partially walk back my argument. As the initial returns and exit polls briefly seemed to be pointing toward a Clinton victory, the correlation between the peso and the S&P 500 (futures) seemed to be very strong and getting stronger, and after the returns started to point increasingly toward a Trump victory, the strong correlation between the peso and the S&P 500 remained all too evident, showing a massive decline in both the peso and the S&P 500. But what seemed like a Trump panic was suddenly broken, when Mrs. Clinton phoned Trump to concede and Trump appeared to claim victory with a relatively restrained and conciliatory statement that calmed the worst fears about a messy transition and the potential for serious political instability. The survival of a Republican majority in the Senate was perhaps viewed as a further positive sign and strengthened hopes for business-friendly changes in the US corporate and personal taxes. The earlier losses in S&P 500 futures were reversed even without any recovery in the peso.

So what explains the turnaround in the reaction of the stock market to Trump’s victory? Here’s David Beckworth:

I have a new piece in The Hill where I argue markets are increasingly seeing the Trump shock as an inflection point for the U.S. economy:

It seems the U.S. economy is finally poised for robust economic growth, something that has been missing for the past eight years. Such strong economic growth is expected to cause the demand for credit to increase and the supply of savings to decline

Though this is not the main point, I will just register my disagreement with David’s version of how interest rates are determined, which essentially restates the “loanable-funds” theory of interest determination, which is often described as the orthodox alternative to the Keynesian liquidity preference theory of interest rates. I disagree that it is the alternative to the Keynesian theory. I think that is a very basic misconception perpetrated by macroeconomists with either a regrettable memory lapse or an insufficient understanding of, the Fisherian theory of interest rates. In the Fisherian theory interest rates are implicit in the intertemporal structure of all prices, they are therefore not determined in any single market, as asserted by the loanable-funds theory, any more than the price level is determined in any single market. The way to think about interest-rate determination is to ask the following question: at what structure of interest rates would holders of long-lived assets be content to continue holding the existing stock of assets? Current savings and current demand for credit are an epiphenomenon of interest-rate determination, not a determinant of interest rates — with the caveat that every factor that influences the intertemporal structure of prices is one of the myriad determinants of interest rates.

Together, these forces are naturally pushing interest rates higher. The Fed’s interest rate hike today is simply piggybacking on this new reality.

If “these forces” is interpreted in the way I have suggested in my above comment on David’s previous sentence, then I would agree with this sentence.

Here are some charts that document this upbeat economic outlook as seen from the treasury market. The first one shows the treasury market’s implicit inflation forecast (or “breakeven inflation”) and real interest rate at the 10-year horizon. These come from TIPs and have their flaws, but they provide a good first approximation to knowing what the bond market is thinking. In this case, both the real interest rate and expected inflation rate are rising. This implies the market expects both higher real economic growth and higher inflation. The two may be related–the higher expected inflation may be a reflection of higher expected nominal demand growth causing real growth. The higher real growth expectations are also probably being fueled by Trump’s supply-side reforms.

I agree that the rise in real interest rates may reflect improved prospects for economic growth, and that the rising TIPS spread may reflect expectations of at least a small rise in inflation towards the Fed’s largely rhetorical 2-percent target. And I concur that a higher inflation rate could be one of the causes of improving implicit forecasts of economic growth. However, I am not so sure that expectations of rising inflation and supply-side reforms are the only explanations for rising real interest rates.

What “reforms” is Trump promising? I’m not sure actually, but here is a list of possibilities: 1) reducing and simplifying corporate tax rates, 2) reducing and simplifying personal tax rates, 3) deregulation, 4) tougher enforcement of immigration laws, 5) deportation of an undetermined number of illegal immigrants, 6) aggressively protectionist international trade policies.

I think that there is a broad consensus in favor of reducing corporate tax rates. Not only is the 35% marginal rate on corporate profits very high compared to the top corporate set by other countries, the interest deduction is a perverse incentive favoring debt rather than equity financing. As I pointed out in a post five years ago, Hyman Minsky, one of the favorite economists of the left, was an outspoken opponent of corporate income taxation in general, precisely because it encourages debt rather than equity financing. I think that the Obama administration would have been happy to propose reducing the corporate tax rate as part of a broader budget deal, but no broader deal with the Republican majority in Congress was possible, and a simple reduction of the corporate tax rate would have been difficult for Obama to sell to his own political base without offering them something that could be described as reducing inequality. So cutting the top corporate tax rate would almost certainly be a good thing (but subject to qualification by the arguments in the next paragraph), and expectations of a reduction in the top corporate rate would tend to raise stock prices, though the effect on stock prices would be moderated by increased issues of new corporate stock.

Reducing and simplifying corporate and personal tax rates seems like a good thing, but there’s at least one problem. Not all earnings of taxable income is socially productive. Lots of earned income is generated by completely, or partially, unproductive activities associated with private gains that exceed social gains. I have written in the past about how unproductive many types of information gathering and knowledge production is (e.g., here, here, here, and here). Much of this activity enables the person who acquires knowledge or information to gain an information advantage over people with whom he transacts, so the private return to the acquisition of such knowledge is greater than the social gain, because the gain to one party to the trade comes not from an increase in output but by way of a transfer from the other less-informed party to the transaction.

The same is true — to a somewhat lesser extent, but the basic tendency is the same – of activity aimed at the discovery of knew knowledge over which an intellectual property right can be exercised for a substantial length of time. The ability to extract monopoly rents over newly discovered knowledge is likely to confer a private gain on the discoverer greater than the social gain accruing from the discovery, because the first discoverer to acquire exclusive rights can extract the full value of the discovery even though the marginal benefit accruing to the discovery is only the value of the new knowledge over the elapsed time between the moment of the discovery and the moment when the discovery would have been made, perhaps soon afterwards, by someone else. In general, there is a whole range of income accruing to a variety of winner-takes-all activities in which the private gain to the winner greatly exceeds the social gain. A low marginal rate of income taxation increases the incentive to engage in such socially wasteful winner-takes-all activities.

Deregulation can be a good thing when it undermines monopolistic price-fixing and legally imposed entry barriers entrenching incumbent suppliers. A lot of regulation has historically been of this type. But although it is convenient for libertarian ideologues to claim that monopoly enhancement or entrenchment characterizes all government regulation, I doubt that most current regulations are for this purpose. A lot of regulation is aimed at preventing dishonest or misleading business practices or environmental pollution or damage to third-parties. So as an empirical matter, I don’t think we can say whether a reduction in regulation will have a net positive or a net negative effect on society. Nevertheless, regulation probably does reduce the overall earnings of corporations, so that a reduction in regulation will tend to raise stock prices. If it becomes easier for corporations to emit harmful pollution into the atmosphere and into our rivers, lakes and oceans, the reductions in private costs enjoyed by the corporations will be capitalized into their stock prices while the increase in social costs will be borne in a variety of ways by all individuals in the country or the world. Insofar as stock prices have risen since Trump’s election because of expectations of a roll back in regulation, it is not clear to me at least whether that reflects an increase in net social welfare or a capitalization of the value of enhanced rights to engage in socially harmful conduct.

The possible effects of changes in immigration laws, in the enforcement of immigration laws and in trade policies seem to me far too murky at this point even to speculate upon. I would just observe that insofar as the stock market has capitalized the effects of Trump’s supposed supply-side reforms, those reforms would have tended to reduce, not increase, inflation expectations. So it does not seem likely to me that whatever increase in stock prices we have seen so far reflects a pure supply-side effect.

I am more inclined to believe that the recent increases in stock prices and inflation expectations reflect expectations that Trump will fulfill his commitments to conduct irresponsible fiscal policies generating increased budget deficits, which the Republican majorities in Congress will now meekly accept and dutifully applaud, and that Trump will be able either to cajole or intimidate enough officials at the Federal Reserve to accommodate those policies or will appoint enough willing accomplices to the Fed to overcome the opposition of the current FOMC.