Archive for March, 2018

The Phillips Curve and the Lucas Critique

With unemployment at the lowest levels since the start of the millennium (initial unemployment claims in February were the lowest since 1973!), lots of people are starting to wonder if we might be headed for a pick-up in the rate of inflation, which has been averaging well under 2% a year since the financial crisis of September 2008 ushered in the Little Depression of 2008-09 and beyond. The Fed has already signaled its intention to continue raising interest rates even though inflation remains well anchored at rates below the Fed’s 2% target. And among Fed watchers and Fed cognoscenti, the only question being asked is not whether the Fed will raise its Fed Funds rate target, but how frequent those (presumably) quarter-point increments will be.

The prevailing view seems to be that the thought process of the Federal Open Market Committee (FOMC) in raising interest rates — even before there is any real evidence of an increase in an inflation rate that is still below the Fed’s 2% target — is that a preemptive strike is required to prevent inflation from accelerating and rising above what has become an inflation ceiling — not an inflation target — of 2%.

Why does the Fed believe that inflation is going to rise? That’s what the econoblogosphere has, of late, been trying to figure out. And the consensus seems to be that the FOMC is basing its assessment that the risk that inflation will break the 2% ceiling that it has implicitly adopted has become unacceptably high. That risk assessment is based on some sort of analysis in which it is inferred from the Phillips Curve that, with unemployment nearing historically low levels, rising inflation has become dangerously likely. And so the next question is: why is the FOMC fretting about the Phillips Curve?

In a blog post earlier this week, David Andolfatto of the St. Louis Federal Reserve Bank, tried to spell out in some detail the kind of reasoning that lay behind the FOMC decision to actively tighten the stance of monetary policy to avoid any increase in inflation. At the same time, Andolfatto expressed his own view, that the rate of inflation is not determined by the rate of unemployment, but by the stance of monetary policy.

Andolfatto’s avowal of monetarist faith in the purely monetary forces that govern the rate of inflation elicited a rejoinder from Paul Krugman expressing considerable annoyance at Andolfatto’s monetarism.

Here are three questions about inflation, unemployment, and Fed policy. Some people may imagine that they’re the same question, but they definitely aren’t:

  1. Does the Fed know how low the unemployment rate can go?
  2. Should the Fed be tightening now, even though inflation is still low?
  3. Is there any relationship between unemployment and inflation?

It seems obvious to me that the answer to (1) is no. We’re currently well above historical estimates of full employment, and inflation remains subdued. Could unemployment fall to 3.5% without accelerating inflation? Honestly, we don’t know.

Agreed.

I would also argue that the Fed is making a mistake by tightening now, for several reasons. One is that we really don’t know how low U can go, and won’t find out if we don’t give it a chance. Another is that the costs of getting it wrong are asymmetric: waiting too long to tighten might be awkward, but tightening too soon increases the risks of falling back into a liquidity trap. Finally, there are very good reasons to believe that the Fed’s 2 percent inflation target is too low; certainly the belief that it was high enough to make the zero lower bound irrelevant has been massively falsified by experience.

Agreed, but the better approach would be to target the price level, or even better nominal GDP, so that short-term undershooting of the inflation target would provide increased leeway to allow inflation to overshoot the inflation target without undermining the credibility of the commitment to price stability.

But should we drop the whole notion that unemployment has anything to do with inflation? Via FTAlphaville, I see that David Andolfatto is at it again, asserting that there’s something weird about asserting an unemployment-inflation link, and that inflation is driven by an imbalance between money supply and money demand.

But one can fully accept that inflation is driven by an excess supply of money without denying that there is a link between inflation and unemployment. In the normal course of events an excess supply of money may lead to increased spending as people attempt to exchange their excess cash balances for real goods and services. The increased spending can induce additional output and additional employment along with rising prices. The reverse happens when there is an excess demand for cash balances and people attempt to build up their cash holdings by cutting back their spending, reducing output. So the inflation unemployment relationship results from the effects induced by a particular causal circumstance. Nor does that mean that an imbalance in the supply of money is the only cause of inflation or price level changes.

Inflation can also result from nothing more than the anticipation of inflation. Expected inflation can also affect output and employment, so inflation and unemployment are related not only by both being affected by excess supply of (demand for) money, but by both being affect by expected inflation.

Even if you think that inflation is fundamentally a monetary phenomenon (which you shouldn’t, as I’ll explain in a minute), wage- and price-setters don’t care about money demand; they care about their own ability or lack thereof to charge more, which has to – has to – involve the amount of slack in the economy. As Karl Smith pointed out a decade ago, the doctrine of immaculate inflation, in which money translates directly into inflation – a doctrine that was invoked to predict inflationary consequences from Fed easing despite a depressed economy – makes no sense.

There’s no reason for anyone to care about overall money demand in this scenario. Price setters respond to the perceived change in the rate of spending induced by an excess supply of money. (I note parenthetically, that I am referring now to an excess supply of base money, not to an excess supply of bank-created money, which, unlike base money, is not a hot potato that cannot be withdrawn from circulation in response to market incentives.) Now some price setters may actually use macroeconomic information to forecast price movements, but recognizing that channel would take us into the realm of an expectations-theory of inflation, not the strict monetary theory of inflation that Krugman is criticizing.

And the claim that there’s weak or no evidence of a link between unemployment and inflation is sustainable only if you insist on restricting yourself to recent U.S. data. Take a longer and broader view, and the evidence is obvious.

Consider, for example, the case of Spain. Inflation in Spain is definitely not driven by monetary factors, since Spain hasn’t even had its own money since it joined the euro. Nonetheless, there have been big moves in both Spanish inflation and Spanish unemployment:

That period of low unemployment, by Spanish standards, was the result of huge inflows of capital, fueling a real estate bubble. Then came the sudden stop after the Greek crisis, which sent unemployment soaring.

Meanwhile, the pre-crisis era was marked by relatively high inflation, well above the euro-area average; the post-crisis era by near-zero inflation, below the rest of the euro area, allowing Spain to achieve (at immense cost) an “internal devaluation” that has driven an export-led recovery.

So, do you really want to claim that the swings in inflation had nothing to do with the swings in unemployment? Really, really?

No one claims – at least no one who believes in a monetary theory of inflation — should claim that swings in inflation and unemployment are unrelated, but to acknowledge the relationship between inflation and unemployment does not entail acceptance of the proposition that unemployment is a causal determinant of inflation.

But if you concede that unemployment had a lot to do with Spanish inflation and disinflation, you’ve already conceded the basic logic of the Phillips curve. You may say, with considerable justification, that U.S. data are too noisy to have any confidence in particular estimates of that curve. But denying that it makes sense to talk about unemployment driving inflation is foolish.

No it’s not foolish, because the relationship between inflation and unemployment is not a causal relationship; it’s a coincidental relationship. The level of employment depends on many things and some of the things that employment depends on also affect inflation. That doesn’t mean that employment causally affects inflation.

When I read Krugman’s post and the Andalfatto post that provoked Krugman, it occurred to me that the way to summarize all of this is to say that unemployment and inflation are determined by a variety of deep structural (causal) relationships. The Phillips Curve, although it was once fashionable to refer to it as the missing equation in the Keynesian model, is not a structural relationship; it is a reduced form. The negative relationship between unemployment and inflation that is found by empirical studies does not tell us that high unemployment reduces inflation, any more than a positive empirical relationship between the price of a commodity and the quantity sold would tell you that the demand curve for that product is positively sloped.

It may be interesting to know that there is a negative empirical relationship between inflation and unemployment, but we can’t rely on that relationship in making macroeconomic policy. I am not a big admirer of the Lucas Critique for reasons that I have discussed in other posts (e.g., here and here). But, the Lucas Critique, a rather trivial result that was widely understood even before Lucas took ownership of the idea, does at least warn us not to confuse a reduced form with a causal relationship.

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What Hath Merkel Wrought?

In my fifth month of blogging in November 2011, I wrote a post which I called “The Economic Consequences of Mrs. Merkel.” The title, as I explained, was inspired by J. M. Keynes’s famous essay “The Economic Consequences of Mr. Churchill,” which eloquently warned that Britain was courting disaster by restoring the convertibility of sterling into gold at the prewar parity of $4.86 to the pound, the dollar then being the only major currency convertible into gold. The title of Keynes’s essay, in turn, had been inspired by Keynes’s celebrated book The Economic Consequences of the Peace about the disastrous Treaty of Versailles, which accurately foretold the futility of imposing punishing war reparations on Germany.

In his essay, Keynes warned that by restoring the prewar parity, Churchill would force Britain into an untenable deflation at a time when more than 10% of the British labor force was unemployed (i.e., looking for, but unable to find, a job at prevailing wages). Keynes argued that the deflation necessitated by restoration of the prewar parity would impose an intolerable burden of continued and increased unemployment on British workers.

But, as it turned out, Churchill’s decision turned out to be less disastrous than Keynes had feared. The resulting deflation was quite mild, wages in nominal terms were roughly stable, and real output and employment grew steadily with unemployment gradually falling under 10% by 1928. The deflationary shock that Keynes had warned against turned out to be less severe than Keynes had feared because the U.S. Federal Reserve, under the leadership of Benjamin Strong, President of the New York Fed, the de facto monetary authority of the US and the world, followed a policy that allowed a slight increase in the world price level in terms of dollars, thereby moderating the deflationary effect on Britain of restoring the prewar sterling/dollar exchange rate.

Thanks to Strong’s enlightened policy, the world economy continued to expand through 1928. I won’t discuss the sequence of events in 1928 and 1929 that led to the 1929 stock market crash, but those events had little, if anything, to do with Churchill’s 1925 decision. I’ve discussed the causes of the 1929 crash and the Great Depression in many other places including my 2011 post about Mrs. Merkel, so I will skip the 1929 story in this post.

The point that I want to make is that even though Keynes’s criticism of Churchill’s decision to restore the prewar dollar/sterling parity was well-taken, the dire consequences that Keynes foretold, although they did arrive a few years thereafter, were not actually caused by Churchill’s decision, but by decisions made in Paris and New York, over which Britain may have had some influence, but little, if any, control.

What I want to discuss in this post is how my warnings about potential disaster almost six and a half years ago have turned out. Here’s how I described the situation in November 2011:

Fast forward some four score years to today’s tragic re-enactment of the deflationary dynamics that nearly destroyed European civilization in the 1930s. But what a role reversal! In 1930 it was Germany that was desperately seeking to avoid defaulting on its obligations by engaging in round after round of futile austerity measures and deflationary wage cuts, causing the collapse of one major European financial institution after another in the annus horribilis of 1931, finally (at least a year after too late) forcing Britain off the gold standard in September 1931. Eighty years ago it was France, accumulating huge quantities of gold, in Midas-like self-satisfaction despite the economic wreckage it was inflicting on the rest of Europe and ultimately itself, whose monetary policy was decisive for the international value of gold and the downward course of the international economy. Now, it is Germany, the economic powerhouse of Europe dominating the European Central Bank, which effectively controls the value of the euro. And just as deflation under the gold standard made it impossible for Germany (and its state and local governments) not to default on its obligations in 1931, the policy of the European Central Bank, self-righteously dictated by Germany, has made default by Greece and now Italy and at least three other members of the Eurozone inevitable. . . .

If the European central bank does not soon – and I mean really soon – grasp that there is no exit from the debt crisis without a reversal of monetary policy sufficient to enable nominal incomes in all the economies in the Eurozone to grow more rapidly than does their indebtedness, the downward spiral will overtake even the stronger European economies. (I pointed out three months ago that the European crisis is a NGDP crisis not a debt crisis.) As the weakest countries choose to ditch the euro and revert back to their own national currencies, the euro is likely to start to appreciate as it comes to resemble ever more closely the old deutschmark. At some point the deflationary pressures of a rising euro will cause even the Germans, like the French in 1935, to relent. But one shudders at the economic damage that will be inflicted until the Germans come to their senses. Only then will we be able to assess the full economic consequences of Mrs. Merkel.

Greece did default, but the European Community succeeded in imposing draconian austerity measures on Greece, while Italy, Spain, France, and Portugal, which had all been in some danger, managed to avoid default. That they did so is due first to the enormous cost that would have be borne by a country in the Eurozone to extricate itself from the Eurozone and reinstitute its own national currency and second to the actions taken by Mario Draghi, who succeeded Jean Claude Trichet as President of the European Central Bank in November 2011. If monetary secession from the eurozone were less fraught, surely Greece and perhaps other countries would have chosen that course rather than absorb the continuing pain of remaining in the eurozone.

But if it were not for a decisive change in policy by Draghi, Greece and perhaps other countries would have been compelled to follow that uncharted and potentially catastrophic path. But, after assuming leadership of the ECB, Draghi immediately reversed the perverse interest-rate hikes imposed by his predecessor and, even more crucially, announced in July 2012 that the ECB “is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough.” Draghi’s reassurance that monetary easing would be sufficient to avoid default calmed markets, alleviated market pressure driving up interest rates on debt issued by those countries.

But although Draghi’s courageous actions to ease monetary policy in the face of German disapproval avoided a complete collapse, the damage inflicted by Mrs. Merkel’s ferocious anti-inflation policy did irreparable damage, not only on Greece, but, by deepening the European downturn and delaying and suppressing the recovery, on the rest of the European community, inflaming anti-EU, populist nationalism in much of Europe that helped fuel the campaign for Brexit in the UK and has inspired similar anti-EU movements elsewhere in Europe and almost prevented Mrs. Merkel from forming a government after the election a few months ago.

Mrs. Merkel is perhaps the most impressive political leader of our time, and her willingness to follow a humanitarian policy toward refugees fleeing the horrors of war and persecution showed an extraordinary degree of political courage and personal decency that ought to serve as a model for other politicians to emulate. But that admirable legacy will be forever tarnished by the damage she inflicted on her own country and the rest of the EU by her misguided battle against the phantom threat of inflation.

What Do Stock Prices Tell Us about the Economy?

Stock prices (as measured by the S&P 500) in 2017 rose by over 20%, an impressive amount, and what is most impressive about it is perhaps that this rise prices came after eight previous years of steady increases.

Here are the annual year-on-year and cumulative changes in the S&P500 since 2009.

2009              21.1%              21.1%*

2010              12.0%              33.1%*

2011              -0.0%               33.1%*

2012              12.2%               45.3%*

2013              25.9%               71.2%*

2014              10.8%               82.0%*

2015              -0.7%                81.3%*

2016             9.1%                   90.4%*            (4.5%)**          (85.9%)***

2017             17.7%                 108.1%*          (22.3%)****

2018 (YTD)    2.0%                  110.1%*           (24.3%)****

* cumulative increase since the end of 2008

** increase from end of 2015 to November 8, 2016

*** cumulative increase from end of 2008 to November 8, 2016

**** cumulative increase since November 8, 2016

So, from the end of 2008 until the start of 2017, approximately coinciding with Obama’s two terms as President, the S&P 500 rose in every year except 2011 and 2015, when the index was essentially unchanged, and rose by more than 10% in five of the eight years (twice by more than 20%), with stock prices nearly doubling during the Obama Presidency.

But what does the doubling of stock prices under Obama really tell us about the well-being of the American economy, and, even more importantly, about the well-being of the American public during those years? Is there any correlation between the performance of the stock market and the well-being of actual people? Does the doubling of stock prices under Obama mean that most Americans were better off at the end of his Presidency than they were at the start of it?

My answer to these questions is a definite — though not very resounding — yes, because we know that the US economy at the end of 2008 was in the middle of the sharpest downturn since the Great Depression. Output was contracting, employment was falling, and the financial system was on the verge of collapse, with stock prices down almost 50% from where they had been at the end of August, and nearly 60% from the previous all-time high reached in 2007. In 2016, after seven years of slow but steady growth, employment and output had recovered and surpassed their previous peaks, though only by small amounts. But the recovery, although disappointingly slow, was real.

That improvement was reflected, albeit with a lag, in changes in median household and median personal income between 2008 and 2016.

2009                    -0.7%                   -0.7%

2010                    -2.6%                    -3.3%

2011                     -1.6%                    -4.9%

2012                    -0.1%                    -5.0%

2013                      3.5%                    -1.5%

2014                    -1.5%                     -3.0%

2015                     5.1%                       2.0%

2016                      3.1%                      5.1%

But it’s also striking how weak the correlation was between rapidly rising stock prices and rising median incomes in the Obama years. Given a tepid real recovery from the Little Depression, what accounts for the associated roaring recovery in stock prices? Well, for one thing, much of the improvement in the stock market was simply recovering losses in stock valuations during the downturn. Stock prices having fallen further than incomes in the Little Depression, it’s not surprising that the recovery in stocks was steeper than the recovery in incomes. It took four years for the S&P 500 to reach its pre-Depression peak, so, normalized to their pre-Depression peaks, the correlation between stock prices and median incomes is not as weak as it seems when comparing year-on-year percentage changes.

But considering the improvement in stock prices under Obama in historical context also makes the improvement in stock prices under Obama seem less remarkable than it does when viewed without taking the previous downturn into account. Stock prices simply returned (more or less) to the path that, one might have expected them to follow by extrapolating their past performance. Nevertheless, even if we take into account that, during the Little Depression, stocks prices fell more sharply than real incomes, stocks have clearly outperformed the real economy during the recovery, real output and income having failed to return to the growth path that it had been tracking before the 2008 downturn.

Why have stocks outperformed the real economy? The answer to that question is a straightforward application of the basic theory of asset valuation, according to which the value of real assets – machines, buildings, land — and financial assets — stocks and bonds — reflects the discounted expected future income streams associated with those assets. In particular, stock prices represent the discounted present value of the expected future cash flows (dividends or stock buy-backs) from firms to their shareholders. So, if the economy has “recovered” (more or less) from the 2008-09 downturn, the expected future cash flows from firms have presumably – and on average — surpassed the cash flows that had been expected before the downturn.

But the weakness in the recovery suggests that the increase in expected cash flows can’t fully account for the increase in stock prices. Why did stock prices rise by more than the likely increase in expected cash flows? The basic theory of asset valuation tells us that the remainder of the increase in stock prices can be attributed to the decline of real interest rates since the 2008 downturn to historically low levels.

Of course, to say that the increase in stock prices is attributable to the decline in real interest rates just raises a different question: what accounts for the decline in real interest rates? The answer, derived from Irving Fisher, is basically that if perceived opportunities for future investment and growth are diminished, the willingness of people to trade future for present income also tends to diminish. What the rate of interest represents in the Fisherian framework is the rate at which people are willing to trade future for present income – i.e., the premium (discount) that is placed on present (future) income.

The Fisherian view is totally at odds with the view that the real interest rate is – or can be — controlled by the monetary authority. According to the latter view, the reason that real interest rates since the 2008 downturn have been at historically low levels is that the Federal Reserve has forced interest rates down to those levels by flooding the economy with huge quantities of printed money. There is a certain sense in which that view has a small element of truth: had the Fed adopted a different set of policy goals concerning inflation and nominal GDP, real interest rates might have risen to more “normal” levels. But given the overall policy framework within which it was operating, the Fed had only minimal control over the real rate of interest.

The essential idea is that in the Fisherian view the real rate of interest is not a single price determined in a single market; it is a distillation of the entire intertemporal structure of price relationships simultaneously determined in the myriad of individual markets in which transactions for present and future delivery are continuously being agreed upon. To imagine that the Fed, or any monetary authority, could control or even modestly influence this almost incomprehensibly complicated structure of price relationships according to its wishes is simply delusional.

If the decline in real interest rates after the 2008 downturn reflected generally reduced optimism about future economic growth, then the increase in stock prices actually reflected declining optimism by most people about their future well-being compared to their pre-downturn expectations. That loss of optimism might have been, at least in part, self-fulfilling insofar as it discouraged potentially worthwhile – i.e., profitable — investments that would have been undertaken had expectations been more optimistic.

Nevertheless, the near doubling of stock prices during the Obama administration did coincide with a not insignificant improvement in the well-being of most Americans. Most Americans were substantially better off at the end of 2016, after about seven years of slow but steady economic growth, than they were at the end of 2008 when total output and employment were contracting at the fastest rate since the Great Depression. But to use the increase in stock prices as a quantitative measure of the improvement in their well-being would be misleading.

I would also mention as an aside that a favorite faux-populist talking point of Obama and Fed critics used to be that rising stock prices during the Obama years revealed the bias of the elitist Fed Governors appointed by Obama in favor of the wealthy owners of corporate stock, and their callous disregard of the small savers who leave their retirement funds in bank savings accounts earning minimal interest and of workers whose wage increases barely kept up with inflation. But this refrain of critics – and I am thinking especially of the Wall Street Journal editorial page – who excoriated the Obama administration and the Fed for trying to raise stock prices by keeping interest rates at abnormally low levels now unblushingly celebrate record-high stock prices as proof that tax cuts mostly benefiting corporations and their stockholders signal the start of a new golden age of accelerating growth.

So the next question to consider is what can we infer about the well-being of Americans and the American economy from the increase in stock prices since November 8, 2016? For purposes of this mental exercise, let me stipulate that the rise in stock prices since the moment when it became clear who had been elected President by the voters on November 8, 2016 was attributable to the policies that the new administration was expected to adopt.

Because interest rates have risen along with stock prices since November 8, 2016, increased stock prices must reflect investors’ growing optimism about the future cash flows to be distributed by corporations to shareholders. So, our question can be restated as follows: which policies — actual or expected — of the new administration could account for the growing optimism of investors since the election? Here are five policy categories to consider: (1) regulation, (2) taxes, (3) international trade, (4) foreign affairs, (5) macroeconomic and monetary policies.

The negative reaction of stock prices to the announcement last week that tariffs will be imposed on steel and aluminum imports suggests that hopes for protectionist trade policies were not the main cause of rising investor optimism since November 2016. And presumably investor hopes for rising corporate cash flows to shareholders were not buoyed up by increasing tensions on the Korean peninsula and various belligerent statements by Administration officials about possible military responses to North Korean provocations.

Macroeconomic and monetary policies being primarily the responsibility of the Federal Reserve, the most important macroeconomic decision made by the new Administration to date was appointing Jay Powell to succeed Janet Yellen as Fed Chair. But this appointment was seen as a decision to keep Fed monetary policy more or less unchanged from what it was under Yellen, so one could hardly ascribe increased investor optimism to a decision not to change the macroeconomic and monetary policies that had been in place for at least the previous four years.

That leaves us with anticipated or actual changes in regulatory and tax policies as reasons for increased optimism about future cash flows from corporations to their shareholders. The two relevant questions to ask about anticipated or actual changes in regulatory and tax policies are: (1) could such changes have raised investor optimism, thereby raising stock prices, and (2), if so, would rising stock prices reflect enhanced well-being on the part of the American economy and the American people?

Briefly, the main idea for regulatory reform that the Administration wants to pursue is to require that whenever an agency adopts a new regulation, it should simultaneously eliminate two old ones. Supposedly such a requirement – sometimes called a regulatory budget – is to limit the total amount of regulation that the government can impose on the economy, the theory being that new regulations would not be adopted unless they were likely to be really effective.

But agencies are already required to show that regulations pass some cost-benefit test before imposing new regulations. So it’s not clear that the economy would be better off if new regulations, which can now be adopted only if they are expected to generate benefits exceeding the costs associated with their adoption, cannot be adopted unless two other regulations are eliminated. Presumably, underlying the new regulatory approach is a theory of bureaucratic behavior positing that the benefits of new regulations are systematically overestimated and their costs systematically underestimated by bureaucrats.

I’m not going to argue the merits of the underlying theory, but obviously it is possible that the new regulatory approach would result in increased profits for businesses that will have fewer regulatory burdens imposed upon them, thereby increasing the value of ownership shares in those firms. So, it’s possible that the new regulatory approach adopted by the Administration is causing stock prices to rise, presumably by more than they would have risen under the old simple cost-benefit regulatory approach that was followed by the Obama Administration.

But even if the new regulatory approach has caused stock prices to rise, it’s not clear that increasing stock valuations represent a net increase in the well-being of the American economy and the American people. If regulations that are costly to the economy in general are eliminated, the benefits of fewer regulations would accrue not just to the businesses whose profits rise as a result; eliminating inefficient regulations would also benefit the rest of the economy by freeing up resources to produce goods and services whose value to consumers would the benefits foregone when regulations were eliminated. But it’s also possible, that regulations are providing benefits greater than the costs of implementing and enforcing them.

If eliminating regulations leads to increased pollution or sickness or consumer fraud, and the value of those foregone benefits exceeds the costs of those regulations, it will not be corporations and their shareholders that suffer; it will be the general public that will bear the burden of their elimination. While corporations increase the cash flows paid to shareholders, members of the public will suffer more-than-offsetting reductions in well-being by being exposed to increased pollution, suffering increased illness and injury, or suffering added fraud and other consumer harms.

Since 1970, when the federal government took serious measures to limit air and water pollution, air and water quality have improved greatly in most of the US. Those improvements, for the most part, have probably not been reflected in stock prices, because environmental improvements, mostly affecting common-property resources, can’t be easily capitalized, though, some of those improvements have likely been reflected in increasing land values in cities and neighborhoods where air and water quality have improved. Foregoing pollution-reducing regulations might actually have led to increased stock prices for many corporations burdened by those regulations, but the US as a whole, and its inhabitants, would not have been better off without those regulations than they are with them.

So, rising stock prices are not necessarily a good indicator of whether the new regulatory approach of the Administration is benefiting or harming the American economy and the American public. Market valuations convey a lot of important information, but there is also a lot of important information that is not conveyed in stock prices.

As for taxes, it is straightforward that reducing corporate-tax liability increases funds available to be paid directly to shareholders as dividends and share buy-backs, or indirectly through investments expected to increase cash flows to shareholders in the more distant future. Does an increase in stock prices caused by a reduction in corporate-tax liability imply any enhancement in the well-being of the American economy and the American people

The answer, as a first approximation, is no. A reduction in corporate tax liability implies a reduction in the tax liability of shareholders, and that reduction is immediately capitalized into the value of shares. Increased stock prices simply reflect the expected reduction in shareholder tax liability.

Of course, reducing the tax burden on shareholders may improve economic performance, causing an increase in corporate cash flows to shareholders exceeding the reduction in shareholder tax liabilities. But it is unlikely that the difference between the increase in cash flows to shareholders and the reduction in shareholder tax liabilities would be more than a few percent of the total reduction in corporate tax liability, so that any increase in economic performance resulting from a reduction in corporate tax liability would account for only a small fraction of the increase in stock prices.

The good thing about the corporate-income tax is that it is so easy to collect, and that it is so hard to tell who really bears the tax burden: shareholders, workers or consumers. That’s why governments like taxing corporations. But the really bad thing about the corporate-income tax is that it is so hard to tell who really bears the burden of the corporate tax, shareholders, workers or consumers.

Because it is so hard to tell who bears the burden of the tax, people just think that “corporations” pay the tax, but “corporations” aren’t people, and they don’t really pay taxes, they are just the conduit for a lot of unidentified people to pay unknown amounts of tax. As Adam Winkler has just explained in this article and in an important new book, It is a travesty that the Supreme Court was hoodwinked in the latter part of the nineteenth century into accepting the notion that corporations are Constitutional persons with essentially the same rights as actual persons – indeed, with far greater rights than human beings belonging to disfavored racial or ethnic categories.

As I wrote years ago in one of my early posts on this blog, there are some very good arguments for abolishing the corporate income tax altogether, as Hyman Minsky argued. Forcing corporations to distribute their profits to shareholders would diminish the incentives for corporate empire building, thereby making venture capital more available to start-ups and small businesses. Such a reform might turn out to be an important democratizing and decentralizing change in the way that modern capitalism operates. But even if that were so, it would not mean that the effects of a reduction in the corporate tax rate could be properly measured by looking that resulting change in corporate stock prices.

Before closing this excessively long post, I will just remark that although I have been using the basic theory of asset pricing that underlies the efficient market hypothesis (EMH), adopting that theory of asset pricing does not imply that I accept the EMH. What separates me from the EMH is the assumption that there is a single unique equilibrium toward which the economy is tending at any moment in time, and that the expectations of market participants are unbiased and efficient estimates of the equilibrium price vector toward which the price system is moving. I reject all of those assumptions about the existence and uniqueness of an equilibrium price vector. If there is no equilibrium price vector toward which the economy is tending, the idea that expectations are governed by some objective equilibrium which is already there to be discovered is erroneous; expectations create their own reality and equilibrium is itself determined by expectations. When the existence of equilibrium depends on expectations, it becomes impossible to assign any meaning to the term “efficient market.”


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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