The Capital Letter: Week of October 19

Even with the California recalculations we are still significantly above the 665k peak reading during the global financial crisis in 2009, so it doesn’t change the narrative of significant strains in the jobs market,” said James Knightley, chief international economist at ING.

There’s still a long way to go, and anyone looking ahead ought to pay careful attention to what’s going on in Europe.

Business activity in the eurozone has slid back into decline, according to a widely-watched survey, as rising coronavirus infections and tighter curbs weigh on the bloc’s economy…

The IHS Markit flash eurozone composite purchasing managers’ index fell to 49.4 in October, its lowest level since June and down from 50.4 in the previous month. A reading below the 50 mark indicates a majority of businesses reported a contraction in activity compared with the previous month.

The drop was driven by a contraction in services activity, which was steeper than economists had expected, although it was partly offset by resilience in manufacturing.

Analysts said the data signalled that the eurozone’s recent economic rebound was losing steam.

It was at least welcome to see the FT acknowledge that the problems were the result not only of the resurgence of the virus, but also the clumsy (over)reaction (“tighter curbs”) to it, even if the newspaper’s writers didn’t put it quite like that.

The investment bankers’ pitch is geared toward individuals and families, as well as private equity firms, who control companies and can decide when to sell them. It also targets company founders, who may only sell one business in their lifetime, making it the most important transaction of their lives.

The strategy appears to be working. Sales of privately held U.S. companies totaled a record $253 billion in the third quarter, up fivefold from the second quarter and up 51% from the third quarter of 2019, according to financial data provider Dealogic. This is despite the COVID-19 pandemic suppressing corporate valuations in some sectors.

Is it harmful to consumers for Google to pay other companies to feature its search engine as the default? That’s a hard case to make, because it’s generally easy for those who prefer other search engines to change the default, as Google and the alternative engines are all free and switching can be achieved in a few clicks; because these lucrative arrangements help to subsidize the devices consumers use; and because most users would probably choose Google anyhow, if its runaway success over the past two decades is any guide.

The argument to the contrary, as it stands so far, is highly speculative. It holds that consumers would be better off if they had to affirmatively choose Google, because other engines would then have more of a chance to compete, and the added competition and innovation would lead to better products and greater choice, and lower rates for those who advertise in web searches. That argument may find some sympathy in court, and it might even be true. We, like the folks behind this lawsuit, have no supernatural ability to see what would happen in that counterfactual world. But it is a poor excuse for a government crusade against one of the country’s most successful private enterprises.

There is much more to come in this lawsuit, and in the additional lawsuits against Google that states are expected to file soon. Google is not a corporate angel, and we will not be shocked if genuinely incriminating evidence of anticompetitive conduct emerges. Further, if Google’s size and influence create problems that don’t fit the antitrust framework, that may be a case for changing other laws rather than stretching antitrust enforcement. Much of the current discontent with Google and other search and social-media companies is about their ideological biases, their internal corporate cultures, their impact on the public marketplace for free speech, and how they relate to China and other hostile foreign governments. But we should not use antitrust law as an all-purpose stalking horse for entirely separate agendas.

This opening salvo, however, is rather underwhelming.

Private equity firms are testing investors’ appetite for returns with new sales of payment-in-kind bonds that offer juicy interest rates but are among the riskiest deals since the Covid crisis began.

The re-emergence of PIKs underscores how fixed-income investors are increasingly being asked to accept higher degrees of risk and more onerous terms from corporate bond issuers as soaring prices of higher-quality assets in recent months has deeply depressed yields.

A duo of highly-indebted borrowers are seeking to raise a combined $1bn through so-called PIK toggle deals, in which issuers are allowed to defer interest payments. The structure allows companies to pay interest using more debt, leading the amount that ultimately needs to be paid at the bond’s maturity to balloon…

The deals follow a flurry of so-called dividend recapitalisations through the loan market, where private equity owners have used borrowings to fund payouts from their portfolio companies.

Even as tiny as the number of expatriating Americans is, the U.S. government has seen fit to build a financial Berlin Wall to keep Americans in — or, at least, to punish them for leaving. Americans who renounce their citizenship face heavy taxes on certain assets. As the Wall Street Journal puts it, “The rules are complicated, but, in general, an exit tax is calculated for individuals with a net worth of more than $2 million as if they sold all of their assets the day before expatriating.” That tax currently runs as high as 37 percent.

Behind the prim, schoolmarmish demeanor of Senator Elizabeth Warren lurks one of the champion authoritarians in current American political life. Senator Warren has proposed increasing the penalty on those who renounce their U.S. citizenship, in part because she has proposed the imposition of a 2-percent annual tax on the savings of wealthy Americans and knows that such a measure would encourage many of those subject to it to consider relocating abroad. There are any number of places in this world where wealthy people can live comfortably.

Washington has long been entranced by the idea that fat cats are somehow getting over on the taxman: The Foreign Account Tax Compliance Act (FATCA) has made it all but impossible for many Americans to obtain ordinary banking services abroad, because our class-warrior politicians believe that private citizens are squirrelling away gazillions of dollars in numbered Swiss bank accounts. (The impregnably private Swiss bank account is mostly a myth.) Washington would, given a chance, subject Americans to a financial panopticon. And the power of financial surveillance is easily abused: Keep in mind that as attorney general in California, Kamala Harris attempted to extort conservative activist groups into disclosing their donors to her office, a transparent act of political intimidation and coercion. The federal courts stopped her — if you are wondering why Republicans fight so hard for judges, there is your answer…

There probably won’t be an exodus of Americans any time in the near future. And the current high number of expatriations may be a blip. But still there is something to be learned from that blip and from Washington’s reflexively heavy-handed attitude toward it. Even if it never amounts to much, the fact that the U.S. government would try to fence us in with financial coercion is dispiriting and grotesque, and it ought to be unbearable.

So, if anybody is listening: Mr. President, tear down this wall.

If making American workplace relations more like those in the social-democratic countries of continental Europe sounds like something out of the political program of Senators Elizabeth Warren (D., Mass.) and Bernie Sanders (I., Vt.), that’s because it is. But a faction on the American right, typified by Oren Cass of American Compass, also wants to increase the power of Big Labor to “represent” more unwilling workers by importing European models of workplace relations. While conservatives should ensure that Americans have a voice in their workplaces, the plan of the redistributionist Right to give more power to Richard Trumka, Mary Kay Henry, and other national union bosses will hurt, not help, workers who are more open than ever to supporting conservatism.

[A] “redistributionist right” would just be the Left with a different social policy. While arrangements to improve the immediate work conditions of workers should be explored, one cannot simply transplant German social-legal institutions such as works councils into the American context. The American political system is far less consensus-driven, far more acrimonious, and much more beholden to partisan special interests than the German one. Switzerland isn’t Germany, but observing the difference in outcomes between government-by-plebiscite in the Swiss system and government-by-plebiscite in California should counsel caution.

In 1946, the country saw what Big Labor, let free of all restraints, could do to the national economy and social life, and it swung to the right in revulsion. It would be a blunder for the Right to import European models and let unions coerce the workforce as they did when back then.

Illinois governor J.B. Pritzker campaigned on a promise to undo our state’s longstanding flat tax protection and has put $56.5 million from his own pocket into his “fair tax” campaign. An amendment before voters on November 3 would allow state lawmakers to add as many state income tax brackets as they wish. Indeed, some in the administration are already signaling that they are interested in starting to tax retirement income.

While all taxpayers are at risk once Illinois state lawmakers can divide taxpayers without facing pushback from constituents, the insidious part is the progressive tax would kick small businesses and our economy as we struggle to recover from the COVID-19 pandemic. Economists roundly warn against adding taxes during a recession. In Illinois, small businesses are responsible for 3 out of every 5 net jobs created. Small-business owners have also suffered the most during the economic fallout from COVID-19.

State lawmakers already passed initial progressive rates in case they win voters’ approval. The hit to over 100,000 small businesses in Illinois will be up to a 47 percent tax increase.

And that’s just the damage so far.

No one in Illinois really believes the same legislators who haven’t balanced a budget in 20 years and ran up a $140 billion pension deficit are going to stop at rates that “tax the rich” yet only give the state’s poorest enough of a break for a fast-food meal. More than half of progressive-tax states hit the middle class with the same top rates paid by millionaires, and there’s every indication that will happen in financial basket-case Illinois.

When small businesses face a tax hike, they’re left with less money to spend on new locations, new workers, new equipment, and improved employee training. It also means less for current workers’ raises.

It’s already hard to make a business succeed here in Illinois, especially if you’re a small start-up without the resources of a big corporation. The progressive tax would make it even harder.

As an editorial in today’s Wall Street Journal points out, the new top tax rate would “move the state to the 10th highest income-tax rate in the country, from 11th lowest today, according to the Tax Foundation. Arizona would move closer to California (13.3% top rate) than Nevada (no income tax).”

One angle to the debate is what effect the tax increase will have on the numbers of people moving in and out of the state, a number, of course, which will have a significant bearing on future tax revenues.

Joe Biden’s tax plan is based on a deathless economic myth: that taxes are actually paid in economic terms by those upon whom they legally fall. The obviousness of this nonsense is clear enough if you put the proposition into plain English: “Don’t you worry, now, we’re not going to raise taxes on you, Bubba — we’re just going to raise taxes on your employer, your customers, your vendors and business partners, the people who make and sell the things you buy and use, your bank, your Internet provider, the companies that build houses and commercial buildings, your landlord, gasoline distributors, all the companies your retirement account is invested in — oh, you won’t be affected at all!”

If Republicans have demonstrated nothing else in this century, it is that the United States cannot eliminate the federal budget deficit, or even stabilize it, under our current tax system. And Republicans who also want to shrink the tax base by reducing or eliminating taxes on favored constituencies make the same error as progressives. For Republicans, that’s a political error, too: Ronald Reagan used to brag about all the low-income and middle-income Americans who were effectively taken off the income-tax rolls on his watch, but that created a problem for his political heirs, who still try to run on federal income-tax cuts in a country in which half of the people pay little or no federal income tax. Republican tax cuts end up being “tax cuts for the rich” because almost any substantial income-tax cuts in the current system would disproportionately benefit high-income Americans, who pay almost all of the federal income taxes.

A broader tax base makes it possible to raise more revenue, and it also helps to stabilize revenue.

“There is only one thing worse than being talked about, and that is not being talked about.”

The relationship between top tax rates and actual tax revenue is far from straightforward. In 2019, with a top tax rate of 37 percent, the U.S. government collected about 16.3 percent of GDP in taxes, while in 1951 — with a top tax rate at a sobriety-inducing 91 percent — the U.S. government collected only 15.8 percent of GDP in taxes. Throughout the 1950s and 1960s, when top tax rates were very high compared to where they are now, the U.S. government collected an average of 17.1 percent of GDP in tax revenue, very similar to the 16.8 percent of GDP collected on average since 2000 and a bit less than the 18 percent average of the 1990s. The Democrats’ faith that raising taxes on the rich would make a lot more money available for college subsidies or infrastructure or free false teeth or whatever is not necessarily supported by experience.

Do neoliberal policy priorities such as low taxes and limited government really need to be ushered out the door? [The WEF’s] Schwab claims that free-market fundamentalism has “triggered a deregulatory race to the bottom,” which suggests that the major economies of the world are operating under some kind of laissez-faire anarchy. This will come as puzzling news to scholars of government regulation.

The same could be said of tax receipts, which Schwab claims have been the subject of “ruinous” competition between international taxing authorities. Putting aside the implied assumption that we should all want higher tax rates and collections, taxation in the United States in no way reflects the big-government bias of critics such as Schwab. For decades we have been informed that heartless austerity measures have starved essential government services of necessary revenue. But whatever is wrong with such services, it’s not a lack of total revenue.

Taxpayers are going to expect a reasonable order of priorities when their money is spent, and the same is true of profit-seeking investors. The global regulatory cartel that technocrats such as Schwab envision — a system of supranational policymaking that insulates politicians and CEOs from the demands and expectations of their most important constituents — is exactly the course of action that will end the “neoliberal revolution,” and with it, the prosperity that it creates.

Despite the additional complexity, the overall conclusions remain. President Trump is the tariff man that he says he is, while President Reagan was a quota man. President Reagan did not always practice the free trade that he preached. As Reagan CEA member William Niskanen put it, the Reagan administration “was on both sides of [trade issues], articulating a policy of free trade and implementing an extensive set of new import quotas.” Another Reagan CEA economist Steve Hanke added “the share of American imports covered by some sort of trade restriction soared under ‘free-trader’ Reagan, moving from only 8 percent in 1975 to 21 percent by 1984.” The Trump administration also has key elements of protectionism, but unlike Reagan has so far mostly avoided protecting domestic producers in ways that profit foreign companies.

Congress passes sweeping policy changes with little care for the preferences of the executive branch, cognizant of the idea that Biden would be extremely unlikely to veto the Democrats’ own bills. And what type of legislation might they pursue? Exactly the proposals that were negotiated as part of a détente with Bernie Sanders and AOC as part of the “Unity Platform,” proposals that to this day are described in impressive detail on the Biden website.

Motivated by this, my coauthors and I spent the past few months doing a deep dive into the economic-policy proposals of the Biden campaign. Despite his reluctance to dwell too much on policy in public, Biden’s platform is perhaps more detailed and carefully spelled out then the platforms of any of the candidates mentioned above. He proposes large changes in the tax code, an expansion of the Affordable Care Act, profoundly transformative energy policies, and a tidal wave of new regulations. Sifting through the proposals, our paper quantified what could be quantified and incorporated the policies into a commonly used macroeconomic model.

Professor Paul Krugman “has a good understanding of the essentials of international trade (the basis for his Nobel Prize Award) and explains them well,” I wrote in December in my new book about President Trump and his economic team. But I added that Krugman “is wrong about most [other] economic subjects . . . [and] helpful for predicting mistakes that would be made by the President’s opponents.” Now is a good time to assess whether the data still support such a harsh evaluation, with special attention to schooling, the economic recovery, and taxation.

In 2003, the Securities and Exchange Commission promulgated a regulation that has engendered an outcome unintended and perverse: a duopoly of two firms enjoying a position as the most powerful arbiters of corporate governance in America. Those firms, Institutional Shareholder Services (ISS) and Glass Lewis (GL), provide proxy-advisory recommendations to investors and asset managers on how they should vote their shares in the many companies that they own. The two account for 97 percent of the market for proxy-advisory services. They have become de facto regulators of America’s public companies. Because of subsequent staff interventions and interpretations, the 2003 regulation evolved from a simple requirement that investment funds provide transparency involving potential conflicts into an SEC policy that was interpreted to mean in effect that funds must vote on all proxy issues, that the funds could avoid liability by retaining proxy advisers, and that the proxy advisers would bear liability only in extreme cases.

The “extreme cases” limitation on the potential liability of proxy advisers means that in practice they are unconstrained by considerations of fiduciary responsibility. So the policy or political preferences of the proxy advisers (or their staffs) carry substantial weight in terms of decisions on proxy proposals concerning executive compensation and corporate policies on a range of social and environmental questions.

At the outset of Trump Administration, when Mark Calabria became the new FHFA director, Fannie and Freddie had the ability to own $1,000 in assets for every dollar of equity on their balance sheets (only holding $6 billion in equity with $6 trillion of liabilities), implying a 0.1 percent capital ratio. By comparison, private U.S. banks have been required to meet an 8 percent capital ratio — and that’s before Dodd-Frank’s additional capital buffers. One could argue that the risk for Fannie and Freddie is further exacerbated by their undiversified sector risk (all of $6 trillion of their assets are in the mortgage space), notwithstanding the fact that they’re no longer invested in the risky off-label mortgages as they were before the financial crisis.

Fortunately the Federal Housing Finance Authority (FHFA), which since 2008 has overseen GSEs, recently proposed a new rule that requires a capital ratio of 8 percent for GSEs, as well as a minimum leverage ratio of 2.5 percent and additional buffers.

Unsurprisingly, there are many opponents to the Fannie and Freddie capital rule in the mortgage-finance industry, whose members stand to have their profitability potentially crimped by the move. Scores of trade groups, including The American Bankers Association, the Center for Responsible Lending, the Mortgage Bankers Association, the Housing Policy Council, and the National Association of Realtors, are all seeking to delay the new rule with the hope of a different policy from a potential Biden administration. These are all organizations that benefit in different ways from the lower mortgage rates that GSE guarantees provide.

Thankfully, the Financial Stability Oversight Council (FSOC) — after being set up ten years ago — is acknowledging for the first time that Fannie and Freddie pose risks to the stability of the financial system, lending additional support to the capital rule from the rest of the regulatory community. In effect, the FSOC will label Fannie and Freddie systemically important financial institutions (SIFIs), something which they’ve done in the past for non-bank private institutions such as AIG and Prudential (designations which FSOC has since rescinded).

While it’s unclear that Fannie and Freddie will leave conservatorship anytime soon, a tighter capital framework would certainly be a precondition to becoming fully private entities….

Regardless of whether they exit conservatorship, the new capital framework is a welcome step to protecting taxpayers from incurring further losses.

Beijing’s push to become totally self-sufficient in semiconductors and to command the heights of the microchip industry is part and parcel of its larger push for global hegemony. If China succeeds, and our manufacturing capacity and market share continues to shrink, we could face a situation in which U.S. tech companies have to rely on a chip supply chain that is shaky at best, and an actual threat to national security at worst.

No matter who sits in the White House on January 21, Americans are realizing that our economic and national security future depends not only on how the technology we rely on is made, but where it’s made. Much of that secure and prosperous future will depend on the health and safety of our microchip industry. As the Latin phrase has it: sine qua non— without it nothing. Without a strong semiconductor sector, the future will look very bleak indeed.

PDVSA’s decreased output is not due to dwindling oil reserves, but instead due to a reduction in its depletion rate. The depletion rate — the rate at which oil companies are depleting their proven reserves — provides the key to understanding the economics of an oil company and the value of its reserves.

Venezuela’s depletion rate has been falling rapidly since 2007. In 2019, it sat at 0.121 percent per year, indicating that it would take 569.41 years for PDVSA to tap half of its reserves.

This has noteworthy economic implications. Because of positive time preference and discounting, the value of a barrel of oil produced today is higher than the value of a barrel of oil produced in the future, provided the price of oil remains the same. Given Venezuela’s incredibly low depletion rate, its reserves are essentially worthless because they are left in the ground for too long.

To put Venezuela’s depletion rate into perspective, consider Exxon, one of the world’s largest oil companies. At the end of 2019, Exxon’s depletion rate was 6.53 percent per year —comparable to that realized by most major oil companies. That rate implies that it would take 10.25 years for Exxon’s oil reserves to be halfway depleted. That is 559.16 years earlier than when PDVSA would deplete half of its reserves. If we discount at 10 percent, the median value of Exxon’s reserves is worth 37.65 percent of their wellhead value (the value that the producer would receive if the oil was sold at the wellhead and not distributed further downstream) — not zero, as is the case for PDVSA.

Thanks to Venezuela’s embrace of socialism and Chavismo, PDVSA has probably destroyed more economic value than any institution in world history. This brings back memories of President George W. Bush’s infamous remark that “this sucker could go down.” It’s no surprise that the clergy are preparing to administer PDVSA’s last rites.

Lebanon has just named Saad Hariri its new prime minister — the same Saad Hariri who resigned from the Lebanese PM post almost exactly one year ago. And, he is enamored with the so-called French plan to bring Lebanon’s economy back to life. But there is one major item in the French plan that is a killer — the immediate imposition of capital controls.

Capital controls as a panacea for economic ills are nothing new. Their pedigree can be traced back to Plato, the father of statism. Inspired by Lycurgus, the tyrant of Sparta, Plato embraced the idea of an inconvertible currency as a means to preserve the autonomy of the state from outside interference…

The imposition of capital controls leads to an instantaneous reduction in the wealth of the country because all assets decline in value. Full convertibility is the only guarantee that protects people’s rights to what belongs to them. Even if governments are not compelled by arguments on the grounds of freedom, the prospect of seeing every asset in the country suddenly lose value as a result of capital controls should give policymakers pause.

In the case of Lebanon, a country whose lifeblood has been the importation of capital, capital controls would be a killer. They would repel the large and important international Lebanese expatriate community. Indeed, the French capital-controls mandate for Lebanon should be pronounced dead upon arrival.

The Europeans have envied the American tech industry for decades. In 2000, the European Council released with much fanfare a plan to “become the most competitive and dynamic knowledge-based economy in the world” and to fend off American juggernauts such as Microsoft. The plan failed so miserably that proponents of European-style industrial policy should think twice about bringing these methods to the United States. American companies continue to lead the world in most important emerging information-based technologies. This time around, even the Netherlands, which historically has supported free markets more consistently than many of its neighbors, together with France recommended more coercive forms of protectionism now that subsidies and planning have failed.

The tech industry deserves plenty of skepticism, but it is also important for the American economy. Although social distancing and stay-at-home orders have become more controversial as the pandemic has dragged on, these options are only available because of important technological advances. Before the advent of Internet services such as video conferencing, cloud computing, and email, sending millions of workers home was unthinkable. In earlier pandemics, the choices available were to stop working entirely and face a complete loss of income or to stay at the workplace and risk succumbing to the disease. Many workers now can perform adequately at home, which has cushioned the economic fallout of the earlier measures to slow coronavirus’s spread. The tech industry is largely responsible for the U.S. economy’s new resilience to threats such as pandemics, which is just one reason why the EU wants its own champions in these areas.

On Tuesday, the Department of Justice (DOJ) filed an antitrust complaint against Google — the highest-profile antitrust lawsuit since the 1998-2002 Microsoft case. The 64-page complaint argues that Google is “unlawfully maintaining monopolies” in search and advertising markets. But politics, not the law, is what is really driving this case.

Many Republicans are upset about perceived anti-conservative bias in the tech industry. That explains the Google suit’s timing — and the likelihood of a similar suit against Facebook before the end of 2020.

While the DOJ and most state attorneys general have been investigating Google for some time, many DOJ lawyers did not believe they had yet built up a solid case, and opposed Barr’s rushed pre-election timing. The New York Times reported in September that some staffers refused to sign onto the complaint. Some even left the case over their objections.

From the contents of the complaint, it is clear why. One of its listed grievances is that Google has become a verb. By this logic, as lawyer Cathy Gellis notes, Kleenexes, Band-Aids, and Popsicles have a potentially unlawful edge in their markets. The complaint’s more serious arguments fall equally short.

Some on the left and some on the right, including many in Congress as well as the president, regard social media as a public forum and, by ignoring the reality that these are spaces created by private companies, effectively ignore the property rights that ought to go with that. The fact that the Internet is an inexhaustible resource appears to have passed them by. The judiciary, too, has magnified this problem. According to the Second Court of Appeals in mid-2019, President Trump cannot block users on Twitter. It ruled that it was a violation of the First Amendment for him to do so. As the Wall Street Journal pointed out at the time, “under the Second Circuit’s ruling, politicians would have to choose between abandoning social media — which would limit their ability to communicate with voters — and tolerating harassment and lies. The decision also opens a potential legal avenue by which regulators and federal courts could become the speech arbiters for online platforms.”

“Everybody” hates Big Tech now. That ought to mean that the time is right for alternatives. If anything, the underlying functionality of the Internet has reached even higher levels than in the pre-Google and pre-Facebook era. The potential to offer users new ways of doing things on new platforms has not gone away and may even have been enhanced. All politicians have to do is preserve the property rights that incentivize entrepreneurs to innovate, and stay out of the way.