The Capital Note: A Blue Wave & the Bond Market

Daniel Tenreiro
·4 min read

Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: the economics of a blue wave and a reevaluation of the sunk cost fallacy.

Blue Wave?

At the outset of the COVID-19 pandemic, economists worried that lockdowns would catalyze a wave of bankruptcies and lead to a protracted recession. The U.S. avoided that scenario through a combination of fiscal largesse and central-bank intervention, as well as behavioral changes that allowed states and cities to roll back some social-distancing measures.

Economic analyses of the election have focused squarely on fiscal policy (which makes some sense, since lawmakers do not set monetary policy). In the past, a “blue wave” would have been considered a worst-case scenario for businesses and their shareholders, given the likelihood of tax hikes and increased regulations. But in 2020, investors are pricing in a major stimulus package should Democrats take the White House and Congress, which would boost GDP by increasing consumer spending.

This analysis overlooks the specific areas of vulnerability in the economy. While the CARES Act played a major role in smoothing consumption this year, the worst-case scenario of the COVID-19 recession was a spike in bankruptcies, which would impose permanent losses in the form of firm-specific human capital, professional networks, and employment relationships. Perhaps the single biggest factor in avoiding this outcome was a spike in corporate-bond issuance enabled by the Federal Reserve.

As Olivier Darmouni and Kerry Y. Siani point out in a recent paper, “Both investment-grade (IG) and high-yield (HY) markets reached historical heights in the post-March 2020 period. As of end of May 2020, investment grade (high yield) issuance reached over $500 billion ($120 billion), compared to just over $200 billion ($90 billion) over the same period last year.” While equity valuations and economic indicators saw massive fluctuations in the months after lockdowns were imposed, corporate-bond spreads remained rather stable, enabling businesses to shore up their balance sheets amid all the turbulence.

Just as bond-market interventions enabled businesses to weather the storm of the pandemic, so too can disruptions to capital markets risk a delayed-onset liquidity crisis, especially if the pandemic persists. The Biden tax plan would lower corporate credit quality, both by increasing taxes on interest income and by reducing the amount of earnings available to pay down debt. At the same time, state and local aid would almost certainly reduce the premium on tax-exempt municipal debt, giving investors an attractive alternative to corporate debt, while a minor pickup in Treasury yields would have a similar effect. A large part of the harms to corporate bonds would materialize before the passage of the legislation, as investors would price in tax reform.

This hit to the credit market would come at a time when $254 billion of investment-grade bonds are currently at risk of being downgraded to junk ratings. With consumer spending holding up rather well throughout the recession, the biggest risks are concentrated on corporate balance sheets that will fare poorly under a Biden presidency.

That’s only the tip of the iceberg: A Hoover Institution report released last week and covered for Capital Matters by Kevin Hassett finds that Biden’s economic agenda would reduce long-run per capita GDP by more than 8 percent if fully implemented.

Around the Web

Good election-day eve for stocks.

As I mentioned in the item above, the monetary response to the pandemic was arguably what kept the U.S. from sliding into a deep, protracted recession. In light of the Fed’s apparent success, Josh Barro has penned an ode to Jerome Powell.

John Cochrane takes a look at the new Hoover Institution report on Biden’s economic plan: “This report puts the neoclassical growth model at the center of policy analysis, rather than the simple Keynesian ISLM model. And that’s exactly appropriate for permanent long-run policies, not short-run get out of a depression policies.”

Random Walk

One of the first things I remember learning in intro microeconomics is the “sunk cost fallacy.” The theory holds that individuals irrationally account for expenses already incurred rather than maximizing their present utility. If you’re at the movie theater watching the world’s worst film, you might sit there miserably for two hours simply to “recoup” the cost of the ticket, even though you’d be better off leaving. It makes intuitive sense, but a new experimental study finds that individuals actually suffer from reverse sunk cost bias. The greater the upfront cost, the greater the willingness to abandon an investment early on:

That is, the larger the initial investment, the lower the likelihood to continue investing in a project. Moreover, whether or not subjects are responsible for the initial investment, does not affect their additional investment. More waste averse individuals also do not react more strongly to sunk cost whereas being in the loss domain decreases additional investment. Importantly, we replicate the sunk cost bias when using hypothetical scenarios. Surprisingly, the reverse sunk cost bias also holds for those participants who exhibit a strong sunk cost bias in the hypothetical scenarios.

— D.T.

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