The Hard Sell

“Mnuchin warns of equities fall without tax reforms”

One of the commenters says it best: “This is the hard sell on tax reform??”

This is just the latest example of how financial market performance has turned from output to input for policymakers in recent years. Granted, Mnuchin’s comment is more political propaganda than policy prescription. It’s worse at the Fed. At the Fed, preemptive strikes on market volatility have become standard operating procedure.

From Chris Cole’s excellent research piece, “Volatility and the Allegory of the Prisoner’s Dilemma” (linked above):

Pre-emptive central banking is a very different concept than the popular idea of the “central bank put”. The classic “central bank put” refers to policy action employed in response to, but not prior to, the onset of a crisis. Rate cuts in 1987, 1998, 2007-2008, and Quantitative Easing I and II (“QE”) programs were a response to weak economic data, elevated financial stress, and large drawdowns in credit and equity markets. To differentiate, pre-emptive central banking refers to monetary action in anticipation of future financial stress to avert a market crash before it starts,even if markets appear healthy and volatility is low. In executing a pre-emptive strike on risk, policymakers rely on changes in faster moving market data (e.g. 5yr-5yr breakeven inflation) rather than slower moving fundamental economic data (e.g. CPI and unemployment). Although well-intentioned, their actions have created dangerous self-reflexivity in markets by artificially suppressing volatility and encouraging rampant moral hazard. Central banks have exchanged ‘known unknowns’ for ‘unknown unknowns’ creating the potential for dangerous feedback loops. A central bank reaction function is now fully embedded in risk premiums. Markets are pricing the supportive policy response before action is even taken. Bad news is good news and vice versa because the intervention is more important than fundamentals. Pre-emptive strikes on risk are contributing to the massive growth and popularity of any asset or strategy with a short convexity or mean reversion return profile. The unintended consequences of this massive short convexity complex will be born from phantom liquidity, shadow gamma, and self-reflexivity.

Anyway, Mnuchin’s comments have nothing to do with tail risk. He is just beating the unwashed masses with a stick to keep pressure on Congress to deliver juicy tax cuts.

This is classic dumb money messaging. You know it’s dumb money messaging because it focuses on market prices and not valuations (traders and arbitrageurs should consider themselves exempt from my nasty sarcasm by definition). Hard selling works well with dumb money because dumb money doesn’t understand how cognitive and emotional biases impact financial decision making, or how to formulate capital market expectations. Mnuchin is basically saying to Average Joe, “if tax cuts don’t go through your 401(k) is going to crater.” That’s the true message and the true target.

See also: literally every penny stock promotion. Or the movie Boiler Room.

Something To Lose Sleep Over

Perhaps the scariest academic paper I have ever read is from a fellow named Marvin Goodfriend. Dr. Goodfriend is a professor of economics and a former Fed Research Director. His paper is titled “The Case For Unencumbering Interest Rates At The Zero Bound”. The reason this paper frightens me is that Dr. Goodfriend’s suggested methods for implementing negative interest rate policies are as follows:

1) Abolish paper currency (replace it with electronic currency)

2) Allow the value of paper currency to float (similar to the way that money market net asset values float)

3) Provide electronic currency alongside paper currency

The mechanisms may vary but the end is the same: the goal is to empower the central bank (in this case the Federal Reserve) to confiscate the cash savings of individuals to implement — at least in the Fed’s view — a more perfect form of monetary policy. Goodfriend views the zero bound on interest rates as an arbitrary constraint on Ever Wise & Enlightened Central Bankers’ policy toolbox, same as the gold standard. Of the gold standard, he writes:

The gold price of goods was determined by a variety of forces impacting the supply and demand for gold such as cost conditions in gold mining, the demand for jewelry, industrial demand, and the strength of economic growth underpinning the demand for money and its required gold backing. Fluctuations in any of the underlying determinants of the gold price of goods would feed into the price level under the gold standard.

Central banks worked increasingly during the 20th century to offset the influence of gold flows on their respective price levels. Central banks forced to buy gold at the pegged money price of gold sterilized the goal inflows, effectively raising their gold reserve ratios against currency and deposits, rather than allowing the gold inflows to generate inflationary growth of the money supply. Such behavior raised the world demand for gold, depressed the gold price of goods, and created global deflation pressure. Those countries losing gold, and thereby under pressure to deflate their domestic money supplies and price levels, chose instead to reduce minimum required gold reserves against currency and deposits, to impose direct controls of one sort or another, or to devalue their currencies in terms of gold. The gold standard was finally abandoned in the early 1970s so that fluctuations in the gold price of goods could be reflected in the money price of gold without destabilizing the general price level.

Similarly, the zero bound for interest rates impedes central banks’ ability to exercise complete control over monetary policy. The paper explains this through the use of a model (I am not much of a macro guy so I will not delve into the derivation of the model here). The plain language translation is that in making consumption choices households weigh whether it is better to spend to consume goods and services now or to save to consume goods and services later. In a deflationary environment households will hoard cash in hopes of spending later at lower prices. This creates a vicious, self-reinforcing cycle that sends prices, wages and economic output on a downward spiral.

To counteract this negative feedback loop the Ever Wise & Enlightened Central banker would impose a negative interest rate. That is, there would be an explicit cost attached to saving and an explicit payment attached to borrowing. Rather than earn interest on your savings account, you would pay interest on it. Rather than pay interest on your mortgage, the bank would pay you for borrowing.

Up is down. Black is white. If you are an academic economist I suppose this is all well and good. You swap some terms around in a model, develop a policy position and then implement it. If you are a real person — you know, the kind who has to make “real” decisions about saving versus spending — this sounds completely insane.

People may be dumb but they are not stupid. No one is going to say “gee, interest rates are negative, I should spend all of my money to avoid this tax on my savings, The Ever Wise & Enlightened Central Bankers will make sure everything works out in the end.” It is self-evident that if a negative interest rate policy ends up being effective, inflation will eventually return and interest rates will shift back into positive territory.

So what people will end up doing is hoarding assets anyway. Now they may not hoard actual cash (if Dr. Goodfriend has anything to say about it central banks will be able to delete units of currency at will). They will find some other asset to hoard though. Gold, silver, Bitcoins. Another thing people might end up saying is, “gee, interest rates are negative and appointed central bank officials with no direct accountability are confiscating my wealth. Maybe it is time for a change in political system.” A friend of mine calls this “villagers with pitchforks risk.”

Central bankers suffer from a collective delusion of control. It is evident when you hear Janet Yellen saying that we are unlikely to experience another financial crisis in our lifetimes, or when Mario Draghi brags about the ECB having neutralized tail risks (something that is by definition impossible). This is no different than tech stock investors claiming earnings no longer mattered in the late 1990s, or structured credit salespeople claiming home prices would never fall all at the same time circa 2005.

Be afraid.