Small Business Investment in the Era of Rising Interest Rates

Its been a while since I've posted here. Its because the majority of my published work know takes place at our new and improved site, whiteanalytics.com. But I thought I'd do an update here as well; can't hurt to present a wider target.

As I haven't mentioned here, the main impetus for my migration to the new site was the fact that I needed the capacity to post Excel spreadsheets and downloadable pdfs. In fact, my website as it now exists is pretty much exactly what I wanted this blog to be from the get-go. And it only took three years!

Anyway, I'm working on a new white paper (pun intended) about a thing I thought of today. The Fed is indicating that it (they?) may/will/should raise interest rates in about a year. That got my thinking about how project selection will change in an era of moderate-to-normal interest rates; my entire economics education has taken place since the ZLB set in.

One implication I thought of today (and my spreadsheet model friends confirmed!) was that as interest rates rise, smaller projects with lower cash flows have higher present values than expensive projects with larger cash flows. I suspect a fact of this is that smaller investment projects currently on the sidelines become more attractive than the big projects that make sense with low rates.

Again, check it out at whiteanalytics.com. Got to drive that traffic.

Back To This...

It's been a while since I posted a Gary Larson. This one is one of my all time favorites. I suppose it could serve as a kind of allegory for those experts who think our labor market is being restrained by a skills-mismatch between employers and the unemployed. Or maybe it just makes me laugh.

Anyway, please visit my new site as well for a more serious take on economic news and analysis.

http://www.whiteanalytics.com/

We've Expanded!

Unlike the U.S. Economy during the duration of this blog, our operation has just undergone a substantial expansion. Please visit us at www.whiteanalytics.com  for news, commentary, a whole host of spreadsheet models and all your favorite FRED Data Transformations.

Meanwhile, this blog will revert to what it once was, a less serious and tedious platform that isn't shy about posting Gary Larson and bad puns, as well as economics.

Self-Indulgent Argument Time: Leverage is a Feature, Not a Bug

Time to pay homage to this blog's silly title and go on a bit of a rant. I'm going to voice what on the face of itself may appear to be an absurd, reactionary promulgation, but here goes: Limits on financial leverage imposed on banks are counter-productive.

In fact, not only have I concluded that limits on leverage are wrong, I'll go one step further: I'm willing to postulate that nine out of every ten people in favor of strict leverage limits haven't really thought through the dynamics of their position, or perhaps are a bit unclear of the parameters of the issue entirely.

Here's the reason why. When all is said and done, "financial intermediation" and "leverage" are actually the same thing. Synonymous. By-words for each other. When a bank accepts a dollar in deposit from a customer and lends $0.90 of it out (keeping $0.10 on reserve at the Fed of course), that increases the bank's leverage, because it has issued a liability in the form of the deposit and acquired an asset with the proceeds in the form of the loan + the reserve it now claims on the Fed. If this leverage- and- risk- multiplying transaction sounds suspiciously like old fashioned "banking," its because it is. Banks borrow funds from net creditors and lend them to net debtors, pocketing the spread between interest paid to the creditors and that charged to the debtors.

Pundits and commentators eager to reign in the "big banks" and Wall Street in general often portray the phenomena of leverage in a far more exotic form, as if it were a fundamentally unsound and dangerous proposition. In the parlance of the cognoscenti, banks "gamble with borrowed money," which is actually the same thing as lending out deposits.

As Alan Greenspan wrote in the memoirs, when considering the implication of an argument, it can help clarify the point if one carries the argument to its logical extreme and see if it makes sense. If the answer to financial stability is strict limits on bank leverage, why not ban leverage entirely? Wealthy shareholders could get together and pool their money into capital funds, and lend it out to borrowers, while accepting no deposits from the common sort of people who presently use banks and thus increase those bank's leverage. The rest of us could resort to stuffing our life savings under the mattress, or bury it in the desert and hope no one finds out. Come to think of it, it makes me wonder if the whole financial regulation movement hasn't been secretly underwritten by the safe manufacturing industry from the very start.

Crimea, Putin, and the End of Economic Unilateralism

The specter of American decline has loomed large in the imaginations of the talking heads in the media and in politicians who offer purported solutions to avoid calamity. We hear about unfair Chinese trade practices hollowing out American industry, the test scores of students in South Korea and Finland relative to our own, or the inevitable collapse of the dollar as its value strains under the weight of our perennial current account deficits.

While most of this has is genesis in hype and speculation, one fact cannot go unacknowledged: the economic hegemony of the United States, and the resulting ability of U.S. policymakers to wield near omnipotent power of foreign governments and institutions, is at an end. This new state of affairs is made painfully evident by the ease of which Vladimir Putin has walked into Crimea and conducted an effective annexation, despite clear objections from Washington, and Brussels to boot.

The reason Mr. Putin has (correctly) calculated that he can get away with this hitherto unthinkable maneuver is simple: He's got the economic muscle to back it up. While Russia's economy may have many critical structural weaknesses that preclude its workers from enjoying standards of living on par with those in Western Europe and North America, it does pull in hundreds of billions of dollars per annum in the form of natural gas and crude oil exports. As a result, Russia has accrued in the neighborhood of $500 billion in foreign exchange reserves, to which is adds every year by dint of its secular current account surplus. This war chest gives the Kremlin the confidence and ability to literally march to its own tune, secure in the knowledge that it can pay its bills regardless of ire it may cause on Capitol Hill. And with demand for fossil fuels ever increasing from developing economies, don't count on this windfall to dry up on any foreseeable time horizon.

The point of all this is not that the primacy of the United States is over, but rather that Washington must accustom itself to playing more of a "first among equals" role on the international political stage. The alternative is for future U.S. Presidents and policymakers to make bold proclamations and draw lines in the sand- lines over which our competitors will be increasingly non-hesitant to march.

Asset Markets See the Light: No Fed Taper on the (near) Horizon

It seems that financial asset markets have lost the jitters they've been feeling for the last several weeks based on the misguided fear of an imminent Fed "taper." The jobs report which came out today had unemployment at 7%, a half a percentage point above the metric Bernanke laid out as a parameter for the current bond-buying regimen of $85 billion per month. This return to complacency following the recent hand- wringing means one of two things: either I'm highly influential and my message has gotten through, or bond and equities traders have actually decided to take the explicit policy pronouncements of the FOMC at face value. I know which option I'd like to believe.

Like I've said, short-term interest rates are going to stay low as long as unemployment remains above at least 6.5%. Bond investors have nothing to fear but a strong labor market. When the FOMC meets on Dec. 18, lets hope they give me an early Christmas present in the form of a vindicated prognostication.

Sumner, Krugman, Williamson, and My Two Cents

There's been a recent row in the economics blogosphere over the nature of quantitative easing, and its long-term effects on the price level. FOMC member John Williamson recently implied that quantitative easing, instead of causing inflation, instead will exert deflationary pressures on the economy in the long-run. Here's a quote: "The Fed is stuck. It is committed to a future path for policy, and going back on that policy would require that people at the top absorb some new ideas, and maybe eat some crow. Not likely to happen. The observation of continued low, or falling, inflation will only confirm the Fed's belief that it is not doing enough, not committed to doing that for a long enough time, or not being convincing enough."

Paul Krugman, Scott Sumner, and Nick Rowe, among others, have already jumped into the fray, with predictably intriguing discourse ensuing. 

Here's my two cents: Williamson mixed up the difference between real and nominal. Its really as simple as that. Quantitative easing, i.e. dramatically increasing the supply of base money in an economy, doesn't by definition induce asset owners to increase their real holdings of money, i.e. a great amount of purchasing power over goods and services in the form of currency or demand deposits; it by definition induces them to increase holdings of nominal balances.

Lets investigate this using some preliminary algebra. The real money supply is equal to the nominal money supply divided by the price level so that we write:

mD = MS/P

This means the real purchasing power of the money supply is equal to total amount of base dollars in the economy, i.e. paper money plus bank reserves at the Fed, divided by the price level, which is the "average" price of all output in the economy. Quantitative easing means an increase in the nominal money supply, the MS term in the above equation. Williamson has in effect postulated that for an increase in MS, mD must rise by the same amount, which implies that P must correspondingly fall to maintain the equality. What he overlooked is that just because a central bank decides to increase the supply of nominal money, asset holders do not necessarily want to hold more purchasing power in the form of money base. Instead, it is the level of prices that rises via inflation so that the newly issued money is held as real balances to keep purchasing power constant.