Greedflation - It's not wages, but profits!

The aftermath of the pandemic and the subsequent economic recovery has raised several questions. Arguably the most salient has been the search for explanations for the rising inflation. 

The immediate and most widely discussed explanation was the wage-price spiral - where wages pressures upward entrench inflation. This was corroborated by the labour market tightness as the pandemic restrictions eased and demand rocketed. There were some signs that this was leading to higher wages. 

Economists and commentators were quick to point to wage-price spiral and express concern at labour's rising bargaining power. Central bank governors, chief executives, and important opinion makers were constantly on newspapers and television channels arguing on the need to contain the wages growth. Andrew Bailey the Governor of Bank of England called for pay restraint by workers. 

But there is now some evidence to question this claim since inflation has outstripped wage growth for 22 consecutive months.

There is another interesting trend, which appears to point to the possibility of a profit-maximisation-price-markup spiral. There has been the spike in business margins and profits of the biggest firms, despite the supply shocks from the pandemic, Ukraine wars, and Chinese lockdowns, and its contribution to the high inflation. Now there is increasing evidence that business concentration and associated price markups may be contributing to inflation. Unsurprisingly, this has not generated anything remotely close in terms of public commentary and calls on corporates for restraint on their price markups. 

The spike in profits of non-financial corporates after the pandemic has been stark. 

The companies passed on the higher cost of production

Companies passed these higher input costs on to their clients, and then went further: margins reached record highs. Earnings before interest and taxes peaked in the course of 2022 at nearly 18 per cent of revenues on average for the largest US listed companies and more than 15 per cent for Europe’s biggest listed groups, according to data compiled by Refinitiv.

And this about Europe

Profit margins at public companies in the eurozone — measured by net income as a percentage of revenue — averaged 8.5 percent in the year through March, according to Refinitiv, a step down from a recent peak of 8.7 percent in mid-February. Before the pandemic, at the end of 2019, the average margin was 7.2 percent.

Economists Isabelle Weber and Ivan Wasner have even documented evidence that these price pass throughs have fed into the inflationary pressures. 

We argue that the US COVID-19 inflation is predominantly a sellers’ inflation that derives from microeconomic origins, namely the ability of firms with market power to hike prices. Such firms are price makers, but they only engage in price hikes if they expect their competitors to do the same. This requires an implicit agreement which can be coordinated by sector-wide cost shocks and supply bottlenecks. We review the longstanding literature on price-setting in concentrated markets and survey earnings calls and compile firm-level data to derive a three-stage heuristic of the inflationary process: (1) Rising prices in systemically significant upstream sectors due to commodity market dynamics or bottlenecks create windfall profits and provide an impulse for further price hikes. (2) To protect profit margins from rising costs, downstream sectors propagate, or in cases of temporary monopolies due to bottlenecks, amplify price pressures. (3) Labor responds by trying to fend off real wage declines in the conflict stage. We argue that such sellers’ inflation generates a general price rise which may be transitory, but can also lead to self-sustaining inflationary spirals under certain conditions. Policy should aim to contain price hikes at the impulse stage to prevent inflation from the onset.

ECB officials have stated that in the fourth quarter of last year half of domestic price pressures in Eurozone came from profits, with the other half from wages. But while wage growth has received all the public commentary, profits growth has been overlooked by academics and commentators. 

As a recent paper by New York University economist Viral Acharya has found rising business concentration translating into higher price markups in the Indian economy, which got pronounced in the aftermath of the pandemic. They use data on Indian non-financial firms to estimate price markups by using the product price changes for a 1% change in input cost of the firm. They analyse the data to make the distinction between the respective impacts of the Big Five firms (Reliance, Tata, Aditya Birla, Adani, and Bharti) and the Top Five in an industry in any year. 

Markups fell gradually from early 1990’s until 2013, but started rising steadily and significantly thereafter, scaling in 2021 the high level of 1.4 in 1990’s, and even when capacity utilization in the Indian industry was low during the pandemic due to collapse of aggregate demand... we find that there is a potentially causal link from market power to markups. To illustrate the econometric results visually, Figure 12 shows the industry-adjusted markups of Big-5 and the rest, establishing a persistent and substantial 0.1-0.3 (i.e., 10-30 percentage points) markup gap between the two groups over the past two decades.

Interestingly, there is no such robust pattern in Figure 13 for Top-5 firms in each industry in a given year (as explained earlier, Top-5 in a given year overlap but do not fully coincide with the aggregate Big-5). In other words, it is the Big-5 which are able to exert extraordinary pricing power and capture economic rents relative to other firms in the industry, whereas Top-5 but non-Big-5 firms in a sector are not associated with such an outcome in markups.

It gets even more specific since Acharya also finds that the Big-Five might be responsible for contributing to inflationary pressures

Further evidence suggests that, in keeping with the rest of the results, lagged sales share of Big-5 groups in an industry feeds into its wholesale price inflation in a year, whereas the lagged share of Top-5 groups does not, with a 10% rise in Big-5 share within an industry associated with a 2.7 percentage point higher WPI inflation next year.

I have blogged earlier that the incentives that underpins capitalism and the enabling regulatory and market structures creates a dynamic of business concentration and profit maximisation among the top firms. This is almost an iron law. The result is market power and higher markups. This figure is a good illustration. 

This has naturally promoted calls for government intervention, including some form of price controls. I'm not sure that's the right way since not only does interventions like price controls engender distortions and perverse incentives, they also do not address the central problem of business concentration and the financial incentives and political economy associated with it. As I have blogged earlier here, here, here, and here, more than its immediate economic consequences, it's the political capture of rule making by large firms that is the big problem facing capitalism today. 

Underlining the point, in the context of the bailout of the Silicon Valley Bank, whose main beneficiaries were the big technology companies, Ruchir Sharma pointed to this in a recent oped,

In Texas, the mayor of Fort Worth recently said that the “main thing” worrying business leaders is this question: if SVB had served the oil industry rather than tech, would the government “have stepped up the same way?”

There are no easy answers here. The simplest response of breaking up large firms simply because they are large is fraught with problems, though that will invariably be the final outcome. A more nuanced approach would be to go back to first principles and strictly apply the regulatory tests of entry barriers, anti-competitive practices, conflicts of interests etc to determine whether the firm's practices are causing market harm and hurting consumer welfare, and then force unbundling or regulatory barriers on the emergence of restrictive market structures. Fortunately some steps in this regard is already underway on both sides of the Atlantic (here and here). But the resistance from the entrenched interests will be very strong and they will be supported by their captured political bidders. 

Update 1 (18.04.2023)

Operating margins of all public US corporates are their highest in over three decades. 

There has been a spike since the global financial crisis, which has been further amplified since the pandemic. 

Albert Edwards has written that "the US corporations have increased prices far beyond simply passing on higher labour and materials costs."

Infrastructure funding update 2023 and implications

This is the latest in the series of annual posts on the state of global infrastructure finance and its lessons for India's infrastructure financing plans. The earlier versions are here, here, here, here, and here. 

The unambiguous takeaway is that contrary to the hype among investment bankers, consultants and boosters in the media, India's infrastructure financing has to come from domestic capital sources. For policy makers captured by this hype, sooner the reality check, better for the country's massive infrastructure financing needs. This is more evidence on a problem on which I have written a very long paper here. 

1. This is the summary of global unlisted infrastructure funding raised over the last 15 years.

2. This is the summary of the destination of these funds - in 2022, just $8 bn was bound for Asia, and the region's CAGR for 2017-22 was -10.8%. It has been in the $4-9 bn range for the last five years. For all practical purposes, such funds are largely US and Europe bound.

3. And within the infrastructure space too, most of the funding is going into renewable energy, telecommunications and internet, and highways. Traditional energy (which includes water and utilities) and social infrastructure are small and declining.   

4. This is the summary of trends on global assets under management (AUM) by the PE industry. As can be seen, infrastructure makes up a very small share.

5. From the same McKinsey report, on AUM in the H1 of 2022.

This is the break-up of the dry powder available across sectors, of which infrastructure is very small.

6.  And this is the break-up of capital raising, which too shows a very small share for infrastructure. 

7. Unlisted or private infrastructure funding has been on the downward trend.

8. Infrastructure was a small share of the total VC/PE investments, domestic and foreign, in the country.

9. And even within infrastructure, as the table below shows, the funding typically goes into renewables and roads. 

10. Finally, most of the investments are in brownfield assets and involve large size deals. 

On a separate note, the Indian VC investments are overwhelmingly on the (mostly copycat) consumer tech, fintech and SaaS side, and has very little going into manufacturing.

The clear conclusion from this are four-fold

1. Given the numbers above, India's infrastructure investment needs will have to be met almost completely from domestic sources. Even in theory, since infrastructure revenues are in domestic currency and since the sectoral returns are smaller compared to other assets, foreign investors cannot be anything other than marginal contributors. 

2. To the extent that local finance, equity and debt, will be required to finance most of infrastructure, the binding constraint to expanding infrastructure investments will be their availability. On both the equity and debt sides, infrastructure demands long-term (patient) capital with moderate returns appetite. Infrastructure will be part of a portfolio of investments, balancing out risks while offering lower returns. 

3. The major share of private equity in infrastructure will go into brownfield assets to replace private or public equity, and therefore will be in the form of large ticket size deals. Given the uncertainties with construction risks, it'll be very difficult to attract investors into greenfield investments and smaller brownfield assets. 

4. Within the infrastructure fold, the major share of investments go into two areas - renewable energy (26%) and telecommunications (30%). These are two sectors where public investments are in any case already a very small share. And most of the remaining target brownfield highways, where too private investments are the norm. In contrast, the dry powder available to invest in urban infrastructure, downstream electricity, public transportation, affordable housing, social infrastructure etc is vanishingly small. 

So, as mentioned earlier, the major part of India's public goods infrastructure funding has to come from the governments, banks, and public markets. In this paper, I had categorised infrastructure into four groups, and shown that most of the public goods investments (urban infrastructure and utilities, electricity distribution, public transport, social infrastructure, irrigation, and affordable housing) will have to come from public sources. 

More specifically, a financing strategy for infrastructure for countries like India could look something like this

1. Infrastructure financing in large countries like India will have to be almost completely driven by local long-term finance. Foreign capital will be marginal and catalytic in certain areas. 

2. Certain types of private infrastructure like electricity generation and telecommunications, and public infrastructure like electricity transmission and national highways, can be mostly privately financed either as greenfield or brownfield. But there are limits to how much private capital is available to invest.

3. Greenfield projects face the problem of very high construction risks (from financial closure, permissions and clearances, right-of-way or site acquisition etc). Therefore the main source of greenfield public goods infrastructure financing will have to be from the government, which alone can bear these construction risks. This government financing can be directly from the budget, from local governments, government corporations, and   government-owned special purpose vehicles. Each of them will have to figure out ways to leverage debt through loans and bonds. 

4. After construction risk is off-loaded, brownfield assets which are revenue generating can be privatised or monetised, thereby freeing up public finance to take on newer investments. A framework that facilitates monetisation is essential to achieve this objective. 

5. Those assets which cannot monetised can be given out in long-term concessions for operation and maintenance. Like with monetisation, a robust framework on concession management and renegotiations is critical to success of concessions too.

Both monetisation and concessions allow for recycling of government equity. 

6. Public finance will have to be leveraged mainly with bank loans, structured through various means like syndication, takeout financing etc so as to address the asset-liability mismatches. 

7. The critical challenge will be to expand the envelope of domestic equity and debt with the interest to invest in infrastructure. The sector is less risky and therefore offers lower and stable returns. This is not the ideal thing for equity investors who are generally looking at higher returns, though within a portfolio infrastructure can be a small asset category. 

8. There are perhaps two approaches to expand the envelope of scarce risk capital equity. One approach would be to facilitate the entry of more infrastructure contractors and O&M operators. This would entail proactive approach by the government to lower entry barriers in public contracting so as to expand the pool of infrastructure contractors and therefore the likely sources of risk capital. These contractors will combine both private and public market equity.

9. Another approach to address the problem of scarce equity is to encourage the development of infrastructure funds. These funds aggregate risk capital from investors (the limited partners) and invest them in a portfolio of infrastructure projects or in the infrastructure contractors themselves (as either private or public equity).  

Typically, the contractors prefer to assume higher risks so as to earn higher returns, which attracts them to construction contracts. In contrast, infrastructure funds prefer to come in after commissioning of the project and are satisfied with the lower but stable returns. 

These two approaches together allow for recycling of scarce private equity capital. 

10. On the debt side, bond markets will have to be deepened to the extent possible so that it can supplement bank loans. But, as I have written on numerous occasions citing evidence from across the world (except the US), there are strong limits to such deepening and they'll remain distant secondary debt sources compared with bank loans. See this and this.

Creating the enablers for pension funds and insurance funds to invest in these bonds is essential to such deepening. On the supply side, enablers like credit guarantees and other credit enhancement instruments should be used to encourage debt issuers, especially the most credit worthy ones, to shift from banks towards capital markets. 

11. The likes of Public Private Partnerships (PPPs) and outright private provisioning will invariably be marginal sources of financing of public goods infrastructure. 

12. Finally, the political economy risks of long-term contracts will have to be mitigated if we are to make any progress in these directions. This would require strengthening of regulatory frameworks (and their enforcement), inviolability of contractual obligations on all sides (so, for example, tariff increases will have to be seen through), and insulation of such contracts from political transitions. 

Weekend reading links

1. Harish Damodaran writes about the contrasting fortunes of two-wheeler and tractor sales in India. Given that 55-65% of two-wheeler sales are in rural areas, and given non-farm rural sector which has not been doing well compared to agriculture sector and they also form a significant share of the rural economy, is the distress in non-farm rural sector contributing to keeping down two-wheeler sales?

The article has an interesting point about how deferral of implementation of stricter emission standards may have contributed to higher tractor sales,

The government had originally planned to introduce new Bharat Stage TREM IV emission standards for tractors with above 50 horsepower engines from October 1, 2020. That would have entailed replacing mechanical pumps for fuel injection with semiconductor-based common rail direct injection (CRDI) engines. But following representations from tractor makers, the implementation of the revised emission norms was deferred and made effective from January 1, 2023. Companies were also given six months’ additional time to sell their existing stock of tractors based on TREM III A standards.

2. The rise of venture debt

Debt was around 30 per cent of all venture capital raised in European tech in 2022, according to figures from Dealroom, compared with around 16 per cent in the previous six years. Cleantech and fintech companies were among the biggest borrowers...

The Silicon Valley Bank was the pioneer and linchpin of a venture debt market that gave start-ups an alternative source of funding, without the need to sacrifice equity stakes or swallow a much lower valuation. Across the US, SVB was responsible for roughly a tenth of all venture debt issued in the year so far. But on its home turf in California, the bank was behind more than 60 per cent of all deals this year, according to data from Preqin.

3. It turns out that many popular Italian cuisine dishes are not after all Italian. In fact, the migration of South Italians in the late nineteenth and early twentieth centuries into the US led to the emergence of a fusion cuisine which has today come to dominate as Italian cuisine in popular imagination. From an FT article,

Panettone is a case in point. Before the 20th century, panettone was a thin, hard flatbread filled with a handful of raisins. It was only eaten by the poor and had no links to Christmas. Panettone as we know it today is an industrial invention. In the 1920s, Angelo Motta of the Motta food brand introduced a new dough recipe and started the “tradition” of a dome-shaped panettone. Then in the 1970s, faced with growing competition from supermarkets, independent bakeries began making dome-shaped panettone themselves... Tiramisu is another example. Its recent origins are disguised by various fanciful histories. It first appeared in cookbooks in the 1980s. Its star ingredient, mascarpone, was rarely found outside Milan before the 1960s, and the coffee-infused biscuits that divide the layers are Pavesini, a supermarket snack launched in 1948... 

Parmesan, he says, is remarkably ancient, around a millennium old. But before the 1960s, wheels of parmesan cheese weighed only about 10kg (as opposed to the hefty 40kg wheels we know today) and were encased in a thick black crust. Its texture was fatter and softer than it is nowadays. “Some even say that this cheese, as a sign of quality, had to squeeze out a drop of milk when pressed,” Grandi says. “Its exact modern-day match is Wisconsin parmesan.” He believes that early 20th-century Italian immigrants, probably from the Po’ region north of Parma, started producing it in Wisconsin and, unlike the cheesemakers back in Parma, their recipe never evolved. So while Parmigiano in Italy became over the years a fair-crusted, hard cheese produced in giant wheels, Wisconsin parmesan stayed true to the original. 

In the story of modern Italian food, many roads lead to America. Mass migration from Italy to the US produced such deeply intertwined gastronomic cultures that trying to discern one from the other is impossible. “Italian cuisine really is more American than it is Italian,” Grandi says squarely. Pizza is a prime example. “Discs of dough topped with ingredients,” as Grandi calls them, were pervasive all over the Mediterranean for centuries: piada, pida, pita, pitta, pizza. But in 1943, when Italian-American soldiers were sent to Sicily and travelled up the Italian peninsula, they wrote home in disbelief: there were no pizzerias. Before the war, Grandi tells me, pizza was only found in a few southern Italian cities, where it was made and eaten in the streets by the lower classes. His research suggests that the first fully fledged restaurant exclusively serving pizza opened not in Italy but in New York in 1911. “For my father in the 1970s, pizza was just as exotic as sushi is for us today,” he adds. 

Like pizza, mozzarella was fast-tracked to global fame through the funnel of mass migration to America from the Italian south. Comparing her recollections with those of my grandmother, it’s clear that Sicily’s elevated “Sunday” dishes (aubergine parmigiana, cannoli, pasta con le sarde) were the ones that went mainstream, thanks to the south’s contribution to the Little Italys of the US. My grandmother, on the other hand, grew up eating tordelli alla massese (large fresh tortelli with a meat filling, cooked in a ragú sauce) and cappelletti in brodo (fresh tortelli in chicken broth), dishes that are almost entirely unknown outside the region.

4. Martin Wolf has some suggestions on how to avoid the next banking crisis. This is an important and under-appreciated aspect,

The best protection against occasional huge banking crises is frequent smaller ones. Fear works. We have seen, for example, some unwise deregulation. That of smaller banks in the US in 2019, which contributed to the recent crisis, is a powerful example. Pressure for deregulation has also been growing in the UK. A shock like this should make mindless deregulation less appealing to politicians and mindless risk-taking less appealing to bankers. Both lessons might have been learnt in the US and elsewhere, for a while.

5. Charles Goodhart argues that bank managers must face personal financial liability

The main cause of moral hazard is limited liability, especially when this applies to bank managers’ large shareholdings, mostly from bonuses. We cannot go back to the pre-Victorian approach of unlimited liability for all, because it would mean that banks could never get equity capital from outsiders. But there is no reason why we could not require senior bank management to face multiple liability, and in the case of chief executives possibly to have unlimited liability. If senior management faced a really serious loss when their bank failed, there would be far less need for shed loads of restrictive regulations.

6. Rana Faroohar points to a potential fault line from the impact of higher rates on real estate holdings of private equity,

Consider, for example, the trouble brewing in commercial property loans, and private equity real estate funds. This is where the shadow bank and small bank stories meet. Small banks hold 70 per cent of all commercial real estate loans, the growth of which has more than tripled since 2021. Following the easing of Dodd-Frank rules for community banks, smaller financial institutions have also invested more in riskier assets owned by private equity and hedge funds (as have other institutions looking for better returns, including pension funds). Small bank funding to commercial real estate is now tightening. This, along with interest rate rises, is putting downward pressure on commercial property values, which are now below pre-pandemic levels. That will curtail capital flows, derail investments and put pressure in turn on private equity funds with loans that are maturing, or which need equity injections... This means asset managers may be forced to go to investors for more capital (which will be a tough negotiation at the moment) or sell property out of their portfolio to cover loans. This has the feel of a doom loop to me. Big real estate indices had already turned negative in 2022... Consider, for example, how rich non-bank asset managers such as Blackstone, Apollo, Carlyle and others became on both residential and commercial real estate in the wake of 2008. This was partly because they were able to make deals that more regulated banks couldn’t. Private equity players have also made new investments in utilities, farmland, transportation and energy.

7. Apple and Microsoft make up 7.1% and 6.2% of S&P 500, making them disproportionately influential drivers of the index. Tech sector itself has more than doubled to 29% of the index by 2021 since 2001.

8. India's interesting services exports growth story

The binding constraint to growth in IT services exports is the deficiency of quality manpower.

9. Tesla may be about to upend the global EV batteries market,

Most of the world’s electric car batteries are now made in China. Accounting for more than 70 per cent of market share by shipments... But Tesla’s new batteries are set to upend the hierarchy of the industry for good. Panasonic and LG Energy Solution have long been the leading suppliers. But in recent years, Chinese makers such as CATL and BYD have steadily won market share away from Korean and Japanese rivals and have grown to dominate the world’s supply. 

Electric car batteries have undergone rapid technological change in recent years. Until now, the priority has been on improving energy density — for longer driving range — by changing the composition of battery materials. The shape of the battery cells has been less of a focus. Currently, most electric car batteries are designed and moulded in the shape and form that ensures the most efficient use of space. That has meant batteries that are shaped like flat pouches or stackable rectangular boxes have been the leading standards for electric cars until now. Cylindrical battery cells, the third type on the market, have long been considered the less attractive option because empty gaps between the round cells when stacked together was seen as wasted space. These made up just a fifth of the global market last year. Yet Tesla is betting big that these will become the future industry standard. Its cylindrical 4680 battery cells, named after their size, with a diameter of 46mm and length of 80mm, have been developed to have energy density of up to five times that of the batteries currently used in most Tesla cars. For both electric car buyers and for Tesla, the cost advantage is clear. The new cells are cheaper to produce than previous versions. They use new material which includes aluminium, a relatively abundant and lower cost metal, and less raw materials overall. Upgraded technology means the batteries are made using fewer parts — also meaning less weight. They are easier to mass produce as they do not have to be customised to fit different car shapes and designs.

This vertical integration would be a shift for Tesla from its practice of relying on an ecosystem of suppliers. But it has its set of advantages. Further, Tesla is also expanding its Nevada plant to make 2 million 4680 cells a year, up from 1000 cells a week in December. And, this indigenisation will also help the company benefit from the incentives under the Inflation Reduction Act.

10. To the list of Martin Skhereli of Turing Pharmaceuticals, Elizabeth Holmes of Theranos, and Trevor Milton of Nikola, comes Charlie Javice, 31, a Wharton alumni, who falsified the number of subscribers of her student finance website, Frank, and sold it to JP Morgan to pocket $45 million in profits.

Javice represented to JP Morgan that Frank had 4.25 m customers when in fact it had only 300,000. This is a standard practice in the startup world where the headline number on users are a signal of growth potential. Founders are not forced to disclose whether these are mere free downloads or registrations, or one-off subscribers, or active subscribers, and several other categories in between. This can be described as subscriber-washing.

11. Martin Wolf has two graphics about global trade. The first points to the progressive downward recalibration of the trajectory of global trade.

The second points to the increasing rise in global trade restrictions.

12. Gillian Tett compares the current bank run with that in 2007-08 and 1997-98 in Japan. The big difference was the speed with which the information spread, depositors pulled out $42 billion, and the bank collapsed. And the contagion spread rapidly across others. As a metric, the share of US households using internet or mobile banking rose from 39% to 66% between 2013-21.

Until now, the models used in finance do not seem to have taken account of the fact that consumer behaviour online might be different from that in the old-fashioned, physical banking world. But one striking feature about American banks, even before the March panic, was that consumers were moving money out of low-paying deposit accounts into better-yielding money market funds at a dramatically faster pace than at similar points before in history.

That might imply that greater information transparency accelerates consumer reaction to news, even outside crises, increasing the risk of “herding”. Either way, we urgently need some behavioural finance analysis, since American banks will stay healthy only if they hang on to deposits — and digital herding could increase the risks of turmoil in other markets, such as Treasury bonds, if shocks emerge there too... The dangerous weakness of fractional banking is that if nobody has a reason to panic, banks are safe; but if everyone runs, a bank can collapse, even if it previously passed tests on issues such as capital adequacy — unless a government steps in. And while the government never used to worry about smaller banks collapsing, now they fear the digital domino effect.

This raises the issue of how fractional reserve banking can survive in the era of rapid and real-time information flows.

In the context of SVB, Morgan Housel writes,

Controlling your behavior amid uncertainty can be hard enough. Controlling your reactions to other people’s behavior is way harder. Fear is more contagious than any virus, and can instantly push people to react in ways that would have seemed unthinkable a moment prior... Bank runs have been happening for centuries. SVB was unique because it had the social web of a tiny town but the balance sheet of a big, disparate, bank. When one person yelled fire, every other deposit holder instantly heard it, and $50 billion rushed out the door.

The urban "doom loop"?

The pandemic induced 'work from home' culture has led to a hollowing of the urban core in the world's biggest metropolitan cities. As property prices have fallen and economic activity declined, a debate has been ignited on the future of cities. 

Thomas Edsall has two articles in NYT here and here which captures the aspects of the debate. He points to Nicholas Bloom, an economist who specialises in management productivity research,

In big cities like New York and San Francisco we estimate large drops in retail spending because office workers are now coming into city centers typically 2.5 rather than five days a week. This is reducing business activity by billions of dollars — less lunches, drinks, dinners and shopping by office workers. This will reduce City Hall tax revenues... Public transit systems are facing massive permanent shortfalls as the surge in working from home cuts their revenues but has little impact on costs (as subway systems are mostly a fixed cost). This is leading to a permanent 30 percent drop in transit revenues on the New York subway, San Francisco BART, etc.

Bloom provides data showing the economic incentives for businesses and employees to continue WFH,

First, “Saved commute time working from home averages about 70 minutes a day, of which about 40 percent (30 minutes) goes into extra work.” Second, “Research finds hybrid working from home increases average productivity around 5 percent and this is growing.” And third, “Employees also really value hybrid working from home, at about the same as an 8 percent pay increase on average.”

The work of Arpit Gupta, Vrinda Mittal, and Stijn Van Nieuwerburgh points to "apocalyptic" drops in property valuations,

In their paper, the three authors “revalue the stock of New York City commercial office buildings taking into account pandemic-induced cash flow and discount rate effects. We find a 45 percent decline in office values in 2020 and 39 percent in the longer run, the latter representing a $453 billion value destruction.” Extrapolating to all properties in the United States, Gupta, Mittal and Van Nieuwerburgh write, the “total decline in commercial office valuation might be around $518.71 billion in the short run and $453.64 billion in the long run.”...

The decline in office values and the surrounding central business district retail properties... has important implications for local public finances. For example, the share of real estate taxes in N.Y.C.’s budget was 53 percent in 2020, 24 percent of which comes from office and retail property taxes. Given budget balance requirements, the fiscal hole left by declining central business district office and retail tax revenues would need to be plugged by raising tax rates or cutting government spending. Both would affect the attractiveness of the city as a place of residence and work. These dynamics risk activating a fiscal doom loop...

As property values of urban office and urban retail fall, with the increased importance of work from home, so do the tax revenues generated from those buildings and the associated economic activity. Since local governments must balance their budget, this means that they need to raise tax revenues elsewhere or cut public spending. The former is bad for the business climate. The latter is bad for the quality of life in the city: cuts to public transit, schools, police departments, sanitation departments, etc. As the quality of public services deteriorates, crime could increase, making public transit potentially even less attractive. More generally, an urban doom loop could ensue, whereby lower property tax revenues beget lower spending and higher taxes, triggering more out-migration, lower property values, lower tax revenues, less public spending, more crime and worse schools/transit, more out-migration.

Some thoughts

1. I'm struck by the certitude of economists whose professional expertise does not lie in urban history and urban economics in making such bold predictions on such critical issues like the fortunes of cities. Talk of evidence-free thinking. This is especially since we are discussing about cities which have survived numerous such crises, some much more devastating, and spanning centuries. 

At best one can describe trends and compare with the outcomes of historical episodes with similar trends. But to make eye-ball capturing grandiose proclamations about doom loops and demise of cities is plain unprofessional and populist. 

2. Before the pandemic property prices in the large cities had become so expensive as to price out most people from these cities into their suburbs or elsewhere. To the extent property prices are central to urban affordability, the sharp drop in property prices are perhaps the most important opportunity that could have emerged to help cities regain their competitiveness and attractiveness for people and businesses. 

3. As history shows, cities, especially the large global metropolises, are exceptionally resilient. They figure out ways to respond to emerging economics trends and adapt themselves. They have gone through several such adaptation and reinvention cycles. Indeed, it's already the case that commercial real estate is being converted into residential properties in many cities. In the initial stages, the sales will happen at lower prices and there will be bankruptcies. But that pain is inevitable in any such adaptation and renewal.

Policy makers need to be aware of such adaptation requirements of cities, spot the emerging trends, and quickly support them with urban planning and fiscal policy levers. Those cities which are able to quickly adapt to these trends are those that will thrive in the new circumstances. 

In fact, the current decline in property prices may be a good opportunity to repurpose the city downtowns and business districts into mixed-use localities from their current status as ghost towns after office hours. This would help cut down carbon footprints from long commutes and improve the quality of urban lives. The productivity of such cities can be even higher than the current ones. Don't bet on New York or London reinventing themselves as mixed-use city cores with greater productivity. 

4. Such renewals and adaptations should not be seen as crises, but as natural processes. Cities are not static entities but are constantly evolving by adapting to changing needs. If one were to make a prediction based on a long history and numerous examples of such crises, it's hard not to come away with the conclusion that the larger cities will adapt to the changes. 

Electric vehicle battery supply chain graphs of the day

FT long read on how the Chinese have taken a very big lead across the lithium value chain. Lithium is the lightest solid and its high electrochemical potential makes it a critical element in EV batteries. The result is overwhelming dominance across the EV supply chain.

While lithium is globally abundant, but unlike elsewhere, mines inside Africa can be brought into production early enough to meet the burgeoning demand. And the Chinese have already struck deals, laid infrastructure, and have started mining or are ready to do so. Australia is the largest lithium producer with more than half the global production, mostly exported to China. 

This is an excellent infographic on lithium.

Inflating away debt

Inflation has the effect of increasing the nominal value of GDP much faster than debt and also reducing the nominal value of the debt stock, and thereby reduces the debt-to-GDP ratio. In terms of its impact on the public debt, the ongoing bout of inflation may be a god send for the heavily over-leveraged western economies. Against this, there is the erosion of purchasing power than consumers face with inflation.

David Beckworth points to the dramatic decline in US public debt to GDP ratio over the last three years since beginning of 2020,

Public debt has increased by roughly $5 trillion over the last three years. But at the same time, the market value of U.S. Treasury securities has gone from a high of 108% of the economy to its current value of 85%. This is one of the fastest declines in the U.S. debt burden and puts its value close to the prepandemic level... The origins of the dramatic change begin in the spring of 2020. The dollar size of the economy fell sharply as federal spending surged. These developments both raised the debt burden by shrinking the tax base from which the debt could be paid and by increasing the national debt. In addition, interest rates dropped to near 0%, making the existing Treasuries worth more since they paid a higher interest rate... All together, these three developments raised taxpayers’ debt burden to the 108% level.

The dollar size of the economy, however, quickly recovered from the pandemic shutdown and was back on trend by mid-2021. This lowered the debt-to-GDP ratio by about nine percentage points. Next came the inflation surge, which further reduced the debt burden by 14 percentage points, bringing it to the current value of 85%. It did this through two channels. First, the high inflation pushed the dollar size of the economy about $1.89 trillion above the pre-pandemic trend. Second, of course, is that the inflation surge caused the Fed to sharply raise interest rates, which lowered the market value of Treasuries by roughly $1.9 trillion... This remarkable transfer of wealth away from bondholders was not limited to the $24 trillion treasury market. Other fixed-income markets like the $12 trillion mortgage-backed securities market and the $10 trillion corporate bond market also saw big losses in market value.

Another important consequence is that being felt in the banking sector. The banks are a major investor in the fixed income securities markets, and the rapid rate hikes and the consequent decline in bond prices have naturally eroded the valuation of their assets side. A recent study found that US banking system assets are overvalued by $2 trillion due to mark-to-market losses

We analyze U.S. banks’ asset exposure to a recent rise in the interest rates with implications for financial stability. The U.S. banking system’s market value of assets is $2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5th percentile experiencing a decline of 20%. We illustrate that uninsured leverage (i.e., Uninsured Debt/Assets) is the key to understanding whether these losses would lead to some banks in the U.S. becoming insolvent-- unlike insured depositors, uninsured depositors stand to lose a part of their deposits if the bank fails, potentially giving them incentives to run. A case study of the recently failed Silicon Valley Bank (SVB) is illustrative. 10 percent of banks have larger unrecognized losses than those at SVB. Nor was SVB the worst capitalized bank, with 10 percent of banks having lower capitalization than SVB. On the other hand, SVB had a disproportional share of uninsured funding: only 1 percent of banks had higher uninsured leverage. Combined, losses and uninsured leverage provide incentives for an SVB uninsured depositor run. We compute similar incentives for the sample of all U.S. banks. Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk. If uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk. Overall, these calculations suggest that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs.

Some observations

1. Adam Tooze describes this as a trillion dollar transfer of wealth from bond investors to bond issuers. For sure, while bondholders have taken a massive hit from the rising interest rates, it should not be overlooked that they were also among the biggest beneficiaries of the extraordinary long period of monetary accommodation. While the likes of Tooze writes about this wealth transfer, nobody was talking about the equal wealth transfer in the other direction from savers to borrowers when rates were low. 

2. The steep rise in public-debt to GDP ratio was deceptive in so far as the increase was due to the steep fall in GDP, which has since reversed as the economies have recovered smartly, thereby regaining a significant part of the rise. 

3. A significant part of the loss suffered by bond investors is borne by the taxpayers through the central bank holdings of treasury securities. But this would be lower in the aggregate compared to the losses suffered by other investors, including banks. 

4. The banks sitting on unrealised losses may be facing a liquidity problem (and not a solvency problem) only if the assets can be nursed back to recover most of their currently depreciated valuations or it can make profits elsewhere to cover these losses. The challenge is to ensure that there are no runs in the meantime. 

5. It's clear that several banks are worse off than even SVB. The Fed's swift announcement of blanket deposit insurance coverage may be the reason why there are no bank runs on them. If so, it should be counted as among a big public policy success. But this success for now should be counted against the long-term moral hazard generated that would incentivise reckless risk taking by deposit taking banks. 

6. An economic rebalancing opportunity exists if the current bout of inflation erodes away a big enough share of the debt and also allows for a soft landing for the economy. That's a hard act to pull off, though not impossible. 

Update 1 (05.04.2023)

Indexation policies on inflation are common in developed countries.

Weekend reading links

1. FT long read on the protests in Israel following the decision by the government to push ahead with judicial reforms that would give government control over appointment of Supreme Court judges and grant Knesset the power to override court rulings that strike down laws.

2. China woos back tech entrepreneurs as it realises the need to continue fostering innovation and foreign investment in its technology sectors if it's to take on the restrictions on technology transfers being imposed by the West. But this has not meant any respite from the Communist Party's relentless drive to control the economy,

In the broader tech sector, meanwhile, the Communist party is still quietly tightening its grip on the industry. Nearly all of China’s largest tech groups are adding state-appointed directors and shareholders in key operating entities. State groups generally make a token investment for a 1 per cent stake. These “golden shares” carry a slew of special rights. Alibaba, for instance, has handed the government “golden shares” in two units dedicated to streaming video and web browsing. At the start of the year, a state-owned fund tied to the CAC paid just Rmb350,000 ($51,000) for 1 per cent of an Alibaba unit in Guangzhou. Documents seen by the Financial Times show the CAC appointed a mid-level official as a director of the company as part of the deal. The official has a vote on “business and investment plans”, mergers and acquisitions, and veto power over certain other business decisions, the company bylaws show.

As part of the efforts to revive confidence in the private sector and foreign investors, the Chinese Prime Minister Li Qiang, former Shanghai Party leader, courted them during the recent China Development Forum meeting. However, this courting too has been accompanied by several disturbing actions against tech entrepreneurs and foreign companies. 

This has always been the way in which the Communist Party has sought to engage with the economy. It first relaxes controls on the private sector and woos investors. Once the momentum sets in and there's a belief that China is turning capitalist, it reins back some of the relaxations to send home the message that the Party is in control. This dialectical approach has been a feature of the Communist Party's approach historically, and continues to remain so. It's therefore facile to assume that the Communist Party has changed its spots. 

3. On China, FT long read on how the country formally shifted from Deng Xiaoping's "hide your strength, bide your time" to Xi Jinping's "dare to fight" strategy in its foreign policy. In the recently concluded National People's Congress, Xi summed up his foreign policy as "dare to fight", signalling a shift towards a directly engaged and interventionist foreign policy. This has been accompanied with hectic diplomacy in Middle East, Xi's visit to Russia, a proposal for peace in Ukraine, and a series of visits by European leaders to China.

This shift is also part of the strategy to demonstrate China's foreign policy prowess commensurate with its economic power, and also to outwit the American attempts to "contain" China. 

“In the past we would declare some principles, make our position known but not get involved operationally. That is going to change,” said Wu Xinbo, dean of the Institute of International Studies at Fudan University in Shanghai... Beijing hopes the Spanish prime minister’s two-day trip will prepare the ground for China-EU co-operation once Spain assumes the rotating presidency of the bloc in July, said one Chinese expert. France’s Emmanuel Macron and Ursula von der Leyen, the European Commission president, will also visit in the coming weeks... In recent weeks, Xi has promoted what he calls “Chinese-style modernisation” as a concept better suited to developing countries than the west’s “rules-based” order... Xi launched the Global Development Initiative in 2021 — another push to use Chinese economic power to rally developing countries. The following year, he announced the Global Security Initiative and this month he pitched the Global Civilisation Initiative, a still-vague policy that appears aimed at challenging the western concept of universal values. “People need to . . . refrain from imposing their own values or models on others,” China’s State Council said on the latest initiative...

China’s argument that modernisation did not have to equal westernisation would be well received in many developing countries, said Moritz Rudolf, a research scholar at Yale Law School’s Paul Tsai China Center, particularly if it brought them material benefits from closer co-operation with Beijing. “It appears to be a counterargument to [US president] Joe Biden’s autocracy versus democracy narrative,” said Rudolf. “It’s an ideological battle that’s more attractive to developing countries than people in Washington might believe.” In Latin America, for instance, overall sentiment towards Beijing’s diplomatic strategy was positive, said Letícia Simões, assistant professor at La Salle University in Rio de Janeiro.

China already has the world's largest diplomatic network

4. Fascinating set of infographics on the problems of higher youth mortality rates and lower life expectancy in the US compared to UK and elsewhere. 

And this about youth mortality

One in 25 American five-year-olds today will not make it to their 40th birthday. No parent should ever have to bury their child, but in the US one set of parents from every kindergarten class most likely will... These young deaths are caused overwhelmingly by external causes — overdoses, gun violence, dangerous driving and such — which are deeply embedded social problems involving groups with opposing interests.

5. A good FT primer on the stresses facing US banks. 

Some banks, notably in Europe, are stuck with big loan books at interest rates fixed far below current levels. Others with a higher share of their book at variable rates can immediately charge more for outstanding loans but risk a wave of defaults from borrowers who can no longer afford to service their debt. Then there is the issue of government bonds, where banks have been holding ever more of their liquidity after post-financial crisis regulations curbed their risk-taking. Bonds bought a year ago have fallen in value because they offer lower interest rates than those sold today, which is fine unless banks are forced to sell them to meet depositors’ demands. Another concern is the unpredictable behaviour of depositors as they look for more lucrative places to park their cash, including money market funds and crypto, if banks are slow to raise rates for savings.

The article informs that the US Fed estimated $620.4 bn in unrealised losses with banks on their securities portfolios at the end of 2022.

Other areas of concern include high exposures to commercial real estate (over 40% of CRE held by banks in the US) and leveraged loans to private equity (which have aggressive repayment and weak covenants), both of which can engender defaults with rising interest rates. There's also the rising cost of capital.

6. Excellent long read on the challenges of perfectionism in life and work,

Fundamentally different from having high standards, perfectionism, the theory goes, holds people back instead of propelling them forward. Research suggests that perfectionists are intensely self-critical and unwilling to take risks for fear of failure or criticism, which can be devastating to their fragile self-image. Increasingly viewed as unhealthy and debilitating, perfectionism is correlated with a vulnerability to anxiety, depression, eating disorders and burnout. Perfectionists don’t simply want to be perfect (if only it were that simple). Rather, they want to be deemed worthy. While typically associated with academic, sporting or professional achievement, perfectionism can apply in any sphere of life, including personal relationships. Perfectionists don’t realise, or have lost sight of, what every parent knows: that love is not earned. Curran’s research shows that perfectionism is rising among young people in the UK, US and Canada at what he calls an “alarming” rate. By far the largest increase is seen in a specific variety called “socially prescribed perfectionism”, or the perceived need to be perfect in order for others to value you. Compared with other varieties (“self-oriented” and “other-oriented” perfectionism), this type also has the most significant correlation with serious mental illness. Perhaps it shouldn’t have been surprising to hear an educator talk about dismantling it...

The realities of adult life for younger generations must seem to confirm the perfectionist’s innermost suspicion: that whatever you do, it’s never enough. When I was at school, knowing how hard my classmates were studying felt like pressure. But I wasn’t being bombarded by images of them doing their homework in effortlessly stylish outfits at aesthetically pleasing desks, while also carrying on fulfilling social and romantic lives. The headmistress probably doesn’t care whether it’s called perfectionism or maladaptive perfectionism. Her aspiration is to free children from fear-driven paralysis, to ensure they never question their essential enough-ness.

7. A few weeks back I pointed to an FT article which highlighted the corrosive impact of smart phones and social media on children's mental health. Another article has described teen mental health as a "reckoning for Big Tech". 

Suicide among those aged between 10 and 19 years old in the US surged by 45.5 per cent between 2010 and 2020, according to the Centers for Disease Control and Prevention. A survey last month from the same government agency found nearly one in three teenage girls had seriously considered taking their own life, up from one in five in 2011... some academics point to a growing body of research that they say is hard to ignore: that the proliferation of smartphones, high-speed internet and social media apps are rewiring children’s brains and driving an increase in eating disorders, depression and anxiety. “Multiple juries are in. They’re all reaching the same conclusion,” says Jonathan Haidt, a social psychologist and professor at New York University Stern School of Business. “When social media or high-speed internet came in, [studies] all find the same story, which is mental health plummets, especially for girls.”

... In January, a report by experts in psychology and neuroscience at the University of North Carolina said teenagers who habitually checked their social media accounts experienced changes in how their brains — which do not fully develop until around 25 years old — responded to the world, including becoming hypersensitive to feedback from their peers. A review of 68 studies related to the risk of social media use in young people published in August 2022 by the International Journal of Environmental Research and Public Health examined 19 papers dealing with depression, 15 with diet and 15 with psychological problems. The more time adolescents spend online, the higher the levels of depression and other adverse consequences, the report notes, especially in the most vulnerable.

8. Even as France grapples with its pension reform challenges, the Spanish Parliament passed a pension reform which mandates higher contributions by younger workers. The fundamental problem with pensions is the same,

Spain’s efforts exemplify the impossible dilemmas faced by many European countries: how to balance decent pensions for existing retireepensios, intergenerational fairness for young people, and financial sustainability. Achieving two of these goals tends to be manageable. Securing all three is hard.

This latest reform comes after the failure to implement the 2013 pension reforms 

In order to limit costs, they had introduced mechanisms that would cap monthly pension payments when the system was in deficit and reduce benefits as the average lifespan increased. These reforms had been due to come into force in 2019 but never did. As soon as it came to cutting the actual pensions of 10mn people who vote, the reforms became unacceptable to the Socialist-led government. Parliament voted to scrap them in 2021, although the PP opposed the decision. That left Spain’s pensions linked simply to inflation. As a result, they rose 8.5 per cent in January. 

9. Interesting that English speaking countries have fared worse than others at increasing housing supply. Three reasons appear to be at work.

There appears to be a deep-seated aversion to urban density in anglophone culture that sets these countries apart from the rest. Three distinct factors are at work here. The first is a shared culture that values the privacy of one’s own home — most easily achieved in low-rise, single-family housing. The phrase “an Englishman’s home is his castle” dates back several centuries. From this came the American dream of a detached property surrounded by a white picket fence, while Australians and New Zealanders aspired to a “quarter acre”. A new YouGov survey bears this out: when asked if they would like to live in an apartment in a 3-4-floor block — picture the elegant streets of Paris, Barcelona or Rome — Britons and Americans say “no” by roughly 40 per cent and 30 per cent respectively, whereas continental Europeans are strongly in favour... Across the OECD as a whole, 40 per cent of people live in apartments, and the EU average is 42. But that plummets to 9 per cent in Ireland, 14 per cent in Australia, 15 per cent in New Zealand and 20 per cent in the UK.

... the second shared problem: planning systems. No matter that the UK has a discretionary approach while the others use zoning — the planning regimes in all six anglophone countries are united in facilitating objections to individual applications, rather than proactive public engagement at the policy-setting stage. This preserves the low-density status quo. Finally, we have what I call the nature paradox: Anglophone planning frameworks give huge weight to environmental conservation, yet the preference for low-density developments fuels car-dependent sprawl and eats up more of that cherished green and pleasant land.

10. Reflecting the importance of food prices, the average Indian spends a very high share of income on food.