Blanket tariffs

Tariffs are taxes levied on goods crossing international borders. They must be paid when required by the importing country.

Here are two examples where the application of tariffs may yield long-term benefits for a country's people:

1. Technological advancement: Consider a country that primarily produces and exports typewriters but lags in computer technology. By imposing import taxes on computers, computer production for the domestic market becomes profitable. As local businesses gain experience and achieve economies of scale, they may develop into efficient computer manufacturers. Eventually the manufacturers will be ready for the export of computers and as fewer jobs in typewriter manufacturing are needed the people still in these jobs can transition to the production of computers.
2. Protecting regulations: Consider a country that wants to transform its economy to produce less carbon dioxide. It imposes tariffs on products produced less carbon efficiently (aka "carbon border adjustment"). This allows the country to maintain regulation around carbon reducing production which may create additional costs for domestic manufacturers. Without such tariffs, local producers, adhering to stricter regulations, might struggle to compete with less regulated international producers. This would potentially even render the regulations counter productive, if production shifts from domestic producers to international producers.

In these cases the tariffs were applied surgically with specific economic objectives. Even here, outcomes may not always be as favourable as described, as other countries may impose their own tariffs, e.g. such that the computers produced in example 1 cannot easily be sold, or forcing the country in example 2 to reduce its exports.

Now, let's consider the implications of a blanket tariff on all imported goods. Let's first note that if that was a smart idea for one country, this cleverness would certainly not be lost on other countries, and they would likewise impose tariffs.

Who benefits from such tariffs?

1. The beneficiaries are shareholders of businesses that produce goods for domestic consumption using domestic inputs, as international competitors are burdened. Due to decreased competition, they can charge higher prices.
2. If production requires special skills, there may be a benefit to workers, as demand for their skills, and consequently job security, increases.
3. Last but not least, the people in control of imposing tariffs may benefit personally, as they gain leverage over businesses by exempting them from tariffs in exchange for favours.

While some businesses and their shareholders will benefit, others will clearly suffer as their ability to export is reduced due to tariffs imposed by other countries in response. The same applies to workers. Workers in declining businesses will have to change jobs and acquire the skills that are now in demand.

While on the surface, gains and losses may eventually balance out, there will be inefficiencies due to:

1. the need to respond to the change and adjust (e.g., open one factory, close another),
2. economic uncertainty resulting from an unpredictable economic environment governed by discretionary (i.e. unpredictable) decisions,
3. limiting economies of scale, e.g., the fact that target markets for factories are reduced, which results in poor utilization (the factory is underutilized at times and overutilized at others), and
4. the fact that production does not take place where conditions are ideal for the type of goods produced (e.g., proximity to other factories, availability of cost-effective skills and resources).

Inefficiency means increased effort or the production of fewer goods. This must have consequences somewhere. People have to work more, there will be reduced investment, or there will be reduced consumption. Or in other words: on average life will become harder for people and economic progress will slow down.

Do we need more populism?

Nobody would even argue that we need politicians who put people first.

What we don't need are politicians who invent problems where none exist. We don't need politicians who offer simplistic solutions while ignoring their ramifications. We also don't need politicians who trade short-term success for medium-term suffering. Least of all, we need politicians who no longer even pretend to be rational and justify their eligibility with claims of divine preference.

Instead, we need a new enlightenment. We need politicians who comprehend and explain trade-offs, allowing people to make educated decisions based on a solid understanding of the issues at hand. Then we get back to what politics is meant to be: the study of ideal social organization.

Prediction markets and election outcomes

During this year's U.S. presidential elections, I have repeatedly encountered discussions about prediction markets, where individuals trade on the election's outcome. These discussions are often accompanied by an uncritical argument that suggests prediction markets are better than polls: "Polls just represent what people want the outcome to be, while prediction markets represent what people believe the outcome will be". 

I am surprised by this lack of critical analysis.

What are prediction markets? They are markets (such as predictIt.org), where traders buy and sell contracts, such as: "If X wins the election, you receive $1; if X does not win, you receive $0". Once the election results are announced, the value of this contract will either be $0 or $1. Prior to that, the value fluctuates somewhere in between. Since traders invest their own money, there is an expectation that they will be motivated to price these contracts "right".

What does the "right" price tell us? In the best-case scenario, we can hope to derive a probability from the prediction market: what is the likelihood of X winning the election? However, it's important that this probability doesn't tell us about the margin of victory. For example, the probability of winning may be very high, while the actual margin of victory could still be very slim. This characteristic makes it challenging to easily disprove the market's prediction. The market might indicate a 95% chance of X winning, but X could still lose. In such a case, the market may still have been accurate, as there was indeed a 5% chance of X losing. 

At what point in time do prediction markets represent the probability? Is it one month, one hour, or one second before voting concludes? Or perhaps after voting has finished? For understandable reasons, prediction markets fluctuate over time, and during a given period, they may forecast one election outcome to be more likely and later predict the exact opposite. One could argue that this behaviour already proves that the market is not not working for the purpose of predicting the outcome.

Going further, the theory that "prediction markets represent what people believe the outcome will be" may actually be quite inaccurate. Instead, these markets might simply represent what people believe others believe will happen next (along the lines of a "Keynesian beauty contest"). A trader might buy at a low price because they anticipate the price will rise, based on their belief that others will buy soon after. They don't have to wait for the election to occur to sell. Such a market price has little to do with the actual election outcome.

For a prediction to have any chance of accuracy, it must be based on facts. What facts does a trader have access to? Primarily their own knowledge and data from polls. They could conduct their own private polls, but given the trading limits applicable on many prediction markets, this would hardly be cost-effective. Ultimately, prediction markets reflect the limited knowledge of traders. More important than that knowledge being limited, it's probably also heavily biased towards the insights of traders. Only a very small fraction of the eligible voting population is trading in prediction markets. So  in the best case, at any given point in time: "prediction markets represent what traders believe will happen next".

Other reasons for trading in prediction markets may include hedging against specific election outcomes. In these cases, the trader is not informing the market but rather relying on it as a gauge of risk. In more autocratic situations, one could even imagine a candidate themselves (or their cronies) hedging against the possibility of losing. In this context, "prediction markets represent what people fear they will lose given a certain outcome".

In conclusion, while I find prediction markets to be a fascinating concept, considering the way they are currently implemented, I have significant doubts about their usefulness for gaining an early understanding of election outcomes.

Low and high interest rates

Before the Covid-19 pandemic, low and yet decreasing interest rates were seemingly understood to be with us for a long time. Paul Schmelzing  (Bank of England, Staff Working Paper No. 845, Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018, Paul Schmelzing, January 2020) analyzed interest rates over the very long run and even suggested that there was a very long-term trend towards lower and lower interest rates "[...] since the major monetary upheavals of the late middle ages, a trend decline between 0.6–1.6 basis points per annum has prevailed [...]". However, his paper provides no explanation for this trend, making it hard to understand if the drivers of this trend do really still exist. The explanation for such a very long-term phenomenon, would obviously also have to be very long-term, e.g. something like a continuously increasing efficiency of markets.

What determines interest rates? The obvious determinants are supply of funds for loans and demand for taking out loans. A further determinant is the behaviour of central banks. By managing their balance sheets and setting interest rates at which they are lending, they can influence demand for savings and demand for taking out loans.

In the past I found the following reasons in various papers related to the question of enduring low interest rates:

Reasons for a decreasing demand for taking out loans:

• The demographic situation, with relatively fewer younger people requiring loans.
• A shift of private sector activity away from loans. This shift is caused by a changing focus of the private sector towards service industries, which may require less investment. On the other hand this is caused by a changing focus towards industries which don't lend themselves to the structure of loans, e.g. technology businesses, with missing collateral and a longer term outlook towards profitability.
  

Reasons for an increasing supply of funds for loans:

• The demographic situation, with relatively more older people holding savings.
• An increasing wealth and income inequality, with wealthier people deriving a declining utility from consumption and therefore having a higher propensity to save rather than to consume.
• An increasing rate of savings and the scarcity of safe assets in developing countries.
  

    
Frequently productivity is discussed in the context of declining interest rates. A fact is that productivity growth has been declining in advanced economies for decades  and recently also in aggregate in emerging economies (Dieppe, Alistair, ed. 2021. Global Productivity: Trends, Drivers, and Policies. Washington, DC: World Bank. doi:10.1596/978-1-4648-1608-6.). On the other hand, there is talk about artificial intelligence and the "Robocalypse", which should result in a productivity increase, if economies manage to handle the structural change and keep people employed. High productivity growth is considered by many to be a driver of higher interest rates, as higher productivity results in a higher return on capital increases. However, it has also been argued that low interest rates may be driving low productivity growth (Banque de France, The Circular Relationship Between Productivity Growth and Real Interest Rates, Antonin Bergeaud, Gilbert Cette, Rémy Lecat, October 2019, WP #734). The rationale being that private sector ventures don't have to put a lot of effort into productivity to maintain their status as a reasonable investment in a low interest rate environment. In summary it seems murky what will happen to productivity growth.    

This was the outlook before the start of the Covid-19 pandemic. What changes have there been since?

• In the beginning of the pandemic significantly increased asset purchases conducted by central banks were decreasing the demand for taking out loans in the public market.
• Governments have significantly increased their spending resulting in an added demand by the government for loans.
• The pandemic has caused manifold production and productivity problems, resulting in an increase in inflation. Putin's invasion of Ukraine is exacerbating supply problems, which go beyond the temporary friction experienced during the course of the pandemic.
• Because of the high level of inflation both the ECB and US Fed have announced a slow down or stopping of asset purchases. The US Fed has started to increase their interest rates and laid out a schedule of further interest rate increases.
  

What does this mean for interest rates in the future?

• very likely short-term interest rates will continue to increase at least until inflation is under control. The US Fed's projection ("dot plot") suggests an increase of the federal funds rate to just under 2% at the end of 2022 and around 2.75% at the end of 2023 compared to a rate of 0.08% at the beginning of 2022.
• very likely long-term interest rates will continue to increase at least until inflation is under control. The US Feds and ECBs asset purchases involve securities with short and long maturities. Assuming government will at least maintain their debt levels (and at historically low debt serving cost, there is really no indication they would change), if those asset purchases slow down, this will create a demand for taking out loans in the public market and will have an impact on a broad range of maturities. The value of securities on the balance sheets are substantial with roughly one third of GDP in the US and the Euro area. If balance sheets were to be completely reduced over twenty years, very roughly, this would mean an additional 1.5% of GDP added to the demand for taking out loans.
• central banks may resume asset purchases once they have brought inflation under control, but combined with increased government spending and debt, this seems to be a potential long-term driver of higher interest rates. It is not clear to me to which degree this balances out with the  previously described drivers towards lower interest rates.
  

In summary, it seems pretty clear that both short-term and long-term interest rates in the short-term will increase. Less clear to me is, for how long long-term interest rates will keep increasing and for how long they will stay at an elevated level.

Corona, inflation and interest rates

So there has been the Corona pandemic and now inflation has risen to high levels not seen for a long time (Euro area: 4.1% last time as high was in 2008, US:  6.2% last time as high was in 1990, Canada: 4.7% last time as high was in 2003). Unexpected inflation is a bad thing. It is costing those who hold their money in savings accounts, term deposits or non-indexed bonds. These are probably the same people who don't have so much wealth to start with. It results in an uncoordinated and probably undesirable redistribution between people.

After the financial crisis in 2008 inflation also briefly surged, but was then followed by a brief period of deflation and very low interest rates ever since. So what will happen this time around?

Let's take a look at the causes of inflation:
 

1. Tariffs on imports from China and "Buy American" policies enacted by the US government contribute to inflation in the US, but can only explain a small part of the inflation showing up there now.
2. Comparably low year-over-year inflation in 2020 (Oct 2020: Euro area: -0.3%, US +1.2%, Canada: +0.7%) would create a spike in 2021 even if prices where just catching up to pre-pandemic levels. This is a one time effect. However, it still does not explain the full level of inflation we are seeing now especially in the US.  
   
3. Misalignment of supply and demand caused by the Corona pandemic over time appears to be a good explanation of current inflation. Especially noteworthy is the shift towards goods from services and from consumption towards savings during the pandemic (and possibly the reverse now). This is exacerbated by tendencies resulting from initial supply shortages to build up inventories in order to hedge against future supply shortages. This cause of inflation is bound to get resolved over time ("transitory").
4. Higher cost of energy also appears to be a good explanation. Cost of energy is a major component of total inflation at this point. However, energy prices have historically fluctuated wildly. Nothing else is to be expected this time.
5. Generally lax monetary policy is not the root cause of the current surge of inflation. Until very recently central banks had a hard time to keep inflation at their target level and prevent deflation. During the pandemic things changed a bit. Governments made social support payments during the Corona pandemic to businesses and individuals. These were at least partially financed through added supply of money. However, most individuals and businesses would have earned and spent much more if there hadn't been the pandemic. So a cause of inflation could be the part of support payments that wasn't well targeted (e.g. "US stimulus cheques").
   
6. Expectations may become the most important driver of inflation. If workers and business are getting convinced that inflation is here to stay this will trigger a spiral of wage and prices of goods increases ("runaway inflation"). The impact of this driver of inflation will depend on how vigorously central banks can demonstrate their readiness to act and to keep inflation on target.
   

Because of the need to manage expectations it does appear quite clear that central banks will act soon. This will result in one way or the other in an increase of (at least short term) interest rates. The question is how much rates with rise and when it will happen. History is not a good guide here, since in the past, when there was inflation at the current level, conditions were quite different. Especially interest rates started at much higher levels. Interest rates are very low now and it appears existing drivers of decreasing interest rates remain in place:

1. an aging population will continue to constrain interest rates as there are relatively fewer borrowers and more lenders
2. increasing inequality will shift the demand for consumption (by poorer people who would  consume more if they could) towards demand for savings (by richer people who feel they receive little utility from even higher levels of consumption)   
3. low real wage increases due to low productivity growth, resulting in a tendency to save more
4. changing methods of financing in the private sector away from debt financing towards equity financing

A lower level of interest rates means there is an outsized leverage of small interest rate hikes (e.g. if the mortgage rate is 2% and increases to 2.50% the result is that somebody who could previously afford a $1M house, can now only afford an $800K house).

Different drivers are pointing in different directions, so without some precise quantitative model it appears to be impossible to provide a substantial assessment. At least the following does seem to be quite likely though:

1. Central banks will deal with the inflation problem.
2. (Short term) interest rates will be raised very soon (the South Korean central bank and the Reserve Bank of New Zealand have already started raising rates: South Korea:  +0.25% (Aug), +0.25% (Nov) to now 1%, New Zealand: +0.25 (Oct), +0.25 (Nov) to now 0.75%).
3. The increase will be lower and of shorter duration than what we have seen in the past. 
4. A recession or significant unemployment caused by increasing interest rates will be alleviated by government investments, which have already been planned for in the US as well as in the EU. These government investments may somewhat compensate for a reduction in private sector investment.
   

Can Bitcoin be money?

Proponents of Bitcoin argue that it is a better money than the money we have today. The arguments in favour of Bitcoin as money appear to be based on the fundamental assumption that government cannot be trusted.

The paper money most of us are regularly using is also called fiat money. Fiat money has no intrinsic value and is not backed by any commodity. A trustworthy government, in this matter frequently represented by an independent central bank, maintains a predictable value of the money by increasing or decreasing the money supply. Fiat money assumes a value based on what it can be exchanged for, e.g. labour, goods or entitlements to interest, dividends or government taxes.

Bitcoin also has no intrinsic value. In contrast to the existing fiat money, practically speaking, Bitcoin can only be exchanged for fiat money. This is not surprising. In order for a vendor to value their goods in Bitcoin, they would have to pay their employees in Bitcoin, pay their input goods in Bitcoin, pay their dividends in Bitcoin etc. Valuing a good in Bitcoin is very different from saying, "this sandwich costs $3, but you can pay me in Bitcoin at the current $/Bitcoin exchange rate". Therefore Bitcoin has no fundamental value.

So if I can't exchange Bitcoin for anything real and it has no fundamental value, why would anybody want to own Bitcoin? In contrast to fiat money Bitcoin has a somewhat predetermined total quantity. If Bitcoin could be exchanged for something real and many people would want to use it for that purpose, its value would change. Imagine today I get one sandwich for 1 Bitcoin. Imagine furthermore in the future there are a lot of people who want to use Bitcoin. Therefore due to a lack of Bitcoin the price of the sandwich in the future will change. It will cost less in terms of Bitcoin, e.g. 1/2 Bitcoin. Note that this change is not due to an oversupply of sandwiches, but due to a lack of Bitcoin. So the only reason I can imagine why anybody would want to own Bitcoin, is because they believe Bitcoin will at some point be able to be exchanged for something of real value and its use and thereby its value will increase (or in short: "with the Bitcoin I own today I will be able to buy more sandwiches in the future").

This reason why somebody would want to own Bitcoin is exactly the reason why it would make for such bad money. It provides an incentive to not spending (e.g. hiring new employees). Furthermore, by design, the value of Bitcoin will change in a hard to predict fashion while creating uncertainty for those trying to operate in that Bitcoin economy. Bitcoin also does not allow for predictable inflation. Predictable inflation helps to reduce economic inefficiencies, which result from so called nominal rigidity, i.e. the observation that it is more difficult to get nominal prices to decrease than it is to get them to increase (e.g. as a business cannot easily lower an employee's wages, the business has to take an action disproportionate to its actual economic situation and will have to lay off employees or close down altogether).

These questions regarding Bitcoin as money are not really new. At some point there was the gold standard, which bears stark resemblance to Bitcoin. After it was abolished in the 1970s to my knowledge no advanced and no developing economy has gone back to or newly adopted that well known gold standard.  

In summary, I can't come up with any serious reason, why Bitcoin would be better than fiat money. Bitcoin as money would create very serious economic challenges. For accepting that, the distrust in central banks would have to be very strongly justified.

How long will COVID-19 keep us restrained?

In the first phase of the outbreak the priority was to limit the number of sick people such that the capacity of the health care system is not exceeded. COVID-19 can be a fatal disease even with very good health care, but in many cases sufficient health care can avoid fatalities.

With the help of restraints, in many regions the case rate has stabilized and the capacity of the health care system has increased such that probably few if any people are dying due to limitations of the health care system in those regions. On the other hand based on preliminary studies (e.g. for Santa Clara, USA, Netherlands) it appears only approx. 3% of the population have reached immunity (in the regions examined), such that without restraints every new case can bring us (almost) back to square one, with case numbers rising (almost) just as in the beginning. The studies also allow guessing a relationship between actual case rates and the reported case rates (the latter are highly dependent on the intensity of testing).

The restraints are in place and keep causing economic damage. So what could the policy be to lift the restraints?

1) Eradicate the disease completely through a strict world wide lock down without any possibly infectious human-to-human contacts. This is probably unrealistic and indeed it seems nobody is pursuing this approach.

2) A cybernetic approach of relax/measure/restrain. Restraints are fully lifted and as soon as case rates go up to capacity levels the most stringent restraints are put back into place. The major flaw with this approach is that it does not give businesses any type of certainty for planning (e.g. a restaurant owner stocking up on perishable supplies, just to learn that she is not allowed operating anymore).

3) An approach of very stringent restraint and near zero case rates until a vaccine is available. The earliest Phase II clinical trials of vaccines with sizeable numbers of participants are currently scheduled to end in December 2020 (this doesn't mean that the vaccine will be available to the general public by this time, even if the trial is successful). The problem I see with this approach is that it is somewhat arbitrary. What guideline is used to decide on the exact level of constraint?  One technical justification could be that a near zero case rate may be easier to control than any other case rate. Another justification could be that the necessary measures for this approach have the same social and economic impact as the measures for an approach with a higher case rate.

4) Lastly I can imagine an approach which keeps case rates constant and close to but below health care system capacity and takes this as a guideline to relaxing the most economically damaging restraints as herd immunity builds up (or a vaccine becomes available). The graph below is the result of a simple simulation, which shows how the number of unprotected contacts can increase over time if the goal is to maintain a stable case rate. If the tolerable case rate can be increased due to improved health care system capacity the time of restraint could be significantly shortened. Depending on the tolerable case rate in about 7-15 months the number of unprotected contacts between people can double and in probably about 10-20 months a sufficient degree of immunity is reached such that restraints can be lifted almost completely.

COVID-19 will probably be on our minds for the next 10-20 months. Regions, which can tolerate and control higher case rates, could get through faster than regions which tolerate lower case rates, assuming recovering from the disease means immunity.

This doesn't mean that business activity has to stall during this time, but it does mean that serious measures to reduce infectious contacts (e.g. washing hands, face masks, distance keeping, working from home, broad testing/individual quarantines, contact tracing) have to be in place, which, however, can be continuously relaxed if the constant case rate approach is pursued. Many of those measures may not impact businesses very much at all, and it is important to chose those measures that have benefit in containing while minimizing impacts on business activity.

Permissible contacts over time assuming a constant actual case rate. The lower case rate is 1000 actual cases per million population per day. The higher case rate is 2000 actual cases per million population per day.The case rate is the actual rate of cases, which according to initial studies, may vary by a significant factor from the reported case rate, depending on the intensity of testing being done (factor 50-85 Santa Clara, USA study, factor 18 Netherlands study). Permissible unprotected contacts is the number of potentially infectious contacts a person can have with an immune or not immune person in order to maintain the case rate. There is 3% immunity in the beginning of month 0. All this assumes an infected person is immune after recovery from the disease.