Risks, Hedges and Opportunities: Rational Expectation

Guest post by Hubert Marleau, Chief Investment Officer, Palos Management Inc.

Rational expectation was an idea that was invented in the 60’s and developed by the “Chicago School” of economics in the 70’s. The Nobel-winning economist Robert Lucas did more than anyone to promote, explore and explain the ramifications of fiscal and
monetary policies on the economy. The model is based on the notion that people look ahead by intelligently extrapolating precedents, trends and relationships. He argued that the more the market can anticipate the conduct of government policies, both monetary and fiscal, the less will their impact be on future economic conditions.

In other words, expectations can compromise policies. He further argued that the effect of policies will be greatest when incentives are surprises and used in areas that can take most advantage of them and the consequential cost is relatively small.

Currently, market participants generally believe that there are no attractive alternatives remaining for either the fiscal or monetary authorities to stimulate growth. The belief is predicated on two observations.

First, the determination of government to slash public spending and/or impose higher taxes to balance budgets makes it difficult for fiscal policy to be more expansionary. A public sector borrowing binge could spark inflation fears and even question the financial stability of government while an increase in tax rates could easily further damage an
ailing economy.

Second, the zero interest rate policy, an engorged balance sheet and a quickly rising money supply under a mandate of price stability seriously limits the Fed’s application of further monetary easing. There is a lot of disagreement at the FOMC about whether further stimulus would be wise.

By the look of it, the situation looks grim and complicated. The de-leveraging forces have dragged down the economy more than expected given the huge degree of expansionary measures in operation. By the same token inflationary pressures have been much more
serious given the slow and stalling recovery.
1) The unemployment rate has been stuck above 9.0% every month since May 2009 and that is about 3 percentage points above where it ought to be.
2) The inflation rate has accelerated since last November and has been above the Fed’s target rate of 2.0% since March.

When one combines the low level of credibility of politicians with the aforementioned facts, the authorities appear to have lost the luxury of combating the weak economy with more spending deficits and printed money. Nevertheless, it is a misconception that absolutely nothing can be done without jeopardizing the austerity plans of the government and the monetary program of the Fed.

The constraints on fiscal and monetary policy efforts are clearly prudential. The economic situation needs to be favourably surprised where it counts, where the financial means exists and where the cost to the government is the least. In this connection, the corporate sector is where fresh new incentives should be applied. It would be a surprising and
“outside the box” idea.
1) The main driver of and the most volatile component over the economic cycles is spending on investment goods. The reason is because employment and productivity are akin to investment in that hiring decisions also takes into consideration taxes and regulations. According to a 2008 study by the O.E.C.D, corporate taxes are found to be harmful for growth.
2) Funds internally generated by non-financial corporations account for as much as 10% of GDP. Yet, capital investment barely exceeds the depreciation rate of capital. Today, businesses are only replacing what is worn out and, in turn, have no need to expand their workforces. They would rather hoard as much cash as possible. Liquid assets now account for 7.5% of total assets, the highest level in 50 years. US non-financial corporations hold more than $2.0 trillion in cash or 13.5% of GDP. This is a huge amount
of financial resources that are not being used productively.
3) In the last ten years, taxes on corporate profits averaged only 2.0% of GDP and contributed no more than 10% of federal receipts.

History shows that when the “animal spirits” are restored, employment and the economy get a lift and sustainable growth is ensured. Moreover the levy of corporate taxes has much greater distorting effect on the economic climate than whatever positive impact
it may have on federal revenues. Rather than focusing on transitory incentives like the expansion of payroll tax cuts and extending spending on unemployment benefits, the government should think outside the box and surprise the market with an overall reduction on capital taxes. It’s a better option.

Businesses care about what the tax rate is going to be when their investments in people and projects begin to bear fruit. The best fix for the current economic malaise is to focus policies where the most good can be had the fastest, and in turn, foster long-term confidence.


One thought on “Risks, Hedges and Opportunities: Rational Expectation

  1. Mr Marleau. you sound a bit like you’ve been sipping from the US Chamber of Commerce cup recently. The US has a high corporate tax rate, that is a given. But their practice of taxing corporations on world wide income is also an issue. This favours off shore investments and gives rise to corporations like Google being taxed on minimal amounts of foreign income. It also leaves them (and big pharma and other tech companies) with huge amounts of cash stranded off shore not wanting to be taxed at the 35% corporate tax rate. Perhaps half of the US corp cash stash is off shore.
    It sounds like you’re suggesting that the US wipe out corporate taxes entirely, but It’s not clear the political system is quite ready for that. Maybe you’d like to propose a VAT tax too? Even the change in the tax basis is too toxic for politicians, notwithstanding that the vast majority of experts think it would be a good change for the economy.
    There are a bunch of good outside the box thoughts out there. Unfortunately, as your friend Mr Ouelette noted, the politicians are having an election, but the “people” are weathering a financial crisis. (Mr Firiedman’s words).

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