Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: the Fed joins the climate club, the end of the free Internet (maybe), California (still) looking at tax increases, New York’s food vendor crunch, and a worrying case for leveraged buyouts.
The Fed Crosses A Green Line
This has been well flagged, but it’s disturbing news, nonetheless.
The Fed:
The Federal Reserve Board announced on Tuesday that it has formally joined the Network of Central Banks and Supervisors for Greening the Financial System, or NGFS, as a member. By bringing together central banks and supervisory authorities from around the world, NGFS supports the exchange of ideas, research, and best practices on the development of environment and climate risk management for the financial sector. The Board began participating in NGFS discussions and activities more than a year ago.
“As we develop our understanding of how best to assess the impact of climate change on the financial system, we look forward to continuing and deepening our discussions with our NGFS colleagues from around the world,” said Federal Reserve Board Chair Jerome H. Powell.
The idea that this is anything to do with “risk” is risible.
To quote, once again, from John Cochrane’s talk at a conference organized by the European Central Bank in October:
Risk means variance, unforeseen events. We know exactly where the climate is going in the next five to ten years. Hurricanes and floods, though influenced by climate change, are well modeled for the next five to ten years. Advanced economies and financial systems are remarkably impervious to weather. Relative market demand for fossil vs. alternative energy is as easy or hard to forecast as anything else in the economy. Exxon bonds are factually safer, financially, than Tesla bonds, and easier to value. The main risk to fossil fuel companies is that regulators will destroy them, as the ECB proposes to do, a risk regulators themselves control. And political risk is a standard part of bond valuation.
That banks are risky because of exposure to carbon-emitting companies; that carbon-emitting company debt is financially risky because of unexpected changes in climate, in ways that conventional risk measures do not capture; that banks need to be regulated away from that exposure because of risk to the financial system—all this is nonsense. (And even if it were not nonsense, regulating bank liabilities away from short term debt and towards more equity would be a more effective solution to the financial problem.)
The Financial Times picks up on the story, and it turns out that the pass has not entirely been sold. Not entirely.
Yes, there’s this:
Only seven [central bank] respondents to the NGFS survey said they were “not currently considering taking climate-related measures”. Most of those considering action said it was aimed at “mitigation of financial risks stemming from exposures to climate-related risks on their balance sheets”.
But:
When asked if they had considered implementing measures to protect themselves from climate risk or to proactively support the transition to a low-carbon economy, more than half said they had not. The main obstacle to potential action identified by most of the respondents was “the risk of creating financial distortions”.
What “proactive” means in the context of this piece is referred to here:
The question of whether central banks should use their vast bond-buying programmes to fight climate change by selling the bonds of the heaviest carbon emitters and buying more green bonds is one of the most contentious areas of monetary policy.
The answer, quite clearly, to that question is that this is something that central banks should not be doing. The purpose of the bond buying by central banks is to keep the economy going, not to reshape it.
Not for the first time, some words of wisdom from Germany’s Ifo Institute:
Clemens Fuest, head of the Ifo Institute in Munich, said it would be “very bad economic policy to use this as the basis for steering capital flows in an economy” adding that it would be tantamount to “a centrally planned economy”.
To some, however, that (I suspect) is a bug, not a feature.
In a recent article for Project Syndicate by economists Mariana Mazzucato (an “agenda contributor” for the World Economic Forum (“Davos”), among other achievements), Josh Ryan-Collins, and Asker Voldsgaard, there is little evident fear of central planning. Indeed:
Our institute’s research and a report by the Bank for International Settlements help explain why. Financial actors struggle to calculate their exposure to climate risks accurately, because the risks are subject to “radical uncertainty,” making it impossible even to assign a probability to different outcomes. In a situation of “unknown unknowns,” the market cannot fix itself.
In the article, they build upon that idea:
ECB President Christine Lagarde and others have also challenged the principle of “market neutrality,” which demands that central banks minimize the impact of their asset purchases and other operations on the relative prices of financial assets. This principle has been the main argument against greening QE. Yet according to Lagarde, in the face of market failures – such as investors’ inability to price climate risks – “we have to ask ourselves … whether market neutrality [in effect the idea that the ECB should buy bonds in proportion to their market weighting] should be the actual principle that drives our monetary-policy portfolio management.”
Lagarde had no central banking experience prior to taking up the presidency of the ECB. She is, primarily, a politician, not a banker, and it often shows.
The idea that the ECB, an institution that not only failed to anticipate the (rather predictable) euro zone crisis, but may have even accelerated it, has a better grasp of “climate risk” (to the extent that there is any, as Cochrane points out, on a five-to-ten-year horizon) is laughable. Markets frequently get things wrong, but, as a rule, the consequences of their fiascos are rather less dire than when central planners blunder (we can talk about the contribution of regulation, not least where the BIS is concerned, to the financial crisis on another occasion).
But market failure or the forecasting abilities of central banks is not the real issue here. The real agenda is using central banks — institutions for the most part free of direct democratic control — as one tool among many to reshape the economy in what those setting this agenda believe to be a more climate-friendly direction.
Back to Mazzucato, Ryan-Collins, and Voldsgaard:
ECB Executive Board member Isabel Schnabel has argued that, because “climate change poses severe risks to price stability,” “traditional mandates” demand strengthened efforts to “support a faster transition towards a more sustainable economy.” The ECB mandate includes a secondary objective (following price stability): to support the European Union’s “general economic policies” and contribute to the achievement of their objectives. In the light of the European Green Deal, Schnabel’s call gains even more force.
The new rhetoric is welcome, not least because central-bank communications alone can affect financial-market behavior. But now is the time for action, with central banks taking concrete steps to align their operations fully with the goal of achieving net-zero carbon dioxide emissions by 2050.
A first step would be for central banks fully to integrate climate-related financial risks into their asset-purchase programs. If credit-rating agencies’ existing criteria fail to do this, then the ECB should support the development of criteria that do. Sweden’s central bank has begun to move in this direction, by introducing “norm-based negative screening” of its bond purchases.
A second step, particularly applicable to the ECB, is to “green” the refinancing programs by which central banks provide liquidity to commercial banks. EU banks could be given lower interest rates when lending to green assets, in accordance to the EU’s new green taxonomy.
Finally, on the financial regulation front, a precautionary approach is needed to reduce uncertainty and avoid worst-case scenarios. Forcing banks to hold more capital against the most unsustainable assets, such as loans financing fossil-fuel extraction, would be an obvious place to start. . . .
Even if this is a discussion that will, with the arrival of Joe Biden in the White House, eventually become as pressing in the U.S. as in Europe, the way in which central banks exercise their regulatory (and emergency bond buying powers) can still seem a little arcane, a topic for central bank nerds. Once understood, as it must be, as being part of the much larger project discussed above, then its significance becomes all too clear.
Mazzucato, Ryan-Collins, and Voldsgaard put it this way:
None of this is to say that central banks should be left to save the planet on their own. On the contrary, an “all hands on deck” approach is required, featuring coordinated action by public banks, finance ministries, industrial policymakers, and other institutions. The goal is not to level the playing field, but to tilt it toward sustainability.
Central banks have shown time and again that they have the power to maintain the economic status quo. Now, they must use that power to support a long overdue green transition. What some view as “mission creep” has now become, as Lagarde put it, “mission critical.”
And if anyone thinks that there will be much of a free-market economy left after this transition gets too far underway, I have a rusting, only intermittently useful, largely unrecyclable wind turbine to sell them.
And if anyone thinks that this change will be subject to detailed democratic review, I have another wind turbine ready to go.
Around the Web
The end of the free Internet?
CapX:
The suspicion that online advertising might prove to be a bubble has been kicking around for several years now. I first saw rumblings back in 2018: Procter & Gamble, the world’s biggest advertiser, had just cut its digital spending by 20%, citing concerns over the true effectiveness of online ads, and claimed to have increased its marketing reach by 10%. There was already plenty of data available that might have dissuaded prospective advertisers: the fact that “click fraud” was already costing the global industry $35bn a year, or that 56% of online ads were never even seen by humans. But in the two years since, the evidence that something is awry has piled up dramatically.
A study last year found that targeted ads, which can cost advertisers as much as 2.68 times the price of non-targeted ads, are in fact only 4% more effective. Another study found that middlemen take as much as 50% of all advertising revenue. As Gilad Edelman wrote earlier this year in WIRED, there are now “piles of research papers… showing that companies’ returns on investment in digital marketing are generally anaemic and often negative.”
For a $325bn a year industry, that’s quite astounding. As Jesse Frederik put it in The Correspondent last year, it’s “a market of a quarter of a trillion dollars governed by irrationality”. Tim Hwang, the former director of the Harvard-MIT Ethics and Governance of AI Initiative, and author of Subprime Attention Crisis, predicts digital advertising will collapse in a similar manner to the housing crisis of 2008. If he’s correct, the ramifications would be huge: “if online advertising goes belly-up, the internet — and its free services — will suddenly be accessible only to those who can afford it”.
Digging a Deeper Hole.
Silicon Valley Business Journal:
In the same week that Elon Musk became the poster boy for the Bay Area exodus by moving to Texas, California lawmakers are considering an increase in the income tax on its wealthiest residents to raise at least $2.4 billion annually to help pay for services to the homeless.
The proposed law would establish the Bring California Home Fund and create a comprehensive, statewide program to address problems tied to homelessness. The legislation, Assembly Bill No. 71, was introduced Dec. 7 by Assembly members Luz Rivas, D-Arleta, and Daivd Chiu, D-San Francisco.
The lawmakers propose a personal income tax hike on earnings over $1 million, along with proposals to raise the state’s corporate income tax rate and close loopholes, among other options, to generate at least $2.4 billion in annual revenue. Details on how the bill would be funded will be worked out as it moves through the next legislative session. . . .
Rationing doing what it does.
Bloomberg:
New York City’s roughly 20,000 street food vendors are in a crisis like they’ve never seen before, crippled by a pandemic that compounded perennial challenges such as ticketing and over-policing for the majority that operate without proper permits.
There’s a relatively easy fix to that problem, advocates say: lifting a 37-year-old cap that limits mobile food vending licenses to about 2,900 citywide and forces many to turn to an underground market for permits.
On Nov. 12, vendors marched with their carts across the Brooklyn Bridge to City Hall in a protest, demanding that city lawmakers pass Intro 1116, a 2018 bill that would gradually increase the number of available permits over the next decade. It would help decriminalize a profession that is largely held by immigrants and make thousands eligible for financial assistance in critical times such as the Covid-19 crisis. . . .
Helping street and sidewalk vendors stay afloat during the pandemic might restore a sense of normalcy in New York City at a time when so many beloved local establishments are shutting down. By one estimate, street vendors contributed almost $300 million to the local economy back in 2012, a number that has likely increased since.
And yet despite being co-sponsored by a majority of the 51 New York City council members, the vendor-reform bill hasn’t been brought to vote, and it’s unclear when it might be.
Speaker Corey Johnson is aware of the importance of street vendors to the economy, a spokesperson for the city council said by email: “At a time when we are facing a dire economic crisis, street vendors offer affordable food options for New Yorkers, and the jobs they provide are a lifeline for immigrants New Yorkers. He is working towards finding ways to help this vital industry.”
Year-round citywide permits cost $200 for two years, and the city also issues about 2,000 licenses that are seasonal or specific, such as for fresh fruits and vegetables only. But that’s not enough, and some vendors have opted to rent permits in the black market — where they can fetch more than a hundred times their price. . . .
Best city government there is . . .
Random Walk
Uh oh.
The Financial Times:
Deal lawyers in the US are warning that leveraged buyouts could become much more difficult to do, after a court said creditors could go after a company’s former directors if a private equity buyer saddles the business with an unsustainable amount of debt.
A recent ruling — in the case of the bankruptcy of retailer Nine West — by Judge Jed Rakoff of the Southern District of New York said creditors can pursue misconduct charges against the previous board of directors, which approved a $2bn leveraged buyout to Sycamore Partners in 2014. The business went bankrupt four years later.
The board had been “reckless” in failing to assess how the LBO debt could leave the new company insolvent, the federal judge wrote in the December 4 ruling.
“Requiring boards to be liable for the results years after a sale would put board members in a position of conflict between what is best for shareholders in the short run versus what is best for directors over the next few years following a transaction,” said Brian Quinn, a corporate law professor at Boston College. “It could be a gamestopper for the private equity business.”
The ruling in the Nine West case is preliminary and the specific situation will now be resolved in a fully-fledged trial or a settlement, but the judge’s statement of legal theory could have long-lasting consequences, said Ryan Preston Dahl, a partner at Ropes & Gray.
“Even a trial and ‘vindication on the facts’ will still leave this preliminary ruling out there stating that a board acts ‘recklessly’ by failing to adequately assess an LBO-buyer’s post-transaction solvency,” he said.
Ropes & Gray found the ruling to be so consequential that it put out a public bulletin to clients last week.
The ruling’s “direction to corporate decision makers is seemingly at odds with their concurrent duty to maximise value for corporate stakeholders — typically satisfied by obtaining the highest possible price from a putative buyer”, the law firm wrote. . . .
Quite how this works itself out, I don’t know. From the Bloomberg report, this ruling looks like an outlier, to say the least. I struggle to see how the venerable “business judgment” principle (that a court won’t substitute its judgment for that of a board so long as the board is acting in the best interests of the shareholders) can be ignored in this way, but maybe there’s something lurking there in the facts.
Andrew Stuttaford is the editor of National Review's Capital Matters.