Tag: Economics

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The main entrance of the Federal Reserve Bank of Chicago

I don’t usually worry much about investment bubbles. There have been a lot of them over the past few hundred years, and most of them (railroads, telegraph, dotcom…) were expensive disasters largely only for the people who invested in them. Some though, such as the Great Financial Crisis of 2007–2009, were expensive disasters for lots of other people as well. So it’s worth thinking a bit about whether the current AI bubble is of the former sort or the latter—and how to protect your finances in either case.

Bad just for investors

One big difference between bubbles that are going to be wretched for everybody when they pop and those that’ll end up mostly okay except for the foolish investor’s portfolio, is whether the excess investment got spent on something of enduring value.

For example, railroad lines got enormously overbuilt in the 1840s in the UK and in the 1880s in the US, leading in both cases to a stock market bubble, followed by a stock market crash and a banking panic. But (and this is my point), the enormously overbuilt railroads were of some value. As the firms went bankrupt, the people who had over-invested lost a lot of money, but the railroad tracks, rights-of-way, and rolling stock all still existed. The new firms that got those assets, free of the excess debt, were often viable firms that went on to be successes—hiring workers, providing transportation, and eventually providing a return to the new investors. The people who got screwed were the old investors. (And not even all of them, as the original investors often saw the overbuilding happening early and sold out just as the clueless people who knew nothing about running a railroad, but just saw stocks soaring and wanted to get in on it, started piling in.)

Much the same was true of part of the dotcom bubble. A lot of money got spent on a lot of things. To the extent that it was spent on buying right-of-way and burying fiber, there was something of enduring value that ended up owned by somebody, making it one of the less-bad bubbles.

The key to avoiding catastrophe in bubbles of this sort is largely just a matter of not investing in the bubble yourself.

Bad for the economy

But some bubbles have produced horrible, wretched, prolonged difficulties for the whole economy. The other part of the dotcom bubble, besides the dark fiber build-out, was the bubble in companies with no profits and no prospect of ever having profits, whose stock prices went up 10x based on nothing but a story that sounded compelling until you thought about it for 10 seconds. As usual, that ended up being very bad for the people who invested in those companies, but it also was bad for the whole economy, because when those firms went bankrupt, they left behind nothing of enduring value.

The result was that the imagined wealth of those companies just vanished. The stock market went down, which was bad for (almost) everybody, and it produced a general economic malaise, because post-dotcom crash it became hard even for legit companies with real assets, a real profit, and a real business plan for growth, to raise money, which made actually producing that growth much harder.

Really bad for the economy

There is, however a step beyond just pouring a bunch of money into a bubble that doesn’t actually produce anything of enduring value, like a fiber optic network or a railroad. That’s when the money is raised with leverage (i.e. debt).

The 1929 stock market crash was a rather drastic example. People invested in stocks not because there was an underlying business that was worth what the investors were paying for it, but purely because the stocks were going up. That might have been okay in other times, but stock brokers had recently started allowing ordinary people (as opposed to just rich people) to buy on margin—where you just put up a fraction of the price of the stock you want to buy, and the broker lends you the rest.

In the 1920s you could buy on 90% margin, where you only put down 10% of the price of the shares. That meant that, if the stock price went down by just 10% your whole investment was wiped out, and the broker would sell you out to raise money to pay off (most of) the loan. And of course, all those sales into a falling market produced more losses, leading to the crash.

Since the 1930s you could only buy stocks on 50% margin, making it much less likely that your broker will sell you out into the teeth of a general stock market crash—although it can still happen.

Bubbles with leverage

A great example of a bubble with leverage is the Great Financial Crises of 2007. (Most people date it from 2008, because that’s when Lehman Brothers collapsed. I date it from 2007 because that’s when my former employer closed the site where I worked and I ended up retiring rather earlier than I’d planned.)

That was a particularly bad bubble. A whole lot of money was raised, with leverage, to buy housing. But very little of the money ended up being spent to build more housing (which would have been something of enduring value that would have lasted through the subsequent collapse). Instead, the money was spent bidding up the prices of existing housing, which then fell in value after the bubble popped.

So we had two of the classic producers of bad bubbles: Nothing of enduring value created, and leverage. The whole things was made even worse by the structure of the leverage in question.

This is getting rather far from my main point, so I won’t go into much details, but to raise the large amount of money that was going into houses, the rules on housing market leverage were being eased over a period of time. It used to be that you had to put 20% down on a house. Then you still had to put 20% down, but only half of it had to be cash, with the other half being funded with a second mortgage on the property (at a higher interest rate). Then they started letting people put just 3% down. Then they started letting people with good credit put nothing down. Then they started letting people with no credit put nothing down. At the same time, “structured finance” obscured just how risky all those mortgages were, meaning that when the bubble went pop lots of “mortgage-backed securities” ended up being worth zero.

Which kind is the AI bubble?

This brings us to the current AI bubble. A whole lot of money is pouring into building two things:

  • Data centers (buildings filled with computer chips of the sort used to train and run AI models)
  • Large language models (non-physical things that are basically just a bunch of numeric weights of a bunch of tokens which can be used to produce streams of plausible-sounding text)

Each of those may have some enduring value.

Data centers will have some. They will probably have a lot less than a network of fiber optic cables, which can be buried and will have value for decades with minimal cost or maintenance. Since newer, faster chips are coming out all the time, a data center is well behind the cutting edge as soon as it’s finished. Plus, training or running an AI model runs those chips hard, meaning that they probably only last a couple of years (due to thermal damage on top of regular aging).

Large language models probably have even less enduring value, because so many people are training new ones all the time. People are always trying to make them bigger (trained on more data) while also making them smaller (so they can run without a giant data center). All that means that your two-year-old LLM probably isn’t worth what you paid to build it, and a four-year-old LLM probably isn’t worth anything.

That’s how things looked a year or so ago—a perfect example of a bubble that would burn the people who sank money into it, but leave the broader economy untouched.

Sadly, that’s been changing.

First, the structure of the leverage has been changing. It used to be rich people and rich companies were building data centers and hiring software engineers to build LLMs. But lately that’s been getting screwy. Those large companies are raising off balance-sheet money with Special Purpose Vehicles (small companies that big companies create and provide some capital to, that then borrow a bunch of money to make something, with the loans collateralized by the things they’re making—but importantly, not an obligation of the big company that created them). Any particular SPV can blow up, if it turns out that the things it built don’t earn enough to pay the interest on the money the borrowed to build them. And large numbers of SPVs can blow up if financial conditions change to make it harder for all the SPVs to roll over their debts as they constantly have to keep their data centers running.

Second, they’re also engaging in weird circular investing and spending arrangements, where company A buys stock in company B which then turns around and pays all that money back to company A to buy chips, letting company A treat it as both income and an investment, while company B can pretend it got its chips for free.

Finally, there’s all the non-financial obstacles that may well throw a wrench into the whole thing. The fact that LLMs are all built on copyright violations. The fact that running data centers requires huge amounts of power and water (that has to be produced and paid for). The fact that producing that water and power brings with it horrible environmental impacts.

What to do

So, if AI is a bubble, and its one of the bad sort that will produce a panic and a recession when it pops, what should you do?

There are a lot of little things you can do that will help. I wrote an article with suggestions at Wise Bread called Are your finances fragile? It talks about what financial moves you can take to put yourself in a better position if there’s a general financial crisis. (If you’re interested in my writing about this stuff more broadly, I wrote a overview of my perspectives on personal finance and frugality called What I’ve been trying to say, that includes a bunch of links to other of my posts at Wise Bread.)

Besides that general advice, there are also a few things to strictly avoid. In particular, strictly avoid thinking that you can find some very clever investment strategy that lets you make money off the popping of the bubble. Yes, after the fact there will be some investments that make a lot of money, but no amount of keen insight will let you find and make those investments, as opposed to the thousands of very reasonable-seeming investments that will blow up just like all the rest.

Along about the end of the Great Financial Crisis I wrote an article called Investing for Collapse, which explains why any such effort is pointless. It holds up pretty well, I think.

Short version? Avoid debt. Keep your fixed expenses as low as possible. Build a diversified investment portfolio that limits your exposure to the most obviously stupid investments, but doesn’t do anything too weird or wacky in an effort to get them to zero—it’s pointless, and will probably do more harm than good.

Good luck when the AI bubble pops!

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My brother suggests that I missed the point in my recent post, where I claimed that being depressed about work is nothing new, and that finding work worth doing was the solution.

I beg to differ.

I was not claiming that things are not way worse. Obviously, the way people are hired, managed, and required to do their tasks are way worse than they used to be. Nor am I claiming that finding “work worth doing” will solve the financial or economic problems—it won’t make it easier to pay the rent or put food on the table.

My claim is that it will help the mental health issues of dealing with late-stage capitalism.

Finding, and doing, work that’s worth doing will make everything else about your life better.

It’s why I was such a strong advocate for frugality and simplicity during those years writing at Wise Bread. Maybe you can find a way to earn more, and maybe you can’t, but anybody can find a way to spend less. And if you spend less, you can focus more on the work that’s worth doing, even if it doesn’t pay as much as the the wretched, soul-destroying work that’s ruining the lives of another generation of workers.

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We have benefited enormously from the vast economies of scale in the vaccine industry. Because childhood vaccines were mandated, the companies that made them could be confident that they’d be able to sell large numbers. That made it worth both doing the research and investing in capacity.

Even flu vaccines have benefited, because government agencies got a bunch of scientists to come together and produce their best guess as to what strains to vaccinate against each year, so that there only had to be one vaccine that everyone got, and mandating that insurance companies had to pay for it.

But with the current administration in the U.S. suggesting that vaccines are generally bad, I fear we’re going to see less of that: fewer mandates are going to mean fewer vaccines being administered. Obviously that’s going to mean more sick people, which is really bad. But almost as bad, it’s going to reduce the economies of scale, meaning that the per-shot cost of vaccines are likely to rise significantly.

This all got me to thinking, what would a post-mandated-vaccines world look like?

Well, only smart people would buy vaccines, and only rich people would be able to afford them.

How many people are both smart and rich? And how rich would you have to be? Depending on how much prices went up, maybe only the top 50% would be able to afford them, maybe the top 10%, maybe the top 1%.

One small upside might be that boutique vaccine shops could find it worthwhile to make better vaccines—modestly better effectiveness, modestly reduced side-effects—because there’d be vaccine competition.

Really, though, there was always a strong push for that stuff for mandated vaccines, because if you’re going to give out 300 million doses, even a tiny improvement is going to really matter.

Still, I read a year or so ago about a version of the Covid-19 vaccine that produced much longer-lasting immunity being discontinued because they couldn’t sell enough of it, because it wasn’t mandated. That’s the sort of thing that might get better in a post-mandate world.

Won’t be a net win for society. Probably not even a net win for the 1% who can afford whatever bespoke vaccines they want, because it costs billions to research and test a vaccine, and even the 1% can’t afford that, unless they all get together and fund joint projects.

A selfie showing the bandage on my arm where I just got my Covid shot

These thoughts brought to you by me getting my Covid shot now rather than waiting until just a few weeks before I go visit my 92-year-old mother—because who knows if it’ll be available then?

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I’ve been hearing for years about how much trouble Social Security is in, and how pretty soon there won’t be enough money left in the trust fund to pay everyone’s pensions in full, and how we’ll have to raise taxes or cut benefits. That’s almost entirely false.

The Greenspan commission that restructured Social Security back in 1983 got almost everything right (which is why we haven’t needed to change Social Security tax rates, diddle around with the cost of living adjustments, nor change the age at which people retire for forty years). The one thing they got wrong?

Back then, about 90 percent of all wages were subject to Social Security payroll taxes. Today, that’s dropped to around 82.6 percent as more income has shifted above the taxable maximum.

Source: Actually, Social Security Nailed It In 1983

The most common suggestion for “fixing” Social Security is to get rid of the ceiling on the amount of income subject to the tax, but that’s the wrong way to think about it. Getting rid of the ceiling would decouple the size of the eventual pension from the size of the income that earned it, which would give conservatives yet another hook for criticizing the program.

The right fix is to boost incomes of those at the bottom, so that once again 90% of all wages are under the Social Security tax ceiling.

Making sure that lower-income people earn enough money to live on will fix Social Security as a side-effect.

Pretty cool, eh?

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In the run-up to the campaign I saw reports of young people, frustrated that Biden hadn’t managed to do the huge student loan forgiveness that he’d tried to do, say that they weren’t going to vote for him or for Kamala. “If he can’t get this thing done, why should I support him?” Here’s why:

“Beginning May 5, the department will begin involuntary collection through the Treasury Department’s offset program, which withholds payments from the government — including tax refunds, federal salaries, and other benefits — from people with past-due debts to the government. After a 30-day notice, the department will also begin garnishing wages for borrowers in default.”

Source: https://finance.yahoo.com/news/student-loans-default-referred-debt-200132438.html

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Poor Ms. Feuerstein. She just suffers and suffers. I bet she’s as tired as the rest of us of the Leopards-Eating-Faces jokes.

China has long relied on the U.S. for soybeans. But with new steep tariffs, it is likely to look even more to Brazil and Argentina.

Source: How Trump’s Tariffs Could Hurt US Farmers and Benefit Brazil – The New York Times

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Many politicians and financial analyst types are suggesting that the Fed should “look through” tariff-induced price hikes. Superficially this makes sense, because a one-time cost increase is not the same thing as inflation. Unfortunately, we know that the results are bad.

The example I’m thinking of is the price shock from much higher oil prices due to the 1973 OPEC oil embargo. As that price shock moved through the economy, first oil prices went up, then gasoline prices went up, but very shortly all prices moved up, because every business faced higher energy costs, and needed to pass at least a fraction of them forward. And then, of course, all the businesses that bought things from those businesses needed to raise their prices further, and workers started demanding higher wages because their costs were going up.

The Federal Reserve tried to “look through” that price shock, not raising interest rates, even though prices were rising. As I say, this makes sense. The one-time price shock will move through the economy, raising many prices by various amounts (depending on how much the inputs for each particular item increase in cost, and the market constraints on price increases for each particular item). Once that all works through the economy, the prices increases should stop.

In fact, raising interest rates could easily make things worse, because the cost of credit is another cost to nearly all businesses, so it’s just another expense that they have to pass on, and it’s a cost to employees, that they’ll want to recover in wage negotiations.

But we know what happened: Inflation rose enough that the Fed eventually decided that it needed to raise interest rates. Higher interest rates hurt the economy, threatening to produce a recession. The Fed cut interest rates to head off the threatened recession, which led to inflation, which led to the Fed raising rates again, etc.

The result was the stagflation of the 1970s, which only ended when new Fed chairman Paul Volker raised rates high enough to produce a severe recession, and then kept them high for long enough to wring the inflation out of the economy.

To me it’s clear that “looking through” the “one-time” price shock of higher tariffs will produce the same result. The Fed can probably mitigate it by holding rates at their current levels until the price shock works its way through the economy (which will probably take a least a year, because many prices (wages, rents, etc.) are only renegotiated annually), and only cut rates after price increases settle back down to close to the Fed’s 2% target.

I assume the Fed governors know this. Do they have the courage to take the right action? Only time will tell.