Ch8: Firms, the Stock Market, and Corporate Governance

An Old-Fashioned Bank Run: The Collapse of Silicon Valley Bank [This post will be updated as new information becomes available. Updated Monday morning March 13.]

Photo from the Wall Street Journal

Rumors spread about the financial state of a bank. Some depositors begin to withdraw funds from their accounts. Suddenly a wave of withdrawals occurs and regulators step in and close the bank. A description of a run on a bank in New York City in the fall of 1930? No. This happened to Silicon Valley Bank, headquartered in Santa Clara, California and the sixteenth largest bank in the United States, on Friday, March 10, 2023.

Background on Bank Runs

In Macroeconomics, Chapter 14, Section 14.4 (Economics, Chapter 24, Section 24.4) we describe the basic reasons why a run on a bank may occur. We describe bank runs in greater detail in Money, Banking, and the Financial System, Chapter 12. We reproduce here a key paragraph on the underlying fragility of commercial banking from Chapter 12 of the money and banking text:

The basic activities of commercial banks are to accept short-term deposits, such as checking account deposits, and use the funds to make loans—including car loans, mortgages, and business loans—and to buy long-term securities, such as municipal bonds. In other words, banks borrow short term from depositors and lend, often long term, to households, firms, and governments. As a result, banks have a maturity mismatch because the maturity of their liabilities—primarily deposits—is much shorter than the maturity of their assets—primarily loans and securities. Banks are relatively illiquid because depositors can demand their money back at any time, while banks may have difficulty selling the loans in which they have invested depositors’ money. Banks, therefore, face liquidity risk because they can have difficulty meeting their depositors’ demands to withdraw their money. If more depositors ask to withdraw their money than a bank has money on hand, the bank has to borrow money, usually from other banks. If banks are unable to borrow to meet deposit withdrawals, then they have to sell assets to raise the funds. If a bank has made loans and bought securities that have declined in value, the bank may be insolvent, which means that the value of its assets is less than the value of its liabilities, so its net worth, or capital, is negative. An insolvent bank may be unable to meet its obligations to pay off its depositors.

The Founding of the Fed and the Establishment of the FDIC as a Response to Bank Runs

The instability of the banking system led to a number of financial crises during the 1800s and early 1900s, culminating in the Panic of 1907. Congress responded by passing the Federal Reserve Act in 1913, establishing the Federal Reserve System. The Fed was given the role of lender of last resort, making discount loans to banks that were experiencing deposit runs but that remained solvent. The failure of the Fed to stop the bank panics of the early 1930s led Congress to establish the Federal Deposit Insurance Corporation (FDIC) to ensure deposits in commercial banks, originally up to a limit of $2,500 per deposit, per bank. The current limit is $250,000.

Deposit insurance reduced the likelihood of runs but increased moral hazard in the banking system by eliminating the incentive insured depositors had to monitor the actions of bank managers. In principle, bank managers still have an incentive to avoid making risky loans and other investments for fear of withdrawals by households and firms with deposits that exceed the dollar deposit limit.

Contagion, Moral Hazard, and the Too-Big-to-Fail Policy

But if these depositors fail to monitor risk taking by bank managers or if a bank’s loans and investments decline in price even though they weren’t excessively risky at the time they were made, the FDIC and the Fed face a dilemma. Allowing banks to fail and large depositors to be only partially paid back may set off a process of contagion that results in runs spreading to other banks. Problems in the banking system can affect the wider economy by making it more difficult for households and firms that depend on bank loans to finance their spending. (We discuss the process of contagion in this post on the Diamond-Dybvig model.)

The Fed and the FDIC can stop the process of contagion if they are willing to ensure that large depositors don’t suffer losses. One mechanism to achieve this result is facilitating a merger between an insolvent bank and another bank that agrees to assume responsibility for meeting depositors withdrawals from the insolvent bank. But stopping contagion in this manner with no depositors suffering losses can be interpreted as amounting to deposit insurance having no dollar limit. The result is a further increase in moral hazard in the banking system. When the federal government does not allow large financial firms to fail for fear of damaging the financial system, it is said to be following a too-big-to-fail policy.

Silicon Valley Bank and VCs

Runs on commercial banks have been rare in recent decades, which is why the run on Silicon Valley Bank (SVB) took many people by surprise. As its name indicates, SVB is located in the heart of California’s Silicon Valley and the bank played an important role in the financing of many startups in the area. As such, SVB provided banking services to many venture capital (VC) firms. As we note in Chapter 9, Section 9.2 of the money and banking text, venture capital firms play an important role in providing funding to startup firms:

VCs such as Sequoia Capital, Accel, and Andreessen Horowitz raise funds from investors and invest in small startup firms, often in high-technology industries. In recent years, VCs have raised large amounts from institutional investors, such as pension funds and university endowments. A VC frequently takes a large ownership stake in a startup firm, often placing its own employees on the board of directors or even having them serve as managers. These steps can reduce principal–agent problems because the VC has a greater ability to closely monitor the managers of the firm it’s investing in. The firm’s managers are likely to be attentive to the wishes of a large investor because having a large investor sell its stake in the firm may make it difficult to raise funds from new investors. In addition, a VC avoids the free-rider problem when investing in a firm that is not publicly traded because other investors cannot copy the VC’s investment strategy.

An article on bloomberg.com summarized SVB’s role in Silicon Valley. SVB is

the single most critical financial institution for the nascent tech scene, serving half of all venture-backed companies in the US and 44% of the venture-backed technology and health-care companies that went public last year. And its offerings were vast — ranging from standard checking accounts, to VC investment, to loans, to currency risk management.

Note from this description that SVB acted as a VC—that is, it made investments in startup firms—as well as engaging in conventional commercial banking activities, such as making loans and accepting deposits. The CEO of one startup was quoted in an article in the Wall Street Journal as saying, “For startups, all roads lead to Silicon Valley Bank.” (The Wall Street Journal article describing the run on SVB can be found here. A subscription may be required.)

SVB’s Vulnerability to a Run

As with any commercial bank, the bulk of SVB’s liabilities were short-term deposits whereas the bulk of its assets were long-term loans and other investments. We’ve discussed above that this maturity mismatch means that SVB—like other commercial banks—was vulnerable to a run if depositors withdraw their funds. We’ve also seen that in practice bank runs are very rare in the United States. Why then did SVB experience a run? SVB was particularly vulnerable to a run for two related reasons:

1. Its deposits are more concentrated than is true of a typical bank. Many startups and VCs maintain large checking account balances with SVB. According to the Wall Street Journal, at the end of 2022, SVB had $157 billion in deposits, the bulk of which were in just 37,000 accounts. Startups often initially generate little or no revenue and rely on VC funding to meet their expenses. Most Silicon Valley VCs advised the startups they were invested in to establish checking accounts with SVB.

2. Accordingly, the bulk of the value of deposits at SVB was greater than the $250,000 FDIC insurance limit. Apparently 93 percent to 97 percent of deposits were above the deposit limit as opposed to about 50 percent for most commercial banks.

Economics writer Noah Smith notes that SVB required that startups it was lending to keep their deposits with SVB as a condition for receiving a loan. (Smith’s discussion of SVB can be found on his Substack blog here. A subscription may be required.)

The Reasons for the Run on SVB

When the Fed began increasing its target for the federal funds rate in March 2022 in response to a sharp increase in inflation, longer term interest rates, including interest rates on U.S. Treasury securities, also increased. For example the interest rate on the 10-year Treasury note increased from less than 2 percent in March 2022 to more than 4 percent in March 2023. The interest rate on the 2-year Treasury note increased even more, from 1.5 percent in March 2022 to around 5 percent in March 2023.

As we discuss in the appendix to Macroeconomics, Chapter 6 (Economics, Chapter 8) and in greater detail in Money, Banking, and the Financial System, Chapter 3, the price of a bond or other security equals the present value of the payments the owner of the security will receive. When market interest rates rise, as happened during 2022 and early 2023, the value of the payments received on existing securities—and therefore the prices of these securities—fall. Treasury securities are free from default risk, which is the risk that the Treasury won’t make the interest and principal payments on the security, but are subject to interest-rate risk, which is the risk that the price of security will decrease as market interest rates rise.

As interest rates rose, the value of bonds and other long-term assets that SVB owned fell. The price of an asset on the balance sheet of a firm is said to be marked to market if the price is adjusted to reflect fluctuations in the asset’s market price. However, banking law allows a bank to keep constant the prices of bonds on its balance sheets if it intends to hold the bonds until they mature, at which point the bank will receive a payment equal to the principal of the bond. But if a bank needs to sell bonds, perhaps to meet its liquidity needs as depositors make withdrawals, then the losses on the bonds have to be reflected on the bank’s balance sheet.

SVB’s problems began on Wednesday, March 8 when it surprised Wall Street analysts and the bank’s Silicon Valley clients by announcing that to raise funds it had sold $21 billion in securities at a loss of $1.8 billion. It also announced that it was selling stock to raise additional funds. (SVB’s announcement can be found here.) SVB’s CEO also announced that the bank would borrow an additional $15 billion. Although the CEO stated that the bank was solvent, as an article on fortune.com put it, “Investors didn’t buy it.” In addition to the news that SVB had suffered a loss on its bond sales and had to raise funds, some analysts raised the further concern that the downturn in the technology sector meant that some of the firms that SVB had made loans to might default on the loans.

Problems for SVB compounded the next day, Thursday, March 9, when Peter Theil, a co-founder of PayPal and Founders Fund, a leading VC, advised firms Founders Fund was invested in to withdraw their deposits from SVB. Other VCs began to pull their money from SVB and advised their firms to do the same and a classic bank run was on. Because commercial banks lack the funds to pay off a significant fraction of their depositors over a short period of time, in a run, depositors with funds above the $250,000 deposit insurance limit know that they need to withdraw their funds before other depositors do and the bank is forced to close. This fact makes it difficult for a bank to stop a run once it gets started.

According to an article in the Wall Street Journal, by the end of business on Thursday, depositors had attempted to withdraw $42 billion from SVB. The FDIC took control of SVB the next day, Friday, March 10, before the bank could open for business.

The Government Response to the Collapse of SVB

The FDIC generally handles bank failures in one of two ways: (1) It closes the bank and pays off depositors, or (2) it purchases and assumes control of the bank while finding another bank that is willing to purchase the failed bank. If the FDIC closes a bank, it pays off the insured depositors immediately, using the bank’s assets. If those funds are insufficient, the FDIC makes up the difference from its insurance reserves, which come from payments insured banks make to the FDIC. After the FDIC has compensated insured depositors, any remaining funds are paid to uninsured depositors.

As we write this on Sunday, March 12, leaders of the Fed, the FDIC, and the Treasury Department, were considering what steps to take to avoid a process of contagion that would cause the failure of SVB to lead to deposit withdrawals and potential failures of other banks—in other words, a bank panic like the one that crippled the U.S. economy in the early 1930s, worsening the severity of the Great Depression. These agencies hoped to find another bank that would purchase SVB and assume responsibility for meeting further deposit withdrawals.

Another possibility was that the FDIC would declare that closing SVB, selling the bank’s assets, and forcing depositors above the $250,000 deposit limit to suffer losses would pose a systemic risk to the financial system. In that circumstance, the FDIC could provide insurance to all depositors however large their deposits might be. As discussed earlier, this approach would increase moral hazard in the banking system because it would, in effect, waive the limit on deposit insurance. Although the waiver would apply directly only to this particular case, large depositors in other banks might conclude that if their bank failed, the FDIC would waive the deposit limit again. Under current law, the FDIC could only announce they were waiving the deposit limit if two-thirds of the FDIC’s Board of Directors, two-thirds of the Fed’s Board of Governors, and Treasury Secretary Janet Yellen agreed that failure of SVB would pose a systemic risk to the financial system.

According to an article on wsj.com posted at 4 pm on Sunday afternoon, bank regulators were conducting an auction for SVB in the hopes that a buyer could be found that would assume responsibility for the bank’s uninsured deposits. [Update evening of Monday March 13: The Sunday auction failed when no U.S. banks entered a bid. Late Monday, the FDIC was planning on holding another auction, with potentially better terms available for the acquiring bank.]

Update: At 6:15 pm Sunday, the Treasury, the Fed, and the FDIC issued a statement (you can read it here). As we noted might occur above, by invoking a situation of systemic risk, the FDIC was authorized to allow all depositors–including those with funds above the deposit limit of $250,000–to access their funds on Monday morning. Here is an excerpt from the statement:

“After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer.”

[Update Monday morning March 13] As we discussed above, one of the problems SVB faced was a decline in the prices of its bond holdings. As a result, when it sold bonds to help meet deposit outflows, it suffered a $2.1 billion loss. Most commercial banks have invested some of their deposits in Treasury bonds and so potentially face the same problem of having to suffer losses if they need to sell the bonds to meet deposit outflows.

To deal with this issue, Sunday night the Fed announced that it was establishing the Bank Term Funding Program (BTFP). Banks and other depository institutions, such as savings and loans and credit unions, can use the BTFP to borrow against their holdings of Treasury and mortgage-backed securities and agency debt. (Agency debt consists of bonds issued by any federal government agency other than the U.S. Treasury. Most agency debt is bonds issued by the Government Sponsored Agencies (GSEs) involved in the mortgage market: Federal National Mortgage Association (Fannie Mae), Government National Mortgage Association (Ginnie Mae), and the Federal Home Loan Mortgage (Freddie Mac).) The Fed explained its reasons for setting up the BTFP: “The BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress.” You can read the Fed’s statement here.

On Sunday, Signature Bank was closed by New York state banking officials and the FDIC. As with SVB, the Fed, FDIC, and Treasury announced that all depositors, including those whose deposits were above the $250,000 deposit limit, would be able to withdraw the full amount of their deposits.

Shareholders in SVB and Signature Bank lost their investments when the FDIC took control of the banks. On Monday morning, investors were selling shares of a number of regional banks who might also face runs, fearing that their investments would be lost if the FDIC were to seize these banks.

President Biden, speaking from the White House, attempted to reassure the public that the banking system was safe. He stated that he would ask Congress to explore changes in banking regulations to reduce the likelihood of future bank failures.

Why Might Good News for the Job Market Be Bad News for the Stock Market?

On Tuesday, August 30, 2022, the U.S. Bureau of Labor Statistics (BLS) released its Job Openings and Labor Turnover Survey (JOLTS) report for July 2022. The report indicated that the U.S. labor market remained very strong, even though, according to the Bureau of Economic Analysis (BEA), real gross domestic product (GDP) had declined during the first half of 2022. (In this blog post, we discuss the possibility that during this period the real GDP data may have been a misleading indicator of the actual state of the economy.)

As the following figure shows, the rate of job openings remained very high, even in comparison with the strong labor market of 2019 and early 2020 before the Covid-19 pandemic began disrupting the U.S. economy. The BLS defines a job opening as a full-time or part-time job that a firm is advertising and that will start within 30 days. The rate of job openings is the number of job openings divided by the number of job openings plus the number of employed workers, multiplied by 100.

In the following figure, we compare the total number of job openings to the total number of people unemployed. The figure shows that in July 2022 there were almost two jobs available for each person who was unemployed.

Typically, a strong job market with high rates of job openings indicates that firms are expanding and that they expect their profits to be increasing. As we discuss in Macroeconomics, Chapter 6, Section 6.2 (Microeconomics and Economics, Chapter 8, Section 8.2) the price of a stock is determined by investors’ expectations of the future profitability of the firm issuing the stock. So, we might have expected that on the day the BLS released the July JOLTS report containing good news about the labor market, the stock market indexes like the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite Index would rise. In fact, though the indexes fell, with the Dow Jones Industrial Average declining a substantial 300 points. As a column in the Wall Street Journal put it: “A surprisingly tight U.S. labor market is rotten news for stock investors.” Why did good news about the labor market could cause stock prices to decline? The answer is found in investors’ expectations of the effect the news would have on monetary policy.

In August 2022, Fed Chair Jerome Powell and the other members of the Federal Reserve Open Market Committee (FOMC) were in the process of tightening monetary policy to reduce the very high inflation rates the U.S. economy was experiencing. In July 2022, inflation as measured by the percentage change in the consumer price index (CPI) was 8.5 percent. Inflation as measured by the percentage change in the personal consumption expenditures (PCE) price index—which is the measure of inflation that the Fed uses when evaluating whether it is hitting its target of 2 percent annual inflation—was 6.3 percent. (For a discussion of the Fed’s choice of inflation measure, see the Apply the Concept “Should the Fed Worry about the Prices of Food and Gasoline,” in Macroeconomics, chapter 15, Section 15.5 and in Economics, Chapter 25, Section 25.5.)

To slow inflation, the FOMC was increasing its target for the federal funds rate—the interest rate that banks charge each other on overnight loans—which in turn was leading to increases in other interest rates, such as the interest rate on residential mortgage loans. Higher interest rates would slow increases in aggregate demand, thereby slowing price increases. How high would the FOMC increase its target for the federal funds rate? Fed Chair Powell had made clear that the FOMC would monitor economic data for indications that economic activity was slowing. Members of the FOMC were concerned that unless the inflation rate was brought down quickly, the U.S. economy might enter a wage-price spiral in which high inflation rates would lead workers to push for higher wages, which, in turn, would increase firms’ labor costs, leading them to raise prices further, in response to which workers would push for even higher wages, and so on. (We discuss the concept of a wage-price spiral in this earlier blog post.)

In this context, investors interpretated data showing unexpected strength in the economy—particularly in the labor market—as making it likely that the FOMC would need to make larger increases in its target for the federal fund rate. The higher interest rates go, the more likely that the U.S. economy will enter an economic recession. During recessions, as production, income, and employment decline, firms typically experience lower profits or even suffer losses. So, a good JOLTS report could send stock prices falling because news that the labor market was stronger than expected increased the likelihood that the FOMC’s actions would push the economy into a recession, reducing profits. Or as the Wall Street Journal column quoted earlier put it:

“So Tuesday’s [JOLTS] report was good news for workers, but not such good news for stock investors. It made another 0.75-percentage-point rate increase [in the target for the federal funds rate] from the Fed when policy makers meet next month seem increasingly likely, while also strengthening the case that the Fed will keep raising rates well into next year. Stocks sold off sharply following the report’s release.”

Sources: U.S. Bureau of Labor Statistics, “Job Openings and Labor Turnover–July 2022,” bls.gov, August 30, 2022; Justin Lahart, “Why Stocks Got Jolted,” Wall Street Journal, August 30, 2022; Jerome H. Powell, “Monetary Policy and Price Stability,” speech at “Reassessing Constraints on the Economy and Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26, 2022; and Federal Reserve Bank of St. Louis.

The Economics of Sneaker Reselling

Buying athletic shoes and reselling them for a higher price has become a popular way for some people to make money. The mostly young entrepreneurs involved in this business are often called sneakerheads. Note that economists call buying a product at a low price and reselling it at a high price arbitrage. The profits received from engaging in arbitrage are called arbitrage profits. One estimate puts the total value of sneakers being resold at $2 billion per year.

Why would anybody buy sneakers from a sneakerhead that they could buy at a lower price online or from a retail store? Most people wouldn’t, which is why most sneakerheads resell only shoes that shoe manufacturers like Nike or Adidas produce in limited quantities—typically fewer than 50,000 pairs. To obtain the shoes, shoe resellers use two main strategies: (1) waiting in line at retail stores on the day that a new limited quantity shoe will be introduced, or (2) buying shoes online using a software application called a bot. A bot speeds up a buyer’s checkout process for an online sale. Typical customers buying at an online shoe site take a few minutes to choose a size, fill in their addresses, and provide their credit card information. But a few minutes is enough time for shoe resellers using bots to buy all of the newly-released shoes available on the site.

In addition to reselling shoes on their own sites, many sneakerheads use dedicated resale sites like StockX and GOAT. These sites have greatly increased the liquidity of sneakers, or the ease with which sneakers can be resold. In effect, limited-edition sneakers have become an asset like stocks, bonds, or gold because they can be bought and sold in the secondary market that exists on the online resale sites. (We discuss the concepts of primary and secondary markets for assets in Macroeconomics, Chapter 6, Section 6.2 and in Microeconomics and Economics, Chapter 8, Section 8.2.)

An article in the New York Times gives an example of the problems that bots can cause for retail shoe stores. Bodega, a shoe store in Boston, offered the limited-edition New Balance 997S sneaker on its online site. Ten minutes later, the shoe was sold out. One of the store’s owner was quoted as saying: “We got destroyed by bots. It was making it impossible for our average customers to even have a shot at the shoes.” Although the store had a policy of allowing customers to buy a maximum of three pairs of shoes, shoe resellers were able to get around the policy by having shoes shipped to their friends’ addresses or by having a group of people coordinate their purchases. An article on bloomberg.com described how one reseller along with 15 of his friends used bots to buy 600 pairs of Adidas’s Yeezy sneakers from an online site on the morning the sneakers were released. Adidas has a rule that each customer can buy only one pair of its limited-edition shoes, but the company has trouble enforcing the rule.

Shopify and other firms have developed software that retailers can use to make it difficult for resellers to use bots on the retailers’ sites. But the developers of bot software have often been able to modify the bots to get around the defenses used by the anti-bot software.

In contrast with owners of retail stores, Nike, Adidas, New Balance, and the other shoe manufacturers have a more mixed reaction to sneakerheads using bots scooping up most pairs of limited-edition shoes shortly after the shoes are released. Like the owners of retail stores, the shoe manufacturers know that they risk upsetting the typical customer if the customer can only buy hot new shoe releases from resellers at prices well above the original retail price. But an active resale market increases the demand for shoes, just as individual investors increased their demand for individual stocks when it became possible to easily buy and sell stocks online using sites like TD Ameritrade, E*Trade, and Fidelity. So manufacturers benefit from knowing that most of their limited-edition shoes will sell out. One industry analyst singled out “The durability of Nike’s … ability to fuel the sneaker resale ecosystem ….” as a particular strength of the company. In addition, manufacturers may believe that the publicity about limited edition shoes rapidly selling out may spill over to increased demand for other shoes the manufacturers sell. (In Microeconomics and Economics, Chapter 10, Section 10.3 we note that some consumers may receive utility from buying goods that are widely seen as popular and fashionable.)

In the long run, is it possible for sneakerheads to make a profit reselling shoes? It seems unlikely for the reasons we discuss in Microeconomics and Economics, Chapter 12, Section 12.5. The barriers to entry in reselling sneakers are very low. Anyone can list shoes for sale on StockX or one of the other resale sites. Waiting in line in front of a retail store on the day a new shoe is released is something that anyone who is willing to accept the opportunity cost of the time lost can do. Similarly, bots that can be used to scoop up newly released shoes from online sites are widely available for sale. So, we would expect that in the long run entry into sneaker reselling will compete away any economic profit that sneakerheads were earning.

In fact, by the summer of 2022, prices on reselling sites were falling. In just the month of June, the average price of sneakers listed on StockX declined by 20 percent. Resellers who had stockpiled shoes waiting for prices to increase were instead selling them because they feared that prices would go even lower. And new limited-edition shoes were taking longer to sell out. According to an article in the Wall Street Journal, “A pair of Air Jordans released on July 13 [2022] that might have once vanished in minutes took days to sell out from Nike Inc.’s virtual shelves.” One reseller quoted in the Wall Street Journal article indicated that entry was the reason that prices were falling: “You don’t want prices to go down, but they’re going down anyways, just because of how many people are selling in general.”

Although a seemingly unusual market, sneaker reselling is subject to the same rules of competition that we see in other markets.

Sources: Inti Pacheco, “Flipping Air Jordans Is No Longer a Slam Dunk,” Wall Street Journal, July 23, 2022; Shoshy Ciment, “Sneaker Reselling Side Hustle: Your Guide to Making Thousands Flipping Hyped Pairs of Dunks, Jordans, and Yeezys,” businessinsider.com, May 3, 2022; Teresa Rivas, “A Strong Sneaker-Resale Market Is Another Boon for Nike,” barrons.com, May 24, 2022; Curtis Bunn, “Sneakers Are So Hot, Resellers Are Making a Living Off of Coveted Models,” nbcnews.com, October 23, 2021; Daisuke Wakabayashi, “The Fight for Sneakers,” New York Times, October 15, 2021; and Joshua Hunt, “Sneakerheads Have Turned Jordans and Yeezys Into a Bona Fide Asset Class,” bloomberg.com, February 15, 2021.

You’ve Decided to Buy Twitter, So Who Are You Going to Call? Investment Banks, of Course

Elon Musk. (Photo from the Associated Press.)

That’s what Elon Musk did in April 2022. In early April, Musk purchased about 9% of Twitter’s shares. On April 25, he became the owner of Twitter by buying the roughly 90% remaining shares for $54.20 per share. The total he paid for these remaining shares came to $44 billion. Following his often unorthodox style, Musk announced his plans in a tweet on Twitter. Where did he get the money to fund such a large purchase?

According to Forbes magazine, in March 2022, Musk was by far the richest person in the world with total wealth of about $270 billion—nearly $100 billion more than Amazon founder Jeff Bezos, who is the second-richest person. While it appears that Musk could afford to buy Twitter without having to borrow any money, Bloomberg estimated that in April 2022 Musk had only $3 billion in cash. Much of his wealth was in Tesla stock or his ownership shares in SpaceX and the Boring Company, both of which are private companies that, therefore, don’t have publicly traded stock. Musk was reluctant to fund all of his offer for Twitter by selling Tesla stock or finding investors willing to buy into SpaceX and Boring.

Musk turned to investment banks to help him raise the necessary funds. Investment banks, such as Goldman Sachs, differ from commercial banks in that they don’t accept deposits, and they rarely lend directly to households. Instead, investment banks have traditionally concentrated on providing advice to firms issuing stocks and bonds or to firms (and billionaires!) who are looking for ways to finance mergers or acquisitions. A syndicate of investment banks, including Morgan Stanley (which served as Musk’s lead adviser), Bank of America, Barclays, and what an article in the Wall Street Journal described as “nearly every global blue-chip investment bank aside from the two [Goldman Sachs and JP Morgan Chase] advising Twitter,” put together the following financing package. Initially, Musk wanted to raise $46.5 billion in financing—more than in the end he needed. Of that amount, Musk would provide $21 billion and the investment banks would provide loans for the remaining $25.5 billion. As collateral for the loans, Musk pledged $60 billion of his Tesla stock.

Musk’s financing was a combination of equity—the $21 billion in cash—and debt—the $25.5 billion in loans from investment banks. To fund his equity investment, he was considering selling some of his stock in Tesla but hoped to attract other equity investors who would put up cash in exchange for part ownership of Twitter. According to press reports, Apollo Global Management, a private equity firm was considering becoming an equity investor. (As we saw in Chapter 9, Section 9.2, private equity firms raise equity capital to invest in other firms.) Musk’s purchase is called a leveraged buyout (LBO) because (1) he relied on borrowing for a substantial part of his purchase of Twitter and (2) he intended to take the company private—the company would no longer have publicly traded stock.

Why would Musk want to buy Twitter? He shared the view of some industry analysts that Twitter’s management had failed to take advantage of opportunities to increase the firm’s profit. The actions of Musk and the investment banks were part of the market for corporate control. As we discuss in Microeconomics, Chapter 8, Section 8.1 (Macroeconomics, Chapter 6, Section 6.1), in large corporations there is often a separation of ownership from control. Although the shareholders legally own the firm, the firm’s top management controls the firm’s day-to-day operations. The result can be a principal-agent problem with the management of a large firm failing to act in the best interests of the firm’s shareholders. The existence of a market for corporate control in which outsiders buy stakes in firms that appear to be poorly managed can make firms more efficient by overcoming these moral hazard problems.

But Musk had another reason for buying Twitter. As he stated in an interview, “Having a public platform that is maximally trusted and broadly inclusive is extremely important to the future of civilization.” It was unclear whether this and similar statements meant that after gaining control of Twitter he might take actions that won’t necessarily increase the firm’s profitability.

Elon Musk’s purchase of Twitter is a high profile example of the role that investment banks can play in determining control of large corporations.

Sources: Kurt Wagner, “Elon Musk Lands Deal to Take Twitter Private for $44 Billion,” bloomberg.com, April 25, 2022; Cara Lombardo and Liz Hoffman, “How Elon Musk Won Twitter,” Wall Street Journal, April 25, 2022; Michele F. Davis, “Elon Musk Vets Potential Equity Partners for Twitter Bid,” bloomberg.com, April 21, 2022; Sabrina Escobar, “Elon Musk Isn’t Twitter’s Only Problem. It Faces a Number of Short-Term Headwinds,” barrons.com, April 21, 2022; Cara Lombardo and Liz Hoffman, “Elon Musk Says He Has $46.5 Billion in Funding for Twitter Bid,” Wall Street Journal, April 21, 2022; Andrew Ross Sorkin, Jason Karaian, Vivian Giang, Stephen Gandel, Lauren Hirsch, Ephrat Livni, and Anna Schaverien, “Elon Musk Wants All of Twitter,” New York Times, April 14, 2022; Rob Copeland, Rebecca Elliott, and Cara Lombardo, “Elon Musk Makes $43 Billion Bid for Twitter, Says ‘Civilization’ At Stake,” Wall Street Journal, April 14, 2022; “The World’s Real-Time Billionaires,” forbes.com, April 24, 2022; Musk’s tweet announcing his offer to buy Twitter can be found here.

Is Vladimir Putin Acting Rationally?

Photo of Russian President Vladimir Putin from the *Wall Street Journal*.

On February 24, when Russian President Vladimir Putin launched an assault on Ukraine he apparently expected within a few days to achieve his main objectives, including occupying the Ukrainian capital of Kyiv and replacing the Ukrainian government. After three weeks, the fierce resistance of the Ukrainian armed forces have resulted in his failing to achieve these objectives. Although the Russian military had expected to experience few casualties or losses of equipment, in fact Russia has already lost more military personnel killed than the United States has since 2001 in Afghanistan and Iraq combined, as well as experiencing the destruction of many tanks, planes, and other equipment.

The United States, the European Union, and other countries have imposed economic sanctions on Russia that have reduced the country’s ability to import or export most goods, other than oil and natural gas. The sanctions have the potential to reduce the standard of living of the average Russian citizen.

Most importantly, the war has killed thousands of Ukrainians and inflicted horrendous damage on many Ukrainian cities.

Despite all this, is Putin’s persistence in the invasion rational or if he were acting rationally would he instead withdraw his troops or accept a political comprise (at this writing, negotiations between representatives of Russia and Ukraine are continuing)? First, recall the economic definition of rationality: People are rational when they take actions that are appropriate to achieve their goals given the information available to them. (We discuss rationality in Microeconomics, Chapter 10, Section 10.4, and in Economics, Chapter 10, Section 10.4.) Note that rationality does not deal with whether a person’s goals are good or bad. In this discussion, we are considering whether Putin is acting rationally in attempting to achieve the—immoral—goal of subjugating a foreign country.

Peter Coy, a columnist for the New York Times, discusses three reasons Putin may continue his attack on Ukraine even though, “The bloody invasion of Ukraine has been a disaster” for Putin. The first reason, Coy recognizes, involves an economic concept. His other two reasons can also be understood within the economic framework we employ in Microeconomics.

First, Coy argues that Putin may have fallen into one of the pitfalls to decision making we discuss in Chapter 10: A failure to ignore sunk costs. Coy notes that Putin may want to continue the attack to justify the death and destruction that has already occurred. However, those costs are sunk because no subsequent action Putin takes can reduce them. If Putin is continuing the attack for this reason, then Coy is correct that Putin is not acting rationally because he is failing to ignore sunk costs in making his decision.

There is a subtle point, though, that Coy may be overlooking: Putin is effectively a dictator, but he may still believe he needs to avoid Russian public opinion turning too sharply against him. In that case, even if recognizes that he should ignore sunk costs he may believe that the Russian public may not be willing to ignore the costs of the death and destruction that has already occurred. In that case, his refusal to ignore this sunk cost be rational.

Coy’s second reason why Putin may continue the attack is that he may believe “just another few weeks of fighting will be enough to subdue Ukraine.” Although Coy doesn’t discuss the point in these terms, it would be rational for Putin to continue the attack if he believes that the marginal benefit of doing so exceeds the marginal cost. (We discuss this point directly in Chapter 1, Section 1.1 “Optimal Decisions Are Made at the Margin,” and provided many examples throughout the text.) The marginal cost includes the additional Russian military casualties and losses of equipment from prolonging the war and the cost of economic sanctions to the Russian economy. (It seems unlikely that Putin is taking into account the additional loss of life among Ukrainians and the additional devastation to Ukrainian cities from prolonging the war.)

The marginal benefit from continuing the attack would be either winning the war or obtaining a more favorable peace settlement in negotiations with the Ukrainian government. If Putin believes that the marginal benefit is greater than the marginal cost, he is acting rationally in continuing to attack.

Coy’s final reason why Putin may continue the attack is that “he has little to lose by fighting on.” Although Coy doesn’t discuss the point in these terms, Russia may be suffering from a principal-agent problem. As we discuss in Microeconomics, Chapter 8, Section 8.1 (also Economics, Chapter 8, Section 8.1 and Macroeconomics, Chapter 6, Section 6.1) the principal-agent problem arises when an agent pursues the agent’s interst rather than the interests of the principal in whose behalf the agent is supposed to act. In this case, Putin is the agent and the Russian people are the principal. Putin’s own interest may be in prolonging the war indefinitely in the hopes of ultimately winning, despite the additional Russian soldiers who will be wounded or killed and despite the economic suffering of the Russian people resulting from the sanctions.

Although as president of Russia, Putin should be acting in the best interests of the Russian people, as a dictator, he can largely disregard their interests. Unlike his soldiers, Putin isn’t exposed to the personal dangers of being in battle. And unlike the average Russian, Putin will not suffer a decline in his standard of living because of economic sanctions.

Appalling as the consequences will be, Putin’s continuing his attack on Ukraine may be rational.

Sources: Peter Coy, “Here Are Three Reasons Putin Might Fight On,” New York Times, March 14, 2022; Alan Cullison, “Talks to End Ukraine War Pause as Russia’s Offensive Intensifies,” Wall Street Journal, March 14, 2022; and Thomas Grove, “Russia’s Military Chief Promised Quick Victory in Ukraine, but Now Faces a Potential Quagmire,” Wall Street Journal, March 6, 2022.

Macro Solved Problems on Treasury Bonds and Defining Inflation

Ernie Banks of the Chicago Cubs poses for a portrait circa 1963. (Photo by Louis Requena/MLB Photos)

With the owners of the Major Labor Baseball teams and the Major League Players Association having finally settled on a new collective bargaining agreement, the baseball season will soon begin. Ernie Banks, the late Hall of Fame shortstop for the Chicago Cubs, was known for his upbeat personality. However bad the weather might be at Chicago’s Wrigley Field, Banks would run on the field and say, “What a great day for baseball! Let’s play two.”

In honor of Ernie Banks, today let’s do two Solved Problems in macro. They both involve errors that students in principles courses often make. So, in that sense they would also work as Don’t Let This Happen to You features.

Solved Problem 1.: Bond Yields and Bond Prices

An article in the Financial Times had the following headline: “U.S. Government Bond Prices Drop Ahead of Federal Reserve Meeting.” The first sentence of the article reads: “U.S. government bond yields rose to multiyear highs on Monday ahead of this week’s Federal Reserve meeting ….”

a. When a media article mentions “U.S. government bonds,” what type of bonds are they referring to?

b. Is there a contradiction between the headline and the first sentence of the article? Is the article telling us that U.S. government bonds went up or down? Briefly explain.

Solving the Problem

Step 1: Review the chapter material. This problem is about the inverse relationship between bond yields and bond prices, so you may want to review Macroeconomics, Chapter 6, Appendix, “Using Present Value” (Economics, Chapter 8, Appendix, “Using Present Value”). You may also want to review the discussion of U.S. Treasury bonds in Macroeconomics, Chapter 16, Section 16.6, “Deficits, Surpluses, and Federal Government Debt” (Economics, Chapter 26, Section 26.6, “Deficits, Surpluses, and Federal Government Debt”).

Step 2: Answer part a. by explaining what media articles are referring to when they use the phrase “U.S. government bonds.” As discussed in Chapter 16, Section 16.6, most of the bonds issued by the federal government of the United States are U.S. Treasury bonds. The Treasury sells these bonds to investors when the federal government doesn’t collect enough in tax revenues to pay for all of its spending. So, when the media refers to U.S. government bonds, without further explanation, the reference is always to U.S. Treasury bonds.

Step 3: Answer part b. by explaining that there is no contradiction between the headline and the first sentence of the article. An important fact about bond markets is that when the price of a bond falls, the yield—or interest rate—on the bond rises. The reverse is also true: When the price of a bond rises, the yield on the bond falls. The reason why this relationship holds is explained in the Appendix to Chapter 6: The price of a bond (or other financial asset) should be equal to the present value of the payments an investor receives from owning that asset. If you buy a U.S. Treasury bond, the price will equal the present value of the coupon payments the Treasury sends you during the life of the bond and the final payment to you by the Treasury of the principal, or face value of the bond. Remember that present value is the value in today’s dollars of funds to be received in the future. The higher the interest rate, the lower the present value of a payment to be received in the future. So a higher yield, or interest rate, on a bond results in a lower price of the bond because the higher yield reduces the present value of the payments to be received from the bond.

Therefore, whenever the yield on a bond rises, the price of the bond must fall (and whenever the yield on a bond falls, the price of the bond must rise. So, we can conclude that the headline of the Financial Times article and the first sentence of the article are consistent, not contradictory: Because the prices of Treasury bonds fell, the yields on the bonds must have risen.

Source: Nicholas Megaw, Naomi Rovnick, George Steer, and Hudson Lockett, “U.S. Government Bond Prices Drop Ahead of Federal Reserve Meeting,” ft.com, March 14, 2022.

Solved Problem 2: Being Careful about the Definition of Inflation

An article in the New York Times contrasted inflation during the 1970s with inflation today:

“Price increases had run high for more than a decade by the time Mr. Volcker became chair [of the Federal Reserve Board of Governors] in 1979 …. Shopper expected prices to go up, businesses knew that, and both acted accordingly. This time, inflation has been anemic for years (until recently), and most consumers and investors expect costs to return to lower levels before long, survey and market data show.”

a. What does the article mean by “inflation has been anemic for years”?

b. In the last sentence what “costs” is the article referring to?

c. Is the article correctly using the definition of inflation in the last sentence? Briefly explain.

Solving the Problem

Step 1: Review the chapter material. This problem is about the definition of inflation, so you may want to review Macroeconomics, Chapter 9, Section 9.4, “Measuring Inflation” (Economics, Chapter 20, Section 20.4, “Measuring Inflation”).

Step 2: Answer part a. by explaining what the phrase “inflation has been anemic for years” means. Anemia is a medical disorder that usually has the symptom of fatigue. So, the word “anemic” is often used to mean weak. The article is arguing that until recently, the inflation rate had been weak, or slow.

Step 3: Answer part b. by explaining what the article is referring to by “costs.” Economists typically use the word costs for the amount that firm pays to produce a good—labor costs, raw material costs, and so on. Here, though, the article is using “costs” to mean “prices.” Costs is often used this way in everyday conversation: “I didn’t buy a new car because they cost too much.” Or: “Has the cost of a movie ticket increased?”

Step 4: Answer part c. by explaining whether the article is correctly using the definition of inflation. In writing “consumers and investors expect costs to return to lower levels” the article is making a common mistake. The article seems to mean that consumers and investors expect that the rate of inflation will be lower in the future. But even if the rate of inflation declines from nearly 8 percent in early 2022 to, say, 3 percent in 2023, prices will still be increasing. So, prices (“costs” in the sentence) will still be higher next year even if the rate of inflation is lower. In other words, even if the rate of increase in prices—inflation—declines, the price level will still be higher.

It’s a common mistake to think that a decline in the inflation rate means that prices will be lower, when actually prices will still be increasing, just more slowly.

Source: Jeanna Smialek, “Powell Admires Volcker. He May Have to Act Like Him,” New York Times, March 14, 2022.

Fanatics: The Unlikely Unicorn

A unicorn is a startup, or newly formed firm, that has yet to begin selling stock publicly and has a value of $1 billion or more. (We discuss the difference between private firms and public firms in Economics and Microeconomics, Chapter 8, chapter opener and Section 8.2, and in Macroeconomics, Chapter 6, chapter opener and Section 6.2.) Usually, when we think of unicorns, we think of tech firms. That assumption is largely borne out by the following list of the 10 highest-valued U.S.-based startups, as compiled by cbinsights.com.

Firm	Value
SpaceX	$100.3 B
Stripe	$95 B
Epic Games	$42 B
Instacart	$39 B
Databricks	$38 B
Fanatics	$27 B
Chime	$25 B
Miro	$17.5 B
Ripple	$15 B
Plaid	$13.4 B

Nine of the ten firms are technology firms, with six being financial technology—fintech—firms. (We discuss fintech firms in the Apply the Concept, “Help for Young Borrowers: Fintech or Ceilings on Interest Rates,” which appears in Macroeconomics, Chapter 14, Section 14.3, and Economics, Chapter 24, Section 24.3.) The one non-tech firm on the list is Fanatics, whose main products are sports merchandise and sports trading cards. Because a unicorn doesn’t issue publicly traded stock, the firm’s valuation is determined by how much an investor pays for a percentage of the firm. In Fanatics’s case, the valuation was based on a $1.5 billion investment in the firm made in early March 2022 by a group of investors, including Fidelity, the large mutual find firm; Blackrock, the largest hedge fund in the world; and Michael Dell, the founder of the computer company.

These investors were expecting that Fanatics would earn an economic profit. But, as we discuss in Chapter 14, Section 14.1 and Chapter 15, Section 15.2, a firm will find its economic profit competed away unless other firms that might compete against it face barriers to entry. Although Fanatics CEO Michael Rubin has plans for the firm to expand into other areas, including sports betting, the firm’s core businesses of sports merchandise and trading cards would appear to have low barriers to entry. There are already many firms selling sportswear and there are many firms selling trading cards. The investment required to establish another firm to sell those products is low. So, we would expect competition in the sports merchandise and trading card markets to eliminate economic profit.

The key to Fanatics success is that it is selling differentiated products in those markets. Its differentiation is based on a key resource that competitors lack access to: The right to produce sportswear with the emblems of professional sports teams and the right to produce trading cards that show images of professional athletes. Fanatics has contracts with the National Football League (NFL), Major League Baseball (MLB), the National Hockey League (NHL), the National Basketball Association (NBA), and Major League Soccer (MLS)—the five most important professional sports leagues in North America—to produce jerseys, caps, and other sportswear that uses the copyrighted brands of the leagues’ teams. (In some cases, as with the NBA, Fanatics shares the right with another firm.)

Similarly, Fanatics has the exclusive right to produce trading cards bearing the images of NFL, NBA, and MLB players. In January 2022, Fanatics bought Topps, the firm that for decades had held the right to produce MLB trading cards.

Fanatics has paid high prices to these sports leagues and their players to gain the rights to sell branded merchandise and cards. Some business analysts questioned whether Fanatics will be able to sell the merchandise and cards for prices high enough to earn an economic profit on its investments. Fanatics CEO Rubin is counting on an increase in the popularity of trading cards and the increased interest in sports caused by more states legalizing sports gambling.

That Fanatics has found a place on the list of the most valuable startups that is otherwise dominated by tech firms indicates that many investors agree with Rubin’s business strategy.

Sources: “The Complete List of Unicorn Companies,” cbinsights.com; Miriam Gottfried and Andrew Beaton, “Fanatics Raises $1.5 Billion at $27 Billion Valuation,” Wall Street Journal, March 2, 2022; Tom Baysinger, “Fanatics Scores $27 Billion Valuation,” axios.com March 2, 2022; Lauren Hirsch, “Fanatics Is Buying Mitchell & Ness, a Fellow Sports Merchandiser,” New York Times, February 18, 2022; and Kendall Baker, “Fanatics Bets Big on Trading Card Boom,” axios.com, January 5, 2022.

Solved Problem: U.S. Treasury Bonds and the Russian Invasion of Ukraine

Supports: Macroeconomics, Chapter 10, Section 10.5, Economics Chapter 20, Section 20.5, and Essentials of Economics, Chapter 14, Section 14.2.

On March 2, 2022, as the conflict between Russia and Ukraine intensified, an article in the Wall Street Journal had the headline “Investors Pile Into Treasurys as Growth Concerns Flare.” The article noted that: “The 10-year Treasury yield just recorded its largest two-day decline since March 2020, while two-year Treasury yields plunged the most since 2008.”

a. What does it mean for investors to “pile into” Treasury bonds?

b. Why would investors piling into Treasury bonds cause their yields to fall?

c. What are “growth concerns”? What kind of growth are investors concerned about?

d. Why might growth concerns cause investors to buy Treasury bonds?

Solving the Problem

Step 1: Review the chapter material. This problem is about the effects of slowing economic growth on interest rates, so you may want to review Chapter 10, Section 10.5, “Saving, Investment and the Financial System.” You may also want to review Chapter 6, Appendix A (in Economics, Chapter 8, Appendix A), which explains the inverse relationship between bond prices and interest rates.

Step 2: Answer part a. by explaining what the article meant by the phrase “pile into” Treasury bonds. The article is using a slang phrase that means that investors are buying a lot of Treasury bonds.

Step 3: Answer part b. by explaining why investors piling into Treasury bonds will cause the yields on the bonds to fall. As the Appendix to Chapter 6 explains, the price of a bond represents the present value of the payments that an investor will receive over the life of the bond. Lower interest rates result in a higher present value of the payments received and, therefore, higher bond prices or—which is restating the same point—higher bond prices result in lower interest rates. If investors are increasing their demand for Treasury bonds, the increased demand will cause the prices of the bonds to increase and cause the yields—or the interest rates—on the bonds to fall.

Step 4: Answer part c. by explaining the phrase “growth concerns.” In this context, the growth being discussed is economic growth—changes in real GDP. The headline indicates that investors were concerned that the Russian invasion of Ukraine might lead to slower economic growth in the United States.

Step 5: Answer part d. by explaining why investors might purchase Treasury bonds if they were concerned about economic growth slowing. Using the model of the loanable funds markets discussed in Chapter 10, Section 10.5, we know that if economic growth slows, firms are likely to engage in fewer new investment projects, which would shift the demand curve for loanable funds to the left and result in a lower equilibrium interest rate. Investors who have purchased Treasury bonds will gain from a lower interest rate because the price of the Treasury bonds they own will increase. In addition, stock prices depend on investors’ expectations of the future profitability of firms issuing the stock. Typically, if investors believe that economic growth is likely to be slower in the future than they had previously expected, stock prices will fall, which would make Treasury bonds a more attractive investment. Finally, investors believe there is no chance that the U.S. Treasury will default on its bonds by not making the interest payments on the bonds. During an economic slowdown, investors may come to believe that the default risk on corporate bonds has increased because some corporations may run into financial problems. An increase in the default risk on corporate bonds increases the relative attractiveness of Treasury bonds as an investment.

Source: Gunjan Banerji, “Investors Pile Into Treasurys as Growth Concerns Flare,” Wall Street Journal, March 2, 2022.

Inflation, Interest Rates, and Stock Prices

Caution: Long post!

An article in the Wall Street Journal quoted an economist at a financial services firm as noting that strong growth in wages could lead to sustained inflation. The article stated that as a result “the yield on the 10-year U.S. Treasury note [rose to] within reach of 2%” and that: “Rising [bond] yields this year have rattled markets and hurt tech stocks in particular ….”

What are the links between wage inflation and price inflation, inflation and bond yields, and bond yields and stock prices—particularly the prices of tech stocks?

The link between wage inflation and price inflation. The monthly “Employment Situation” reports from the Bureau of Labor Statistics (BLS), in addition to providing data on payroll employment and the unemployment rate, also provide data on average hourly earnings (AHE). AHE are the wages and salaries per hour worked that private, nonfarm business pay workers. AHE don’t include the value of benefits that firms provide workers, such as contributions to 401(k) retirement accounts or health insurance. The following figure shows changes in AHE from the same month in the previous year. The figure shows that since the Covid-19 pandemic first began to affect the U.S. economy in March 2020, AHE have moved erratically. But since the fall of 2021, growth in AHE has been consistently above the 2 percent to 4 percent range that prevailed in the years after the end of the Great Recession of 2007–2009.

Employee compensation is the largest cost for most firms. For the economy as whole, employee compensation is about 80 percent of total costs. When firms pay higher wages per hour, their costs per unit of output don’t rise unless the wage increases are greater than the rate of growth of labor productivity, or output per hour worked. Increases in wages in the range of 5 percent to 6 percent are well above the rate of growth of labor productivity and, so, firms are likely to pass through the wage increases by raising prices. Note that the higher prices may prompt workers to push for higher wage increases to offset the decline in the real purchasing power of their wages, potentially setting off a wage-price spiral. (We discussed the possibility of a wage-price spiral in a recent post here.)

The link between inflation and bond yields. When investors lend money by, for instance, buying a bond, they are concerned with the interest rate they will receive after correcting for the effects of inflation. In other words, they focus on the real interest rate, which is equal to the nominal interest rate, or the stated interest rate on the loan or bond, minus the expected inflation rate:

Real interest rate = Nominal interest rate – Expected inflation rate.

We can rewrite this relationship as:

Nominal interest rate = Real interest rate + Expected inflation rate.

The second equation indicates that if investors expect the inflation rate to increase, then, unless the real interest rate changes, the nominal interest rate will increase. The Fisher effect is the idea associated with Yale economist Irving Fisher that the nominal interest rate rises or falls by the same number of percentage points as the expected inflation rate. So, for instance, if investors expect that the inflation rate will increase from 3 percent to 5 percent, then the nominal interest rate will also increase by two percentage points.

Because of real-world frictions, such as the broker fees that investors pay when buying and selling bonds and the taxes investors pay when they sell a bond that has increased in price, the Fisher effect doesn’t hold exactly. Still, most economists agree that an increase in the expected inflation rate will cause an increase in nominal interest rates. The following figure shows movements in the interest rate on 10-year Treasury notes (blue line) and in inflation (red line). Note that, roughly speaking, the interest rate on the 10-year Treasury note is higher when inflation is higher and lower when inflation is lower. (We discuss real and nominal interest rates in Macroeconomics, Chapter 9, Section 9.6 and in Economics, Chapter 19, Section 19.6. We discuss the Fisher effect in Money, Banking, and the Financial System, Chapter 4, Section 4.3.)

The link between bond yields and stock prices. As wage inflation leads to price inflation and price inflation leads to higher interest rates on bonds—particularly U.S. Treasury bonds—why might stock prices be affected? First, investors consider U.S. Treasury bonds to be default risk free, which means that investors are certain that the Treasury will make the interest and principal payments on the bonds. Stock investments are much riskier because they depend on the future profits of the firms issuing the stocks and those profits may fluctuate in ways that are difficult for investors to anticipate. So as interest rates on Treasury bonds increase, some investors will decide to sell stocks and buy bonds, which will cause a decline in stock prices.

Second, most people value funds they will receive now or soon more highly than funds they will receive in the more distant future. For instance, if someone offered to pay you $1,000 today or $1,000 one year from now, you will prefer to receive the money today. In other words, the present value, or value today, of a payment you won’t receive until the future is worth less than the face value of the payment. For instance, the present value of $1,000 you won’t receive for a year is worth less than $1,000 in present value. The higher the interest rate is, the lower the present value of payments, such as dividends, that you will receive in the future.

Economists believe that price of a financial investment, like a bond or a stock, is equal to the present value of the payments you will receive from owning the asset. If you own a bond, you will receive interest payments and payment of the bond’s principal when the bond matures. If you own a stock, you will receive dividends, which are the payments that firms make to shareholders from the firms’ profits. Therefore stock prices should reflect the present value of the dividends that investors expect to receive from owning the stock. (We discuss present value and the relationship between interest rates and stock and bond prices in Macroeconomics, Chapter 6, Appendix, in Economics, Chapter 8, Appendix, and, more completely, in Money, Banking, and the Financial System, Chapter 3, Section 3.2 and Chapter 6, Section 6.2.)

The Wall Street Journal article we quoted above notes that the rising interest rate on the 10-year Treasury note was causing price declines in tech stocks in particular. The explanation is that tech firms often go through an initial period in which they may make very low profits or even suffer losses. Investors may still be willing to buy stock in tech firms because they expect the firms eventually to increase their profits and the dividends they pay. But because those profits will be earned in the future—often after a period of losses that may stretch for years—the present value of the profits and, therefore, the price of the stock depends more on the interest rate than would be true of a firm making breakfast cereal or frozen pizza that will be steadily earning profits through the years. Therefore, we would expect, as the article indicates, that the prices of tech firms are more likely to decline—or to decline more—when interest rates rise than is true of other firms.

The following figure shows the interest rate on the 10-year Treasury note (blue line with scale given on the left) and the values of the Nasdaq composite stock index (red line with the value for January 1, 2010 set equal to 100 and the scale given on the right). The Nasdaq includes the stocks of more tech firms than is true of the other widely followed stock market indexes—the S&P 500 and the Dow Jones Industrial Average. The figure shows that the declining interest rate on 10-year Treasury notes that began in late 2018 and continued through mid-2020 coincided with increases in the prices of the stocks in the Nasdaq index—apart from the spring of 2020 during the beginning of the Covid-19 pandemic. The most recent period shows that increases in the interest rate on the 10-year Treasury note have corresponded with a decline in the Nasdaq, as noted in the article.

Source: Sam Goldfarb, “Elevated Bond Yields Approach Key Milestone,” Wall Street Journal, February 7, 2022; U.S. Bureau of Economic Analysis, “Prices, Costs, and Profit per Unit of Real Gross Value Added of Nonfinancial Domestic Corporate Business,” January 27, 2022; and Federal Reserve Bank of St. Louis.

New Information on Fed Policy Affects Stock and Bond Prices

Jerome Powell (photo from the *Wall Street Journal*)

Most economists believe that monetary policy actions, such as changes in the Fed’s pace of buying bonds or in its target for the federal funds rate, affect real GDP and employment only with a lag of several months or longer. But monetary policy actions can have a more immediate effect on the prices of financial assets like stocks and bonds.

Investors in financial markets are forward looking because the prices of financial assets are determined by investors’ expectations of the future. (We discuss this point in Economics and Microeconomics, Chapter 8, Section 8.2, Macroeconomics, Chapter 6, Section 6.2, and Money, Banking and the Financial System, Chapter 6.) For instance, stock prices depend on the future profitability of firms, so if investors come to believe that future economic growth is likely to be slower, thereby reducing firms’ profits, the investors will sell stocks causing stock prices to decline.

Similarly, holders of existing bonds will suffer losses if the interest rates on newly issued bonds are higher than the interest rates on existing bonds. Therefore, if investors come to believe that future interest rates are likely to be higher than they had previously expected them to be, they will sell bonds, thereby causing their prices to decline and the interest rates on them to rise. (Recall that the prices of bonds and the interest rates (or yields) on them move in opposite directions: If the price of a bond falls, the interest rate on the bond will increase; if the price of a bond rises, the interest rate on the bond will decrease. To review this concept, see the Appendix to Economics and Microeconomics Chapter 8, the Appendix to Macroeconomics Chapter 6, and Money, Banking, and the Financial System, Chapter 3.)

Because monetary policy actions can affect future interest rates and future levels of real GDP, investors are alert for any new information that would throw light on the Fed’s intentions. When new information appears, the result can be a rapid change in the prices of financial assets. We saw this outcome on January 5, 2022, when the Fed released the minutes of the Federal Open Market Committee meeting held on December 14 and 15, 2021. At the conclusion of the meeting, the FOMC announced that it would be reducing its purchases of long-term Treasury bonds and mortgage-backed securities. These purchases are intended to aid the expansion of real GDP and employment by keeping long-term interest rates from rising. The FOMC also announced that it intended to increase its target for the federal funds rate when “labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.”

When the minutes of this FOMC meeting were released at 2 pm on January 5, 2022, many investors realized that the Fed might increase its target for the federal funds rate in March 2022—earlier than most had expected. In this sense, the release of the FOMC minutes represented new information about future Fed policy and the markets quickly reacted. Selling of stocks caused the S&P 500 to decline by nearly 100 points (or about 2 percent) and the Nasdaq to decline by more than 500 points (or more than 3 percent). Similarly, the price of Treasury securities fell and, therefore, their interest rates rose.

Investors had concluded from the FOMC minutes that economic growth was likely to be slower during 2022 and interest rates were likely to be higher than they had previously expected. This change in investors’ expectations was quickly reflected in falling prices of stocks and bonds.

Sources: An Associated Press article on the reaction to the release of the FOMC minutes can be found HERE; the FOMC’s statement following its December 2021 meeting can be found HERE; and the minutes of the FOMC meeting can be found HERE.