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Trump's Taxes Show Something’s Wrong With the Capital System

Trump's Taxes Show Something’s Wrong With the Capital System

The world is finally learning the details of President Donald Trump’s taxes. The revelations raise all kinds of issues, from the president’s own conflicts of interest to the degree to which the wealthy are able to game the tax system. But Trump’s taxes also show there are potentially serious problems in the way the U.S. financial system allocates capital.

Over the past decade, Trump lost large amounts of money on a series of businesses — golf courses, hotels, resorts, and so on. These were operating losses, rather than losses from investment in business growth. While it’s possible those losses were overstated with creative accounting, the overall takeaway is that Trump isn’t very good at creating profitable businesses. What’s more, he has hundreds of millions of dollars in loans still outstanding.

Why would U.S. financial markets dish out such huge sums of money to a businessman who routinely fails to channel that money into profitable projects? Trump is obviously quite famous and well-known, but fame alone doesn’t make someone a good investment. More likely, there is simply a lot of cheap capital sloshing around in the U.S. financial system.

Since the mid-2000s, it has become much easier to borrow money than it used to be:

Trump's Taxes Show Something’s Wrong With the Capital System

This is probably not because lenders have become more risk-tolerant; spreads between mid-grade corporate bonds and long-term Treasuries have not fallen over time, and junk bond spreads are about where they were in the early ‘90s. Nor does it appear to be because lenders have become more patient, as spreads between long-term and short-term Treasuries are actually a bit higher than in the ‘90s.

That means the main source of cheap money is simply the overall decline in interest rates. Central banks lowered rates to near zero and engaged in multiple rounds of quantitative easing to fight the Great Recession and never raised rates back to where they had been. Meanwhile, some argue a savings glut from East Asian exporters has pumped more cheap money into the U.S. financial system.

But if the world is being drowned in a flood of cheap capital, then that suggests another mystery: Why are stock returns still so high? U.S. stocks performed almost as well in the 2010s as during the boom years of the ‘80s and ‘90s:

Trump's Taxes Show Something’s Wrong With the Capital System

Standard economic theory says this isn’t supposed to happen. When a surfeit of loanable funds floods into the financial system, it’s supposed to drive down the return on capital. Cheap money should result in marginal businesses (like Trump’s golf courses) getting funded, and this should create more competition, driving down profits and stock returns for even the healthiest businesses.

But this isn’t happening. Profits have actually risen as a share of GDP since the turn of the century:

Trump's Taxes Show Something’s Wrong With the Capital System

Trump may not be making much profit, but plenty of businesses are. And even though financial markets are throwing lots of money away on businesses like Trump’s, those marginal enterprises are unable to compete away the profits of the winners.

The obvious conclusion is that standard economic theory doesn’t apply to the current situation. Economists Simcha Barkai and Matthew Rognlie have both written papers arguing the apparent high returns on capital are actually something else. Barkai calls it the “profit share,” while Rognlie labels it “factorless income.”

One possible source of these profits is increasing market power, which Barkai suggests could come from rising barriers to entry. But Rognlie doubts this thesis, arguing instead that financial markets have simply become disconnected from companies’ real investment decisions in ways economists don’t yet understand. Though cheaper money may make some marginal businesspeople such as Trump more eager to spend on questionable projects, in other words, it hasn’t had this effect in general.

This suggests financial capital is being rationed in the U.S., rather than allocated by the price mechanism. Investors are willing to lend huge amounts of money very cheaply, but only to a tightly circumscribed set of borrowers -- big powerful companies, famous personalities like Trump, and so on. That would make corporate investment similar to the post-2008 mortgage market, in which rates have been low but lending standards have been tightened so much that many people can’t borrow at all.

If capital is being rationed in the U.S., then it means many smaller, unproven but capable businesses are probably struggling to get the money they need to expand and grow. If the system is ignoring these promising upstarts to throw money at big names, then lowering market bond yields further won’t boost investment much and could even lower productivity as capital is misallocated to monopolies and hucksters.

Instead of thinking about how to lower the price of capital, then, central banks might think about how to channel capital specifically to borrowers who are currently shut out of the market. Otherwise, the U.S. could just end up with more Trump-style losses.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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