Regime Uncertainty: Political Risk is Transaction Cost!

We walk through the weirdly powerful math that makes a stable $10,000 profit stream worth $50,000 in one world and $1,000,000 in another. Then we apply the same present value logic to politics and show how unpredictable rules raise transaction costs, inflate the effective discount rate, and freeze long-term investment.
• the discount rate as the hidden driver of valuation
• why the consol bond makes present value intuitive
• P = X / R as a shortcut for long-lived assets
• how low interest rates mechanically boost asset prices
• discount rates as opportunity cost plus inflation plus risk
• regime uncertainty as political risk priced into investment
• how New Deal “experimentation” can prolong a downturn
• modern examples through tariffs tax policy and regulation
• a listener puzzle on why Coke concentrate costs more
Tell me what the answer is.
If anybody knows of a recording of the George M. Cohan play, Broadway musical, I would certainly like to be able to find it.

Michael Munger, "How Interest Rates Set Asset Prices: One Weird Trick," The Daily Economy, May 28, 2025 

Robert Higgs, "Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War," The Independent Review, Spring 1997 

Amity Shlaes, The Forgotten Man: A New History of the Great Depression (HarperCollins, 2007)

Franklin D. Roosevelt, Oglethorpe University commencement address, May 22, 1932 

Book o-da-week:  Robert Higgs, Depresssion, War, and Cold War, (reprint) Independent Institute. 

If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !

You can follow Mike Munger on Twitter at @mungowitz 

Transcript

The Discount Rate Thought Experiment

Michael Munger 0:00

This is Mike Munger, the knower of important things from Duke University. Here's a question. Consider two firms. They make exactly the same product, sell it to the same consumers, and earn exactly the same ten thousand dollars a year in real terms. In profit forever. So we can ignore inflation. Those two firms are actually the same firm in two different states of the world. State one, the firm is sure that the discount rate for those profits is twenty percent. State two, the firm is sure that the discount rate is one-tenth of one percent. Now is anything about those two firms that are actually one firm different? No. Is firm two worth the same amount of money as firm one? Not even close. If the discount rate used to value that stream of profit is 20%, the firm is worth $50,000. If the rate is one-tenth of one percent, that is, you're very certain about the future, the same firm, same product, same customer, same $10,000, is worth a million dollars. Nothing changed, only the discount rate changed. And that number did all the work in determining the value of the firm. Now, that's that one weird trick for understanding financial value. And the discount rate is largely determined by well, transaction costs. Today we're going to use it twice. First to explain how interest rates, discount rates, quietly set the price of everything bonds, houses, stocks, whole companies. Then we're going to point to the same formula and look at politics. It turns out that the discount rate is not set by banks. Governments set it too, whenever they make the rules of the game unpredictable. You discount the future more if the future is unpredictable. Economists have a name for that, regime uncertainty. Once you see the mechanism, you'll understand why Emily Schles could look at the 1930s and conclude the thing prolonging the Great Depression wasn't the crash, it wasn't capitalism, it was the relentless, undisciplined political tinkering that followed, raising the transaction cost of investing. Straight out of Creedmore, this is Tidy C.

SPEAKER_01 2:21

I don't think about a system where there were no transaction costs.

unknown 2:25

It's an imaginary system. There always are transaction costs.

SPEAKER_01 2:34

And it is costly to transact.

Consol Bonds And A Clean Formula

Michael Munger 2:42

Let's start with a strange but useful instrument, the console, C-O-N-S-O-L. In 1751, the British government under Chancellor Henry Pelham rolled a tangle of expensive war debts into a single new bond. It paid a fixed coupon rate, 3% of face value every year forever. No maturity date, no moment when you cash it in for principal, just a check indefinitely. Now, economists love consoles because they simplify a hard problem. Ordinarily, valuing a bond means adding up a stream of discounted future payments one year at a time, all the way to maturity, which is some fixed future date. That's tedious. A console never matures. The math collapses into a strikingly clean rule. It's the present value of an infinite series. The price of the bond equals the yearly payment divided by the prevailing interest rate. So full stop, that's simple. P equals x over R. P equals X over R. The price of the bond is equal to the yearly payment divided by the prevailing interest rate. Now, that little formula generalizes to almost anything that produces a stream of value over time, even if it's not infinite, particularly if the discount rate is pretty high. So if it just goes out into the indefinite future, rental property, a patent, a firm's expected profits. You know the payment, you know the discount rate, you know the price, or at least you have an estimate of the price. Because most long-lived assets are, for practical purposes, close enough to a console that 30 years is close to forever when you're discounting. The formula is not just a curiosity. It's the hidden engine under most of the asset prices you see quoted every day. Which is why the rate matters so much more than people expect. Push the interest rate from 20% down towards zero. And holding profits fixed, the value of the firm doesn't creep upward, it explodes upward. 5,000, 10,000, 50,000, 100 million, without the firm doing one additional thing to earn it. For roughly three decades, the Federal Reserve held the federal funds rate artificially below what the standard policy rule would recommend, sometimes near zero outright. Every asset that is priced off that rate, stocks, real estate, whole industry, inherited an artificial boost that had nothing to do with their underlying productivity. Now, hold that thought because we're about to point to the identical formula, somewhere nobody usually points at it, the rules of the game themselves.

Risk Inflation And Transaction Costs

Michael Munger 5:26

Here's the transactions cost aspect. So far, R is meant the interest rate. But the discount rate, the thing that investors use to consider how valuable something will be in the future, is the sum of three elements. The opportunity cost of borrowing, which is the rental cost of money in this case, the risk or uncertainty that surrounds that specific investment, and the rate of inflation or the devaluation of the asset being loaned. These elements are actually general. Suppose you have a chainsaw. Happens I just borrowed my son's chainsaw, a steel 261C. It's a great chainsaw. It really makes hard jobs easy. Suppose someone wanted to rent the chainsaw. Now the rental price would be the sum of the opportunity cost. The renter has the saw, so the owner isn't able to use it. The risk it'll be damaged or won't be returned. And the devaluation or depreciation of the asset, returned with less value than when it was borrowed. Now, I have used chainsaws for many hours. I understand how to tighten the chain, mix fuel, check the bar oil reservoir, and to use that motosierra safely. My son might be willing to rent me the saw at a low price. But suppose I was sketchy. Can't be sure that I'll take care of the saw, might break it, might not return it. At a minimum, then my son would charge a high price, but he might not be willing to rent out the saw at all. It's just too risky. So in the formula P equals X over R, that R is really doing a broader job than the cost of funds. It's the rate at which a decision maker discounts a future dollar to make it comparable to a dollar today. And that discount rate has to include every risk attached to actually collecting the payment. So in this case, we're trying to decide what X should be. And X, that is the payment that my son would have to get in order to be willing to rent out the saw, would have to be so high that it approaches the price of the saw itself, and no one's going to rent for that. That's default risk, inflation risk. If you're a business owner, political risk.

Regime Uncertainty And Capital Strike

Michael Munger 7:35

The chance that the rules under which you earn $10,000 a year get rewritten before you get to collect it. Economists call a severe, sustained version of political risk regime uncertainty, a term that the great economist and economic historian Robert Higgs developed to explain why private investment stayed depressed over most of the 1930s, even after output looked like it had begun to recover. Higgs' insight was that investors weren't just pricing in a bad economy, they were pricing in a government whose next move on property rights, taxation, and the structure of markets could not be forecast. And an unforecastable R doesn't behave like a slightly higher R. It behaves like a discount rate with no stable value at all. Now we're talking about a variance of a future forecast. If we run that through our formula, that can send the present value of a long-lived investment towards zero, even if the expected annual profit never budges. And if the expected annual profit is zero, we will see what Franklin Roosevelt angrily called a capital strike. People will just keep their money in the bank because it's not worth investing. So this does raise knowledge problem as a challenge. The progressive response, though, was to invoke tétonnement or trial and error or groping for a solution. This notion of experimentation as a discovery process is part of the DNA of the progressive organon, the approach of the Roosevelt administration, as was made clear by Roosevelt himself in his 1932 speech at Oglethorpe University. Here's what he said. Now, this is the summer of 32, is before he was elected. Let us not confuse objectives with methods. Too many so-called leaders of the nation fail to see the forest because of the trees. Too many of them fail to recognize the vital necessity of planning for definite objectives. True leadership calls for setting forth of the objectives and rallying of public opinion in support of these objectives. So, pause the quote for a moment. That's just nonsense. You can't say we're going to plan to have people invest in industry. They have to do that because they think they're going to earn a profit. Back to the quote. But above all, try something. End of quote. Well, they tried everything, and they pretty much announced they were going to try everything, and they were constantly going to be changing what they were doing. Completely unsurprisingly, business left its money in the bank because otherwise they were just going to lose it. So Amity Schlaes in her 2008-2019 books, Goldberg in 2019, showed that there's a great difference between experimentation by individuals working on many different dimensions at the margin, that is, people trying things out to see if they work, and a constant change in the tax policy, the aggregate policy, definition of property rights, the fundamental direction of policy. Each economic entrepreneur individually is trying out an idea, and they're going to be disciplined by the logic of profit and loss. Entrepreneurial governments, and I'm making quote marks, entrepreneurial. Entrepreneurial governments are trying out a single large-scale experiment where the very fact of policy uncertainty kills off the prospects by raising the discount rate of future profits. And it kills growth in the private sector, which, conveniently, justifies further public sector intervention in a death spiral of constant reform where you can blame the businesses for not investing. But the reason they're not investing is the constant experimentation. So, what caused the Great Depression?

Why Investment Stayed Frozen In 1936

Michael Munger 11:26

Preconditions were set up by enormous debt and very bad monetary policy, as has been shown by Milton Friedman and Rose Schwartz in their Monetary History of the United States. But the reason that the depression was great, meaning really long and awful, was transaction cost. A volatile and unpredictable discount rate caused by regime uncertainty deflates the value of committing capital to anything with a payoff more than a year or two out, again for reasons that have nothing to do with real output or expected profits. Same formula, same mechanism, opposite sign. Businesses will not invest. And this was typical of 1936 and 1937. All of the investments that firms were willing to engage in had a six-month, nine-month, maybe at most a year, expected return. They weren't going to invest in anything long term. And the Roosevelt administration blamed them for that, but they were doing that because of the constant bold experimentation, which meant that I didn't know what was going to happen a year out. I couldn't make any guess about whether I would be able to earn revenues that would exceed my costs. Any stable rule, even a bad rule, lets a firm write a contract, sign a lease, hire an engineer, calculate a present value. What's awful is an unstable rule, one that might flip in the next legislative session or in the next whim of an executive order from a president who just sees himself as all-powerful. The next agency rulemaking, the next executive order, all of those things force the firm to spend real resources just finding out what the law is, or to abandon the investment rather than pay the cost of finding out. Uncertainty about the rules is itself a transaction cost. It gets capitalized directly into the price of everything that has a long life. Roosevelt specifically said he was going to be changing everything constantly. He announced that. You didn't see that again until the Great Recession following 2008. President Obama literally did the same thing, announcing that the changes in tax policies and bailouts would be continuous and unpredictable. Once again, regime uncertainty caused an extended recession. What that means is we've learned exactly nothing. President Trump has created the greatest level of regime uncertainty since Roosevelt, easily surpassing Obama as a risk ninja. Constant changes in subsidies, tariff rates, and immigration worker policies have made it impossible for businesses to guess what profits will be.

Tariffs Taxes And Regulatory Whiplash

Michael Munger 13:59

Let's make this concrete with three categories, each one a different flavor of the same disease. The rate is not merely high, that is, the discount rate is not merely high, it's unknown, and it keeps changing. First, tariffs and constant change. Consider a manufacturer deciding whether to build a plant that sources components from three countries. The profitability of that plant depends on tariff schedules that in recent years have been imposed, escalated, paused, exempted, and then reimposed, sometimes within the same fiscal quarter, sometimes in the same week. It's not that tariffs are high, hybrid fixed tariffs can be planned around. A firm builds those into its cost structure and prices accordingly. It's harmful, but it's not death. The damage comes from tariffs that are high this month, absent next month, doubled the month after, applied to some trading partners and not others by criteria that change with the news cycle because of the whims of the president. A firm cannot discount a 10-year supply chain investment at a stable rate when the single biggest line item in its cost structure is being set by press releases. The rational response isn't to guess, it's to wait. Or to over-diversify at a cost premium simply to buy insurance against a policy nobody can forecast. Second, tax policy and constant change. This is the same story, there's just a different lever. A firm evaluating a piece of long-lived capital equipment needs to know how long that equipment will be depreciated for tax purposes over its useful life. Bonus depreciation, expensing rules for research costs, the corporate rate itself. When those provisions are enacted with sunset dates, revised retroactively or left to expire and then restored after the fact, the firm isn't facing a known tax rate. It's facing a distribution of possible tax rates with no stable center. Two firms with identical expected pre-tax profits can arrive at wildly different aftertax present values and therefore capitalization or the value of their stock, depending on which of several plausible tax regimes they assume will be enforced five years from now. And the honest answer is neither of them actually knows. Third, regulation on safety. This third category is subtler because safety regulations sound like it should be the most stable of the three. After all, physics doesn't change. But the compliance requirement does. A plant that must decide whether to install a particular safety system faces a regulator whose standard has, within a single administration's term, been tightened, then stayed pending litigation, then rescinded, then proposed again in a completely different form. If the firm installs the equipment and the rule is rescinded, it has sunk capital it didn't need. If it waits and the rule snaps back retroactively, it faces penalties or a forced, more expensive retrofit. There's no discount rate that correctly prices a coin flip between two entirely different regulatory worlds. So firms often do the economically rational but socially perverse thing. They just put investment off. Delay it altogether, including the safety investment, until the rule stops moving. Notice what all three share. In each case, the expected value of compliance or noncompliance may not have changed much at all. What changed is the variance, the width of the distribution of possible futures a firm has to plan around. And the variance in R, the discount rate, run through the very same present value formula from the first part of this podcast. It destroys investment value just as surely as a high level of R does. Regime uncertainty isn't a different phenomenon from the interest rate story. It's the same math applied to the same rate, but this time it's political risk that's getting discounted. This is where Amity Schley's history in her book The Forgotten Man becomes more than a good story, becomes a case study in exactly this mechanism. Schlay's argument is that the stock market crash of 1929 explains the onset of the depression, but it doesn't explain the duration. What explains the duration in her telling is the decade that followed, an unbroken sequence of large, improvised, and frequently contradictory interventions. The National Industrial Recovery Act shifting industry codes, the undistributed profits tax that punish firms for retaining earnings and not wasting money, labor law rewritten on short notice, tariff policy inherited from Smoot Hawley layered under all of it, each one arriving as an experiment rather than a settled rule. Try something. If it fails, admit it frankly, and try something else. Well, that's a fine disposition for a laboratory or a firm. It's a worst case disposition for a government setting the rules that business must discount decades of investment against, because every new experiment resets the clock on what the rules actually are. If we put Schlay's and Robert Higgs together, you get a single coherent transaction cost story. Regime uncertainty, Higgs shows, is harmful to investment. Amity Schlay's gives the history that shows that regime uncertainty was not just characteristic, but was the intention of the New Deal. It wasn't any one New Deal policy was necessarily ruinous on its own terms. It was that the policy environment as a whole behaved like a discount rate with no stable value, tariff-like unpredictability, tax-like unpredictability, regulatory unpredictability, all three simultaneously for a decade. If we run that through the formula from the first part of this podcast, we don't get a firm worth one-tenth as much. You get a firm whose owners cannot compute a present value at all and they simply decline to invest and close, which is precisely the pattern of depressed private investment that let unemployment remain high after output had begun to recover. So

The Big Takeaway On Present Value

Michael Munger 19:49

a dollar of profit ten years from now is worth exactly as much as the rate you use to bring it back to today. Discount rates are a kind of time travel, but the dollar is transformed by the trip. Central banks that hold that rate artificially low inflate the value of everything long-lived for reasons that have nothing to do with productivity. Governments that make the rules of the game unpredictable actually do the opposite of their intention. They inflate the effective rate, or more precisely its variance, and deflate deflate the value of everything long-lived for reasons that have nothing to do with the usual story about creativity and profit. Whoa.

A 1937 Musical About Market Fear

Michael Munger 20:30

That sound means it's time for the twedge. I found a Broadway musical by George M. Cohen. It was started on Broadway, debuted in 1937, and this was one of the songs called Off the Record. It's sung by the Franklin Roosevelt character. I looked for a recording of it, but I've been unable to find one. If anybody knows of a recording of the George M. Cohen play, Broadway musical, I would certainly like to be able to find it. But the part of the song I I have the script. My speeches on the radio have made me quite a hero. I only have to say my friends and stocks go down to zero. Don't print it, it's strictly off the record. So the title of the song is off the record, and that's supposedly that is the Franklin Dell Nor Roosevelt character singing that. When he says my friends, it means he is going to propose a new bold experimentation and the value of stocks all go down to zero. Well,

Why Coke Concentrate Can Cost More

Michael Munger 21:33

the letter from a year ago, which I missed. Dear Mike, knower of important things. I hope all is well. This week a friend of mine asked me why it was cheaper to buy Coke in individual bottles than the concentrated mix. I would expect individual bottles to have much higher shipping and storage costs. For reference, a concentrated mix makes 6.5 liters of coke for each liter of mix, coming to a bit over $1.50 per liter of Coke. At one of the largest supermarket chains in Germany, the price is as low as .79 euros per liter on sale and up to normally not on sale €10. Now that's for a two-liter bottle. So why would it be that it's $3 for two liters of Coke if you buy the concentrate, and less than half that if you buy the Coke that is not concentrate? I told my friend that I didn't know the answer to his question, but that the answer certainly involved transaction cost, and that we should ask you the nerve important things. I hope that gives me at least partial credit. All the best from your European listeners, PT. P.S. Could it be price discrimination? Restaurants need to save space and use more coke than the average consumer and are willing to pay more for the concentrated syrup. They also have high markups on coke, leading to an even higher willingness to pay. End of letter. Well, I PT, I don't know the answer to that. It's a terrific example. And let me make sure that there were a bunch of numbers there. If you buy the concentrated mix and you are able to mix it with carbonated water for free, it's going to cost a Euro fifty per liter or three Euros for two liters of Coke that you make from the concentrate. If you go to the grocery store, you can get a 1.5-liter bottle for 0.79 euros, less than one euro. And you often can find the two-liter bottles for a Euro 10. Why would it be that the bottles of Coke are so much cheaper than the concentrate? Because it seems like shipping on the bottles of Coke would be much more expensive. I don't know the answer to that. I'd like to think the answer is transaction cost, but I also would like to challenge our listeners. Tell me what the answer

Book Of The Week And Sign Off

Michael Munger 24:04

is. The Book of the Week is Robert Higgs' book on the subject we've been talking about. A lot of people know his book called Crisis and Leviathan. This book was published by Oxford University Press, and it's called Depression, War and Cold War: Studies in Political Economy. Oxford University Press, 2006. It was later reissued by the Independent Institute under the title Depression, War and Cold War: Challenging the Myths of Conflict and Prosperity. I highly recommend it. Robert Higgs is one of my heroes, and that book that describes regime uncertainty is one that deserves a lot more attention than it gets. Well, that's it for this week. Talk to you again next week on The Answer is Transaction Costs.