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FLOWS - Liquidity, Credit and Debt

Lurking Beneath The Taper: More Trouble In Repo Land 09-18-14  Alhambra's Jeffrey Snider via Contra Corner blog,

Since we are now in the middle of the final month of a quarter, checking repo stats shows what we have come to expect of a fragile liquidity system. Once again, repo fails spiked sharply in the latest weekly statistics from FRBNY as primary dealers and the Fed’s own repo “fix” fail to affect the “resiliency” that FOMC members appear desperate to attach.  However, since the repo market is far, far away from the everyday nobody pays much attention.

The problem with liquidity is always that it’s not what you see today when all seems well and abundance is seemingly effective, it is actually what to expect when you need it most.  From the standpoint of central banks, that has been their operating assumption (at least as portrayed publicly) since the nineteenth century.  The Federal Reserve itself was dedicated on the principle of currency elasticity, which is exactly this point – to be that liquidity when it is most needed as private markets shy away.

Unfortunately, modern incarnations of these central banks still mostly apply nineteenth century rules, policies and even understanding to a 21st century banking system that does not so easily follow generic incantations of simplistic theory.  

The “money supply” right now is no such thing, as money has vanished from banking. 

Liquidity itself is not dependent on “money supply” so much as the means and channels for flow. 

That was a lesson learned the hard way by those that assured everyone in 2007 that all was “contained.”

The message of resiliency is then a main part about incorporating those shortcomings into the current framework. When Janet Yellen proclaims that markets are so “resilient” that she would prefer they not even bother about such negativity she means to say that the Fed is more than aware of flow and liquidity and has taken that to heart.  Indeed, they instituted the reverse repo program (actually it was just an expansion of existing lines) last year to live up to elasticity doctrine in the real “currency” of the modern bank: collateral.

There has been a noticeable uptick in reverse repo usage in the past few months, but nothing that would suggest anything awry.

Outside of the surge in May, there is a seeming straight line upward trend that was established all the way back when the Fed first tapered in December.  In that important respect, there does seem to be some correlation with reverse repo usage and the repo market.  That includes the very important changes that have taken hold of repo volumes in US$ terms.

While focus is often placed on UST collateral, MBS repo was at least astride UST in terms of size and volume.  That changed quite a bit after QE3 began as you would expect given how QE strips the “market” of needed and usable securities.  However, we can also see this same imprint in the UST repo market as well.

Again, that makes sense given that QE4 was instituted to take UST collateral, a topic that has gained actual attention in the past eighteen months (including a very needed adjustment to the Open Market Desk policy almost from the start).  From these figures we can reasonably assume that where QE was impactful in turning repo volumes lower, its taper has accomplished the opposite.

In addition to the very real concerns of secular stagnation and asset bubbles, rather than how the economy actually exists right now, these repo “costs” are a major factor in the impetus toward the monetary exit.  However, like everything else with monetary intrusion, simply ending the manipulation is not the same as never having undertaken it.  In another example erasing the figment of monetary neutrality, there is a clear diminishment in repo capacity and thus “resiliency” on this side of the QE taper.

The change in repo volume since the middle of 2014 has been significant, but only just now approaching levels that would be considered “normal” last year (and before).  Yet, for all that additional volume there has been a repeated signal of distress through fails.  There was the major episode in June just as repo volume had turned upward, and then again in July as the same occurred.  And, as I noted at the beginning, we are now in the third major instance of a fails problem (without any corresponding surge in reverse repo usage that was “supposed” to occur if the Fed’s “fix” were anything like one).

What we are left with is much worse than when this all started.  The problem of QE in repo terms was that it not only stripped usable collateral from dealer inventories and from other holders where it might be used as supply, it has seemingly diminished the entire repo market’s capacity to withstand even a relatively minor increase in volume.  What was normal in 2013 seems to create something of a stir in function in 2014. That these are mostly clustered around quarter ends continues the systemic weakness that has been apparent in every major market “event” of this period, adding to the judgment that “resilience” is nothing but PR and wishful thinking.

The problem for “markets” is that this is a primary liquidity conduit indicating significant and persistent degradation under, again, very benign conditions.  In my analysis, there is no doubt that QE is the primary culprit here and that its removal is not “allowing” a healing process to begin but instead revealing the damage.  With the Fed’s reverse repo program having no input whatsoever, it just adds to the weight of evidence that policymakers don’t really know what they are doing and are just making it up as they go.

With compliant media that gives total deference to orthodox economics, the speeches and soundbites are enough reassurance to stave off much needed inquisition.  For now.

FUNDAMENTALS - An Overvalued Market By An Measure

• 44 VC start-up companies in the IPO pipeline with a valuation of more than $1 billion each, despite no earnings and scarce revenues—-is indicative of late stage bubble dynamics - January 2000!
• During the 66 months since the March 2009 bottom, when the S&P 500 rose by 200%, the speculative precincts of the stock market have soared by orders of magnitude more. The Russell 2000, for example, peaked at a gain of nearly 260%, and, of course, the biotech and social media indices went off the charts, registering gains north of 300%.
• This time the fallacy of Wall Street’s ex-items hockey stick is even more blatant and transparent. During the period since late 2011, the stock market has risen nearly 50% yet reported S&P earnings per share are up hardly 10%. And virtually, the entirety of even that plodding gain is attributable to the surge of corporate buybacks in the interim. Indeed, as the WSJ reminded yesterday, the run rate of share repurchases in the first half of 2014 had nearly regained the blow-off level of 2007.
• Even if we had not experienced an unprecedented 68 straight months of zero interest rates that must now be normalized in the years ahead, and a global boom that is coming unwound everywhere from China and Japan to Turkey, Europe and Brazil, why would you consider a 20X multiple on the big cap stocks “well within the range of historical experience”?
• The market is pushing 20X honest reported earnings, therefore, and is sitting exactly where it was in the fall of 2007.

"Even the leading venture capitalists now recognize that the insanity of the dotcom era has re-emerged."

Excerpted from: How Financial Bubbles Fester And Burst—Even As The Fed Says Not To Worry 09-17-14 David Stockman

THEY NEVER SAW 2007 COMING EITHER - WHY?

The Fed.. " still professing to see no significant speculative excesses because they are looking in the wrong place. Janet Yellen, for instance, keeps insisting that stock valuation multiples are still well within “historic ranges”. So do not be troubled.

Well, she’s talking about the global big cap stocks represented in the S&P 500 and is buying the Wall Street ex-items hockey stick that projects $125 per share next year (15.8X) after you exclude recurring “non-recurring” losses; and also after setting aside various asset write-offs that reflect the penchant for capital destruction (job restructurings, plant and store closures and excess purchase price or goodwill charges) that has become epidemic in big company C-suites during the era of bubble finance.

So the bubble blindness starts here. The very last thing you can believe is Wall Street’s version of the so-called broad market multiple—especially near the end of a Fed money printing cycle. When the S&P 500 peaked at 1570 in October 2007, for example, Wall Street’s forward-looking ex-items hockey stick was about $115 for 2008—-or hardly 14X.  Nothing to worry about there. It was all good and in the historic range.

Until it wasn’t, and the index hit 670—-a 57% plunge—-17 months later. And by the way, ex-items earnings for 2008 came in more than 50% lower—–at about $55 per share, and only $15 per share on an honest GAAP basis.

For the four-year period as a whole, the Wall Street sell side claimed ex-item earnings of $2.42 trillion for the entire basket of big cap global companies. And that was the sum of what actually happened, not the hockey sticks projected for each up-coming year. On average over the period, therefore, the broad market traded at 17.3X ex-items EPS—not “cheap”, as Wall Street had claimed prior to the bust, by any means.

But that’s Wall Street’s version of “earnings”. You would think the Fed would at least give some weight to the fact that in its wisdom, Washington spends several billion per year at the DOJ and SEC prosecuting companies and executives for violations of GAAP—sometimes even hairline infractions. So presumably there is something valuable in adherence to honest and consistent corporate accounting and disclosure.

But when I looked at the same four years (2007-2010) for the S&P 500 based on what companies had actually reported to the SEC in their filings, rather than the manicured version of their earnings touted by Wall Street, it turns out the cumulative net income was only $1.87 billion on a GAAP compliant basis.

So based on the financial reports vouched for by CEOs and CFOs not wishing to risk a spell of hospitality at one of  Uncle Sam’s country club’s, S&P 500 earnings were a staggering $550 billion less than the street version. In truth, therefore, the Wall Street version of earnings was over-stated by nearly 30%, and the broad market traded at an average multiple of 23X during this four year period.

This is another way of saying that the market—especially near a bubble top—-is always held to be “not yet fully valued” and tends to trade reliably at about 15X the sell-side’s ex-items hockey stick. And it means absolutely nothing.

At the present moment, in fact, LTM earnings for the S&P 500 are about $100 per share based on GAAP and historically consistent treatment of pension accounting. The market is pushing 20X honest reported earnings, therefore, and is sitting exactly where it was in the fall of 2007. Back then reported earnings peaked at $85 per share—about 18.5X the market top reached during the last Fed bubble.

Self-evidently, the monetary politburo has learned nothing in the interim. And that is especially so for Janet Yellen who spent the spring and summer of 2008 at Fed meetings opining about the to-and-fro of “in-coming” macroeconomic data without even noticing that a ferocious explosion was brewing on Wall Street.

Yet this time the fallacy of Wall Street’s ex-items hockey stick is even more blatant and transparent. During the period since late 2011, the stock market has risen nearly 50% yet reported S&P earnings per share are up hardly 10%. And virtually, the entirety of even that plodding gain is attributable to the surge of corporate buybacks in the interim. Indeed, as the WSJ reminded yesterday, the run rate of share repurchases in the first half of 2014 had nearly regained the blow-off level of 2007.

Beyond that, the corporate profit margins embedded in the $100 per share of GAAP earnings posted for the LTM through June had soared beyond the 2007 peak and was now in financial terra incognita.

So even if we had not experienced an unprecedented 68 straight months of zero interest rates that must now be normalized in the years ahead, and a global boom that is coming unwound everywhere from China and Japan to Turkey, Europe and Brazil, why would you consider a 20X multiple on the big cap stocks “well within the range of historical experience”?

But the next point is even more telling.  The S&P 500 is the last place where the bubble finally manifests itself. During the 66 months since the March 2009 bottom, when the S&P 500 rose by 200%, the speculative precincts of the stock market have soared by orders of magnitude more. The Russell 2000, for example, peaked at a gain of nearly 260%, and, of course, the biotech and social media indices went off the charts, registering gains north of 300%.

What happened, therefore, is blatantly obvious.  As the venture capital world cashed-in during the mid-cycle surge, Silicon Valley was flooded with winnings from IPOs and a tsunami of new institutional capital looking to get on the bandwagon. This, in turn, fueled an outpouring of more start-ups, bolder VC valuations and, soon, a plentitude of candidates for the parade of earning-less and increasingly revenue-less IPOs.

As detailed by Wolf Richter below, even the leading venture capitalists now recognize that the insanity of the dotcom era has re-emerged. One of these days, even the monetary politburo may notice.  But by then it will be too late. Again.

By Wolf Richter At Wolf Street

Not everything is hunky-dory in the world of stocks. The S&P 500, which has been hovering near its all-time high and hasn’t experienced a decline of 10% in three years, has been the focal point of breathless media coverage. But beneath the surface, the stocks of smaller companies are being put through the meat grinder.

Bloomberg found that 47% of all stocks in the Nasdaq have skidded at least 20% from their 12-month high; 40% of the stocks in the Russell 2000 and, chillingly, 40% of those in the Bloomberg IPO index have made that same trip south. They’re now languishing in their own bear-market purgatory. Investors have been fleeing these companies for months. I wrote about that phenomenonin May, but it has gotten worse since.

Yet, 44 startups that have not yet gone public and have not yet been acquired have valuations of over $1 billion, with five of them in (or nearly in) the $10 billion club. Uber tops the list with a valuation of $18 billion. And Snapchat, one of these $10-billion outfits, doesn’t even have revenues yet.

It’s at this confluence of excess and exuberance on one side and sub-surface carnage on the other that a voice from the venture capital world speaks up: Bill Gurley, a partner at Benchmark and investor in Uber, Zillow, OpenTable, and others, lamented in an interview with the Wall Street Journal the “excessive amount of risk” piling up in Silicon Valley: “In some ways less silly than ’99 and in other ways more silly than in ’99,” he said.

That comparison to the final outburst of craziness of the dotcom bubble before it blew up is ominous, even for him. But not for the entrepreneurs out there today, of whom perhaps as many as 60% or 70%, he said, “weren’t around in ’99, so they have no muscle memory whatsoever.”

And he pointed at the result of nearly free money sloshing into Silicon Valley, and why all excesses end badly: when startups are raising hundreds of millions of dollars, as they are these days, they’re encouraged to spend it, and so they speed up their “burn rate.”

And I guarantee you two things: One, the average burn rate at the average venture-backed company in Silicon Valley is at an all-time high since ’99 and maybe in many industries higher than in ’99. And two, more humans in Silicon Valley are working for money-losing companies than have been in 15 years, and that’s a form of discounted risk.

These “excessive amounts of capital” lead to trouble as startups are getting used to reckless spending.

And that can be seriously, negatively reinforced by the capital market. In the software-as-a-service world, where the risk is potentially among the highest, Wall Street has said it’s OK to lose tons of money as a public company. So what happens in the board rooms of all the private companies is they say, “Did you see that? Did you see they went out and they’re losing tons of money and they’re worth a billion? We should spend more money.” And there are people knocking on their door saying, “Do you want more money, do you want more money?”

They do want more money. To justify the additional capital, these companies, which often don’t have revenues and can’t even imagine what it would be like to generate enough cash internally to survive, increase their burn rate. They move into digs with more expensive leases, and hire more people and increase their compensation, and they serve delicious free lunches…. Excessive capital reinforces every mortal sin a business can commit [read... How the Surge of Hot Money Pushes San Francisco to the Brink].

And so Gurley rephrased what bankers have known for eons – that bad loans are made in good times. The way he sees it “bad business behavior is coincidental with the best of times in our field.” Excessive amounts of capital nurtures this bad business behavior and covers it up and distracts from the core of what a business should do. Incentives get distorted and priorities take a turn for the bizarre. Everyone who has been around the scene with open eyes has seen the symptoms. “So, the crazier things get, the worse people execute,” he said.

Excessive amounts of capital lead to a lower average fitness because fitness, from a business standpoint, has to be cash-flow profitability or the ability to generate cash flow. That’s the essence of equity value. And so I think we get further and further away from that in the headiest of times.

The excesses are spreading around. Now landlords in San Francisco that are charging “two or three times what the rent was three years ago” are demanding 10-year leases, he said. If they thought rents would continue to go up, they wouldn’t try to lock in the current rates for ten years. They know something the startup world has learned in 2000 and 2001 but has already forgotten. But their strategy won’t work.

When the money flow dries up, “the types of gymnastics” that these companies would have to do “to readjust their spend is massive.” When the prior tech bubble imploded, “half the companies went bankrupt, and they couldn’t pay the lease over the 10-year period.” Many of these companies simply evaporated after they’d blown through their investors’ money. In 2001, tech companies announced nearly 700,000 job cuts. And this time? Excessive amounts of capital thrown around willy-nilly by giddy investors with grandiose hopes at companies with puny if any revenues and endless losses always ends badly.

How much does it cost to manipulate the entire IPO and startup market? Not much. And it’s getting cheaper! It was leaked that VC firm Kleiner Perkins Caufield & Byers would sprinkle $20 million on Snapchat. But the tiny deal would raise Snapchat valuation to $10 billion. Read… Pump and Dump: How to Rig the Entire IPO Market with just $20 Million

PATTERNS - Options Buying

Click to Enlarge & Full Discount Table

BACKDROP

WHAT THE MARKETS LOOKED LIKE WHEN THIS BEGAN

(Technically Breaking Down)

WHAT OCCURRED

PATTERNS - Russell at Trend Line Support

PATTERNS - MACRO DIVERGENCES

PATTERNS - "M" Tops

FINANCIAL REPRESSION NOW TARGETING AMERICANS ABROAD

7.6M AMERICANS LIVING ABROAD are now being treated lke crooks by being cut off by banks and brokerages as a result of US FINANCIAL REPRESSION A U.S. crackdown on "money laundering and tax evasion" is the excuse for the blatant and punitive abuse.

Many registered firms are being forced to close accounts for Americans abroad or decline to open new ones, in order to avoid

• Increased compliance costs,
• The consequences for potential errors (punitive US regualtory fines).

Foreign Account Tax Compliance Act (Fatca).

• Congress enacted it in 2010 after learning that foreign banks, especially in Switzerland, had profited by encouraging U.S. taxpayers to hide money with them abroad. The main provisions of Fatca took effect in July.
• As a result, foreign financial firms must report to the Internal Revenue Service investment income and balances above certain thresholds for accounts held by U.S. customers.
• Nearly 100,000 banks and other companies have registered with the IRS.
• If they hadn't, all their customers would have 30% withheld from income received from U.S. sources, such as interest and dividends.
• a bank official must sign a statement guaranteeing compliance with Fatca. "Banks look at this from a liability perspective," he said. "The less the bank has to report to the IRS, the less risk there is."

AGGRESSIVE ENFORCEMENT

Theightened enforcement of rules against so-called illicit finance, such as money laundering or financial transactions that breach U.S. sanctions. Enforcement is again intensifying after a pause during the financial crisis, making it more expensive or difficult to move money from one country to another. Among those affected by the tightened policies are retirees of modest means

BEING INTENTIONALLY PUT IN PURGATORY

Americans abroad are also encountering troubles with U.S.-based investment accounts. In recent months, firms including Fidelity Investments, Charles Schwab Corp., T. Rowe Price and others have told overseas investors and advisers they may no longer buy or trade mutual funds.

READ MORE: Expats Left Frustrated as Banks Cut Services Abroad 09-11-14 WSJ

CRONY CAPITALISM - Cartels, Monopolies and the New Crony Capitalists

Click to Enlarge

Competition Is for Losers 09-12-14 WSJ

If you want to create and capture lasting value, look to build a monopoly, writes Peter Thiel

What valuable company is nobody building? This question is harder than it looks, because your company could create a lot of value without becoming very valuable itself. Creating value isn't enough—you also need to capture some of the value you create.

This means that even very big businesses can be bad businesses. For example, U.S. airline companies serve millions of passengers and create hundreds of billions of dollars of value each year. But in 2012, when the average airfare each way was $178, the airlines made only 37 cents per passenger trip. Compare them to Google, which creates less value but captures far more. Google brought in $50 billion in 2012 (versus $160 billion for the airlines), but it kept 21% of those revenues as profits—more than 100 times the airline industry's profit margin that year. Google makes so much money that it is now worth three times more than every U.S. airline combined.

The airlines compete with each other, but Google stands alone.

Economists use two simplified models to explain the difference: perfect competition and monopoly.

"Perfect competition" is considered both the ideal and the default state in Economics 101. So-called perfectly competitive markets achieve equilibrium when producer supply meets consumer demand. Every firm in a competitive market is undifferentiated and sells the same homogeneous products. Since no firm has any market power, they must all sell at whatever price the market determines. If there is money to be made, new firms will enter the market, increase supply, drive prices down and thereby eliminate the profits that attracted them in the first place. If too many firms enter the market, they'll suffer losses, some will fold, and prices will rise back to sustainable levels. Under perfect competition, in the long run no company makes an economic profit.

The opposite of perfect competition is monopoly. Whereas a competitive firm must sell at the market price, a monopoly owns its market, so it can set its own prices. Since it has no competition, it produces at the quantity and price combination that maximizes its profits.

To an economist, every monopoly looks the same, whether it deviously eliminates rivals, secures a license from the state or innovates its way to the top. I'm not interested in illegal bullies or government favorites: By "monopoly," I mean the kind of company that is so good at what it does that no other firm can offer a close substitute. Google is a good example of a company that went from 0 to 1: It hasn't competed in search since the early 2000s, when it definitively distanced itself from Microsoft MSFT and Yahoo!

Americans mythologize competition and credit it with saving us from socialist bread lines.

Actually, capitalism and competition are opposites.

• Capitalism is premised on the accumulation of capital, but under perfect competition, all profits get competed away.
• The lesson for entrepreneurs is clear: If you want to create and capture lasting value, don't build an undifferentiated commodity business.

How much of the world is actually monopolistic? How much is truly competitive? It is hard to say because our common conversation about these matters is so confused. To the outside observer, all businesses can seem reasonably alike, so it is easy to perceive only small differences between them. But the reality is much more binary than that. There is an enormous difference between perfect competition and monopoly, and most businesses are much closer to one extreme than we commonly realize.

The confusion comes from a universal bias for describing market conditions in self-serving ways: Both monopolists and competitors are incentivized to bend the truth.

Monopolists lie to protect themselves. They know that bragging about their great monopoly invites being audited, scrutinized and attacked. Since they very much want their monopoly profits to continue unmolested, they tend to do whatever they can to conceal their monopoly—usually by exaggerating the power of their (nonexistent) competition.

Think about how Google talks about its business. It certainly doesn't claim to be a monopoly. But is it one? Well, it depends: a monopoly in what? Let's say that Google is primarily a search engine. As of May 2014, it owns about 68% of the search market. (Its closest competitors, Microsoft and Yahoo!, YHOO +0.23% have about 19% and 10%, respectively.) If that doesn't seem dominant enough, consider the fact that the word "google" is now an official entry in the Oxford English Dictionary—as a verb. Don't hold your breath waiting for that to happen to Bing.

But suppose we say that Google is primarily an advertising company. That changes things. The U.S. search-engine advertising market is $17 billion annually. Online advertising is $37 billion annually. The entire U.S. advertising market is $150 billion. And global advertising is a $495 billion market. So even if Google completely monopolized U.S. search-engine advertising, it would own just 3.4% of the global advertising market. From this angle, Google looks like a small player in a competitive world.

What if we frame Google as a multifaceted technology company instead? This seems reasonable enough; in addition to its search engine, Google makes dozens of other software products, not to mention robotic cars, Android phones and wearable computers. But 95% of Google's revenue comes from search advertising; its other products generated just $2.35 billion in 2012 and its consumer-tech products a mere fraction of that. Since consumer tech is a $964 billion market globally, Google owns less than 0.24% of it—a far cry from relevance, let alone monopoly. Framing itself as just another tech company allows Google to escape all sorts of unwanted attention.

Non-monopolists tell the opposite lie: "We're in a league of our own." Entrepreneurs are always biased to understate the scale of competition, but that is the biggest mistake a startup can make. The fatal temptation is to describe your market extremely narrowly so that you dominate it by definition.

Suppose you want to start a restaurant in Palo Alto that serves British food. "No one else is doing it," you might reason. "We'll own the entire market." But that is only true if the relevant market is the market for British food specifically. What if the actual market is the Palo Alto restaurant market in general? And what if all the restaurants in nearby towns are part of the relevant market as well?

These are hard questions, but the bigger problem is that you have an incentive not to ask them at all. When you hear that most new restaurants fail within one or two years, your instinct will be to come up with a story about how yours is different. You'll spend time trying to convince people that you are exceptional instead of seriously considering whether that is true. It would be better to pause and consider whether there are people in Palo Alto who would rather eat British food above all else. They may well not exist.

In 2001, my co-workers at PayPal and I would often get lunch on Castro Street in Mountain View, Calif. We had our pick of restaurants, starting with obvious categories like Indian, sushi and burgers. There were more options once we settled on a type: North Indian or South Indian, cheaper or fancier, and so on. In contrast to the competitive local restaurant market, PayPal was then the only email-based payments company in the world. We employed fewer people than the restaurants on Castro Street did, but our business was much more valuable than all those restaurants combined. Starting a new South Indian restaurant is a really hard way to make money. If you lose sight of competitive reality and focus on trivial differentiating factors—maybe you think your naan is superior because of your great-grandmother's recipe—your business is unlikely to survive.

The problem with a competitive business goes beyond lack of profits. Imagine you're running one of those restaurants in Mountain View. You're not that different from dozens of your competitors, so you've got to fight hard to survive. If you offer affordable food with low margins, you can probably pay employees only minimum wage. And you'll need to squeeze out every efficiency: That is why small restaurants put Grandma to work at the register and make the kids wash dishes in the back.

A monopoly like Google is different. Since it doesn't have to worry about competing with anyone, it has wider latitude to care about its workers, its products and its impact on the wider world. Google's motto—"Don't be evil"—is in part a branding ploy, but it is also characteristic of a kind of business that is successful enough to take ethics seriously without jeopardizing its own existence. In business, money is either an important thing or it is everything. Monopolists can afford to think about things other than making money; non-monopolists can't. In perfect competition, a business is so focused on today's margins that it can't possibly plan for a long-term future. Only one thing can allow a business to transcend the daily brute struggle for survival: monopoly profits.

So a monopoly is good for everyone on the inside, but what about everyone on the outside? Do outsize profits come at the expense of the rest of society? Actually, yes: Profits come out of customers' wallets, and monopolies deserve their bad reputation—but only in a world where nothing changes.

In a static world, a monopolist is just a rent collector. If you corner the market for something, you can jack up the price; others will have no choice but to buy from you. Think of the famous board game: Deeds are shuffled around from player to player, but the board never changes. There is no way to win by inventing a better kind of real-estate development. The relative values of the properties are fixed for all time, so all you can do is try to buy them up.

But the world we live in is dynamic: We can invent new and better things.

Creative monopolists give customers more choices by adding entirely new categories of abundance to the world. Creative monopolies aren't just good for the rest of society; they're powerful engines for making it better.

Even the government knows this: That is why one of its departments works hard to create monopolies (by granting patents to new inventions) even though another part hunts them down (by prosecuting antitrust cases). It is possible to question whether anyone should really be awarded a monopoly simply for having been the first to think of something like a mobile software design. But something like Apple's monopoly profits from designing, producing and marketing the iPhone were clearly the reward for creating greater abundance, not artificial scarcity: Customers were happy to finally have the choice of paying high prices to get a smartphone that actually works. The dynamism of new monopolies itself explains why old monopolies don't strangle innovation. With Apple's iOS at the forefront, the rise of mobile computing has dramatically reduced Microsoft's decadeslong operating system dominance.

Before that, IBM'shardware monopoly of the 1960s and '70s was overtaken by Microsoft's software monopoly. AT&T T -0.17% had a monopoly on telephone service for most of the 20th century, but now anyone can get a cheap cellphone plan from any number of providers. If the tendency of monopoly businesses was to hold back progress, they would be dangerous, and we'd be right to oppose them. But the history of progress is a history of better monopoly businesses replacing incumbents. Monopolies drive progress because the promise of years or even decades of monopoly profits provides a powerful incentive to innovate. Then monopolies can keep innovating because profits enable them to make the long-term plans and finance the ambitious research projects that firms locked in competition can't dream of.

So why are economists obsessed with competition as an ideal state? It is a relic of history. Economists copied their mathematics from the work of 19th-century physicists: They see individuals and businesses as interchangeable atoms, not as unique creators. Their theories describe an equilibrium state of perfect competition because that is what's easy to model, not because it represents the best of business. But the long-run equilibrium predicted by 19th-century physics was a state in which all energy is evenly distributed and everything comes to rest—also known as the heat death of the universe. Whatever your views on thermodynamics, it is a powerful metaphor. In business, equilibrium means stasis, and stasis means death. If your industry is in a competitive equilibrium, the death of your business won't matter to the world; some other undifferentiated competitor will always be ready to take your place.

Perfect equilibrium may describe the void that is most of the universe. It may even characterize many businesses. But every new creation takes place far from equilibrium. In the real world outside economic theory, every business is successful exactly to the extent that it does something others cannot. Monopoly is therefore not a pathology or an exception. Monopoly is the condition of every successful business.

Tolstoy famously opens "Anna Karenina" by observing: "All happy families are alike; each unhappy family is unhappy in its own way." Business is the opposite. All happy companies are different: Each one earns a monopoly by solving a unique problem. All failed companies are the same: They failed to escape competition.

Adapted from Mr. Thiel's new book, with Blake Masters, "Zero to One: Notes on Startups, or How to Build the Future," which will be published by Crown Business on Sept. 16. Mr. Thiel co-founded PayPal and Palantir and made the first outside investment in Facebook.