Pointing a Finger at Currency Manipulators

President Obama famously said that he wanted to increase the export sales of the US  -- he said he wanted to double their value between 2010 and 2015. In July of 2010 I wrote about this and among other things I likened this doubling to something like the US basketball team scoring 200 points per game in an international competition. I will show below that based on two years of experience, it appears to be even less likely the US will double exports. I bring this up not so much to gloat but so as to head off what appears to be right around the corner – a vigorous attempt by Obama’s administration to paint other countries as exchange rate manipulators and international cheats. It is no secret that the dollar has been rising against the yen and euro – and that portends the usual finger pointing. I try to explain why that approach won’t help matters at all and could make the international trade situation worse. What our government won’t say is that the dollar has been depreciating for many years now and remains a shadow of its former self. If any country has used currency depreciation to its advantage, it is the USA.

Let’s get to the trade data first. I used standard GDP data from the US Bureau of Economic Analysis. http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&910=X&911=0&903=128&904=1999&905=2012&906=A

As in my last post on this subject, I use trade data that is in the real terms – that is, the figures have filtered out any price change. In 2010 US exports of goods and services in real terms equaled about $1.67 trillion. In 2012 they had increased to $1.84 trillion, an increase of about 10%. But to put it into a longer term perspective, US exports were $1.19 trillion in 2000. This means that despite a weakening currency it took 12 years for exports of goods and services measured in real terms to increase by 55%. If we ignore the exports of services and just focus on merchandise, the story is similar. US exports of goods in 2012 were $1.54 trillion increasing by about 20% since 2010 and by about 96% since 2000. Exports of goods took 12 years to almost double and increased by about 20% in the last two years. So how can Obama expect to double them again in five years? It is not possible.

Let’s not hold the President to a 100% gain in five years – let’s just see what it might take to keep the champagne flowing for a while. During the last two years the US dollar fell. It fell against the currencies of Canada, China, and Japan but it rose against the euro. The trade-weighted value of the dollar fell by about 10% in those years. Thus, the large improvement in US exports of the last two years seems to have been aided by a depreciating dollar against many foreign currencies (except the euro).

But that information does not in any way establish a strong link between exchange rates and trade results. A look back at the dollar since 1999 shows the dollar has depreciated even more. The trade weighted dollar continuously declined against the world’s major currencies during the time from 2002 to 2012. It declined in those 10 years by more than 20%.  The dollar declined even more against the Japanese yen, Chinese renminbi, and Canadian dollar. The dollar fell against the euro by approximately 50% during those 10 years and despite some recent appreciation of the dollar against the euro, the dollar is still almost 20% below the euro’s beginning value and some 30% below its value in 2002.

As our government starts pointing its finger at China and other countries as currency manipulators, it will do well to understand a few further points. What matters to a country is its net exports – not it exports. Net exports are defined as exports minus imports. For example, if exports double next year while imports triple, the net impact of exports AND imports on spending and employment would be negative. So while we are doing cheers for export growth, what do we know about imports? If we measure from 2010 we find that US goods and services imports measured in real terms increased by 7% and since 2000 by 37%. As a result the US net export balance improved modestly from $-451 billion in 2000 to -$420 billion in 2010 and to -$402 billion in 2012.  So while this key balance has improved we could say it improved by about 4% in two years and by about 11% in 12 years. That’s not much improvement given all the currency depreciation we have witnessed.

Why didn’t we do better than that? What can the President do to make exports AND net exports improve more quickly in this country? The answer is that it isn’t easy. Lasting trade improvements come from durable and real improvements in global competitiveness. Exports will rise and imports will fall if the people of the world increasingly want US goods and services. What makes our goods attractive beyond the current exchange rate? For one thing it helps if our trading partners are strong and growing. We should hope that Europe, China, Japan and other key trading partners find good ways to exit the world slowdown and grow more rapidly. The more they grow, the more they will buy from us. 

But we also must have the best goods and services at the best prices. We need an economic environment that makes firms freer to compete globally. While that involves breaking down foreign barriers it also means having clearer and more supportive regulations as they relate to business activities and costs. The current environment in the US is not conducive to major industry investments in competitiveness. Policy uncertainty is rife with respect to national debt, Fed stimulus, energy, banking, health, and much more. "Depreciating" government regulations would do much more right now for our trade balance than would depreciating our currency!

President Obama could greatly improve our trade performance and that would be an important source of economic growth. But he needs it to be a major and clear objective –not just a talking point. Free trade agreements with Pacific and European counterparts would help but are no more than hot air given the President’s clearly expressed desires to support environmental and union demands. Clearing up uncertainty about federal government business regulation sounds good but there is little evidence of any real focus there. It will be a lot easier for Obama to point his finger at currency manipulators and shift the blame elsewhere. Does that sounds familiar?

Velocity, Kleenex, and Drugs

I had a cold last week. I blew my nose so many times that the stock of Kimberly-Clark Corporation increased by 10%. I also took some pills. The pills sometimes work for me but I must have waited too late – as the waterfall from my nose kept up for at least three days. Anyway, as my cold was appearing to diminish I wondered if I should stop taking the pills. It is a dicey situation – if you stop taking the pills your cold continues and maybe even worsens. If you continue taking them and you are really on the mend – it dries you out so badly that it starts a dry cough that sometimes makes you even sicker. The Fed is in a similar situation and I believe the Fed is about to give us all a major dry cough. Below I try to explain why something called monetary velocity is at the heart of the Fed’s dilemma.

According to the popular M2 measurement of money, the value of the money supply increased from $7.3 trillion in 2007 to over $10 trillion in 2012. The increase was about 38%.  More striking is the performance of something called bank reserves – something the Fed has more direct control over. Reserves went from $94 billion in 2007 to $1.6 trillion in 2012. What the Fed intentionally injected into the system increased by 17 times.

This is not news – but it does quantify two things – the Fed was extremely active in injecting money and the result is a lot more money in the financial system. Ordinarily this kind of aggressive stimulus administered in a recession does the following – reduce interest rates, increase bank borrowing, increase spending, and subsequently increase output and employment. In the case of 2007 to 2012, we are all frustrated that the monetary expansion did not have a larger impact on output and employment. Fed Chairman Bernanke and most of his advisors want to continue the stimulus. In a recent speech Bernanke intimated that the Fed (1) despite an economic recovery that begin in 2010 would not begin to remove the money from the system and (2) would not sell government bonds from its portfolio, simply allowing those bonds to mature. What do these two statements mean?

In Forbes the title of a recent article was “Fed’s Balance Sheet Swells to a Massive $2.9 trillion on Treasury Buys.”  I wish my balance sheet would swell a little too! That was in 2011 – now the balance sheet is up to $4 trillion. But this does not mean that the Fed is wealthier. It just means that it has created money (recall the $10 trillion M2 referred to above) by buying Federal government bonds from the public.  That is the usual way the Fed increases the money supply – it buys the bonds we hold and sends us money that we deposit into our bank accounts. It is a cool system. So long as there are a lot of government bonds out there – and as long as we are willing to sell them, the Fed has a great way to inject money into the system. And yes – the Fed can do this at will – they do not need any gold or any silver or permission from Nancy Pelosi to do this kind of thing.

When Bernanke says he will not sell any part of those $4 trillion of bonds he holds – he is saying that he is not going to take money out of the system. Note that when the Fed sells its holding of government bonds – they send the public a bond and you and I send money to the Fed. When the Fed sells bonds – money in the system decreases. Not selling the bonds means Bernanke will not take money out of the system. So the stimulus remains.

When Bernanke says he is going to hold those bonds until they expire or mature the plot thickens (sickens?). When the bonds expire, the Treasury will pay the holder of the bonds the face value on the bonds. Aha – so the Fed gets even richer! No it doesn’t because the Fed turns around and gives the money back to the government. In the first place the government does not have enough money to really give it to the Fed (unless it borrows even more). In the second place, the Fed is not allowed by law to get rich.

Notice that the government originally owed both interest and principal to the public. So when the Fed bought all these government bonds – the government essentially got to skate. That is, the Fed’s purchasing these bonds means the Treasury has reduced the interest and principal effectively owed by the government. The Fed bailed out the government with its monetary policy. This is what people call monetization of debt. It is tantamount to the Fed printing money so the government can spend more than it collects in tax revenue.

So basically what Bernanke is saying today is – we are bankrolling the government and we are going to continue doing it. And that gets me back to my cold and the pill dilemma. Bernanke is doing this because he is afraid that if he stops supporting the government, the economy will fail. He could not handle the Twitter buzz if the economy fails. But if the patient is really on the mend, then failing to withdraw the drug could cause some real complications or what I referred to last week as Unintended Complications.

My liberal friends say tone it down Larry – there is no inflation anywhere. Why are you so worried – all that money isn’t hurting a fly? Not true.  First, there is inflation and it is growing. But that was my point two weeks ago. This week I am making a different point and it has to do with a concept called monetary velocity (V).

I won’t go into the equations and all the technical mumbo jumbo, but let’s define something called the BAM (Bang Associated with Money). BAM tells you the potential impact of money on spending. BAM is the joint result of two things – (1) the amount of money times its (2) circulation or V. Look at the dollar bill in your pocket. That is part of M2. You have it now but when you spend it the hair stylist gets it. Then he spends it at the liquor store. That dollar bill may get used quite a few times during the year. Thus $1 of M2 supports a lot more than $1 of spending. How much more spending – how much more BAM – depends on both M2 and on V.  

BAM = M2 times V.

We know what happened to M2 between 2007 and 2012. It increased dramatically. But what about V? V equaled about 1.93 in 2007. It has been declining ever since. As of the end of 2012 it was about 1.54. That is a reduction of V of about 20%. Recall that M2 increased by 38%. So you might say that the BAM factor increased by about 18% (= 38% - 20%) between 2007 and 2012. So while the money supply might have been hoping for a BAM impact of 38% -- we didn’t get that much impact because V fell. M2 increased but V decreased. So BAM increased by 18%. As a result the monetary impact on output and employment was a lot less than the Fed hoped. That’s the past, what about the future?

What many people are worried about is that V will not stay down forever. The V being down is very much related to uncertainty about the future. It is very much determined by banks that are reluctant to lend money – and by people who are paying down their personal debts to get into better financial condition. But what happens if the economy keeps improving and at some point confidence surges? What happens if the Fed does not remove any M2 but V goes back to a more normal number? Instead of BAM equaling 18% today it could jump to 38%! It would equal 38% at a time when we no longer need stimulus!

In one way that sounds good. We will finally get some oomph in the economy. But keep in mind that this 20% increase of BAM will get distributed between output and inflation. For example – if BAM increases by 20% this year – we could get any of the following possibilities:

o   Output goes up by 20% and inflation increases by 0%

o   Output goes up by 10% and inflation increases by 10%

o   Output goes up by 0% and inflation increases by 20%.

Even in an extraordinary year national output would not go up by more than 6-8%. Can we handle an inflation rate of 12-14%? I don’t think so. That is a very sore throat! Bernanke says he won’t reduce M2 but so long as M2 remains high everything depends on the future course of V. Maybe it will not bounce back to 1.9 anytime soon. But clearly V is going to return to something more typical as the economy approaches normalcy. Leaving M2 fixed is a sure way to make sure that inflation becomes a major future economic problem. Of course so long as the Federal government does not deal with its long-term fiscal crisis there is enormous pressure on the Fed to keep monetizing the debt. A coordinated movement away from both monetary and fiscal policy is necessary for a stable economic future. Monetary policy needs to be reversed but we will not see this until the government joins the process. Our President says debt is not a major problem today. I totally disagree. 

Managing Unintended Consequences

We all know about Unintended Consequences (UC). Say it out loud – UC.  For those of you whose native language is not English you should pronounce UC a little like the word duck or muck, but without the d or the m. It is not a pretty sound and UC is not a pretty topic. But if you ask me UC is the place that liberals, conservatives, and other people might find some common ground.

Liberals often categorize conservatives as selfish people who represent the interests of wealthy individuals and businesses. Conservatives view liberals as people who like to stand for worthy causes especially when it involves using other people’s money. These descriptions probably fit some liberals and conservatives but most of the ones I know cannot be so easily stereotyped.

Most US liberals and conservatives grew up in similar schools and churches and pretty much buy into mainstream culture and philosophy. It would be hard to find many who disagree with the so-called golden rule – do unto others as you would have others do unto you. I don’t know how many stories and movies revolve around a character being aided unexpectedly and then sometime in the future repaying the kindness.

Liberals and conservatives share many such cultural values. But clearly it is not hard to find times when they disagree and often passionately. In recent days some liberals have championed policies which would increase taxes paid by rich people. Some conservatives responded by saying that we wouldn’t need to tax rich people so much if some people asked for less in the way of unearned entitlements. Liberals ask for gun control laws to protect our children and conservatives retort that such laws are ineffective and take away fundamental rights. The disagreements go on and on.

These disagreements exist despite a lot of share values. We often debate for good reasons. For example, liberals and conservatives disagree about the fundamental nature of man. A conservative sees people as fundamentally fixed while liberals believe society can change people. Conservatives are wont to engage in change while liberals persist in a belief that changing external circumstances can lead to better social outcomes.

So there is plenty of reason for liberals and conservatives to disagree even though they might seek the same outcome. Part of this can be explained by UC.  We are all familiar with UC. I was trying to mix a Manhattan and by accident I poured gin instead of bourbon. Yuk. You and your girlfriend wanted to end the evening in an enjoyable way and nine months later there were three of you. You get the picture, UC.

Professor Philip Adler at Georgia Tech introduced a lot of us to UC in the 1960s under the banner of bubble management. He told us that management is like a big balloon. He likened the solution to a management problem to pushing your finger into a bubble that formed on the surface of the balloon.. Adler warned that EVERY TIME you push your finger into the bubble on a fully inflated balloon it creates another bubble somewhere else on the surface of the balloon. It is a little like Newton’s Law of Motion III – to every action there is always an equal and opposite reaction. Good management means making the resulting bubble in the balloon smaller than the initial one.

So UC is always with us. You have to manage those bubbles. The main reason we have such big issues in Washington these days is that many of those people there have Law Degrees and never studied with Dr. Adler.  Managing UC means you always worry that your policy becomes counterproductive. Companies say they manage risk. What does that mean? It means UC. It means that in the course of deciding to build a new plant in Budapest they begin with a clear statement of all the good reasons why one would like to build a plant in that location. 

But you don’t stop there. Someone then says – what could go wrong? Is it possible that there are negatives that we have not fully accounted for? Even after you build the plant you keep asking this question. If the government changes and it imposes harsh penalties on foreign firms then maybe it is time to close that factory or move it to Bloomington.  Parents do the same thing all the time with their kids. Jimmy wants a BB gun. Mom says, you will shoot your eye out. But mom I am 45 years old now. Nevermind.

Liberalism or Progressivism or whatever you want to call it has promoted and continues to advance and expand the application of government solutions. Many of their goals are honorable. But the problem is that UC has been put on the back burner. If Samsung is willing to incorporate contingency planning then why is government so reluctant to admit UC?  There are many reasons but clearly the providers of government services often become the promoters of it. They become the cheerleaders. A harsh program evaluation could mean loss of a job for the government worker. Or the government worker might simply believe that more is always better. That worker might not zealously look for UC. Governments don’t measure profits to indicate the success or failure of a new program so it is harder to quantitatively evaluate UC. Often the simple metric that shows that more people are being served suffices to "prove" the validity of the program. Of course there is also the simple fact that it is much easier to give new benefits than it is to take them away in a democracy.

No matter what the reason we leave the measurement, analysis, and discussion of UC to the other guys or we kick them down the road for another time. The more the conservatives complain about UC the more the liberals dig in their heels. Thus the issue of good government management becomes a fight instead of a collaborative effort to improve the lives of citizens. Some people laughingly would say that good government management is a non sequitur. Good government is impossible.

Imagine if someone had the nerve to say any of these things in public…

·        More lenient abortion laws cause more unwanted pregnancies
·        Increasing the minimum wage helps very few poor people and increases unemployment of teens
·        Poverty programs reduce the desire to be independent and self-supporting
·        Alternative energy is bad for the economy because it is too costly
·        Illegal aliens create social burdens
·        Tax loopholes make the rich richer

Anyone who ventured such statements at a cocktail party might get slugged by an otherwise sweet and caring grandmother. Our liberals and conservatives have turned discussion into fights. Hot words set off other hotter words and possibly a few punches.  But everyone knows that all those statements have some truth to them. 

Everyone knows that every policy has an UC. The real question is not whether or not they exist – the question is how large and how important they are.

We have had plenty of experience with government programs. We have seen both the benefits and the UC of programs to reduce unwanted pregnancies, reduce poverty, promote alternative energy, improve healthcare, make Americans more secure at home and abroad, and so on. Today we are faced with large national debts and no one wants to spend or tax needlessly. Gutting good programs makes no sense. Taxing people more for programs that do not succeed only hurt the country.

I am not so naïve as to think that comparing prospective benefits with the UC of a government program is easy or definitive. But I do know that what we have been doing lately can only lead to worse outcomes for all of us. Most people agree that the current sequester was never meant to happen because it is so onerous and wrong. The fact that the House has been passing legislation that has no chance of passing in the Senate and the Senate passes nothing means that we make our mistakes permanent. Surely we can make all of our government programs more effective. Surely we can cut waste. 

Companies do this all the time. They hire and fire; they restructure; they hire new marketing consultants; they cut costs to meet new competition. Yet our government will not even discuss the effectiveness of trillions of dollars of programs. Voters and their representatives need to think like Professor Phil Adler – push in that balloon and expect something negative to happen. But make that UC as small as possible so that you get the very most bang from the tax buck. 

Inflation, Unemployment, and Bonnie & Clyde

One of the most frequently discussed indicators of a country’s economic well being is inflation, yet I am finding that hardly any two people would agree on its definition much less its measurement. It is sort of like sex. Remember when a past US president said he did not have sex with that woman? Perhaps according to some definitions of sex he didn’t but we all knew he did something that sounded like sex. No matter how you define inflation – seems to me it is on its way but it is not too late to head it off at the pass.

Wikipedia uses the following words in a paragraph about inflation, “general rise in the level of prices of goods and services… erosion in the purchasing power of money… the loss of real value in the internal medium of exchange.”

In March of 2013 why should you care about inflation? For one thing, when the price level of goods and services is rising, you care. No one loves paying more for beer and pork rinds at the 7/11. But alas, beer and pork rinds are only a part of what I buy and who knows what you buy? That is, when prices of beer and pork rinds increase, the impact on you could be very different than the impact on me. And that gets us back to some seemingly innocuous words in the definition – “general price level.” In this case “general” is referring to someone but if your name isn’t General, then one wonders what that means. Another reason we care about inflation relates to policy. Our Fed and our government is telling us that since inflation is so low presently we ought to have a policy that stimulates spending enough so that inflation goes back to a more normal level. This policy of stimulation will have many impacts on us through its effects on prices, interest rates, employment and more. But I will get back to this second point below.

A general price level is something that you and I will never experience. That is because it is a mathematical expression or an equation. The general price level of goods and services averages together the prices that we pay for goods and services. A general price level for the USA then is based on some average person’s purchases. That “average person” is not me and it is not you. It is the average of me, you, Paul Krugman, Peter Wachtel and a lot of other people. So if you eat Peter Pan peanut butter seven times a day, then your own personal price level is going to be quite different from the general price level. If this month found that peanut butter prices fell by 20% you might be happy as a clam about your price level even while the nation’s price level was increasing and making most people frown.

To make things even more complicated, there is not just one general price level. There is a very broad national price level called the GDP Price Deflator that averages together the prices of all final goods and services bought by consumers, businesses, governments, the foreign sector, and inter-planetary travelers. It not only includes the prices of peanut butter, beer, and pork rinds, but also the steel purchased by manufacturing companies, and the tanks purchased by the defense department. A more popular and commonly used level of prices in the US is the consumer price index or the CPI.  But the CPI has several versions. One applies to urban consumers while a different one is focused on urban wage earners. Apparently urban workers and urban consumers do not buy the same things in the same proportions.   These are both called an “all items” index because they are measuring the prices of all the goods and services that urban consumers and/or workers buy. The list includes goods in the following categories: food, beverages, housing, apparel, transportation, medical care, recreation, education, communication, and others. Let’s agree – that’s a mountain of stuff being averaged together each month!

In December of 2012 the CPI all items index for urban consumers had a value of about 230. In December of 2011 its value was 226. Looking at this all items CPI index you would conclude that the general level of prices in the USA rose in 2012. From that one comparison you do not know which prices went up because the overall increase is a result of averaging together changes in the prices of food, beverages, housing, etc. If you use go to the Bureau of Labor Statistics Website (http://data.bls.gov/cgi-bin/surveymost?cu ) you will find a lot of data and you can try to figure out which of those categories of goods and services contributed most to the rise in the general level of prices.

It turns out that there are two categories of the all items index that are bad actors. These two categories are the Bonnie and Clyde components of price indexes. Food and Energy (F&E) misbehave frequently. They stay out late and then sleep it off in the morning. While the prices of all the other categories of goods and services typically rise and fall more or less together from month to month and year to year – F&E prices tend to leap around like jack rabbits. You just never know which direction they are going to move and by how much. Because F&E behave this way, they have to go to timeout. 

No just kidding but it is almost true. Because they behave so erratically we have another price index called the All Items Less F&E for All Urban Consumers.

You are frowning because you understand that removing F&E prices makes this index less comprehensive and representative. And you would be right. But keep in mind that a general price index is supposed to be telling us about the thrust of all goods and services. An index containing food and energy is misleading for three reasons. First, the F&E swings the all-items index and misrepresents the movements in the other goods and services categories. Second, because F&E changes are so erratic from month to month – they misrepresent the general direction of prices. For example, because of food and energy prices we saw dramatic swings in the all items index – 4% increase in 2008, -0.5 % decrease in 2009 and then a 3% increase in 2011. Meanwhile the all items less food and energy showed some variability but hugged an average of about 1.8% per year.   Most prices were growing at a little less than 2% per year. The All items index showed a very different and extreme pattern – a very misleading pattern of the general thrust of the prices of most things you buy. Third, when F&E prices swing wildly we often react and change our purchasing patterns. When F&E prices are rising rapidly we find ways to reduce our purchases of these items and that reduces the impacts on us in ways that are not captured in the all items index.

In early 2013 we are wondering where future inflation is headed. If we look at the All items CPI index we see a blur of upward and downward movements dominated by F&E price changes over the last 10 years with no clear direction. If instead we look at the all items CPI less F&E we see what looks like a wave rising and falling gently over time. After showing a declining inflation rate from about 2006 to 2010, this inflation rate has been trending upward – measuring about 2% in 2012 but portending future increases in the coming years. 

This gets us back to government policy. Our national goal is to bring the unemployment rate down. Policy stimulus is one way to do that but it has great risks. If the stimulus leads to more inflation then it sets off all kinds of alarm bells that are very bad for employment. With the inflation rate rising in a growing economy, it is not hard to predict that continued stimulus will increase current inflation and expectations about future inflation. We learned in the past that stimulus raises interest rates, oil and other commodity prices, increases wages and other business costs, and generally creates adverse conditions for output and employment growth. Inflation might be in the 2% range today but all indications are that the best way to reduce the unemployment rate is to have less stimulus and lower inflation.