Tuesday, April 30, 2013

Quit Yellen and Start Jellin’

If Ben Bernanke steps down next year as Chairman of the Fed, his successor might be Janet Yellen. A lot was written about her last week. The following Yellen quote from a recent speech was highlighted in several articles,

"With unemployment so far from its longer-run normal level, I believe progress on reducing unemployment should take center stage for the [Federal Open Market Committee], even if maintaining that progress might result in inflation slightly and temporarily exceeding 2 percent."

This seemingly innocuous statement deserves more attention, especially since until 1978 the Fed had a singular mandate – to use its tools to pursue price stability.  The European Central bank (ECB) also has a similar singular mandate. But the Humphrey-Hawkins Act of 1978 created a dual mandate for the Fed – including price stability and full employment as its two key goals.

While Yellen’s above quote sounds reasonable there are some who acknowledge that until 2008, the Fed acted as if it still operated largely with a single price stability mandate. Attaining full employment was a secondary objective at least until recently. Fiscal Policy was thought to be the more appropriate means to deal with employment and economic growth. There are some who believe that Yellen and some others on the board would like to permanently create more balance between the two goals – raising the stature of employment and growth in the Fed’s work. Yellen will hoist full employment above price stability for the foreseeable future.

It is understandable that national interest should be concerned about employment and economic growth. It seems reasonable to want to aim all our policy guns at this plague. But many things that seem reasonable on the surface sometimes seem dead wrong after looking into them more closely. So that’s what I want to pursue here. As you will see below, I conclude that changing the Fed’s objective to favor employment would be very risky, inefficient, and wasteful. So let’s get started.

First, note that we believed in a single price stability mandate for the US Fed for about 60 years. The ECB insisted on this single mandate and despite what appears to be some wavering recently, the ECB continues with it. There must be some strong reasoning behind the Fed focusing on price stability.

Second, recall that John M. Keynes invented something called the liquidity trap. Modern Keynesians dispensed with this extreme behavioral assumption but maintained models that always had a preference for fiscal over monetary policy as it had to do with affecting real variables like employment and output. So Keynesians didn’t think much about using monetary policy to control employment and output.

Third, Monetarists challenged Keynesians by admitting that in the short-run, monetary policy could have a very large impact on employment and output. But Monetarists insisted that these impacts were possible only if the stimulus policy was unexpected – it had to be a surprise to be effective.  In the longer-term, the effects would dissipate as the impact was fully understood. So-called Neo-Keynesians agreed that such monetary surprises had only a short-term impact. Both groups of economists agreed that part of the undoing of the short-term impacts was eventual increasing inflation and interest rates.

Fourth, much of the discussion today assumes that there is no need to worry about the Fed’s recent and future monetary explosion having an upward impact on inflation and interest rates. But history is clearly rife with examples of inflation catching up when least expected. Policymakers have been caught many times with their guards down. Inflation was not there and then it was, like magic.

Inflation is like a fire. I once had a small fire in one pot on my stove. I could not believe how quickly it spread. Once inflation spreads, the FED acts quickly to eradicate it. Episodes of extreme fed tightening have led to either pronounced decreases in economic growth or absolute reductions in output. When the fire spreads you have to bring out the big hoses – and this pretty much ruins the kitchen – until you have time to rebuild. The below link takes you to a discussion where the author points out several, dismal time periods following tight money – 1956, 1960, 1968, 1973, 1978, 1980, 1989, and 2000 http://www.econbrowser.com/archives/2006/02/should_the_fed.html

The Fed swears it will do better this time. It will know when to pull out the money in a reasonable way that does not disturb the economy. History is not on the Fed’s side. If you believe the Fed I have a fire insurance plan to sell you.

Fifth, Yellen and others are making us all take a very clear risk. Is it worth it? They say – okay, it is possible that focusing on employment today will bring more inflation sometime in the future.  But they believe that this risk looks like chicken-feed compared to the pains of the unemployed today. But again, they do not fully explain the problems of inflation. As I said above, when inflation comes it might first rise slowly and to levels that are only a little above the 2-3% range.  But experience in other countries and the US shows that once inflation starts rising it is very hard to contain. That is why countries try so hard to maintain price stability. Turkey, Brazil, and Israel are countries that experienced inflation rates above 100% per year in the recent past. Talk to someone who lived in those countries and you know why people prefer price stability.

You believe it can’t happen here and now. But notice that hyperinflation has to start somewhere. It starts at 3% and then spreads from there. And by the way it usually got going because governments could not constrain their spending and the central bank monetized and compounded these political errors.

When inflation does get started it messes everything up – workers often get higher wages but since inflation rises faster than their incomes they get lost in the dust. Interest rates rise and make creditors feel richer until they find out that prices rose faster than investment income. People spend much too much of their productive time learning how to protect their money balances as they buy cuckoo clocks and other collectibles instead of bonds and stocks and real estate. Firms prefer producing later because prices will be higher than they are today.

In short, using monetary expansion is a very risky way to target employment and economic growth. It might work for a little while but the Fed and the rest of us know that sustainable increases in the economy are not going to come until the nation’s real problems are attended to. The US faces many threats to employment and output including housing, financial, demographic, global competition, and more. The more we fiddle with expansionary monetary policy the more we raise the risk of slower growth and divert attention from the real solutions. My advice – quit Yellen and start jellin’. 

Tuesday, April 23, 2013

Why We Are Lousy Investors by Guest Blogger Robert Klemkosky

 We have known for a long time that greed and fear play a prominent role in investors’ decisions. A mix of both is healthy for the markets; greed makes us strive for higher returns, which also entails higher risk, and fear makes us avoid excess risks or reckless risks. The trouble starts when greed or fear gets out of control. Too much greed and asset prices go up too much and bubbles form, such as technology stocks in 1996-2000. Too much fear and selling occurs and asset prices plunge. Of the two, fear can be a more powerful force than greed because it can turn into a panic and result in a financial pandemic such as what just occurred in 2008 with stock prices and the credit markets.

In reality, investors should follow the advice of Warren Buffett and buy on fear and sell on greed. But emotions and psychology prevent most investors from doing that consistently. Investors do the wrong thing at major turning points in the market, such as buying record amounts of mutual fund shares at market peaks (first quarter of 2000) and selling record amounts of mutual fund shares at market bottoms (fourth quarter of 2002). And selling stocks at the bottom of the bear market in March 2009 only to see the stock market go up 100 percent in the next nine months.

We all like to think of ourselves as rational and logical, but there is much evidence that we are far from national and logical when making investment decisions. Behavioral finance is a discipline that analyzes how our emotional inclinations and psychological biases affect and influence our investment decisions, both as individuals and collectively.

Overconfidence is one of the major biases that affects investment decisions. We consistently overestimate our knowledge, skills and abilities. We have illusions of control even if events are more random. We overestimate the precision of information and underestimate risks. If we have been successful, we have a tendency to become more overconfident and take on more risk. So don’t always assume that you have better knowledge and skills than others and don’t ever equate stock market performance during a bull market with investor IQ.

There is also a disposition effect in that investors have an aversion to losses. They hate losses about twice as much as they like gains, and will take risks to avoid losses but not gains. One result is that investors sell winners and keep losers, exactly the opposite of what they should do, especially for tax purposes. Investors  hate to admit mistakes which include stock market losses, so there is also regret aversion.

Investors have a tendency to extrapolate the past, especially the recent past. The human mind is not good at figuring out the probabilities of future events, so the easiest thing to do is assume past trends will continue. We expect bull markets to continue as well as bear markets. We select stock or funds that have done well in the past, expecting that performance to continue in the future. We miss major turning points in the market.

Investors have beliefs and convictions about stocks and the market. When presented with information, they have a tendency to accept or listen only to information that confirms and supports their beliefs and filters out information that conflicts with their beliefs and experiences. The rational thing to do would be to seek out information that does not support our beliefs and convictions. This is referred to as confirmation bias.

When we look back, things seems much more obvious and we delude ourselves into thinking that events were predictable and we had the foresight to make those predictions. In other words, we forget our original forecasts or thinking and use the outcome as if it was our original forecast. We think events that happened were predictable and events that didn’t happen were unlikely. It’s  why we take credit for our successes and blame others for our failures.

Lemmings are rodents that would follow each other over a cliff to their deaths. Their behavior explains a lot about investor behavior and is sometimes called herd mentality. Investors are very comfortable going along with everyone else which is usually what happens in bull and bear markets. It seems investors get greedy together or get fearful together, which is why we have the bull and bear markets.

People feel comfortable investing in companies they work for or companies in their locale. It’s a reason why investors are underrepresented in stocks outside their country. But what happened at Enron, Lehman Brothers and other companies shows the risk of investing in company stock to the detriment of a diversified portfolio. We also become very loyal and attached to a stock that, for example, has performed well and has made us a successful investor. So investors have a tendency to ride it up and ride it down. They forget that a stock doesn’t love them and doesn’t even know they own it.

Individuals have a money illusion bias in that they don’t factor inflation into long-term financial decisions, such as providing college educations for their children or retirement. At 4 percent inflation, money loses half its value in approximately 10 years, and goods and services cost about 50 percent more in nominal terms. People also underestimate the power of compounding. If you invest $1000 at 6 percent for 30 years, you have wealth of $5144 at the end of the period. If you take on a little more risk and invest at 8 percent, you nearly double your ending wealth, $10,002, versus investing at 6 percent.

Understanding the basic concepts of behavioral finance will make us better investors. We don’t need a degree in psychology to use the concepts of behavioral finance successfully. Being cognizant of the behavioral biases and not succumbing to emotions, especially fear and greed, will go a long way toward better investment performance.

Tuesday, April 16, 2013

Chained CPI -- Much Ado About Nothing

A lot is being said about President Obama’s brave gesture to control entitlement spending in his new budget for 2014.  He is apparently compromising by agreeing to change the cost-of-living adjustment for social security benefits. He says we can save some money by using a chained price index instead of a wage earner index. I thought it was illegal these days to put wage earners in chains, but maybe I don’t understand this whole thing.

The President’s proposal, according to my absolutely perfect estimates, will save Social Security (SS) approximately $2.7 billion per year. Keep in mind that our current annual government spending is closing in on $4 trillion. You don’t have to be a math major to realize how small $2.7 billion is compared to $4 trillion. Graphics can sometimes work. Imagine Dolly Parton’s bra. That’s what the government spends each year. Now imagine…Never mind. You know what I mean.

The Labor Department has data on price indexes so I compared the chained price index (CPI-C) values to those published for the Urban Wage Earners Price Index (CPI-W). We don’t actually know what inflation will be in the future but if it is anything like it was in the past, then we can make estimates of the effect of the new index. The CPI-W is what is now used to adjust social security payments for inflation each year. The President wants to replace it with the CPI-C. Comparison data is available from 2000 to 2012 on the BLS website. Using the price index data I calculated two annual inflation rates for each year from 2001 to 2012.

Guess what I found? Guess Again. Isn’t this fun! Anyway, the differences between the inflation rates of CPI-C and CPI-W didn’t add up to a hill of beans. In 2004 the average SS recipient would have lost $15 if the government had used the CPI-C instead of the traditional CPI-W. Seriously – that’s about a buck a month. 2010 would have been the worst year for social security recipients – they would have lost $94 that year if the CPI-C had been in place in that year or just a little more than $8 per month (a pack of Marlboro?)

If we add up over all 12 years from 2000 to 2012 I find that President Obama’s huge concession would reduce the SS benefits of the average recipient by a little more than $513 (in 2013 prices). During those 12 years this person would have received more than $168,000 from SS. The proposed approach will have cost them $513. Please! You people talking about the President’s brazen compromise, please think about these numbers. He is causing almost no harm to SS recipients and he is doing absolutely nothing to resolve the national deficit and debt problem.

Why do we see such big numbers reported in the news? The answer is that they are projecting changes for the future. They do not know what the future inflation rate will be so they are making forecasts. One thing is for sure about the future – they are projecting that inflation will increase. So when they estimate that the impact on us will be something like $130 billion in the future, they are basing this number on a lot of inflation in the next decade. $130 billion received in say 2023 will be based on people having MUCH HIGHER incomes and social security benefits. Comparing $130 billion a year to current budget numbers is the old Apples and Oranges trick. This trick is meant to scare you.

One more point. There is nothing to guarantee that this proposed change to a chained index will always save the government money relative to a fixed-weight wage earner index. It is true that a chained index allows for the calculated price level to incorporate buyer’s adjustments away from the highest priced goods. But the truth is that people do not always behave that way. If during a particular year we have people gravitating to very popular but higher prices goods, then the chain index will show a HIGHER inflation rate than the CPI-W. 

Maybe the president should stop looking for things that are politically pleasing and focus on the real business of budgets and compromises. As for you – like good consumers everywhere you can beat the system.  Recall that the CPI is an average of prices paid by the “average” household. Don’t be average! You can make your future SS dollars go farther if you work hard at being a good buyer. If the price of orange juice is going up, then just drink more drinks whose prices are not going up. Try a nice tall glass of JD!

Tuesday, April 9, 2013

Snowstorms, Windshield Wipers, and Employment

After last week’s employment rate announcements, the US stock market took a big dive. Many words were written about the dire information in the report.  The report published by the Bureau of Labor Statistics consisted of about 20 short paragraphs accompanied by about 30 data tables and can be found at http://www.bls.gov/news.release/empsit.nr0.htm

I am sure that people thousands of miles away from the US will be impacted by the reactions to this report. Bus drivers in Delhi will be discussing the terrible situation in US labor markets. Angry teens in Bangladesh will set a few Russian Ladas on fire to show solidarity with union members in Wisconsin.  You get the picture – information moves fast and at long distance in 2013.

Except for the back of my father’s large and muscular hand, nothing came fast when I was a kid. I recall television advertisements that allowed me to send a few cents to someone somewhere and in return I would get a toy submarine. If you put baking soda in that toy submarine it would submerge in your bath tub just like a real submarine. Anyway, I can remember that it took weeks if not months for that stupid toy submarine to show up in my mailbox at 3170 Oak Avenue. I would check the mailbox every day! Girls were slower back then as well but that is another story. You get the picture. Children were supposed to learn patience.

The question is whether we are better off or not with all this speed today. I’d like to move on to phones and texting but let’s stay with the employment release of last week. The key message of this release is that while payroll employment increased in March, it did not increase enough to provide further evidence of a stronger economy. That is, the 88,000 increase in employment was a big disappointment. But was it really?

First, keep in mind that monthly employment changes are typically small. The total number of people employed in the USA in February of 2013 was about 135 million. So the percentage increase of 88,000 in March employment was about 0.65% (=.0065). If I lost 0.65% of my body weight I would lose about one tenth of one pound. Woowee.  Anyway, notice that even if the employment change had been more like 300,000 new jobs in March that performance would only amount to a tiny percentage increase. What matters more is the future course of employment changes. At 300,000 new jobs per month for a whole year – employment would increase by 3.6 million or by about 2.6% for 2013. That would be pretty nice. So far in the three months of 2013 employment has increased by an average of 168,000 per month. At that rate we might get 2 million jobs for the year for an increase of about 1.5%. To conclude this first point – the 88,000 was nothing to write home about – but what matters less is one month and what matters more is the future trajectory. The first quarter is not where we want it but by no means should we be burning our bras and/or jock straps.

Second, what does the 88,000 increase tell us? The answer is “not much.” Suppose you are like me and your weight varies a lot. So let’ suppose my typical weight change is about plus or minus 50 pounds per month. One month I gain 60 pounds. The next month I lose 40 pounds. Suppose I tell you I gained 55 pounds in March. Is that evidence that I am going to gain a ton of weight in April? In May? It does not. My weight swings a lot from month to month. The typical upswing or downswing is around 50. It would take a much larger swing in one month for you to bet on me gaining again and again. Of course, you’d bet more money if you saw me gaining more than 50 pounds each month for several months.

A statistical analysis of the payroll employment figure shows very high variability from month to month – to the tune of about 90,000 workers. Next to that the 88,000 means very little. It tells us nothing about the future.

In summary, the one month change of 88,000 is not only tiny but it is not statistically large enough to suggest anything is happening in the way of a trend. I can tell you that jobs have increased by about 504,000 in 2013 and in the 12 months between March of 2012 and 2013 the increase in payroll employment has been 1.9 million. The more data we have, the more complete the picture becomes. Yet the market knew most of that before Friday morning and the market seemed to go crazy because of the 88,000 announcement. Even the local Bloomington Herald Times had many articles analyzing last month’s dismal number.

Why does a seemingly meaningless number get so much attention? Aside from the fact that the news media has to sell information, my guess is that we get all this drama because we demand it. And we demand it these days because the future is so uncertain. Will we have a double dip recession? Is the economy on the mend and about to grow quickly? Does the economy have several years of slow growth ahead? If we knew the answer to these questions, we could plan our lives better and perhaps more profitably.

This uncertainty theme hits home if you think about driving in a snow storm on a road that you don’t know well. You do know that there are many twists and turns in the road. But with the snow, you cannot see more than a few inches ahead of your windshield. In such a situation, you are staring intently ahead and every time you see a change in the scenery, you are ready to begin turning the steering wheel in one direction or the other. Turning too slowly means you might miss the turn. Of course turning because of a false signal means you quickly steer the other way. You are on top of the situation and you watch everything that moves! You adjust quickly. Sometimes the information is correct and sometimes it is not. But you are watching every change as if your life depended on it.

Our deeply uncertain economic times are like such a snow storm. Each time an economic number comes out we react to it as if it had great content for the future. When we discover it had no such content, then we react to that discovery.  Telling the government to slow its delivery of monthly news is like asking for your windshield wipers to quit working. Ignoring highly erratic data is like driving straight ahead on a curvy road. Since there is always uncertainty about the future, we are stuck with living through a roller coaster ride of economic news. But with uncertainty heightened as it is today the roller coaster is no less than the infamous Kingda Ka.

One more point.  We learned nothing new about employment in March of 2013. The economy and employment continue to be deeply affected by very long-term factors (e.g. demographics, industrialization, globalization, government policy and regulation) and dealing with the aftermath of a deep and prolonged global financial crisis. Few spots in the world are growing rapidly and despite a lot of policy experimentation, both Republicans and Democrats are going to be disappointed if they are hoping to see anything but lackluster growth for the time being. Even if we got a huge spike in employment in April or May it won’t mean much of anything insofar as the big picture is concerned.

By the way, I am happy to report that I have not changed my tune in the last three years – in March of 2010 I said we would not have any real growth until we overcame three problems. My reading today is that we have made some progress on only one of the three and thus we are firmly stuck in economic purgatory. See my post – The Whack-A-Mole Recovery…. http://larrydavidsonspoutsoff.blogspot.com/2010/03/whack-mole-recovery-or-good-news-is-bad.html

Tuesday, April 2, 2013

Davidsonian Economics and the Death of Macro

Macro was born and it is in the process of dying. I am not being melodramatic. Lots of things have finite life cycles. Take the hula hoop. It was great while it lasted and back surgeons are still raking in the dough as a result of it. But it is now hard to find a hula hoop. The death of macro is not necessarily a negative thing -- I would call it evolutionary. It came, it served, and then it outlived its usefulness. I will argue below that we will replace it with something I humbly call Davidsonian Economics. I am really crappy at naming things so if you are among the first 10,000 people to write back with a better name I will give you 79% of my future royalties.

To explain the process and what this means to us requires me to write a little about the evolution of macro ideas. I am going to try to do this in two ways. For normal humans I am going to summarize the main points and use a lot of bolding and underlining. Soon you can go off to your regular routine – e.g. kissing the dog and petting the wife. For those of you afflicted with bottomless boredom and something akin to a PhD, I will drone on with details until you are ready to rent the full library of Fidel Castro’s speeches.

First, the brief summary and by brief I mean less than 743 paragraphs. Great ideas always stem from real human problems. When I grew up polio was a disease that affected too many people. Scientists then found a cure and mankind was made immeasurable better. The results are not always so clear for social sciences – but during and after the Great Depression a lot of people wanted to try to “cure” us of future depressions and recessions. John Maynard Keynes was one of those people.  His work was carried on by economists we call Keynesians.

Today we are faced with the lingering impacts of a Great Financial Crisis and World Recession– and many great minds are trying to find a cure for the latest social science disease – slow economic growth. So if you believe what I write below then you have become a Davidsonian – and we will have started a new economics we will call the Davidsonian School of Thought. Our colors will be Cream and Crimson and our favorite liquor will be of course JD. I hope to add some cheerleaders soon. Now to the evolution we call macro...

Before the 1930s – No Macro – Adam Smith’s “invisible hand” cured most economic disturbances; economic growth theory focused on supply factors. Neither monetary nor fiscal policy was used to offset short-term recessions. Monetary policy was geared to keeping prices stable in the long-run.

1960s Keynesians said workers were slow to discover rising prices and could be “fooled” into supplying more labor whenever asked. Governments could fool firms into thinking prices and profits would rise when government stimulated demand. An increase in government spending or a reduction in income tax rates would, therefore, lead to more demand for goods and services and firms would produce more goods and services. Workers would find out later that their wage increase didn’t buy more goods and services as they discovered the higher prices of goods and services. By then the recession was healed. Keynesians preferred fiscal policy over monetary policy.

1970s Neo-Keynesians and Monetarists saw the Stagflation of the 1970s and emphasized what happened when workers caught on to the policy-demand-inflation game. After a period of rising demand and economic growth, workers would want bigger wage increases and this led to another recession – but this time with higher inflation. Ugh. Stimulus worked as long as you could fool the workers about the cost of living. These economists saw the risks involved with macro policy but gave it a green light so long as policymakers didn’t get carried away.

1980s Rational Expectations believed that workers, after living through inflation and stagflation, would be better at incorporating inflation expectations into their current wage bargains. Thus they were harder to fool. This took the bang out of the ability of government to stimulate the economy with fiscal or monetary policy. If policymakers were not careful, a stimulus would have little to no effect on employment and output.

1980s and Beyond Neo-Supply-siders seeing that the impact of demand-based stimulus policy had peaked started focusing on using policies that directly impacted the decision to employ workers and produce more output. While supply-side policies do not adversely affect inflation they do often appear to worsen the income distribution. Politically supply-side policies are a little like gun confiscation advocates in Nevada.

2013 and Davidsonians find us with a new behavioral assumption – that politicians are dumber than rocks and cannot be trusted to fashion a successful economic program. Despite really strong (as in kimchi) economic demand stimulus, the US economy continues to clank along at school-zone speeds. Even the mention of new expanded stimulus programs sends shock waves over national debt reaching crisis proportions. Such policies immediately create uncertainty and very conservative behaviors on the part of workers and firms. 

Notice that if you are not asleep yet we have gone full circle in the last 75 years from a time when we had no demand policies; to when they were lauded; to a precautionary phase; to no impact; to finally a stage of perverse impact. That puts us back to where we were before the 1930s.

We are back to something more like the Classical Theory. The only way to improve employment and economic growth is to restore competition and remove regulations that prevent wages and prices from clearing markets.  Today Keynesian stimulus programs reduce confidence and need to be replaced by financial and aggregate supply policies that raise confidence and reward firms that improve productivity and control costs. The days of fooling firms and workers is over. There is no magic wand. You can't get something for nothing. Cyprus reminds us all one more time of the dangers to debt. What makes the economy grow has never changed -- entrepreneurs and businesses need to innovate and take risk. We need an environment that rewards and facilitates that process.