Tuesday, November 25, 2014

Slow and Unbalanced Growth in the United States

Like a pig in mud, I love to root around in the data. A macro guy loves it when the BEA releases another quarter’s worth of GDP.  Like a goat on top of a waste dump, you just never know what you will find. So you just dig in.

And I did just that. The data for the third quarter of 2014 was recently released and now that the smoke has cleared, I thought I might spend a perfectly fine afternoon seeing what I could see. And the results are pretty interesting. Have you heard the term “unbalanced growth”? The US economy looks today like a teenager with a pea-size head and arms that drag on the ground. We can only hope that things equalize in the future!

I use the Q3 results to do some comparison analysis. I could wait a few months to do this exercise but I could also wait to bite into that super-hot slice of pizza too. So we could get a collective burnt roof of our mouth here by focusing on the third quarter. But what I do here is as kosher as a Wolfies hot corned beef sandwich on rye. So not to worry.

The first thing I noticed is that the annualized value of real GDP reached $16.2 trillion in 2014 Q3. Now that is a pile of stuff. Back in 1999 Q3 Real GDP was $12.1 trillion. So in those 15 years we increased national output by about a third. Even if we compare today’s output to 2007 Q3 right before the recession started, we are enjoying 7% more than 7 years ago.

7% more in seven years is nothing to write home about but it does establish that even after a major recession and an ensuing slow growth period, we are producing a large amount of output today – considerably more than the outputs of the past.  Again – I am not making a case that things are wonderful in Macroland. But the most recent data establishes the fact that we are producing more than ever.

That fact might not be surprising but it gets a lot more fun when you bring out the Hookah. Err I mean the rest of the data. As you probably know, real GDP has several major components – based on the buyer – households, firms, governments, and the foreign sector.

So let’s see how these sectors contributed to the larger amount of production in the USA. That is, who is responsible for buying about a third more when we compare 2014 to 1999? I summarize with the table below.

The table has component shares of Real GDP. If the share of a category was 10% in 1999 and then 10% again in 2014 – that means that that buying by that group kept up with GDP. The share did not change in those 15 years because it kept up. So in the final column in the table – a POSITIVE SIGN means that category was growing FASTER than Real GDP in those 15 years. A NEGATIVE SIGN means it grew SLOWER than Real GDP. 

What do we see from the table? First, we definitely have unbalanced growth. Second, while consumer good spending was a leading sector, the growth was coming mainly out of durable consumer goods like autos. Spending on nondurable goods like food and clothing did not keep up with RGDP as its share of spending fell. Third, while the federal government purchased a larger share of the nation’s output, state and local governments’ share fell by 2.7%. Finally and perhaps most importantly, gross private domestic investment’s share fell from 18.5% to 16.8% of GDP. Yes spending increased, but it grew considerably slower than real GDP for the last 15 years. As you know this category is the key to future innovation and productivity. While there was a marginal increase in the share of business purchases of equipment, it was the structures part of investment that lagged. Similarly on the retail side, residential housing’s share fell by 2.2% of Real GDP. Finally while exports' share rose by 3.5%, imports share rose by 2.7% and therefore net exports increased by only 0.7%.

Keep in mind that Real GDP increased by about 33% in 15 years. But that amounted to an average of less than 2% per year. All those categories in the table with a MINUS sign, therefore, grew more slowly than 2% per year. The slow growth economy of the last 15 years essentially was propelled by the Federal government (shares of defense and non-defense increased by similar percentages ) and household spending on durable goods and was held back by State and Local Government spending and the construction of business and residential buildings.

One could conclude the slow economic growth was caused by a highly unbalanced growth and recovery. One could also conclude that whatever policies offered to promote recovery have not worked. The Keynesian spending multiplier is premised on the idea that while stimulus might be aimed at a single sector, the results would spread across the economy. Such has not happened and it might help if policymakers try to understand why.

Table. Share of Real GDP in Q3 in 1999 and 2014 and Change
from Q3 1999 to Q3 2014
                                               1999  2014  CHG
Exports                                      9.7   13.1     3.5
PCE                                         64.6   67.9     3.3
Durable Goods                          5.9     8.8     2.9
Imports                                    12.9   15.8     2.7
Investment in Equipment          5.6     6.3     0.7
Federal Government                  6.8     7.1     0.3

State and Local Gov.               13.6   11.0   -2.6
Residential Investment              5.3     3.1   -2.2
Investment in Structures           4.1      2.8   -1.7
Gross Private Investment        18.5   16.8   -1.7

Non-Durable Goods                14.9   14.6   -0.3

Tuesday, November 18, 2014

Guest Blogger Chuck Trzcinka The Psychology of the Minimum Wage

Chuck Trzcinka is Professor of Finance and James and Virginia Cozad Faculty Fellow of the IU Kelley School of Business.

The political support for raising the minimum wage stems from psychology not economics. The economics is abundantly clear-the minimum wage cuts jobs. The higher the minimum the more the harm. The Congressional Budget Office released a survey of economic studies last year and concluded that raising the minimum wage to $10.10 will reduce employment by between 500,000 to 1,000,000 jobs. When you increase the cost of something, business will find ways to reduce its contribution. For example, McDonalds has added 7,000 touch-screen kiosks in its European stores. Furthermore, the survey showed that over 70% of those receiving the minimum wage are not from poor families. The CBO argued that a better way to help is to raise the “earned income tax credit” would have little effect on jobs.

So raising the minimum wage, even having a minimum wage in the first place, makes no economic sense, but it is unquestionably politically popular. Voters soundly rejected Democrats in Tuesday's election but embraced a visible plank in the party's platform by backing minimum wage hikes in four Republican-leaning states and two cities. By January, more than half the states will have higher wage floors than the federal government. Voters in Alaska, Arkansas, Nevada and South Dakota passed ballot initiatives raising the minimum wage to $9.75 an hour even as they swept Republican Senate and gubernatorial candidates into office. All told, the initiatives will raise minimum hourly earnings for 609,000 low-wage workers, according to the National Employment Law Project.

            Why is it so popular if it doesn’t help the poor? The reason is that it makes us feel better. Psychologists use a concept called “cognitive dissonance” to describe a situation where facts confront our most basic views. For example, young people are reluctant to save for retirement because this means accepting that they will grow old. Similarly, when we interact with low wage workers it makes most of us uncomfortable. They only have skills that command a wage below what we think is below a “living wage”. It is certainly below our living wage. The low wage confronts our belief that we are living in a “fair” economy.  Our response is psychologically to reduce the source of dissonance. If we raise the minimum wage we will either eliminate the job or have a higher wage worker. We will not ever meet a low wage worker and we will believe that the economy is more fair and just. The minimum wage is really about making those who are wealthier feel better.

The problem of course is the economics. The poor would be far better off if the minimum wage was lowered or eliminated and we expanded the earned income tax credit. But then our idea of “fairness” would be challenged by low wage workers. We would never think to ask any of these people why they were willing to work for a low wage since this conversation is uncomfortable. It’s better to get government to impose a wage floor and never meet them. 

Tuesday, November 11, 2014

Guest Blogger Buck Klemkosky: The QE Punch Bowl Has Been Taken Away. Is the Party Over?

William McChesney Martin, former chair of the Federal Reserve Board, famously stated that “the job of the Fed is to take away the punch bowl when the party is still going.” A quote from the 1960s, but very relevant today as the Fed voted in October to end the third quantitative easing (QE3) program.

At the end of six years of QE programs, the Fed had purchased $3.9 trillion of mortgage-backed securities and Treasury bonds, increasing its balance sheet from $800 billion to $4.7 trillion. This represents 26 percent of U.S. Gross Domestic Product (GDP), a historically high amount, relative and absolutely. But the Fed is not alone. The Bank of Japan just announced its QE program will be expanded and its balance sheet is already 57 percent of Japan’s GDP. The European Central Bank has just started a QE program and its balance sheet, at 21 percent of Euro GDP, will certainly get larger.

What did the Fed do before QE? For 95 years of its 101-year existence, the Fed exerted monetary control through short-term interest rates, supplying credit to the banking system to lower rates or withholding credit to increase rates via open market operations. The Fed also has the right to change reserve requirements for the banking system, the amount of cash and other liquid assets banks need as a percent of deposits, and the discount rate, the amount the banks pay to borrow reserves from the Fed. The Fed also has used selective credit controls and moral suasion. The short-term interest rate targeted by the Fed is called the “Fed funds” rate which is based on interest rates for overnight loans between U.S. banks. This rate was fairly easy to manipulate when there were $30 billion-$40 billion of excess reserves in the banking system. At present the Fed is targeting a range of 0 to .25 annual rate for the Fed funds rate.

What are the implications of Fed monetary policy since the new unconventional tool of quantitative easing has been initiated? The big question now is whether the Fed will be able to raise the Fed funds rate in the future. As the Fed went through the three QE programs, it purchased bonds from banks and others and paid for them by crediting bank reserve accounts at the Fed. To the banks these reserve balances were as good as cash that could be lent out or invested. Because of the slow-growth economy, low loan demand, Dodd-Frank and other issues, the banks left much of the reserves at the Fed recreating $2.7 trillion of excess reserves, those not needed to support deposits. With that magnitude of excess funds in the system, the Fed will find it challenging to raise interest rates via traditional methods. There is no longer a viable Fed funds market. Plus the Fed has already announced that it will maintain its $4.5 billion balance sheet so selling a lot of bonds to drain liquidity from the system is not an option. What to do? The Fed could raise the interest rate on bank reserves. However, this may not be politically feasible because it would be boosting bank profits, including those of foreign banks with U.S. deposits, with no risk on the part of the banks. Another alternative would be to target other short-term bank borrowing markets such as the Eurodollar, Libor, commercial paper and repo markets. 

It is difficult to assess the effectiveness and impact of the QE programs as we never know what would have happened if there had been no QE programs. It is also difficult to differentiate between the impact of the QE programs and the zero interest rate policy the Fed has maintained since late 2008. But certainly the QE programs have reinforced expectations that short-term interest rates would not be raised as they have not been to date. The S&P 500 closed at an all-time high in November, the U.S. Treasury 30-year rate and mortgage rates were below 4 percent, the yield on the 10-year Treasury was below 2.5 percent, unemployment was 5.9 percent and the Shiller Case housing index has rebounded 25 percent since the lows of 2011. So it has been successful by some measures. But, the economy has grown only by 2.2 percent annually since the recession ended in June 2009, way below past economic recoveries. Inflation has also remained subdued, averaging 1.4 percent annually since the recession ended. The Fed has a 2 percent inflation target and inflation has been below the target for 29 straight months. The Fed remains concerned about the economy and the deflation that Europe and Japan have already experienced.

Some think that QE is a dangerous monetary tool because of unpredictable side effects. One would include igniting inflation and inflationary expectations beyond the Fed’s 2 percent target if banks stimulate the economy with their $2.7 trillion of excess reserves. A second would be financial instability as investors take on more risk reaching for yield and creating asset bubbles. A third is that the huge Fed balance sheet may interfere with conventional monetary policy and tools in the future. Only time will tell whether the side effects and effectiveness of the QE programs are understated or overstated. The debate may go on for years.

Whenever the Fed choses to do so, the task of raising interest rates has gotten more difficult and risky. When will that happen? The consensus seems to be mid-2015 at the earliest and perhaps not until 2016. When it happens, let’s just hope that the QE punch bowl doesn’t leave the economy and investors with a hangover. Or the punch bowl may need to be refilled (QE4) to keep the party going.

Wednesday, November 5, 2014

Trick or Treat -- The Fed's Balance Sheet

Like many of you I have been reading all the articles written about the US Fed ending its quantitative easing program. There is enough stuff there to choke Mr. Ed the talking horse. As I was reading it occurred to me that I am a total monetary geek. I was still wearing parachute pants when I took my first course in money and banking. Since then I have become a Fed Watcher and can’t wait until the minutes of the last meeting of the open market committee.

So let me say that I was mystified that little of what was written in the last week focused on one critical aspect of the Fed’s balance sheet. And there was a lot written. Much was a postmortem on quantitative easing. Did it work or not? And while looking at the past is always valued, we should spend equal time thinking about how the end of quantitative easing will affect the future.

The frustrating thing is that what was written about the future uses too many code words. I don’t know how many times I have read that quantitative easing has increased the size of the Fed’s balance sheet. How many of you know the definition of a balance sheet? How many of you took Professor Gamonida’s accounting class at Georgia Tech and learned about balance sheets? Aha – not many of you. How many of you have ever learned a thimble full of information about the Fed’s balance sheet? Aha!

So in the name of global harmony and to the tune of the Georgia Tech Fight Song, I will quickly and easily introduce you to the arcane basics of Federal Reserve Accounting – and more importantly explain why a key issue is being ignored.

The first thing to note about balance sheets is that they are not found on your mattress under the quilt. A balance sheet brings together much of your financial stuff. On one side its lists the value of all the good stuff like your cool Converse Chuck Taylors, what’s left in your bank account after your spouse went for her weekly facial, saving your saving account balance, your house, your car, cash stuffed in your pillow, and your Uncle Charles. Just kidding, your Uncle Charles in not an asset. All the other good items you own are called assets.

Your balance sheet also has another column that lists all your ouch stuff. Mostly that’s what you owe. So if you owe $46,000 on your Yugo, then the $46,000 loan is called a liability. You have liabilities or debts under such categories as credit card debt, car loans, mortgages, college loans, and so on. The money you owe to Pete your gambling friend is often not included in public balance sheets.  If your assets do not equal your liabilities there is always a balancing item that makes your assets equal your liabilities plus balancing item. But we don’t need that fact to go forward.

Are we going forward? Are you awake?

The Fed has a balance sheet. It is very cool. The main asset the Fed holds is bonds. The Fed at last count has close to $4.5 trillion of bonds. Wow.  $4.5 trillion could buy a lot of chicken wings at Buffa Louie’s. Most of these are government bonds with short-term maturities. But since quantitative easing started, more and more of these bonds are longer-term government bonds and housing market derivatives.

What you read about over and over is that the Fed’s balance sheet rose from just under $900 billion to about $4.5 trillion. Fed assets exploded because of QE. And like your waistline after a six month luxury cruise, the amount is still with us. In the name of colossal calamity, the Fed bought an extra $3 trillion or so of bonds and still holds them. As of last week they are no longer buying more bonds. But the stockpile remains.

Much of what you read focuses on this stockpile. Will the Fed let it slowly mature and just burn the cash when they receive interest and principle? Or will the Fed quickly get rid of all those bonds? Clearly if they did the latter it could be disruptive to credit markets. So the Fed is in a bond pickle and that’s what everyone seems to be talking about.

But that leaves out one spectacular element. Why did the Fed buy all those bonds in the first place? Is the Fed a bondoholic? Aha! They bought all those bonds because that is how they flood the economy with money. Between say 2009 and today, the Fed added about $3 trillion of money to the economy. The hope was that all that extra money would lead to bank loans, spending, and economic growth. But what happened was that after averaging almost zero in 2007 and 2008, bank excess reserves rose to about $2.8 trillion today. That is, banks did not loan out much of that money. They asked the Fed to hold onto it for them. Perhaps holding it for a better day when people really want to borrow money. Meanwhile the Fed is sitting on money that the economic system has shown it doesn't want.

All this information about money and bank reserves is what is found in that second column of the Fed’s balance sheet and is called liabilities of the Fed. And that is what is not being talked about much in the papers. Your kids came home from trick or treating with a mountain of candy. What are you going to do with all that stuff? Your kids do not need all that candy and Fed and the banking system do not need all those excess reserves. 

The Fed could quickly get rid of those reserves but they worry it will disrupt markets. The way to reduce the excess reserves is for the Fed to sell their assets. All that selling could be disruptive to bond markets sending bond prices down and rates up. Yellen and her gang do not want to be held responsible for driving up rates. So what is there to worry about? The Fed is holding a bunch of money for banks who don’t want to use it. No big deal. Right? Wrong. As the economy recovers, borrowers will return to banks. And banks will have an almost limitless fund to make those loans. It is like all that Halloween candy. You can hide it from the kids for a while, but sooner or later they will find it and you will soon have a problem on your hands. Better to trash the candy on November 1.

QE was a travesty because we all knew this would happen. The Fed has put itself in a no win situation. It made a big announcement last week to stop doing stupid things. But now it is stuck with a mountain of stupid things. I guess we never learn.