Tuesday, June 30, 2015

Low Hanging Fruit and Politicians

What a couple of weeks! If only there were three rings at once we could call it a circus. This has been more exciting than a fireworks display at a Zippo convention.

Obamacare, Gay Marriage, Iran, Race, Greece, Presidential jockeying, the Pope, Ted 2, and Bruce Jenner. You can’t fault Washington if you are bored. Stuff is happening. Of course, depending on which issue it is, you are either happy as a clam or ready to move to Canada.

I am trying to filter it all down. JD helps but there is a lot to get my hairy arms around. So it hit me. There are basically two themes to follow. The first one is that society has gotten to a new place. It is a place where nothing is easy. All the political fruit within arm’s reach is gone. All that is left requires a ladder. And ladders are notoriously dangerous.  In short, there are no easy answers. 

The second theme is that politicians are, well, politicians. I found this on Wikipedia: There have been some publishers who criticized politicians for being out of touch with the public. Areas of friction include the manner in which politicians speak, which have been described as too formal with too many euphemistic and metaphorical expressions, and is commonly perceived as an attempt to "obscure, mislead, and confuse"

So if you are pissed and possibly confused then there it is – we live in a world where it takes real and tough analysis and negotiation to solve our problems. And the people who should lead the process are simply not up to the task -- caring more about wooing voters with simplistic slogans that actually solving problems. 

Think about some of the problems that got a lot of of time in the last weeks…
            Guns – if there was a simple solution President Obama would have already found it and proposed it.
            Iran, Russia, Syria – being friendly with these people does not seem to be working.
            Healthcare – solving the healthcare needs of more than 300 million people in a country whose national debt is approaching 100% of GDP is not a trivial undertaking
            Racial Discrimination – Stamping out the last vestiges of hateful, persistent discrimination is challenging to say the least
            LGBTs – marrying religious freedoms with economic and social opportunity in a secular society is no easy union
            Income Inequality – despite decades of trying to reduce poverty in this country it hangs on like a drunk at closing time

If you are on the fringe of the debate on any of these issues you will hate what I am about to say. To some of you fringers it is either your way or the highway. What I am about to say is that both sides have at least a smidgen of merit. And both sides hold to their beliefs tenaciously. Iran, Russia, and Syria have some legitimate views. Russia might feel threatened by a growing Europeanization of their adjacent neighbors. Maybe there are racists and homophobes whose lives were somehow diminished by gays or blacks. Having better opportunities for healthcare makes sense for a country. The Constitution seems to allow people to have guns. Poverty makes no one proud.

I am not arguing that any of the above statements in any way proves the point of one side or the other. The above paragraph is meant to say that there are two sides to every debate and we have reached a point in history when resolving these issues is not the real goal.  The real goal is for my side to win. The real goal is to support ideology or to pad the pocketbooks and power of those who represent those ideologies. In the meantime some of us would prefer solutions and we know this will take patience and VERY hard work. Yet the charade goes on. 

We hope our elected officials will assemble all the data and do the analysis and then duke-it-out in government institutions. But so far that is not what we see. What I see are politicians on both sides of the spectrum hurling na├»ve and damaging statements, cleverly disguised insults, and silly statements. Basically they are saying things like “trust me and I will solve all these problems. Do not trust my adversary as he/she wants to hurt you.” Really!

Since the ice melting is diluting my fine JD I really should finish this. So let me end with one example: income inequality. It seems to be the strongest candidate for my points today. Political candidates make it sound so easy to transfer a dollar from some rich guy to a homeless person on the street. Perhaps we spent too much time reading fairy tales. Ahh Robin Hood. Such a nice boy with tight pants. But please. Spend a little time at a soup kitchen or a park bench and get to know the clients. You could sprinkle hundred dollar bills on many of these people and it wouldn’t do a thing for the poverty rate.

My liberal friends are ready to BBQ my testicles on the nearest Big Green Egg. But wait. I am not saying that poverty programs are useless. I am not saying that government does not have some role to play in reducing poverty. I am not saying that high income people should not share their wealth. What I am saying is that whatever we have been doing for 50 years does not seem to be working well enough. Lyndon Johnson said these programs were going to eliminate poverty! Yet there it is worse than ever.  

To make any real headway today is going to take harder work. It will take real leaders who understand that the easy choices are gone. It will take people who can objectively evaluate, explain, listen, and then implement policies that matter. 

Honestly, can you name a living leader ready for this job? 

Tuesday, June 23, 2015

Greasing the European Union

When you grease your car it reduces friction and makes it run better. Many machines need grease. The question these days seems to be whether or not the EU needs grease. And by that we mean Greece!

I don’t usually like to implicate others in my madness but I should thank my colleague Michele Fratianni for years of discussion about the EU.

We start with the idea that the EU is like a machine. It can work well or it can work poorly. To understand what contributes to EU performance one needs to know more about it. Wikipedia says the EU is “a politico-economic union of 28 member states that are located primarily in Europe.” That little group of words is correct but it is also subject to a wide degree of interpretation. One of the key points is that the EU is a union with most of the political clout residing in the individual countries. While a central EU institution (like the EU Parliament) might decide to impose a law or regulation on its members – that law or regulation would have to go through 28 national governments separately to become EU law. If the USA were such a union, Obamacare would have had to pass in the 50 legislatures and be signed by 50 Governors. If one country failed to pass it then it would not have become USA law.

So the first point is that the EU is not a highly centralized form of government. It has central bodies but the main clout remains in the 28 countries that comprise the member states. For more information about the EU see http://europa.eu/about-eu/institutions-bodies/index_en.htm

Much of what has transpired under the rubric of the EU has been a movement toward a single market space for its members. The underlying belief is that freer trade among the 28 countries would make them all better global competitors. Notice that 28 countries believe this – or they never would have joined the EU and they never would have passed hundreds of rules and regulations in their national governments. These hundreds of new rules and regulations essentially make it easier and less costly for a business to operate in Europe. They eliminated numerous barriers to trade among the 28 countries.

While the EU has been growing since the end of World War II, one of those barriers was not fully removed until 1999. If you are going to make the EU a single market then it hardly makes sense to have marks and liras and lats. Wow – what a mess trying to do business with all those piles of currencies!

The euro was thought to be an important part of reducing trade barriers. And so far – 19 of the 28 countries have joined in a European Monetary System with its own Central Bank that emits euros in much the same way as the US Fed emits dollars. And therefore, the ECB has become a very strong centralizing policy institution. While its rules were adopted by representatives of the EU nations – monetary changes do not have to go through each of the governments. Thus the ECB is truly a supra-national body.

I don’t want to get hung on that last point. My main point here is that the EU is here to help! It is a voluntary organization solidified by formal treaties meant to improve economic outcomes for every country from tiny Latvia to super power Germany.

If I can now direct my remarks to the 19 countries in the EMU – one specific thing to note is that these countries willingly gave up their own currencies. That means also that they gave up a policy tool. These countries can no longer adjust the values of their own currencies. They can try to influence the ECB to change the value of the euro – but there are no longer any dracmas to depreciate. When countries encounter into slow growth, they will sometimes depreciate their currency as a means to make their goods look more competitive in the global marketplace. These 19 countries, including Greece, no longer have that tool available.

Thus there are many tears being shed for Greece these days. But let’s face it—this is a bit silly. Depreciating ones currency might be something to use for small day to day adjustments but it doesn’t make reality go away. Competitiveness is basic. A kid wins the state track meet in the 100 meter dash because she worked harder and smarter for years. Maybe a competitor had another teaspoon of sugar the day of the meet, but it is fundamentals that determine the winners year in and year out. The exchange rate is like the sugar. It is not the solution.

Worse yet, currency depreciation is self-defeating. A continuous depreciation may help the trade balance and growth for a while, but the depreciation of the currency means that imports are priced higher and cost more. To the extent that depreciating countries import materials and capital goods, they because less productive. Worse is when speculators see a declining currency value in a country without any solutions – and they flood the markets with even more of the sad currency. This makes the depreciation even worse and causes panic

Greece is in trouble because it tricked the EU. It pretended to want to be a good member. Everyone knew that Greece and several other countries were not as solid as others when they joined. But the implicit bargain was that they would give up the dracma and try to be more competitive – more like the other countries. Well they didn’t. They acted more like Zorba the Greek than Ms Merkel.

I looked at some numbers. I compared European countries competitiveness before and after 1999 when the European Monetary Union began. If European countries losing their own currencies attempted to sharpen their competitiveness after 1999, then we should have seen improvements in their trade balances. And we do see some improvements between 1999 and 2007 (before the world financial crisis muddied the water). Trade improvements came for Germany, Austria, and the Netherlands.

Unfortunately, despite small initial improvements these next countries had vast deterioration in their balances of trade with the world – Greece, Ireland, Italy, and Spain. For example, the balance in current of account for Spain before 1999 was a deficit of less than 1% of GDP. By 2007 this deficit was about 10% of GDP. The story is the same for the other countries mentioned. In the case of Greece, the current account deficit was almost 14% of GDP in 2007.

Don’t cry for Greece. Greece accepted a gamble – a gamble that could have paid off handsomely. But they conned the game. They now need to decide what they want. They can have their dracma back and hope its depreciation solves their competitiveness problems. Or they can get down to the serious business of governing a country within the EU. Either way I think the EU will be fine.

Tuesday, June 16, 2015

The Fed, Inflation, and Recessions

In my post last week I stated that recessions were often caused by monetary policy actions. Some people think it is bazaar if not evil to say such a thing. Policy is formed to create good outcomes – not recessions. But policymakers are just like you and me – prone to error and especially so when we think we are doing something for the greater good.

Since I sometimes write things based on what I think I know, I decided to bring up some data and see if there is any truth to what I think I know about inflation and recessions. But let’s first review the simple theory since it is relevant to current monetary policy.

     Monetary policymakers worry the economy is fragile so they keep interest rates low by letting the money supply expand faster than my belt at a July 4th BBQ.
      In so doing they risk overheating the economy
     When the economy expands too quickly this leads to higher inflation
     Upon seeing higher inflation, the Fed restricts money, interest rates rise, aggregate demand contracts, and a recession ensues.
     Cinderella is then run over by her coach. Yes she was a little tipsy.

Looking at graphs never proves a theory but I am so old that I have forgotten how to run proper scientific experiments and besides, many of you are cynical enough to believe I faked the results anyway.  You can check or reproduce my results by going to the FRED data service at https://research.stlouisfed.org/fred2/  . Then choose the Consumer Price Index for All Urban Consumers: All Items. Then choose annual rates of change. That is what I call “inflation’.

I begin this story by looking at seven US recessions from 1970 to 2008. That means we are looking at almost 40 years of US history. If you want to go back farther that is okay with me but I figured that is enough years for our purposes here. These seven recessions are shown on the graph below as vertical shaded areas.

Inflation went from:
           less than 2.5% to more than 5% right before the 1970 recession started
           a little more than 2.5% to more 10% before the 1974 recession
           just over 5% to around 13% before the 1980 and 1982 recessions
           under 2.5% to over 5% before the 1992 recession
           about 2% to over 3% before the 2002 recession
           about 2% to about 4% before the 2008 recession

Every one of these seven recessions was preceded by a substantial and worrisome increase in the inflation rate.

That’s pretty interesting. Do I hear clapping in the background? But some of you sharp cookies (since when is a cookie sharp?) are saying stuff like the following. This proves nothing since Larry is focused on just two variables. If money is part of the story, then clearly I need to show the following – inflation was worrisome enough to elicit a Fed tightening of policy and that tightening caused the economy to contract. And the coup de gras (Charlie, coup de gras is not a race car) is that I need to show that nothing else was a major contributing factor to each of these recessions. For example, some of you smarty-pants will point out that the dot-com bust was a major factor causing the 2002 recession.

To the above I say raspberries (why is there a P in raspberries?). I could add more data but this is a family blog and I don’t want to pollute the environment.  I challenge you to do some simple search research with your favorite search engine using words like inflation, monetary policy, recession, 1980.  You will find it difficult to dismiss the strong possibility that too much money caused inflation and too much inflation caused tight money and ensuing economic contractions.

Which leads me to the following question: Does the future or at least the next few years have to imitate the last 40 years?

     Maybe that graph and all the discussion above is irrelevant for beyond 2015. 
     Maybe all that money injected recently will not ever cause higher inflation.
     Even if inflation does begin to rise, maybe the Fed won’t tighten vigorously
     Even if the Fed worries about rising inflation and tightens, maybe it won’t cause a recession

Since this blog is about you as much as me, I won’t answer those questions. But I am wondering what you think about them. Are we in a new world in which inflation is not a problem? Will that new world imply that the rules of money have been revoked? Will the Fed escape a period of historical monetary increases without causing a dent in the future economy? Does Janet Yellen know how to cha cha cha? 

Tuesday, June 9, 2015

Lesson 5 The FED and Monetary Policy Gone Bad

In 2015 we in the US regard the Fed as the only macro policy game in town.   In macro we teach about macro problems and macro policies. Because Congress is largely dysfunctional there is little hope that they could pass a bill which adequately addresses macro problems. What is often referred to as fiscal policy, or use of government spending and taxes to address the economy, is now mainly neutered. That mostly leaves The Fed as the only policy game in town. 

So there is much attention focused on Fed policy. In this summer of 2015 we are told that the Fed will soon change its policy. But there is much uncertainty about when and by how much the policy will change. So the financial markets are a little crazy. And the economy bobs up and down. Do we really have to experience all this madness?

I think not. The problem is that the Fed is trying to do something it is ill-suited for. It has taken about 60 years to figure this out but I think it is getting plainer all the time. It is like the 40 year old man who after a brief bout of unemployment gets a new job. Yet his mother isn’t satisfied. Honey – did you brush your teeth before you went to work? Were you nice to your new boss? Did you polish your brown shoes? This man has things under control and he doesn’t need his mother giving him bad advice. Mom – stop it! Fed – stop it!

This Fed is like this doting mother. The economy might have needed some Fed support in 2008. But if you look at your calendar, you will note that was seven years ago. The recession ended in 2009 and the US economy has been expanding ever since. I know of no theory of macroeconomics that says that expansionary policy must continue until everyone on the planet believes there is a 100% chance the economy might not regress.

Think about the theory of macro policy. First, John M. Keynes did not believe monetary policy should be used to stimulate the economy.  He likened it to pushing on a string. Second, he did believe the government could and should stimulate the economy – using what he likened to a priming operation. In a priming operation the government spends a little more and taxes a little less to get a little bit of spending going. Presumably this injection of spending will increase our incomes and our confidence and get things moving. Like the ball in a pin-ball machine, the ball doesn’t exit before it bangs against numerous cushions that indicate increases in your score. The injection of a little bit of stimulus gets us all spending before the injection ball exits the economy.

Keynes was writing in the 1940s and much has happened to this humble theory in the last 70+ years. Keynes’ followers (Keynesians) decided to quantify all this and before we knew it we had an elegantly expressed general theory in which the government and the FED could alter monetary and fiscal policies to keep the unemployment rate always at full employment with a corresponding GDP Gap equal to zero. Gone was the priming issue. Gone was the skeptical attitude about monetary policy. And of course gone were the days of conservative government budgeting and near-zero inflation. 

Consider where we live now – in a world where
            it is expected that the Fed if not the government will stimulate until we reach full employment;
            we have annual budget deficits and almost no surpluses and a national debt that is soaring;
            inflation has followed EVERY significant policy stimulation; and
            these inflation bouts were followed by policy reversals that led to recessions or very slow growth periods.

Anyone with an objective attitude about macro policy as practiced in the US since the end of World War II could not be very happy with these results. We clearly have a frying pan- fire-frying pan experience. What went wrong? It seems pretty straight forward. Macro is a legitimate social science. If macro indicators are showing a significant recession or slowdown, then policy variables can be altered so as to increase aggregate demand which in turn stimulates other spending until the macro indicators can be drawn with happy faces around them.

That sounds pretty easy. But the truth is much different. Hey mom, I have a temperature. Okay honey. Stick your head in the refrigerator and you should be fine in a few minutes. That sounds pretty stupid. But our Keynesian approach to macro problems and policy is the same. Follow me on this. I believe in macro. I believe that when real GDP declines this is a problem needing study and remediation. Okay so far? But what I do not believe is that EVERY TIME real GDP or other macro indicators fail to achieve better values, that we have a generalized macro problem requiring monetary and/or fiscal policy.

How is it possible that a macro slowdown is not caused by macro factors? Simple. We have a macro construct called aggregate demand. And Jim and Toni have five kids. Peter slugs Diane and she cries. Then the other three kids cry. Uncle Charlie comes in and sees five unhappy kids and concludes that Jim and Toni have been abusing their children. He sees virtually the whole family in disarray. The problem must have been caused by the parents, Jim and Toni. That’s what our brilliant macro economists do when they see aggregate demand falling. If AD is going down, then macro policy needs to bring it back up. Presto!

But in my family example above, the problem is that Peter is a mean boy and slugs people. There is no family problem. There is a Peter problem. The solution should be to fix Peter (please no Jenner jokes) . Fixing the whole family is misplaced. It lets Peter off easy. It is inefficient and won’t lead to a solution for a happier family.

And so it is with a fixation on aggregate demand and the national unemployment rate. There may be times when all of aggregate demand is declining. And in those times a general AD approach might seem reasonable. But in many or most cases, the problem showing up in AD is really a specific problem stemming from housing, or autos, or Japan, or other parts of AD or AS. Yes, sometimes AD is falling because of aggregate supply problems. In these cases, AD policy is wrong and inefficient at best. The right policies are those that address the real problems be they housing or autos or Japan or AS.

Today our Fed continues a zero interest rate policy* that intends to stimulate aggregate demand. The leaders explain with great pride that they will not relent in this generous policy so long as we have even the tiniest negative GDP Gap. Yet the economy jumps up and down and financial markets have fits because there are plenty of problems with the economy that do not get addressed because the Fed is so focused on AD – and AD hasn’t been the problem for years. Should the economy continue to slowly heal itself despite the FED, we can be sure that we will soon be wondering why inflation got so bad so fast – and wondering why the FED's abrupt policy reversal is throwing us into the next recession. 

* One more point. A zero interest rate policy might seem innocent enough. But note that in order for the Fed to keep interest rates near zero, it takes actions. To keep interest rates near zero in the last two years meant increasing the money supply. This is done by increasing something called the monetary base. It grew by 39% from Q1 2013 to Q1 2015. The result was that the narrow version of money, M1, grew by 20% during that time period,. The wider version, M2, grew by 13%. Money is exploding despite the fact that we have a growing economy. This is risky business. 

Tuesday, June 2, 2015

Lesson 4 Potential Output, the GDP Gap, and the Intelligence Gap

This post is really about inflation but I didn’t want to mention inflation in the title so as to not scare you. Actually it is really about inflation policy so let’s start there before we get into excruciating technical definitions, mathematical equations, and kimchi recipes.

Some of you are old enough to remember inflation. Inflation means the cost of cherished goods and services is rising. One day you went to Whole Foods for one small bag of groceries and it cost you $1,000. Today you go and that same bag of non-pesticidal fruits and nuts costs you $1,100. You would say, yikes Helen, those dirty scum-#$%^&*s at Whole Foods are ripping us off and making it impossible to send our genius Golden Retriever Bogey to Harvard. Or you might simply say that inflation was 10%.

Since the great recession in 2008 the inflation rate has been very low in the USA. While the inflation rate was generally rising between 2001 and 2008 it has been falling ever since. It did rise briefly to nearly 4% during 2011, but it reversed course and inflation has been falling ever since.

So there are great minds who basically say “Inflation who?” implying that inflation is like your brother-in-law after the divorce. You ain’t gonna have to see him again! Very smart economists who teach at wonderful places like San Diego State and Harvard would swear on a stack of Paul Krugman articles that the Fed can pump in money and the government can spend its way to oblivion and back – and still not awaken a comatose inflation dragon. I know. I am mixing metaphors. Or was that a simile?

I know you have been waiting patiently for some really boring definitions but I had to get you ready. If you are like a lot of my friends, you haven’t read an economics book since Prof Schaffer’s class in 1964. Potential Output and the GDP Gap exist for one and only one reason – to help us predict future inflation. The above suggests that inflation is hiding at the moment. But this blog is all about how and why inflation might awaken from its long slumber and possibly be in a very ugly mood.

Remember GDP? GDP is a nation’s output. It is measured fact. It is the size of that pile of goods and services that got produced this year. It could be really big this year because Zeus was happy or it might be small because Kim Kardashian forgot to go shopping. Either way, GDP is what got produced.

Potential GDP is part of a fairy tale or what economists like to proudly call a counterfactual. Potential GDP is what GDP could have been. It’s like your kid’s potential. Okay, so he can’t actually hit the broadside of a barn with a large pumpkin but you are pretty sure that if he practices a lot he will soon be starting on the mound for the Royals. Potential GDP is how much output would have been produced this year if the economy’s resources were fully utilized. It is possible that actual GDP could equal its potential in a given year – but honestly, when is the last time your kid started for the Royals?

The GDP Gap is the difference between Actual GDP and  Potential GDP. Most of the time, the current GDP is well below its potential because most of the time resources are not being fully utilized. Thus, most of the time the GDP GAP is negative.

The main productive resource that tends to lag is employment. Those dern workers just love to sit around and watch Oprah every day instead of going to work and producing huge mounds of widgets and zidgets. Or those dad-gummed firms love to fire workers who then sit around and watch Oprah. In either case, if there are unemployed workers looking for work, this excess shows up as a negative GDP gap.

Here is the point – an excess of workers seeking employment (or improved employment) and a corresponding negative GDP Gap represent a weak economy with weak spending It is one that grows slowly and one that is not capable of producing inflation. As a result the US Fed is more concerned about the weak economy than it is about rising inflation. That relative concern retards their movement to a more normal policy. It puts off the day when the Fed removes a lot of money and stimulus from the economy. When employment improves and the GDP GAP turns toward positive territory, then the Fed will turn its sights towards mediating inflation. The big question now is when will that day come? When will policy return to normal? The GDP Gap is heading towards positive so we know a policy change will come.

The intelligence gap has to do with the Fed’s reluctance to move to a saner policy. Why do I say saner? The economy is exhibiting a return to stronger economic growth. Inflation is not one of those things that require bugles and a formal announcement heralding its arrival.  I know that GDP turned sour in the first quarter of 2015 but everyone including your barber’s Doberman knows about the temporary factors like a massive dock strike and storms attributed to global warming caused economic problems in Q1 that will not be repeated in Q2.

Now we have economists giving the Fed even more ammunition to continue a risky policy. A recent report (Changing Labor Force Composition and the Natural Rate of Unemployment, by Daniel Asronson, Chicago Fed Letter, #338) explains that labor will not be fully employed until the unemployment rate reaches between 4.5% and 4.9%. That means we will have a negative GDP Gap until the unemployment rate reaches about 4.5%. That means the Fed has a numerical excuse to not worry about inflation and to not engage in a more conservative policy for quite a while.  Meanwhile the economy gains momentum and some measures of inflation (percentage change in the CPI less food and energy) are closing in on the 2% goal value. Once at the goal value notice that it won’t take long to exceed it. And then the Fed will be in a really difficult position. Do they really want to have to aim all their guns on inflation knowing that a major abrupt change in policy will greatly weaken spending in the economy.

A quicker return to a gradual approach that started yesterday is what was needed. Waiting until tomorrow promises going from the frying pan to the fire.