Tuesday, November 24, 2015

Conservatives and Free Trade

In the last Republican debate it became very clear that Republicans and conservatives do not all march to the same Gene Krupa. Republican presidential aspirants espoused widely divergent views on many subjects notably Syria, immigration, tax reform, and free trade. To note these differences is not a bad thing and knowing we have healthy debate means some thought and effort is going into important policy issues.

Today I want to focus on the debate about free trade. In the good-old-days of a decade ago or longer, I thought that conservatives favored free trade while modern liberals and progressives did not. You could count on Democrats to be against free trade agreements as part of support for labor and environmental issues. Republicans in contrast liked the efficiency and growth that came from expanding capitalism beyond ones borders.

But those simple differences evaporated. Knowing one’s party does not guarantee a position about free trade and free trade agreements. So I thought now is a good time for me to step back and says some things about free trade. The first thing to note is that free trade suffers from the same language inadequacy as say, free markets and free Internet. In all three cases there is no such thing as "free". In the latter case building and operating an Internet takes labor and capital and ingenuity. So someone has to pay for it. In the case of free trade and free markets, they only exist in the minds of economists and are less a real event or outcome and more a desirable though unattainable goal.

It’s like you wanting to fit into your wedding suit from 1969. That suit was long ago donated to some important charity but you have black and white photographs of you smiling and being totally unaware of what the next 46 years would bring in terms of large rib-eye steaks, mounds of mashed potatoes with gravy, and huge servings of apple pie-a-la-mode. But there is no reason that you should not strive to fit into a suit that resembles that one of long ago.

And that’s how I feel about free trade and free markets. Real markets have lots of warts. There is always someone or something that interferes. Find any book called "Introduction to Microeconomics" to remind yourself of all the assumptions that need to be met to yield the results of free markets. For one thing, no business firm can monopolize the market. For another, the prices and qualities of most goods and services must be known by the many buyers and sellers. And too, you don’t get the competitive outcomes if the Department of Labor tells the companies how much to pay the workers.

You can diet all you want but you are not getting into that old suit and you won’t have hair where hair does not grow anymore. But you can get close and the attempt to get closer can bring favorable results. Touching toes that you have not seen in decades is definitely a plus.

Economists prefer freer markets because the closer you come to having more competition and fewer trade impediments, the better chance you have of allocating resources in a way that benefits us. Free markets and competition drive prices to levels that give firms a normal profit and return on investment. These prices come closer to resembling the costs of production and thus do not waste precious resources. You pay pretty much what the stuff is worth. If it takes $25 to make a pair of yoga pants, then the market price of a pair of yoga pants is that $25 plus a normal profit for the firm that goes to repay the time and trouble to buy the materials, sew them, advertise them, and so on. A government that demands that firms price yoga pants at $1 per pair is going to mess up the supply chain. 

I can hear some of you closing your browsers and complaining – Come on Davidson, the world doesn’t work that way. Firms rip us off and the government adds layers of costs to protect workers, the environment, and Donald Trump’s hairdresser. And advertising – don’t get me started.

Notice that I said that there is no such thing as free competition. One firm recently tried to price a drug at hundreds of times what it cost to produce. Firms sometimes use a lack of competition to get much higher than normal profits. Lack of competition is what allows the worst outcomes including a horrible allocation of goods and services. 

We will never get rid of all barriers to competition. Corrupt firms will hide information and cheat in myriad and clever ways. Corrupt governments will use tax power and regulation to help their powerful friends gain advantages or to prostitute themselves for votes. But that doesn’t mean we can’t recognize all this and still promote freer competition.

The same goes for free trade. Free trade sounds terrifying to some people. Some say that Haiti cannot compete against the US. If we ask Haiti to reduce tariffs on corn, beans or wheat, you will hear the protests all the way to Washington. But please explain why the world has been moving towards freer trade since World War II. The World Trade Organization now has 161 members that agreed on major reductions in import tariffs and on other policies designed to reduce protectionist trade barriers. Or maybe you want to talk about the European Union’s 28 members who operate in a virtually single market zone where once there was a complex of trade impediments and tariffs. Freer trade and competition work and countries vote for it.

Also part of the real world beyond the corruptions I discussed above are real policy tradeoffs. Every country has a long list of goals that include ways that government intervenes and promotes growth, security, fairness, environmental quality, poverty, and many more. In the real world we recognize the benefits of freer international trade but have to compare those advantages to gains coming from pursuing other goals. It is no secret that the WTO has been working without agreement on its latest round of negotiations since 2001. The closer we get to reducing remaining trade barriers the more we seem to encroach on other national goals. It does not help that the world’s economy has been weak since 2008 – struggling countries care less about gains from trade and more about keeping the food on the table.

It is easy to see why a free trade agreement is so controversial today. Free trade is the right thing to do but it appears to jeopardize other goals. Some politicians will see an opportunity to accept a watered down trade agreement if it gives them the chance to advance other policies. Witness the 2000 plus pages and 30 chapters of the latest proposed agreement (TPP). It is ironic that those who often hate free trade agreements are so willing to sign one now. Equally ironic is that those who usually love free trade agreements see what is going on and don't want to be part of it. I guess the truth of the matter as it relates to free trade is what is contained in those 30 chapters and 2000 pages and if the trade-offs are worth each ounce of free trade advanced. It is okay if free trade Republicans decide that this agreement does pass muster.

Tuesday, November 17, 2015

Lesson 11 The Fed and Raising Interest Rates

You would have to be a starving artist or an ex high school football star to not notice that just about everyone is talking about the possibility that the US Federal Reserve is on the cusp of raising interest rates in the USA. Some of us like the idea of higher interest rates because we are old and want our saving accounts to grow faster. Others hate the idea because higher rates make it more expensive to borrow. And with less national borrowing those people worry that the economy might tip into another recession.

You can’t get into an Uber car or stand in the check-out line at Lucky’s Food Market without hearing people talk about the Fed and interest rates. So I thought it might be nice to sit here and sip and tell you everything I know about the Fed and interest rates. The first reminder is that the Fed has no direct effect on most interest rates. It is sort of like Uncle Bob. Aunt Cami can yell at Uncle Bob to rake the leaves. But Uncle Bob is Uncle Bob and he will rake those leaves when he is good and ready to do so. Of course if Aunt Cami yells loud and long enough she might influence him. And that’s the way the Fed works. The Fed cannot use an interest rate app to dial-up a mortgage rate or a car loan rate. 

Capitalists like me would say that interest rates are set in markets and are determined by the dynamic interaction of savers and investors. Or you might say interest rate changes arise from the interactions of bankers and other financial firms with the rest of us. Either way, you are acknowledging that rates on car loans or mortgages generally rise when people want to borrow more money. They fall when borrowers are fewer but banks are full of extra cash.

So what is it with the Fed and interest rates? Like Aunt Cami (and Uncle Bob), the Fed has a few tools it uses to influence savers and investors. The Fed can influence expectations by whispering they are planning to influence rates in one direction or another. That would be like Aunt Cami saying that she is growing impatient and is on the verge of yelling at Uncle Bob. Sometimes that works and Uncle Bob starts raking like a team of banshees. If that doesn’t work the Fed can go to Plan B or do what’s called quantitative easing and act as a very large buyer or seller of mortgages or other loans. Thus the Fed’s activity in the markets affects the supply and/or demand for assets – assets whose rates they are trying to influence. I am told that QE is not being used now. So that leaves us with something called the Federal Funds Rate (FFR).

The FFR is something akin to a quark.  Most of us will never see, smell or touch a FFR – unless you are a banker. The FFR is the rate of interest on a loan between two banks. Bank A has extra money. Bank B has a juicy new loan prospect but no money. So Bank A loans its excess to Bank B. Bank A charges Bank B the FFR. And we all live happily ever after. 

But what happens if all the banks want to lend to clients and none of the banks have extra cash? That is when Supergirl – er I mean the Fed steps in. The Fed buys government bonds from banks – thus adding liquidity or money to the banking system. This not only gives banks more money for loans but it also keeps the FFR low. As this amounts to a lower cost of funds for banks – banks can now keep  car loan and mortgage rates low too.

To raise interest rates the Fed does the opposite. To raise the FFR the Fed sells government bonds to banks – drawing money out of the system making money costlier. Bankers may or may not pass these costs along to people who borrow. But often it does work that way. So we say the Fed influences most market rates as it moves the FFR up and down.

In short the Fed can affect market interest rates and the world is watching to see if they will start raising the FFR this December. Lets suppose they do start doing this in December. How much will the FFR rise initially? How much will it rise in total over time? How long will the Fed keep the FFR high? One way to answer these questions is to look back at other times the Fed started raising interest rates.

So I plotted some FFR data – quarterly data – from 1980 to present. And here is what I found. See the table below for the details.
(1) Since 1980 there have been five times when the Fed moved to raise interest rates.
(2) Typically rates rose for 4-5 quarters but in 2004 the increase went on for almost three years (11 quarters). 
(3) Notice also that the rate at the beginning of the rising cycle was only 1.4% in 2004. During the four other episodes the initial rate was already pretty high averaging from 4.8% to 8.8%.
(4) The average rate increase in the first quarter  was about 54 basis points – or less than half a percentage point. For example in 2004 the rate was initially raised from 1.4% to about 1.9%.
(5) Over the full course of the policy period rates rose by an average of 267 points. The FFR increases were anywhere from 177 points to 382 points. In 2004 the rate started at 1.4%, immediately went to 1.9% and then over three years rose to about 5.2%. 

Year    #Qtrs Rate    Increase1   Increase2
1983      5      8.8      66                   259
1988      5      6.7      52                   307
1994      4      3.9      66                   208
1999      5      4.8      34                   177
2004    11      1.4      52                   382

Year is when the FFR began rising
#Qtrs is the number of quarters until the FFR declined
Rate is the value of the FFR at the beginning of the cycle
Increase1 is the number of basis points the FFR increased in the first quarter
Increase2 is the number of basis points the FFR increased before it decreased

The past can only be a rough guide to the future. 2016 will not be a copycat of any of these previous five cycles. It won’t exactly copy the past because 2016 will not be the same as the years before those past interest raising cycles.

But the past always informs and helps to put things into perspective. Rates do not usually rise by huge amounts and the tightening spells have lasted between one and almost three years.

At the end of 2015 rates are historically low and the world economy is barely moving along. Thus, market forces are not expected to present much pressure toward raising interest rates in the near future.  Most economists are predicting an initial FFR rise in the neighborhood of maybe 25 basis points. Should the Fed raise the FFR by 25 points in December or in early 2016 it does not follow that rates will swiftly climb in the next four quarters. In fact it is altogether possible that the 2016 cycle will be much more like the 2004 cycle than any of the others.      

The key takeaway is that the hullabaloo over when the Fed will begin raising rates is nothing compared to the anxiety that will arise once it begins raising rates. The drama will have only begun. Stepping to the open door of an aircraft flying at 12,000 feet is daunting but only the beginning of the story. 

Tuesday, November 10, 2015

The Common Cold or Economic Anemia?

Peter has had a cold for nine consecutive weeks. He is running out of Kleenex and good cheer. That’s a long time to have a cold. Peter looked back at his precise records. In the last 67 years he has had 10 colds. The longest one lasted three weeks. Most of them lasted only one week. Nine weeks? Maybe it isn’t a cold! Maybe Peter should be worried.

In similar fashion, Real GDP in the USA has grown by less than 2.5% for nine years running (if we count 2015 which is not over yet). This “economic cold” has lasted since 2007 just before the recession turned real GDP change negative. We have been blowing our collective economic nose every year since. Below are the annual real GDP growth figures (percentage change from the year before):

            2007  1.8%
            2008 -0.3%
            2009 -2.8%
            2010  2.5%
            2011  1.6%
            2012  2.2%
            2013  1.5%
            2014  2.4%
            2015  2.0% (based on 3 quarters)

If this was your kid’s GPAs for each term at Harvard, you might call the Dean and ask what is going on when your brilliant kid has such a mediocre record. The US economy is capable and expected to do much better. For example, the average annual growth rate of real GDP since the end of WWII is about 3.2%. Before the recession started between 1990 and 2006 – the average was 3% per year.  3% is an average of many years  -- during the past we have had recessions followed by strong growth periods many times. The average is not the best we can do. It is what one might call normal.

So I chose 2.5% for my analysis this week because it is clearly below normal. It might be a good rate for Germany or France of Japan – but it is not good for the USA. Nine consecutive quarters below 2.5% growth probably indicates that something is wrong – and that something is not the common cold or an allergy attack.

When you look at my table above – forget the two recession years when real GDP fell. Look instead at the years when we might have had a rapid recovery (with rates well above 3%) and then a sustainable growth phase. We had neither. In those 6 years the best we could do was 2.5% (in 2010). Look at the pattern – a little above 2% one year followed by a little below 2% the next. Those 6 post-recession years average to about 2% per year.

Our politicians seem to agree that this is not acceptable economic performance. But what galls me is that they are not really very serious about doing anything. When is the last time you saw Hillary or Bernie or any of the 92 Republicans shouting about the need to increase economic growth. While they will each say that growth is important, the energy behind a growth remedy is surely lacking compared to the many hot button issues that generate a lot of heat and light (abortion, gays, healthcare, income distribution, immigration, and so on).

This is crazy stuff because if you get higher growth – we take care of some of these problems anyway. Consider if we had grown in the last six years by 3% per year instead of 2% per year. That means real GDP would have grown to $17.3 trillion in 2015 instead of to $16.3 trillion (it was $14.4 trillion in 2009). Just having average growth in the US economy after the recession would have netted us an extra $1 trillion in income. That equates to about $3000 per person. I won't calculate the number of extra jobs but that number would be considerable too. 

Or put another way, this means that whatever is wrong with the US economy since 2009 is robbing the average family of four of about $12,000 each year. Is that not enough to get someone’s attention? 

Government dis-function is the culprit here. The pundits tell us each night that voters are mad as hell at failure in Washington. This trillion dollars of wasted energy explains why they ought to be angry. If candidate X really wants to stand out from the crowd -- he or she might run on a platform of giving them their jobs and a trillion dollars back. Democrats and Republicans approach growth from very different platforms and ideologies. That's okay with me. But let's at least make growth the heart of the debate. Let's at least have a debate. What is causing less-than average growth? How can we address those causes? This is not quantum physics folks. 

Tuesday, November 3, 2015

Triplets and the Tax Reform Blues

The WSJ on October 29th  featured an article by Republican Candidate Ted Cruz about tax reform. Cruz joins Jeb Bush and some of the other candidates in laying out thoughtful pro-growth tax reforms. We will be seeing more and more of these as we approach the coming presidential election.

While there is much to discuss and debate about the particulars of these tax reform plans, today’s blog post is more about the elephant in the room. Somehow these serious attempts to reform taxes and promote economic growth avoid or miss some important consequences and therefore make it very easy for the opposition to demagogue such plans.

It is no secret that income distribution and the national debt are twin ticking time bombs. Yet none of these tax reforms advance any serious if debatable discussions about how tax reforms might impact these issues. Democrats can’t do a sit-up without lamenting what has happened to the income distribution. Whether you agree with their policies or not, many of us wonder how long the economy can tolerate this apparent dislocation of wealth away from the poor to the rich. Clearly we do not want to be responsible for policies that exacerbate this widening gulf. But this is red meat for Democrats every time a Republican offers a tax reform program that skirts this issue. I don’t think Cruz’s recent article said one word about the effects of his program on income distribution.

Why? Perhaps it is because he wants us to assume that his plan will improve the situation. Economic growth lifts all boats. I agree with that statement but like many economic truths it is contingent. The truthfulness of it is related to other things happening in the economy. Doing push-ups is good for you. Give me 20. It will make you stronger and happier and sexier. But coach, I have a broken arm! Oops…maybe you should not do any push-ups right now.  So Cruz and the other tax reformers owe us a serious explanation for why their policies will not worsen and might even improve income distribution. If they don’t do it themselves – this leaves a lot of room for Democrats to make up outrageous stories. I can just see Hillary right now explaining how a flat tax is going to save billionaires zillions of dollars while the poor guy gets enough to buy a lottery ticket.

The other elephant in the room is national debt. Advocates of tax reform plans resemble the cheesy used car salesman promising that if you buy this plan you will grow hair and sleep through the night without one trip to the lavatory. As in the income distribution discussion, these Rs are whistling and crossing their fingers behind their backs while promising that a flood of tax revenues will flow over the dam. Lower tax rates mean tax revenues will jump higher than Michael Jordan on a trampoline. If debt is a problem, then these Rs need to do their homework and do some serious calculating about tax reform and debt. I would rather have them arguing about specific assumptions and elasticities than be such easy prey for the Ds. Silence is not golden.

Of course there is another approach that can work. Maybe Cruz and his playmates should admit that tax reform might not have a positive impact on the distribution of income and the debt. What? Larry are you nuts? Probably. But here is my point. The income distribution did not get out of whack easily. Maybe some serious thinking about the real causes of a poor income distribution would result in a serious policy aimed directly at those problems. Admit that tax reform is about growth. Tax reform cannot brush your teeth and walk your dog. An honest discussion and feasible policies to improve income distribution could go a long way politically.

The same goes for debt. Tax reform does not have to impact debt if it is tax neutral. It is a slam dunk that debt is not the result of deficient taxes but results from an incessant desire for government to spend more and more. Don’t hang your tax reform hat on the debt. Admit it has little to do with the nation’s crushing debt. And then have a separate program that goes after runaway spending. If you don’t think spending is running away just read my recent post “US Government: Liars and Thieves.“  Since I wrote it Congress decided to add another $80 billion on top of what was already a generous trajectory for spending.

So there you are. Tax reform is needed but it doesn’t stand a chance of passing if the good guys don’t couple it with serious approaches to income distribution and national debt. It is too easy to sabotage tax reform if nothing is said about these evil sisters. We might think about triplets.