Tuesday, October 25, 2016

Fed Gone Wacky?

Bloomberg.com had an article last week with a photo of a smiling Janet Yellen which said that the Fed was elated that the inflation rate was rising in the US. On the same day was an article “The Fed Embraces a More Diverse Future” that had several quotes from Fed officials decrying disparate effects of unemployment on minorities. Minneapolis Fed President Neel Kashkari promised to “spend a day in the life of a struggling black family in order to better understand that experience.” The article concluded  

“While the Fed may have no direct ability to do anything about this relationship, it may be less willing to call an overall unemployment rate of 4.5 to 5 percent full employment if it coincides with a black unemployment rate of 8.5 to 9 percent.

I wanted to know more about the explicit goals of the Fed. I found the below words at a Federal Reserve website https://www.federalreserve.gov/faqs/money_12848.htm
The Congress established the statutory objectives for monetary policy--maximum employment, stable prices, and moderate long-term interest rates--in the Federal Reserve Act. In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

Wow. Double Wow. The Fed’s explicit job is to control inflation and employment. Yet today’s Fed officials are happy to see more inflation and are not content when they reach their goal of full employment.

Interesting is how cavalier the Fed is departing from its statutory mission. I can see it now. Hey coach I think I would be more popular if I played guard on our football team. But son, you are a quarterback. Come on coach, the linemen are cool guys and I always wanted to hang with the cool guys.

The Fed has no mission and has no ability to affect the composition of unemployment. If they drive the unemployment rate below the usual definition of full employment – they can provide some jobs for those at the lower end of the labor pool. But history shows that such jobs do not last very long. Driving unemployment so low will cause the economy to run fast enough to absorb more workers. But like any engine that runs faster than normal for a while – it will generate frictions that eventually bring it back to normal – if not requiring a new engine! History suggests also that the aftermath of such reckless driving is often the dreaded scourge stagflation wherein both inflation and unemployment rise together. At some point the Fed then has to tighten and cause a recession and even more unemployment. Thus gains are not only temporary but they end up worsening the entire economy.

As for the seemingly perverse joy over a September rise in the inflation rate, this just underscores my point. Yellen has recently been quoted as saying it would be okay for the economy to run hot for a while. I like my coffee hot but she is delusional if she thinks a hot economy is a good thing. Higher inflation and a hot economy won't accomplish anything except to raise and then dash the expectations and lives of those least able to deal with such changes. 

Unfortunately our current Fed has fallen for the liberal line that one should focus on the short-run. Despite relying on nothing more than dreams and drugs, our Fed wants to make people feel happy that it is doing something. But like many do-gooders, the Fed has neither the tools nor the mission. Just because Congress is broken it does not mean the Fed can pull a rabbit out of a hat. Unequal incomes may be a problem but like the QB who wants to be an offensive lineman, the Fed is neither qualified nor licensed to solve this problem. Mrs Yellen -- please just stick to your job description.  

Tuesday, October 18, 2016

Lesson 16: International Investment

Those of you with post-kindergarten training may or may not know that governments keep international trade statistics. Even some of our current presidential candidates know that.  These statistics are found in something called the Balance of Payments Accounts and are found at bea.gov . 

While there are two equally groovy parts to the BOP figures most politicians only know about one part of it, the Current Account. The Current Account is on the top and we wouldn’t expect those people to actually read all the way down to the bottom, right? They are busy people. Also the history of the world and the solar system has emphasized the Current Account so it would be unfair to criticize our politicians for only knowing about the Current Account.

This Current Account is where we publish statistics that have to do with exports and imports of goods and services. We sell Chevys to China and they sell rice and replicas of the Great Wall to us. It’s a cool deal. Some of our political leaders have noticed that our dear country almost always has a deficit in our Current Account. And that burns them. After all – the word “deficit” is not a nice word. If your teacher said you had deficits in your behavior, you would feel injured and probably never get a PhD in science or classical studies. This deficit in Current Account means that we are buying more stuff from other countries than they are buying from us. This is especially true of China and since we have a very long list of other issues with China, our politicians complain and sometimes cry that this deficit with China is worse than Dengue Fever and needs to be stopped.

I have written thousands of posts (I exaggerate all the time) which explain why Current Account deficits are not necessarily bad things and I don’t won’t to repeat all that minutia here. I see the Tuna is already starting to nod off.

This post is about the other part of the BOP Accounts – the part at the bottom that most people ignore. It is the part that our politicians don’t have a clue about. So you should feel very special that I am doing this for you today and send either money or JD to thank me.

The second part of the BOP account is called the Financial and Capital Account (F&C Account). What a name! Can you imagine being in the first grade and having a name like that? No wonder no one looks at this account. But this account is the coolest kid on the block and has a lot to tell us.

The F&C Account records all the financial trades between countries. We don’t usually call these import and exports – instead we talk about outflows and inflows. If China invests in America we call that an investment inflow. We like it when foreigners open up US bank accounts and when they buy our bonds, stocks, and companies. All of those financial inflows are recorded in our F&C Account. At the same time, we also like it when US citizens invest abroad. We usually call that diversification. You don’t want all your eggs in one basket and you don’t want all your investments in US bonds, stocks, etc.

When foreigners invest in America we call that an inflow. When US citizens invest abroad we call that a financial outflow. Globalization means that citizens around the world have become increasingly interested in investments both at home and abroad. 

So as a public service and hopefully for money and booze I will acquaint you with some of the financial flow numbers. Below I will refer to some numbers from a close cousin of the F&C Account called the International Investment Account or IIA (the F&C Account focuses on the one period flows between countries while the IIA reports the resulting total ownership positions). 

As it turns out, there are some looming risks associated with the IIA account that we should be worrying about. Unfortunately our leaders are playing with their bellybuttons and/or are unaware of these trends.

I went to the bea.gov web site and downloaded a spreadsheet of IIA information from 2000 to 2015. Here is some of the information from that download:

                                         2000   2007   2015
US Ownership of F. Assets   7.6    20.7    23.3   
F. Ownership of US Assets   9.2    22.0    30.6
Data is trillions of US dollars
F. stands for Foreign

This little table tells you the following:

·       Globalization of financial markets was very evident in the new century with foreign ownership more than tripling from 2000 to 2015.

·       Most of that increase came between 2000 and 2007.

·       Then the activity slowed – especially with respect to US ownership of foreign assets. After growing by $13.1 trillion in the first period, it grew by $2.6 trillion between 2007 and 2015.

·       Foreign ownership of US assets slowed as well but it still increased by almost $9 trillion between 2007 and 2015.

·       If we focus on the 2007 to 2015 time period we see a much wider gulf – foreigners owned $7.3 trillion more of us than we owned of them. Nearly all of that gap can be explained by what is called portfolio investment (in bonds and stocks). That gap was $1.6 trillion in 2000; $1.3 trillion in 2007; and then $7.3 trillion in 2015.

What’s going on? Why are foreigners so interested in our financial markets?

First, since the financial crisis, the US has done better economically than other countries. A relatively stronger economic profile means more confidence in our financial products. Think Greece, China, and Venezuela.  

Second, think US government deficits and debt that have supplied a lot of investment opportunities to both residents and foreigners. Foreigners gobbled up our huge pile of new government bonds!

Third, while foreign companies did increase their acquiring and merging with in US companies, most of the gap mentioned above came from investments in private bonds, government bonds, and equities.

Fourth, notice that despite the gap, US citizens have shown a strong and growing appetite for foreign bonds and stocks. Despite a financial crisis foreigners continued to buy US assets and Americans continued to buy foreign assets.

What do we make of all this? When the gap is favoring US assets, this implies two important things. First, people need dollars to buy US assets so this has strengthened the dollar. Second, when foreigners buy our assets this pushes our asset prices up and interest rates down. With the huge increases in national debt and the needs of firms to finance their investment projects, this asset demand from foreigners prevented our interest rates from rising/stocks falling and thus helped to keep the US economy growing.  

And this is what concerns me. What happens when things turnaround? What happens when other major countries strengthen and their assets look more desirable to global investors? What happens when our government increases its debt even more as foreigners desert US financial markets? Financial globalization made the US wealthier when the rest of the world was weak and uncertain. Financial globalization will have the opposite impact if the US grows weaker relative to Europe, Japan, China, and other countries. Our politicians have complained loudly about the Current Account Deficit. Just wait to see what happens when buckets of money leave the US to be invested elsewhere. Then we will be clamoring about deficits -- deficits in the F&C Account!  

Tuesday, October 11, 2016

Debt? What Debt?

After the Presidential debates one would have wondered if national debt is in the vocabulary of our two candidates. Surely Donald Trump’s business deals in the 1970s and Hillary’s personal appearance are more important than the national debt. At least those two issues were discussed. But nary a word was uttered about the national debt. 

Each try to outdo each other with policies that would increase the debt but none seemed worried that a larger debt might be a problem. Surely making college free is more important that a nation’s debt. Surely giving families more time off from work is more important than a nation being able to pay off its debts.

So here I go again about debt. Debt is both easy and complicated. It is both beneficial and dangerous. It is seductive like a night with a hooker and debilitating like the rash that follows. And like the drug addict, he or she is the last one to ever admit that he or she is hooked. What a topic!

Debt is easy to understand. Consider three stories.

Story 1. You get to the end of the month and you spent all your cash. Luckily you have a plastic card that lets you buy a few more essentials. Or maybe you buy a few more Miller Lites or a lottery ticket. Next month you conserve a bit and are able to buy all you need and payoff your credit card. In that case, the debt lasts only a month. That story is both simple and nice. Debt was an instrument to accomplish an objective.

Story 2. You want to buy a house or a horse. Or a hose. These items all start with H and all three of them are durable goods. If you take care of them they last a while. It makes sense to pay for them over a time period that is similar to the life of the durable good. So you use credit to buy a durable good and you pay it off over time. That is another simple and acceptable role for debt. If you are a humble employee in the workforce you don’t buy a $4 million dollar house. It is too expensive. It would create too much debt to pay back. Instead you buy a house whose payments are comfortable for your monthly income.

Story 3. You buy that $4 million dollar house. Or maybe you really like JD but you decide to instead buy a new $400 bottle of Pappy. You like the Pappy so much that you buy a bottle a day and a few extra bottles for your friends. Clearly you cannot afford $12,000 per month for bourbon. But it REALLY tastes good. Your mortgage lender or your credit card company likes you to take on more debt. At least until the day comes when you quit paying them.

Story 3 is a silly story, right? But we know that people and countries do this kind of behavior. People go into debt for all sorts of reasons – houses, cars, education, jewelry, gambling, drugs, and more.  Countries get hooked on defense spending, pension programs, healthcare, and more. When I say hooked I am not implying anything negative about spending on any of these items. The problem comes when you spend more than you can afford and you find it difficult to stop.

But what can you afford? That’s an interesting part of all this. Except for the dishonest and corrupt, most of us think we can afford our debt. Like me, many of you bought your first house, looked at the size of the mortgage, and started to shiver and shake. Can I really pay back that amount? I was young then and did not know what would happen to me. But a good financial system has criteria and rules and they are willing to bet on people who have track records and/or whose current situations warrant trust.

This brings to mind two challenges. First, we make mistakes and accidentally take on debt that is too high. Second, unexpected things unfold that change the equations. Worst among these is that you lose your job and/or your future income turns out to be much lower than you expected. Also terrible is that unexpected expenses crop up and eat up your income – healthcare, a family member needs help, your kid gets accepted to Harvard, and so on. Whatever the case, stuff happens and then you can no longer pay the debt.

When you can no longer pay the debt is when things get tough. There is no easy way out. You are between the proverbial rock and hard place. Even if you find a way to not fully repay your creditors, you are back to square one. You have lost the durable good that you can no longer afford. And now, you will find it much more difficult to get new credit – so you will have to live on what you earn. The choices at that point are very unattractive.

Notice that all of this would have been avoided if you had not taken on the debt. Or that you had taken on the debt in a more sustainable way. That leads to unpleasant but rational realities like borrowing much less than the bank will allow. That might mean buying a cheaper house or car or going to IU instead of Harvard but it also means that contingencies are easier to deal with. Another option is to wait. While you wait you save money and later make a good down payment on the durable good. No alternative is foolproof in an uncertain world. But some options reduce the probability of a catastrophe.

Debt is inevitable. Debt can have unforeseen negative and debilitating consequences. So it is good to handle it carefully.

All the above applies to countries too but it gets more complicated. For one thing, having its own currency means that most countries can print money to pay debts. At least for a while. Excessive currency creation we know might work for a while but then it causes inflation and other instabilities that transmit a message to creditors – this ship is taking on water and may sink.  

Think about what happens when a country gets a debt problem. Below I am summarizing some of the things we have learned from debt crises over the years in many different places. The first signs come when the debt gets big enough for people to notice. At that point investors shy away from the debt and that reduces bond prices and raises interest rates in that country. If the debt is not attended to debt rating agencies downgrade the debt causing rates to rise even more. A reduction in purchases of debt by foreigners may cause the currency to depreciate. A rapidly depreciating currency is worrisome and will sometimes cause a country to try to stabilize the downswing. It does this by buying its own currency using foreign reserves – and then the level of those reserves fall. That sends another worrisome signal to the world.

Then the world waits to see if the government gets the point. Everyone knows they have gone into too much debt and need to do something about it. The more the country hesitates to reduce its debt in conventional ways – the more confidence falls, the more interest rates rise, money flows out, the currency depreciates, and foreign reserves plummet.

I am getting depressed. Where is that JD?

What about the US today? Where are we? Actually we are okay. Yes the debt went from roughly 30% of national income to more than twice that in the past decade – and is scheduled to rise even more based on current laws. Some estimates have US debt closing in on about 100% of GDP soon. But that is BEFORE we factor in any of the current proposals by the candidates for more spending and/or less taxes. So maybe we are talking well over 100% by the time the new President gets rolling.

But that’s not the whole story. What happens if we have a crisis? We are due for a recession in the next few years. Given alarming trends in China, Russia, Iran, and Syria might we decide to spend a lot more on defense and security?  Will we need to bail out business and/or student debt? Such scenarios could send our national debt soaring to well above 100% of GDP. Then what will happen? Nothing good! Now is the time to worry about that. Not after the fit hits the shan. 

Tuesday, October 4, 2016

Lesson 15 Money and Monetary Policy

Janet Yellen is the head of the Fed. She and her colleagues at the Fed determine the nation’s money supply. Much has been said about her management of money and lately she is being labelled a lackey of the President and Mrs. Clinton. I doubt she is lackey but I would say that she is guilty of drinking the same Kool-Aid as her liberal progressive buddies in government.

We grew up with Kool-Aid and I don’t mean to disparage that lovely and colorful drink with enough sugar in it to start a diabetic colony.  What I mean is that Yellen, Obama, Clinton and many others share a similar philosophy in general and in particular with respect to the magical qualities of money.

And that’s what makes this post today so much fun. Money itself is about as exciting as your Uncle Ed who rocks himself to sleep at 1 pm in the living room while you watch his cigar ash fall on his partly open bathrobe. Money is paper. Or money is electronic entries that get transferred from one account to another. 

This is not exciting stuff. You buy something – whip out a bill or a debit card – and the deed is done. Nothing to write home about there. It’s like your best friend Peter. You wear plaids and so does he. You wear stripes and so does he.
Although money itself lacks any real excitement, governments can turn it into Charlie Sheen on crack. There was a day when the world did not have money. We called that barter. A farmer would trade three carriage loads of corn for two dresses. That worked okay but corn farmers could not always find dressmakers and so pretty soon money evolved. If everyone carried money it made transactions much simpler.

Money went through a number of stages. Money needed to be around. At first it was commodities – stuff that most people already had and knew the value of – like corn or wheat. Then they were replaced by commodities that seemed to be more durable and held value better – like silver and gold. Silver and gold are pretty but those commodities are heavy or bulky and not easy to safeguard or carry to Sam’s Club. The next stage created paper money  wherein the paper money had to be backed by gold. Paper was essentially valueless but it represented an amount of gold.

Are you history-lovers still awake? Finally came the stage where money could be pulled out of a hat. Not really a hat but essentially the same thing. Central banks create money at will. They need nothing but a magic wand and an Internet connection. Money is “backed” by faith that the central bank will always create the right amount. Not too much and not too little. Like Goldilocks, we like just the right amount of money. The Fed pretends to give us what we want.

And here is where ideology comes in. The conservative school of thought sees the world as being very complicated and uncertain. The right amount of money is no easy thing to attain. Jim suddenly needs money to fix his roof. Dan swears money off when he decides to live in the forest. Imagine figuring out the right amount of money for a whole country day by day. Humbly, conservatives prefer a passive approach. Transactions usually grow by about 5% per year. So let the money supply grow by 5%. End of story. Go fishing.

But liberals always think they know more and apparently they are nervous people who don’t like fishing. They erect giant data collecting machines and try to measure the demand for money on a minute by minute basis. They take great delight and credit by measuring and the ups and downs of money and then trying to match those demand changes with more or less money. Think Whac-a-Mole. Liberals admit that sometimes they get it wrong. They admit that sometimes they even cause recessions when they get it wrong. But alas they are progressives and they are pretty sure that sometime in the future their models will be more correct and the world will be saved. Think Don Quixote.

If the above is not enough to make you reach for the JD pitcher there is more. Even though the infamous JM Keynes said that controlling money was like pushing on a string other modern liberal economists decided to give monetary policy a bigger role in society. Matching money supplied to transactions needs was way too boring for these moderns. So they decided they would match money to employment, prices, exchange rates, and hooker sales. If employment was too low then pump a bunch of money. If prices are too high take it back out. If exchange rates rise then blame China. If hooker sales go up or down call Charlie Sheen.

Talk about a way to guarantee that your name will get into the Bloomington Herald Times on a regular basis. The Fed now has so many balls in the air that it would take a multi-headed hydra to try to catch them all. But undaunted they collect data every day and they have serious discussions and then they go home to their mansions and foreign sports cars.

Yellen and her buddies at the Fed and in the government are not necessarily colluding. They simply have this faith that they know how to manage a 21st century global economy. That they have been doing it badly never concerns them. They never question this faith that more active policy is better. They are modern and smart. They will learn from their mistakes and finally get it right. They will save us.

Their disease is incurable because failure begets more activism and then more failure. Nowhere in their playbook is taking a deep breath. Nowhere in their training is the idea that too much variance and activism creates uncertainty. Nowhere in their discussions is that it takes time to disentangle short-term noise from long-term trends. Nowhere in their arsenal is the knowledge that some problems are non-monetary in nature and require non-monetary solutions. 

Lackey? I don't think so. Misguided and dangerous? I think so.