Sunday, June 25, 2017

Mr. Tuna Goes to Washington

With healthcare and tax reform in reverse and the debt ceiling sagging, I thought it might be fun to create some perspective. This will seem silly compared to all the serious things politicians say to us but sometimes it may be helpful to step back and see the essence of the situation – the proverbial bull in the china shop.

Imagine the Tuna sitting in his ill-fitting Walmart suit at the Sixth National Bank of North Avenue. He is more nervous than usual waiting for the Vice President of Horrible Loans to arrive. Tuna has a large roll of toilet paper next to him on which he has written down all his past debts, current income, and expenses. He also has a good luck charm from his glory days of tackling swift runners like the Kilt.

Luckily, the VP is in a good mood and offers the Tuna a bowl of Starbuck’s finest blend and then the fun begins. How much debt do you have, Mr. Tuna? Please call me Charlie the Tuna. Okay, Mr. Charlie the Tuna, how much debt do you owe? A ton, sir. In US dollars, I owe about a million give or take a grouper or two. Wow – that’s a lot of debt. I see you are retired, how much do you earn, including Social Security benefits each year? Together the missus and I earn about $60,000 per year. Hmm, says the VP. How much do you spend each year? Well sir, we are quite frugal in our household. We try to not spend more than $100,000 per year, if you count Mrs. Tuna’s weekly mani-pedi.

Why are you here today, Mr Charlie the Tuna? Well, we need to buy some of that long-term healthcare stuff, and we also want to buy an Airstream travel trailer. So we are going to need another $300,000. Tuna is quite confident that he has answered all the VP’s question and is beaming with pride.

So let me summarize, says the VP. You owe a million now. You spend $40,000 more each year than you earn, and you now want to borrow another $300,000. Yup, that’s about it. Tuna is very optimistic that the both of them understand the situation perfectly.

Then the VP asks another series of questions. Is it possible that you could spend a little less money each year? For example, could you cut back on large rib-eye steaks? Or maybe end your subscription to Hustler Magazine, or maybe even not subscribe to HBO? Or maybe you could get a paper route to earn more money? Tuna is confused. All those things sound crazy. Cut back on large rib-eyes? Reduce his porn intake? Work more? Geez, the next thing the VP might ask him to do is run a mile in short pants.The Tuna stands up and tells that VP a thing or two. Surely there are other banks that would treat him more fairly.

Okay, I had an extra JD with my bagel this morning. But I swear to you that this silly little tuna tale is exactly what is going on (in sophisticated language) in Washington, DC. The Congressional Budget Office projects government spending, revenues, and debt from 2017 through 2027. These numbers are based on past legislation. National debt held by the public will rise from $15 trillion to $25 trillion – or from 78% of GDP to 89% in 2027. The 78% today is the largest since World War II. So debt is basically huge today and promises to get much bigger even before we factor in proposed changes in infrastructure spending, tax reform, military spending, and so on. 

Government spending is also expected to grow – from about $4 trillion this year to $6.5 trillion in 2026. Taxes will also be rising but not fast enough. The federal government deficit will be about $600 billion in 2017 and without any new legislation will grow until it reaches $1.4 trillion in 2027. That means for every year between 2017 and 2027, yearly deficits will be somewhere between $600 billion and $1.4 trillion. That adds up!

These numbers are no better than the Tuna’s mythical situation above. This country is an economic train wreck. No wonder the economy is stuck in low gear. Our politicians put us in a no-win situation. If they raise taxes or reduce spending, we know that will have negative impacts that are nearly impossible to tolerate in this political climate. If they allow the debt numbers to rise even more, we could be the next Puerto Rico, and I don’t mean anything about rum.

That’s just the macro situation – it gets even uglier when we drill down to specifics. Senator A wants to spend more – not less – on defense. Senator B wants German Shepherds to have free health care. He won’t take a nickel away from any social program. Senator C says he loves old people and won’t threaten their ability to afford Mediterranean cruises nor will he touch spending on Medicare or Social Security. Senator D wants to reduce tax rates, and Senator E has a crush on Nancy Pelosi.

What’s the point of my rant? The harm has already been done, and our government officials do not recognize what is clear to many workers and business managers. Potential workers are staying out of the economic system. Firms are not investing in capital. The economy lags. Politicians give us technical crapola to divert our eyes and ears from what is real. What is real is that we are between a rock and a hard place, and the only salvation comes in ways that demand a first step backward. Someone is going to have to give up something. Few politicians will admit the truth because they fear they will lose their jobs. I don’t see any leaders out there. It will get worse before it gets better.

Merry Christmas from the Grinch. 

BTW. Charlie the Tuna didn't get the loan and decided to un-retire and run for the US Congress and swim with the big spenders.

Tuesday, June 20, 2017

Inflation and Rocky: Down But Not Out

The table below explains why people are saying, what’s up with inflation? In the decade including 2007 to 2016, the US inflation rate averaged 1.9% per year. If we compare that to any of the full decades from 1950 to 2010, that 1.9% is lower than any of the 10-year averages. The lowest annual inflation rate for a decade was the 2.3% of the 1950s. The 1.9% is also lower than the average annual rate of about 4.7% per year from 1950 to 2010.

What happened to inflation? Why is it so low? Are we in a new zone wherein low inflation is guaranteed for the foreseeable future? Or is it like Rocky and will bounce off the canvas once he clears his head?

Since only the Tuna knows the future for sure, I can’t really answer those questions. But a good place to start is with an understanding of tires and pumps. No just kidding. A good place to start is with some basic macro. And basic macro says Rocky might be wobbling right now but don’t count him down and out.

Inflation is the percentage change in prices for a nation. We use words like “basket of goods and services” to evoke the idea that inflation is not about the price of pickles or goat cheese. "Basket of goods and services" makes one think of all the goods and services the people of a country might typically buy. Inflation refers to how the cost of that basket of goods and services changes over time. If it cost $100 dollars one year and then rose to $105 the next year, we would call that a national inflation rate of 5%. If that same basket of goods and services fell to $104 in the next year, we would call that a deflation rate of about -1%.

You can see why people might worry about inflation. If your wages did not rise but the inflation rate was 5%, then you would feel poorer because your income would buy fewer goods and services. Ouch. The same goes for all your saving. If you have $1000 in the bank, it too will buy less because the cost of things went up. Double ouch.

That brings me to my first point. How could inflation rise by more than your wages? It doesn’t make much sense that it could go on very long. Sure, greedy businesses might want to raise their prices but if wages don’t rise and people can’t buy as much, then surely the price increases won’t stick for very long.

But look at the table. Inflation has kicked up many times and for as long as a decade or more. How is that possible? The first answer is government. The second is expectations.

Consider how government figures into this. Suppose firms raise prices but not wages. Consumers can't buy as much as before. The economy begins to slow. Governments don’t like recessions, so as the economy slows, the government decides to stimulate spending. Government stimulation thereby replaces the reduction in private spending with an increase. With spending restored, inflation sticks.

So firms raise prices again. What fun! Inflation is on a roll. Meanwhile workers are saying, what’s up? Dudes, you keep raising prices but not wages and we keep getting poorer. Cagey firms might then give in to wage demands. Notice that higher wages mean that workers can buy more and this keeps the inflation party going. But the trick for firms is to NOT raise wages enough to seriously damage their profits.  

For a while (much of the 1960s and part of the 1970s), workers got wage increases but they never quite caught up. And then viola!, workers figured it out and demanded a proper wage increase. In 1979, coal miners asked for a 39% wage increase for their coming three-year contract. Other workers followed. That was like taking a 2x4 to company profits and caused a couple of recessions in the beginning of the 1980s. Once workers expected higher inflation they wanted higher wages. This is the second impetus to higher inflation as firms pass along those new costs into even higher prices for goods and services. 

Those recessions created the incentive for the government to jump in again. Except by 1980 the government had accumulated an ugly national debt and wasn’t prepared to bail out the firms. No bailout? Without the bailout and with a weak economy, firms were much less apt to try to raise prices. The table shows the inflation rate moving in a better direction after 1980. With government stimulus and inflationary expectations falling, it made sense that actual inflation would decrease.

One more point that may seem to fly in the face of all the above. Milton Friedman coined the phrase "money, that's what I want". No wait, that was the Beatles. Forget that.  Friedman said, “inflation is always and everywhere a monetary phenomenon.” Milton Friedman was not simplifying when he said the above. So we have to add a bit to our story to bring in money.

According to Friedman and other monetarists, a government is limited in how much it can stimulate spending. In the above storytelling, I glibly spoke the company line that a government deficit could be used to stimulate spending. But that idea exaggerates their powers. Government deficit spending is less powerful if people believe that a deficit will be temporary. The more people think that the government will soon either retract spending or raise taxes, the more they adjust their spending (downward) to that expected reality.

So it is not the government deficit itself that permits spending and inflation to increase. It is the act of the Central Bank monetizing the government debt that seals the deal. Government deficits cause interest rates to rise. The Central Bank reacts to those rising rates by flooding the economy with money. And that money is the magic grease to keep the spending and inflation going. The money is not the cherry on the top – the money is the ice cream, the cherry, the bowl, and the JD.

That brings us to today. Workers are too worried about a weak economy to push for higher wages. The government has no more bullets and can’t increase spending. Thus, inflation is at bay. But that’s not the whole story. The rest of the story is the money that is sitting in bank excess reserve accounts. So long as the money sits in those accounts, we are at risk of them turning into real loans and real spending power. It won’t take a huge change to get all that green moving. The Fed is scared to death to drain those reserves from the system. They are ready to be spent. The unemployment rate is down and labor markets are tightening worldwide. Thus workers will soon feel their oats and will be ready to jump on higher wages.

It won’t take a forest fire to get things started. Little bits of information flow that make us more optimistic about the future. That growing optimism combined with a forest full of money can suddenly spark a spending spree. And that could ignite inflation expectations and lead to workers demanding higher wages. None of that could happen without all that money sitting around. With government stimulus stuck in neutral, a stronger economy can't cause a sustainable rise in inflation. With government stimulus unchanged, inflationary expectations can't unleash a wave of higher wages. It's the money that is the risk today. With trillions of dollars in excess reserves, spending can expand elastically, wages can grow without limit, and inflation will rear its ugly head. To Janet Yellen: Get rid of that money before it comes back to bite us all. Let's keep Rocky on the mat. 

Inflation Rate of the
Consumer Price Index
By Decade (In Annual % Change)

1950s                           2.3
1960s                           3.1
1970s                         11.2
1980s                           5.9
1990s                           3.2
2000s                           2.7

2007 to 2016               1.9

Tuesday, June 13, 2017

CO2 Emissions by Country: What's Up?

As the Paris Accord consumes more of our attention, I thought it might be fun to look at some numbers. We know that countries will invest resources in policies designed to curb CO2 emissions. But we don’t know all the determinants of a country’s capacity to create CO2. My little data analysis comes up short with respect to a smoking gun. There is some interesting dirt, however.

I started out with a simple model that says that the amount of CO2 a country emits ought to have something to do with fundamentals like size of the economy, the population, and, of course, its number of cows. I look at these relationships and find some corroboration. But it is very clear from the data that there are other factors that are important. As the world moves forward with CO2 policies, it behooves us to be more clear about what actually causes CO2 to be high/low for a country. Clearly one-size-fits-all policies make no sense. 

The US was the world’s second largest CO2 emitter in 2015, behind only China. The next biggest emitters were India, Russia, Japan, Germany, Iran, South Korea, Canada and Saudi Arabia. (Table in million of metric tons,

                     CO2s   Rank










Saudi Arabia

Guide to below tables. The order of each table's rows is in terms of CO2 emissions above. The rank found in the rank column in each table below refers to rank of the item being displayed. In this way we can quickly see how each of these factors correlates to a country's emissions. 

The size of the economy should have something to do with CO2 emission. And it seems to hold true since the US and China are very large emitters and have large economies. (World Bank, mostly 2015 data, nominal GDP in billions)
    Billions        Rank
China  11,158  2
US  18,037  1
India  2,116  5
Russia  1,326  8
Japan  4,383  3
Germany  3,364  4
Iran  425  10
Korea  1,378  7
Canada  1,553  6
Saudi Arabia  653  9

But this simple relationship between emissions and size of economy breaks down because Russia is the 8th largest economy but the 4th largest emitter. Iran, the 7th largest emitter, has the 10th largest economy. Its economy is tiny compared to the others.

Next, I calculated a statistic for each country that is found by dividing the amount of CO2 emitted by the size of the economy. If the economy size was the key explanation for how much a country emits, then the size of this stat should be similar for each country. 
C02 per
Economy       Rank
China 0.95 4
US 0.29 8
India 1.16 3
Russia 1.33 2
Japan 0.29 9
Germany 0.23 10
Iran 1.49 1
Korea 0.45 6
Canada 0.36 7
Saudi Arabia 0.77 5
Median 0.60

The US is the largest economy and the 8th
 largest emitter in terms of CO2 per nominal GDP, with a value of 0.29. Notice that value for the US is half the median country (0.6) value and about one-sixth the value of Iran’s value of 1.5. India’s CO2 output per unit of GDP is four times the US value. The US, Japan, and Germany are under-polluting (higher ranks) based on CO2 per GDP. Iran, Russia, India and China over-pollute relative to GDP.
This statistic varies a lot by country. Iran’s score is about four times that of the US. Russia’s is close to three times the US value. Germany has the lowest statistic of any of the 10 countries at 0.23. These numbers suggest that there is something other than the size of the economy that determines how high a country ranks on emission.

So naturally I turned to cows. Luckily there is data on cows by country and I calculated the emission of CO2s per cow in each of these countries.

                     Co2 per
      Cow        Rank
China 93 4
US 58 8
India 13 10
Russia 88 5
Japan 313 2
Germany 60 7
Iran 70 6
Korea 206 3
Canada 46 9
Saudi Arabia 1012 1

Again, the range was wide from a score of 1012 Co2s per cow for Saudi Arabia to a low of 13 for India. Perhaps the flatulence of Saudi cows is higher than those of Indian cows. But the message is clear. We cannot explain the ranking of emitters by number of cows. There must be something else.

The ranking of countries by population is almost identical to the ranking of emitters.










Saudi Arabia

(Population is in billions)

But higher population does not mean proportionally more emissions. When I calculate emissions per person for each country (table below), there is still a lot of variability from a value 16,073 for the US to only 1,872 for India. Emissions of countries with large populations like China and India are not proportional to population. Whew. Less populated countries like Saudi Arabia and Canada tend to have higher CO2 scores per person. More interesting are the US and Russia who have large populations and CO2 per person.

CO2 per
Person      Rank
China  7,734  9
US  16,073  1
India  1,872  10
Russia  12,275  5
Japan  9,900  6
Germany  9,641  7
Iran  7,504  8
Korea  12,267  4
Canada  15,441  3
Saudi Arabia  16,049  2

The last table below brings all this together. Here we see how each country did with respect to ranking on CO2 per GDP, per person, and per cow. Remember, a low rank (e.g. 1 or 2)  means more CO2 emission. So a low number is a high score on pollution -- a low number below is "bad". Thus a high number is "good".

The countries with the lowest scores and the worst CO2 rankings are S. Arabia, Russia, S. Korea, and Iran. For Russia and Iran the lowest rankings relate to higher CO2 per GDP.  Saudi Arabia gets poor scores because of high CO2 per person and per cow.

The countries with the highest (best) numbers did best on pollution emission. Germany was good across the board while India did well on account of not polluting in proportion to their large populations of people and cows.

The remaining countries were mostly in the middle. The USA, however, scored very poorly on CO2 per person though the USA did well when comparing CO2 to GDP. Japan doesn't seem to have enough cows.

Yes, some of this is facetious. But I reported it all for several reasons. First, I was well into my JD. Second, there might be some interpretations when you break down the numbers. It is obvious why a country with a huge population might have a small CO2 output per person or cow. But less obvious why China's CO2 per GDP is pretty strong despite having a very large GDP. Finally, this analysis suggests that any one-size-fits-all remedies may not succeed. CO2 emission might be strongly related to size of population, GDP, number of cows, policy or other things. What each country can or should do to improve CO2 should be the subject of much more analysis and discussion than I am hearing these days. We all nod when someone says that money and technology will solve the problem. I'm not sure it is that simple.

Summary of Ranks 
CO2 per
             GDP   Person   Cow   Sum
China      4            9           4        17
USA        8            1           9       17
India        3          10         10       23
Russia      2            5           5      12
Japan       9            6           2       17
Germany 10          7           7       24
Iran            1          8           6       15
S Korea     6          4            3       13
Canada      7           3           9       19
S. Arabia    5          2           1         8  

Tuesday, June 6, 2017

LFPR and the New Macroeconomics

The civilian labor force participation rate (LFPR) tells the percentage of the population that wants to work. That is, it counts those with jobs and adds those who are looking for jobs and relates that number to the size of the population. Not everyone wants to be in the labor force -- some are too young or too old. Some are busy getting education. Some are sick. Some don't want to work for a variety of reasons. So LFPR is never close to 100%. 

US LFPR generally increased after World War II until early 2001 after it reached a little more than 67% of the population. Since then it has been falling and was recorded as 62.7% in May 2017. This roughly 4% decline is meaningful -- 4% of the US population of 230 million people is about 9 million people who no longer participate in the labor force. To put that number of 9 million in perspective – that’s about how many people work in manufacturing. That’s like everyone in New Jersey deciding they would no longer take or look for a job. No New Jersey jokes please. 

This new 16-year trend is important. I am going to argue that it is very important and may constitute the beginning of a new phase of macroeconomics and policy. As I said last week, macro is becoming obsolete. Monetary and fiscal policy are out of bullets. Supply-side policy has political downsides. So what’s left?

The answer might reside in the LFPR. Today’s experts repeat over and over that the lackluster economic growth predicted for the future is caused by lack of business spending on capital and a reluctance of people to join the labor force. One could go further and say that the former is related to the latter – firms are pessimistic and won’t invest more because they see LFPR as a major problem and do not see a government that is doing anything about current economic challenges.

Future macroeconomic theory and policy, therefore, should be focused on LFPR. I have mused in this blog in the past that if labor is not forthcoming and if the labor that does come is not prepared for the jobs of the future, then maybe we should focus on that mismatch. In macro we usually take that mismatch as secondary and hope it will be solved by national economic growth induced from traditional monetary and fiscal policies. But that puts the cart before the horse. Maybe today we need to focus on labor mismatch and if we solve that then maybe economic growth will improve in the process.

This post today is a humble beginning in this direction, and my only goal is to shed some light on the data. Today I look at some of the data as it relates to the LFPR. I got the data from the FRED service at the St. Louis Federal Reserve Bank. I look at data from 2002 to 2017. The goal is to better understand or break down the above-mentioned roughly 4% decline in labor participation in the USA.

Consider first, men versus women. The table below shows that LFPR for both men and women fell between 2002 and 2017 – but it fell more for men – falling almost twice as much.
                        Women    Men   Gender Gap
2002                 59.6          73.9    14.3
2017                 57.0          69.0    12.0
Change             -2.6          -4.9    

Next, look at age. In 2002 almost 84% of those in the prime work ages (25-54) looked for and/or found work. Younger people worked too – 76% was the LFPR for those aged 16-24. Those 55 years or older had a much lower rate at 34%. The changes in the next 25 years are interesting. For the regular working ages the LFPR went down by only 2%. Those at the younger end found participation rates falling by at least twice as much as their seniors. As for the older folks, they are participating dramatically more – an increase of almost 6% in their LFPR!

                        25-54    55+  16-19 20-24
2002                83.7      34.2    76.7   75.4
2017                81.7      39.9    71.9   70.4
Change            -2.0      +5.7    -4.8    -5.0

Finally I look at education. The first column looks at high school graduates 25 years and older; the second is college graduates 25 years and older. The impacts of college education on LFPR are dramatic. While college-educated people did participate somewhat less in 2017, the change for high school grads was much larger – almost five times as large.
                        High School              College
2002                          64.4                75.4
2017                          58.0                74.0
Change                      -6.4                 -1.4

This excursion through some data is meant to be a first step in looking deeper into a major macroeconomic challenge. Surely this is not enough data to form solid conclusions. Curious minds would wonder about other and finer breakdowns as they relate to education, training, age, race, location, industry, and more.

What is going on in the last 16 years? This data suggests that the largest groups to explain a slowdown in labor participation are young males with less education. Surprisingly, older people who should be enjoying time on Alaskan cruises sipping JD seem to be increasing their participation.

A scientific friend of mine said that most good science starts with data and ends with understanding. Labor force participation data needs to be better understood. Then perhaps we will know WHY participation is flagging and perhaps what we can do about it. Let's get back to work!

Tuesday, May 30, 2017

Do We Need a Bigger Pot?

You planted your lovely Japanese Maple in a nice pot and it flourished – at least for a while. So you added some fertilizer and moved the plant to a sunnier location. That helped but only for a while. Your neighbor suggested JD but you didn’t agree. Other friends suggested you try moving it to a bigger pot.

The economy is not so different from the Japanese Maple. When growth slows, we want to do something to restore healthy growth. It is not always obvious which is the best remedial path to follow. So we will always have some difference of opinion as to how to proceed. History helps us think about these competing policy ideas.  

Macro has a history of policy preferences. Before the 1940s arrived, we had no strong preferences for active policy and we preferred to let the markets work. Adam Smith’s invisible hand would heal the economy. As policy makers stood by, it was believed that prices and wages would fall enough to restore weak demand to stronger levels. Competition and markets would ensure growth in the longer term.

The Great Depression shook that theory. Despite large reductions in wages and prices, the economy did not return quickly to its former strength. John M. Keynes was among a number of economists whose theories supported a stronger role for government in rehabbing a sick economy. While Keynes was not a big fan of monetary policy, he did believe that fiscal policy could be used to kickstart a weak economy. If people were too pessimistic about the future to spend, then the government could spend or perhaps induce people and companies to spend through tax breaks.

This was the start of Keynesian aggregate demand policy. It was notable for three reasons. First, it gave a stronger role and perhaps an obligation for government to intervene when an economy was in recession or headed for one. Second, it was very specific that the intervention had something to do with reviving flagged demand for goods and services. Third, other followers of Keynes were less negative about monetary policy and added monetary policy to fiscal policies as acceptable government macroeconomic tools.

This approach to macroeconomic policy became the status quo until the late 1960s and 1970s when we experienced a series of supply shocks and a run of stagflation. Increasing AD was not the remedy for this disease, since a policy to get people to buy more would worsen inflation. And worse yet, with inflationary expectations high and rising, any increase in spending would cause even more supply shocks and stagflation.

What to do? Nixon threw up his hands in frustration and landed on wage and price controls as the solution. Even Spiro Agnew knew that wouldn’t work. The controls were stopped in 1974 after three frustrating years of failure. We were eventually treated to a remedy in the early 1980s when the Fed stopped AD and inflationary expectations in their tracks with 20%+ interest rates. We had two recessions as a result. Lesson: don’t let AD get out of the corral. Getting it back in is too painful.

Reagan and Thatcher wondered if there was an easier way to combat stagflation. And they hit upon aggregate supply policy. The idea is that sometimes a weak economy is not primarily caused by reluctant consumer spending, but rather by uncertain business firms who don’t want to take risks involved with producing more. It’s not easy to tell what is causing an economy to slow. But clearly there are times when uncertainty of business firms is what is mostly responsible for low levels of employment and output.

Depending on which famous economist you bribe, he will tell you that AS policy is either the best thing since sliced bread or worse than a Syrian Bar Mitzvah. But the sad truth is that the concept has been thoroughly trashed by people who refer to AS policy as a Trojan Horse, Voodoo, or Trickle-Down Economics. You would never give your kid any of those names. The challenge is that AS policy is aimed to increase the incentives of business firms to produce. So instead of AS policy directly impacting your ability to spend, it starts by stimulating firms with the idea that they will then produce more and probably hire more workers and then they will spend like the Tuna after winning the lottery.

So what about now? The situation now is that AD policy was tried, and it is out of bullets. The Fed has kept interest rates at zero so long that interest no longer impacts spending decisions. Of course, old fools like me are constrained from spending because the interest earnings of our retirement accounts are producing very little spending power. And if monetary policy is out of bullets, fiscal policy did about all it could to give us cash for clunkers and now the government is in debt with all projections showing the nation’s debt situation getting worse and worse. Don’t count of the usual fiscal policy to get spending roaring again.  

So if AD policy won’t work, what are we left with? Yup, we are pretty much left with the Voodoo. I think AS policy is worth the risk. Maybe it won’t directly and immediately improve the distribution of income. But most of us would be more than happy to have growing job opportunities and rising incomes. Okay, maybe all those rich business executives will gain more than I will from an AS Policy – but right now many people would be pretty happy to just get a job and/or a fat raise.

AS policy is like making the pot bigger. The plant already has too much fertilizer on it. The roots need some room to grow. This might not lead to a miracle but tax reform, deregulation, and a number of other AS policies can lead to more economic capacity and growth. AD will follow. So will our incomes. 

Tuesday, May 23, 2017

The Fed and the Feds

Add an “s” to a word and it becomes plural. Simple. One JD tastes good. Two JDs taste even better. There is no real confusion. The meaning of “s” is pretty clear. The same goes for the possessive “s”. That one is Larry’s JD. The “apostrophe s” is pretty clear. That is my JD and not yours.

But add an “s” to the word Fed and you get chaos. The Fed is the Federal Reserve, the central bank of the USA. The Fed is not your typical branch of government. For years, I taught that the US Fed is independent of the US government. It is not a part of the administrative, legislative, or judicial elements of the government. Ms. Yellen and the board of the Fed make important decisions about monetary policy without approval from any of those branches. It is true that the Fed itself and its administrators are created/confirmed by the government, but once in office they pretty much do what they want to do.

If you add an "s" to Fed you get the Feds. The Feds are the government, or in this discussion today, the US Treasury Department. The Treasury carries out the financial aims of the President and Congress. When government spends more than it receives in revenues, the Treasury sells government bonds or borrows from the public. That government budget deficit is what accumulates into a large national debt when the government continually spends more than it takes in. 

The confusion between the Fed and the Feds arises because they both play in a sandbox called the bond market. The Fed buys and sells already outstanding government bonds (and a few other things) as a means to carry out its monetary policy. The Feds (the Treasury) sell brand-spanking new bonds to finance the government's annual deficits. 

There was a time when the Fed was required to buy government bonds from the Feds. But in March 1951 an agreement between the Fed and the Treasury called “The Accord” let the Fed buy Hondas. Just kidding. The Accord said the Fed could no longer buy bonds from the US government. This freed the Fed from being a lap dog to the Treasury and gave it more independence to pursue its preferred monetary policies. 1951 is also known by some as the day rock 'n' roll was born. 

What a relief to not have to buy all those government bonds. Life would be easier for the government if the Fed just printed money and gave it to the government to spend willy nilly. But the Accord said no way. The government would have to find real suckers to buy all those bonds.

Are you art history majors keeping up? Great! This story has an ending. Ms. Yellen and Treasury Secretary Mnuchin run away to Ukraine together and lived happily ever after. Just fooling with you again. But there is a conclusion here about interest rates.

While the Accord agreement prevents the Fed from buying bonds from the Treasury, it does let them buy them from Pete and Charlie. You might have read that the Fed has a ton of government bonds. Experts use fancy phrases like the “Fed’s balance sheet” but those of us who got Cs in accounting know that means the Fed owns enough bonds to paper the entire Great Wall of China. They bought those bonds because the government sold them to the public and this flood of bonds caused interest rates to rise. Since the Fed hates it when interest rates rise, they bought these bonds from the market (not from the Treasury). The Fed's intent was to stabilize the government bond market and keep interest rates lower than a limbo stick at a Gary Coleman convention. 

Thus, the Fed has a lot of government bonds despite the Accord.

What the Fed does with this gargantuan pile of bonds in weeks ahead is why I wrote all that stuff above. The Fed could simply sell the bonds. Just as you advertise that you have a rusted patio chair to sell, the Fed can let the world know it wants to sell its government bonds. Since the Fed has a lot of bonds, this announcement would send bond prices plummeting and interest rates soaring. While the Fed is looking to normalize interest rates, they don’t want them soaring. So selling a bunch of their bonds too quickly is not in the cards. 

Even if the Fed sells them gradually, markets are not stupid. There are a lot of bonds.
One smart cookie noticed that many of these bonds are maturing. That is, the Fed will receive a final payment from the government and the bonds will disappear. But that is not the whole story. Where does the Treasury get the money to pay off these maturing bonds? Since the government has a whopping deficit, it can only get the money by selling even more bonds. As they do that action, interest rates would  rise and the Fed would buy more bonds from Charlie and Pete. Hmmm – an action by the Fed to reduce its bond holding causes the Fed to hold more bonds. Dern. No cigar here.

So for sure the impact of the Fed reducing its balance sheet will be upward pressure on interest rates. Whether the Fed sells its portfolio tomorrow or the next day, whether they sell the bonds or simply not renew them, the result is the same. Higher interest rates! What is the moral of the story?

A doughnut store opened across the street, and you gained 100 pounds. Despite your protestation and decision to drink one less JD per day, you are in for quite a challenge to restore normalcy.

You can swear off doughnuts but that just makes you hungrier. So long as the store is there and you don’t like hunger, you will not lose much weight.

The government has huge deficits and debt. That’s the candy store. The Fed hates 
owning all that debt but it also hates what happens when they sell it or don’t buy more of it. That's the Fed getting fat. 

The process of returning to financial normalcy starts with a government that balances its budget. It also goes with a Fed that attends to its monetary policy goals and adheres to both the wording and spirit of the Accord. The Fed is not the problem. The Feds are the problem. If government stops having large deficits then monetary policy is easier. It won't matter if the government sells short-term bonds or long term bonds. A balanced budget means they won't be selling much of either. Ms Yellen can then go fishing.