Cause and Effect and Interest Rates

As humans, we struggle with cause and effect, and it is understandable that President Trump does too.

I yelled at a student one day as I was driving on campus and almost hit him crossing in front of me. Clearly, he almost caused an accident. He chased me down and yelled at me for driving too fast. He told me that I almost caused the accident. Hmmm. Was he the cause and I the effect? Or was it just the opposite? With no police officer or bystanders around to adjudicate, I guess I will never know.

Monetary policy is even murkier as it relates to cause and effect. You may have heard that the Fed has decided to normalize interest rates in the USA. After keeping rates near zero for many years, the Fed has been using its levers to raise something called the Federal Funds Rate (FFR). It is believed that when the FFR rises, it pushes or pulls lots of other rates up. Thus, one might believe that when the Fed raises the FFR, it causes increases in interest rates on cars, houses, business loans, and so on.

It is also true that any of those interest rates can rise without any actions of the Fed. That is because interest rates are market variables. If people decide they want more chili dogs and fewer cheeseburgers, this can drive the price of hot dogs up and cheeseburgers down. We call that a market phenomenon. Similar forces are at play with respect to loans and interest rates. If the economy strengthens, more people want to use loans to buy houses and cars. Companies often want to borrow more so they can expand their businesses to meet the demands of a stronger economy. A rising economy, therefore, tends to raises interest rates on all sorts of loans.

With respect to cause and effect, we have learned two things. Thing 1 – the Fed can impact interest rates. Thing 2 – the economy can affect interest rates.

There is a Thing 3 worth mentioning. You alert folks might have noticed that the government has decided that it should borrow more because it spends more than it takes in taxes. I wrote about that recently. As of this year the government needs to borrow around $800 billion just to cover its deficit in 2018. That annual amount is heading toward $1 trillion per year. The government will be floating a bunch of treasury bonds to borrow all that money.

I could go on with other things affecting interest rates in the USA – putting pressure on them to rise. But most of us can’t balance three things in our increasingly senile brains, so let’s stop there. The point is that the Fed is only one of the three. Even if the Fed stopped its current policy of interest rate normalcy, these other factors would keep driving interest rates upward.

So what should we do? In one sense of cause and effect, rising interest rates are bad because they make buying cars, houses, and other things more expensive. But notice with Thing 2 that one cause of rising interest rates is a strong economy. Interest rates rising are the effect and not the cause. Clearly, we don’t want to have a policy to weaken the economy to bring interest rates down. So let them rise.

If interest rates are rising because of government debt, then that’s a different story. We can and should try to reduce interest rates in this case for two reasons. First, the cause is not a strong economy. Second, government deficits and debt are very worrisome risk factors on their own. Thus we can kill two birds with one stone. Reduce government debt, and this will reduce the risks of high government debt and reduce interest rates.

Forget the Fed. They are not the cause of much of anything as they try to restore normalcy. Let the economy grow at a reasonable rate, and let’s manage our government debt. If we do all that, we will likely forget interest rates and enjoy a better economy. 

Stock Prices and Recessions

As some of you financial wizards might be aware, we had some volatility in the US stock market recently. Those of you with some memory left will recall that the stock market tanked about ten years ago and scared even Charlie the Tuna.

Friends of my age might have a load of stocks. If stock prices fall and stay low, then our retirements are going to see fewer Mediterranean cruises. You younger folks are still building your nest eggs and will find that a poor stock market threatens your retirements too -- if not your ability to send your kids to college. So I decided to look into stock price changes. I used the S&P 500, which is an average of the prices of 500 stocks. I could have used the Dow Jones or some other index and probably would have come to similar conclusions.

Below I analyze annual changes in the S&P 500 from 1970 to 2017. Nathan is counting on his fingers right now but my calculator says that is 48 years. 48 years is a long time. The Bee Gees and Barry Manilow were top recording artists in 1970.

The goal of looking at 48 years is to give you an idea of what happened over a pretty long period -- as well as what didn't happen. In that way, you can use history to form an opinion about what might happen in the future. Of course, Nolan knows that the past is no guarantee of the future except maybe in fire engines, but if we don't use the past I am not sure how we can evaluate the future.

During the 48 years between 1970 and 2017, there were 6 recessions. The years included in those recessions are listed in the table below. Next to the year is the percentage change in the S&P 500 of that year. Some observations:

1. These recessions occupied at least part of 12 of the 48 years.
2. In 6 of those 12 recession years, the S&P 500 value decreased*. The largest decrease was the 38% in 2008.
3. The smallest decrease was the 7% decline in 1990.
4. In the 1970 recession, the S&P rose by a very small amount.
5. In all of the 6 recessions except for 2001, there was at least one year when the S&P 500 increased in value. (For the 2001 recession, stocks fell in 2002 and 2003!) After a recession starts and the S&P declines, it usually increases in the last year of the recession. For example, the S&P rose by 32% at the end of the 73-75 recession.
6. The S&P 500 fell in three years that were not recessions -- 1977 (-12%), 1994 (-2%), and 2015 (-1%). That means in the 36 years that were not recession years, the S&P 500 increased in 33 of those years.
7. The S&P fell 11 times in the 48 years period – 8 times during the 12 recessions years and 3 times in the 36 non-recession years.

What do we learn from all this?

• Stock prices fall mostly in recessions but can decline in other years too. 
• Stock prices fall in the beginning of a recession and generally begin rising in the last year of the recession. 
• If there is no recession, it is highly likely that stocks will not decline. 

Will the future follow the past? There is no way to know. And sadly, it is not easy to predict when the next recession will begin in the USA. But today we are not in a recession and so long as that remains true, the likelihood is that stock prices will not decline. Since they just recently decreased, the likelihood is that the decrease will be temporary.

The table includes only recession years as defined by the National Bureau of Economic Research. Stock prices come from Wikipedia.

Year     %Change

1970      0.10

1973       -17

1974       -30

1975      +32

1980      +26

1981       -10

1982      +15

1990        -7

1991      +26

2001      -13

2008      -38

2009      +23

*When I write that the market fell in a particular year, I am basing that on the change of the market index for one year relative to the previous year. The index might have fallen many times in a year but if the value of the year was higher than the previous year, it would be considered as an increase. 

Trade War

Trade negotiation is inevitable, while trade wars are rare. Will today’s actions lead to a trade war? Much of the discussion of a looming trade war comes from those who emphasize that the US has a trade deficit with many countries. This means that we buy more from those countries than they buy from us. Thus, they have much more to risk in a trade war. We buy a lot from them and if we stop buying it will harm those countries mortally. 

There is nothing wrong with that logic except that it is incomplete. It focuses only on the bilateral relations between us and them. The bigger picture examines the importance of trade to the USA and its main trading partners. 

Let’s begin with a review of the countries that purportedly take advantage of us in the USA. President Trump’s goal is to reduce bilateral trade deficits. Below I list the biggest bilateral US trade deficits in billions of dollars in 2017:

            China             $375

            Mexico              71

            Japan                 69

            Germany           64

            Vietnam             38

            Ireland               38

            Italy                   32

            Malaysia            25

            India                  23

            South Korea      23

(Also among the top 15 countries are Thailand, Canada, Taiwan, France, and Switzerland.)

According to President Trump those countries are the “bad actors.” Notice that China holds a special distinction because the US trade deficit with that one country roughly equals the trade deficit with the next nine. China and the others, according to the logic discussed above, ought to cave soon because they sell so much to the USA. If we tax all that inflow to the US, it could hurt them a lot.

Let’s widen the story. Think about the importance of trade to these countries. The next table shows the total trade deficit of each country – the trade deficit of each country with the rest of the world. That deficit is presented as a percentage of each country’s GDP. Note that the corresponding number for the USA in 2017 was 2.8%.

           

            China             Surplus

            Mexico             1.4

            Japan                3.9

            Germany       Surplus

            Vietnam            6.2

            Ireland              0.9

            Italy                  1.4

            Malaysia           3.0

            India                 6.4

            S. Korea        Surplus

The point? These countries, except China, Germany, and South Korea, have trade deficits too.  How willing do you think they will be to making their deficits larger so that the US can have a smaller one?

Next, let’s turn to imports. If President Trump had his way, we wouldn’t import anything, except for maybe Cognac and a cigar or two. But he wants the bad actors to buy more from us. He wants them to import more. Below I report each country’s imports as a percentage of its GDP. US imports were 15% of GDP in 2017.

 China               18%

            Mexico            40

            Japan               15

            Germany         40

            Vietnam          99

            Ireland            88

            Italy                28

            Malaysia        64

            India               22

            South Korea   38

The point? These countries love imports even more than we do. But how much more can a country import when it already has a trade deficit? How much more of US exports can they consume?

It is nice to think that we are being taken advantage of by the rest of the world. But the larger truth is that many countries have trade deficits and already import a lot of goods and services. This reality is surely going to stiffen their backs as the US tries to solve its own trade problems by limiting imports to the US and raising exports to the rest of the world.

           

The End of the World?

No, my friends, I am not writing about the Supreme Court. I am not even writing about Donald Trump. I am writing in response to months, if not years, of hand-wringing by some of my friends about various unfolding trends that promise something akin to the end of the world.

Artificial intelligence (AI), productivity, globalization, and the demise of baby boomers are among trends that cause all sorts of consternation if not hyperventilation. I won’t argue that these trends won't disturb our happy society. I won’t even argue that they are not already affecting many people in many places.

Concern for these and other issues is legitimate. What I am saying today is that, while there is much truth to the fact that we have considerable challenges ahead, the end of the world is nowhere in sight. Our biggest challenge is to decide as a nation what we can do so that jobs continue to exist and people are paid enough to keep the economy growing. This is our biggest challenge because it will take thoughtful policy in a very complicated US and global economy. There will always be more than one way to resolve these issues. In a world where politicians would rather spit that compromise, it is hard to see how they can be trusted to do the right thing. Whatever they could do won’t be perfect but sadly it is not clear that they are capable of anything besides giving hateful interviews to greedy media organizations.

But we do have time and it is possible that sanity might return to the political arena. Maybe it will take a severe recession or a flood of Biblical proportions, but there is at least some hope. In the meantime, I suggest we look at some data to reassure ourselves that the end of the world has not already come.

On the first line of the table below are numbers for the productivity of the private non-farm business sector. These are index numbers representing productivity in 2006 and 2018, and then the percentage change in the index over those 13 years. Notice that productivity in the business sector rose by around 15%.

The second line has comparable numbers for employment. The employment numbers are for all employees of non-farm businesses. They are in millions. In 2006, we had 137 million employees in the US. That number took a big dip in the recession down to 130 million in 2010 but then reached 148 million in early 2018. That amounted to an 8.5% increase.

The final row is the employment cost index. This index measures changes in wages and benefits of private industry workers. Starting at an index value of 102.1 in 2006, wages and benefits rose to almost 133 by 2018. That’s an increase of 30 percent.

The upshot of this little table is that we are nowhere near falling off the earth. While these numbers were clearly affected in a negative way by a very scary recession, they show that productivity grew, employment grew, and the wages and benefits of workers increased even faster.

I purposely leave you with this impression of growth. I could have compared this time to previous ones. I could have compared the wages and benefits change to inflation. I could have dissected the employment numbers by manufacturing versus services. There is a lot more I could have done to put changes from 2006 to 2018 in a more complete perspective. But I save that for other posts and other purposes.

I am not trying to say that this is the rosiest of times. I am not trying to say that we don’t need to get to work on solutions. But what I have tried to do with this little table is to suggest that we stop panicking. This is not the worst of all possible worlds. I am no Pangloss but then, again I am no Martin either (characters in Voltaire’s Candide). Pessimism might be warranted by some things we see today – but pessimism surely will not provide the answers. This glass is definitely half-full. How can we get policymakers to work together for us -- to make the glass even more half-full?

2006         2018       %Change

Productivity            94.4        108.2          14.6

Employment         136.5        148.1             8.5

Wages & Benefits 102.1        132.5           29.8

Note: The values are for the first quarters of these years.

CBO Budget Projections as of April 2018

The Congressional Budget Office provides projections of federal government outlays and revenues. This projection process is thought to be a bipartisan effort. I thought it would be useful to share their latest projections for discussion. I won't say a lot in this post. Just present the facts. My table below was constructed without the aid of JD by me based on 10-year projections found at the website indicated below. Since 10 years is a very long time, I thought it would be better to focus on the five-year period, 2018 to 2023.

The top of my table presents the usual suspects for government budgeting -- spending, deficits, and debt. I ignored tax revenues in this piece so I could focus mostly on spending or outlays. The bottom of my table gives some details about what are called "mandatory" versus "discretionary" outlays. The first column gives projections for 2018. The second column reports the same information for 2023. The final column is the percent change over that five-year period.

First, the top of the table. Total outlays will rise by 45% in the five years from 2018 to 2023. If you divide 45 by 5 you get 9. Nathan, you do not need to get your calculator. Ignoring compounding, the math implies a 9% average annual increase over five years. I know you will get a 9% raise each year over the next five years. Right? Notice that GDP is expected to rise by only 32% over those years.

On the third line is net interest outlays expected to be paid on the nation's debt. Those expenses will more than double -- a 145% increase from $316 billion in 2018 to $774 billion in 2023. In terms of dollars, the $458 billion increase is the largest for any subcategory of spending. Notice that the national debt is expected to increase from $20 trillion to $26.6 trillion over that time period. And interest rates will rise as well. The table shows that we will make no effort to reverse the increase in debt. The already high annual federal government deficit of $804 in 2018 will increase to more than a trillion dollars in 2023.  Yup -- a one-year government deficit of over a trillion dollars in 2023.

Mandatory spending will gobble up most of the 45% increase of all outlays. While there are a large number of Mandatory Programs, you can see from the table that almost all of that increase is expected to go to spending on Social Security (Old-Age and Survivors), Medicare, and Medicaid. The remaining Mandatory Programs are peanuts compared to what we spend on the big three. Discretionary spending will rise by 16% in comparison. Discretionary spending includes defense and other programs that must be legislated by Congress.

I won't ruin your perfectly nice day by going through all the categories. I will let you do that on your own with your favorite beverage. But notice how so many perfectly lovely programs are being squeezed out because we have to pay more for the big three.

This puts liberals in a bad spot. How do liberals balance the squeezing out of so many programs by three social programs they also love? You conservatives should not be so happy either. While these figures do not have all of defense spending, they do show that military is being squeezed too. How do you get more of what you want out of government and not have these nasty deficits and debts? Seems like being between a rock and a hard place.

Five-Year Projections of Outlays by the CBO 2018 to 2023 as of April 2018. The below link has 10 year projections from which I took these five years. https://www.cbo.gov/about/products/budget-economic-data#3.  Data in columns 1 and 2 are in millions of dollars. Since fiscal year 2018 was not finished in April, 2018 is considered to be a projection.
				2018	2023	% Chg
Mandatory				2,546	3,760	48
Discretionary				1,280	1,481	16
Net Interest				316	774	145
Total Outlays				4,142	6,015	45
Deficit				-804	-1,352	68
Debt held by public				15,688	24,338	55
GDP				20,103	26,595	32
Mandatory Outlays
Old-Age and Survivors Insurance				840	1,155	37
Disability Insurance				144	176	22
Medicare				707	1,032	46
Medicaid				383	493	29
Exchange subsidies and
related spending				58	76	31
Children's Health Insurance Program				16	13	-15
Earned income, child, and etc				87	99	14
Supplemental Nutrition Assis. Prog				69	65	-6
Supplemental Security Income				51	64	24
Unemployment compensation				30	47	57
Family support and foster care				32	33	4
Child nutrition				24	30	24
Civilian	Retirement			102	122	20
Military	Retirement			54	70	28
Income security for Veterans				83	111	34
Agriculture				17	15	-15
Deposit insurance				-14	-8	-46
MERHCF				10	13	26
Fannie Mae and Freddie Mac				0	2	NA
Higher education				-4	7	NA
Discretionary Outlays
Defense				622	710	14
Non Defense				658	771	17