Politics Today and Marginal Analysis in Economics

Those of you who took a course in economics remember the idea that to establish any optimal decision, it usually took the intersection of marginal this or marginal that. 

Probably the most famous of these marginal analyses relates marginal cost to marginal revenue. When MR=MC, we know the firm is producing the output that yields the maximal amount of profits. If MR>MC, then you know you can make greater profits by producing more. If MR<MC, then producing another unit would raise cost more than revenue so you would not produce more.

We have marginal equalities that guide just about all important economic questions –among them are how much to produce, how many workers to hire, how much to pay workers, and where to set your price.

So when we hear so much commotion these days about government spending and taxation, it might be good to remember that most of what we know in economics is all about marginals. The word marginal means “at the edge of something”. Or in terms of most economic applications, it means a small change from a given starting value. 

When we talk about marginal cost we ask, how much will costs change if we produce one more unit of output? We don’t say, how much will costs change if we go from producing 1 car to producing 10,000 cars….or a million cars? Or if we are producing 16 million cars today then we might ask, how much will total costs change if we produce 17 million cars?

Marginals are about small changes for good reasons. It is much easier to think of a small change in output as having known and quantifiable cost changes associated with it. A small change in output probably means more or less the same factory space, with the same utility costs, with same property taxes, and so on. Yes, a small output change might require more worker hours but the relationship between a small change in output and the change in employment ought to be well known.  Contrast that to someone who says, let’s increase output from 1 million cars to 100 million cars. Wow. Estimating the costs of a large change like that could be a lot more complicated and uncertain.

The above is why I am getting nervous about the coming election. Many of the viable candidates on the Democratic side are making a case for non-marginal change. They want big changes. And who can blame them? We have big and enduring problems, and these might require major policy changes. I am not saying that it is wrong to want to make large changes. What worries me, instead, is the confidence that these politicians seem to have about how these large changes will benefit us and how much they will cost. I don’t care if one takes the side of the Ds or the Rs in this context of billions and trillions of dollars. The trouble is believing any of them when they start throwing around trillions of dollars like Jack Daniels mini-bottles on an Alaska Air flight.

One source of these estimates is a group called the Committee for a Responsible Federal Budget http://www.crfb.org/blogs/would-medicare-all-require-middle-class-tax-hike .

With respect to Medicare for All, they estimate a bill of about $27 to $35 trillion dollars. That’s a lot of JD. That amount for one program is equal to 100% of GDP and is larger than the national debt. I don’t know how we can be sure of that amount as we switch millions of people out of their own insurance policies and into the government program. In fact, since private premiums would go down, it is unclear how much more we will pay. Of course, I don’t know how anyone could estimate how much more healthcare we will consume when the price for so many people will go down.

The candidates, of course, have very different opinions about who should pay for this program. One candidate thinks the rich will pay the full amount. Do the rich really have an extra $30 trillion just hanging around? Other candidates think the middle class will have to pay a bit of the price tag. They have not told us how much they would pay. 

Maybe they don’t really know!!!! Private estimates are all over the place. One source saying that tax burdens will double for millions of us. Another says the vast majority of workers will pay less for healthcare. Your politics might have you leaning one way or another. But be honest – these folks are pulling this out of their butts. I’d suggest a colonoscopy.

I won’t belabor the point by adding to this discussion all the other programs being debated on the campaign trail including free education ($2.4 trillion), a write-off of past educational loans ($1.6 trillion), the Green New Deal ($93 trillion) … and free JD. While there is much debate about who exactly would pay for this (rich, middle class, military budget reductions), the truth is that if any of these numbers for spending are even close, it is going to be a very major hit on the country.

The point remains. With extremes running the political process how can we believe any of this? Large changes have got to be tough to swallow regardless of these estimates. Why can’t we go back to marginal changes? Is the risk of causing incredible havoc really something we want to face? Why can’t we just go back to the smaller changes of a marginal analysis? Maybe that is too boring? 

The Fed Again -- Are you Kidding?

If you bother to read some of the articles about Federal Reserve policy lately, the facts and terminology are stunning. So stunning that I have no idea what they are talking about.

Apparently a couple of weeks ago something happened in the financial markets and the Fed had to buy a bunch of bonds -- and once again the Fed flooded the markets with money. I have read a bunch of articles about this event and even more recent ones that acknowledge the Fed is still pumping money in. If this was a fire department pouring water on a fire, surely by now the planet would be totally submerged.

All this has to do with something called bank reserves. While learning the money supply process takes a semester course, the truth is that it is pretty simple. First, the Fed decides the economy needs more money. Second, the Fed buys assets from banks -- mostly outstanding government bonds held by banks. Third, the Fed pays for these bonds with money. This is a special kind of money that banks can hold as reserves. Fourth, banks then lend it out and the world is awash with money.

Reserves is a technical word but by law, banks are not allowed to loan out all the money they receive. That would be risky. Banks want to loan the money out because that's how banks screw the public -- um, I mean that's how banks earn revenues and profits. The Fed regulates how much they have to hold back in reserves.

Point: the Fed injects money into banks. Banks loan some of it out. Banks hold some back as reserves. Now wasn't that easy? Send your tuition payments to me at my usual address.

Now that you are experts on bank reserves, you can understand what the Fed did recently. When market rates jumped like cockroaches in a frying pan slathered with olive oil, the Fed concluded that banks didn't have enough reserves. Simple, the reason rates were rising so much is that banks didn't have enough money sitting in vaults ready to lend to each other. Translation, reserves were insufficient for market activity. So voila, the Fed pumped a bunch of money into the markets.

Here's my question about all this. Look at the graph below. It shows bank reserve balances since 1950. The chart looks weird, and you can hardly see the amounts before 2009. Essentially the amounts were chump change. Bank reserves then jumped to $2.8 trillion.What????? From basically zero, they jumped to almost $3 trillion dollars.

Why? Because the Fed was correctly playing its role as a lender of last resort. The great recession of 2008-09 needed a boost from the Fed and we got it to the tune of $2.8 trillion. According to the lender of last resort theory, once the economy is growing and safely past a recession, they can pull that money out. As the chart below shows, they did begin pulling some money out in 2015 -- some six years after the end of the recession.

The chart also shows that the amount remains at a little lower than $1.6 trillion. Given that zero was a normal amount of reserves before 2008, why all of a sudden is $1.6 trillion in reserves not enough to accommodate most hiccups in the economy? Why did short term interest rates jump to the sky when we have $1.6 trillion of reserves sitting in banks?

This is a new world and one I don't understand. And despite all the articles that have been written in the last weeks, I have seen not one word to explain why $1.6 trillion in bank reserves is insufficient. Accordingly, I would ask those geniuses at the Fed why they now think they need to pump even more reserves into the banking system. Apparently now, $1.6 trillion isn't enough.

Sadly, I know why. Over-regulation of banks and the usual liberal/progressive monetary policy ideology are responsible. The Fed wants to be the big dog in town. The Fed wants to save the day. The Fed wants to jump into the economy every time they sense even the smallest hiccup. Sad but true. We deserve better policy. Dear Fed: Figure out why $1.6 trillion in reserves isn't enough in 2019. Then fix that problem. Quit flooding us with money! We are drowning.

Candidate Warren and Skin in the Game

Do you have skin in the game? Do you have a frog in the race? Do you have a cabinet full of JD? We know what these phrases mean. They are asking if you have something to lose.

Why ask these questions? Usually it has something to do with the earnestness of someone commenting on an issue. If you have no real connection to the issue, then maybe your opinion is not as important as those of others more directly involved. 

“Let’s raise lip stick prices by 100% tomorrow”, said Peter.  Diane, who actually wears lipstick disagreed. If Peter has no lipstick and no real connection to lipstick, we might want to put more stock into Diane’s opinion on this matter. Of course if the topic changes to jockey shorts, then the situation might be reversed. Peter is a known jockey shorts wearer.

Presidential candidate Elizabeth Warren recently introduced the Accountable Capitalism Act. If passed it would affect all companies with more than a $1 billion in annual sales. All those companies would have to obtain a new Federal Charter. CEOs and directors would have to serve stockholders and the workforce, its customers, the local and global environment, and community and societal factors.

This is newsworthy for several reasons. First, it makes explicit that companies can no longer be solely focused on stockholders. Second, it makes explicit who all the stakeholders are. Third, it expands the scope of government as it relates to regulating business by creating a very complicated and unspecified (ie risky) responsibility for CEOs and company directors.

Let’s take the explicit part first. Please tell me how a billion dollar company can ignore any one or more of these mentioned stakeholder groups. I cannot imagine a director’s meeting where the agenda did not include issues relating to the employees, the local community, social responsibility, and so on. The issue is not so much whether companies do this sort of thing – because they do.

The issue here is to shift the responsibility for running the business from the CEOs and directors and into the hands of workers, union leaders, community representatives, and perhaps members of the Greenpeace Fund. Yes, when it comes to pricing milk in March and deciding on where to buy other productive inputs, Elizabeth Warren believes we need a conglomeration of these people to vote and make the decisions. It is not enough that federal and local government entities regulate many aspects of business (health, safety, hiring, firing, etc), we now need, according to a broad committee, to make sure directors do the best thing for everyone.

And what is the best thing for everyone? And who is everyone? Should local City Council members be on each board? Should United Way officials help companies vote on safety policies? Maybe the local Boys and Girls Club should be represented as well. What expertise do these and other stakeholders have when it comes to objectively judge the impacts of the myriad business decisions made by CEOs and boards?

These questions are not meant to be my usual silliness – but rather to focus on the main issue here. The main issue has to do with how you choose or regulate who is on the board and who is off. When it was only stockholders interests, making decisions was easy. Stockholders are the reason the corporation exists. Think about the origins of corporations. A simple view is that someone decided they had a great idea that would sell. Today all sorts of people are sitting behind their computers trying to develop the next best Internet Application. At some point they need money to keep their efforts going. Just because they have brains and energy does not mean they also have enough money to fund their development process.

These entrepreneurs raise the money from people who want to invest in projects that will give them great returns. Most of us don’t want to take that kind of risk. Even when companies make it and are more mature, many of us worry that buying company stock is too risky for us. We put the money instead into government bonds that offer less risk. Luckily for those entrepreneurs there are people willing to take that risk.

I am not trying to romanticize capital, but I am trying to point out that companies come into existence and stay that way because there are people who don’t mind having skin in the game. Without those people, you can have the greatest ideas and the best employees – but you don’t make it.

Point – stockholders have skin in the game and thus are important contributors to the existence and life of a corporation. Compare that contribution to that made by any of the other stakeholders mentioned by Warren. Clearly the City Council loses but loses a lot less than the stockholders when the company has a bad year. What about the workforce? I think the answer there is more complicated. Employees are clearly critical.  While employees are not always stockholders, they stand to lose a lot if the company has a very bad year. They might get laid off or fired. They might not get a raise. These are not insignificant amounts of employee skin.

In the worst case of a company going out of business, the employees differ in one fundamental way from stockholders. First, an employee’s loss might be looked at in terms of a month or more of unemployment. Some of that loss might be cushioned by unemployment insurance. Most employees will find new jobs. But when the value of the stock plummets and stays low – the stockholder loses the sum. The stock value does not return by buying into another company. The loss of investment is permanent.

This in no way minimizes the losses employees suffer -- but it does point out a difference between temporary and permanent losses.

I am not sure of all the specifics related to Warren’s proposed policy. Clearly companies make mistakes. Clearly companies impact workers, schools, children, the environment, and many other things. But running a company is not for everyone. Running a company is not for political ideology. Running a company means being successful and not going out of business. Typically, when a company is run well it must treat its employees well and it must attend to the very many modern regulations and social responsibilities. If it ignores these stakeholders it does it at its own peril. 

I am not convinced that getting government into the game of day to day management is the best way to help all these stakeholders. Hopefully Candidate Warren will convince us of why these new broad corporate committees will be better for any of us.

US Government Budgeting: The Elephant in the Room

Apparently, the government cannot see the elephant in the room.

There has been little discussion of US budgeting challenges lately. It used to be a lot of fun to have the two parties rant about how the other party was spending the country into ruin. But no longer. They’d rather scream about other things. Or maybe they have decided to put things off. Most recently, they decided to postpone discussions of the budget for 2020 for three weeks. Can you believe that? They postponed for three weeks. Do you really think they will be more prepared to work on the budget in three weeks? That’s rich.

So that gives us an opportunity to get back to basics about the budget. I created the table below to show you where the budget sat in 2018. These numbers are history in the first column. The 2020 column shows where they plan to go. These numbers are already legislated. They could change, of course, if they enact changes to the 2020 budget in the coming weeks.

Keep in mind that some people would look at the 2018 numbers and worry. In 2018, the federal government spent $823 billion dollars more than it collected in taxes. We call that a budget deficit and that number is large by historical standards. That’s a big discrepancy. Usually, a government will excuse a large budget deficit if the country is in a recession. But we were not in a recession recently, nor are we in one now. The unemployment rate is at historic lows.

Each year a government has a budget deficit, it must issue debt to pay the deficiency. Since we have had mostly deficits every year since the Tuna was a little fish, the national debt gets larger and larger. The table shows that the debt will grow by more than a trillion dollars each year over the two years. It will reach $23.7 trillion in 2020. Note—we must pay that debt. Since there are no plans to reduce the annual government deficit, this debt will just increase for the foreseeable future.

The rest of the table shows us how we spend our federal tax dollars. The total spending includes everything, but the individual amounts in the table do not include every category of government spending. The main ones are all there, though.

Notice first that over these two years, spending is planned to increase by $409 billion and that amounts to a 10.7% increase. I hope you get to spend that much more on your household over those years. Note that inflation is coming in lately at about 2% per year so the 10.4% increase is pretty generous. It does not look like the government is worried about spending too much and how that impacts deficits and debt.

Second, look down the 2018 column to see the biggest spending numbers. What do we spend our money on? If you add together Social Security and Medicare, you get a total of about $1.7 trillion. Those two programs gobbled up 45% of the entire government spending in 2018. Of the projected change through 2020, the increase in those two programs is expected to be $192 billion and that amounts to 47% of the total spending increase.

Even though the large defense spending figure leaves out some of the total amount of military spending, one can see that defense spending is a major part of the overall budget and at 11.6%, it is one of the fastest growing spending categories through 2020.

While the expected $390 billion of net interest (on the national debt) is not among the largest numbers, it shows that our continuing debt has consequences. We spend more on net interest than on income security, on Veterans, and it is coming close to equaling how much we spend on Medicare. A smaller debt would imply less interest paid. But no one in our government seems very concerned about that. 

Table. US Federal Deficits, Debt and Spending

Table. US Federal Deficits, Debt and Spending
Actual and Projected
	2018	2020*	Change	% Change
Deficit	(823)	(1,008)	(185)	22
Debt	21,462	23,688	2,226	10
Total Spending	3,829	4,238	409	11
Defense	627	700	73	12
Non-Defense **	579	622	43	7
Social Security	992	1,097	105	11
Medicare	728	815	87	12
Medicaid	369	418	49	13
Income Security	290	302	12	4
Veterans	93	104	11	12
Net Interest	325	390	65	20
In billions of dollars.
* 2020 figures are estimates based on current law
Source: https://www.cbo.gov/about/products/budget-economic-data
**Non-Defense Discretionary Spending includes many
different government programs not listed individually.

Is the Saving Rate Too High?

Last Friday in the Wall Street Journal, it was announced that consumer spending slowed to a crawl in August. Consumer spending rose by only 0.1% in August after a 0.5% increase in July. The worry expressed in the article is that this portends a poor third quarter 2019 for the broader measure of US economic health -- real Gross Domestic Product. Maybe it means a national recession is coming?

As usual, the folks at such publications have nothing to do but try to write exciting stories when very boring economic information trickles out. Imagine the top execs at the WSJ sitting in their expensive chairs drinking lattes in the afternoon after the government announced the data. Nolan, the head guy, says, "Hey dudes, nothing happened to consumer spending last month."

Charlie nearly spills his extra hot mocha and agrees and says,"Noley, we all know that monthly data jump around more than a tuna in a shark tank. In fact, the increase of 0.5% in July when annualized was more than 6%. That's hot stuff for consumer spending in real terms."

Peter wakes from his nap and congratulates both his colleagues on their drink choices and adds that "if you average the increases in July and August, you get a very reasonable number of about 0.3% which when annualized would be around 4% per year. Real growth of consumer spending of 4% for two months ain't bad."

Much ado over nothing. I thought I would dig deeper to see if there might be something going on and I decided to follow up on some words in the article about saving. There is a national statistic known as the personal saving rate. Let's call it the PSR. The PSR tells us what percent of a household after-tax personal income is not spent -- that is, it tells you the percent of income that is saved. I asked my buddy FRED at the Saint Louis Fed to graph the PSR for the US from 1959 to the present. See the table below.

Many things will influence the PSR, and you can see from the below graph that it has had some interesting cycles. During those times when the PSR was generally rising, it meant that consumer spending was probably weak; when the PSR was falling consumers were having a little more fun on Amazon.com.

We are told we should save. Saving is good! Why? Because it helps you prepare for spending in the future. It also supports economic growth by allowing more spending on capital projects. Capital projects and various innovations often need funding. If banks are full of saving funds, then it facilitates the flow of funds from those who don't need the money right now to those who do. So you might say that ample savings is good for the future growth and expansion of business and the economy.

But the other side of the coin (must there always be the other side of the coin?!) is that spending today gets pinched the more we save today. Interesting that a rise in saving is a signal of less spending today and more spending tomorrow. Retirees and future retirees know that very well.

Thus we see why some analysts might wring their hands over the recent rise of the PSR. In the table, you can see that the recent rise is part of a longer term trend that started back in 2005. That rising trend, however, appears to be more a return to long-term normalcy than a record-breaking threat to consumer spending. The most recent rates were in the neighborhood of about 7%. But the average rate over the entire period was closer to 9%. A closer look at the chart shows many quarterly PSRs of well above 10% (in 1973 the peak rate was 14.5%).

As usual, the real story is a lot more complicated than the daily press has time or interest to tell you about. Woowee -- the PSR went up in August. Sort of like you getting on the scale and your weight went up two pounds after a Grand Slam breakfast a Denny's. A return to normalcy in the saving rate might pinch spending now but it clearly is an important thing for the country's long-term gains in productivity and output.