Employment. Where is Hercules?

This post is about employment in the US and how it has changed since 2007. Most of us know that the situation is not pretty but this six year perspective suggests the problem may be deeper than we think. This post is not about the solutions -- it is more about the depth and nature of the problem. The table below contains data from the Household Survey conducted monthly by the US Bureau of Labor Statistics ( www.bls.gov ). These statistics compare household employment status in the latest period (end of 2013) with the year before (end of 2012) and with six years before (2007).

The bottom line is that while the US economic recession technically ended in the middle of 2009, despite all we have done to promote rapid growth with policy, the economy remains a far cry from where it was in 2007. If we were discussing the results of a weight loss clinic we would provide you with a beginning weight and compare that to our present weight. The usual diet advertisement shows a svelte Dan Marino next to his puggy former self. If we use this technique to describe the US labor force we would start with a svelte image and end up six years later with something that looks a little like a whale.

Some of you will point your finger at failed monetary and fiscal policy. Unprecedented levels of aggregate demand policy leaves us bloated. Others would say we are paying for greed. Still others point to globalization, industrialization, education, or changes in demographics. Likely the problem is a blend of all that and more. But the fact remains, if you do the comparisons, you have to be bowled over by the dimensions of the problem. Neither side of the political spectrum has been effective in advocating and implementing anything close to a remedy. The data below suggest it is time to stop politicizing and start scratching our collective head. No, let’s not compromise on simplistic, naïve, and politically digestible policies. The policy decision is a whole other thing! But let's at least start with a measurement of the problem.

This is the “before” photo. (m means millions)

                                                    Dec. 2007

Populations 16+                                 233.2 m

Employment                                      146.3 m

Part-time Employment*                         4.8 m

% of population in the labor force         65.9%

Number of people unemployed              7.4 m

People want in the labor force               4.4 m

Sum of last two items                         11.8 m

Unemployment rate                   4.8% or 7.7%

Where are we today?                 

                                                     Dec. 2013

Populations 16+                                246.8 m

Employment                                     144.4 m

Part-time Employment*                        8.0 m

% of population in the labor force      62.6%

Number of people unemployed           10.0 m

People want in the labor force              5.9 m

Sum of last two items                        15.9 m

Unemployment rate                6.5% or 10.3%

*Part-time work for economic reasons – meaning they would have preferred full-time work.

Conclusions

Population grew in those six years between 2007 and 2013 by 13.6 million people, yet employment fell by 1.9 million persons. As a result of these two factors we went from almost 66% of the population working to less than 63 percent. If employment had reached 65.9% of the population by December of 2013, employment would have stood at 162.6 million. So one conclusion is that if we used 2007 as a point of comparison, employment in the US today is about 18.2 million below where it should be (162.6-144.4). In the year between December 2012 and 2013 employment increased by 1.4 million people. That is a start. But notice at that rate it would take more than 13 years to hit an employment to population ratio of 65.9%. Of course 13 years assume that population growth is zero and we know it won’t be. Main point – we need more like 3 million new jobs per year to return to past employment. We are still a long way from that kind of growth.

Not only did employment fall in six years but another 1.5 million people who wanted a job simply quit looking and were deemed outside the official labor force. Between the two figures we have 15.9 million people wanting a job – 4.1 million people more today wishing they had a job compared to the number 2007. While the official unemployment rate went from 4.8 to 6.5 percent, the rate that includes these discouraged workers went from 7.7 to 10.3 percent.  Of course there are now about 8 million people who were included in the employment statistics in 2013 who say they are seeking full-time work. That compares to only about 4.8 million in 2007 who said they were part-time because of economic reasons. Adding these folks to the employment challenge just makes the challenge even taller.

We have a massive challenge in 2014. I grew up in an America that was full of hope and optimism. We had our share of wars and social problems but we believed that our economy would provide jobs and careers. If we continue down the current employment path for many more years people doing the right things and who graduate from schools will find themselves wondering if and when they will be gainfully employed. For too many reasons to mention here, this is not what we want for your children and grandchildren.

The proportions and risks today regarding employment are not too different from other major challenges we have faced in the US. But like Sputnik or terrorism, it will take a major concerted effort to make a dent in the problem. Unfortunately we have a government that will need a lot of prodding. Congress looks more like a herd of goats about to go over a cliff than a group intent on solving and implanting real programs for economic and employment growth. The President offers no real comprehensive realistic path either. 

BLS TABLE:

	Dec 2007	Dec 2012	Dec 2013	Change: One year	Change:    Six year
Pop	233,156.0	244,350.0	246,745.0	2,395.0	13,589.0
CLF	153,705.0	154,904.0	154,408.0	(496.0)	703.0
LFPR	65.9	63.4	62.6	(0.8)	(3.3)
EMP	146,334.0	143,060.0	144,423.0	1,363.0	(1,911.0)
EMP:POP	62.8	58.5	58.5	-	(4.3)
EMP PT	4.8	8.2	8.0	(0.2)	(4.3)
UN	7,371.0	11,844.0	9,984.0	(1,860.0)	2,613.0
UN RATE	4.8	7.6	6.5	(1.1)	1.7
NOT IN LF	79,451.0	89,445.0	92,338.0	2,893.0	12,887.0
WANT in LF	4,398.0	6,532.0	5,932.0	(600.0)	1,534.0

Bear Case by Guest Blogger John Succo

John Succo graduated from Indiana University with a graduate degree in finance concentrating in option pricing theory in 1984. His work bio includes stints at Morgan Stanley, Paine Webber, Lehman Brothers, Alpha Investments, and Vicis Capital. In 2012 he became an adjunct professor for Indiana University and created IU Capital, a synthetic multi-asset fund where students manage risk around a variety of asset classes including equities, fixed income, currencies, commodities and derivatives.

 

SP500 companies’ adequate profits have been due to increasing margins on slow (if not now stagnant) revenue growth. Margins are at all-time highs and have been driven by lower interest expenses, stock buybacks (which retire outstanding shares and increase per share earnings at the expense of more leverage, making earnings "riskier"), and wage compression (wage participation of earnings are at recent history all-time lows). It will be extremely difficult for companies to improve these margins further.

There is negative margin pressure now building. Interest rates must normalize at some point and we are seeing pressure for that now. QE by the Fed has artificially kept interest rates low: they have been buying 70-90% of all treasury issuance causing their balance sheet to explode to $4 trillion and owning nearly 30% of the entire publicly traded treasury market. Interest rate risk is very high and just a 100 bps rise in rates would destroy the Fed's capital. The Fed's objective has been to drive investors into risky assets by creating no alternative; they have also targeted low volatility as a secondary measure to keep investor sentiment high, which is at all-time extremes right now. But tapering their asset purchases are now a function of risk and will continue. The Fed, BOJ, and to some extent the ECB have no way to "ease" except for asset purchases, so any new "weakness" in economic activity cannot be met by monetary policy and the markets will quickly lose confidence, which is the primary driver (psychology) of higher asset prices at this point.  Wage compression is now at the point where it will begin hurting consumption and work against margins. Higher rates will make it difficult to continue stock buybacks at the current pace and cause interest expense to rise. Corporate cash is a function of high corporate debt and rolling the debt will be more expensive.

Total debt in the economy is still 350% of GDP, levels that cannot be sustained. Some mortgage debt has been destroyed but an increase in public debt has offset this. Public debt is the least productive debt and as rates rise will become unserviceable: current interest expense is $450 billion a year and every 100 bps rise increases that expense by $200 billion. The treasury is now being forced to extend maturities and just normal rates will cause that annual expense to rise to nearly $1 trillion, creating systemic untenable deficits and crowding out of capital (even higher than normal rates). Additionally margin debt is at an all-time high, which is a precursor for too much risk and price inflation in financial assets.

As this process begins risky asset prices will suffer dramatically, normalizing rates and bottoming those prices but at much lower levels. Valuations by any measure are at least 30% overvalued and much more so if we truly are in a stagnant revenue paradigm. The Shiller P/E, the best measure of relative valuation, is over 26x, 56% higher than average. Pre-1987 crash gold went down and the 10 year yield rose 200 bps, very similar to today.

Deficits and Deficits

When I was just a little kid the teachers pointed out to my parents that I had an attention deficit. They thought my attention deficit should get more attention. As a result I became an expert on deficits in the fifth grade. A deficit means you are short on something – something presumably valuable and important. Pointing deficits out can be hurtful but the purpose is to signal a need for a remedy. When your fellow fifth grade students chanted songs about your social deficits that was just rude. But when Mrs. Montgomery told my parents of my attention deficit she was very much hoping that my father would beat me with a stick long enough so that I might not run my mouth incessantly while she was teaching the class how to count.

Today some of our government leaders, who apparently are not much farther along in intelligence than my fifth grade colleagues, are pointing out that the government budget deficit is not the only deficit our country should be concerned with. They list a number of worrisome deficits – in infrastructure, education, and little blue pills. What could be wrong with pointing out that we have national deficits in many areas and that these need attention?

Answer – there is nothing wrong with pointing out national problems. But please – we didn’t know we had these deficits? I think we knew. The problem is that by using the term “deficit” they are implying that each of these individual social deficits is equally important to the nation’s budget deficit. And this is where they are being disingenuous, misleading, and pretty much just plain wrong.  

What they are REALLY SAYING is the following….what we need to do in this country is to spend more and we can spend as much as we want to spend. Who cares if we can’t pay for solving all of mankind’s ills – we can just borrow money. And then we can borrow more. Because we are nice guys and because we won World War II and because Harry Reid knows the mafia – we can borrow all we want. Sure someday we will have to raise taxes on the rich to close the national budget deficit but that won’t be a problem either. By closing all these social deficits we will make the nation great and there will be no unintended side effects. Tax revenues will gush in.

Do they really think that we are so naïve or stupid that we would believe that story?  It is fine to be a liberal or a progressive or just a person with a desire to help other people. But today we find ourselves in a situation following a global crisis in which the government spent a lot of money. It is no secret that the national debt has multiplied and borders on 100% of the economy. Is there a tablet on a mountain somewhere that says 100% is the ceiling? I don’t think so. But when you almost triple what was considered a normal amount of debt burden, someone out there knows that. If you had a normal debt load and subsequently tripled the amount you owed, then your banker might be interested….especially if you come into the bank and ask for ANOTHER loan.

Hi Mr. Banker. Nice shirt and tie. I love paisley. Anyway, I want to buy another condo on a golf course in Florida.

Hi Larry. Nice sweatpants. Didn’t you just buy a condo in Florida? And didn’t you tell me then that you could barely afford it?

Hi Mr. Banker. Nice watch. I love Timex. Yes, but that other condo was not on a golf course and I plan to take up golf and alligator petting.

It sounds hard-hearted to say that finance is more important than people. That’s what some of these liberals are trying to say but it isn’t true. There is nothing more important than people. But there are good ways and bad ways to help people. That’s the real question – which is the best way?

Okay – so we take the advice of the liberals and spend a lot of money on education, infrastructure and Harry Reid’s latest pet project. And so the debt moves a little above 100%. Won’t that be groovy? What’s the harm?

There are three answers. First, the harm is that if other countries do a better job of cleaning up their debts, we will look less financially stable in global terms. That could spook financial markets. Spooking the financial markets doesn’t just affect rich people. Lower stock prices and higher interest rates would not be welcome in any corner of the economy. Second, when the government dominates financial markets the private sector has a harder time getting loans on good terms and this hurts their ability to be competitive. Third, and worse, there comes a point when enough debt is enough. What happens if we reach that point and a big hurricane levels Bloomington? Or a flood wipes out Arizona? Or killer bees migrate to Nevada and knock out the gambling industry? If you have reached the point of no return on debt and you have a national disaster, there is no money in the till to take care of emergencies. Then you are between a rock and a hard place meaning that there are no good options. Not tending to debt today means we put ourselves in a position where we can no longer help ourselves when emergencies arise. Maybe then we would ask for aid from Haiti.

The way to help people through government is to do it in a financially sound way. A millionaire who wants to help his local food shelter does no one any good if he borrows to support the homeless – and borrows so much that he cannot repay his loans. The last half century has witnessed a government that borrows more to support its programs. That trend is helping no one and threatens to a make it impossible to keep up levels of support in the future. There is only one deficit and it needs to be tended to ASAP.

Mo-cro Economics for 2014

Thanks to Buck for looking back and summarizing 2013 last week. Today I take a look into the future. I begin with a brief (haha) discussion of the economy in 2014. Then I turn to singular events that might occur in 2014. 

When one forecasts economic growth one-year ahead he has to look at several things. First are the longer-term trends that are playing out. Long-term trends are usually pretty well known and have their impacts dispersed over several years or even decades. Population changes, industrialization, and globalization are often cited as impacting GDP gradually over many years. The year ahead is also impacted by events we call shocks -- unexpected factors that come and go -- often unpredictably. For example, extreme weather changes may cause food or energy prices to fluctuate much more than one might have ever expected. A third factor impacting the forecast for one year ahead is momentum. 

We already know a little about how long-term trends may slow economic growth in 2014. As for shocks, they are largely unexpected and can not be forecast well. The interesting factor for 2014 is momentum. When you say that your team is on a roll -- you are citing the power of momentum. You might not be sure of exactly why they are winning, but each time they win another game it gives you confidence they will win another one. If momentum is strong it totally subjugates long-term trends because you admit that the usual cause and effect might not be at work. This also ignores random or shock events that might affect future wins or losses. It just says -- the economy seemed to strengthen last year so I guess it will strengthen more this year. Note -- there might be lots of reasons for concern about the coming year based on known trends -- but momentum seems somehow to swamp all that -- at least for a while. That's what I mean by Mo-cro Economics in 2014. 

Momentum makes intuitive economic sense. This is because in macro we have two factors that often operate. The first is the jobs-income-spending-jobs link. As job growth improves so does income, spending, and then jobs. Even if the growth of jobs improves only a little compared to the previous year -- momentum is carried forward by the expected improvements in incomes and spending. Second, expectations matter. In a deep recession people hunker down. The uncertainty about the future worries people and limits their spending as they ready themselves for perhaps worse times. But after several years of economic growth, this negative mentality wears down. Goods get older and need to be replaced. As the economy improves and expectations get more sanguine -- people spend more -- incomes and jobs grow faster. 

2013 was seen as one more year distancing the US economy from the memories of the recession that ended several years ago. While not every macroeconomic indicator improved, the large body of them did. Especially important was the improvements in employment. I am guessing that at least in 2014, this wave or momentum will steadily build and produce continued gains in employment, income, and spending. 

Notice what this says and doesn't say. First, we should expect overall national economic growth in 2014 to be as least as strong as it was in 2013. Second, whatever long-term trends threaten us, they will likely be swamped by momentum in 2014. Third, shocks may arise that make this forecast very wrong. But since it is impossible to forecast the unexpected, we let that remain as it is. 

The last time I did forecasts was in December 2011 for the year 2012. Since I was wrong on all 13 forecasts, I decided to take a year off. But I am back again to try for 2014. Below are my non-economic forecasts for 2014. 

1. Pope Francis and Barack Obama will marry in Sochi and will honeymoon in Havana

2. Victor Oladipo will run for president despite the fact that 2014 is not a presidential election year and he is not old enough to run

3. Psy and Miley Cyrus will team up and start a new dance craze called the Gangnam Twerk

4. The Nobel Peace Prize will go to Kim Jong Un and Dennis Rodman

5. A new International trade treaty will result in free trade zone comprised of Iran Israel, Iraq, Illinois, Iowa and Indiana. It will be called the I-Zone and all citizens of the I-Zone will receive free I-phones, I-pads, and I-balls.

6. Airlines will allow unlimited phone service on all flights and will issue all customers without phones noise cancelling headphones and boxing gloves.

7. Janet Yellen will promise to keep interest rates at zero percent until all baby boomers have left planet Earth or until eight-track players dominate the music scene again, whichever comes first.

8. Boeing will settle a new labor pact with their union allowing all Seattle manufacturing employees to smoke doobies at lunch.

9. Joe Biden will cackle like a hyena.

10. Obamacare will be replaced by Hillarycare. You will sign up for your policies using colored crayons.

11. Gillette Blades will become the new official sponsor of Duck Dynasty

12. Fifty years ago Congress passed a resolution allowing the President more freedom to authorize combat actions against North Vietnam. Next year Congress will pass a resolution authorizing the President to do pretty much whatever he wants to do. 

13. Downton Abbey will be overtaken by jihadists.

14. This blog will continue to spout. Happy New Year all!

2013: Better than Expected by Guest Blogger Buck Klemkosky

Note: this summary for 2013 is provided by Guest Blogger Buck Klemkosky. Because it is long, you will see below his introduction and summary with 12 topics in the middle. Any of these topical areas can be read in full by scrolling down to the appropriate footnote number.

Americans, especially investors, have a lot to be thankful for in 2013. Remember, the year started with everyone worrying about falling off the fiscal cliff. Due to the budget impasse, automatic federal spending was cut through the sequester, and taxes were raised for the wealthy. Economic forecasters and other pundits were predicting that the sequestration would hamper economic growth or possibly cause a recession.

The Economy – The U.S. economy has performed better than expected with annual real GDP growth expected to be 2.4 percent for the year. The economy was bolstered by auto sales, housing and the consumer. It is difficult for the economy to have any meaningful growth without consumers being part of it, and they were in 2013, overcoming the supposed “fiscal drag” of the sequester and the austerity measures of state and federal governments. Economic prognosticators had forecast 2013 economic growth of less than 2 percent, so the economy performed better than forecast and the third and fourth quarter numbers suggest a stronger trajectory for the economy and consumer spending going into 2014.

Inflation[i]

Industrial Production[ii]

The Fed[iii]

Deficits and Defaults[iv]

The Volker Rule[v]

The Financial System[vi]

The Corporate Sector[vii]

Employment[viii]

Household Debt[ix]

Household Wealth[x]

Energy[xi]

Investable Assets [xii]

2013 – Recessions caused by financial crises take longer to recover from than normal cyclical recessions because debt has to be taken out of the system. This appears to have been completed in the U.S. for the household and financial sectors in 2013. Hopefully, this has set the foundation for continued economic growth in 2014 and beyond. The corporate, household and financial sectors in the U.S. are all in better shape than any time in the last decade or longer. The European economies and financial systems appear to have stabilized, and Abenomics in Japan has produced positive economic growth and stock returns in excess of 60 percent in 2013. China’s economic growth has come down over the last five years but still a solid 7.5 percent. Global and U.S. economic growth should be higher in 2014, with U.S. economic growth expected to be around 2.5-3.0 percent. Don’t expect 2014 stock market returns to replicate 2013; in 2013, markets anticipated and reflect economic momentum and other positive developments expected to occur in 2014.

The one big unknown is what if any problems have been created by the Fed’s zero interest policy and QE. It has created stock and bond market wealth and now housing again. Hopefully it has not created any significant bubbles or misallocations in the economy. So Fed actions and other macroeconomic events will continue to make headline news in 2014 and influence financial markets. Financial markets have performed much better than the real economy for several years, including 2013.

---

[i] The views on inflation have been all over the map. Many are worried about the enormous amounts of liquidity pumped into a global financial system by central banks and the potential for hyperinflation. Others worry that deflation may be the problem going forward. The inflation rate in 2013 was 1.1 percent, less than the 2 percent the Fed is targeting, as are the European Central Bank and the Bank of Japan. The most obvious danger of too-low inflation is the risk of falling into outright deflation of persistently falling prices. As Japan’s experience shows, deflation is damaging economically and hard to rectify. So central banks are more concerned about deflationary pressures than inflation.

[ii] U.S. industrial production, which measures the output of manufacturers, utilities and mines, hit a milestone in November 2013 when the index surpassed the pre-recession peak of December 2007. While manufacturing is still below its 2007 peak, overall production is up 21 percent since the end of the recession in June 2009 and up in 2013 relative to 2012.

[iii] The U.S. Federal Reserve celebrated its 100^th anniversary in 2013 and perhaps never in its history has it faced the complexity and risk it now does. At the end of 2013, three rounds of quantitative easing (QE) have inflated the Fed balance sheet to $4 trillion, up from $800 billion before QE started in 2008. QE3 started in September 2012 and entailed purchasing $85 billion monthly of U.S. Treasury bonds and mortgage-backed securities. Annualize that and it comes to more than $1 trillion a year of bond purchases that end up in the Fed’s balance sheet. QE3 is not sustainable and the Fed just announced that it will start tapering in 2014 by reducing monthly bond purchases by $10 billion. Chairman Bernanke announced in May 2013 the possibility of reducing or tapering the amount of bond purchases but delayed any final decision until December 2013, his last major decision as his second four-year term ends in January 2014. From May to December, tapering or lack thereof was the most talked-about and analyzed event in 2013 and it will continue to be as long as QE3 exists.

The Fed also will continue its accommodative monetary policy by keeping short-term interest rates close to zero even after unemployment rates fall below 6.5 percent unless inflation exceeds 2.5 percent. Janet Yellen takes over as Fed chair in February 2014 and is expected to continue Bernanke’s monetary policies.

[iv] Congress passed a 21-month budget resolution in December 2013, the first since 2010. While many applaud the ability of a dysfunctional Congress to even pass a budget, few seem to be happy about it. As a percentage of GDP, the federal deficit has fallen from more than 10 percent in 2011 to 4 percent in 2013 and less than 4 percent projected in 2014. Prerecession, a deficit of 4 percent of GDP used to be considered reckless; now some consider it austerity and a fiscal drag on the economy.

While a flawed budget deal may be better than no budget deal, one of the flaws in the U.S. fiscal policy is that congressional voting on spending is separated from voting on borrowing via the debt ceiling. The debt ceiling law has been in effect since 1917 but was not a political issue until the 1970s. Since the Carter administration, Congress has voted 45 times to increase the debt ceiling. Linking the vote to borrow to the vote to spend would seem logical, but don’t count on congressional rationality in this day of partisan politics. This will become headline news again in February 2014, when the federal debt is again expected to approach the debt ceiling of $16.7 trillion.

[v] The Federal Reserve Act, passed in 1913, was 31 pages long. The Dodd-Frank law, passed in 2010, was 2,391 pages long. It entails 398 rules, of which 161 have been finalized, and the Volker Rule is the latest. From its conception to finalization by five government regulatory agencies, the rule has grown to 963 pages, containing 2,826 footnotes and posing 1,347 questions. All this verbiage is to basically prevent proprietary trading by banks. They can still trade for clients, but most banks had already eliminated proprietary trading in anticipation of the rule. Full compliance is not required until July 2015. Monitoring and compliance will be complicated, and there may be unanticipated consequences such as less liquidity and more cost to trade less actively traded issues such as corporate bonds.

[vi] In 2013, the U.S. financial system was much stronger and transparent than before the financial crisis. Dodd-Frank, Basel III and other regulatory changes have taken debt and leverage out of the system, increased capital and monitoring not only of banks but also non-bank financial institutions. Hopefully regulators now understand how complex and interconnected the financial system is. One thing that has not been fully resolved is the too-big-to-fail issue. The 10 largest financial institutions in the U.S. in 2013 had more than $11 trillion of assets, compared with $7.8 trillion at the end of 2006. The market share of the 10 largest has increased, and thus their potential for systemic risk.

[vii] Corporate profits relative to GDP remain at historically high levels in 2013: 10 percent versus an average of 6 percent. While revenue growth was subpar, corporations were able to grow earnings through cost controls and share buybacks. Corporations today spend 60 percent more on share buybacks than on dividends, even though dividend growth has been positive. Because of economic and political uncertainty, corporate investment has not kept pace with profitability. Another reason is that the capacity utilization rate is slightly below 80 percent at the end of 2013, so there is no urgent need for capital expenditures until utilization picks up another 5 or 6 percent. Corporate balance sheets are in great shape and corporate cash as a percent of assets is at historical high levels. Even so, U.S. corporations set records in 2013 for issuing bonds, both investment grade and high yield, taking advantage of historically low interest rates. Two of the largest bond issues of all time occurred in 2013; Verizon issued $49 billion to finance an acquisition, and Apple $17 billion, even though the company had $70 billion in the bank, half of that overseas for tax reasons.

[viii] Job growth averaged about 190,000 monthly in 2013. The unemployment rate fell to 7.0 percent at the end of 2013 but not all of the improvement in the rate was due to job growth. The labor participation rate fell to a 30-year low of 63 percent, meaning millions of people have left the labor force for whatever reason. Still, at the end of 2013 there are 1.2 million fewer people working in the U.S. than at the end of 2007.

[ix] Financially, households have put their houses in order, so to speak. They have paid down more than $1 trillion of debt since the financial crisis, mostly mortgage debt which comprises about 70 percent of household debt. The debt service ratio, debt payment as a percent of disposable income, also fell to a 30-year low in 2013 as it approached 10 percent. With household balance sheets in better shape and consumers more confident, U.S. household debt increased in 2013, the first annual increase since 2008. One area of debt that is of concern is student loans; the amounts outstanding surpassed $1 trillion in 2013 and they had the highest delinquency rates at 12 percent.

[x] U.S. households lost $19 trillion in the financial crisis: $9 trillion in stocks, $7 trillion in housing and $3 trillion in other assets. This didn’t all happen simultaneously as stock prices started to increase in March 2009 and housing prices continued to drop through 2011. The peak loss was approximately $15.0 trillion. Household net worth, the value of assets minus debt, set a record of $77.5 trillion in 2013. However, adjusted for inflation, this amount is in real terms about the same as the $69 trillion of household net worth in 2007. Add in population growth and average household net worth is still below 2007. Less debt, housing prices up 12 percent in 2013, and stock prices up 29 percent have all contributed to the record levels of household net worth. One thing that has  not contributed has been interest rates; historically low interest rates, both short and long-term, have caused financial repression for households. Since 70 percent of household assets are financial in nature, interest rates and stock prices are the main drivers of household wealth.

Household net worth is 615 percent of after-tax income in 2013 compared to a peak of 662 percent in 2007, so households may not feel as wealthy today versus 2007. Plus the distribution of net worth is more unequal today than any time since the 1920s. The same is true of the distribution of incomes.

[xi] One of the major milestones in 2013 was that the U.S. became the world’s largest producer of energy, surpassing Russia. This is mainly due to natural gas production, but oil production also is ramping up. Because of horizontal drilling and fracking, the U.S. has the potential to become North American energy independent. The U.S. has started to export liquefied natural gas and has become the leading exporter of products derived from oil and natural gas. Lower energy costs have given the U.S. a real competitive cost advantage over European and Asian manufacturers, and the U.S. has started to attract direct foreign investment to the U.S. because of cheaper energy. This cost advantage should be sustainable for a decade or longer.

[xii] The star of 2013 was the stock market; the S&P 500 had a return of 29 percent, including dividends, the best one-year return since 1998. The consensus forecast at the beginning of 2013 was 8 percent. The NASDAQ and Russell 2000 did even better. In 2013, the Dow Jones Industrial Average hit 16,000 for the first time and the S&P 500 1,800. The NASDAQ crossed 4,000 for the first time in 13 years, except back then it was on its way down from its peak of 5,048 in 2000 and in 2013 on the way up. Bonds have been a mixed bag in 2013 with corporate bonds, both investment grade and high yield, providing positive returns of 5-7 percent.

However, long-term U.S. Treasuries did have negative returns. The big losers in 2013 were most commodities, especially gold, which fell more than 30 percent from its peak price of $1,800 per troy ounce. Some believe the commodity super cycle that started in 2000 may be over. Short-term money market instruments were also losers, as the Fed continued its zero interest rate policy. Real short-term interest rates were negative after adjusting for inflation.

Merry Christmas and a Happy New Year

Thanks for being part of my blog this year. Betty and I want to wish you a wonderful holiday. I hope your Christmas is filled with everything you want and that you have time to reflect on all the goodness and beauty around us. Sprouting has been a blessing for me in retirement and a great way to communicate with so many of my neighbors, friends, former colleagues and students, and family. We don't always agree with each other but it sure is fun hashing it out.

Next week we will have a special summary of 2013 from our frequent guest blogger Buck Klemkosky. So stay tuned and have a wonderful holiday.

S&P Newtonians – Have they lost their apples?

As November came to an end and shoppers duked it out at Macy’s and Victoria Secret, the financial news heralded the stellar performance of the stock market. Much of the news documented in one way or another how much the stock market valuations have grown this year and in the past few months. Some Newtonians concluded that what goes up must come down. Other analysts believe there is more room for stock prices to rise. Which is it—up or down?

As you know I am a humble macroeconomist and not a finance whiz and therefore I admit to treading in shark infested waters. What I read tells me that the risks lie toward mean-reverting behavior. After stocks have gone up so much it seems reasonable that they would take a breather. While that sounds pretty rational I think that view is missing some vital information. I see several reasons why stocks could continue rising and therefore I am more optimistic than many of the pundits.

Let’s face it the majority view has a lot going for. For one thing a look at stock market behavior over time does underscore a tendency of markets to deviate from and then return to longer term trends. And the famous PE (price to earnings) ratios mostly support the view that stocks cannot keep up rapid price increases. Stock prices have raced ahead of earnings – especially since earnings are slowing down. If you expect earnings to continue to slow as the world economy struggles then price to future earnings look high today – thus there is plenty of room from the PE camp to suggest a slowing or a retraction in stock prices.

So how can I support a more optimistic view of future stock prices? One point is that earnings have been volatile. During the recession them plummeted. After the recession earnings moved dramatically upward. It is natural they would fall off that rapid acceleration to something more normal. Thus, a slowing in earnings does not bode poorly for now or for the future.

My second point is based on an even longer-term view of stock prices. I am going to use the S&P 500 average for my analysis but what I am about to say works for most broad measures of US stock prices. The S&P 500 bottomed out in the recession at 676 in March 2009. That represented a major contraction relative to the heady days of pre-2008. Since March 2009 the S&P 500 rose to around 1,800 . From the bottom in March 2009 to July 2013 the S&P 500 rose by 166%.  That is pretty spectacular and you can see why some people think that behavior cannot be maintained.

But there is more to the story. If you compare this so-called high stock price level in November 2013 to the previous peak in November of 2007 of 1,520, you see that in a time period of six years the market has gone above that previous peak but is only 18% higher.  A gain of 18% in four years is not spectacular. Do not forget that those stock returns buy less because the prices of goods and services were rising during those six years. The Consumer Price Index rose by 14% in those six years. So you could conclude that in purchasing power terms, the peak level of the S&P 500 is only about 4% higher than it was six years ago. That peak resembles the humble Smokies more than the Rockies!

If we compared today’s so-called high level of stock prices to the previous peak in 2000 of 1,527, then today is 18% above that peak. Today’s peak is only 18% above the peak of 13 years ago! With inflation of 37% since 2000, the buying power of today’s market high is about 19% less than the peak in 2000.

We have a market high recently but when we compare it realistically to previous highs, it doesn’t look very spectacular and therefore does not imply a major contraction is ahead of us. The S&P 500 would have to rise from the 1,800 range to something greater than 2,200 to be comparable in buying power terms to the peak of 2000.  I am not predicting anything like that. But the US economy is growing. Companies are making profits. The fear of another major global collapse is receding. Employment is gathering steam. Smaller investors are getting back into the US markets. There is no reason why stock prices cannot continue their upward trajectory. If only the Fed and Congress would do their respective parts by not mucking up the economy.

Obama Reversing Undesirable Changes in the Income Distribution

I read the following quote in an article on Bloomberg last week. “President Barack Obama, setting out a theme that he’ll pursue in the final years of his presidency, said growing income disparity in the U.S. is the “defining challenge or our time” and Washington must confront it.

And then I remembered why I started this blog – to drink more JD. Geez Mary, what is our President trying to say? Let’s try some possibilities:

          1.   I discovered recently that income disparity is growing and we need to get together and do something about it.

           2.  I have spent the last six years focused on nothing but income disparity and only got this Boehner T-shirt   

 3.  I have spent my life devoted to correcting income disparity and have not succeeded so I am going to use the last years of my Presidency to doing more of the same.

The good thing is that this president is loyal to his goal of income redistribution. The bad thing is that he doesn’t have a clue about how to go about getting what he wants. Even if he waived a magic wand and turned all the Republicans into card-carrying liberal democrats, he would not get what he wants.

How can I support such an outrageous statement? Let me count the ways? First, the bull in the China shop is right in front of him but he doesn’t see it. Is he going to switch gears to income distribution before he is finished with employment? I mean which way is it? Which is his main goal? Some of what he hopes to get with reducing income disparity comes when the economy is growing again and employing more people. Did he relegate economic growth and employment to position #2? Or #3? Is that really the way to help people with low incomes catch up?

Second, he already made headway on policies to redistribute income. If Obamacare does not redistribute money to the poor, I don’t know what it does? But that’s not enough. He raised taxes on the rich in the last “kick the can down the road” exercise, increased spending and participation in most social programs, plans to reduce what the government pays to doctors, medical device companies, etc. Even with all that the data seems to show little to no improvement in the lot of people with lower incomes. Maybe he should go back to point 1 above – fix the economy.

Third, as it relates to income redistribution his plan is a repeat of very old dogma that got us to where we are now. There is not one new trick in this deck of dog-eared cards. Increase social spending, increase the minimum wage, raise taxes on the rich, have the government spend more on infrastructure, and so on. Come on! We did all that for 50 years and we have more poor people now than ever. And more rich people too. And guess what? While there are ways to measure the successes of some government programs it is not going to be easy to repeat those successes again starting tomorrow.

The infrastructure idea sounds nice but it will take decades to impact income distribution. Remember all those shovel-ready jobs of a few years ago? The problem Mr. President is not that we need to spend more on social programs or infrastructure. It is that we need to create an environment of short-term expansion and long-term economic growth. I already discussed the former above, now let’s think about the long-run.  

Why hasn’t the economy snapped back and resumed normal economic and job growth? Answer: because there is stuff wrong with the economy. If there is stuff wrong with the economy then you fix it. Don’t push the blood back into the bullet hole – sew the hole shut! A guy walks into an emergency room after being run over by a cement truck and has multiple injuries and asks if he can bum a cigarette and a few band-aids. What’s a good doctor to do? Surely not give the guy what he is asking for. 

I doubt I will be exhaustive but consider what needs to be attended to:

            Demographics mean labor force growth is much lower than it used to be subtracting close to 1% per year from economic growth

            Financial reform and regulation remains incomplete some five years after the recession providing an aura of uncertainty

            Housing reforms  remain incomplete. Banks still do not know the definition of a qualified mortgage.

            Global competition from countries that have lower wages eat away at low and middle skills jobs

            As more and more jobs are growing in highly technical fields, US education cannot produce graduates that place better than the median in world  comparisons of 15 year-olds
             Reams of pages of new regulations on firms

National debt is 100% of GDP

Okay I must have left something out. I know, I left Obamacare out on purpose. But do you really think we should be spending our precious time the next two years debating emotionally and heatedly about adding or not adding a  few points to tack onto the tax bill of rich doctors and lawyers? Let me say this as loudly as I can – I TOTALLY AGREE THAT WE NEED TO BOLDLY FACE INCOME DISTRIBUTION PROBLEMS.  I totally agree that income disparity is very wrong both economically and morally. But there are ways to do this that will work and other ways that won’t work.

The next ten years will not be like the last five. They will not be like your grandfather’s business cycle. We have a mess of problems that hurt lower income people. Some problems are short-run oriented related to the recession. Others have more to do with negative longer-term trends playing out. Raising the minimum wage or taxing the rich takes the eye off the ball. The term is worn out but we have a perfect storm affecting lower income people. The usual life vests are not going to be enough. We need to focus on what it takes to generate a decade or two of stronger economic growth. 

Obamacare’s Medical Devices Tax is a Heart Stopper

Almost exactly two years have gone by since I posted about the Medical Devices Tax (Obamacare, Jobs, and Global Competitiveness, November 22, 2011). In that post I worried about the negative impacts of the new tax on US employment. Two years later there is evidence that the worries were well founded even though the tax has not yet begun to bite. Since Congress may have the chance to save the day for the Medical Device Tax yet in 2013 and since there are some who would not repeal this part of Obamacare, I thought I would wade into this topic one more time.

This time I am spouting about an article written by Kent Gardner, chief economist for the Center for Governmental Research (Rochester Business Journal, November 15, 2013).  Gardner alleges that “Joint replacement earns a whopping profit for the implant manufacturers and a very good living for the surgeons and hospitals involved. And private insurers, Medicare, Medicaid and the Veterans Administration pay most of the bills.” He thinks these firms are doing just fine and uses three arguments to explain why the tax won’t have negative effects”:

1.     These firms are cartels and therefore medical device firms won’t pass the tax along to higher prices

2.     The tax will not cause US jobs to go overseas

3.     The tax will not cause any reductions in innovation and competitiveness

So let’s take a closer look at Gardner’s arguments. He says medical device firms are like cartel members. Wikipedia offers this definition of a cartel,

a formal (explicit) "agreement" among competing firms. It is a formal organization of producers and manufacturers that agree to fix prices, marketing, and production.^[1] Cartels usually occur in an oligopolistic industry, where the number of sellers is small (usually because barriers to entry, most notably start-up costs, are high) and the products being traded are usually homogeneous.

Implicit in this definition is that the cartel brings the members high or excessive profits. 

So Gardner is wrong on a lot of counts. First, there is no formal agreement among medical devices companies as there is in OPEC. Second, if there is an informal agreement to do all this bad stuff, then this is against the law – and these guys must be pretty good to have eluded the regulators for so long.

Third, these companies are not homogeneous. There is a relatively large number of medical device companies, and there is plenty of entry and exit, especially among the smaller innovative firms. . While there might be small numbers of companies in very specific segments of the industry, this is what one should expect when advanced science is behind specialization, continuous invention, and innovation. A company that leads in a particular kind of product, for example, may enjoy a monopoly position for a little while. But this is also true for cellular phones and many other electronic products – do we want to put additional taxes on Apple and Samsung because they lead their industry? Probably not. A small number of firms doing everything they can to take leadership is good for product price and quality and, of course, the consumer. Think Nokia if you want evidence that even a small number of firms can produce real competition.

Fourth, most of the data I am finding does not support the notion that these companies are making obscene or even risqué profits. I looked at rankings of profit measures by industry –published by Yahoo Finance and a consulting company, Analyxit . These rankings generally show that the Healthcare and Medical Devices sectors make very reasonable net profits as a percentage of revenue. For example Yahoo Finance found Medical Devices had a net profit ratio of about 13%, ranking it 42^nd among industries. In contrast Finance sectors had returns ranging from 36% to 81%.  The return on equity ranking showed Medical Devices at 14% with a ranking of 82^nd. Analyxit ranked Healthcare, including Medical Devices, as eighth among nine sectors based on net profits as a percentage of revenue. Again financial companies led the list with returns averaging 17%. Healthcare’s percentage was 4%. In the middle of the pack were utility companies with a ratio of 8%.

Gardner says these firms will not pass the extra cost of the tax onto consumers. He reasons… “When firms hold significant market power – as they do in this industry – the connection between cost and price has been weakened. Price is largely driven by demand factors, not cost: Monopolists already charge what the market will bear.” Gardner’s argument flies in the face of what we teach freshmen in economics every year. Market power translates into an inelastic demand curve -- which means that firms without much competition do not have to worry much about losing customers when they increase prices – and would as a matter of fact pass the extra costs caused by the tax into higher prices.

I would agree that these firms will eat the tax as a reduction in profits and not pass the cost along to medical consumers in the short-run. But this is not because these firms have market power. The main reason that profits will fall is that medical device manufacturers have long term contracts with hospitals and other health providers and cannot easily increase revenues to offset rising costs from the new tax. Won’t these firms benefit from a tidal wave of new enrollees in Obamacare? Probably not. Many of the newly insured will be younger and not require medical devices like new hips and knees.

What I showed two years ago is that while a 2.3% tax on revenue sounds trivial, the result is that the tax is a much larger percent of a company’s profits. While some people think profit is a dirty word, the fact is that profits are used to invest in research, product development, safety, and other critical outlays that invent and improve products. The more the government takes of these profits the less is available for increasing product quality and being competitive. Large for-profit firms are already seeking foreign locations and will be followed by private companies. And the negative impact on smaller entrepreneurial firms is disproportionate because in the early years a company often makes small or no profits despite having rising revenues. The upshot is that a 2.3% revenue tax will mean business losses and an end to these small businesses. Inasmuch, the bigger firms will gobble their assets and this will lead to less, not more, competition. A correlated worry is that all these firms will turn away from devices that cannot promise immediate returns or serve smaller markets. This bodes ill for future important improvements in the device industry.

But aren’t corporate taxes low? The answer is that despite some loopholes, US corporate income taxes are among the highest in the world. Domestic companies are already reducing employment and globalization means many are seeking production and market opportunities globally. The medical device news is full of stories about layoffs and new joint ventures, both domestic and foreign. Combining a high corporate tax with another 10-30% of income going to a medical device tax makes it more desirable for medical devices companies to find locations and markets where better profits can be made. China, India, Ireland, Costa Rica, Singapore and a growing list of countries are quite willing to compete on corporate profits as a way of winning production as well as R&D facilities.

The upshot is that this tax is not good for US employment nor US-based innovation and competitiveness. The US should be happy to have the world’s leading medical device companies and it should be fighting to keep it that way. Worse yet is the misleading contention that this tax increase will break up this medical devices cartel and lead to more competition. It will do just the opposite as large US companies get larger by combining with suppliers and competitors – and as they move more and more operations abroad.