The Fed, Inflation, and Recessions

In my post last week I stated that recessions were often caused by monetary policy actions. Some people think it is bazaar if not evil to say such a thing. Policy is formed to create good outcomes – not recessions. But policymakers are just like you and me – prone to error and especially so when we think we are doing something for the greater good.

Since I sometimes write things based on what I think I know, I decided to bring up some data and see if there is any truth to what I think I know about inflation and recessions. But let’s first review the simple theory since it is relevant to current monetary policy.

     Monetary policymakers worry the economy is fragile so they keep interest rates low by letting the money supply expand faster than my belt at a July 4^th BBQ.

      In so doing they risk overheating the economy

     When the economy expands too quickly this leads to higher inflation

     Upon seeing higher inflation, the Fed restricts money, interest rates rise, aggregate demand contracts, and a recession ensues.

     Cinderella is then run over by her coach. Yes she was a little tipsy.

Looking at graphs never proves a theory but I am so old that I have forgotten how to run proper scientific experiments and besides, many of you are cynical enough to believe I faked the results anyway.  You can check or reproduce my results by going to the FRED data service at https://research.stlouisfed.org/fred2/  . Then choose the Consumer Price Index for All Urban Consumers: All Items. Then choose annual rates of change. That is what I call “inflation’.

I begin this story by looking at seven US recessions from 1970 to 2008. That means we are looking at almost 40 years of US history. If you want to go back farther that is okay with me but I figured that is enough years for our purposes here. These seven recessions are shown on the graph below as vertical shaded areas.

Inflation went from:

           less than 2.5% to more than 5% right before the 1970 recession started

           a little more than 2.5% to more 10% before the 1974 recession

           just over 5% to around 13% before the 1980 and 1982 recessions

           under 2.5% to over 5% before the 1992 recession

           about 2% to over 3% before the 2002 recession

           about 2% to about 4% before the 2008 recession

Every one of these seven recessions was preceded by a substantial and worrisome increase in the inflation rate.

That’s pretty interesting. Do I hear clapping in the background? But some of you sharp cookies (since when is a cookie sharp?) are saying stuff like the following. This proves nothing since Larry is focused on just two variables. If money is part of the story, then clearly I need to show the following – inflation was worrisome enough to elicit a Fed tightening of policy and that tightening caused the economy to contract. And the coup de gras (Charlie, coup de gras is not a race car) is that I need to show that nothing else was a major contributing factor to each of these recessions. For example, some of you smarty-pants will point out that the dot-com bust was a major factor causing the 2002 recession.

To the above I say raspberries (why is there a P in raspberries?). I could add more data but this is a family blog and I don’t want to pollute the environment.  I challenge you to do some simple search research with your favorite search engine using words like inflation, monetary policy, recession, 1980.  You will find it difficult to dismiss the strong possibility that too much money caused inflation and too much inflation caused tight money and ensuing economic contractions.

Which leads me to the following question: Does the future or at least the next few years have to imitate the last 40 years?

     Maybe that graph and all the discussion above is irrelevant for beyond 2015. 

     Maybe all that money injected recently will not ever cause higher inflation.

     Even if inflation does begin to rise, maybe the Fed won’t tighten vigorously

     Even if the Fed worries about rising inflation and tightens, maybe it won’t cause a recession

Since this blog is about you as much as me, I won’t answer those questions. But I am wondering what you think about them. Are we in a new world in which inflation is not a problem? Will that new world imply that the rules of money have been revoked? Will the Fed escape a period of historical monetary increases without causing a dent in the future economy? Does Janet Yellen know how to cha cha cha? 

Lesson 5 The FED and Monetary Policy Gone Bad

In 2015 we in the US regard the Fed as the only macro policy game in town.   In macro we teach about macro problems and macro policies. Because Congress is largely dysfunctional there is little hope that they could pass a bill which adequately addresses macro problems. What is often referred to as fiscal policy, or use of government spending and taxes to address the economy, is now mainly neutered. That mostly leaves The Fed as the only policy game in town. 

So there is much attention focused on Fed policy. In this summer of 2015 we are told that the Fed will soon change its policy. But there is much uncertainty about when and by how much the policy will change. So the financial markets are a little crazy. And the economy bobs up and down. Do we really have to experience all this madness?

I think not. The problem is that the Fed is trying to do something it is ill-suited for. It has taken about 60 years to figure this out but I think it is getting plainer all the time. It is like the 40 year old man who after a brief bout of unemployment gets a new job. Yet his mother isn’t satisfied. Honey – did you brush your teeth before you went to work? Were you nice to your new boss? Did you polish your brown shoes? This man has things under control and he doesn’t need his mother giving him bad advice. Mom – stop it! Fed – stop it!

This Fed is like this doting mother. The economy might have needed some Fed support in 2008. But if you look at your calendar, you will note that was seven years ago. The recession ended in 2009 and the US economy has been expanding ever since. I know of no theory of macroeconomics that says that expansionary policy must continue until everyone on the planet believes there is a 100% chance the economy might not regress.

Think about the theory of macro policy. First, John M. Keynes did not believe monetary policy should be used to stimulate the economy.  He likened it to pushing on a string. Second, he did believe the government could and should stimulate the economy – using what he likened to a priming operation. In a priming operation the government spends a little more and taxes a little less to get a little bit of spending going. Presumably this injection of spending will increase our incomes and our confidence and get things moving. Like the ball in a pin-ball machine, the ball doesn’t exit before it bangs against numerous cushions that indicate increases in your score. The injection of a little bit of stimulus gets us all spending before the injection ball exits the economy.

Keynes was writing in the 1940s and much has happened to this humble theory in the last 70+ years. Keynes’ followers (Keynesians) decided to quantify all this and before we knew it we had an elegantly expressed general theory in which the government and the FED could alter monetary and fiscal policies to keep the unemployment rate always at full employment with a corresponding GDP Gap equal to zero. Gone was the priming issue. Gone was the skeptical attitude about monetary policy. And of course gone were the days of conservative government budgeting and near-zero inflation. 

Consider where we live now – in a world where

            it is expected that the Fed if not the government will stimulate until we reach full employment;

            we have annual budget deficits and almost no surpluses and a national debt that is soaring;

            inflation has followed EVERY significant policy stimulation; and

            these inflation bouts were followed by policy reversals that led to recessions or very slow growth periods.

Anyone with an objective attitude about macro policy as practiced in the US since the end of World War II could not be very happy with these results. We clearly have a frying pan- fire-frying pan experience. What went wrong? It seems pretty straight forward. Macro is a legitimate social science. If macro indicators are showing a significant recession or slowdown, then policy variables can be altered so as to increase aggregate demand which in turn stimulates other spending until the macro indicators can be drawn with happy faces around them.

That sounds pretty easy. But the truth is much different. Hey mom, I have a temperature. Okay honey. Stick your head in the refrigerator and you should be fine in a few minutes. That sounds pretty stupid. But our Keynesian approach to macro problems and policy is the same. Follow me on this. I believe in macro. I believe that when real GDP declines this is a problem needing study and remediation. Okay so far? But what I do not believe is that EVERY TIME real GDP or other macro indicators fail to achieve better values, that we have a generalized macro problem requiring monetary and/or fiscal policy.

How is it possible that a macro slowdown is not caused by macro factors? Simple. We have a macro construct called aggregate demand. And Jim and Toni have five kids. Peter slugs Diane and she cries. Then the other three kids cry. Uncle Charlie comes in and sees five unhappy kids and concludes that Jim and Toni have been abusing their children. He sees virtually the whole family in disarray. The problem must have been caused by the parents, Jim and Toni. That’s what our brilliant macro economists do when they see aggregate demand falling. If AD is going down, then macro policy needs to bring it back up. Presto!

But in my family example above, the problem is that Peter is a mean boy and slugs people. There is no family problem. There is a Peter problem. The solution should be to fix Peter (please no Jenner jokes) . Fixing the whole family is misplaced. It lets Peter off easy. It is inefficient and won’t lead to a solution for a happier family.

And so it is with a fixation on aggregate demand and the national unemployment rate. There may be times when all of aggregate demand is declining. And in those times a general AD approach might seem reasonable. But in many or most cases, the problem showing up in AD is really a specific problem stemming from housing, or autos, or Japan, or other parts of AD or AS. Yes, sometimes AD is falling because of aggregate supply problems. In these cases, AD policy is wrong and inefficient at best. The right policies are those that address the real problems be they housing or autos or Japan or AS.

Today our Fed continues a zero interest rate policy* that intends to stimulate aggregate demand. The leaders explain with great pride that they will not relent in this generous policy so long as we have even the tiniest negative GDP Gap. Yet the economy jumps up and down and financial markets have fits because there are plenty of problems with the economy that do not get addressed because the Fed is so focused on AD – and AD hasn’t been the problem for years. Should the economy continue to slowly heal itself despite the FED, we can be sure that we will soon be wondering why inflation got so bad so fast – and wondering why the FED's abrupt policy reversal is throwing us into the next recession. 

* One more point. A zero interest rate policy might seem innocent enough. But note that in order for the Fed to keep interest rates near zero, it takes actions. To keep interest rates near zero in the last two years meant increasing the money supply. This is done by increasing something called the monetary base. It grew by 39% from Q1 2013 to Q1 2015. The result was that the narrow version of money, M1, grew by 20% during that time period,. The wider version, M2, grew by 13%. Money is exploding despite the fact that we have a growing economy. This is risky business. 

Lesson 4 Potential Output, the GDP Gap, and the Intelligence Gap

This post is really about inflation but I didn’t want to mention inflation in the title so as to not scare you. Actually it is really about inflation policy so let’s start there before we get into excruciating technical definitions, mathematical equations, and kimchi recipes.

Some of you are old enough to remember inflation. Inflation means the cost of cherished goods and services is rising. One day you went to Whole Foods for one small bag of groceries and it cost you $1,000. Today you go and that same bag of non-pesticidal fruits and nuts costs you $1,100. You would say, yikes Helen, those dirty scum-#$%^&*s at Whole Foods are ripping us off and making it impossible to send our genius Golden Retriever Bogey to Harvard. Or you might simply say that inflation was 10%.

Since the great recession in 2008 the inflation rate has been very low in the USA. While the inflation rate was generally rising between 2001 and 2008 it has been falling ever since. It did rise briefly to nearly 4% during 2011, but it reversed course and inflation has been falling ever since.

So there are great minds who basically say “Inflation who?” implying that inflation is like your brother-in-law after the divorce. You ain’t gonna have to see him again! Very smart economists who teach at wonderful places like San Diego State and Harvard would swear on a stack of Paul Krugman articles that the Fed can pump in money and the government can spend its way to oblivion and back – and still not awaken a comatose inflation dragon. I know. I am mixing metaphors. Or was that a simile?

I know you have been waiting patiently for some really boring definitions but I had to get you ready. If you are like a lot of my friends, you haven’t read an economics book since Prof Schaffer’s class in 1964. Potential Output and the GDP Gap exist for one and only one reason – to help us predict future inflation. The above suggests that inflation is hiding at the moment. But this blog is all about how and why inflation might awaken from its long slumber and possibly be in a very ugly mood.

Remember GDP? GDP is a nation’s output. It is measured fact. It is the size of that pile of goods and services that got produced this year. It could be really big this year because Zeus was happy or it might be small because Kim Kardashian forgot to go shopping. Either way, GDP is what got produced.

Potential GDP is part of a fairy tale or what economists like to proudly call a counterfactual. Potential GDP is what GDP could have been. It’s like your kid’s potential. Okay, so he can’t actually hit the broadside of a barn with a large pumpkin but you are pretty sure that if he practices a lot he will soon be starting on the mound for the Royals. Potential GDP is how much output would have been produced this year if the economy’s resources were fully utilized. It is possible that actual GDP could equal its potential in a given year – but honestly, when is the last time your kid started for the Royals?

The GDP Gap is the difference between Actual GDP and  Potential GDP. Most of the time, the current GDP is well below its potential because most of the time resources are not being fully utilized. Thus, most of the time the GDP GAP is negative.

The main productive resource that tends to lag is employment. Those dern workers just love to sit around and watch Oprah every day instead of going to work and producing huge mounds of widgets and zidgets. Or those dad-gummed firms love to fire workers who then sit around and watch Oprah. In either case, if there are unemployed workers looking for work, this excess shows up as a negative GDP gap.

Here is the point – an excess of workers seeking employment (or improved employment) and a corresponding negative GDP Gap represent a weak economy with weak spending It is one that grows slowly and one that is not capable of producing inflation. As a result the US Fed is more concerned about the weak economy than it is about rising inflation. That relative concern retards their movement to a more normal policy. It puts off the day when the Fed removes a lot of money and stimulus from the economy. When employment improves and the GDP GAP turns toward positive territory, then the Fed will turn its sights towards mediating inflation. The big question now is when will that day come? When will policy return to normal? The GDP Gap is heading towards positive so we know a policy change will come.

The intelligence gap has to do with the Fed’s reluctance to move to a saner policy. Why do I say saner? The economy is exhibiting a return to stronger economic growth. Inflation is not one of those things that require bugles and a formal announcement heralding its arrival.  I know that GDP turned sour in the first quarter of 2015 but everyone including your barber’s Doberman knows about the temporary factors like a massive dock strike and storms attributed to global warming caused economic problems in Q1 that will not be repeated in Q2.

Now we have economists giving the Fed even more ammunition to continue a risky policy. A recent report (Changing Labor Force Composition and the Natural Rate of Unemployment, by Daniel Asronson, Chicago Fed Letter, #338) explains that labor will not be fully employed until the unemployment rate reaches between 4.5% and 4.9%. That means we will have a negative GDP Gap until the unemployment rate reaches about 4.5%. That means the Fed has a numerical excuse to not worry about inflation and to not engage in a more conservative policy for quite a while.  Meanwhile the economy gains momentum and some measures of inflation (percentage change in the CPI less food and energy) are closing in on the 2% goal value. Once at the goal value notice that it won’t take long to exceed it. And then the Fed will be in a really difficult position. Do they really want to have to aim all their guns on inflation knowing that a major abrupt change in policy will greatly weaken spending in the economy.

A quicker return to a gradual approach that started yesterday is what was needed. Waiting until tomorrow promises going from the frying pan to the fire. 

Lesson 3 Productivity: Not Such a Mystery

Alan S. Blinder wrote an article a couple of weeks ago in the Wall Street Journal called “The Mystery of Declining Productivity Growth ” (May 15). Who doesn’t like a good mystery? So I picked up the article and started looking for who killed Cock Productivity.  And then it hit me. This could be Lesson 3. All of you HomeEc majors are going to love this one.

Now that you have GDP under your garter belt it is now time to master another macro indicator, productivity. And it is a good one to master. Productivity is important, misunderstood, and controversial. And because productivity is the result of dividing two numbers, it is arithmetically challenging.

Productivity is important because it is a key driver of a nation’s output growth. We all have t-shirts that say Go Growth because we have fallen prey to this macro mantra. Recall that GDP is like a mountain of stuff. We like the mountain to get bigger each year. Macro says it gets bigger each year if we have one or more of the following:

            More labor producing stuff

            More capital (plant, equipment, software, etc) producing stuff

            More Productivity (Better ways of producing so that using a given amount of labor and capital gives you even more stuff)

Productivity is misunderstood. First, it is defined as output per unit of labor input. (Note: for those of you who know the difference between a two-factor and a one-factor production function please ignore my using labor productivity rather than total factor productivity. It seems easier to discuss this topic using labor productivity. I realize that technically it is not correct. But it does no harm for my purposes here).

To calculate productivity you therefore have to divide output by the number of labor inputs. People love rising productivity as much as a grilled cheese sandwich on white bread. Suppose Lila goes to a yoga camp and comes back to the factory all stretchy and happy. Her experience at that yoga camp means that Lila can now produce 10 Nehru jackets each day instead of her former best output of 7. She is still just 1 worker – but now her productivity is 10 instead of 7.  Her boss, Mohammed, is quite happy with this result. Getting more work out of Lila and paying her the same means Mohammed can afford more chicken wings and wheat beer at the Upland Brewery on Friday night. Of course, since Lila can produce so much more in a given day, Mohammed has other choices – he can reduce the price of his Nehru Jackets and/or give Lila a pay raise.

Do you see why we like productivity to increase? Workers who become more productive lead to higher output, higher profits, higher wages, and lower prices. Slower growth or lower growth of productivity is not good and leads to the opposite. So companies and countries try very hard to improve worker productivity.

Rising productivity is good but it is pretty complicated. A second reason for misunderstanding is that if Lila can produce so much, maybe old Mohammed can fire Adore, her co-worker who has been known to read Herman Hesse novels on the production line. That doesn’t sound so good. Higher productivity can lead to a reduction in employment. Some of you are old enough to recall when the tractor replaced the horse.  A lot of horses and agricultural workers got replaced when tractors increased the productivity of Ag workers – the ones who could master those new-fangled tractors.

Like Hillary Clinton therefore, productivity has a checkered past. This leads to controversy. One controversy has to do with the question of employment. Some productivity gains are very bad for some workers who get displaced by the new technology. But recall – stronger productivity also means more output, increased competitiveness, higher wages and so on.  The higher output can lead to more employment. A new technology causes an initial employment decline and it may take years before the output effects generate more employment. So it is a tough call for politicians to actively promote increased productivity – even though it is the key way to increase GDP for the future.

Okay we are almost done and it is getting close to 5 PM and I can hear JD screaming for me. Here is where we get to the mystery, whodunit, and then the solution. Alan Blinder notes that productivity growth slowed in the USA since 2005. It is barely crawling at 1.3% per year compared to a rate of 2.9% before that. You used to be able to dunk the basketball. Now you can barely touch the bottom of the net using a trampoline. This is a serious decline.

Blinder in his Alan Blinder sort of way says this is both a problem and a mystery. We should solve this mystery. But in my humble opinion Prof Blinder may have been spending a little too much time lately in Colorado and Washington State. He lays off this mystery to things like getting free services off the Internet and how much of the current tech boom (Facebook, Twitter, Snapchat) creates employment but not much output. He also says that businesses are churning less and that means less output from entrepreneurs.

There might be some truth to Blinder’s story but being one of the liberal persuasion it seems that Blinder simply does not want to admit to a whole other set of factors that might be important enough to have cut productivity growth by more than half. These items are not a mystery. Two recent articles offer a totally different view from Blinder– and suggest that the mystery is not very mysterious.

Martin Feldstein writes “US Underestimates Growth” (WSJ 5/19/15) and concludes that measurement problems during a time of rapid technological change underestimate GDP. The output and productivity are there – it is just that the government’s methods to measure them are not flexible enough. Feldstein goes on to say that approaching the productivity problem needs to address why firms are not buying more capital, why workers are not joining the labor force, and why smaller firms are not innovating. His advice is to focus on reducing tax disincentives and reforming taxes so firms want to invest and workers want to work. This,of course, is basic supply-side economics.

Dan Mitchell’s conclusion is pretty obvious from his title. “Big Government Is an Anchor on America’s Economy, Undermining Investment and Wage Growth” (WSJ May 16, 2015). Mitchell focuses on the thousands of new regulations imposed on financial, banking, and other firms in the years since 2008. These regulations create additional costs and uncertainty that prevent firms from expanding more and from workers actively seeking employment. 

Feldstein and Mitchell emphasize productivity problems that seem pretty obvious. I am not sure why Blinder sees this slowdown as such a mystery. Maybe his ideology does not include supply-side solutions and this we are left with mystery. I wonder what Sherlock Holmes would say about all this. 

A More Positive Take on Givers and Takers

Candidate Romney and Republicans were rightfully castigated for inelegantly dividing us into givers (who pay most of the taxes) and takers (who receive entitlements).  Thus this terminology is tainted much like PBR is no longer considered a luxury good. Even if there might have been a valid point made with these unfortunate words, the truth is that both sides of the political spectrum have used them to recruit and to divide us.

So let’s start over. I want to give a fresh interpretation to givers and takers and I want to prove to you that these words need not divide us. In truth, I think if  you read on you might see that these same words can bring us together in important ways. Okay I am pretty optimistic and am making a huge claim. But given our present state of discord, what can we lose? Despite all we give and have given, we still have shameless ghettos, too many homeless people, growing addictions and too many children growing up with single parents amid violence. As a young man in the 1960s I never would have believed that we could give so much money in the next half-century and still not make better headway against social and economic problems.  

I want to start this discussion with the givers. Since I make a lot of typos, let’s simplify and called them Gs. Americans are Gs. So are people from other countries but the tradition of giving is prevalent in American culture. Think of all the things we give every day. We give money and we give our time. We serve on boards and committees of local not-for-profits and we attend Habitat for Humanity building parties. We give to the the local Boys and Girls Club and Stonebelt. We give time and money to local food banks and often contribute to national charities like United Way and the Wounded Warriors Project. We support NPR and many local radio stations like KEXP in Seattle. Of course we also pay taxes to local, state, and federal governments to support many programs. Clearly we give and we usually give generously. People of most ideologies and parties give. Giving unites us. We might have our favorite or least favorite charities and programs but the point is that we are a people that gives. 

The Giving USA Foundation estimated that Americans gave $335 billion to charities in 2013. About two-thirds of that was given by individuals. Another $5 trillion is paid into local, state, and federal government taxes each year. 

Why do we give so much? There are many reasons we give. We give to the government to stay out of jail. Some give to gain tax advantages. We give to impress our neighbors and colleagues. We give because we believe it is the right thing to do. Most religions teach that we feel better and are better persons when we are charitable. Christians teach that God gave up his only son to save us. This makes me wonder why God only had one son and no daughters, but let’s save that for another post.  The Golden Rule says to treat others as we would have them treat us. Maybe there are other reasons we give but I have gone to few spiritual meetings where the main idea is that personal salvation and enlightenment come from selfishness at the expense of others.

Okay so we give and we give a lot. To satisfy this strong need to give is to need someone to take. If we want to be a G then there had better be some takers or Ts. So we can’t divide on this score. In advanced mathematics we would say G=T. This says that having Ts is a good! It is not a bad.  If a G is good then a T is good.

Some of you are biting your finger nails all the way down to your toes. But I am getting there so gulp down a little more JD and be patient. Order some Nachos La Torre if you think that will help.

So G is good and T is good. Here is the next thing that unifies us. We don’t want our hard-earned money wasted. Okay – Charles is rich enough that he wastes a lot of money, but Charles is special. If most of us give we want to see it have impact. We want it to help. If we give $100 to a charity and we find out that $99 of it went to pay an administrator and only $1 went to a poor person,  we probably would quit giving money to that charity. Or if that charity was not careful in using our money so that it didn’t really help anyone, we wouldn’t be happy with that one either. Republicans and Democrats do not disagree about this point either. We want our giving to go to Ts and to have full impact on them.

Amazing. Nothing to disagree about so far. To have Gs we have to have Ts. We want our money to be effective and not  wasted.

So what is the problem? I think the problem starts with the Gs. The problem is that we not only like to give but we are busy people. We are also trusting people. When I give money to one or to many government or non-governmental organizations I don’t have the information or the time to make sure my money and your money is used well. I simply trust that if someone works for one of these organizations, they are going to be capable, and competent and caring and honest. I don’t  have time to check it all out. Sometimes it takes years or more before we find out that some part of government or some local charity is not getting the job done. 

The problem or the challenge is that making sure our money is well spent is haphazard.  Sure there are plenty of people discovering inefficiencies and corruption in the system of giving and taking – but these audits are not an objective, consistent, and effective enterprise. Companies evaluate employees. S&P evaluates the financial strength of companies. Agencies watch over pharmaceutical companies to make sure drugs are safe. Teachers are evaluated by students and principals. We have a society wherein many activities are continuously and consistently monitored and evaluated. But we have few trusted institutions for private and public giving and taking.

So what happens in the absence of this monitoring of giving and taking? What happens is that we either do it randomly or we let politicians do it for us. And those politicians sometimes use a lack of transparency as a way to empower themselves. Party X tells you that the programs of Party Y are bad. Party Y tells you that the programs of Party X are bad. And then the media have a ball with all that. The Republicans are mean people who hate the poor and want to kill poverty programs. Democrats are silly people who think rich people and corporations are evil and need to pay much more in taxes. Come on. Really?

So what’s the point? What can we do? First, quit talking about Gs and Ts. Second, let’s get more serious about evaluating how all this G is used. Is it not possible to have a bipartisan or an otherwise objective approach to evaluate government programs? In  today’s political arena, we get the opposite of this sensible approach. What we get is defensive, debilitating allegations and behaviors. Why can't Democrats be the ones who lead honest evaluations of the effectiveness of poverty and other entitlement programs? Or should they continue to yell and scream when Republicans dare to limit growth in spending on a specific entitlement? Why can't Republicans lead the way in pointing out corruption or waste in their favorite programs? Or do they mostly relish a fight to the finish to always get more money for their programs regardless of their impacts?

So there we are. We need takers. Regardless of party or ideology, we also need our money to be well spent. But we have a system that either avoids the right data or purposely distorts it. We let politicians hide the truth and exploit our ignorance for ideological or party ends.   The solution to the problem is simple. If everyone else has to expose their activities to oversight and objective evaluation, then why can’t government programs be subject to real and frequent business audits? Gs would be happier because they would believe their money is being better spent. And Ts would benefit from the reduction in waste and corruption. 

This is a task that unifies us and puts politicians on notice that we won’t be conned. It isn’t really about Gs versus Ts or Rs versus Ds. This is all about the public having proper oversight over representatives who have infinite capability to raise tax giving through our tax system. 

Lesson 2 GDP and US

Advanced Annualized GDP in 2009 dollars for the first quarter of 2015 was reported to equal $16.3 trillion. For those of you who are not good with trillions or counting zeroes, that amount is more than what Roseann Barr used to weigh. After the GDP number was announced the stock market had a fit, virgins sought lovers, and the press wrote 7 million stories. Rush Limbaugh was, well, Rush Limbaugh.

A couple of weeks ago we talked about me doing a better job of teaching macro to those of you who don’t wake up each morning thinking about supply and demand and Paul Krugman in skivvies. It is one thing to try to capture macroeconomic events; it is another thing to try to explain economic events to people who think an asset is an anatomical part. So this is Lesson 2 and it involves an economic indicator that was announced with great sound and fury last week. You would think that Bruce Willis had grown hair but this kind of frenetic reaction is often the case. Gross Domestic Product is one of those national macroeconomic indicators that tell us how our national economy is doing. It doesn’t tell us everything and it doesn’t often warrant all the commotion but it does have its place and communicates something to us. Of course, like when the doctor says your heartbeat is registering 23 beats per minute, you start asking a lot of questions about the future. And that’s where it gets more interesting. The same is true for GDP.

First, the actual words I used above came from the Bureau of Economic Analysis table in which it was presented to us. It uses words like, first quarter, annualized, advanced, and 2009 dollars. Each of these technical words has meaning and each word helps you understand GDP.

But before we discuss those words, recall that GDP is a measure of national output or production. It is how much we produced. In the first three months (first quarter) of this year, we apparently produced $16.3 billion of goods and services. GDP is not a measure of beauty nor is it an infallible measure of national welfare. It is just output.

The word Advanced means that even though this number was published after March 31 when the quarter ended, it is considered advanced. It will take a lot longer before the full story about Q1 is known. In a month or so we will get a second reading. And that will be followed by even more revisions.

Annualized means that we wave a magic wand and transform the quarterly number into a yearly or annual equivalent. If Hillary Clinton played for the Indianapolis Pacers and she scored 7 points in the first quarter, you could say she was scoring at “a full game pace” of 28 points. Of course, if her hair got mussed we will never know how much she might have scored in the whole game. Accordingly, we actually produced something more like $4.1 trillion goods and services in the first quarter. If that pace kept up for four quarters, it would translate into roughly $16.3 trillion. When it comes to GDP “talking annual smack” is more understandable than “talking quarterly smack.”

I feel the need to have a smoke even though I don’t smoke.

We still need to say a few more words about measuring national production. Note that it is easy to think of all the goods and services piled up in a big mound. It would be a big mound but you can imagine all the cars and trucks, and buses, and haircuts that got produced in Q1 2015. The big question is what happens after we die. But another big question is how we actually measure that really big pile of stuff.  And the answer is pretty easy. If something got produced in Q1 then only three things could have happened to it: (1) It got finished and went to a buyer who forked over some money for it. Or (2) it got finished and is sitting in finished goods inventories because it was too ugly to buy or (3) it didn’t get finished and half of a truck is sitting somewhere waiting to be completed.

The stuff that got finished and sold is said to be final demand. Final demand is broken down by who gets the goods and services. It is traditional to break it down into two parts – Donald Trump and the rest of us. No just kidding. It is broken down into four parts – Consumption measures goods and services going to households; Fixed Investment measures stuff going to firms like plant and equipment and also new houses; Government spending measures goods and services purchased by governments; and Net Exports measure the net purchases of the foreign sector.

Okay, one more thing. GDP is supposed to measure the quantity of production (sometimes referred to as real GDP) but we all know that when this stuff is sold as Final Demand that it is purchased at the latest (Q1 2015) prices. So with another magic wand, poof, we remove all the price change since 2009. The stuff this year gets valued as 2009 prices so as to not muddy the physical output measure with price change.

Here are a few things we know from the recent GDP data announcement. At $16.3 trillion in Q1 it was the highest output ever recorded in the USA. Way to go team! It was a mere $10 billion higher than production in Q4 2014. Compared to a year before GDP was up $500 billion. Compared to Q1 2008 it was almost $1.5 trillion higher in 2015. Clearly that pile of stuff is getting bigger.

None of the above seems to warrant champagne and wild parties with scantily clad ladies playing beach volley ball. But the truth is that we do not get excited about GDP because of its past value. We get excited because the past values are our latest clues as to what might be happening in the future. The future does excite us. We want to be ready for the future. Firms need to decide how many people to hire and what to pay them. Households must decide whether to buy that new refrigerator. GDP yesterday might tell us something about tomorrow’s economy. Or it might not. Consider some of the facts told about GDP in Q1 2015:

            The Q1 increase was small because of temporary negative things like a dock strike and bad weather

            The Q1 increase was small because the foreign balance deteriorated.

            The Q1 increase was small because after four quarters of strong growth, firms cut back on buying equipment and building new structures

            The Q1 increase was small because state and local governments cut spending and the federal government spent less on national defense

            Consumers continued buying at a decent clip in Q1

These facts help firms, investors, and the rest of us think about what might happen in the future. Q1 has come and gone but this report helps us think about our decisions today that impact the future. The report doesn’t tell us the future and it doesn’t make our decisions. But it does give us something to think about as we move forward. And as we do we will also pay attention to the latest information about other indicators like employment, wages, and Bill Clinton’s speaking fees. 

4 Men in a Room by Guest Blogger John Succo

Government officials are legally allowed to lie to the public; something about Plato and the good of the Republic.

Central bankers are not. Thus the common quality among them for obfuscation and rhetoric. But in their last minutes they did lie about consumer sentiment, or they can’t think straight, maybe both. They also can’t predict things very well, wrong much more than they are right. Clouded thinking derived from their own academic hubris. Their analysis is more selected than stochastic. Someone once mentioned an ivory tower. And now the Prince of them all is advising PIMCO. Good luck.

We have negative nominal interest rates in Switzerland. I can’t tell you why until my final exam question is answered, but I bring it up to talk about the ridiculousness of it.

Capitalism doesn’t work at zero and negative interest rates. The price of money is nothing or worse? Think about that. How does anyone save to invest; capital formation stops. Everyone runs for the stock market. They borrow money to buy stocks even, the greatest carry trade ever. Margin debt is untenable.

And our central bankers convince the masses that this is perfectly legitimate. Consumer sentiment is now saying it’s not, something is very wrong. Pension funds are solvent because they insist they can earn 8% on their assets in a  0% world; if they were realistic they would all be underfunded. What happens when they go to sell their stocks that they have piled into pretending they can pay for their liabilities? Who is going to buy from this mass exodus.

The 4 men in a room who manipulate the stock market think they can. Heck they buy everyday smoothing out any corrections, keeping the ball rolling and the rich socialists happy. Socialism locks in the wealth of the already wealthy and stifles nasty competition they don’t want. The 4 men have infinite capital to do this, or so they think. When real selling comes knocking they will find out they really don’t.

Until then they just keep on keeping on. They have directives so it’s not their fault. Their directors have directives, so no one can be faulted.

The public ignores this when things are going well. People are inductive not deductive, preferring empirical evidence before they change their minds. But markets though non-linear are ultimately deterministic so the rub will come. Then they will have new empirical evidence supporting the old empirical evidence they have already forgotten.

Central banks have fostered $50 trillion more in global debt since the last debt collapse, amassed at much lower interest rates and most of it government debt which has zero productivity. That’s economic socialism and is sowing the seeds to destroy the last vestiges of capitalism.

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.

LGBTQs and Macro

Last week was very disappointing for me. I wrote a blog about a non-macro topic and it got more hits in one week than any of the 300 pieces I have written in the last five years. You would think I would be happy about that – but it tells me two things. First, nobody likes macro. Second, despite my hard work over five years many of you admitted to me that most of what I write you don’t understand at all. So you are outed – you don’t like macro and you think I stink at macro.

As my mother would say, Larry, eat your peas. She would also say make lemonade out of lemons. So I made some lemonade and that didn’t seem to help at all. Then I decided I would write a blog focusing only on things I know little or nothing about. That gives me a lot of leeway. But then I couldn’t think of anything to write about. Then I decided I would write a blog only on LGBTQ topics. But I wrote everything I know about that last time. Finally I decided to sip a little JD and then I hit upon a great idea. I will continue to write about macro topics and I will try to make them understandable to anyone over the age of six having a non-negative heartbeat.

I did that once. When Jason was a toddler in red sweatpants I wrote a series of lectures on macroeconomics for him. He went on to a degree in economics in college and excels at disagreeing with almost everything I write in this space. So that proves that I am capable of writing great things if only I try. It also shows that if I write about Ashley in one blog I have to say something about Jason in the next one. 

As a child and then as an adult I always loved Kraft Macaroni and Cheese. ChiliMac is pretty awesome too. My favorite song was Mac the Knife. So it was only natural that I would want to study mac-roeconomics. I was dismayed when I found out that macroeconomics was not food study and that it involved math, graphs, and something called variables. But I persevered. It took three universities and four degrees to figure out supply and demand. With that knowledge safely tucked under my beard Indiana University decided that hiring me was cheap and easy and letting me loose on students might not destroy more than a hundred years of academic tradition.

With all the above filler as an introduction I now turn to my true love, nude beer making. No, just kidding. I now turn to macroeconomics. Since many of you never completed a macroeconomics course and since most of you have forgotten whatever you might have learned in that course, I am now going to make things so crystal clear to you that when you read future blogs you will understand them perfectly and you will be able to explain those blogs to your friends and pets.

The place to start for you rookies is with anatomy vavava voom. Suppose you are going down the street and your friend says – Hi, how are you? You say, fine. That explains macroeconomics. In macroeconomics your friend is Canada and you are the USA.  Macroeconomics is all about the economic health of a country. Your friend then says – you don’t look so fine. You look like crap. Your GDP is sagging, your unemployment rate is flabby, and your inflation is barely beating.

You go to your doctor to get another opinion. He takes your blood pressure, temperature, and asks you to turn your head and cough. He looks at a bunch of indicators and uses them to explain why you look like crap. You feel better knowing that there are a bunch of things wrong with you. He then makes some outrageous guesses about what is causing your indicators to be so negative and gives you a prescription for drugs including Viagra. Or he might suggest that you go to a specialist. He then charges you enough money to pay for his next vacation on Jeju Island.  Yes, she will fly first class.  

Hopefully you are still awake and are getting the point. You look like crap. No just kidding. You look just like your Mother. Kidding again. The point is that macro is about the health of a country. Macroeconomists make huge sums of money despite taking the summers off by making up indicators that measure the macroeconomic health of places like the USA, Greece, and Oz. And like everything else on this planet we sort of know what is going on but we have lots of disagreements. What does it mean when your doctor says you are healthy? What does it mean to be healthy? There could be lots of opinions here. So we have a lot of indicators that must be evaluated.

The same is true of macro. There is no one single thing that determines the economic health of a country. So we mostly agree to analyze a bunch of economic indicators. One that gets a lot of attention is GDP or Gross Domestic Product. In class I usually refer to GDP as stuff we produce where stuff is a highly technical term meaning all that crap that passes for a good or a service. Then there is the unemployment rate which hardly needs explanation despite the fact that the US Department of Labor publishes a million different versions of it. The list of macroeconomic indicators grows from there including such spicy items as inflation, interest rates, exchange rates, earnings, debt, the length of Donald Trump’s hair, and more.

Okay – so for you literature and philosophy majors I will stop there. This is our introduction to macro. Macro is all about the health of a country’s economy. It includes numerous indicators when taken together can help you decide just how healthy the economy is. The implicit assumption is that once you make this judgment, you then try to decide WHY the economy is not at its peak health and then figure out WHAT we can do to improve it. That cause and effect approach will be covered more completely in lessons 2-768.  Or you could just go backing to listening to your favorite Jimi Hendrix song, Purple Macro. Okay admit it – Macro is very easy and cool. 

LGBTQs in Indiana

We who live in Indiana recently went through a disturbing experience with legislation that turned many a dinner table into a debate forum at best or a war scene at worst. This blog post is not about the legislation, its origins, or its impacts. It is more about me thinking out loud about something that both troubles and intrigues me. This process is both professional and personal.

It is professional because I spout off weekly and at least some of you take a minute to listen. I studied and taught economics for about 40 years and it is hard to turn that thing off. It is personal because I am coming out. No, just kidding. I am not gay. But my daughter is a lesbian. And a lot of her friends are LGBTQ. And a lot of my friends and colleagues are too. And some of my friends also have LGBTQ children.

This personal aspect has changed over the years. Like many people I didn’t know one LGBTQ person. As a young teen I was afraid to go into certain public bathrooms because my friends told me that gay men would accost me. That was the sum total of my knowledge. Of course, no one ever did accost me but that image hung in my head for many years. I remember once after pitching in a little league game, a young boy approached me and said he heard I was Jewish. I said that was true. And then he said – but Jews are devils and have horns. He was very confused. Point – when you don’t have any personal experiences, you can carry around some really weird ideas.

As LGBTQs have become more courageous and have come out in greater numbers, more of us see more clearly that LGBTQs are just like anyone else. Robin William’s portrayal of a gay man in Bird Cage was one of many important pieces of art that helped me see LGBTQs in a new and different light. Okay they are different in their sexual orientation. Jews won’t mix meat and dairy.  Koreans show respect by bowing and often the younger colleague pours the Soju for his senior counterpart. In some religions women are treated as less than equal. What is true about these and other groups is that we are all different.  But most of us share many common values – like love of God, practice of the Golden Rule, raising good children, having loving partners, working hard, etc.

For some who may not have had the benefits of knowing LGBTQs, you should realize they are as diversified as any other group you care to single out. LGBTQs have everything we have – smarties, dummies, many with very conservative life behaviors and others with very crazy and colorful lifestyles. I know LGBTQ realtors, fitness instructors, business owners, and academic administrator. My daughter’s lesbian friends are public radio hosts, cops, veterinarians, healthcare workers, and roller derby queens. Speaking of my daughter, she lifted a 72 pound kettle bell over her head with one hand while holding a JD in the other hand. I once employed a woman who did excellent layouts for my newsletter. Her partner is a retired IU professor. They have been together longer than most married couples I know.

Going on with this line of analysis should be unnecessary today. Knowledge and attitudes have changed. Most of us know many LGBTQs.  It is not respectful to them to have to make a point that we all know is true.

But this leads me to my main question. Why do some Christians insist that LGBTQs are sinners? Why is it that some Christians believe they would lose important religious rights if they had to cater a gay wedding? Why would they feel so horrible in catering this wedding, that it would undermine their own sense of spirituality?

One Christian friend told me that if a lesbian asked Christ to forgive her and if she renounced her sexual orientation, then she would be saved. Being a lesbian, he explained, is not the problem – it is acting as lesbian that is the sin. So if she stops that, then all is okay. But is it really okay? Yes, we want fewer divorces. Yes we want sinners to change their behavior. But is it really a sin against man or society if a loving LGBTQ couple dates, marries and does all the behaviors compatible with that love? If that is your personal belief then I won’t try to persuade you otherwise. But personal belief and public economic and business activity in a secular country are different things.

The Indiana legislation poked a finger into the eyeball of LGBTQs. I am not sure what impacts the amended law will have in the future. But I do know that it raises a very interesting question for the future. Can we really continue to think of LGBTQs as persons whose lives offend other so much that business or other laws can potentially be used to deny them normal functioning in society? I hope the answer is no. 

National Debt Insanity

My parents lived through the Great Depression. Like millions of others they were severely impacted and the experience shaped the rest of their lives. In the case of my parents they always distrusted banks and they rarely used credit. Anyone who has ever lived through a financial crisis – and there have been many across the globe and years – were similarly impacted and if nothing else they personally understand the unintended effects of debt.

For the rest of us who have not shared these painful experiences the stories and warnings of parents and grandparents seem distant if not wrong. We live in modern times and have institutions that are regulated and surely it is okay if we expand our uses of credit. Our President recently promoted the idea of much more credit for college students despite the fact that college loans are not only risky but are already growing faster than a dandelion in a Phinney Ridge lawn in April.

Students really need those loans. People have to mortgage houses. You will need a bank loan to buy that Prius. Some of us use credit cards because we often spend more than we earn in a month. Governments prefer to expand public debt because of many worthy projects and because raising taxes seems cruel to citizens. No one disputes the omnipresence and productive aspects of debt. But like a good JD poured over an extra-large ice cube sitting in the right whisky glass, something might be necessary but that does not mean there isn’t a possibility of overdoing it.

When it comes to our personal lives, many of us understand all this. And that means we realize that there is a limit to how much we can borrow. If you have massive student loans then despite a decent job the payments on a new house are probably out of range. There are practical reasons for keeping debt at bay. For one thing you have to make the payments on the debt. The more of your income that goes to paying interest the less you can use for that new Fender Startocaster or the expensive bottle of Pappy Van Winkle.  If debt goes high enough then maybe you will have to put off buying those yoga pants or a much needed mani-pedi (whatever that is).

Debt limits what you can afford to buy. But the issue of debt gets more dangerous than postponed gratification. What if you get laid off and cannot pay your mortgage? You may have to borrow even more money just to stay out of jail. This is a familiar story and we all know how painful it can be. With a smaller debt you might have endured a temporary job loss. Otherwise the options are not good. Look at current issues with Greece. There are no good answers for Greeks. Every option is painful.

With all these stories and realities around us, it is amazing to me that our government – the whole damn bunch of loonies – wants to subject us to unnecessary increasing financial jeopardy. Even Alex Trabek might balk at this kind of jeopardy.

What I am referring to is the current discussion about the US budget for 2016. Virtually no one in government represents the financial stability of our country. All branches and both parties have given the secret handshake and agreed that it would be silly to reduce the size of the US debt. Some Democrats have signaled they want to spend significantly more – particularly on Social Security Benefits. One fraternity of Republicans wants more spending on security and national defense. Another  wants lower tax rates and tax reform. But notice that none of them are seriously standing up for lower debt. Debt be damned or at least ignored.

Our government representatives take these positions knowing a few things. First they know that the USA is well into the sixth year of an economic recovery and expansion – one that has been lackluster at best. It is also one that will be followed by a recession. I don’t have a good gauge for exactly when recessions come, but surely within the next few years one will come. So despite today's higher incomes they don’t want to pay down debt. If not now, then when? During the next recession? I think not!

Second they know that national debt is much higher than normal. Okay – normal is not easy to define. But let’s face it – our national debt used to be about 35% of the size of GDP. Now it is twice that. Third, despite spending caps and tax increases on the rich, future plans are for the national debt to get even higher – more like 80% of GDP.

Hey Larry you are eating more popcorn than normal. What is normal anyway? Maybe 80% of GDP is just fine. So let’s talk about normal. The gross debt of the US is a big number but more meaningful for economic analysis is the debt held by the public.

The table below shows that we raised the debt dramatically during our last recession – notice the debt went up by 140% (from $5 to $12 trillion) between 2007 and 2014. But that isn’t apparently enough. From $12 trillion they plan another $8 trillion to reach more than $21 trillion. By 2025 the debt will be four times what it was in humble 2007. 

One benchmark for normal comes from our European neighbors. While some European countries are notable for large government debts (e.g. Greece, Italy, Belgium) countries that adopted the euro currency agreed to keep their net debts to less than 60% of GDP. That’s 19 countries who believe that there should be limits to debt. Most of them are usually well below the 60% figure.

So the US is well above most European countries. But the stupidity doesn’t end there. The Congressional Budget Office estimates how much more the debt will grow because of recent policy suggestions by both parties. Conservatively, the debt in 2025 could easily be another $5 trillion higher if government goes along with some of these ideas.

So – is a national debt of 80% of GDP too high? Will I be just fine if I add about 100 pounds of cheeseburger-induced fat to my belly? Maybe maybe not. But clearly the reasonable thing is to not go in that direction. Getting back to what we usually consider normal would create a lot less risk. No one wants another financial crisis tomorrow.

                Debt Held by the Public

            Year   In Trillions    % of GDP

            2007     5.0                  36.3*

            2014   12.0                  74.1

            2025   20.1                  77.1

*Note – between 1973 and 2007 the debt ranged anywhere from 24% (1974) to 49% (1995).

Paying for the Privilege of Investing at a Loss by Guest Blogger Buck Klemkosky

For the first time in recorded history, many European countries plus Japan have experienced negative interest rates. Government bond yields on short-term debt as well as debt up to 10-year maturity have turned negative in many countries, including Austria, Denmark, France, Germany, Finland, Switzerland, Sweden and Japan. More than 25 percent of European sovereign bonds sell with negative yields. Those governments can sell debt and get paid by investors for doing so. For investors, buying a bond with a negative yield means you won’t get all of your money back.

There have been many periods where real rates of return (inflation-adjusted) have been negative, but this is the first time nominal rates have turned negative. For example, if $100 is lent for one year with interest of 4 percent payable at the end of the year plus principal, the nominal yield or return, assuming annual compounding would be 4 percent. If inflation was 2 percent during the year, the real yield or return would be approximately 2 percent. If inflation exceeded 4 percent, the real yield would have been negative. This has occurred  many times and places throughout the world when inflation became higher than expected. This happened in the U.S. in the late 1940s, 1970s and recently in the 2000s. Bond yields reflect inflationary expectations, so unexpected or unanticipated inflation hurts bond investors as required yields go up and bond prices down.

What happens if an investor is willing to pay $105.50 for the same bond that pays $4 interest plus $100 of principal back at the end of the year? The investor is guaranteed a $1.50 loss and a nominal yield of -1 percent. If annual inflation was 2 percent, the real yield would be -3 percent. Why would investors pay $1.50 to lend or invest $100? Has the world turned upside down or have investors just gone nuts?

Investors would not usually lend or invest money at negative nominal yields if inflationary expectations were positive. But if deflation was expected, investors could still earn a positive real return. In the above example, if deflation was 2 percent for the year, the real return to the investor would be +1 percent. Deflation is good for bond investors because they are paid back in a more valuable currency that will have more purchasing power. If it is good for bond investors, deflation is bad for borrowers as they pay back interest and principal in a more valuable currency. Deflation usually occurs when economies are not doing well so it can be a double whammy for borrowers.

Deflationary pressures have plagued Japan for nearly two decades and Europe and the U.S. more recently. If not outright deflation, most countries have experienced disinflation, the slowing down of the rate of inflation. The consumer price index (CPI), sometimes called the cost-of-living index, measures on a monthly basis the cost of a fixed basket of goods and services purchased and used by a typical consumer. Typically, food and energy are stripped out of the headline inflation number, which includes all goods and services, because of their volatility and what is left is called core inflation. The difference between headline and core inflation numbers can be significant. In the U.S. for the 12 months ending in February, the headline inflation rate was zero, while the core inflation was 1.7 percent. For the 12 months ending in January 2015, the headline inflation rate was -0.1 percent. The Eurozone and other European countries have experienced deflation in both the headline and core measures. This has prompted most major central banks to target an inflation rate of 2 percent although this target has not been met for several years now.

Low inflation, deflation and deflationary expectations have been mostly responsible for the negative bond yields. Central banks have also played a major role, especially their impact on short-term interest rates. One consequence of the financial crisis and Great Recession is that central banks have loaded banks with excess reserves, those not needed to support loans and deposits. If banks do not make loans or invest, the excess reserves build up at the central banks. In the U.S., for example, excess reserves have increased from $20 billion in 2007 to $2.6 trillion today. The Fed pays banks .25 percent annually on excess reserves but the European Central Bank (ECB) charges banks -0.2 percent as an incentive for banks to lend or invest excess reserves. This negative 0.2 percent has put downward pressure on short-term interest rates here and in Europe.

A new regulatory environment has also impacted interest rates. In the U.S., banks must pay an insurance premium to the Federal Deposit Insurance Corp. The Dodd Frank Act requires insurance on nearly all deposits even though only those up to $250,000 are insured. The net result is that insurance premiums cost banks 0.2 percent annually on each dollar deposit and can be as high as 0.45 percent for a large bank with large deposits. J.P. Morgan recently announced that they will charge up to 5.5 percent on certain deposits meaning customers pay 5.5 percent annually for the privilege of depositing money at the bank, a negative interest rate for sure. J.P. Morgan and other big banks are obviously trying to eliminate high-cost deposits by charging fees for large deposits. This has further reinforced low and negative short-term interest rates.

Another regulatory factor is the new liquidity rules banks in the U.S. and Europe must cope with. Banks must hold high-quality liquid assets equal in amount to the deposits that may run or be withdrawn in times of stress. To meet this requirement, banks are investing in U.S. Treasuries and other sovereign bonds with zero risk of default. U.S. banks, for example, own $2 trillion of U.S. Treasury bonds. European banks are doing the same. Add in the amount of sovereign bonds the central banks own or will own and there is a shortage of high-quality sovereign bonds available for other investors, putting downward pressure on interest rates. The U.S. has experienced negative interest rates on overnight borrowing using U.S. Treasury securities as collateral because of their scarcity. The ECB quantitative easing (QE) program that just started in Europe plans to purchase $1.2 trillion of European sovereign bonds over the next 18 months. Many question whether this is even possible but it surely will be a drag on European interest rates.

European interest rates are lower than the U.S. because of a weaker Eurozone economy and the start of its QE program. This is true for the corporate sector as well where European bond yields are 1.5 percent less than equivalent U.S. yields. Nestle was the first corporation to have a negative yield on its debt, prompting a new slogan, “In Nestle We Trust.” Many U.S. corporations are rushing to Europe to issue new debt in euros to take advantage of these low rates. There may be more corporate debt with negative yields in the future.

Buying a bond with a negative yield does not necessarily mean investors expect a loss. Foreign investors may buy a negative yielding bond if they think the currency the bond is denominated in will appreciate, making money on the currency change not the interest yield. The Swiss franc has been unpegged from the euro and has appreciated considerably, which is why the yield on the 10-year Swiss government bond has been negative as well as Nestle’s. The strong dollar has made investing in the U.S. more attractive and has put downward pressure on U.S. interest rates. While it guarantees a loss if a bond is held to maturity, some investors may assume interest rates will be even more negative before the bond matures enabling them to sell at higher prices prior to maturity.

It appears that investors are more worried about “return of capital” versus “return on capital” and are willing to accept negative interest rates. Given the flight to quality, investors are willing to lose a little to make sure they don’t lose a lot.

Is the bizarre world of negative interest rates coming to the U.S? Probably not as the Federal Reserve contemplates raising short-term interest rates in 2015. There is a big divergence in global monetary policies as the U.S. tightens and Europe and Japan maintain loose monetary policies. The U.S. economy is doing better than Europe and Japan so higher relative interest rates are justified. But they may not move significantly from the historically low rates that exist today. Great for borrowers but repressive for savers. But it is strange and unprecedented historically to pay someone to borrow money from you.

The AIIB -- A Gift Horse in the Mouth?

The latest popular addition to the alphabet soup of global financial institutions is the AIIB, slated to begin operations this year.  Be thankful for this abbreviation as it stands for Asian Infrastructure Investment Bank. Drink three Old Fashions (made with JD) and then say Asian Infrastructure Investment bank 17 times while doing 11 burpees. See what I mean? AIIB is much easier. The name, however, is misleading and the new politics it brings is even stranger. Like not knowing which branch of Islam is the good one, understanding AIIB can be pretty confusing.

The first confusion is the term Asian. Calling this bank Asian is like calling any team with LeBron James something other than LeBron. Cleveland Cavaliers? Really? The AIIB should be called China and her friends. China will be the main stockholder despite being joined by almost 30 other countries. Key US allies are now trying to decide whether or not to join including Australia, Japan and South Korea. Britain, Germany, France and Italy have also promised to think about joining. The objective of the AIIB is to provide project loans to developing countries. These loans will focus on building infrastructure.

Since it will have representatives from all world regions it is hard to call this bank "Asian". AIIB is another Chinese development bank. Since the US sponsors similar world financial organizations with names like the World Bank and the Asian Development Bank (ADB), everyone knows these institutions are very much dominated by the US. Thus you can see why the US  is concerned when so many countries jump on China’s latest bandwagon. Are these countries with us or China? This reminds me of the grammar school basketball court when my team was unable to recruit the tall agile kid. The US feels threatened. 

We are hearing a lot about the AIIB mostly because we worry about our basketball team. No not really. Some US officials are worried that the AIIB will somehow steal our luster. But the truth is that worrying about the AIIB and China is a lot like worrying that the new handsome kid at school is wooing your girlfriend – when the truth is that she was about to dump you anyway.

Think about how we in the US sometimes think about the World Bank and and ADB. "There they go again  -- giving away our hard-earned money to creepy countries filled with graft, corruption and people who continue to insist on speaking foreign languages."  Yes, we are sometimes very upset that our money is not used more successfully by foreigners who rarely send a thank-you card. Or who sometimes forget to pay us back what we are owed in full. We should be thanking China for risking their renminbi in these same places rather than our dollars.

You are not convinced. You are worried that China will be better at this game than we are. You are worried that China will not only help these countries invest development funds more wisely but these other countries will then be so appreciative so as to shower their new Chinese friends with bouquets of Plum Blossoms and endless deep tissue Swedish massages. China and these developing countries will then skip off into the horizon holding hands and singing songs about Mao Tse Tung.  

But think about it a minute or three. First, China is facing difficult economic challenges. Their own development plans have floundered and growth is barely half of what it used to be. And even with all the past China Kudos, the average person in that huge country earns in a year about what the average American earns in 6 weeks. Okay China has some money to lend. But please – if the money comes with Chinese advice or partnership, are we really worried about competition from them?

Second, let’s get back to the girl who wants to dump you. We are less than appreciated by many developing countries. Why? We are nice guys and we look really good in Levis and yoga pants! One reason we are not fully appreciated is that they don’t always like our advice. It’s like when Mummy tells you to do your homework before you go online to Addictinggames.com. Or when Frau Merkel lectures Alexis Tsipras on financial management. When YOU want a loan you don’t appreciate the banker telling you how to spend it. These countries often do not like the US advice that comes through world financial organizations.

So she might dump you because she doesn't appreciate your advice. But the final point is to wonder why you liked her to begin with. Okay she has blue eyes and she dances like Madonna – but maybe she just isn’t your type. Look around the world. Developing countries are not doing well financially and in many cases once prospering countries replaced past rulers with “democratically” elected dictators. Do you prefer to dance with Cuba or Argentina? Columbia or Haiti? Maybe getting dumped isn't such a terrible thing. Buck up Charlie. 

The bottom line is that some of these developing countries are dubious candidates for our affection. If China wants to lead a brigade of unsuspecting lenders to steal the affection of the developing world it might help to notice that China has little to help them with and the developing countries have little promise to improve. If we are really worried about China then we should be gleeful about the fact that the AIIB will both weaken China, its partners, and all those politically delinquent countries who seem quite unhappy with US help. It is okay -- you may now do a happy dance.