10,000 Tariffs

In working on my last post about import villains, I stumbled across an incredible realization. Steel and aluminum are just the tip of the iceberg. Most of us mere mortals have not tried to explore the labyrinth of information called the Harmonized Tariff Schedule (HTS) where we list all the tariffs levied against our trading partners. My reaction to perusing that schedule is a lot like the feeling one gets when they first try to understand all the notes on the neck of a guitar. Yikes, I didn’t realize all those notes were in so many places! Luckily, on a six-string guitar in one octave, there are only 72 places for notes.

The HTS contains 22 sections of goods categories broken into 99 chapters covered on 3,710 pages including over 12,000 import tariffs. Are you kidding me? I didn’t even know there were 12,000 goods.

What’s my point? My point is that a trade novice evaluates or judges the change in the tariff on steel imports without any real understanding of the whole tuna. Imagine such a novice who thinks that we don’t have many tariffs and that a 25% tariff is weirdly high or unusual. In that case you might come to one kind of conclusion about steel and aluminum. I am tired of typing steel and aluminum so let’s just say S&A.

But now, after a fascinating morning with my friend Google, I know there are more than 12,000 goods tariffs. One of them is the 127% levied on Chinese paper clips. Paper clips! I found examples of very high tariffs including those on canvas sneakers, leather and foot ware, synthetic yarns, canned tuna, and a large variety of lovely foods from the EU including cured ham, truffles, oats, and mineral water.

Inasmuch, a less naïve person would interpret the newly increased S&A tariffs in a different light. A 10% or even a 25% tariff is neither startling or unusual. That does not mean I am supporting or advocating these new tariffs – it simply means we need a more realistic approach to evaluating them. From the reactions in the press, you would have thought that CNBC had purchased Fox Business News. Not so.

These new tariffs are really like a blip in the ocean. Given all the tariffs we already have on imports, I doubt these new tariffs are going to drastically change those 3,710 pages. But it is interesting that among all those 12,000 goods that somehow S&A avoided a tariff and that past attempts to levy them had been so unsuccessful.

Why do we have so many import tariffs? Is the world so unfair to the US that we had to slap on tariffs to be competitive and save US jobs? Or is this more of the same game of government spoils that is applied so routinely by companies within our borders? The government has a lot of elected officials with lovely salaries and benefits. Perhaps we have so many protections because it pays well?

I am asking more questions than I am answering. But this thing with S&A really opens a much bigger set of questions once we view it in a wider context:

Why have we not had tariffs protecting S&A when we protect so many other industries?

What does any of this have to do with US national security?

How many of these 12,000 existing tariffs improve national security?

How many other goods should have tariffs because of national security?

Do we really need any tariffs to protect national security?

How can we preach the values of competition when we seem so far from the ideal?

While the WTO made initial progress in removing barriers to trade, why is the Doha Round dead after so many years of negotiation?

Have we given up on the idea that reduced trade barriers are good for the global economy?

Where is my JD?

Import Trade Villains

The President correctly pointed out that the US has large and persistent trade deficits. Those deficits have mostly to do with goods traded since we have a surplus in services. He then decided to put some import tariffs on steel and aluminum. Apparently, after his trade gurus spent a lot of time poring over the data, some of them recommended that iron, steel, and aluminum deserved our attention -- and therefore some protection. It does not take a genius or a phone call to your local steel mill to learn that employment in those industries has been hurt. If I was a steelworker, I would be happy that the President was willing to help me.

But the connection between US persistent large goods trade deficits and these new tariffs is lacking and I am wondering what those gurus were smoking when they advised our President on how to solve this pressing trade imbalance using tariffs. They must have known that the US has already set in motion more than 100 cases within the World Trade Organization to overturn unfair and illegal trade practices in China and other countries. But I guess that wasn't getting enough attention, and they thought that starting a trade war would be a better approach.

Today I want to show you some data that I obtained from my secret contract in Moscow. Just kidding. I got this data from a perfectly legitimate organization called Facebook. Just kidding again. I got it from the US Census Bureau at https://www.census.gov/foreign-trade/Press-Release/current_press_release/index.html.

The Census breaks down US goods imports and exports into five major categories which you will find in the below table. The negative signs in the third and fourth columns show you that the US has a goods trade deficit in EVERY one of these main categories. So when it comes to laggards in trade -- blame all of them. Steel and aluminum -- the two main categories for the new tariffs -- are found as very small parts of Industrial Supplies. While imports are larger than exports for Industrial Supplies, notice the difference is tiny compared to the trade deficits in Consumer Goods and Vehicles.

How one could have looked at that table and decided to single out steel and aluminum, I can't fathom. If trade deficits are bad and hurt US workers -- I think I might have started with Japan and Korea -- those terrible places that sell us things like Hondas and Hyundais. By the way, if you look more closely at Industrial Supplies the key import villain is not steel or aluminum. It is crude oil.

If you want to know the full set of villains the following list shows you the worst offenders in January 2018 for each of the five categories. I chose the worst villains because they contributed more than 10% to the imports of each of the main categories. Notice that you can't find steel or aluminum in this list of villains:

1. Fish, shellfish, fruits frozen juices
2. Crude oil
3. Telecom equipment, computers, computer accessories
4. Passenger cars and parts
5. Cell Phones, pharmaceutical preparations

If we went after all the countries that sell us all that stuff, that would be a real trade war. But what's the point? What if we won a trade war? Where would they get us?

There is an answer to all this and some economists spout this information regularly even though it puts more people to sleep than Benadryl. I am not shouting but I will put this next sentence in all caps. WE HAVE PERSISTENT TRADE DEFICITS IN THE USA BECAUSE WE MAKE MISS PIGGY LOOK LIKE A VEGAN. WE SPEND TOO MUCH AND SAVE TOO LITTLE. Are you asleep yet?

Those awake might protest. You might ask: What does spending and saving have to do with persistent trade deficits?

Answer 1: When a country consumes more than it produces, it must buy goods from outside the country.
Answer 2:  When a country saves too little, domestic investors have to find savers elsewhere. When foreigners buy US assets they first have to buy dollars, driving the value of the dollar higher, imports higher, and exports lower.

If we are really serious about reducing trade deficits in this country, the way forward is simple. Stop all this stupid trade war stuff and implement policies to do two things:

1. Raise output relative to spending.
2. Raise saving relative to investment.

QED.

Table 2017 Goods Trade Data  (Census Bureau)
In Billions of Dollars				Net Exports
			Net	as %
	Exports	Imports	Exports	of Exports
1. Foods, Feeds, Bev,	132.9	137.8	-4.9	-3.7
2. Industrial Supplies*	462.9	507.6	-44.7	-9.7
3. Capital Goods	532.8	640.7	-107.9	-20.3
4. Auto. Vehicles, etc	157.6	359	-201.4	-127.8
5. Consumer Goods	197.8	602.2	-404.4	-204.4
6. Other Goods	62.8	95.6	-32.8	-52.2
Total	1,546.8	2,342.9	(796.1)	(51.5)

* Industrial Supplies includes iron and steel products and aluminum

Unit Labor Costs

One of the creepy things about learning economics is all the technical jargon. Diminishing marginal utility, gross private domestic investment, and the production possibilities frontier are good examples. What the hell are these things? That can be the subject of another post because today I want to focus on another term economists throw around like salmon at the Seattle Fish Market.

Today I want to discuss unit labor costs. Say that 30 times and I promise you and all those within 50 feet of you the best sleep you have had in months. It's better than a My Pillow. To make sure I don’t lose you, let’s rename it ULC. ULC rhymes with sulk but that has no consequence here. 

ULC could be the most important macroeconomic variable in town this year. So you should know her. If you saw ULC sitting alone at the end of a bar, you would ordinarily tip toe quietly in the other direction. But this year, ULC is the Queen of the Ball.

That’s quite a claim. Yet I don’t hear anyone talking about her. Before I am done with you today, I want to convince you that ULC is at the heart of many issues we discuss today – rising wages, rising prices, the next recession, and of course, the size of our new tariffs on Armagnac.

Imagine any product – let’s think about a bottle of JD. Most of the cost of producing one more bottle of JD is what you pay the employees to produce it. This includes their wages and any other earnings they might receive in the way of benefits. Logic suggests that, if everything else is the same, a rise in labor costs means the company will have to charge more for a bottle of JD. If it used to cost $10 to produce another bottle of JD and now it costs $12, then one would expect the price to reflect that cost increase. 

The labor representative will interrupt us now and point to the fact that the extra wage won't lead to a price increase because the JD workers were more productive this year. The price of a bottle of JD depends on the labor cost and the labor productivity.

For example, suppose wages go up 5% this year. Don’t we have to charge more for a bottle of Jack? Nope – it depends on how productive labor was. Suppose workers got really jacked up this year and produced 10% more bottles of Jack. That is, you got 10% more Jack for 5% more money. In that example the cost of labor in each bottle of Jack was lower! Thus they can sell the Jack at a lower price.

ULC is, therefore, a delicious macro concept that summarizes the key factors impacting the cost of goods and service:

• ULC went up – cost per unit is higher and therefore we ought to raise price (or take lower profits)  
• ULC went down – cost per unit is lower and therefore we can lower price and be more competitive (or keep prices the same and take higher profits)
• ULC did not change – cost per unit is the same. Go fishing.

So you can see that ULC is a vital part of the economy and yet most of you thought it meant Underware Latex Creep.  

Here is the most fun part. The graph at the bottom of this life-saving exercise shows you the history of changes in ULC since before Joe Biden was born. I won’t bore you millennials with all that history stuff but you can see that before 1980, ULC was quite the party animal. It was all over the place – rising by almost 13% in 1974 not long after a mere blip of 1% a few years before. Imagine if you were selling Kool-Aid in the front yard and the cost of getting your mom to make the Kool-Aid for you rose by 13% one year. If you passed that cost increase on to your customers, they might decide to go down the road to Peter's house.

Notice that since 1980, ULC became more well-behaved. It has its cycles but they are much less pronounced. The mean change of costs per unit is about 2.5%. Notice also that just about every recession —the grey bars – was preceded by a rising trend in ULC. Clearly, when costs per unit are on the rise the resulting higher prices of goods and services seems juicy – but if this keeps up the economy can no longer handle it.

This brings us to the present. The average change in ULC is remarkably less than 2.5%, and there is no discernible upward trend. After it dropped into negative territory recently, it jumped back to positive territory but there is no clear upward trend. In fact, if you look at behavior since around 2011, you might see a downward trend.

If it ordinarily takes a few years of rising ULC to cause a recession, there is little in this graph to suggest an imminent recession or slowdown in the economy. But aren’t wages beginning to rise faster? Won’t that make ULC jump and signal bad times ahead? Yes, wages might rise but remember ULC is impacted by productivity changes as well. If productivity changes as much or more than ULC – then ULC won’t change at all.

So fasten your seatbelts, kids. This is a race between wage growth and productivity. Which one are you betting on for the next few years?

Tariffs and Courage, Guest Post by Charles Trzcinka, Professor of Finance, Kelley School of Business, Indiana University

My brother is losing his job this month because of foreign competition. At his age and with his roots in the community where he lives, it will be a struggle to replace the income. He is exactly the person whose life experiences should drive him to support the protectionism that is flowing out of the White House. He does not. He makes all arguments that economists make about tariffs costing far more than the benefit and weakening the industries that are protected. He certainly is on solid ground. Arguing against free trade is like arguing against evolution. The scientists have accumulated so much evidence that the arguments for protectionism are taken as a demand for welfare or a demonstration of a psychological problem. Moreover, in the case of trade, there is 200- year history of building our economy with free trade— that is having lower tariffs than anyone we trade with. Tariffs are also very anti American who compete in markets around the world. I was in Hungary just after the fall of the communist regime when a British CEO told me that “everywhere in the world where there is money to be made, you will find an American”. Even our universities have benefited from global competition. Unlike, profit-making firms, universities have long had virtually unlimited H1B visas which means there are much fewer restrictions on immigrants. In principle, the result has been lower wages and in practice it has resulted in more competition. The free trade in ideas and people has given Americans far better universities which by any metric are the best in the world. This story repeats in many industries.

We now have an administration that uses rhetoric to encourage the worst protectionist views. President Trump thinks that all trade agreements are “unfair”, that the World Trade Organization is a waste of time, and that trade deficits show that other countries are “taking advantage of us”. In imposing steel and aluminum tariffs, the White House has politicized trade policy and opened itself to furious lobbying efforts. The policy has become more “carve outs galore” than a coherent trade effort.

Ronald Reagan and George Bush used tariffs as a threat to open markets and reduce trade barriers. If the Trump administration moves in this direction it will be strong positive factor for the economy. However, the simplistic statements from the White House have united economists who know that the facts and logic are strongly against these views. While economists differ on how much China cheats and what should be done about it, virtually nobody thinks deficits show anything other than low savings and all agree that trade has built the wealth of this country. Economists who make these arguments often do not have much “skin in the game” and some argue this makes them wrong. Not having a stake in the argument tells us nothing about the truth of the argument and it is too easy and cheap to dismiss the argument for free trade based on who is saying it. Still, it is courageous for someone who is losing his job to agree. My brother is an example of an American who takes personal responsibility seriously and doesn’t look to broad trade protection to save his job. He doesn’t let his personal experience distort his views. Neither should anyone who thinks and votes on the question of tariffs. There are winners and losers for every policy decision and the protectionists need stop imaging a fantasy world where there are no trade-offs. We have built this country with free trade and there is no case for ending it with broad tariffs. Just ask my brother.

Nero Fiddles as Rome Burns

As I was writing last week’s post about Macroeconomic Fuzziness, it occurred to me that there are some things that are not so fuzzy. It not only made me think of Nero but also reminded me of a book written by Herman Hesse titled Journey to the East. A traveler boards a train taking him to a very clear destination. During his travels, however, the traveler gets off and on the train. Somehow the destination got obscured each time, and he found himself lost or moving in the wrong direction. Luckily, he found his way back to the train and moved again towards his destination.

Hesse was writing about spiritual things, but this story says much about macroeconomic policy. There is nothing so fundamental to survival and standard of living as economic growth. Whether the location is Catalonia or California, the truth is that economic growth makes everything easier. This should not be interpreted to say that economic growth is everything. It isn’t. But it is to say that without economic growth, everything else struggles. When the economic pie is growing, we might fight over our share of the increase, but when the economic pizza stays the same, the only way for Jim to get more is for Toni to take less. Like Hesse's traveler, we often get lost and forget that growth is so critical. 

Inasmuch, it is important to keep economic growth on the front burner. It does not have to grow at a lightning pace, but it does have to grow enough to keep us out of each other’s hair. Nowadays, we keep referring to populism. I looked at a couple of definitions of populism and they contained the words “ordinary people”. Populist policy is aimed at improving the lives of ordinary people. It follows that economic growth is a perfect part of populism because there is no way to improve the economic situation of ordinary people without it.

Yet, we hem and haw. Sometimes Republicans appear to be helping rich people at the expense of ordinary people. Sometimes Democrats appear to be assisting minorities at the expense of ordinary people. And these Republicans and Democrats often have good reasons to be doing these things. But if they go too far and ordinary people are injured, then they make their complaints known. And so, we get back on the train and head in the right direction.

That brings us to our present government. I am told repeatedly that this government is populist. But I don’t see it. I do see some smatterings of policy supporting economic growth. I applaud those. But then I see just the opposite. Most recently, the proposals relating to protectionism seem to fly in the face of economic growth. I can’t find a single rational explanation for why one would want to save a few thousand jobs (steel and aluminum) in America while at the same time destroying tens of thousands of jobs (drink and auto manufacturing and other users of steel and aluminum) in America. 

Maybe the political optics of helping some manufacturing workers seems attractive to some politicians but surely this cannot help economic growth. If other countries retaliate against the US, then the gloom spreads to many other US firms that export to those countries.

Or better said, how does protectionism fit the description of populism relating to ordinary people? Or worse, how does protectionism fit in with anything good for the USA?

This story is not hard to understand. Local manufacturers of steel and aluminum want less competition. They want to be freer to charge higher prices. To whom do they charge these higher prices? They charge these higher prices to all those companies in the US that use steel and aluminum to produce Miller Lite beer and Ram Macho Power Wagons. Then these companies pass along these cost increases to ordinary people. But let’s not stop there. Our tariffs on foreign products make countries like Canada and Mexico wonder what it means to have a free trade agreement. Any country wounded by these tariffs will ponder assessing similar taxes against products from the USA. So guess what happens to ordinary people who work to produce goods going to those countries?

The world is a tough place. Companies and countries cheat and skirt the rules of international trade. It is always easy for a politician in any country to promote protectionist policies. But do they really work? We have had subsidies against imported steel in the past. Yet steel is still not viable and needs yet more protection.

I looked at employment data from the Bureau of Labor Statistics for the primary metals industry. These numbers include employees in the production of iron, steel, and aluminum. Clearly, this is an industry with declining employment. From 1990 to 2017, the number of jobs decreased by 317,000, or 46%. During that same time, all US manufacturing jobs declined by 5.2 million, or 30%. All private sector jobs in the US, in contrast, increased by 33 million, or 36%. It makes one wonder what can be done in the way of tariffs and protectionism to an industry in job decline for more than a quarter of a century. If protectionism is our game, then how do we best help ordinary people?

That brings me to my final point. There are ways we can create growth. There are ways we can augment and develop a skilled labor force that is the envy of the world. But guess what? The more we get diverted into arguing about the pros and cons of protectionism, the more time we are wasting with respect to moving this parade forward. Is anyone seriously putting forth proposals to permanently expand employment opportunities in the USA today?

            Year               Primary Metals

                                    Employment

                                    In thousands

            1990              689

            1995              642

            2000              622

            2005              466

            2010              362

            2015              392

            2017              372

https://data.bls.gov/pdq/SurveyOutputServlet

Lesson 21 Macroeconomic Fuzziness

I had another one of those chats with a nice person who reads my blog. It always starts out with a nice compliment but then winds its way around to the fact that some people cannot understand one thing I say. They count the number of times I use the word JD and then go back to their usual productive lives.

This is both frustrating and understandable. I started learning macro from Professor Bill Shaffer at Georgia Tech in 1965. Since that first course, I have taken an embarrassing number of econ courses in college and graduate school, and I've taught an even larger number of econ courses since starting my career. While some of my econ colleagues were rocket scientists, I always loved the idea that you could help people understand the world better by studying econ.

Because some of my blog friends don’t have a lot of background in econ, I wish I could help them better understand what is happening “out there”. And there is a lot happening. The economy is or isn’t about to implode. The Fed might raise interest rates three or four times in 2018. The Federal government is planning to make its very large debt position even larger. Inflation is going to rise, the value of our stocks is going to fall, and we will all soon be panhandling on the sidewalk in front of Nick’s English Hut.

There is plenty “out there” to discuss. And that’s the problem, or should I say that’s the challenge. Economics has three parts. First, economics wants to provide answers about what is going to happen in the future. Second, to do that, economics must have some basic fundamentals that can be applied to the future. Third, economists are always checking the reliability of these fundamentals by looking backward. If they seemed to hold in the past, then maybe they can be used to think about the future.

Fundamentals? There are lots of them. For example, we believe that if you give a person an extra dollar that person will spend some of it. The marginal propensity to consume (MPC) tells us how much of an extra dollar received will be spent. (Some of the extra dollar goes to taxes and some goes into saving. The rest is spent.) This fundamental is used, among other things, to estimate how much extra spending will be done by people receiving tax breaks in 2018 and beyond.

The MPC is a potentially useful idea but we don’t want to apply this idea if it isn’t true. So we look backwards. Economists do studies to inquire how people really act. Give a dollar to Nolan. Let’s see what he does with it. Here’s a dollar for Ashley, let’s see what she does with it. We won’t all do the same thing with an extra dollar. But studies of the usefulness of the MPC in macroeconomics look to see if it is a reliable indicator of what all of us did when given an extra dollar. Thus, the past can be very useful. How have Americans behaved when given tax cuts in the past? When Americans were given a tax break of $1 billion, did they spend more on goods and services? If so, how much? Looking at more than one tax cut over time and over many families, did they have a reliable spending response?

Fundamentals can be argued about in terms of basic intuition. Focusing on income and spending might be too narrow. And history might find that tax cuts have had different impacts at different times. Thus, we might have a lot to argue about the past. If we can’t all agree about the nature of an economic fundamental and its reliability in the past, then clearly we will have a lot to argue about its application to the future.

Atoms don’t behave like humans. Apply heat to an atom and it behaves according to physical laws. Physical sciences, therefore, are more useful for predicting the future. Social sciences have fundamental laws of behavior but because they involve human behavior, they have less predictability.

We don’t give up trying to predict the future, though, just because Nathan doesn’t act like an atom. People are very curious about the future and are willing to tolerate a less than 100% accurate economic prediction. This underscores why macroeconomics always seems so iffy and controversial and why economic predictions are often off the mark. We spend a lot of time arguing about fundamentals and even more time disagreeing about whether a given fundamental was accepted or not accepted by a given past historical period.

To complicate matters further, we have ideologies mucking up our discussions. If macroeconomics sounds precarious based on past behaviors of fundamentals, this apparent unsoundness is compounded by the fact that we have extreme camps of economists who differ almost as radically as Catholics and Baptists. Conservative economists believe government is an evil that disturbs the natural and good order of things. Liberal economists have faith that the government is necessary to restore order and save us from the greed and stupidity of mere mortals.

This ideological split taints every fundamental and every economic prediction and ensures that each camp will totally disagree with the other ones about everything from peanut better to BB guns.  

This brings us full circle. It is fun and challenging to help some of you understand current macroeconomic issues. To do that takes blog posts that can never lack at least a few ifs, ands, and buts. A discussion of any topic worth writing about will be full of definitions and theories along with attempts to verify them with historic episodes. But history never proves anything perfectly, and ideology always provides ample grounds for near-theological disagreement. So I will ask for your patience and hope that this little post today helps you understand why things always have to sound so complicated.

Surging Interest Rates

Last week I wrote about the hysteria about rising inflation. This week I want to focus on interest rates. The story line goes something like this. The Fed has recently been raising interest rates and the Fed now plans to raise them several times next year. This increase in interest rates will pummel the economy and therefore the stock market will take a dive more powerful than a flock of pelicans in a feeding frenzy.

The below chart is useful for thinking about interest rates and recessions. Both lines are annual averages for each year. The chart goes from 1953 to 2017. The blue line is the interest rate set by the Fed. It is called the Federal Funds Rate but we can call him FFR. The red line is the rate on 10 year Treasury Bonds. Let's call that one 10TB. 10TB is usually on top of FFR but please no sexual jokes. The FFR is below most interest rates since it is known to be a measure of the cost of funds for banks and other financial institutions. These institutions lend money at a rate above FFR so as to make profits. Being a floor rate -- when the Fed raises the FFR we expect most other rates to rise too. A rising tide lifts all boats or something like that.

As the chart below shows the Fed has raised the FFR, depending on how you count them, about 12 times over those 65 years. You can also see there are 9 vertical grey bars in the chart indicating recession years.In the case of every one of those recessions you can see that they were preceded by a rise in the FFR. But notice too that this FFR/Recession relationship is less like Fred and Ethel and more like Ricky and Lucy. That is, the relationship is highly unstable.

          It took a huge increase in the FFR from 1976 to 1980 (and then to 1982) to cause two recessions. The FFR went from 5% to more than 15% -- a tripling -- to create those two recessions.

          The 1990 recession was preceded by a rise in the FFR from 6.7% to 9.2% from 1987 to 1989. Strangely the FFR was already starting to fall before the recession hit.

          The next recession didn't start until 2001 and while the FFR doubled from about 3% to 6.2%, it took from 1993 to 2000 to increase that much. Like the recession in 1990, this one didn't last very long.

          The big recession of 2008/2009 looks peculiar. The FFR rose from 1.4% in 2004 to 5% in 2007 but then fell to 1.9% right before the recession. So we have four years of FFR action before that recession. But how much the FFR had to do with that recession depends on whether you use the 5% rate in 2007 or the 1.9% rate in 2008. And, of course, that recession had a lot to do with bad housing loans and less to do with FFR policy.

Some people seem to have a lot of clarity on their favorite bourbon as well as the impact of the FFR on the economy. I don't see it myself. While I love JD I also realize there are a lot of very interesting bourbons out there. And when it comes to the Fed lifting rates in 2018, I am not highly confident that such policy actions will lead to the economy or the stock market crashing.

A note on interest rates. This graph is very interesting. Notice the strong upward trend in interest rates before 1981 and the following 37 year downward trend. Much of that has to do with inflation. It makes sense that interest rates should be impacted by inflation. If you expect a rise in the inflation rate, investors demand a higher market interest rate -- because they know that inflation reduces the buying power of the future interest and principle payments they will receive. Just as coal miners wanted a 39% pay increase in 1979 (for a three-year contract) to shield them from high expected future inflation, financial market investors want higher returns.

Thus inflation and inflation expectations distort the graph. But for my purposes today, working with market rates creates no real distortions. The FFR is always quoted in nominal terms and the question here concerns whether policies that raise the FFR have a reliable relationship with dire changes in the overall economy. My answer is no.

One caveat. Caveat is a foreign word for cover my butt. Should the Fed raise the FFR a lot  more and should they sustain that policy for a couple of years, then I'd start selling my bitcoins and Apple stock.
   

Inflation is Roaring Back

A picture is worth a thousand words. Right?

I guess you can answer that question. At the heart of current discussions about the US economy is whether or not the inflation monster has awakened from its long nap and is about to devour us. Since the future is all about the future and only the Great Tuna knows the future, the rest of us can only make silly statements and forecasts about it. So in that spirit I thought I would ask Fred to draw a picture that we could gaze upon.

But before we gaze, let me try to summarize the issues. The US economy is stronger as evidenced by a low unemployment rate, tighter labor markets, rising wages,  higher inflationary expectations, and higher actual inflation. While most of that sounds lovely and juicy like a large steak au poivre, apparently people who own things like stocks and bonds were scared out of their bejeezers by this story. When hearing this information from Charlie Sheen, they sold their stocks like a new shipment of socks in Venezuela.

Another way of saying this is that we are in a new epoch in which good news is bad news. A strong economy apparently means a weak economy. A strong economy with promises of better profits and higher incomes means something horrible is going to happen. Are we supposed to hope for bad news so that will mean better future outcomes? To be less sarcastic, the false news being spread is that a strong economy and tight labor markets mean that wages and prices will grow too fast -- with the buying power of the wages being eroded as productivity peaks and falls. In the meantime, the Fed will react by raising interest rates and somehow moving interest rates up a few notches will cripple the strong economy. And then the rise in government deficits will pile on the parade by causing even more inflation.

Don't you just love macro? You don't have to answer that.

So there we are as we gaze at the chart below. I graphed two series -- the red line is the CPI. The blue is earnings of workers in the private sector. Each is monthly data from 1970 to the end of 2017. I graphed the growth rates of both series -- each represents the percentage change in that month relative to the value in that month a year before. Thus the data points are monthly but they are smoother than taking the percentage change from one month before. Some of the month-to-month craziness or variance gets removed and lets our eyes focus on more persistent or durable changes.

The reason for graphing these two series over a long period is to gain some perspective on the more recent changes. For example, look at the red line (inflation) since 2015. It is clearly rising indicating a rising inflation rate. Notice that the blue line (workforce earnings) shows no such increase. In fact, the wage line has been generally falling and flattening since about 1997. Thus, the very clear uptick in inflation does not seem to be caused by anything happening to wages. Perhaps inflation is being impacted by oil prices or the price of Donald Trump's hair cuts. Or maybe inflation got tired of being so low. The rise seems large only in relation to the very low rates after the last recession.

One clear thing in the chart is that inflation and wage gains often accelerate before a recession. The grey bars indicate recession years. Before most of the recessions wages and prices did accelerate and that was mostly because the economy was growing at unsustainable rates. Notice too that it often takes several years of rising inflation and wages before bad things start to happen.

Also notice from the chart that we do not know when the next recession will start and clearly we know that the economy has not been rising at unsustainable rates. Much of the writing in the last years laments that the economy is growing too slowly. But these things can change and we are right to wonder if the economy will grow faster, wages and prices will careen upward, and a recession will follow. It is right to wonder. But it seems crazy that such a possibility makes us crazy. Crazy enough to cause a stock market collapse.

Graphs are food for thought. I pointed out a few things from the graph. What about you? What does this graph whisper to you? Is inflation on its way to scary levels?

Americas on First. Whats on Second.

Abbot and Costello made a very funny skit about baseball – the most famous lines were: who's on first; what's on second; I dunno is on third. It is one of the funniest bits ever. Try it at youtube: https://www.youtube.com/watch?v=kTcRRaXV-fg

The point of that bit is that language can be confusing. Abbott and Costello talk past each other in a very revealing way. It reminds me of what we have today with the phrase "America First". In the destructive political environment we live in today, even such innocuous words can cause extreme, emotional, even violent reactions from the poles of the political spectrum. So I thought I would have a little fun with that today.

In grade school, I was usually first in line for recess and lunch. Being first was not anything to envy. America is not first in a lot of things and for good reason. I doubt we could ever place first in a rugby or a badminton match. And of course, China and India have us beat on population, and we are even pretty far down the list when it comes to income per person. You can’t be first at everything.

Which brings up lots of things America is good at. We are best in the world at American football. No one makes bourbon or JD like Americans. It’s not easy to beat America at swimming or average wealth per person. Then there is Kentucky Fried Chicken and McDonalds.

So what is the big deal when it comes to America First? President Trump says he wants to make America great again and he wants to do it by putting America first. That sounds pretty intuitive but maybe not. Think about most relationships. Percy Sledge’s second verse in his song When a Man Loves a Woman goes like this:

When a man loves a woman
Spend his very last dime
Trying to hold on to what he needs
He'd give up all his comforts
And sleep out in the rain
If she said that's the way
It ought to be

Sleeping out in the rain is not my idea of a good time but Percy had it right – the best way to have a great relationship is to put your friend in first place. There is no competition here. A rising tide lifts all boats. Not putting yourself in first place is sometimes the best way to be tied for first place.

Got you humming the song, right? What a great song. Anyway, the point is that this works for America too. I am trying to not imagine a ménage à trois with President Trump, Theresa May, and Angela Merkel but it is true that the US has great relationships with many countries. Thumbing your nose at them or somehow threatening them is not always the best way to do what’s good for the USA. Again, America First might mean America selfishly making nice with our friends abroad. (Notice I said with our friends.)

So is there any sense in which America First is a positive slogan? I think so. When you won the spelling bee in fifth grade you were proud of yourself. When you played on the state championship athletic team you were equally proud. When the US Olympic team came in first you might have raised your fist into the air with pride. Moving to first chair in the orchestra made your parents beam with pride. Being first can be the sign of things that are very good for us.

You practiced every day. You set goals and tried to achieve them. You learned the value daily of learning from your mistakes. A competition can sometimes make you even better than you were. This learning doesn’t just make you the kid that got the trophy. It turned you into a person who takes great pride in solving problems, learning new things, and being a great example for people around you.

Trying to make America first in terms of job opportunities, corporate competitiveness, and governance is valuable. It is not so much that we come in first. What matters is that we try to come in first. Being first isn’t great for everything. Being first despite everyone else is clearly not often the best path. Being first to make yourself better, however, is hard to argue with.

But what about America first with the underscore on America? We have 300+ million here some of whom were not born in America. My mother came to the USA in 1929. Apparently, her father was not good at picking years. But they came from Budapest and made the USA their home. My mother became a citizen and I never once heard her say Hungary first. She taught me about Hungarian culture and she made stuffed cabbage Hungarian style that was to die for. But like many of us, she rooted for America. Her husband (my father) fought in World War II and like most people in America he wanted America to win the war.

Does that mean that we all have to approve of everything done by the American government or its people? Of course not. This is a free country and we have the rights to disagree, to speak out, to protest, and so on. But the question of America First in this context is how you come down on the great majority of things. If it turns out that you resist everything done by Americans, then I would question why you even want to live here. America First means to me that you have taken America to be your home and that when it comes to the full system, warts and all, America comes first and the rest of those places are at least a step behind.

Depreciating the Dollar

Secretary Mnuchin was asked if he ever spanked his child. He said he had heard that a spanking might be an effective parental tool at times for some children. The next day, he was arrested for advocating spanking to world leaders.

No not really. He did not say that. But Mnuchin did say he had heard that a depreciated currency might lead to more exports from that country. Immediately he was piled on by everyone from Tiny Tim to Tom Brady. Despite Mnuchin repeating a mantra found in almost every book on international trade, the world decided that Mnuchin had cleverly advocated a US policy to reduce the value of the dollar. Shout it from the housetops -- the new US policy is to depreciate the dollar so exports will rise and Americans will be protected from the world's vandals. No, not really. Could the press get any lamer?

But this is not about beating up the press. It is about ideas and facts. The first fact is that the dollar, despite limping a bit lately, is pretty darn strong. Second, most of us haven't a clue what it means to have a policy to depreciate the dollar. So let's work on that today. First, do 10 burpees.

The lovely chart below I graciously got from our good friend FRED at the St. Louis Fed. https://fred.stlouisfed.org/ It shows the exchange value of the euro versus the dollar. The euro is just one of many currencies I could have used, but this one is fine for our purposes. The chart shows that before 2000, one euro was able to command about 1.15 dollars. By 2008, the euro greatly appreciated (the dollar depreciated) to where one measly little euro could buy almost 1.6 dollars. At that time, the dollar was really weak. At the close of the business day on Friday, January 26, 2018, the quote was 1.24 dollars to a euro. Since 2008, the euro is much weaker and the dollar is much stronger.

• Since way back before 2000, the dollar weakened considerably through about 2008.
• Since 2008 the dollar is much stronger
• Since 2009, 2010, and so on the dollar is stronger
• There is a weakening of the dollar since sometime in 2017.

As far as the euro data show, the dollar is pretty strong. Things have turned of late but clearly not enough to change the general impression of a strong dollar.

So my first point is that there is no evidence of any real weakening of the dollar. But what if this short-term turn means the dollar is going to continue to fall. So what? And would our government want that outcome enough to actually promote it?

Even small birds know that a depreciated currency is good for exports, right? Sorry Charlie, but not really. Often a depreciated currency simply means a country's goods have become less competitive in global markets. If foreigners prefer France's goods over US goods, they don't need as many dollars and thus the value of dollar falls. Thus the depreciated dollar may simply be the sign that a country's goods have lost favor in the world. A falling dollar does nothing to heal the thing that produced the decline in competitiveness.

But that is not the whole story. Not by a long shot. A depreciated dollar means that US households who want to import Cognac from France or sausages from Germany will find all that stuff costs more. If they really prefer these imported goods over US goods and continue buying them, then they have to pay more. Ouch. I am not sure our US government wants to be responsible for that ouch.

And that's not even the whole story. We love it when foreigners invest in the USA. If they buy stocks, they drive the stock market up and we get richer. If they buy bonds, they drive interest rates lower and we can borrower cheaper. If they invest in new businesses, employment and wage opportunities improve. In short, we love it when foreigners invest in the USA. If foreigners believe the dollar will fall, then this weakens any returns they would expect to gain in the USA. That's because to bring their earnings home to their countries, they will have to use a depreciated currency. Would Mr. Mnuchin really want to be responsible for telling those foreigners not to invest in the USA?

It is true that some countries -- especially developing countries that rely greatly on foreign exports for growth and development -- take measures to depreciate their currencies. It is unfair and it hurts the US when these countries do so but that does not mean that it makes sense for rich, industrial countries like the US to copy them. Often when these countries behave like that they are breaking international trade rules, and there are ways to address those issues without following bad policy with more bad policy.

Furthermore, playing exchange rate bingo with the rest of the world is not a winning strategy. We can hope to expand our exports by depreciating the dollar but then export-dependent countries will simply retaliate. They have much more to lose than we do. It is hard to see us winning that game and in the meantime we all suffer.

Mnuchin denied it was the policy of the USA to depreciate the dollar. Let's all hope he really means that.

Stocks and Apples

I don’t like to write about the stock market. While the values in the stock market are often related to global macroeconomics, the changes more often mirror my dance moves after a night of consuming JD. But like a good bottle of JD, it is not easy to ignore Da Market.

So today I focus on Da Market as measured by something called the Wilshire 5000. The Wilshire 5000 is not as well known as its cousins: the  DJ Average, the S&P 500, or the NASDAQ. Wikipedia defines the Wilshire index as a market-capitalization-weighted index of the market value of all stocks actively traded in the United States.

I am writing about the stock market because we are obsessed by it. Everyone watches the market indices daily and we cheer its upward advances. More popular than the Philadelphia Eagles, we can’t wait until its next upward movement. But nasty people called shorties tell us that the market, like the apple that supposedly hit Newton on the head, must come plummeting down to earth. With apples, they cite something called the Law of Gravity. With stock prices, it all has to do with Pee Wee Herman or PEs or something like that.

Apples or stocks, what goes up must come down. So I decided to look at the data today and report to you what I found. Take a deep breath – there is no forecast here. Do with it what you will.

Before we begin looking at my huge table below, let’s make one point. The Wilshire 5000 went from a value of 3,291 in 1990 to 27,655 in 2017. When it comes to these 28 years, it is pretty clear that Newton had nothing to say about stock prices. If my calculator is correct, that amounts to a nominal capital gain of 742%. I will take that.

But let’s not stop there. Most people are not as conservative as me. Call me Buy and Hold Larry. Other people are more active in stock markets. Others might have a shorter horizon than 28 years. That’s who my wild and crazy table is for.

What’s in the table? Betty wonders what I do in my office all the time. Basically, I make up tables and rearrange the flowers in my JD bottles. Anyway, the table below was created by going through 324 months of data, one month at a time. I found there were 10 time periods between 1990 and 2017 in which the value of the market peaked, fell for at least a few months, and then returned to its previous peak. The idea of this kind of breakdown is to see what happens after stock prices begin to slide.

Begin with the first row of the table. In June of 1990, the market peaked and was 5% higher than the previous peak. After June of 1990, stock prices fell. They fell and then rose until reaching the previous peak in June 1990. It took 9 months to regain that previous peak. 

This down-up pattern happened 10 times since 1990. Typically prices began falling after a 22% increase since the previous peak and then took about 20 months to fall and then rise to reclaim the previous peak.

But notice there are large variances among the 10 time periods. Half the time, it took 10 months to recover. But notice that in five of these episodes, it took 5 months or less for stock prices to recover. And then there were the episodes in 2000 and 2007 where it took 81 and 63 months, respectively, to regain the previous peak.

It is pretty clear from the table that the time it takes to return to a previous stock price peak is highly variable. Many times it took less than half a year. The average time is less than two years and the median time is less than one year. And then – tada – there were two times when it took 5-7 years. So if the stock market does seem to rise over time, your recommended behavior very much depends upon your time horizon. If you can live through poor stock markets for 7 years – then the past suggests you have no worries. Buy a sailboat. 

The final table column is interesting too. It lists the percentage change from the previous peak to the subsequent peak and downturn. For example, the second line in the table says that between 1990:6 to 1994:1, the stock market rose by 37%. It was after that 37% increase that led to stocks subsequently falling and then rising again. In the case of 1994:1, a previous increase of 37% led to a 13-month cycle. It is interesting that the longest cycles in the table (81 and 63 months) were preceded by relatively modest increases in stock prices of 12% and 10%. The 42% increase in stock prices before 2015:7 surprisingly lead to a down-up cycle of only 11 months (before prices returned to previous highs).

In short, there does not seem to be any correlation between previous stock price increases and subsequent months of return to the previous peak stock price. And thus the 25% increase in stock prices between 2015:7 and 2017:12 does not warrant any special concern from the standpoint of this analysis.

When will prices hit another peak? I am not sure. But if and when stock prices begin to fall, this analysis suggests that the time before the next peak might only be a few months. Of course it might be 8 years too. Those who would scare you out of stocks right now ought to explain to you when they think stock prices will fall – and then when they will return to the previous peak.  

Peak      Months    Wilshire Percent

               To Next    Value      Change

               Peak

1990:6      9             3,446            5

1994:1     13            4,709          37

1996:6       4            6,629          41

1997:2       3            7,647          15

1997:10     4            9,215          20

1998:7       5          10,822          17

1999:7       4          12,640          17

2000:3     81          14,096          12

2007:10   63          15,556          10

2015:7     11          22,097          42

Average  20                               22

Median     5                                17

Out of the Economic Wilderness

Things go in stages. I remember a time when I put a lot of gunk on my hair so it would stand up straight in what was known as a flat top. Then I had a wave. The Air Force preferred something closer to my scalp. Post-Air Force, I let it grow for about four years. My hair had a lot of stages. Today, well, there are a few spots missing here and there.

And so it is with economic thought. I had the luck of taking a wonderful course in the history of economic thought at the University of North Carolina. A main goal of that course was to see that economic thinking evolves over time and very much reflects the natures and problems of a given time or place. This recognition of the temporary nature of economic ideas gives one some confidence that whatever the prevailing wisdom might be today, it is sure to be supplanted by something else in the near future.

As a graying economist, I have seen lots of change during my career. When I was at the University of Arizona getting a masters degree (while stationed in Tucson with the Air Force), the bravado of Keynesians was revealed in their confidence about the accuracy of forecasts of Keynesian models. Keynes had reacted to the failure of previous so-called Classical Models to explain the Great Depression. But it was the eventual failures of Keynesian models that led to a host of competing theories by unreconstructed Keynesians, monetarists, and supply-siders.

Today, we have a mish-mash of models with elements of each of those schools of thought. But there is a very clear and common thread among them that focuses on the apparent short-run instability of advanced industrial (rich) nations. We argue among ourselves about the proper policy in a given country at a given time but the argument is framed within a short-run model that encourages us to focus on moving the economy back to short-run equilibrium. If inflation is running too hot, we try to bring its temperature back down. If the economy is languishing with high unemployment and slow growth, we give it a pep pill. The pill might be designed to alter short-run demand or supply but the focus is always on overcoming an undesirable stage of an economic cycle.

This bouncing around has gone on in the USA at least since the early 1960s when John F. Kennedy announced his famous tax cut that would move us out of a recession. Since then, we have handed the policy ball back and forth between quelling rapid inflation and stimulating recessed spending. One byproduct of this has been a dizzy economic experience. Another offshoot is a national debt that reaches for the sky. There have been a few times when the debt as a share of the economy abated somewhat, but mostly it rises and then rises more. Today, it approaches 100% of the size of the US economy and promises to go even higher than that.

I think the dizziness plus debt is wearing us out. Worse is that it is becoming more and more obvious that this preoccupation with the economic cycle is distracting us from recognizing and treating what has become the new scourge of industrial nations. Today, we debate whether the economy is too strong or too weak. Today, we debate whether or not to have stimulative monetary policy. We argue about the stimulative impact of rebuilding the nation’s infrastructure. Imagine all those workers paving during the day and spending at night! 

But the truth is that short-run policy never seems to accomplish anything as we careen from recession to expansion back to recession. And worse than that is that the experience of industrial nations has changed. Whether this change was brought about by industrialization or by globalization, the result is that we are weakened by modernity. Our ability to grow is at risk. Our main economic challenge has gone from trying to reduce the amplitudes of economic cycles to raising our long-run economic growth path. Last week I used the example of a long distance runner. Let’s try it again. You want to win the marathon. To run 26 miles at a fast enough pace to win, you don’t swallow a handful of sugar. You train hard. You build your wind capacity and your muscles.

We are familiar with the difference between short-run and long-run policies. While the richer nations have been toying with cyclical policies, the poor developing countries knew they could catch up only if they focused on long-run structural issues like energy, transportation, legal systems, and so on. Before they could provide adequate incomes and opportunities for their citizens, they had to build a modern infrastructure. Now it is the industrial countries that need to rebuild to meet the challenges of the day. We should replace our short-term focus with longer-term ideas.

What does that entail? The remedies should mirror the problems. Everyone seems to acknowledge that modern competition has reduced the demand for workers in the US and in other rich countries. Despite the fact that the US unemployment rate is very low, we acknowledge that too many people have dropped out of the labor force, taken jobs beneath their skill levels, or work part-time when they prefer 40 hours per week. This is clearly not a short-term issue especially when we know that technology is bringing robots on that might be smarter and prettier than your average macro professor.

This labor supply challenge is constantly on our minds but we process the information with old and worn-out models of the short-run. We continue to ask for more of the same policy gruel – juice up the money supply or give the middle-class a tax break. But we are not in a recession and we don’t need policies that cause the national debt to grow even more. What we need is to reorient the way we think. 

Tending the economic cycle does not create more sustainable economic growth. Economic growth is the salve that soothes but economic growth requires an understanding of how to compete in a high- tech world that wants to replace human hearts with robot brains.

We had to figure out how to evolve from an agricultural to an industrial economy. The transition was not pretty but we had to quit thinking about wooden plows and mules and focus on tractors. Now it is time to figure out how to move from the tractor to the driver-less, sun-powered robot. Arguments about traditional monetary and fiscal policy while creating mountains of debt, are not going to help. Where do we find someone to lead us out of the wilderness? Who understands that in the long-run we are not dead?

Economic Growth Confusion

Mixing apples and oranges doesn’t sound too bad until you start making an apple pie. That’s the way I feel about the careless use of terms like "economic growth". Economic growth has so many meanings that it is easy to confuse people. These misunderstandings are particularly troubling today, because of the implications for growth-caused inflation and interest rates.

It is common to discuss the growth of the economy. You can talk about national growth last quarter or last year. Or you can average it over many past years. Forecasters discuss economic growth in the coming year. All that is fine.

What is not fine is mixing these popular uses of the term economic growth with the outcomes of an economic growth model. An economic growth model’s output is probably misnamed. What it ought to be called is JD. No, that’s not right. It ought to be called "long-run economic growth". 

A growth model is a simple mathematical expression that posits that economic growth is equal to the sum of the growth rates of the labor force plus the growth of labor productivity. (Note there is something called a two-factor economic growth model but that complicates matters beyond my meager goals today). Let’s write the economic growth equation:

  Long-term Economic Growth Rate = 

  Growth Rate of the Labor Force

                         

  + Growth Rate of Labor Productivity

Don’t you just love equations?

I use the word "long-term" to make a point. This equation is NOT meant to explain or predict changes in a nation’s output (real GDP) from day to day or from year to year. It is meant to explain how our permanent or sustainable capacity to produce changes over fairly long periods of time.

You could ask, How will economic growth in the next 10 years differ from the previous 10 years? That would be an acceptable use of the growth model described above. When answering that kind of question, the growth model ignores lots of short-term distractions and focuses on what it takes to permanently alter the capacity to produce goods and services. It is inherently supply-side-oriented. Clearly how much labor you have available is critical to sustain an ability to produce. The productivity of labor matters too, and that productivity is very much influenced and determined by how the quantity and quality of capital (plant, equipment, software, etc) change.

The trouble comes when people use discussions of the economic growth equation to talk about the next year or two. Capacity growth is important to next year but so are a lot of other things. For example, low labor force participation might endanger economic growth in 2018 but to focus too much on that one indicator is to not be playing with a full deck of cards.

What is the full deck of cards? Macroeconomic models we use to explain and forecast short-term changes in output (and prices) generally focus on events and factors that impact both the demand and supply of goods and services. A tax cut for moderate income people might encourage them to spend more and therefore impact demand. An increase the energy prices in 2018 might cause the cost of running factories to increase and lead to impacts through the supply of goods and services.

The full deck of cards includes Jokers, Queens, and Kings – and anything and everything that might influence our desires to buy and to sell. Thus, it is possible and desirable to intertwine long-run supply-side factors with the many short-term factors that will impact economic growth. To ignore the short-term changes is to imperil our judgment about the short-run.

The upshot of this is that output growth next year could be much faster or much slower than the long-run model predicts. When we hear the words "capacity output", we think of some kind of physical wall or constraint. But the truth is that for a year or two, output can grow much faster or much slower than capacity. How is that possible? 

Think of a distance runner who knows his sustainable pace for the long race. Call that long-run capacity growth. But think what happens at mile 17 when his arch rival moves ahead of him. For a time, he may run much faster than his overall pace to psychologically attack that rival. If he tries to sustain this high rate, he will run out of gas. But he can dig deep for a little while. Similarly, capacity might be growing at 2% per year but the economy could grow faster than that for a little while.

In the economy, labor force and productivity determine the sustainable long-term pace. But in the short run you can jam more workers into stores and factories than can be sustainable. Think of December when so much output gets sold. That’s not sustainable over the whole year.

The main confusion today is about how faster economic growth might influence such things as inflation and interest rates. Suppose spending kicks into higher gear while capacity moves like a snail. In that case, one might predict stresses leading to higher interest rates and inflation. Instead, suppose spending grows faster while short-run supply does the same. In this case, the economy is not stressed and there may be no additional pressures on inflation and interest rates.

Energy, business deregulation, some of the elements of tax reform, as well as the residual impacts of a global surplus suggest a national supply response that will not bring along the usual increases in wages, interest rates, and inflation. At least not right away. All this could change in a year or two and then we have plenty to worry about. It might be a good idea for policymakers to goose the long-run growth model faster. We will need that extra permanent capacity to keep the economy from strangling itself. 

Notice this implies nothing for the usual monetary and fiscal policy and everything about how a country improves its labor force –  its size, its quality, and its productivity.