Confessions of a Two-Handed Economist

President Truman is famous, among other things, for saying he wanted a one-handed economist who would not say “on the one hand this, but on the other hand, that.” In other words, he didn’t always want a complete and balanced analysis – he wanted to know where things were headed. No hemming and hawing!

Truman would have hated me. I love to tell the whole story no matter how much my audience falls asleep.  I am probably a nine-handed economist. So today I am stopping all that. Today, I am one-handed, and today I will tell you what I really think. Today is the day I am part of a panel at Big Arts on Sanibel Island. So I am killing two birds with one stone – writing this blog and using this lunacy as my presentation to the grey-haired audience at Big Arts.

Sanibel Island is an absolutely wonderful place. Thanks to Chuck and Nancy Bonser, who will remain unnamed, we were introduced to this paradise located off the coast of Fort Myers, Florida. We have been going there off and on for the last 30+ years. It not only has wonderful birds to watch, shells to collect, and seafood to eat, Sanibel has a warm and wonderful group of locals who always make us feel incredibly welcome whether we are bellying up to the bar at the “office” (Sanibel Grill) or arguing politics and economics at the Sanibel Café or listening to incredible music at George & Wendy’s Restaurant and the Keylime Bistro.

Thanks to Chuckie B, I have been teaching a course and also participating in panel presentations at a place called Big Arts. I will be teaching again at Big Arts in 2018 but before that class begins, I am part of a panel today! I am supposed to talk about the future of the US economy and think I have 15 minutes to deliver a totally persuasive forecast.

So here goes. My forecast is that the US economy will grow faster in 2018 than it did in 2017. That means a growth rate in the range of 3.5% to 4.5%. All you Never-Trumpers can hang up on me now. You have better things to do than to read or listen to this. I know you were hoping for a feeble growth forecast but I am not a politician, and I am trying to be a one-handed economist today. It’s all about the economy, and as usual, you can take it or leave it.

Below are my bets that underlie this forecast. But first are the risks. Just kidding. I am not going to discuss the risks. I have only one hand today and even though there are trends that argue against me, I am going to ignore them. Take that President Truman!

First is brother Mo. Mo is short for momentum. Most of the time forecasters bet on Mo. It’s like knowing that Uncle Jason always stops at the local grocery store on his way home from work and buys one can of Rainier. He never deviates. But sometimes unexpected factors cause him to alter his pattern. Ashley might want him to stop at the Whole Foods. Whatever. On a given day it makes sense to bet on Jason's Rainier and on the economy pretty much performing like it has for the last few years. Go Mo!

Second is gathering confidence. Each year in which the economy does not fall into a recession and employment rises and inflation seems a little less likely to fall creates a floor of confidence that allows the economy to not only continue growing but to grow even faster. Confident consumers are more willing to buy and firms are more willing to produce.

Third is what is happening in the rest of the world. The US led much of the world out of the last recession and is now ready to step back and let some of the other countries pull the wagon. As many of the hardest hit countries recover and as Europe and Japan strengthen, it creates a global environment of growth to which the US benefits.

Fourth is interest rates. Many people worry that rising interest rates will nip my last three points in the bud. But I doubt that will happen. The interest rates we know and love are not controlled by the Fed. The Fed may plan to raise interest rates but that doesn’t mean that rates will behave. Telling your child that you are going to cut his allowance does not always elicit the desired change in behavior. As in the case of the errant child, interest rates are impacted by many things. While the world is getting stronger, it is still typified by an overcapacity in which supply is greater than demand. Output can expand greatly without the usual cyclical factors that raise prices, price expectations, wages, and interest rates. The data supports this view. Last week I showed a graph that questions if and when a new Fed policy to raise interests will actually lead to that result. It's definitely not a slam dunk.

Fifth is geopolitical. My observation as a kid was that bullies loved to harass kids who would not fight back. Bullies often stay away from kids who will dish out at least a little punishment. The US is saying some tough things to the world’s bullies – I don’t need to name them since it is pretty obvious who these bullies are. Some of you worry that this will lead to war and some really horrible consequences. I don’t. I don’t think our government wants war any more than previous governments did. But our government is doing some things that make us less easy to bully. So I am betting that there will be a lot of noise about US defense and security and very little negative reaction that might put my growth forecast in jeopardy.

Sixth is "da Market". The past changes in stock market indexes cannot be ignored. A lot of wealth has been created. While uncertainty about the future means we won't go on a spending spree, it is hard to ignore those trillions of dollars accumulating in our financial statements. Spending some of those wealth increases will add to the party. Another aspect of rising stock prices is the falling cost of capital. The higher are stock prices the lower is the cost of raising a given amount of capital. With interest rates stalling and stock prices rising, it will be a great time to buy plant and equipment. 

Finally, I like that the pendulum is swinging. Government financial regulation, climate change policy, other EPA rules, and other government regulations on business can move a wee bit away from where they were heading in the past eight years without causing the world to explode. I know some of you want ever more progress on various social policies and government regulation. You have good hearts and smart minds. But I don’t think you know enough about the effects of economic growth on all the things you cherish. I am, therefore, happy to see the pendulum swing back a bit with the hope it will generate growth without harming the future of the US and the planet.

Notice I didn’t say much about tax reform. In my humble opinion it might be eighth in the list of seven I just discussed. It should help economic growth but it is such a hodgepodge of good things and gimmicks, I am not ready to pronounce the tax reform as the greatest thing since sliced bread. No, I am not crazy about its implications for the national debt. 

I stuck my neck out. You are invited to chop away. Hope you have a wonderful 2018!

IMF says Global Economic Upswing Creates a Window of Opportunity

The International Monetary Fund publishes a world economic outlook every six months. The latest one was just published this month (https://blogs.imf.org/2017/10/10/global-economic-upswing-creates-a-window-of-opportunity/ ) and is entitled "Global Economic Upswing Creates a Window of Opportunity".

This report is not for the faint-of-heart as it is long and treacherous and filled with words and phrases like "raising potential output" and "strengthening international cooperation". Far be it for me to summarize the most current document but I thought I would copy a key table (see the bottom of this post) and then go on and on a bit about some of that.

First, notice that the title of the table says the global recovery is continuing at a faster pace. Yet, the top of the table says that after growing at 3.6% in 2017 (technically this is a forecast since we have not yet shopped for Halloween much less Thanksgiving or Christmas in 2017) we will grow at 3.7% in 2018. For those of you who know a little about statistics, I doubt that 3.7 is statistically different from 3.6.  For those of you who were never punished by a Stats class and don't know a standard deviation from your local neighborhood deviant, this means that the entire publication is suspect. While the thousands of words in the report support this view of faster growth, we all know that the main table of the report says the world will not grow faster next year. It might grow faster. It might grow slower. And Humpty Dumpty had a great fall.

Read down farther and you will learn the following world areas/countries will grow slower in 2018 than in 2017:

Advanced Nations
Euro Area         
Germany               
Italy                       
Spain                     
Japan                     
UK                       
Canada                 
Russia                   
China                   
Emerging Europe 
Mexico 

Given the title of the report and table say that world  growth will be faster, there must be some places that will grow faster in 2018.   The table says these places will grow faster -- the US by a smidge, France, CIS less Russia, India, Brazil, Saudi Arabia, Nigeria, South Africa, and Low Income Developing Countries.

How you can average the growth rates of the slower list with the faster list and come up with faster world growth is a mystery to me. If I was writing this report based on this table I would say that the world seems to be on its last JD of the night. Or maybe -- "While growth in our bigger world markets is stuck in first gear, we see some hopeful spots for growth in some developing countries."
         
Second is the part of the title that claims that 2018 is a window of opportunity. I recall being in high school and thinking that my bedroom window provided a great opportunity to escape in the wee hours of Sunday morning. But when was my bedroom window not a window of opportunity? And so it goes for the IMF -- why is 2018 going to be a window of opportunity that wasn't there in 2017? And the answer is that  the IMF thinks we have kicked the policy can down the road long enough because growth was too weak in too many countries. But now that so many countries are doing so much better, they will button down, quit kicking cans, and attend to important things like economic growth.

Wow --- what is the IMF smoking because I would like some of it. No, the world is not growing any faster according to their own numbers and mostly is growing faster in places like Kokomo (fictional one of the song and not the one in Indiana), Gotham, and Atlantis. And in what places will politicians in 2018 resoundingly decide that long-term economic growth is their number one priority? Watch France. Their child Prime Minister is trying such things and every union in France is suggesting that statues of Emmanuel Macron be broken into tiny little pieces.

If that isn't enough, the IMF has the audacity to imagine that this is a great opportunity for countries to get together in a pro-growth fit and further reduce trade barriers and expand international economic cooperation. Really? Have they looked around? What part of the world is not cracking up? Have they read about Spain or Brexit?  What free trade agreement is universally loved?

From the above you would think that I am either into my third JD of the morning or that I am pessimistic about 2018. I won't comment on the former since children might be reading this but I am not pessimistic. My reading of the world economy is that modest growth is good since it doesn't create huge imbalances and threaten high inflation. Momentum is our friend as more and more countries attach to a slightly stronger world economy. The biggest risks arise from the absence of what the IMF predicts -- that we will continue to kick the growth policy can down the road and countries will outdo themselves with counterproductive protectionist policies. That is -- the economy is fine -- it is the politicians that we have to worry about. Let's hope they take an extended vacation.

Iran, Climate Change and Prediction Error

Mark Twain is famous for saying that "it is difficult to make predictions, especially about the future." My mother often predicted that I would become a bum.  She was right. As a happily retired guy I am sure that Betty would agree with my mom’s vision. 

Predicting the future is both necessary and humbling. Squirrels don’t have spreadsheets and mathematical models, but they gather nuts in anticipation of the coming winter. The playboy squirrels who don’t predict so well lose a lot of weight after winter arrives.  Clearly we learn from squirrels and we predict lots of things that improve our lives. But predicting the future is not an easy thing since the future by definition is unknowable. Those who take actions in anticipation of a specific future often make mistakes – sometimes very damaging ones.

Yet we predict and forecast. I grew up in Florida. During hurricane season we all become forecasters. Will that storm turn into a hurricane? Will that hurricane hit land? If so when will it hit? Where will it bring the most disastrous winds and lightning? Weather forecasters are almost always wrong when it comes to predicting these critical facts about hurricanes.Maybe that is an extreme example but I don’t think so. We modern folks with our math and models forecast a lot of things. It is important to do so. And we do so knowing that we are often wrong.

If you are still awake your mind might be wondering and thinking about all the ways we predict the future. My reason for writing today arises because of what I see as a very inconsistent approach by our present leaders with respect to forecasting some very important things.

The Obama administration is VERY sure that climate change is coming and that without major policy changes and a lot of investment, we and the rest of the world will be threatened. I think he said that climate change is our most important future challenge. There are some very important people and very sophisticated models supporting the urgent need to spend trillions of dollars to change and prepare for things that will happen in the distant future – some expected to arrive more than 50 years from now.

Despite the fact that the future is hard to predict and despite the huge sums of money involved, the president is laser focused on attending to these challenges immediately. In his and his supporters’ minds, this expenditure is worth the risk. His policy makes us all invested bettors on future climate.

Compare this aggressive approach to another important future challenge – nuclear weapons. The world is already in accord that countries will not produce more nuclear weapons. And that accord is for good reasons. While it seems highly irrational that any nation, even a rogue nation, would fire nuclear weapons at another country, we worry that all nations are not always rational. It is like the idea of someone yelling fire in a crowded movie theater. It seems quite irrational to yell those words – yet we have laws to prevent crazy or mean people from doing such things. The world has agreed to control nuclear weapons for similar reasons.

Yet the same administration that worries about climate change wrecking our countries is willing to predict that Iran and North Korea can be trusted to not yell fire in a crowded movie theater – or to not unload a nuclear weapon on one of the rest of us. Obama can vividly see water levels rising and shorelines being over run despite knowing that all this future information is model-driven and about the future 50 years from now. Yet the same Obama cannot imagine a religious zealot or a desperate dictator shooting a nuclear weapon. He cannot see those countries most threatened by nuclear Iran and North Korea arming themselves. He seems to minimize any real threat from a world with increasing amounts of nuclear weapons in the most unstable places. 

Kerry and Obama repeatedly say that the recent accord with Iran will prevent them from obtaining a nuclear weapon yet they also agree that within 10 years Iran will be able to manufacture such weapons freely. They publicly agree that after those 10 years it will take only one year to be ready to aim and fire. So why are we not aggressively trying to prevent that outcome? My grandson Nolan will not be 13 yet in 10 years. I am not particularly crazy about him having to worry about Iran or North Korea or some other despotic place. Clearly this is at least as important as the impacts of climate change on him. Right? 

So here is my question. In the case of global warming, President Obama is willing to forecast the absolute worst. In the case of Iran and North Korea his “models” assume the absolute best. Most economic forecasters that I know (who are not ideologically motivated) bring a “show me” attitude to forecasts. They are always skeptical about their model’s predictions. They always discount the certainty of what we think we know. They always follow their forecasts with a list of caveats longer than a drug company’s list of side-effects in a television commercial.

Why is Obama so sure about the intensity of climate change and so sure that Iran and North Korea will turn into the cutest and sweetest puppies? Why can't we apply conservative and consistent forecast approaches to policies related to climate and national defense? 

50 Shades of Grey: The Economic Report of the President 2015

A colleague of mine whose Stage Name is Dr. Bobby J alerted me to the fact that the Economic Report of the President (ERP) was published this February.  The ERP2015 is the latest in a long line of such annual reports that are widely available since 1995 when I was just a macroeconomist in diapers. Here is what the web site says about this annual publication: http://www.gpo.gov/fdsys/browse/collection.action;jsessionid=FKpBJ8tDXS8K1LZ8TlQvpC8sD7VGYWcnJs3yWr3DfJ2wXPJhXlJG!-1529450296!-1448731224?collectionCode=ERP&browsePath=2015&isCollapsed=false&leafLevelBrowse=false&isDocumentResults=true&ycord=0
 

The Economic Report of the President is an annual report written by the Chairman of the Council of Economic Advisers. It overviews the nation's economic progress using text and extensive data appendices. The Economic Report of the President is transmitted to Congress no later than ten days after the submission of the Budget of the United States Government. Supplementary reports can be issued to the Congress which contain additional and/or revised recommendations. Documents are available in ASCII text and Adobe Portable Document Format (PDF), with many of the tables also available for separate viewing and downloading as spreadsheets in Microsoft Excel (XLS).

I know – I am putting you to sleep. But for those of you who like to keep up with the economy, let me recommend this 414 page document for several reasons. First, it always contains an analysis of the past year and a forecast of the future economy. The 2015 ERP doesn’t say a lot about 2015 but does have a very complete forecast of the US economy for the coming 10 years. While you might not agree with the forecast, at least you see its composition and causal factors. 

Second, the document is full of historical data. There are charts, tables and figures in each chapter. Even better is the appendix which houses 26 historical tables. The latter makes it easy for you to research questions relating to past inflation, past unemployment rates, and so on. The 26 tables have just about everything you could want from GDP to wages to ownership of government securities.

Finally, the body of the report has several chapters that look into what the current administration believes are key economic issues and goals. The ERP2015 has chapters on Challenges in the US Labor Market, Business Tax Reform, Economic Benefits and the Foundation for a Low-Carbon Energy Future. These chapters contain the explanations and defenses for the Administration’s new budget proposals. These chapters are, of course, very political, biased, and incomplete.

50 Shades of Grey is a movie that my mommy won’t let me see. But I did some research and found that the term “50 shades of grey” has an interesting meaning. It means that any issue may have a lot of facets to it. And one can believe that because the issue is so complicated and multifaceted that one cannot easily come to a simple binary conclusion about it. Thus all the shades of grey mean  you can’t summarize an issue and say it is right or wrong; good or bad; hot or cold. Apparently there is something in the movie about whips and chains but I won’t go into that.

Interesting in the ERP2015 is the whole issue of income distribution. As we know, President Obama is very keen on improving income distribution. His speeches and what you see in the various chapters of this volume constitute a case for improved worker earnings. He also favors entitlements for the poor and middle class and higher tax rates on the rich as means to attain income equality.

While economists might favor the goal, some would argue about the means or ways. Some economists point to a trade-off between income equality and national economic growth. Others worry that Obama’s approach would create a larger and thus riskier national debit.

ERP2015 adds fuel to this discussion. The writers noted that there are three salient facts about US  economic performance – slowdowns in US labor force and productivity and widening of the income distribution. So the President’s economists did an interesting analysis. They asked what might have happened to the nation’s average income if each of these slowdowns had NOT occurred between 1973 and 2014. By doing this exercise we get some insight into the relative importance of each of these three problem areas. The shades of grey are:

            If the labor participation rate had not fallen, incomes would have risen by an additional $3,000 per person.

            If the income distribution had not fallen, incomes would have risen by an additional $9,000 per person

            If productivity had not fallen, incomes would have risen by an additional $30,000.

Can we conclude anything from this exercise by the President’s economists? I think so. While we could have raised incomes with policies that increase labor participation or income equality, the big dog in this contest is productivity. High productivity alone would have increased incomes by 58%. Productivity accounted for 72% of the improvements brought by all three factors. Economists do these kinds of analyses all the time but they are not beyond criticism.We have to recognize that this analysis is counterfactual. We are asking what might have happened in the past had one or more factors behaved differently.  Much depends on the models used. One could criticize this analysis on many counts. Even if the conclusions are correct for the past, that does not mean the same effects would be generated in the future. 

With these caveats, the black or white part of this is the overwhelming role played by productivity in increasing national income. This does not say that policies for income redistribution are wrong or bad – but it does establish a clear pecking order as we think about  the future.

While ERP2015 is clear about policies to improve these three factors as a means to increase national income, there is a clear bias in this report. The bias is in using government spending and regulation to enhance productivity. Another bias is ignoring any adverse impacts of income equality policies on productivity growth. Almost totally silent in these 400+ pages is any discussion of the known and published long-term increases in national debt – and how increases in national debt in the decade ahead will be a drag on national income.

Unrestrained entitlements, aggressive family-friendly workplace policies, expanded regulatory zeal in health and energy, and half-hearted business tax reform contribute to an environment of rising government debt and business uncertainty. The President is right to place his focus on rising productivity. But the debate is not so much about the goal but on how you get it. Too much policy emphasis on income inequality if it does have the above trade-offs promises to hurt all Americans. A more complete and less biased approach in this book would have been refreshing. 

Mo-cro Economics for 2014

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

9. Joe Biden will cackle like a hyena.

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

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

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

13. Downton Abbey will be overtaken by jihadists.

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

2013: Better than Expected by Guest Blogger Buck Klemkosky

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

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

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

Inflation[i]

Industrial Production[ii]

The Fed[iii]

Deficits and Defaults[iv]

The Volker Rule[v]

The Financial System[vi]

The Corporate Sector[vii]

Employment[viii]

Household Debt[ix]

Household Wealth[x]

Energy[xi]

Investable Assets [xii]

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

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

---

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Age of Uncertainty

By Buck Klemosky -- Guest blogger. Buck is the former Dean of the Graduate School of Business at Sungkyunkwan University in Seoul.

“The world seems more uncertain today than at any other time in my life,” stated Howard Marks, a successful money manager for nearly 50 years, to his Oaktree clients. John Bogle, the legendary founder of Vanguard echoes the same message in the New York Times: “This is the worst time for investors that he has ever seen – and after 60 years in the business that is saying a lot.”

The source of this uncertainty comes from the Eurozone, the U.S. economy, the global economy, the Chinese economy and other developing countries, QE3, corporate earnings, confidence on the part of both consumers and corporate leaders, structured deficits and sovereign debt, the fiscal cliff, the depressing state of politics, and government regulatory initiatives

A long list of problems and challenges, to be sure. But they all lead to four possible scenarios for the U.S. economy:

1.       The U.S. replicates Japan’s experience of slow growth and deflation in the next decade.

2.       The U.S. economy falls into a recession in 2013.

3.       The U.S. economy returns to normal with real growth of 3.0-3.5 percent.

4.       The U.S. economy experiences higher than expected inflation (2 percent annually), which could be coupled with a growing economy or a stagnant economy.

Because of the uncertainties mentioned earlier, it is extremely difficult to assign reasonable probabilities to the four scenarios with any degree of confidence. Europe continues to be an unsolved problem with huge risks and much uncertainty. We are not sure what should be done to fix the problem, what can be done, let alone what will be done. The best that can probably be expected is that Europe will muddle through.

The U.S. fiscal situation is a mess. Long term, the entitlement programs need to be curtailed, the fiscal deficit needs to be reduced, and government debt kept at a reasonable level relative to GDP. State and local governments have the same problem, plus the federal government continues to download fiscal burdens to the states. If spending on government health and retirement programs cannot be curtailed, there is no hope of getting federal deficits and debt under control. The present value of all federal entitlement programs is $60-80 trillion versus GDP of $15 trillion in 2012. The programs are not sustainable, especially with the 76 million baby-boomers reaching retirement age and living longer than expected.

Politicians have refused to take any action to solve some of these problems. The fiscal cliff looms ahead. Nothing certainly will be done before the Nov. 6 election, but come January 2013, the Bush tax cuts could expire in combination with massive spending cuts at the federal level. The combination of tax increases and spending cuts could push the U.S. economy off a cliff into recession. Hopefully Congress and the president can put away their partisanship and ideological purity to take actions to prevent the cliff scenario.

The Chinese economy has slowed, not so much by government economic statistics, but by more measurable statistics such as electricity usage, exports and imports of material resources. Global economic weakness and inflation have eroded China’s cost advantages in exports, the main prop of China’s economy. It will make a big difference whether China’s economy will experience a soft landing or a hard landing.

Confidence plays a big role – perhaps a self-fulfilling one – in influencing economic growth. While consumer confidence has perked up recently, they still appear to be affected by the trauma of the financial crisis, the decline of home and stock prices, unemployment, government bailouts, and political uncertainty. Given the depth of the trauma, it may take time for consumer confidence to fully recover. This has certainly been reflected in the stock market. While the S&P 500 has more than doubled in value since the March 2009 lows, investors have withdrawn nearly $500 billion from U.S. stocks during that period, and the trend continues.

Corporate confidence and investment play a big role in economic growth, and right now confidence among U.S. chief executives has reached a three-year low, according to a recent survey by the Business Roundtable. The end result being that corporations are sitting on $2 trillion of cash and not making the capital expenditures needed for economic growth. Corporations face the same uncertainties listed earlier, plus the possibility of new regulations, Obamacare, slowing export markets, and a host of others. It will take sustainable economic growth for them to regain their animal spirits and invest the cash sitting on the sidelines.

The Fed has been extraordinarily aggressive in its monetary policy since the financial crisis and recession. Short-term and long-term interest rates are at historical lows. The Fed has also implemented quantitative easing, QE1, QE2 and QE3, as well as Operation Twist. QE1 and QE2 resulted in the Fed purchasing more than $2 trillion of U.S. government securities and mortgage-backed securities. Operation Twist resulted in the lengthening of the duration of the Fed’s bond portfolio. While QE1 and QE2 had definite upper bounds in the amount of bonds to be purchased, QE3 is opened ended in that the Fed will purchase $40 billion of mortgage-backed securities each month until the employment market improves. The QEs have taken the Fed in directions never taken before. Risks abound, especially the possibility of higher inflation because of the massive amounts of liquidity pumped into the economy and the risk of exit if and when inflation picks up. There is now $2 trillion to $4 trillion of excess liquidity available and where it goes could have good or bad consequences for the U.S. economy.

To quote Donald Rumsfeld, the U.S. Secretary of Defense in 2002, “There are known knowns – there are things we know that we know. There are known unknowns – there are things we now know we don’t know. But there are also unknown unknowns – there are things we do not know we don’t know.”

It appears the world economy today is dominated more by the unknown unknowns. But uncertainty doesn’t always mean downside. There could be an upside to all of the problems and challenges facing the U.S. economy. So  things may not turn out as bad as expected. While the U.S. has been experiencing the slow growth scenario lately, there are some economic positives. Both U.S. manufacturing and service sectors have shown positive growth recently, U.S. home prices have increased 6.9 percent over the first six months of 2012, stock prices are up 14.6 percent over the first three quarters of 2012, corporate earnings, while growth has slowed, have held up in the slow-growth economy, and the U.S. is becoming more self-sufficient in energy.

But the bottom line is that it’s probably wise to be cautious until some of these uncertainties become more predictable and/or resolved. While uncertainty creates both risk and opportunity, it may be better to emphasize safety over aggressiveness in the foreseeable future. There could also be some event not listed above or predictable that could impact investment results. We live and invest in interesting but uncertain times. More things can happen than will happen. But that is what uncertainty is all about.

My Forecasts for 2012

Since it is only a couple days after Christmas I thought I might try something a little different in the blog this time.  All of you are probably still in the giving spirit or in the spirits. So there is no sense in me trying to be too analytical. Many of you are already sick of shopping and you have returned most of your gifts to Walmart so you are open for diversion. Those of you with visiting relatives are posting signs on your refrigerator that indicate that fish and visitors begin to smell after three days.

But this is a MACRO blog and I can’t just blather on about post-Christmas blahs. So what I am going to do is provide you with my forecasts for 2012.

First Peyton Manning will overcome his neck injury and will star with Kim Kardashian in a new reality TV show about the art of hiking a football. I won’t say who will play center but some of you wise guys have already figured it out.

Second, the Indiana University Football Team will win the conference championship in 2012 but will not be bowl-eligible because high school conference winners are not allowed to compete at the university level.

Third, the US election in 2012 will be won by David Letterman. He will run on the Funny Party Ticket arguing that the current batch of DC politicians are not funny and he is.

Fourth, the euro currency will go out of use and will be replaced by the Hungarian forint.

Fifth, Andra Klemkosky will replace Robert Klemkosky as the Dean of Business at SungKyunKwan University in Seoul.

Sixth, small business owners will be given a new Eli Lilly growth hormone so they are not so small.

Seventh, with the FDA closed for roof repair, any drug having gone through testing by movie stars at the Betty Ford Clinic will be approved and available for immediate sale at whatever price the market will bear.

Eighth, Pharmaceutical companies,  Cook Medical, the Post Office, and Topless Bars in DC will become government enterprises managed jointly by Kim Jung Un and the Donald.

Ninth, Vietnam, North Korea, Sanibel Island, and Ireland will become the 59^th and 60^th states of the USA.

Tenth, US rich people will be asked to move to Nova Scotia and Latvia but will be required to send their pay checks to President Letterman.

Eleventh, poverty status will be extended to all remaining US citizens so there will be no need for anyone to have to work or even pretend to work. The unemployment rate, therefore, will fall to zero percent, the lowest level in 362 years, guaranteeing re-election of the Letterman /Bashar al-Assad ticket.

Twelfth, world GDP will be equal to this year’s plus or minus.

Thirteenth, I cannot remember where I left my car keys and the 13^th thing.

I hope you are having a great holiday with lots of spirits and whatever else your usual holiday rituals might dictate. Please do not harm your relatives because some of them might be planning to leave you money. I look forward to bringing you more Macrocrapola in the New Year.