Wolf's Howl is Off-tune:Data Shows Why Macro Stimulus Can't Work

Martin Wolf continues his Keynesian tirade in the Financial Times, “The German model is not for export,” May 8, 2013, page 7. As in the US, a policy debate rages on in Europe as predictions call for impending slower economic growth.  Germany and a few other European countries push austerity.  So Wolf has to beat the Keynesian spending drum even louder to get a hearing for his stimulus advocacy. In this article Wolfe says that much of Europe is doomed to a protracted era of slow growth because Germany and the IMF are encouraging European countries to emulate Germany. Of course it would be difficult for most countries to mirror one of the world’s strongest export champions and so Wolf worries that Europe is in for big trouble.

I have written about the counter-productive results of more stimulus when debts are huge and I won’t repeat all that here. Today I take Wolf to task over misinterpreting the current economic situation in Europe. Wolf says that Germany has been able to replace declining domestic demand by producing more external or foreign sales. He says this causes a big problem for the other European countries because Germany’s surpluses translate into trade deficits among the rest. He says a combination of weak domestic plus weak external spending is killing European countries. I show below that Wolf’s assessment is not the case. Worse, the data shows vividly why more macro stimulus cannot be the answer to our slow growth woes. 

I went to Eurostat – a great place to look at macroeconomic data for the EU countries. http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/  I look at GDP data as a way to see how EU countries have fared since the crisis hit. More specifically I examine key spending data. I looked at changes in the data between 2006 and 2012. In 2006 the EU economy was chugging along before the financial crisis hit and spread. Let’s call that the “before” photo. Sort of like the picture of Terry Bradshaw before he went on his diet. 2012 is the after shot – after the recession and after the economy had several years to recover. Terry says he lost 40 pounds. What happened to the EU?

I first looked at consumer spending. From reading Wolf you might think it had declined – or it was still struggling. If we look at all 27 EU countries together, the total growth of consumer spending increased by about 12%. Germany did a little better – about 14%.  But Germany was among the worst countries. 20 EU countries did better than the EU average. Slovakia led the group with an increase of 61% in consumer spending. Among this group of 20 countries having stronger than 20% increases in consumer spending were Switzerland, Bulgaria, Norway, Poland, and Lithuania. Of course, there were several countries with dismal domestic consumption spending and those included the usual suspects – Iceland, Ireland, Greece, UK, and Portugal. As a benchmark, US consumption grew by about 17% from 2006 to 2012.

What about Germany’s great trade splurge? Germany’s export sales increased by 29% from 2006 to 2012. That was stronger than its domestic consumer spending growth but clearly short of the US export growth of 45%. The overall EU’s export growth was about 24% but 21 EU countries had export sales growth faster than the EU average and 16 of those exceeded Germany’s rate. Slovakia managed an 82% increase in export sales. If most EU countries had bad trade deficit outcomes as Wolf alleged, it was because of their even stronger growth of imports. That means domestic spending must have been increasing – that is, Europeans were consuming more at home – some of the products were produced at home while others were brought in from abroad. That doesn’t sound like deficient domestic demand to me.

So why are these EU countries having such a bad time? The answer which Wolf never discusses is in what the EU calls fixed capital expenditures or what is sometimes called gross private domestic investment. Fixed capital includes domestic spending on plant, equipment, housing, etc. This spending category is interesting. Germany’s fixed capital was 91% lower in 2012 than it was in 2006. For the whole EU the number was -90%. For the USA it was -77%. EVERY EU country showed negative change in fixed capital spending from 2006 to 2012. The worst performance was from Greece (-115%) and the best from Sweden (-63%). If anything has not recovered in the world economy it is business spending on plant and equipment and national spending on housing.

Wolf is so wrapped up in Keynesian macroeconomic stabilization policy that he can’t even see that the main problem with slow growth and a return to stability in the EU and the US is mostly located in one single part of GDP. There is no real export issue and there is no consumer spending issue. The issue is that no country has sufficiently addressed the things that caused the crisis to begin – the housing and financial crises. People are not buying homes and firms are not borrowing to expand. It is pretty simple. The FED and ECB flooded the world with liquidity and drove interest rates to nothing. 

The US government introduced historical levels of fiscal stimulus. Yet we in the US are not growing much faster than our European counterparts.  More stimulus from monetary or fiscal policy means unsustainable debt and financial bubbles. Yet Wolf and other liberals continue to want more of the same. The data suggest that what we need is what we needed from the beginning – a satisfactory response to housing and financial problems. Yet most experts continue to admit after half a decade that they still have not brought forth anything to tackle excessive risk, too-big-to-fail, transparency, and various other elements of the housing/financial crises. I guess it is easier to cry Wolf (for more stimulus).

Cartoons

Dear friends,

I want to thank my college buddy Jim Gibson for adding a cartoon to this week’s blog post. Jim played defensive tackle for Bobby Dodd at Georgia Tech in the 1960s but was even more well known for the cartoons he posted on the football bulletin board. The coaches loved being lampooned by Jim. Jim also was recently given credit for the Georgia Tech logo he designed almost 50 years ago that is still in use today. Go Tech! Hopefully Jim will draw more cartoons for us in the future. 

Global Economic Growth: the Pause that Refreshes?

Any athlete knows there are times in a contest when you rest. A marathoner can’t sprint the last mile if she tries to sprint all the miles. The sprint takes it out of you. The world economy was on a sprint before the last crisis hit. The downturn didn’t hit all places at the same time – but a look at world growth in 2005 and 2006 looks like a global economic sprint. Some policymakers long for a return to those heady days. I try to explain below why a fast return may not be the best approach to sustainable gains and lower unemployment.

The average annual growth rate of the world's advanced economies (35 countries labeled so by the IMF) from 1995 to 2004 was a modest 2.8 percent. The median growth rate of the real GDP of these economies  was 3.9 percent in 2006. In 2006 the top 17 countries had real GDP growth rates ranging from 3.9 percent to 10.1 percent. IMF projections for 2014 have the top 17 countries growing anywhere from 1.6 percent to 5.5 percent. (The data and the list of countries can be found in table A2. Advanced Economies: Real GDP and Total Domestic Spending  http://www.imf.org/external/pubs/ft/weo/2013/01/pdf/tables.pdf )

Clearly 2006 was a very strong period of world economic growth. The strong growth was shared across most countries. The recession stopped all that with no change in world growth  in 2008 and a contraction of 3.5 percent in 2009. World growth returned to positive but averaged only 1.4 percent per year between 2011 and 2012.  We are clearly still far off the torrid growth pace of 2006. With respect to these 35 countries the great majority will be nowhere near their 2006 paces even by 2018. The IMF forecasts the following real GDP growth relative to the strong growth of 2005 and 2006:

•   4 countries will return to past high growth by or before 2014: US, Australia, Japan, Norway
•   6 countries will return to strong growth by 2018: Germany, France, Greece, Portugal, UK, Taiwan
•   25 countries will not return to strong growth rates by 2018.
•   Some 12 years beyond 2006, only 10 countries are predicted to return to strong economic growth. Some of the 25 countries on the list that will not repeat past strong growth include Italy, the Netherlands, Canada, South Korea, Iceland, Estonia, Singapore, Czech Republic, and Hong Kong.

For people in many of these countries, this slow growth is not desirable. Unemployment is too high and many business firms are having trouble staying afloat. Interest rates are low preventing savers from reaching their investment goals. Houses remain empty or unsold and excess capacity deteriorates. Countries have large debts that limit their use of traditional fiscal policies. The negatives are stark and frustrating.

But there may be a silver lining. Like a pause in the runner’s pace, this growth respite is not all bad. To understand this we look back at the 2005/2006 period’s strong growth. With so many countries growing so quickly at the same time, we placed impossible demands on world commodities markets. To produce so much economic output for the world takes inputs. Output requires energy, steel, aluminum, copper, rubber, and many more commodities. Demand for food commodities also spiked. Bringing all this together we saw commodities prices ebb by 2002 and then increase dramatically thereafter until falling sharply in the middle of the global recession.

The prices of many commodities doubled (or more than doubled) in the run-up after 2002. While the global recession caused a temporary hiatus in inflation the subsequent economic recovery witnessed a return to strong commodity price growth. Recent pessimism about economic growth in Europe and China has taken some steam out of commodities but with the US, China, and many other emerging countries showing resilience, commodity demand and commodity prices are ready to resume a rapid upward clip. The only real thing that will forestall them is a more gradual return to stronger growth among the leading countries.

A quicker turnaround in world growth sounds good on the surface but if it brings with it another bout of extreme commodity price inflation, it is doubtful that firms will be able sustain a stronger pace of output in the face of rapidly increasing business costs. We see now how uncertainty about rising medical costs and taxes puts a lid on hiring – another bout of rising commodity prices would just add to that.

It seems perverse but right now good economic news is not necessarily unqualified good news. We want to finish the race in first place. Running too hard right now is not the way to do it. It might be frustrating watching some runners catch up, but we need to have some patience and some trust that the tortoise might again beat that pesky hare.

Quit Yellen and Start Jellin’

If Ben Bernanke steps down next year as Chairman of the Fed, his successor might be Janet Yellen. A lot was written about her last week. The following Yellen quote from a recent speech was highlighted in several articles,

"With unemployment so far from its longer-run normal level, I believe progress on reducing unemployment should take center stage for the [Federal Open Market Committee], even if maintaining that progress might result in inflation slightly and temporarily exceeding 2 percent."

This seemingly innocuous statement deserves more attention, especially since until 1978 the Fed had a singular mandate – to use its tools to pursue price stability.  The European Central bank (ECB) also has a similar singular mandate. But the Humphrey-Hawkins Act of 1978 created a dual mandate for the Fed – including price stability and full employment as its two key goals.

While Yellen’s above quote sounds reasonable there are some who acknowledge that until 2008, the Fed acted as if it still operated largely with a single price stability mandate. Attaining full employment was a secondary objective at least until recently. Fiscal Policy was thought to be the more appropriate means to deal with employment and economic growth. There are some who believe that Yellen and some others on the board would like to permanently create more balance between the two goals – raising the stature of employment and growth in the Fed’s work. Yellen will hoist full employment above price stability for the foreseeable future.

It is understandable that national interest should be concerned about employment and economic growth. It seems reasonable to want to aim all our policy guns at this plague. But many things that seem reasonable on the surface sometimes seem dead wrong after looking into them more closely. So that’s what I want to pursue here. As you will see below, I conclude that changing the Fed’s objective to favor employment would be very risky, inefficient, and wasteful. So let’s get started.

First, note that we believed in a single price stability mandate for the US Fed for about 60 years. The ECB insisted on this single mandate and despite what appears to be some wavering recently, the ECB continues with it. There must be some strong reasoning behind the Fed focusing on price stability.

Second, recall that John M. Keynes invented something called the liquidity trap. Modern Keynesians dispensed with this extreme behavioral assumption but maintained models that always had a preference for fiscal over monetary policy as it had to do with affecting real variables like employment and output. So Keynesians didn’t think much about using monetary policy to control employment and output.

Third, Monetarists challenged Keynesians by admitting that in the short-run, monetary policy could have a very large impact on employment and output. But Monetarists insisted that these impacts were possible only if the stimulus policy was unexpected – it had to be a surprise to be effective.  In the longer-term, the effects would dissipate as the impact was fully understood. So-called Neo-Keynesians agreed that such monetary surprises had only a short-term impact. Both groups of economists agreed that part of the undoing of the short-term impacts was eventual increasing inflation and interest rates.

Fourth, much of the discussion today assumes that there is no need to worry about the Fed’s recent and future monetary explosion having an upward impact on inflation and interest rates. But history is clearly rife with examples of inflation catching up when least expected. Policymakers have been caught many times with their guards down. Inflation was not there and then it was, like magic.

Inflation is like a fire. I once had a small fire in one pot on my stove. I could not believe how quickly it spread. Once inflation spreads, the FED acts quickly to eradicate it. Episodes of extreme fed tightening have led to either pronounced decreases in economic growth or absolute reductions in output. When the fire spreads you have to bring out the big hoses – and this pretty much ruins the kitchen – until you have time to rebuild. The below link takes you to a discussion where the author points out several, dismal time periods following tight money – 1956, 1960, 1968, 1973, 1978, 1980, 1989, and 2000 http://www.econbrowser.com/archives/2006/02/should_the_fed.html

The Fed swears it will do better this time. It will know when to pull out the money in a reasonable way that does not disturb the economy. History is not on the Fed’s side. If you believe the Fed I have a fire insurance plan to sell you.

Fifth, Yellen and others are making us all take a very clear risk. Is it worth it? They say – okay, it is possible that focusing on employment today will bring more inflation sometime in the future.  But they believe that this risk looks like chicken-feed compared to the pains of the unemployed today. But again, they do not fully explain the problems of inflation. As I said above, when inflation comes it might first rise slowly and to levels that are only a little above the 2-3% range.  But experience in other countries and the US shows that once inflation starts rising it is very hard to contain. That is why countries try so hard to maintain price stability. Turkey, Brazil, and Israel are countries that experienced inflation rates above 100% per year in the recent past. Talk to someone who lived in those countries and you know why people prefer price stability.

You believe it can’t happen here and now. But notice that hyperinflation has to start somewhere. It starts at 3% and then spreads from there. And by the way it usually got going because governments could not constrain their spending and the central bank monetized and compounded these political errors.

When inflation does get started it messes everything up – workers often get higher wages but since inflation rises faster than their incomes they get lost in the dust. Interest rates rise and make creditors feel richer until they find out that prices rose faster than investment income. People spend much too much of their productive time learning how to protect their money balances as they buy cuckoo clocks and other collectibles instead of bonds and stocks and real estate. Firms prefer producing later because prices will be higher than they are today.

In short, using monetary expansion is a very risky way to target employment and economic growth. It might work for a little while but the Fed and the rest of us know that sustainable increases in the economy are not going to come until the nation’s real problems are attended to. The US faces many threats to employment and output including housing, financial, demographic, global competition, and more. The more we fiddle with expansionary monetary policy the more we raise the risk of slower growth and divert attention from the real solutions. My advice – quit Yellen and start jellin’. 

Why We Are Lousy Investors by Guest Blogger Robert Klemkosky

 We have known for a long time that greed and fear play a prominent role in investors’ decisions. A mix of both is healthy for the markets; greed makes us strive for higher returns, which also entails higher risk, and fear makes us avoid excess risks or reckless risks. The trouble starts when greed or fear gets out of control. Too much greed and asset prices go up too much and bubbles form, such as technology stocks in 1996-2000. Too much fear and selling occurs and asset prices plunge. Of the two, fear can be a more powerful force than greed because it can turn into a panic and result in a financial pandemic such as what just occurred in 2008 with stock prices and the credit markets.

In reality, investors should follow the advice of Warren Buffett and buy on fear and sell on greed. But emotions and psychology prevent most investors from doing that consistently. Investors do the wrong thing at major turning points in the market, such as buying record amounts of mutual fund shares at market peaks (first quarter of 2000) and selling record amounts of mutual fund shares at market bottoms (fourth quarter of 2002). And selling stocks at the bottom of the bear market in March 2009 only to see the stock market go up 100 percent in the next nine months.

We all like to think of ourselves as rational and logical, but there is much evidence that we are far from national and logical when making investment decisions. Behavioral finance is a discipline that analyzes how our emotional inclinations and psychological biases affect and influence our investment decisions, both as individuals and collectively.

Overconfidence is one of the major biases that affects investment decisions. We consistently overestimate our knowledge, skills and abilities. We have illusions of control even if events are more random. We overestimate the precision of information and underestimate risks. If we have been successful, we have a tendency to become more overconfident and take on more risk. So don’t always assume that you have better knowledge and skills than others and don’t ever equate stock market performance during a bull market with investor IQ.

There is also a disposition effect in that investors have an aversion to losses. They hate losses about twice as much as they like gains, and will take risks to avoid losses but not gains. One result is that investors sell winners and keep losers, exactly the opposite of what they should do, especially for tax purposes. Investors  hate to admit mistakes which include stock market losses, so there is also regret aversion.

Investors have a tendency to extrapolate the past, especially the recent past. The human mind is not good at figuring out the probabilities of future events, so the easiest thing to do is assume past trends will continue. We expect bull markets to continue as well as bear markets. We select stock or funds that have done well in the past, expecting that performance to continue in the future. We miss major turning points in the market.

Investors have beliefs and convictions about stocks and the market. When presented with information, they have a tendency to accept or listen only to information that confirms and supports their beliefs and filters out information that conflicts with their beliefs and experiences. The rational thing to do would be to seek out information that does not support our beliefs and convictions. This is referred to as confirmation bias.

When we look back, things seems much more obvious and we delude ourselves into thinking that events were predictable and we had the foresight to make those predictions. In other words, we forget our original forecasts or thinking and use the outcome as if it was our original forecast. We think events that happened were predictable and events that didn’t happen were unlikely. It’s  why we take credit for our successes and blame others for our failures.

Lemmings are rodents that would follow each other over a cliff to their deaths. Their behavior explains a lot about investor behavior and is sometimes called herd mentality. Investors are very comfortable going along with everyone else which is usually what happens in bull and bear markets. It seems investors get greedy together or get fearful together, which is why we have the bull and bear markets.

People feel comfortable investing in companies they work for or companies in their locale. It’s a reason why investors are underrepresented in stocks outside their country. But what happened at Enron, Lehman Brothers and other companies shows the risk of investing in company stock to the detriment of a diversified portfolio. We also become very loyal and attached to a stock that, for example, has performed well and has made us a successful investor. So investors have a tendency to ride it up and ride it down. They forget that a stock doesn’t love them and doesn’t even know they own it.

Individuals have a money illusion bias in that they don’t factor inflation into long-term financial decisions, such as providing college educations for their children or retirement. At 4 percent inflation, money loses half its value in approximately 10 years, and goods and services cost about 50 percent more in nominal terms. People also underestimate the power of compounding. If you invest $1000 at 6 percent for 30 years, you have wealth of $5144 at the end of the period. If you take on a little more risk and invest at 8 percent, you nearly double your ending wealth, $10,002, versus investing at 6 percent.

Understanding the basic concepts of behavioral finance will make us better investors. We don’t need a degree in psychology to use the concepts of behavioral finance successfully. Being cognizant of the behavioral biases and not succumbing to emotions, especially fear and greed, will go a long way toward better investment performance.

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Chained CPI -- Much Ado About Nothing

A lot is being said about President Obama’s brave gesture to control entitlement spending in his new budget for 2014.  He is apparently compromising by agreeing to change the cost-of-living adjustment for social security benefits. He says we can save some money by using a chained price index instead of a wage earner index. I thought it was illegal these days to put wage earners in chains, but maybe I don’t understand this whole thing.

The President’s proposal, according to my absolutely perfect estimates, will save Social Security (SS) approximately $2.7 billion per year. Keep in mind that our current annual government spending is closing in on $4 trillion. You don’t have to be a math major to realize how small $2.7 billion is compared to $4 trillion. Graphics can sometimes work. Imagine Dolly Parton’s bra. That’s what the government spends each year. Now imagine…Never mind. You know what I mean.

The Labor Department has data on price indexes so I compared the chained price index (CPI-C) values to those published for the Urban Wage Earners Price Index (CPI-W). We don’t actually know what inflation will be in the future but if it is anything like it was in the past, then we can make estimates of the effect of the new index. The CPI-W is what is now used to adjust social security payments for inflation each year. The President wants to replace it with the CPI-C. Comparison data is available from 2000 to 2012 on the BLS website. Using the price index data I calculated two annual inflation rates for each year from 2001 to 2012.

Guess what I found? Guess Again. Isn’t this fun! Anyway, the differences between the inflation rates of CPI-C and CPI-W didn’t add up to a hill of beans. In 2004 the average SS recipient would have lost $15 if the government had used the CPI-C instead of the traditional CPI-W. Seriously – that’s about a buck a month. 2010 would have been the worst year for social security recipients – they would have lost $94 that year if the CPI-C had been in place in that year or just a little more than $8 per month (a pack of Marlboro?)

If we add up over all 12 years from 2000 to 2012 I find that President Obama’s huge concession would reduce the SS benefits of the average recipient by a little more than $513 (in 2013 prices). During those 12 years this person would have received more than $168,000 from SS. The proposed approach will have cost them $513. Please! You people talking about the President’s brazen compromise, please think about these numbers. He is causing almost no harm to SS recipients and he is doing absolutely nothing to resolve the national deficit and debt problem.

Why do we see such big numbers reported in the news? The answer is that they are projecting changes for the future. They do not know what the future inflation rate will be so they are making forecasts. One thing is for sure about the future – they are projecting that inflation will increase. So when they estimate that the impact on us will be something like $130 billion in the future, they are basing this number on a lot of inflation in the next decade. $130 billion received in say 2023 will be based on people having MUCH HIGHER incomes and social security benefits. Comparing $130 billion a year to current budget numbers is the old Apples and Oranges trick. This trick is meant to scare you.

One more point. There is nothing to guarantee that this proposed change to a chained index will always save the government money relative to a fixed-weight wage earner index. It is true that a chained index allows for the calculated price level to incorporate buyer’s adjustments away from the highest priced goods. But the truth is that people do not always behave that way. If during a particular year we have people gravitating to very popular but higher prices goods, then the chain index will show a HIGHER inflation rate than the CPI-W. 

Maybe the president should stop looking for things that are politically pleasing and focus on the real business of budgets and compromises. As for you – like good consumers everywhere you can beat the system.  Recall that the CPI is an average of prices paid by the “average” household. Don’t be average! You can make your future SS dollars go farther if you work hard at being a good buyer. If the price of orange juice is going up, then just drink more drinks whose prices are not going up. Try a nice tall glass of JD!

Snowstorms, Windshield Wipers, and Employment

After last week’s employment rate announcements, the US stock market took a big dive. Many words were written about the dire information in the report.  The report published by the Bureau of Labor Statistics consisted of about 20 short paragraphs accompanied by about 30 data tables and can be found at http://www.bls.gov/news.release/empsit.nr0.htm

I am sure that people thousands of miles away from the US will be impacted by the reactions to this report. Bus drivers in Delhi will be discussing the terrible situation in US labor markets. Angry teens in Bangladesh will set a few Russian Ladas on fire to show solidarity with union members in Wisconsin.  You get the picture – information moves fast and at long distance in 2013.

Except for the back of my father’s large and muscular hand, nothing came fast when I was a kid. I recall television advertisements that allowed me to send a few cents to someone somewhere and in return I would get a toy submarine. If you put baking soda in that toy submarine it would submerge in your bath tub just like a real submarine. Anyway, I can remember that it took weeks if not months for that stupid toy submarine to show up in my mailbox at 3170 Oak Avenue. I would check the mailbox every day! Girls were slower back then as well but that is another story. You get the picture. Children were supposed to learn patience.

The question is whether we are better off or not with all this speed today. I’d like to move on to phones and texting but let’s stay with the employment release of last week. The key message of this release is that while payroll employment increased in March, it did not increase enough to provide further evidence of a stronger economy. That is, the 88,000 increase in employment was a big disappointment. But was it really?

First, keep in mind that monthly employment changes are typically small. The total number of people employed in the USA in February of 2013 was about 135 million. So the percentage increase of 88,000 in March employment was about 0.65% (=.0065). If I lost 0.65% of my body weight I would lose about one tenth of one pound. Woowee.  Anyway, notice that even if the employment change had been more like 300,000 new jobs in March that performance would only amount to a tiny percentage increase. What matters more is the future course of employment changes. At 300,000 new jobs per month for a whole year – employment would increase by 3.6 million or by about 2.6% for 2013. That would be pretty nice. So far in the three months of 2013 employment has increased by an average of 168,000 per month. At that rate we might get 2 million jobs for the year for an increase of about 1.5%. To conclude this first point – the 88,000 was nothing to write home about – but what matters less is one month and what matters more is the future trajectory. The first quarter is not where we want it but by no means should we be burning our bras and/or jock straps.

Second, what does the 88,000 increase tell us? The answer is “not much.” Suppose you are like me and your weight varies a lot. So let’ suppose my typical weight change is about plus or minus 50 pounds per month. One month I gain 60 pounds. The next month I lose 40 pounds. Suppose I tell you I gained 55 pounds in March. Is that evidence that I am going to gain a ton of weight in April? In May? It does not. My weight swings a lot from month to month. The typical upswing or downswing is around 50. It would take a much larger swing in one month for you to bet on me gaining again and again. Of course, you’d bet more money if you saw me gaining more than 50 pounds each month for several months.

A statistical analysis of the payroll employment figure shows very high variability from month to month – to the tune of about 90,000 workers. Next to that the 88,000 means very little. It tells us nothing about the future.

In summary, the one month change of 88,000 is not only tiny but it is not statistically large enough to suggest anything is happening in the way of a trend. I can tell you that jobs have increased by about 504,000 in 2013 and in the 12 months between March of 2012 and 2013 the increase in payroll employment has been 1.9 million. The more data we have, the more complete the picture becomes. Yet the market knew most of that before Friday morning and the market seemed to go crazy because of the 88,000 announcement. Even the local Bloomington Herald Times had many articles analyzing last month’s dismal number.

Why does a seemingly meaningless number get so much attention? Aside from the fact that the news media has to sell information, my guess is that we get all this drama because we demand it. And we demand it these days because the future is so uncertain. Will we have a double dip recession? Is the economy on the mend and about to grow quickly? Does the economy have several years of slow growth ahead? If we knew the answer to these questions, we could plan our lives better and perhaps more profitably.

This uncertainty theme hits home if you think about driving in a snow storm on a road that you don’t know well. You do know that there are many twists and turns in the road. But with the snow, you cannot see more than a few inches ahead of your windshield. In such a situation, you are staring intently ahead and every time you see a change in the scenery, you are ready to begin turning the steering wheel in one direction or the other. Turning too slowly means you might miss the turn. Of course turning because of a false signal means you quickly steer the other way. You are on top of the situation and you watch everything that moves! You adjust quickly. Sometimes the information is correct and sometimes it is not. But you are watching every change as if your life depended on it.

Our deeply uncertain economic times are like such a snow storm. Each time an economic number comes out we react to it as if it had great content for the future. When we discover it had no such content, then we react to that discovery.  Telling the government to slow its delivery of monthly news is like asking for your windshield wipers to quit working. Ignoring highly erratic data is like driving straight ahead on a curvy road. Since there is always uncertainty about the future, we are stuck with living through a roller coaster ride of economic news. But with uncertainty heightened as it is today the roller coaster is no less than the infamous Kingda Ka.

One more point.  We learned nothing new about employment in March of 2013. The economy and employment continue to be deeply affected by very long-term factors (e.g. demographics, industrialization, globalization, government policy and regulation) and dealing with the aftermath of a deep and prolonged global financial crisis. Few spots in the world are growing rapidly and despite a lot of policy experimentation, both Republicans and Democrats are going to be disappointed if they are hoping to see anything but lackluster growth for the time being. Even if we got a huge spike in employment in April or May it won’t mean much of anything insofar as the big picture is concerned.

By the way, I am happy to report that I have not changed my tune in the last three years – in March of 2010 I said we would not have any real growth until we overcame three problems. My reading today is that we have made some progress on only one of the three and thus we are firmly stuck in economic purgatory. See my post – The Whack-A-Mole Recovery…. http://larrydavidsonspoutsoff.blogspot.com/2010/03/whack-mole-recovery-or-good-news-is-bad.html

Davidsonian Economics and the Death of Macro

Macro was born and it is in the process of dying. I am not being melodramatic. Lots of things have finite life cycles. Take the hula hoop. It was great while it lasted and back surgeons are still raking in the dough as a result of it. But it is now hard to find a hula hoop. The death of macro is not necessarily a negative thing -- I would call it evolutionary. It came, it served, and then it outlived its usefulness. I will argue below that we will replace it with something I humbly call Davidsonian Economics. I am really crappy at naming things so if you are among the first 10,000 people to write back with a better name I will give you 79% of my future royalties.

To explain the process and what this means to us requires me to write a little about the evolution of macro ideas. I am going to try to do this in two ways. For normal humans I am going to summarize the main points and use a lot of bolding and underlining. Soon you can go off to your regular routine – e.g. kissing the dog and petting the wife. For those of you afflicted with bottomless boredom and something akin to a PhD, I will drone on with details until you are ready to rent the full library of Fidel Castro’s speeches.

First, the brief summary and by brief I mean less than 743 paragraphs. Great ideas always stem from real human problems. When I grew up polio was a disease that affected too many people. Scientists then found a cure and mankind was made immeasurable better. The results are not always so clear for social sciences – but during and after the Great Depression a lot of people wanted to try to “cure” us of future depressions and recessions. John Maynard Keynes was one of those people.  His work was carried on by economists we call Keynesians.

Today we are faced with the lingering impacts of a Great Financial Crisis and World Recession– and many great minds are trying to find a cure for the latest social science disease – slow economic growth. So if you believe what I write below then you have become a Davidsonian – and we will have started a new economics we will call the Davidsonian School of Thought. Our colors will be Cream and Crimson and our favorite liquor will be of course JD. I hope to add some cheerleaders soon. Now to the evolution we call macro...

Before the 1930s – No Macro – Adam Smith’s “invisible hand” cured most economic disturbances; economic growth theory focused on supply factors. Neither monetary nor fiscal policy was used to offset short-term recessions. Monetary policy was geared to keeping prices stable in the long-run.

1960s Keynesians said workers were slow to discover rising prices and could be “fooled” into supplying more labor whenever asked. Governments could fool firms into thinking prices and profits would rise when government stimulated demand. An increase in government spending or a reduction in income tax rates would, therefore, lead to more demand for goods and services and firms would produce more goods and services. Workers would find out later that their wage increase didn’t buy more goods and services as they discovered the higher prices of goods and services. By then the recession was healed. Keynesians preferred fiscal policy over monetary policy.

1970s Neo-Keynesians and Monetarists saw the Stagflation of the 1970s and emphasized what happened when workers caught on to the policy-demand-inflation game. After a period of rising demand and economic growth, workers would want bigger wage increases and this led to another recession – but this time with higher inflation. Ugh. Stimulus worked as long as you could fool the workers about the cost of living. These economists saw the risks involved with macro policy but gave it a green light so long as policymakers didn’t get carried away.

1980s Rational Expectations believed that workers, after living through inflation and stagflation, would be better at incorporating inflation expectations into their current wage bargains. Thus they were harder to fool. This took the bang out of the ability of government to stimulate the economy with fiscal or monetary policy. If policymakers were not careful, a stimulus would have little to no effect on employment and output.

1980s and Beyond Neo-Supply-siders seeing that the impact of demand-based stimulus policy had peaked started focusing on using policies that directly impacted the decision to employ workers and produce more output. While supply-side policies do not adversely affect inflation they do often appear to worsen the income distribution. Politically supply-side policies are a little like gun confiscation advocates in Nevada.

2013 and Davidsonians find us with a new behavioral assumption – that politicians are dumber than rocks and cannot be trusted to fashion a successful economic program. Despite really strong (as in kimchi) economic demand stimulus, the US economy continues to clank along at school-zone speeds. Even the mention of new expanded stimulus programs sends shock waves over national debt reaching crisis proportions. Such policies immediately create uncertainty and very conservative behaviors on the part of workers and firms. 

Notice that if you are not asleep yet we have gone full circle in the last 75 years from a time when we had no demand policies; to when they were lauded; to a precautionary phase; to no impact; to finally a stage of perverse impact. That puts us back to where we were before the 1930s.

We are back to something more like the Classical Theory. The only way to improve employment and economic growth is to restore competition and remove regulations that prevent wages and prices from clearing markets.  Today Keynesian stimulus programs reduce confidence and need to be replaced by financial and aggregate supply policies that raise confidence and reward firms that improve productivity and control costs. The days of fooling firms and workers is over. There is no magic wand. You can't get something for nothing. Cyprus reminds us all one more time of the dangers to debt. What makes the economy grow has never changed -- entrepreneurs and businesses need to innovate and take risk. We need an environment that rewards and facilitates that process. 

Pointing a Finger at Currency Manipulators

President Obama famously said that he wanted to increase the export sales of the US  -- he said he wanted to double their value between 2010 and 2015. In July of 2010 I wrote about this and among other things I likened this doubling to something like the US basketball team scoring 200 points per game in an international competition. I will show below that based on two years of experience, it appears to be even less likely the US will double exports. I bring this up not so much to gloat but so as to head off what appears to be right around the corner – a vigorous attempt by Obama’s administration to paint other countries as exchange rate manipulators and international cheats. It is no secret that the dollar has been rising against the yen and euro – and that portends the usual finger pointing. I try to explain why that approach won’t help matters at all and could make the international trade situation worse. What our government won’t say is that the dollar has been depreciating for many years now and remains a shadow of its former self. If any country has used currency depreciation to its advantage, it is the USA.

Let’s get to the trade data first. I used standard GDP data from the US Bureau of Economic Analysis. http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&910=X&911=0&903=128&904=1999&905=2012&906=A

As in my last post on this subject, I use trade data that is in the real terms – that is, the figures have filtered out any price change. In 2010 US exports of goods and services in real terms equaled about $1.67 trillion. In 2012 they had increased to $1.84 trillion, an increase of about 10%. But to put it into a longer term perspective, US exports were $1.19 trillion in 2000. This means that despite a weakening currency it took 12 years for exports of goods and services measured in real terms to increase by 55%. If we ignore the exports of services and just focus on merchandise, the story is similar. US exports of goods in 2012 were $1.54 trillion increasing by about 20% since 2010 and by about 96% since 2000. Exports of goods took 12 years to almost double and increased by about 20% in the last two years. So how can Obama expect to double them again in five years? It is not possible.

Let’s not hold the President to a 100% gain in five years – let’s just see what it might take to keep the champagne flowing for a while. During the last two years the US dollar fell. It fell against the currencies of Canada, China, and Japan but it rose against the euro. The trade-weighted value of the dollar fell by about 10% in those years. Thus, the large improvement in US exports of the last two years seems to have been aided by a depreciating dollar against many foreign currencies (except the euro).

But that information does not in any way establish a strong link between exchange rates and trade results. A look back at the dollar since 1999 shows the dollar has depreciated even more. The trade weighted dollar continuously declined against the world’s major currencies during the time from 2002 to 2012. It declined in those 10 years by more than 20%.  The dollar declined even more against the Japanese yen, Chinese renminbi, and Canadian dollar. The dollar fell against the euro by approximately 50% during those 10 years and despite some recent appreciation of the dollar against the euro, the dollar is still almost 20% below the euro’s beginning value and some 30% below its value in 2002.

As our government starts pointing its finger at China and other countries as currency manipulators, it will do well to understand a few further points. What matters to a country is its net exports – not it exports. Net exports are defined as exports minus imports. For example, if exports double next year while imports triple, the net impact of exports AND imports on spending and employment would be negative. So while we are doing cheers for export growth, what do we know about imports? If we measure from 2010 we find that US goods and services imports measured in real terms increased by 7% and since 2000 by 37%. As a result the US net export balance improved modestly from $-451 billion in 2000 to -$420 billion in 2010 and to -$402 billion in 2012.  So while this key balance has improved we could say it improved by about 4% in two years and by about 11% in 12 years. That’s not much improvement given all the currency depreciation we have witnessed.

Why didn’t we do better than that? What can the President do to make exports AND net exports improve more quickly in this country? The answer is that it isn’t easy. Lasting trade improvements come from durable and real improvements in global competitiveness. Exports will rise and imports will fall if the people of the world increasingly want US goods and services. What makes our goods attractive beyond the current exchange rate? For one thing it helps if our trading partners are strong and growing. We should hope that Europe, China, Japan and other key trading partners find good ways to exit the world slowdown and grow more rapidly. The more they grow, the more they will buy from us. 

But we also must have the best goods and services at the best prices. We need an economic environment that makes firms freer to compete globally. While that involves breaking down foreign barriers it also means having clearer and more supportive regulations as they relate to business activities and costs. The current environment in the US is not conducive to major industry investments in competitiveness. Policy uncertainty is rife with respect to national debt, Fed stimulus, energy, banking, health, and much more. "Depreciating" government regulations would do much more right now for our trade balance than would depreciating our currency!

President Obama could greatly improve our trade performance and that would be an important source of economic growth. But he needs it to be a major and clear objective –not just a talking point. Free trade agreements with Pacific and European counterparts would help but are no more than hot air given the President’s clearly expressed desires to support environmental and union demands. Clearing up uncertainty about federal government business regulation sounds good but there is little evidence of any real focus there. It will be a lot easier for Obama to point his finger at currency manipulators and shift the blame elsewhere. Does that sounds familiar?

Velocity, Kleenex, and Drugs

I had a cold last week. I blew my nose so many times that the stock of Kimberly-Clark Corporation increased by 10%. I also took some pills. The pills sometimes work for me but I must have waited too late – as the waterfall from my nose kept up for at least three days. Anyway, as my cold was appearing to diminish I wondered if I should stop taking the pills. It is a dicey situation – if you stop taking the pills your cold continues and maybe even worsens. If you continue taking them and you are really on the mend – it dries you out so badly that it starts a dry cough that sometimes makes you even sicker. The Fed is in a similar situation and I believe the Fed is about to give us all a major dry cough. Below I try to explain why something called monetary velocity is at the heart of the Fed’s dilemma.

According to the popular M2 measurement of money, the value of the money supply increased from $7.3 trillion in 2007 to over $10 trillion in 2012. The increase was about 38%.  More striking is the performance of something called bank reserves – something the Fed has more direct control over. Reserves went from $94 billion in 2007 to $1.6 trillion in 2012. What the Fed intentionally injected into the system increased by 17 times.

This is not news – but it does quantify two things – the Fed was extremely active in injecting money and the result is a lot more money in the financial system. Ordinarily this kind of aggressive stimulus administered in a recession does the following – reduce interest rates, increase bank borrowing, increase spending, and subsequently increase output and employment. In the case of 2007 to 2012, we are all frustrated that the monetary expansion did not have a larger impact on output and employment. Fed Chairman Bernanke and most of his advisors want to continue the stimulus. In a recent speech Bernanke intimated that the Fed (1) despite an economic recovery that begin in 2010 would not begin to remove the money from the system and (2) would not sell government bonds from its portfolio, simply allowing those bonds to mature. What do these two statements mean?

In Forbes the title of a recent article was “Fed’s Balance Sheet Swells to a Massive $2.9 trillion on Treasury Buys.”  I wish my balance sheet would swell a little too! That was in 2011 – now the balance sheet is up to $4 trillion. But this does not mean that the Fed is wealthier. It just means that it has created money (recall the $10 trillion M2 referred to above) by buying Federal government bonds from the public.  That is the usual way the Fed increases the money supply – it buys the bonds we hold and sends us money that we deposit into our bank accounts. It is a cool system. So long as there are a lot of government bonds out there – and as long as we are willing to sell them, the Fed has a great way to inject money into the system. And yes – the Fed can do this at will – they do not need any gold or any silver or permission from Nancy Pelosi to do this kind of thing.

When Bernanke says he will not sell any part of those $4 trillion of bonds he holds – he is saying that he is not going to take money out of the system. Note that when the Fed sells its holding of government bonds – they send the public a bond and you and I send money to the Fed. When the Fed sells bonds – money in the system decreases. Not selling the bonds means Bernanke will not take money out of the system. So the stimulus remains.

When Bernanke says he is going to hold those bonds until they expire or mature the plot thickens (sickens?). When the bonds expire, the Treasury will pay the holder of the bonds the face value on the bonds. Aha – so the Fed gets even richer! No it doesn’t because the Fed turns around and gives the money back to the government. In the first place the government does not have enough money to really give it to the Fed (unless it borrows even more). In the second place, the Fed is not allowed by law to get rich.

Notice that the government originally owed both interest and principal to the public. So when the Fed bought all these government bonds – the government essentially got to skate. That is, the Fed’s purchasing these bonds means the Treasury has reduced the interest and principal effectively owed by the government. The Fed bailed out the government with its monetary policy. This is what people call monetization of debt. It is tantamount to the Fed printing money so the government can spend more than it collects in tax revenue.

So basically what Bernanke is saying today is – we are bankrolling the government and we are going to continue doing it. And that gets me back to my cold and the pill dilemma. Bernanke is doing this because he is afraid that if he stops supporting the government, the economy will fail. He could not handle the Twitter buzz if the economy fails. But if the patient is really on the mend, then failing to withdraw the drug could cause some real complications or what I referred to last week as Unintended Complications.

My liberal friends say tone it down Larry – there is no inflation anywhere. Why are you so worried – all that money isn’t hurting a fly? Not true.  First, there is inflation and it is growing. But that was my point two weeks ago. This week I am making a different point and it has to do with a concept called monetary velocity (V).

I won’t go into the equations and all the technical mumbo jumbo, but let’s define something called the BAM (Bang Associated with Money). BAM tells you the potential impact of money on spending. BAM is the joint result of two things – (1) the amount of money times its (2) circulation or V. Look at the dollar bill in your pocket. That is part of M2. You have it now but when you spend it the hair stylist gets it. Then he spends it at the liquor store. That dollar bill may get used quite a few times during the year. Thus $1 of M2 supports a lot more than $1 of spending. How much more spending – how much more BAM – depends on both M2 and on V.  

BAM = M2 times V.

We know what happened to M2 between 2007 and 2012. It increased dramatically. But what about V? V equaled about 1.93 in 2007. It has been declining ever since. As of the end of 2012 it was about 1.54. That is a reduction of V of about 20%. Recall that M2 increased by 38%. So you might say that the BAM factor increased by about 18% (= 38% - 20%) between 2007 and 2012. So while the money supply might have been hoping for a BAM impact of 38% -- we didn’t get that much impact because V fell. M2 increased but V decreased. So BAM increased by 18%. As a result the monetary impact on output and employment was a lot less than the Fed hoped. That’s the past, what about the future?

What many people are worried about is that V will not stay down forever. The V being down is very much related to uncertainty about the future. It is very much determined by banks that are reluctant to lend money – and by people who are paying down their personal debts to get into better financial condition. But what happens if the economy keeps improving and at some point confidence surges? What happens if the Fed does not remove any M2 but V goes back to a more normal number? Instead of BAM equaling 18% today it could jump to 38%! It would equal 38% at a time when we no longer need stimulus!

In one way that sounds good. We will finally get some oomph in the economy. But keep in mind that this 20% increase of BAM will get distributed between output and inflation. For example – if BAM increases by 20% this year – we could get any of the following possibilities:

o   Output goes up by 20% and inflation increases by 0%

o   Output goes up by 10% and inflation increases by 10%

o   Output goes up by 0% and inflation increases by 20%.

Even in an extraordinary year national output would not go up by more than 6-8%. Can we handle an inflation rate of 12-14%? I don’t think so. That is a very sore throat! Bernanke says he won’t reduce M2 but so long as M2 remains high everything depends on the future course of V. Maybe it will not bounce back to 1.9 anytime soon. But clearly V is going to return to something more typical as the economy approaches normalcy. Leaving M2 fixed is a sure way to make sure that inflation becomes a major future economic problem. Of course so long as the Federal government does not deal with its long-term fiscal crisis there is enormous pressure on the Fed to keep monetizing the debt. A coordinated movement away from both monetary and fiscal policy is necessary for a stable economic future. Monetary policy needs to be reversed but we will not see this until the government joins the process. Our President says debt is not a major problem today. I totally disagree. 

Managing Unintended Consequences

We all know about Unintended Consequences (UC). Say it out loud – UC.  For those of you whose native language is not English you should pronounce UC a little like the word duck or muck, but without the d or the m. It is not a pretty sound and UC is not a pretty topic. But if you ask me UC is the place that liberals, conservatives, and other people might find some common ground.

Liberals often categorize conservatives as selfish people who represent the interests of wealthy individuals and businesses. Conservatives view liberals as people who like to stand for worthy causes especially when it involves using other people’s money. These descriptions probably fit some liberals and conservatives but most of the ones I know cannot be so easily stereotyped.

Most US liberals and conservatives grew up in similar schools and churches and pretty much buy into mainstream culture and philosophy. It would be hard to find many who disagree with the so-called golden rule – do unto others as you would have others do unto you. I don’t know how many stories and movies revolve around a character being aided unexpectedly and then sometime in the future repaying the kindness.

Liberals and conservatives share many such cultural values. But clearly it is not hard to find times when they disagree and often passionately. In recent days some liberals have championed policies which would increase taxes paid by rich people. Some conservatives responded by saying that we wouldn’t need to tax rich people so much if some people asked for less in the way of unearned entitlements. Liberals ask for gun control laws to protect our children and conservatives retort that such laws are ineffective and take away fundamental rights. The disagreements go on and on.

These disagreements exist despite a lot of share values. We often debate for good reasons. For example, liberals and conservatives disagree about the fundamental nature of man. A conservative sees people as fundamentally fixed while liberals believe society can change people. Conservatives are wont to engage in change while liberals persist in a belief that changing external circumstances can lead to better social outcomes.

So there is plenty of reason for liberals and conservatives to disagree even though they might seek the same outcome. Part of this can be explained by UC.  We are all familiar with UC. I was trying to mix a Manhattan and by accident I poured gin instead of bourbon. Yuk. You and your girlfriend wanted to end the evening in an enjoyable way and nine months later there were three of you. You get the picture, UC.

Professor Philip Adler at Georgia Tech introduced a lot of us to UC in the 1960s under the banner of bubble management. He told us that management is like a big balloon. He likened the solution to a management problem to pushing your finger into a bubble that formed on the surface of the balloon.. Adler warned that EVERY TIME you push your finger into the bubble on a fully inflated balloon it creates another bubble somewhere else on the surface of the balloon. It is a little like Newton’s Law of Motion III – to every action there is always an equal and opposite reaction. Good management means making the resulting bubble in the balloon smaller than the initial one.

So UC is always with us. You have to manage those bubbles. The main reason we have such big issues in Washington these days is that many of those people there have Law Degrees and never studied with Dr. Adler.  Managing UC means you always worry that your policy becomes counterproductive. Companies say they manage risk. What does that mean? It means UC. It means that in the course of deciding to build a new plant in Budapest they begin with a clear statement of all the good reasons why one would like to build a plant in that location. 

But you don’t stop there. Someone then says – what could go wrong? Is it possible that there are negatives that we have not fully accounted for? Even after you build the plant you keep asking this question. If the government changes and it imposes harsh penalties on foreign firms then maybe it is time to close that factory or move it to Bloomington.  Parents do the same thing all the time with their kids. Jimmy wants a BB gun. Mom says, you will shoot your eye out. But mom I am 45 years old now. Nevermind.

Liberalism or Progressivism or whatever you want to call it has promoted and continues to advance and expand the application of government solutions. Many of their goals are honorable. But the problem is that UC has been put on the back burner. If Samsung is willing to incorporate contingency planning then why is government so reluctant to admit UC?  There are many reasons but clearly the providers of government services often become the promoters of it. They become the cheerleaders. A harsh program evaluation could mean loss of a job for the government worker. Or the government worker might simply believe that more is always better. That worker might not zealously look for UC. Governments don’t measure profits to indicate the success or failure of a new program so it is harder to quantitatively evaluate UC. Often the simple metric that shows that more people are being served suffices to "prove" the validity of the program. Of course there is also the simple fact that it is much easier to give new benefits than it is to take them away in a democracy.

No matter what the reason we leave the measurement, analysis, and discussion of UC to the other guys or we kick them down the road for another time. The more the conservatives complain about UC the more the liberals dig in their heels. Thus the issue of good government management becomes a fight instead of a collaborative effort to improve the lives of citizens. Some people laughingly would say that good government management is a non sequitur. Good government is impossible.

Imagine if someone had the nerve to say any of these things in public…

·        More lenient abortion laws cause more unwanted pregnancies
·        Increasing the minimum wage helps very few poor people and increases unemployment of teens
·        Poverty programs reduce the desire to be independent and self-supporting
·        Alternative energy is bad for the economy because it is too costly
·        Illegal aliens create social burdens
·        Tax loopholes make the rich richer

Anyone who ventured such statements at a cocktail party might get slugged by an otherwise sweet and caring grandmother. Our liberals and conservatives have turned discussion into fights. Hot words set off other hotter words and possibly a few punches.  But everyone knows that all those statements have some truth to them. 

Everyone knows that every policy has an UC. The real question is not whether or not they exist – the question is how large and how important they are.

We have had plenty of experience with government programs. We have seen both the benefits and the UC of programs to reduce unwanted pregnancies, reduce poverty, promote alternative energy, improve healthcare, make Americans more secure at home and abroad, and so on. Today we are faced with large national debts and no one wants to spend or tax needlessly. Gutting good programs makes no sense. Taxing people more for programs that do not succeed only hurt the country.

I am not so naïve as to think that comparing prospective benefits with the UC of a government program is easy or definitive. But I do know that what we have been doing lately can only lead to worse outcomes for all of us. Most people agree that the current sequester was never meant to happen because it is so onerous and wrong. The fact that the House has been passing legislation that has no chance of passing in the Senate and the Senate passes nothing means that we make our mistakes permanent. Surely we can make all of our government programs more effective. Surely we can cut waste. 

Companies do this all the time. They hire and fire; they restructure; they hire new marketing consultants; they cut costs to meet new competition. Yet our government will not even discuss the effectiveness of trillions of dollars of programs. Voters and their representatives need to think like Professor Phil Adler – push in that balloon and expect something negative to happen. But make that UC as small as possible so that you get the very most bang from the tax buck. 

Inflation, Unemployment, and Bonnie & Clyde

One of the most frequently discussed indicators of a country’s economic well being is inflation, yet I am finding that hardly any two people would agree on its definition much less its measurement. It is sort of like sex. Remember when a past US president said he did not have sex with that woman? Perhaps according to some definitions of sex he didn’t but we all knew he did something that sounded like sex. No matter how you define inflation – seems to me it is on its way but it is not too late to head it off at the pass.

Wikipedia uses the following words in a paragraph about inflation, “general rise in the level of prices of goods and services… erosion in the purchasing power of money… the loss of real value in the internal medium of exchange.”

In March of 2013 why should you care about inflation? For one thing, when the price level of goods and services is rising, you care. No one loves paying more for beer and pork rinds at the 7/11. But alas, beer and pork rinds are only a part of what I buy and who knows what you buy? That is, when prices of beer and pork rinds increase, the impact on you could be very different than the impact on me. And that gets us back to some seemingly innocuous words in the definition – “general price level.” In this case “general” is referring to someone but if your name isn’t General, then one wonders what that means. Another reason we care about inflation relates to policy. Our Fed and our government is telling us that since inflation is so low presently we ought to have a policy that stimulates spending enough so that inflation goes back to a more normal level. This policy of stimulation will have many impacts on us through its effects on prices, interest rates, employment and more. But I will get back to this second point below.

A general price level is something that you and I will never experience. That is because it is a mathematical expression or an equation. The general price level of goods and services averages together the prices that we pay for goods and services. A general price level for the USA then is based on some average person’s purchases. That “average person” is not me and it is not you. It is the average of me, you, Paul Krugman, Peter Wachtel and a lot of other people. So if you eat Peter Pan peanut butter seven times a day, then your own personal price level is going to be quite different from the general price level. If this month found that peanut butter prices fell by 20% you might be happy as a clam about your price level even while the nation’s price level was increasing and making most people frown.

To make things even more complicated, there is not just one general price level. There is a very broad national price level called the GDP Price Deflator that averages together the prices of all final goods and services bought by consumers, businesses, governments, the foreign sector, and inter-planetary travelers. It not only includes the prices of peanut butter, beer, and pork rinds, but also the steel purchased by manufacturing companies, and the tanks purchased by the defense department. A more popular and commonly used level of prices in the US is the consumer price index or the CPI.  But the CPI has several versions. One applies to urban consumers while a different one is focused on urban wage earners. Apparently urban workers and urban consumers do not buy the same things in the same proportions.   These are both called an “all items” index because they are measuring the prices of all the goods and services that urban consumers and/or workers buy. The list includes goods in the following categories: food, beverages, housing, apparel, transportation, medical care, recreation, education, communication, and others. Let’s agree – that’s a mountain of stuff being averaged together each month!

In December of 2012 the CPI all items index for urban consumers had a value of about 230. In December of 2011 its value was 226. Looking at this all items CPI index you would conclude that the general level of prices in the USA rose in 2012. From that one comparison you do not know which prices went up because the overall increase is a result of averaging together changes in the prices of food, beverages, housing, etc. If you use go to the Bureau of Labor Statistics Website (http://data.bls.gov/cgi-bin/surveymost?cu ) you will find a lot of data and you can try to figure out which of those categories of goods and services contributed most to the rise in the general level of prices.

It turns out that there are two categories of the all items index that are bad actors. These two categories are the Bonnie and Clyde components of price indexes. Food and Energy (F&E) misbehave frequently. They stay out late and then sleep it off in the morning. While the prices of all the other categories of goods and services typically rise and fall more or less together from month to month and year to year – F&E prices tend to leap around like jack rabbits. You just never know which direction they are going to move and by how much. Because F&E behave this way, they have to go to timeout. 

No just kidding but it is almost true. Because they behave so erratically we have another price index called the All Items Less F&E for All Urban Consumers.

You are frowning because you understand that removing F&E prices makes this index less comprehensive and representative. And you would be right. But keep in mind that a general price index is supposed to be telling us about the thrust of all goods and services. An index containing food and energy is misleading for three reasons. First, the F&E swings the all-items index and misrepresents the movements in the other goods and services categories. Second, because F&E changes are so erratic from month to month – they misrepresent the general direction of prices. For example, because of food and energy prices we saw dramatic swings in the all items index – 4% increase in 2008, -0.5 % decrease in 2009 and then a 3% increase in 2011. Meanwhile the all items less food and energy showed some variability but hugged an average of about 1.8% per year.   Most prices were growing at a little less than 2% per year. The All items index showed a very different and extreme pattern – a very misleading pattern of the general thrust of the prices of most things you buy. Third, when F&E prices swing wildly we often react and change our purchasing patterns. When F&E prices are rising rapidly we find ways to reduce our purchases of these items and that reduces the impacts on us in ways that are not captured in the all items index.

In early 2013 we are wondering where future inflation is headed. If we look at the All items CPI index we see a blur of upward and downward movements dominated by F&E price changes over the last 10 years with no clear direction. If instead we look at the all items CPI less F&E we see what looks like a wave rising and falling gently over time. After showing a declining inflation rate from about 2006 to 2010, this inflation rate has been trending upward – measuring about 2% in 2012 but portending future increases in the coming years. 

This gets us back to government policy. Our national goal is to bring the unemployment rate down. Policy stimulus is one way to do that but it has great risks. If the stimulus leads to more inflation then it sets off all kinds of alarm bells that are very bad for employment. With the inflation rate rising in a growing economy, it is not hard to predict that continued stimulus will increase current inflation and expectations about future inflation. We learned in the past that stimulus raises interest rates, oil and other commodity prices, increases wages and other business costs, and generally creates adverse conditions for output and employment growth. Inflation might be in the 2% range today but all indications are that the best way to reduce the unemployment rate is to have less stimulus and lower inflation.