Vanishing Austerity, Lies, and Water Lilies

Cartoon by Jim Gibson

As we approach a new silly season wherein Washington turns its sights once again to fiscal farce, it is good to look at some numbers. The usual actors will despair of the unfairness of austerity and will no doubt quote half-correct and partial figures to explain why renewed fiscal stimulus is urgently needed to save the US economy. And naturally, much will be said about the roles played by government changes in tax revenues and spending. The truth is that the great majority of temporary austerity has come through changes in taxes and it is difficult to find any significant reductions in government spending from here to eternity. The numbers show that there is already plenty of government spending stimulus in works. It is hard to fathom a story of even more.                                           

To see the fiscal policy contributions more clearly we need to use numbers from a special Congressional Budget Office report about Automatic Stabilizers http://www.cbo.gov/publication/43999 

Numbers I quote below are taken from a spreadsheet associated with this report. A special report is necessary since the usual published federal government budget numbers reflect a mix of the impact of both (1) intended policy and (2) the effects of the economy on tax revenues and spending. For example, in 2009 when the economy slumped – unemployed workers automatically paid less tax while government spending increased to pay those newly eligible for unemployment insurance and other social programs. In 2009 without any legislation or government action, these automatic changes in spending and tax revenues amounted to $305 billion. The deficit widened by $305 billion before we took any policy actions into consideration.

The government did enact legislation in 2009 to reduce tax revenues by $165 billion and increase spending by $484 billion. These intended policy changes added another $649 billion to the government deficit in that single year. That $649 billion is the part that we identify as stimulus.  The total change in the government budget of -$954 billion was composed of a cyclical part (-$305 billion) and an intended policy part (-$649 billion).

This coincides with our understanding that intended fiscal policy contributed a very large stimulus at the onset of the recession that began in 2008 and ended mid-2009. The first column of the table below shows that after 2009 the published deficit figures show improvements (the column reports changes in the budget and the positive signs indicate improvements or smaller deficits) in the deficit until 2016 . Except for 2011, each year shows a positive number – meaning an improvement in the government budget deficit. 

In the years between 2011 and 2015, the cyclical or automatic impacts do not amount to much – most of the measured changes are the result of intentional policy. Between 2011 and 2015 the measured deficit is improving largely because of policy changes.

You might think this is because the government cut spending. But the table shows that the intent of government was to increase spending by a total of $380 billion in those five years. So apparently the improvements in the budget did not come through spending reductions. Intended changes in government revenues totalled $1,179 billion over those five years. Tax legislation explains the budget improvements.

My friends tell me that the world will not end in 2015 and it is interesting to see what the CBO envisions for 2016-2019 with regards to the intended impacts of legislation. The improved budget situation reverses itself. In all three years the deficits worsen. While the usual published numbers (in the first column) show a mild reversal – it is mild only because they are assuming a strong economy that will improve the deficit by a total of $350 billion in three years. This sanguine haul of bounty is not enough unfortunately to offset the planned changes to the budget that totals increased deficits of $525 billion. Somehow the horse got out of the barn. While 2016-2019 does show a few extra bucks coming into the treasury via taxes, the overwhelming reasons for the return to larger deficits is a cornucopia of spending – a total of $769 billion of spending added in just those three years.

This fall you will hear all kinds of stories about how we bit the bullet and reined in runaway government spending as we took control over national deficits and debt. These same politicians and economic gurus will tell us that while we need to responsibly manage our national debt in the long-run, our weak economy demands much needed stimulus. A similar sad story comes from Mr. Bernanke at the Fed. Just let us water the flowers a little longer and they will start to bloom!

But it is all a lie. Unless our flowers are water lilies we are in a lot of trouble. We have done nothing to approach our fiscal problems. We had a sort of short-term austerity that came largely from higher taxes. Spending was not cut. In 2015 spending will roar back and threaten our finances once again. A stronger economy will cloud some of these facts because tax revenues will automatically climb. But in the oft chance that the economy grows slower than forecast by the CBO, the publicly recorded numbers will reflect even worse deficits than the tables now show.

All the figures below are changes in the given year . The Rev and Spend columns have cyclical changes removed from the measured changes in government revenues and spending, respectively. These are intended policy changes.

Def	CycDEF	PolicyDEF	Rev	Spend	Year
-954	-305	-649	-165	484	2009
119	-67	186	120	-66	2010
-6	8	-14	142	156	2011
210	23	188	138	-50	2012
244	-36	280	296	16	2013c
229	-22	251	315	64	2014c
186	92	94	288	194	2015c
-46	166	-213	67	280	2016c
-59	142	-201	44	245	2017c
-70	41	-111	132	244	2018c

Free Trade Agreements, Harry Houdini, and Amateur Magicians

 Cartoon by Jim Gibson

Free Trade Agreements are showing up in the news a lot these days. I generally favor anything that smacks of free trade just as I might gleefully accept a glass of Jack with ice cubes. We teach/preach that free trade is good because it removes obstacles to trade, generates more competition, and allows for the benefits of comparative advantage.

So why am I responding so negatively to news articles about the US trying to consummate a free trade agreement with the European Union (EU)? What about recent attempts to agree on US participation in the Trans-Pacific Partnership? How about those 13 proposed bilateral agreements with various and sundry countries (eg. Thailand, New Zealand, Ghana)? I should be really happy that all this free trade activity is going on.

But I am not that impressed and see this like I see the magician’s hand as he waves the magic wand. Magicians use many tricks but none better than sleight of hand. Sleight of hand takes years of practice and involves a very natural movement that attracts the eyes of the audience towards something the magician wants them to see – and more importantly away from the place he or she does not want us to look. For example, a pretty scarf goes out with one hand while the other swiftly and secretly removes a quarter from your pocket.

Our government prefers for us to be reading about all sorts of positive plans rather than focus on the everyday drama of resolving real problems. It is NOT news that government continues to make almost no progress on unemployment, government debt, immigration and more. In this environment advocating free trade seems like a free lunch. Even though it is next to impossible that any free trade agreements will be negotiated and signed by the US government in the near future, the photo ops are spectacular. Our government leaders can toast with important leaders around the world and pontificate about the great benefits of free trade as economic and social problems ferment and threaten to boil over.

I cannot imagine a worse time for free trade agreements. Every country I can think of has high and rising unemployment. Even in the US where the unemployment rate has been falling, we have much pressure for politicians to preserve and protect jobs and companies. This is not the ideal time to be explaining to the American public that the government is reducing long-held protections and allowing greater competition in the most sensitive of industries. It sounds great to say that a new trade agreement will open up opportunities abroad – while the other hand is really picking your pocket – that is, allowing dozens of other countries to compete with your own workers on home soil. And the recent history of globalization underlines how workers in low-income countries can impact the jobs of US workers. If you think the congressional debates about immigration and national debt are loud and ugly now – wait until these free trade pacts show up at Congress.

A second reason to believe that this is all a sham is to make note of the lack of general progress towards multi-lateral (involving more than two countries) trade agreements. The big momma of all such agreements is what is called the Doha Round of the World Trade Organization. This round of negotiation started in 2001. If you had a kid in 2001 he is now almost ready to go to high school and start dating girls with tattoos. That’s a pretty long time. The WTO has had previous rounds and while none of them was easy to conclude, none have taken this long. It is what some people call the problem of the “low hanging fruit.” It was fairly easy to make progress in lowering tariffs when tariff rates exceeded 100%. But the world has changed a lot and the protections that are in line to be removed, are a lot more difficult. For example we want Europeans to gobble biotech foods and they want us to make it easier for European companies to get contracts from the US government. That is not easy stuff. It might be easier to make French American’s third official language!

Sure, we recently concluded free trade agreements with South Korea, Colombia and Panama – but come on – we have pretty special relationships with those three countries. Yet, it took quite a while. Imagine this – once an EU-USA FTA is agreed by EU and US administrations, the agreement would then have to be passed in the capitals of 29 EU countries and the US Congress.  Maybe on some future date when the world recession is a faint memory and all our economies are hitting on all cylinders would such a feat be possible.

So all this trade talk today is simply noise. World leaders have subtle revolutions at least bubbling under the surface. They need to divert our attentions from all their failures to something that looks like Bourbon and Apple Pie (I kid you not – there is a restaurant in the Capital Hill neighborhood of Seattle named Pie Bar that basically sells only pie and whisky. And yes I was there and had a JD and Key Lime Pie!).  These free trade negotiations give the government people something to do. But the reality is that they not only are intended to fool the audience, but they may actually be making things worse because practicing all these tricks is keeping them from putting the food on the table. These guys are clearly amateur magicians and stand to create more harm than amusement. Watch out when they tell you that they are going to saw you in half!

Supply-Side Voodoo

This blog post uses a four-letter word – Supply-side macro policy (SSMP). Many people upon hearing SSMP get that look that often occurs when fingernails accidently screech on a blackboard. Otherwise they shake their heads as if someone just admitted they didn’t pick up their dog’s poopie while doing the circle at Green Lake Park.

Because SSMP has such a checkered reputation (Trojan Horse, Voodoo Economics Trickle Down, Charlie Sheen) most economists make up other names when they advocate a SSMP approach – restructuring, growth policy, tax reform, etc. But even with all this cover provided by taxonomical innovations, there is very little thrust today in the advocacy of SSMP. And let me say in all-caps, that there have been very few times in the USA when we have needed SSMP more that we do today. Okay so I didn’t use all caps. I thought that would be rude and annoying and why diss you now when you are already deep into my second paragraph?

After writing the above this weekend, I saw on Monday, July 8 the article by Princeton’s Alan Blinder on the Opinion Page in the Wall Street Journal, “The Economy Needs More Spending Now.” It is interesting that Blinder admits that “long-run growth is supply determined” and recommends SSMP for the long-run. But this is a Keynesian trick because he strongly advocates only demand-side stimulus now and we all know what Keynesians think about policy for the long-run, ie Keynes’ famous line that we are all dead in the long-run!

The proof that we need SSMP now has several parts. First and foremost is that we have exhausted demand-side macro policy. Whether from the standpoints of monetary or fiscal policy, we have used all of our demand-side policy bullets. There is no more ammunition we can throw at stimulating the economy through the demand side. If anything, the markets are pushing interest rates back up to normal values and there is little more the Fed can do to keep them down. The government knows it has to start addressing deficit and debt problems and simply cannot maintain trillion dollar deficits into the future without severe negative ramifications. 

It is like the field soldier who is out of bullets but he has a couple of grenades next to him. He cries that he is out of bullets and must surrender. His friend says, “but you have a whole bunch of grenades.” He retorts that he heard that sometimes grenades don’t work well and he had better just surrender. Demand-side policies are exhausted now and we have a basket full of SSMPs yet no one is strongly advocating them.

The second and more important reason we should focus on SSMP is that they directly address a myriad of factors or trends that are the root cause of our current problems. Business firms are reluctant to hire workers and produce more output. SSMPs directly aim at improving conditions in labor and output markets. It is commonplace for analysts to list all these supply-side obstacles so I won’t go into much detail. But rising business costs and uncertainty stem from a slew of new regulations relating to coal, energy, capital adequacy, financial leverage, lending to new homeowners, college borrowing, healthcare, Medicaid, immigration, and so on. One SSMP approach would resolve the uncertainty by directly addressing these regulatory issues. Reduce the uncertainty by making the regulations clearer. Of course it is also possible to re-think and change some of these regulations so that they have less negative impacts on employment and output decisions. If we cannot speed or change these regulations, then we are left with them but we can enact SSMPs that offset some of their negative effects.

What are these magical SSMPs? One kind of SSMP goes directly at the labor pool and finds ways to improve the desirability of adding another worker. There are many ways to give firms more incentives to hire. Labor subsidies or reductions in labor taxes might lead to larger government deficits and therefore should be aligned with tax reforms. Broadening the tax base is one way to bring in revenues while you lower tax rates that are more closely aligned with decisions to hire and produce.

Since firms often borrow to expand output or productive capacity, using financial and banking reform to transform all those bank reserves into loans has great supply-side appeal. Foot dragging on such regulations keeps banks in a holding pattern. Rising interest rates might deter some companies from borrowing – but lack of funds makes it virtually impossible to borrow. The same reasoning applies to mortgage markets and school loans.

A third reason to focus on SSP today has to do with the risk of higher inflation. Anything that has the potential to rekindle rising inflation threatens our employment and output goals. When workers begin to expect higher inflation then they are more motivated to ask for pay increases. Suppliers in commodities markets behave the same way. When bankers see more inflation coming, they raise interest rates. The upshot is that expectations of rising inflation become embedded in today’s prices with resulting negative impacts on business costs and profits. In today’s monetary and fiscal environment, any policy moves that lead to larger deficits or looser money will be self-defeating. On the contrary, tighter monetary and fiscal policies can be viewed as SSMPs because of their downward impacts on inflationary expectations and an improved competitive environment.

US unemployment is too high and output is too low.  In a market equilibrium sense, that means both supply and demand for labor and output are too low. The question then is one of causality. Some analysts cling to the idea that demand is the culprit and they advocate more demand stimulus. We gave demand policies more than a fair chance. It is now time to turn to supply. Bring on the Trojan Voodoo Trickle Down!

Immigration Reform, Guitar tabs, and Forecasting

We cannot be too sure where politicians will go next with legislation for immigration reform. There are lots of angles here both political and economic. One discussion in the press lately has to do with CBO forecasts of the impact of immigration reform. The CBO found that when they forecast out 10 or 20 years they get a net positive impact of immigration reform on the US economy. They found that more legal immigration creates jobs and incomes and tax revenues. While there will be social costs of more immigrants, the CBO found that the extra revenues far outweighed the benefits.

We read these forecasts and then choose our favorite spears and throw them at each other. Imagine how many serious as well as drug-induced debates are going on right now about the CBO study. That makes me think about guitar tabs and forecasting. As I understand it a guitar tab is a sort of sheet music to help you learn how to play the guitar. It is along story but I decided that foot tapping to I Wanna Hold Your Hand was not enough for me, so I purchased a guitar and starting taking lessons. Learning a guitar takes a lot of practice. Part of it is exercise to teach you to put your fingers in the right places on the guitar. Anyone who has ever watched a real guitar player knows that they move their hands all over the guitar at high speed and with almost no effort. Anyway, I am spending a lot of time doing mindless practice moving my hands around the guitar strings as if I was caressing a hot steamy bottle of JD.

It is VERY apparent when looking or listening to me “play” that I am about 10,000 hours away from being the next Tiny Tim. But there ain’t no other way but to put in the hours. I must admit that I often drink or watch Fox Business News while I practice so it isn’t real torture or anything like that. So what does this have to do with Immigration legislation and the CBO?

The answer is that practicing with tabs on a guitar is NOT playing songs. And the CBO estimates of the economic impact of immigration reform are NOT the impacts of immigration reform. Just because practicing tabs is not playing real music, that does not mean that practice is not valuable. The CBO estimates are dead wrong – but that does not mean they are not valuable. It also means that one party can say the estimates are just right while the other one says they are backwards.

Before any televised sporting event, there is often a gaggle of experts who tell us who is going to win that game. Analysts never agree but the process of listening to the analysts gives you a pretty good idea of the kinds of things that will determine the outcome. No analyst ever gets all the details and the main outcome right – but some will have been “righter” than the others. That’s the way we can think about the CBO report. It has value not because it will be right, but because the report and the ensuing debate help us focus on the kinds of things that will happen if the legislation is passed.

How can this be helpful to us now as we debate the issue? First, it should make us a little less confident in our own economic projection. If we really listen to those with opposing views, we may learn something. Second, if we start looking seriously at the assumptions made by the CBO about very specific impacts, we realize that this is very much “educated” storytelling. Do those economists at the CBO REALLY know how fast immigrant incomes will rise over the next decade or two?  Do they know how many babies they will have? How many will lose their jobs? Please! Either side of the debate can tweak an assumption about the future and come away with different conclusions about net economic impact. Third, every decade has its surprises. What if Mexico goes to war with Cuba? Or global warming makes Canada the new Caribbean? Stuff happens right?

The upshot is that while the CBO report is totally wrong about the economic impact of Immigration Reform the report does facilitate a debate that will be useful. But keeping in mind how fragile are the numerical conclusions, it is natural to guess that the political debate will be overshadowed by the ethical and ideological issues. One congressman said he would never vote for reform if it meant that criminals – illegal aliens – would be allowed a path toward citizenship. Another one countered that it is simply wrong to evacuate people or families that had been living and paying taxes in the US for extended period of time. While these two opinions might be extremes it is probable that many congressional votes will be more determined by these kinds of issues than by a very fragile set of economic impact numbers. A dysfunctional Congress has yet another chance to resolve difficult issues. We can only guess what the outcome will be. 

Real Interest Rates, Fremont, and the Land of Oz

Happy summer solstice.  I recently attended the Fremont Solstice parade and for those of you who know anything about that Seattle event, I can tell you that there is nothing I could write about in this blog that could ever be as exciting and fun as that parade.  But those visual images cannot compare to the parade going on in our financial markets!

About a year ago in June I posted an article about negative real interest rates. It turns out that it has been the most popular by far of all my postings.  http://larrydavidsonspoutsoff.blogspot.com/2012/06/negative-real-interest-rates-cannot.html

The main point of that article was to underscore how low real interest rates were last summer.  I am not sure why that post hit the mark but in any case I think it is time to update the results to summer 2013. My conclusion is that real rates are on the rise, the Fed is not soon going to change its policies, and every time the Fed tries to do the right thing the financial markets will get hysterical like they did last week.

After the Fed’s announcement that they might begin to taper the famous quantitative easing programs as early as later this year, market rates have started to rise. Expectations can be a powerful factor in credit markets, so the mere notion that rates “might” rise in the future can send them surging today. The benchmark 10 year government treasury rate increased half a point in the last month and almost 90 basis points since last summer.  So for sure – market rates are rising.

What happens to real interest rates, however, depends also on another fragile psychology factor – inflationary expectations. Most measures of expectations of future inflation rates have moved slightly downward since last year – meaning markets and surveys currently do not soon expect markedly higher inflation.  Economic problems among our main trading partners suggest continuing slack in our export sales and possibly even lower inflation in the near future.

With market interest rates rising and expected to keep rising and with inflation expected to remain stable or fall, we have to conclude that real interest rates are headed upward in the very near term. What about after that? Since market interest rates are well below their norms, it is not easy to see a reversal. But the inflation factor offers more room for story-telling and rising uncertainty. In two recent postings I made the point that just like interest rates, inflation today is well below normal values. It is only a matter of time before the effects of monetary policy, a stronger domestic economy, and a declining value of the dollar begin to push inflation back closer to 3%.

So while real interest rates are rising right now, there is still some question as to their continued future course. What happens to real interest rates will be the outcome of a race between market rates and inflationary expectations. The more inflationary expectations rise relative to market rates, the less increase there will be in real interest rates. But that outcome misses the well-known effect of changes in expected future inflation on market interest rates. The higher is expected future inflation the higher are market interest rates. In sum – this is what the medium terms holds for the real interest rate:

·        Stuff causes market rates to rise and the real interest rate to rise

·        Inflation expectations rising causes real interest  rates to fall

·        Inflation expectations rising causes market rates to rise and real interest rates to rise.

·        Result – real interest rates will begin rising with or without a rise in inflationary expectations.

And, of course, that matters because it is the real interest rates that measure the payoff to saving and investing. Significantly rising real interest rates favors savers over investors.  Rising real interest rates also cause slower economic growth so in today’s uncertain economic environment rising real interest rates are not welcome. This puts pressure on the Fed to continue its quantitative easing as markets seemed to be shouting last week.

Could the markets' lamentations be correct? What is true is that most of us do not react well to change. A change in Fed policy now is simply that – a big fat change in your face.  So the market cries out. But when the surgeon begins to wean you off the pain medicine and you cry out, at some level you understand that your future is one with zero pain  medicine. You are glad that the doctor is reducing your dose because you know it is the right thing to do.

It is the same with real interest rates. They are rising and they are going to keep rising. But Dr. Bernanke and his gang of associates are not ready to reduce the pain medicine. Investors are not convinced that the patient is healed. So the big question is when will the patient be ready. When will the Fed announce that the patient is healed and when will the patient believe it? Okay Doc I am ready to reduce the medicine because I know I don’t need it anymore.

I can’t see this happening for a while. Sure, there are numerous signs that the US economy is on the mend. But then again there are just as many worrisome signs both at home and abroad. How long will Europe’s economy struggle? Will it get worse before it gets better? China is also facing rising interest rates? Can China rein in excessive credit growth and inflation without causing an even bigger economic slowdown? Will Japan’s three-part program work after decades of stagnation? If all these places slow how will Brazil and other emerging nations manage to recover?  The world’s post-crisis economy is not back on track and this does not help confidence in the US economy.

Those are global worries – but there are plenty of domestic ones to boot. Will our dysfunctional government grow even more dysfunctional this year? Will we postpone once again legislation that address our financial and economic problems? Is the recent housing boom just a bubble? Will labor market trends swamp any reductions in the unemployment rate that might be part of moderate growth. Is higher inflation going to erode already marginal income gains?

The upshot is that the Fed is in a pickle. Everyone knows the Fed must reverse its policy. Everyone knows that rising real interest rates are coming. Yet global and domestic worries prevent the Fed from making any changes to its current policy. Every time it even imagines a change in policy the financial markets are going to be hysterical. 

We could learn some lessons from Oz. The scarecrow always had a brain and the cowardly lion was always brave.  We didn’t need three rounds of quantitative easing and we didn’t need endless stimulus from the government. From the beginning of the economic recovery we have needed good policies that aim at real problems: housing, banking, finance, immigration, healthcare costs, etc. Without apparent progress on these real problems, the Fed is stuck in a no-win position, Some people want more drugs and despite the rationality of tapering any deviation from the current stimulus will be met with chaos that will whiplash our precious portfolios. 

The Perils of Tampering and Tapering by Guest Blogger Robert Klemkosky

Since May 22, volatility in most markets (stocks, bonds and currencies) has increased, not only in the U.S. and Europe, but also in Asia and especially in emerging markets. That happened to be the date that Fed Chairman Ben Bernanke testified before a congressional joint economic committee. In answer to a question about slowing the Fed’s monetary stimulus, he replied “If we see continued (economic) improvement and we have confidence that it is going to be sustained, then we could – in the next few meetings – take a step down in our pace of (bond) purchases.” He also warned that “premature tightening would carry a substantial risk of slowing or ending the economic recovery.”

The above response was in reference to the Fed’s most recent qualitative easing (QE) program called QE3 or QE Infinity. The two prior QE programs had definite purchase amount targets and schedules. QE 1 involved the purchase of $1 trillion of mortgage-backed and U.S. Treasury bonds in 2008 and 2009. QE2 involved another $600 billion of bond purchases from November 2010 to June 2011. QE3 was more open ended in that the Fed announced in August 2012 that it would purchase $85 billion of bonds each month until, later announced, the U.S. unemployment rate falls below 6.5 percent.

$85 billion monthly may not sound like much, but do the math, and it comes to more than $1 trillion annually. The QE programs have bloated the Fed balance sheet from $800 million before the financial crisis of 2008-2009 to $3.3 trillion today – four times larger in five years.

The purpose of the QE programs was to reduce long-term interest rates and increase asset prices, stocks, bonds and housing. By increasing asset prices, which has happened, less in housing than stocks and bonds, the Fed counted on the wealth effect and lower interest rates to increase confidence and stimulate consumer spending and corporate investment. The Fed also was concerned about deflation and has targeted 2 percent as the desirable inflation rate.

Bernanke’s response was certainly measured and cautions, and some have referred to it as “splitting hairs,” but it has created turmoil in the markets. Since then, bad has become good, and good has become bad in terms of economic news and market reaction. When the economic news is too good, long-term interest rates rise and bond and stock prices fall. If the news is bad, the opposite effect takes place. Investors prefer Goldilocks economic news, not too good or too bad.

As mentioned earlier, the QE programs have been successful in keeping long-term interest rates low, thus supporting higher bond prices; lower mortgage rates have helped increase house prices by 13 percent in the last year after a drop of 33 percent from peak prices in 2006; and the stock market as measured by the S&P 500 is up 140 percent from the low of March 2009. How about its effect on the U.S. economy? Who knows what the U.S. economy would have been like without the QE programs, but their impact has not been as dramatic as the Fed had hoped them to be.

June 2013 marks the fourth anniversary of the present economic recovery. Economic growth has averaged around 2 percent during the four-year economic recovery period – one of the slowest recoveries in the post-WWII era. Even though economic growth was 2.4 percent in the first quarter of 2013, the 15 quarters of growth have been very uneven, from highs of 4 percent in the fourth quarters of 2009 and 2011 to lows of less than .5 percent in the first quarter of 2011 and the fourth quarter of 2012. Plenty of hopes and disappointments for U.S. economic growth.

Employment and job creation has been one of the biggest problems in the recovery. There are still 2.5 million fewer people employed today than in 2007, and the unemployment rate remains high at 7.6 percent. For many, it has been a jobless recovery. The private sector of the economy has done a better job of creating employment than the government sector, which has shed more than 1 million jobs at the state, local and federal levels.

But the operative word now is tapering; when will the Fed begin to gradually reduce its $85 billion monthly purchases of bonds, and when will it stop completely? It seems the market has become, if not addicted, fixated on the supposed benefit of the QE monetary stimulus, and thus the bad news is good news scenario. But no matter when the start of the tapering or the end of QE3, the Fed cannot keep purchasing $1 trillion of bonds each year. While inflation and inflationary expectations don’t appear to be a problem in the short term and even out to five years, continued monetary stimulus could result in inflation in the longer term – especially given the fiscal and monetary stimulus undertaken recently by Japan and the Bank of Japan as well as the Eurozone and the European Central Bank.

Eventually normalcy for the economy hopefully will prevail, and real interest rates will then become more positive, which means that nominal interest rates will rise. The 10-year U.S. Treasury bond yield has already recently increased from 1.6 percent to 2.4 percent, but even 2.4 percent is a historically low rate. The question is when will rates rise further? Given all of the uncertainty, it is not obvious to investors. But a return to more normal economic growth without fiscal or monetary stimulus may be a welcome and positive event for investors. It has been six long years since the Fed got so entangled in the economy. Less entanglement should be a huge positive, but it will create uncertainty and risk, especially for the bond markets. But tapering will be better than tampering. It will mean a return to normalcy. The Fed only needs to signal its exit plan with clarity and less opacity so investors are not left guessing as now.

 

Fiscal Discipline Now Rather Than Later

Cartoon by Jim Gibson

Great news! The US government budget deficit is smaller than we expected. Now we don’t have to worry about that pesky thing. According to the Congressional Budget Office (CBO) we can expect the US budget deficit for 2013 to weigh in at only $642 billion. That amounts to 4% of the nation’s GDP. That is $200 billion less than expected just a few months ago. Get out the Swisher Sweets and Bud Light – it is time to celebrate.

That really is good news. What is not so good news is that more and more we are hearing that this improvement means we can forget about working on our government debt problems. Before this news was known various economists were reluctant to deal with the national debt problem because such a policy might weaken our economy and prevent a full recovery. Now that the major scare seems to be over, these people are emboldened and louder than ever. But they have it backwards. The recent budgetary progress means it will be even easier to solve our economic problems because we are that much closer to removing the negative impacts of the government on the economy.

Joe, the 5 foot 3 inch 400 pound 14 year old exclaims to his mom – I only gained 20 pounds this year. That’s great honey let’s celebrate by eating a fried potato farm.  That’s pretty much what these people are saying about the debt. A $642 billion deficit in one year means we ADD another $642 billion to our huge government debt. Adding $642 billion instead of $842 billion is definitely a good thing – but it does nothing to reduce the swollen debt. It simply makes it bigger at a slightly slower pace.  But notice that when you are at $642 billion it makes it easier to get to $442 billion…and then to $222 billion. This is the time to keep plugging away at the problem. It is not the time to smoke a cigar and hope good things keep happening.

The CBO’s figures show that the net federal debt which was at a bloated 66.8% of GDP in 2012 will rise to 68.8% this year and then to 69.9% in 2014. More typically this debt was about 35% of the economy before the crisis hit. So let’s say the debt load doubled in about five years. Even with very optimistic assumptions, the CBO sees the debt load at about 66% in 10 years (2023). It is like admitting that after averaging a svelte 200 pounds for much of your life, you have now ballooned to 400 pounds. You now have a 10-year plan to get back down to 375! What a joke. How stupid do they think we are? Don’t answer that.

Can I really make comparisons with overweight people and the government debt? Of course I can. While it is not easy or trivial to decide an optimal country debt load it is very difficult to deny that a country that usually runs debt loads of 35% is not in some way harmed by debt loads of twice that amount. Some experts say that the debt explosion was caused by a weak economy. But notice that the CBO has the debt load at 66% in 2023. They do not believe the economy will be weak for 10 years. It is not the economy that is causing the debt. It is government’s inability to govern that is causing this drag on the economy. Call this drag crowding out or simply call it risk aversion. Either way, too much debt is slowing us down and hurting the average citizen.

One more point that supports a more aggressive approach gets to the idea of jeopardy. Our President moans on camera about our inability to help flood victims one day; tornado victims another day; and Boston bombing victims yet another day. We should all be frustrated about the fact that there are important unmet needs that turn up every day. Your kid needs new braces for her teeth. Sorry honey, we just bought a car we can’t afford and the monthly payments mean we have to wait to get your teeth straightened. Obama cannot complain he doesn’t have enough money to help tornado victims at the same time he supports programs that keep our debt at no less than 66% of GDP for the next 10 years. If you want to be able to help in an emergency then you need an emergency fund. There is no emergency fund because we will spend this year $642 billion more than the government collects.

All of this is made worst by the fact that we know that interest rates are going to rise from their very low levels. This is important for many reasons but a primary consideration is that as interest rates rise we will pay more interest expense on the national debt. With the value of the debt rising AND interest rates rising – interest expense will be a larger and larger component of government spending. Interest expense cannot be cut. It must be paid. This makes cutting the annual deficit and the total debt even harder. It makes helping tornado victims harder.

The worry warts tell us that any attempts to reduce the deficit through policy will be more than the economy can handle. They compare a possible US plan to balance the budget to draconian efforts in Europe that have been blamed on much slower growth in that part of the world.   But we don’t have to do anything extreme with taxes and spending that would send us careening into another recession. We have seen numerous proposals floated that have teeth but which only gradually bring back fiscal discipline. But it is difficult to talk rationally about a national debt management plan when even the smallest unexpected reduction in the deficits leads to demands for more government stimulus. We now have a window of opportunity to restore competitiveness to our US economy. Having a larger national debt is not the route to that competitiveness.

Krugman versus Reinhart & Rogoff

Cartoon by Jim Gibson

Imagine the bar fight when Danny accused Mike of not being a scientist. You aren’t a scientist – nah nah nah. Yea, but your mom wears combat boots. It sounds pretty stupid – and sounds even stupider when Economist Krugman dukes it out with colleagues Reinhart and Rogoff.  I am guessing they are not having lunch together at the faculty table. Is Macroeconomics a science? Are these guys scientists? And why does it matter? In brief I would say yes, yes, and because we think it matters even if it doesn’t.

Wikipedia says a science is “a systematic enterprise that builds and organizes knowledge in the form of testable hypotheses and predictions about the universe…refers to a body of knowledge itself, of the type that can be rationally explained and reliably applied.”

For those of you not sufficiently trained in globbygook, just about anything fits this definition of a science if it is trying to “figure-out” something. Your two-year old puts your best carving knife into the light socket and you explain to him that there is something called ‘lectricity and note that the knife will take the ‘lectricity out of the wall and into your body and it will hurt.  You might not know it but you are acting as a physicist and you are using a body of knowledge called physics. Physics explains why the electricity will go into your body and harm you. Hundreds of other kids have already tested the hypothesis and laid a solid empirical foundation to support the theory. Pretty cool – physics is obviously a real science.

But so is macroeconomics. I can’t tell you how many hours I spent theorizing about econ stuff and how many more hours I spent running little experiments that end up either supporting or not supporting hypotheses.  For my doctoral dissertation I had a theory that said that Nixon’s Wage and Price Controls of the early 1970s would reduce inflation only if they reduced inflationary expectations. I spent about a year drinking JD and formulating a model, gathering data, and then running a bunch of statistical tests that might reject or not reject my theory.  To be scientific you need to start with a problem that you want to explain, have an explanation, and then try to put your explanation to the test. If your explanation fails the test, then you move on to sales or painting. If your explanation does not fail the test, then you hold on to it for a while – a least until someone has a better explanation than yours. It is like being a sheriff in the cowboy days of the Old West. You were sheriff until someone came along who was faster at the draw. Truth, like sheriffs, evolves. 

If you are still awake, you might retort that while economists pretend to do all that stuff, they are not REAL scientists like physicists and geneticists and sexologists. And for that opinion, you would be wrong. Why? Because Wikipedia cannot be wrong.  Look again at the definition of a science and you will see that the only real criterion is that you are trying to test your hypotheses. There is no single criterion that says whether your test is strong enough.  There is no single test of a theory being “good enough.”  You are the sheriff until someone beats you to the draw.

You might be surprised but if you think about it, it isn’t so strange. Take meteorology.  There are some things these weather people know and get right every single time. If a cloud reaches a saturation point then it is very likely to rain soon. But if you ever lived in Florida during hurricane season you know that there are some things that meteorologists almost never get right. Where exactly will the full force of a hurricane hit Sanibel Island? When will it arrive? How long will it stay there? These are very critical and important questions. Meteorology has a lot of good theories and they have put these theories to the test many times – but they still don’t succeed much when it comes to the most important questions.  Geneticists know a cell deformity or marker when they see one. But they still do not know when or if YOU will get pancreatic cancer. Other medical sciences can treat the symptoms of your cold but they cannot stop millions of people catching colds every year. 

Every science is the same. There are no REAL sciences. You either use the scientific method to advance knowledge or don't. Every science has things it can easily explain and other things it cannot. Let’s face it we have contrasting theories with respect to every aspect of our life. Should we floss or gargle? Take vitamins? Use synthetic oil in your car? Should I have my prostate checked every year? Who was better the Beatles or the Stones?

I am not belittling science. There is much we know. I am just making the point that there is much we don’t know. The low-hanging fruit is gone and every science is in the process of discovering new and important things. In that discovery process there are always competing models, competing scientists, and competing opinions. This is true in macroeconomics and it is true in physics.

So what’s the rub with respect to macro? The answer is that there is room for difference of opinion in some very important areas. Think of what we are trying to accomplish with policy. It looks easy on a power point slide – but how do we REALLY get the US economy to grow faster? Note that whatever policy we deliver, it will involve the actions and reactions of firms and households, spenders and savers, investors, domestic citizens and foreigners, and so on. Psychology and expectations will always be at work. The ages of the population this year and next will impact how policies create changes in behavior. It is a wonder that we ever get this question right. What size ark should we build when the floods come? I am guessing we could get some very different answers to that question too.

What galls me is not that economists get things wrong and not that they disagree about policy. What galls me is when they do not even try to act like scientists. Not checking data that supports a very strong policy position is poor science. Shooting from the hip without any real attempt to utilize a large body of information and data is likewise unforgivable. Arguing in voices that sound more like competitors in divorce court does nothing but reduce the confidence that people have in macro science. Economists need to put on their big-boy pants and quit acting like children. There will always be politics and ideology. The best economists will try their hardest to be above that fray. 

Pop-Up Inflation

Cartoon by Jim Gibson

In my last post I worried that inflation is coming back and likened Fed policy to – frying pan, fire, frying pan. In writing that I admit that trends showed there was some room for the inflation rate to fall further and I don’t have a good prediction for when inflation will rise again. The importance of this is that important people keep putting pressure on the Fed to keep the pedal to the metal. Any deviation from this monetary flooding is met with fear. Last week Bernanke happened to mention that the Fed was thinking about reversing policy – and the markets immediately went into the tank.

It is interesting that the markets are testing the Fed. The markets seem to love all that money. But that doesn’t mean it is good for Main Street or for employment. A recent article by Andy Kessler (Wall Street Journal, the Fed Squeezes the Shadow Banking System, May 23, 2013, page A17) explains that the Fed has robbed the private sectors of a lot of government bonds and mortgage-backed securities. All this stuff is sitting in the Fed’s vaults and is not being used as collateral for the private sector’s loans. I love Kessler’s line, “In other words the Fed’s policy – to stimulate lending and the economy by buying Treasurys…is creating a shortage of safe collateral, the very thing needed to create credit…”

James Bullard of the St. Louis Fed is worried that inflation is too low and he wants the Fed to keep stimulating the economy. As Kessler says, that is strangling the economy. Worse yet, the risk of a giant pop gets larger and larger the more money is out there. Bernanke is afraid to remove even a dime of it because of the market’s reactions. It is like promising to go on a diet tomorrow. Really, I have a headache today but I will start it tomorrow. Image how the financial markets are going to react when he finally has to remove some money from the system.

Back to this disinflation thing. It is easy to see why the US inflation rate is not going to increase in the next few months. The most obvious factor is slower expected growth in Europe, China, Japan, and most of the world outside of the US. World economic growth spills over into US markets for good reasons. First, when those countries stagnate they buy fewer of our goods. Thus US export sales decrease. Second, as money moves out of those countries and into ours, this has the effect of raising the value of the dollar. The higher value of the dollar dents exports further but it also makes imports cost less. Both factors push US inflation and inflationary expectations downward.  In my last posting I showed a strong medium-term downward trend in inflation. Clearly both medium- and short-term trends are pushing inflation expectations downward. That means less upward pressure on wages and the prices of various other inputs to the production process.

So long as world economic growth is restrained, it is hard to imagine the US inflation rate soaring back this summer. But damaging risk remains. Many people who worry about global warming admit that temperatures have not been rising in the last decade. But they look beyond all that and focus on what happens if you don’t combat warming immediately.  They are alarmed. Well I am alarmed about inflation coming back and putting us back into another deep recession. Europe will not be in a recession forever. China will find a way to grow faster. Japan may figure out its problems. The US is seeing wealth rise as stock and housing prices return to stable values. Many emerging nations are devaluing and restructuring.

No, these problems do not have to be solved soon or at one time. The way our financial markets work is through bits and pieces of information that begin to form a mosaic. When the image of a stronger world economy starts to emerge it won’t take long for inflationary expectations to rise. It is like the jack-in-the-box – you turn and turn and turn the crank but Jack stays in the box – at least until that critical moment. Jack-in-the-box is fun but not when the Fed is at the crank. If the Fed has not done a thing to impede rising inflationary expectations, we can expect a quick return trip from the frying pan to the fire. And it won’t be pleasant. They can take some of the sting out by starting the process now. 

Inflation History Lesson: From the frying pan to the fire and back again

Cartoon By Jim Gibson

Inflation is back in the news. While there are a few folks worried about rising inflation much of the energy has been focused on it falling (often called disinflation). The latest news on inflation in April showed it negative, -0.4% in April after -0.2% in March (a negative inflation rate means prices are falling and is often called deflation). Consumers generally like inflation to fall, so this is good news for them. It was also cheered by asset holders because lower inflation means the Fed has more room to pump up the economy. Of course, if disinflation or deflation continues, many will take this as a sign that the economy is once again going into a recession. And that is not good news.

So here we are. As usual we have a difference of opinion. Some experts are worried about the inflation rate rising while others are worried it is going to fall. While the past is never a perfect guide for tomorrow, it doesn’t hurt to review what the data shows us. And what the data shows is disconcerting. While inflation may well fall more in the near future there is every reason to bet it will come back with a vengeance. This data came from Fred at the St. Louis Fed. Fred is a handy-dandy free data and graph service. http://research.stlouisfed.org/fred2/

The graph below plots annual values of two measures of US inflation from 1959 to present. One measure is based on the well-known Consumer Price Index for All Urban Consumers. The second one is drawn from the less-well-known Personal Consumption Expenditures Deflator Excluding Food and Energy. Inflation rates are created by taking annual percentage changes in these indexes. Because these index names are long and ugly I am going to called them Steve (blue line in the chart) (like in Steve Martin who is wild and Crazy) and Angela (red line in the chart) (as in Angela Merkel who is not wild and crazy).

Steve inflation is published by the US Labor Department and is based on surveys of prices paid by the typical urban consumer. Steve inflation often swings wildly because food and energy are important parts of Steve and these prices can gyrate like Britney Spears after a night on the town. For example the graph shows Steve inflation rising to about 14% in 1979 only to fall back to about 3% within a few years. Much of that was attributed to food and energy. Not that food and energy prices don’t affect consumers – but they do distort what is happening to the prices of what most of the consumers buy. 

That is why I added Angela inflation – she is constructed and published by the US Commerce Department as a tool to deflate personal consumer spending. Angela is a little more boring because the Commerce Department has removed those pesky food and energy prices from this version of the PCE deflator. (This index also makes an attempt to remove some of the bias caused by Steve’s assumption that people do not economize on goods and services whose prices are rising the fastest.)

So that’s Steve inflation and Angela inflation. A quick look at the chart shows that Steve swings around like a young lady at a ho-down in Arkansas. Angela is more conservative and I must conclude – much more refined and reliable. Some might say that Angela is smoother! But notice too that Angela and Steve have the same general tendencies or trends. So while they might disagree on the extent of inflation during a particular year or two – they both agree on the general direction of inflation. Notice that from 1959 to 1979 they both were rising and thereafter falling. You might say that the most current trend of inflation was to flatten at a little less than 2.5% starting in about 1990.

Apparently what goes up must come down. As we think about where we are today and what will come tomorrow it is good to see these trends. But they are only part of the story. For example, you might want to extend the downward trend since 1979 into the future. That would argue against a quick return to higher inflation. Then again, you might think that 15 years of falling inflation is long enough for the trend and therefore you might want to predict a reversal of trend. In that case you are worried about rising inflation.

There is more to see in this graph. Notice the vertical shaded areas – they depict recessions. We have had eight recessions since 1959. After seven of those eight recessions the inflation rate fell. That makes economic sense. Recessions are times when buyers slow their purchases and firms find it more difficult to sell goods. They often discount their prices to get rid of excess inventories. These disinflation periods following recessions can be very shallow and short (e.g. after the 1970 recession) or they can be much longer and more pronounced (e.g. after the 1980 recession). After the 1990 recession the inflation rate fell for almost 10 years.

Now look at inflation behavior before each recession. In all the recessions except for 1982, the inflation rate was rising before the recession started. In all those cases you had sharp changes in Fed policy – increasing interest rates to try to cool off the inflationary economy. But as soon as the recession was evident, the Fed reversed engines and reduced interest rates. In one sense the policies worked – you can see that inflation did fall. But the unintended consequence of the tight money policy was a recession.

So what do we have? We have inflation rising followed by tight money followed by inflation falling followed by loose money followed by rising inflation. This cycle goes on and on. The prudent thing would be to bring monetary policy back to neutrality once the worst of the recession is over. Why? To answer that question we have to look into what caused the pesky inflation to begin with. The graph shows that food and energy prices must have had some impact driving overall inflation upwards – especially in the 1970s. But food and energy prices do not explain the upward thrust of inflation that occurred in in the late 1980s, late 1990s, and then again after the turn of the century.

Fed policy had very much to do with driving inflation periods higher after those recessions. This belief is based on policy data. I used the level of the federal funds rate (ffr) as my measure of monetary policy. When the Fed wants to tighten policy they raise their goal for ffr; when they want to loosen money they reduce the ffr. So here is what I found:

·        The 1982 recession ended in November 1982. The ffr went from 15.1% in early 1981 to 6.6% in March of 1988. In other words – the Fed kept monetary policy very loose more than six years after the end of the recession.

·        The 1990/91 recession ended in March of 1991. The first quarter of 1989 had a ffr of 9.8%. It was reduced until February of 1994 to the point where it was 3.3%. Again the ffr was kept very low until three years after the end of the recession.

·        The 2001 recession ended in November of that year. The ffr was about 6.5% at the end of 2000 and continued down to 1.8% until November of 2004 – three years after the end of the recession.

·        Finally the 2008/2009 recession ended in June of 2009. The ffr started at 5.3% in mid-2007. It started down and has remained at 0.25% as of today. Today is now four years after the recession. It is unclear when the Fed will again begin the raise rates.

What is the history lesson? The Fed is an aggressive agent for monetary policy. It strikes hard at rising inflation and tries to offset recessions. But it also has a tendency to be very late when it comes to withdrawing monetary stimulus after recessions end. After the last four recessions, the Fed was late when it came to leaving the dance. They left four years late! They are still dancing some four years after the last recession.

Why not stay at the dance? The answer is in the data. Monetary policy eventually revs up the economic engine. Recessions do not last forever and the economy returns to strength. Always worried they didn’t do enough, the Fed keeps the stimulus going for too long and the result is – higher inflation and then a need to fight inflation again. And then another recession.

To my scientific friends – I know a graph or two does not constitute real scientific proof  of anything. Someone else might be able to manipulate data that shows a fuzzier result. But I have been reading the literature and watching the economy for decades. I don’t think you can deny the fact that the Fed can best be described by the old adage -- from the frying pan into the fire and back again. It is time for the fed to reduce monetary stimulus and forestall the usual recession-inflation-recession nightmare.

Error Correction: Wolf's Howl is Off-Tune

Tuesday I posted an article that had two main points -- (1) Germany's improvements in exports did not, as Wolf argued, have any strong negative impact on the exports of other EU countries. (2) The main slowdown in demand in Europe came from capital spending and not from overall domestic demand. I concluded that Wolf's continued emphasis on stimulus spending was wrong-headed since the main problem in Europe seems to come from one sector -- capital spending.

In looking at my spreadsheets again, I found errors in the part that measures changes in capital spending. These errors do not change the above conclusions -- but since technically I wrongly quoted some numbers. I decided I needed to come clean!

In the article I said that capital spending had decreased in all EU countries. The numbers were very strong -- for example I erroneously said that overall EU capital spending had decreased by 90%. My corrected numbers show that EU spending on capital declined by 4% and that 14 of these countries exhibited declines ranging from -66% for Ireland to -1% for Latvia.

While these errors are important, they do not detract significantly from my conclusions.Consumer spending and export sales were very strong among the EU countries between 2006 and 2012.  The main spending sector contributing to slower growth in the EU was capital spending. The problem is not overall aggregate demand -- the problem is no real solutions for financial and housing problems.

I feel better now. Thanks.