Unfair Competition with Exchange Rates

On September 15, 2015 I wrote about exchange rates and said they were wild and crazy, like Steve Martin. I looked back over my previous posts and I have quite a few aimed at exchange rates and exchange rate policy. So for those of who are retired or simply bored I encourage you to spend a day or two memorizing all that stuff. My main reason for mentioning those past pieces is that they have a lot of background about exchange rates that I will avoid today as I focus on exchange rate data. 

My reason for writing about the data is that the word data sounds cool. Data this data that. Data is almost as cool as heteroscedasticity. But nevermind all that. Data is full of stories. Data without good statistical analysis means little but it can make you think. 

One thing we hear over and over these days is how China and many other countries take advantage of the USA when they depreciate their currencies. When other countries depreciate their currency that action appreciates the dollar and makes our exported goods less competitive. The story goes on that we have to shut down factories, fire workers, and make widows sew undergarments for Donald Trump.  Of course, the impacts of an appreciating currency are not that simple, but politicians like simplicity.

Today, instead, I share some data on this story about the appreciation of the US dollar. First, I will describe the data. I am using six key exchange rates for this analysis. The first five are well-known and are expressed as how many of the following currencies one can get with one dollar – European euro, Japanese yen, Canadian loonie, Mexican peso, and Chinese yuan. No offense to the Swiss or Brits, but I wanted to keep this manageable and I think the currencies I chose are the main ones for the dollar. A sixth exchange rate is a trade weighted index of the dollar evaluating it against a very broad group of currencies. Think of  TW as indicating how the dollar is doing against the currencies of nearly all our global trading partners.

So one decision I made was to choose these six exchange rates. A second decision related to examining changes over time. Did the dollar appreciate? The answer depends on the time period for the comparison. So here is what I decided. First, my data starts in 1999 – the starting year for the euro currency. Second, I eyeballed the data and decided that there were turning points in many of these currencies at or near the beginnings of 2005, 2008, and 2015. I agree, the results might have turned out somewhat different if I had chosen different dates. Third, I chose to use the data in January of those years. My table compares the April values of the exchange rates in 2016 to the January values in 1999, 2005, 2008, and 2015. All the data came from  https://research.stlouisfed.org/fred2/graph/

Check out the table below. The top half of the table has the actual exchange rates. Reading across the first line you can see the value of the dollar in January of 1999. In January of 1999 one dollar could purchase 86 euro cents. That dollar could also get 113 yens, 1.52 loonies, 10.13 pesos, or 8.28 yuans. The index number for what a dollar could buy in terms of a large number of currencies was 114.47. The second line shows you what the dollar could buy in January 2005. The fifth line shows you similar information for April 2016.

Let’s now use that information to see how the dollar has fared. Take the long haul first. Let’s look at the last column which contains information about the TW, the trade weighted value of the dollar. It was 114.47 in 1999 – 17 years ago. Some of you were mere children 17 years ago. In those 17  years the TW dollar value went to 119.5. In those 17 years the dollar appreciated by 4.4%.

This 4.4% increase in the value of the dollar against most of the world’s currencies supports the notion that the dollar appreciated. The question is what you make of that information. If we divide 6.6% by 17 years we could say that the dollar appreciated by an average of 0.3% per year. If we compare that 4.4% change over 17 years to changes in GDP or inflation or your waistline, you would conclude that 4.4% is not a huge issue. Or think about how much US firms might be impacted by the 4.4% increase in the dollar. Suppose those firms raised their prices by a total of 4.4% over the course of 17 years. Is that enough to convince you that those firms became less competitive? Were they forced to shut down because of this 4.4%? Is this a red herring so that politicians can protect us against evil beasts lurking in dark forests?

So you ask – Larry what in the Hades is this TW thing? Let’s instead talk about that evil monster China. Hmmm – how much did the dollar appreciate against the Chinese currency? The chart shows that a dollar could get you 8.28 yuan in 1999 and 6.5 yuan in 2016. That is NOT an appreciation of the dollar. The dollar fell against the yuan by 21% since 1999. Looking down the China column in the bottom half of the chart shows that the dollar has fallen against the yuan since 1999, since 2005, and since 2008. Only if you measure over the last 15 months can you see the dollar rising against the yuan – by less than 5%.

One more calculation -- how the dollar fared during the 11 year period between 2005 and 2016. The dollar appreciated at roughly a 5% to 9% clip against the Yen, the Loonie, and against our major trading partners. It is up 16% against the Euro, up 58% against the Peso, but down 21% against the Yuan. Much of that occurred after it became known that the financial crisis was spreading from the US to the rest of the world. As those countries are recovering and showing more stability today there is less need for the dollar to provide cover.  

Since I am running out of JD and your patience, I will end with this. The dollar is not greatly appreciating against anything in general. It is clearly rising in the last 15 months, except against the yen. But that increase is smaller than the increases that occurred right after the global recession spread. Further, if you look at the value of the dollar today you see some very different stories from country to country. 

The dollar has appreciated greatly against the Mexican peso while mostly depreciating against the Chinese yuan. If you want to find stories explaining subpar US growth and employment I suggest you look beyond exchange rates. There is no clear story here. More than likely the dollar strength reflects the weaknesses in other countries.  If and when the rest of the world stabilizes the dollar will return to a lower level. I doubt that political attacks on our trading partners will do much to normalize the dollar. 

Table. US Dollar Value Relative to Selected Currencies, 1999 to 2016

Date Euro  Yen Loonie Peso China TW 1999 0.86 113.29 1.52 10.13 8.28 114.47 2005 0.76 103.34 1.22 11.26 8.28 109.58 2008 0.68 107.82 1.01 10.91 7.24 98.65 2015 0.86 118.25 1.21 14.70 6.22 112.77 2016 0.88 108.07 1.30 17.76 6.50 119.50 Percent Change  to 2016 since 99 2.0 -4.6 -14.4 75.4 -21.5 4.4 since 2005 15.5 4.6 6.1 57.7 -21.5 9.1 since 2008 29.6 0.2 28.7 62.9 -10.2 21.1 siunce 2015 2.3 -8.6 7.2 20.9 4.5 6.0 Note: Exchange rates are foreign currency units per dollar in January of each year The quote for 2016 is April of 2016.

Cash: It's Just as Good as Money by Guest Blogger Buck Klemkosky

What Yogi Berra said is only partially true. In fact cash and money are not the same thing. There is a lot more money in the world and the U.S. than cash. Currency is another name for cash and in the U.S. it includes coins minted by the U.S. Treasury and bank notes ($1 to $100 bills) printed by the Federal Reserve Bank. The U.S. has $47.6b of coins in people’s pockets or piggy banks and $1,369.2b of FRB notes floating around. Not all are circulating in the U.S. as the dollar can be used in almost any country in the world. No one knows exactly how many dollars are outside the U.S. but government estimates are up to one-half. They have been talking about a cashless society for years but the amount of U.S. coins and notes increases 5-6% annually.

Currency (coins plus FRB notes) in circulation in the U.S. is $1,416.8b. Money includes all that currency but in addition includes bank demand (checking) deposits, shares at credit unions and money market funds and outstanding traveler’s checks. That equation describes M1, a narrow version of the money supply which totals $3,050.2b today. M1 plus savings deposits and time deposits less than $100,000 equals M2, which totals $12,466.7b. M2 is a broader measure of the money supply which the Fed monitors closely in setting monetary policy. 

Currency in circulation is less than half of M1 and 11.4% of M2. So cash may be as good as money but it’s not the same as money which is more widely used and more important in economic transactions.

Cash may be just as good as money for small economic transactions but obviously very burdensome for large transactions. Analysis of the denominations of currency outstanding tells an interesting story. In the U.S., $100 notes outstanding total $1,080.b, 78% of all notes. In Europe, there are $322b of €500 notes ($550) outstanding, 30% of total euro notes; Switzerland has $39b of SF1000 ($990) notes, 92% of all Swiss notes and Japan has $67b of ¥10,000 ($88.50) notes, 92% of all yen notes outstanding. Luxembourg, a country notorious as a tax haven, has euro notes outstanding equal to 200% of its economic output.

The obvious question is why there are so many large denomination bills outstanding in these countries? Most Americans don’t carry a lot of $100 bills and many Europeans don’t know the 500-euro note exists; most are in Russia and other countries outside the Eurozone. Swiss retailers usually will not accept the SF1000 bill for payment. 

Subtracting the amount of U.S. currency abroad still leaves over $2000 for each of the 330 million U.S. citizens and over $5000 per household. The obvious answer is that many of the high-denomination notes play little role in the functioning of the legitimate economy. It is the currency of choice for illegal purposes such as drug trafficking, money laundering, fraud, tax evasion, corruption and terrorist activities. It has been estimated by the IRS that $350b-$400b annually is not reported as income because of cash transactions in the underground economy. A 2011 study found as much as 18% of all taxable income goes unreported costing the government nearly $500b in revenue. There are legitimate reasons for having cash transactions but the probability of abuse increases.

Many are in favor of abolishing all high-denomination bank notes to make it more difficult to carry on illicit activities. Canada scrapped a C$1000 note in 2000 and Singapore a S$10,000 note in 2015. In 1969, the Fed and U.S. Treasury stopped issuance of $500, $1000, $5000 and $10,000 bills although they remain legal tender. At the end of 2015, $300m of these bills are still outstanding, most as collector’s items. While the U.S. Treasury says they have no plans to change the denominations in use today, the European Central Bank will consider abolishing the €500 note later this year. Achieving international consensus to eliminate other high-denomination bank notes will not be easy but it will be on the G20 agenda later this year for consideration.

Another reason some are making the case to eliminate cash as another “outdated relic” is monetary policy and the advent of negative interest rates. Banks in the Eurozone, Sweden, Denmark, Switzerland and Japan already have to pay to deposit funds at their respective central banks. If negative rates should ever filter down to bank depositors, it would incentivize everyone to convert deposits to currency. Large corporations and institutions with billions of dollars in deposits can’t easily convert them to physical cash; it would have to be stored in warehouses and vaults, incurring storage and security costs. Some large banks already impose a fee on large corporate deposits. Individuals could more easily convert deposits to cash and put it under the mattress, but at the risk of theft. Conversion of deposits to cash and hoarding of cash would diminish the effectiveness of monetary policy. The ability of a central bank to implement negative-interest-rate policies would be made less effective by cash hoarding. For example, the amount of SF1000 bills has increased by 17% since the Swiss Central Bank imposed negative interest rates on bank reserves in December 2014. Even though bank depositors don’t yet pay negative interest rates, this shows the sensitivity of big-bill cash hoarding to the possibility.

While there hasn’t been much progress toward a cashless society in the U.S., some countries such as Sweden and South Korea have seen the use of currency diminish. South Korea, for example, is a checkless society although bank notes are available. Every major building there has an ATM machine which allows one to pay bills via wire transfer to any other bank with no fee. The technology certainly exists to have a cashless society in the U.S. and elsewhere using mobile phones, online banking and more sophisticated ATM machines. Digital transactions would be cheaper, faster and provide more transparency. Those engaging in illicit activities would not like it or if worried about “big brother” overseeing their activities. There would have to be a central bank system to provide trust and stability unlike Bitcoin and several other private digital currencies. But don’t expect currencies to fall by the wayside any time soon; currencies have been around for 4,000 years and probably will be for many more decades. People like the security of having physical cash at their disposal as Yogi undoubtedly did.

The Fed Wishes You a Happy April Fool's Day

I don’t usually write short punchy things for my blog but I just couldn’t help myself yesterday after I read the paper and noticed that Mrs Yellen was being lauded for her recent remarks in which she assured the world that the Fed would hold off on its plan to become again a responsible Central Bank. Apparently people who operate in the stock market were given an unexpected Easter egg from Mrs Yellen and they reacted by pushing the stock market a bit higher.

So what’s my beef with all that? Or more appropriately, what’s my tofu?

Let’s imagine that you were perfecting your best run on the ski slope in Maggi Valley when you heard a loud crack and the next thing you knew was that ski patrol people were buckling you into a sled bound for the nearest hospital. Both you and the doctor stared at your swollen and oddly bent leg. Aha said the doctor – you seem to have injured your knee. Clearly this North Carolina doctor had trained at Harvard.

Dr Tarheel concluded that what you needed was a large shot of pain medicine. That pain medicine worked quickly and you felt much better. In fact you felt so good that you kissed four nurses and you patted Dr Tarheel in a place that was reserved for only Mrs Tarheel. You couldn’t walk very well but who cared! Off you went assisted by metal crutches. Later when the pain returned, you gobbled a few more pills and life was good.

Back home in Atlanta, you realized that you still could not walk. So you saw Dr Charlie and he explained that there was serious damage in your knee and he would have to operate. Your rehab would be both painful and long. Nurse Peter smiled and agreed wholeheartedly. Painful and Long? Life is too short for painful and long. You are a busy man. People need you on your feet. Maybe someone will invent a new way to solve knee issues that is not painful and long. And man, that pain medicine is good stuff. You might take three pills this time instead of two.

So as time goes by you get pretty good at those crutches. Of course, your ankle starts to hurt because of the extra stress of walking with crutches and you start getting bellyaches from all those drugs. Dr Charlie calls and asks how things are going and you explain that you still don’t have time for the operation. People need you and you just can’t let those other people down. And by the way, could you give him a prescription for new pain pills that will help with the swollen ankle and the hurting stomach?

Enough? Silly? Not really. Because no one gets it. Mrs Yellen doesn’t get it and the stock market doesn’t get it. This country has real structural problems that are not going to go away. The Fed has become the drug of choice – basically healing nothing and making us feel a little better, maybe giddy at times. In the meantime the drugs are creating imbalances in markets. Savers have gone half a decade with close to zero for a return. They need to go to the racetrack to get decent returns on their money. Banks riddled with new regulations sit on reserves while firms refuse to ask for loans. These imbalances are accumulating and will leave us on a cliff waiting for a stiff wind. 

If only China were stronger. If only Europe would grow faster? If only oil prices would rise another couple of bucks. If only the sun would rise in the West. The Fed is waiting and meanwhile we are getting swollen ankles and tummies. Shame on you Mrs Yellen! Do your job and return to responsible central banking. Maybe if those people who run the rest of the government knew you had some principles, they might start doing their jobs too. Now where is that JD? 

Global Interest Rates Turn More Negative by Guest Blogger Buck Klemkosky

For centuries, the bedrock assumption of finance was that borrowers paid interest and lenders and investors received interest, and that nominal interest rates would always be positive. That assumption has been turned upside down in recent years as lenders are now paying interest to borrowers; this prevails mostly in the commercial banking industry on banks’ deposits, called reserves, at the central bank. These reserves can either be required to back customer deposits at the bank or excess, those not needed to back customer deposits. Central banks are now charging commercial banks in 23 countries for their reserves on deposit or on their excess reserves.

Ever since the Great Recession (2008-2009), central banks have had to do the heavy lifting getting economic growth back on track and reducing deflationary pressures. First came the near-zero interest rate policies (NZIRPs), then quantitative easing (QE) and now the negative interest rate policies (NIRPs). The NZIRPs were implemented to boost aggregate demand by consumers and corporate investment by lowering borrowing costs. Another intent was to create a wealth effect by increasing bond, stock and housing prices, making consumers less risk-averse and more willing to spend or invest. QE programs involved massive amounts of bond purchases by central banks with the intent of lowering long-term interest rates on mortgages, auto loans and corporate bonds. The NIRPs work on the supply side by making loans more readily available to borrowers. Central banks impose an interest rate on bank reserves to motivate banks to lend excess reserves to borrowers to help invigorate lethargic economic growth. And there are unprecedented amounts of excess reserves on deposit at central banks.

The central bank of Sweden was the first to have an NIRP in 2009 but dropped it and raised interest rates as the economy improved. The ECB started its NIRP in June 2014 at -0.3%, joining Sweden (-0.5%), Denmark (-0.65%) and Switzerland (-0.75%). In January Japan joined the 22 European countries, 19 in the Eurozone, by implementing an NIRP with a -0.1% charge on some bank reserves as well as maintaining a massive QE program. In March, the ECB made a further cut in its negative rate to -0.4% and increased its QE program to €80b monthly, including the purchase of investment-grade corporate bonds denominated in euros. They also cut the short-term borrowing rate by banks to zero. Interestingly, the ECB imposed a negative rate on itself by offering to pay banks 0.4% to borrow money on a longer-term basis up to 4 years, as long as the banks lend the borrowed money.

These NIRPs have carried over to the bond markets as $7t of bonds, mostly government, have negative yields. This represents 25% of all government bonds outstanding in developed countries. In Japan and Switzerland, government bond yields are negative out to 10 years maturity, 8 years in Germany and the Netherlands, 7 years in Belgium and France, 5 years in Sweden and Denmark, 4 years in Italy and 2 years in Spain. A year ago there was less than $1t of government bonds with negative yields. There are also billions of dollars of corporate bonds with negative yields mostly in Europe and Japan. Some corporate bonds have been issued with a negative yield, Nestlé in Switzerland and more recently a bank in Germany. Today two-thirds of the $26t of government and corporate bonds in the Bank of America Merrill Lynch bond index have yields that are less than 1% or negative.

What are the potential problems with NIRPs? There are a multitude. Low and negative interest rates are challenging for banks that borrow (take deposits) short term and lend or invest long term. Thus far banks have been reluctant to impose negative rates on deposits but have had to lower rates on loans, sometimes negative, to stay competitive. Their net interest margin is being squeezed. Life insurance companies are also impacted as they have guaranteed rates on annuities and other insurance products. Money market funds have struggled with NZIRPs and NIRPs just exacerbated their margins or lack thereof: eleven of the largest money market funds in Japan have turned away new deposits and may return existing funds to depositors. NIRPs present problems to defined benefit pension plans that have assumed returns on investments well in excess of bond yields. More NIRPs may have dire consequences for many financial institutions. And NIRPs are a repression on savers who are receiving near-zero interest rates and perhaps negative in the future.

In addition to financial institutions and savers, NIRPs potentially increase risks to financial system stability by creating bubbles in financial assets like stocks and bonds and real assets like housing. It may also create problems for investors chasing yields in riskier assets and longer maturity assets. Many believe the primary objective of NIRPs is to weaken currencies and make a country’s exports more competitive. This is a zero-sum game if all countries try to devalue and risks the potential of currency wars and trade protectionism. Finally, NIRPs may signal that prior monetary policies such as NZIRPs and QE have failed and people will lose confidence in central banks and then they have a credibility problem.

One unintentional consequence of NIRPs has been cash hoarding and a surge in safe sales in Europe and especially Japan. The cash hoarders are ordinary citizens responding rationally to NIRPs which work only if savers spend or invest their money. Money is unproductive if stuffed under a mattress or in safes and safe deposit boxes. Cash hoarders prefer large denominations as do those carrying out illicit activities such as drug trafficking, money laundering, tax evasion, corruption and terrorist activities. The high denomination notes like the $100 bill, the €500 note, the SFR1000 note and the ¥10,000 note make up the largest portion of the respective paper currencies. 

Demand for these has accelerated in Europe and Japan; circulation of the SFR1000 notes ($1010) grew 17% in 2015 after Switzerland imposed a NIRP in January 2015.

Cash hoarding is an impediment to NIRPs and because of that some economists want to retire high-denomination notes and others to eliminate all paper currency and go digital. Theoretically negative interest rates can go lower but are constrained by cash hoarding, shadow banks and other factors.

NZIRPs, QE and NIRPs all had the same objective of stimulating stagnant economies. The question is have they worked? Japan has had an NZIRP and QE for some time but their NIRP is just two months old. The initial reaction to it was not as expected. The yen did not weaken, but strengthened relative to the dollar by 8%, savings increased and borrowing declined as citizens began to hoard cash. An NIRP has not helped Europe which is still experiencing anemic growth and deflationary pressures. There have not been a lot of positives so far with the NIRPs, except perhaps for lower borrowing costs, especially for governments, but that also could have unintentional consequences. The lack of robust economic growth in the countries that have implemented these policies may be due to other economic headwinds, and these economies may have been in worse shape if the policies had not been adopted. 

Christine Lagarde, managing director of the International Monetary Fund, states “if we had not had those negative rates, we would be in a much worse place today with lower growth and lower inflation.” Former Fed Chairman Ben Bernanke stated in his blog that negative interest rates “appear to have both modest benefits and manageable costs” and that “market anxiety over below-zero borrowing costs seems to me to be overdone.”

Even though the Fed raised short-term rates in December, some, including Congress, are questioning whether the U.S. could experience negative interest rates in the future. Janet Yellen, Fed chairperson, stated in congressional testimony in February that negative rates were discussed in 2010 but not implemented at that time. She also stated that she was not aware of anything that would prevent the Fed from implementing a NIRP but it would need further investigation of legal hurdles. The Fed already includes a negative interest scenario in bank stress tests and short-term U.S. Treasury bills have occasionally had negative yields.

If these monetary policies lose their efficacy or potency, what might be the last salvo of monetary policy? One possibility is what the late Milton Friedman referred to as a “helicopter dumping policy” (HDP). This would entail the central banks directly financing government spending or tax cuts, or directly sending checks to tax payers. This would be a more dramatic monetary policy than the three prior ones and would certainly be the “big bazooka” in stimulative monetary policy.  It is hard to imagine HDPs ever being implemented, but a decade ago the same could have been said about NZIRPs, QE or NIRPs.

Lesson 12 Balance of Payments: 2015 Data is in or is it?

As my loyal followers might recall, some of my posts are a tad more educational than others. Those of you who have degrees in silly things like fine arts and biology often appreciate my patient and vainglorious attempts to make every day complicated economic concepts even more complicated. If you look back among the 9,763 stories I have posted in the last 217 years you will see 11 such insightful JD motivated dramas. Today is #12.

Balance of payments is one of those sad macroeconomic indicators that MSW grads from Harvard know nothing about. If you asked all the remaining presidential candidates what BOP means they would probably guess it is the name of a dance invented by Bill Haley and the Comets. So I have chosen a wonderful topic for today’s blog and I want you to know that a test will follow.

BOP is a pretty optimistic and archaic name for data that attempts to record all cross-border or international transactions. Wow – what a goal – to record all international transactions! So let’s start out with the very well-known fact that BOP data are about as accurate as a CNBC presidential poll.  The BOP data is a noble gesture but if you think it is hard to measure how much your kid earned at her Lemonade Stand today, then imagine trying to account for ALL cross border trades in goods, services, stocks, bonds, bank accounts and what the Tuna would refer to as college boys gone wild in Tijuana.

But they try. I won’t defend the methods except to say that people who do this kind of thing are vastly underpaid professionals and most of them care very much about doing a good job. And who would bribe the guy in charge of measuring the exports of Chevy hubcaps to Havana? These government workers are saints and deserve a two-for one coupon at the Colonel Sanders Restaurant of their choice.

Before I get into the nitty gritty, I want to say in all seriously (ha ha) that BOP is the main event these days and helps us to understand things like economic growth, interest rates and so on. For example, BOP changes should help us understand why the dollar rose by 20% last year.  So don’t get lost in the trees – a forest of delicious fruits will unfold if you stick with this. Your life will never be the same. 

Let’s start with the easy stuff. Exports are the goods and services we ship to other countries. In 2015 we shipped $2.2 trillion to our trading partners. Of course we also bought that same kind of stuff from foreign countries and that amounted to $2.7 trillion in 2015. If you music majors can do the math, that means that we had a goods and services trade deficit of about $500 billion in 2015. I had a reading deficit once and that was not pleasant. So you can imagine the anguish when a lovely country like the US has a goods and services deficit of $500 billion. But here is the cool part. This deficit means that there are $500 billion dollars scattered across the world that didn’t want to buy US goods and services. We sent them $2.7 billion but they only sent $2.2 billion back. Thus they are holding $500 billion.

The suspense builds. What did foreigners do with all that money? Probably the first thing that comes to mind is to get rid of it. If you don’t want dollars – then you probably sell the dollars for renminbi or yens or some other currency. If that was the only outcome, then all that selling of dollars would probably cause the value of the dollar to depreciate.

But foreigners have other choices. They can use the dollars to invest in America. In this case invest should be taken broadly meaning they can use the dollars to open bank accounts, or buy stocks and bonds, real estate, a US company or buy a famous US monument like Mount Rushmore or Stone Mountain. If they do that instead of selling their dollars then the dollar does not depreciate and instead the prices of financial assets increase and/or interest rates decrease.

Back to the BOP accounts in 2015. Something called the Current Account measures exports, imports and a couple of other things. The exact deficit in the current account in 2015 was $484 billion after being $390 billion in 2014. Thus in 2015 we left even more dollars around the world.  But the Current Account is only half the fun. This brings us to what is called the Financial & Capital Account. Here is what I learned about the F&C account in 2015. After adding $977 billion to their US assets in 2014, foreigners only invested another $426 billion in the US in 2015. That is quite a turnaround. If I stopped the story there it would appear that in 2015 the dollar should have depreciated since foreigners were not pouring their dollars into US exports or US assets. All that would  make the dollar sound pretty unpopular.

But there is one more part to the F&C Account. That part has to do with US investments abroad. In 2014 US citizens added $792 billion to their foreign asset holdings. In 2015 that number fell to $242 billion. US citizens were investing more at home rather than abroad. Now put these two facts together – foreigners were investing less in the USA and US citizens were investing less abroad. In a crazy uncertain world, money was staying at home!

Cutting through all the numbers – according to the Current Account $484 went out of the USA for goods and services in 2015. According to the F&C account $209 billion came back to the USA to buy financial stuff. Thus there are $275 billion unaccounted for in the usual transactions in the BOP. Where are those dollars and what are they doing? Somehow they must be desired because during 2015 the value of the dollar increased. I think most of us know that global tensions created a healthy appetite for US dollars. But somehow BOP is not fully recording that appetite.

Right now that $275 billion is recorded in the F&C account as a “statistical discrepancy.”  Or in an accountant’s words—we have a $275 billion fudge factor in our accounting. I am guessing that revised data will show more foreigner investment in US assets. One likely suspect is governments who bought dollars in an attempt to depreciate their currencies. Otherwise the BOP data leave it very hard to explain a 20% rise in the value of the dollar in 2015. 

The Services Growth Engine

I often hear people lament the decline of real production and wealth as our nation has evolved from agriculture and mining to things like manufacturing and then finally services. To these people there was something real and tangible to digging stuff out of the ground.  Even manufacturing seemed lame compared to endowments of real landed wealth. Imagine their thoughts about basing a nation’s economy on services. The definition of a service is something that disappears upon production! How can you base an economy on something that disappears and soon as it is delivered!

But let’s face it, some countries do quite well when it comes to surviving and growing without having natural resources and some do it today mostly with services. According to the CIA Factbook the services sectors comprise nearly 80% of national output in the USA and UK. Bermuda counts 92% of its GDP as created by services. In contrast, Afghanistan, Burma, Ethiopia, Somalia, and Togo were among the countries where agriculture represented more than 30% of total output. A quick look down the list of countries makes it pretty clear that most higher income countries live off services production. See the table below for recent US data on employment. 

What are these services? Some of the largest services providers in the USA include real estate sales, state and local government, finance, banking,  insurance, healthcare, retail trade, wholesale trade, entertainment, education, tourism, transportation, and more. In each of these cases, a service is provided to a customer. When the cruise ship kicks you off the boat, the only tangibles you possess are the selfies you took and those extra 10 pounds hanging over your alligator belt. Yet GDP was created, workers were paid, and importantly capital was created and retained.

People worry that since there is no land or metals involved, somehow economic power expressed within services can disappear as easily as it arrived. But that is not true of services alone. Locusts or other such things have destroyed land and its ability to produce crops. A good red tide can kill fish and other sea creatures in the millions. Tsunamis, earthquakes, tornadoes, and asteroids can easily undo the value of natural wealth. A new invention makes one commodity almost obsolete as it is replaced by another.  So it is no great advantage or staying power guaranteed by land and commodities.

Think about tourism. No good is produced when a travel agent sells you a trip to Sanibel Island. You consume touristic output as you travel to this lovely destination. But notice how much lasting capital gets created by this event -- not because you want to buy a Chevy – but because you want to spend a few days getting a sunburn and indigestion. Your vacation wouldn’t be much fun if you didn’t have at least a Trump Hut for shelter and a bevy of restaurants and bars to quench your thirsts. Why are those buildings that produce touristic services any less real, enduring, or impactful than a tomato farm's harvester or a shoe manufacturing's factory?

Some people argue that many services are very low price or low skill. They worry that a transition from manufacturing makes a country poorer. They see manufacturing replaced by, say, retail outlets. But let’s be honest – not all manufacturing is high value added and many of these same people have complained that manufacturing companies take advantage of US workers or worse yet ship the jobs abroad. We still have a lot of low wage low skills manufacturing jobs in the USA but how long will they last? So maybe this claim is a bit exaggerated. And of course, it is easier for foreign countries to entice these lower skill manufacturing companies from our shores. It is a little harder to do the same with the Macys store in Bloomington.

And what the above argument completely ignores is the existence and importance of very high skilled services. Not all services workers push brooms or wash cars. People who dream up convenience Aps for our phones sell no phones yet they provide a lot of employment. Medical research professionals are indispensable to high tech manufacturing companies who will use the inventions and innovations to support superior goods. Since high tech services (in finance, health, transportation, tourism, etc) rely on higher paid and highly educated professionals – growth in these areas take advantage of US prowess in education and training.

I get my telecom services from AT&T. My monthly combined bills for TV, phones, and Internet are sizable. I pay much more for those services than I paid for the phones, TV, and computer. Think of the range of employment offered to service workers at AT&T. Think of all the capital invested by AT&T to support these services. Maybe not all those jobs pay super-high wages, but most of them defy the usual stereotype of the broom pushing service-worker.

We have enough to argue about. Going back to an economy based on land, commodities or even manufacturing just doesn’t make sense for the USA. Services are here to stay. They produce jobs and they are supported by huge capital stocks. Let’s appreciate our US trade surplus in services. Let’s appreciate what we have today and build on it. There is no guilt in a services economy!

Below is a table I created with data I took from the Bureau of Labor Services of the US Government.

Employment in February of 2016 (bls.gov) Thousands of jobs
                                 
NonFarm Employment Total      139,343

Goods                                                19,042
Mining & Logging                    861
Construction                           5,962
Manufacturing                      12,219

Services                                             98,042                                
Wholesale Trade                     5,816
Retail Trade                          15,239
Trans and Warehousing          4,738
Utilities                                      552
Information                             2,729
Finance                                   8,016
Real Estate, Rental, Leasing   1,481
Professional and Bus Svs      19,137
Education                                3,591
Healthcare                             14,847
Social Assistance                    3,449
Leisure and Hospitality         14,374
Other Services                         5,555

Government                                       22,259
Federal government                 2,730
State government                     5,227
Local Government                 14,302

Globalization and the Trumpaline

A trampoline is a thing you jump on. If you get really good at it you can do flips and all sorts of amazing gymnastic maneuvers. Right now everyone is jumping on Donald Trump so I thought I would jump on him too. Let’s call this a Larry Cannonball on the Trumpaline.

I will leave all the exciting stuff to other people and focus on the one thing that I think I know a little about – industrialization and globalization. Okay smarty pants – those are two things but in some ways they amount to the same thing because they are known to chew up jobs. Industrialization is a force that has been going on for centuries but it got a very hot reputation when it resulted in tractors replacing horses and plows. 

Ever since then we acknowledge that new technologies and innovations destroy jobs. Of course, we have also learned that while each significant industrialization phase creates its own destabilizing impacts the net result takes time and usually leads to not only more national employment but also higher wages and incomes.

Lauren’s great grandpa used to be the guy who blew out the candles in all the street lamps in Bloomington. Electricity knocked him out of work but that whole electricity thing also led to cool inventions like vacuum cleaners and blenders and pretty soon all sorts of people had great jobs as electrical engineers and bar tenders. If you take a big swig of JD, close your eyes, and think about your life you can easily think of all the labor-displacing inventions that caused similar disruptions but eventually came to be ho hum. I make light but these are no small things. When the textile industry abandoned the NE part of the US – it wasn’t very funny to those displaced by the invention of air conditioners that made work in the South more tolerable. Now we all say "yawl" and I "guarandamnteeit".

Most of us don’t fight industrialization very hard. We know it works. We like the fact that all those street lamps can be turned off with the push of one button and we like the fact that we can afford vacuum cleaners and bartenders. One of the reasons we have social programs is to try to make the transitions a little gentler. Helping those persons who become unemployed or otherwise disadvantaged by change is both good for the head and the heart. So we usually embrace change. Some of us love change but that is not necessary so long as society allows these transitions. The truth is in the pudding since not many of us are demanding a return to the horse and plow.

That brings us to globalization. Globalization is pretty much the same thing as industrialization except it allows us one more angle – the good guys (us) versus the bad guys (foreigners). Globalization is the same as industrialization because it does the same things – it creates havoc for some people while opening up avenues for growth and change for the rest of us. If a company closed operations in Indianapolis and reopened in Guadalajara Mexico you could hear the labor union and Donald Trump screaming all the way to the South Pole. How dare those blankety blanks leave Indianapolis to go to Mexico? They must be national traitors and they should be hung in the public square or in the Hoosier Dome.  Trump has made it very clear that he will make America great again by pulling all those companies back to Indianapolis and Detroit. Hillary Clinton is saying similar things. 

It sounds great. Let’s save American jobs. How can one argue with that? For one thing, it amounts to asking us to return to horses and wooden plows. Industrial transitions do not just occur in America. Now that dozens of countries are freer to compete in global markets the marketplace for change is everywhere. New ideas and innovations that improve our lives are developed and sold everywhere. To think that all that stuff would always be made in America does not make any sense. China will be the best place to make some items but even China is outsourcing output to Vietnam. Mexico will be a place of manufacturing for other things and they will outsource some of their supply chain to Chile. To think that Donald Trump or anyone else can or should fight globalization is silly.

For another thing fighting globalization means voting against change and the transitions that actually make American workers worth what they want to earn – close to $50,000 per year. We talk about greedy US companies who want to go to Mexico to take advantage of lower labor costs in Mexico. Now they are greedy. Yesterday and for how many years were those same companies employing American workers? Unions might complain about this or that but the truth is that many people raised families for decades because of the jobs offered by these companies. Were they greedy then? I don’t know whether they are more or less greedy today. What they are doing is fighting to succeed and in some cases to survive.  Competition across the globe is intense. To not change is to die.

So long as the average income of educated and/or trained workers in many emerging markets is less than $10,000 per year it is pure folly to think that US workers hired at $50,000 will offer the best place to do business.  To save the company and American jobs, a US multinational will move some operations out of the US. Of course to save the remaining jobs they will continually have to improve productivity of the domestic workforce or even the higher skilled jobs will be threatened. Think of wave after wave of enemy combatants coming after your defensive position. Building a bigger wall might work for a while. But what you really need is an advantage.

Trump vilifies other countries for trying to come into the global economy and for daring to compete with the USA. The only real solution to this challenge is not to regulate US companies but to unleash them. Making America great means American companies winning in the global marketplace. It means change and growth. Don’t tell me that centuries of US growth are over. Tell me we have a plan to empower US companies so they can do what is necessary to continue producing good jobs and incomes in America.  The world is not always a fair place. Making it even less fair isn’t the solution. We have so many advantages over emerging market competitors they are impossible to list. We should use them and quit bellyaching!

Socialism

I wanted to write something thoughtful about socialism. Socialism seems to be sexier than ever and so I had a lot of motivation. And then like reading a four hundred page textbook on sexual dysfunction, I soon glassed over and wondered why I had begun the project in the first place.

That got me thinking again about Bernie Sanders, his supporters and critics, and the possible usefulness of understanding socialism better. I began by searching around for definitions of socialism and that didn’t seem to help very much. If you read enough you soon find that like drugs and bourbons – there are many different kinds of socialism. So I started looking for a common refrain or set of words that were party to most of the definitions and I hit on “state or social ownership” and “democratic control over the means of production”. These are interesting words but hardly ones that we use very much today.

One theme or set of words that made more sense to me was something like “a way of organizing society in which major industries are owned and controlled by the government rather than by individual people and companies.” Now that one I could sink my teeth into. Immediately China and Vietnam come to mind. In Russia the government owns Gasprom and in Venezuela PDVSA is one of many large companies owned by the government. In Sweden and Norway the government owns many companies too. According to that definition there are many socialist countries.

But as I said above, there is no single definition of socialism and as it turns out there is no simple manifestation of it either. Some countries own many companies while in other countries the government owns only a few. But the differences go even further than number of companies owned. Nowadays we would say that a country is more socialist if the government plays a large and active role in society. One might say that Germany is socialist not so much because the national government owns some banks but more so because government spending is a large percentage of the national economy (as it also is in Belgium, France, Finland and several other countries). In this case the notion of socialism has more to do with the size and reach of government. In this definition a country is less socialist and more market-oriented if it has relatively less government spending and regulation.

I draw two conclusions from the above. First, socialism is not a binary yes/no answer.  Countries are more or less socialist and there are few extreme cases today in which 100% or 0% of all activity is within the government sphere. Thus all countries are at least a wee bit socialist. Second one can always discuss how socialist a country is by looking at how much of national activity is done or largely affected by the the control of government. 

The reason for going through all the verbal torture above is to make the point that “we are all socialists.” The US is already socialist if you agree that about 17% of all US employees work for a local, state or federal government office. Or that the federal government’s debt is approaching 80% of the size of the economy. Or that federal, state, and local government tax revenues will soon reach $6.6 trillion or 36% of the national economy.

So this whole thing about the US becoming a social state is a red herring – no offense intended to small fish. Most of us operate in an environment of markets with a medium to heavy involvement of government. Thus we are both capitalist and socialist. Even China, once the leader of the Communist world, has deregulated many state-owned enterprises and has allowed market forces to effect prices, wages, and other key economic indicators.

So forget that Bernie Sanders is called a socialist or that America is going to become a socialist country. The real question is how to make America’s economy better or how to address our worst economic problems and make the economy work better for all of us. In pursuit of those goals we have a choice but it isn’t between capitalism or socialism. 

The choices are about how we use government to pursue these goals. On the far left we have ideas that essentially greatly increase government reaches. On the far right we have the opposite. There used to be a day when we had a middle approach that took it for granted that we probably should not greatly increase or decrease the role of government but should find ways to make the current extent of government work much better.

A more moderate approach is a compromise and that satisfies almost no one. We could find solutions for the middle class and we could find ways to deal with global competition and industrialization. There are ways to create fairer taxes and more economic growth. But the sad thing is that we will never get any of these things because we would rather argue about who is socialist and who is not. 

One last point about socialism. It seems odd that the people who seem to yell loudest about wanting socialism are the ones who do not live in socialist systems. In Cuba and China, for example, citizens would not be able to broadcast their opinions especially if they questioned socialist policies. And while capitalism may not be perfect it has a long way to go to equalize the economic sins of some socialist systems. In the Soviet Union one could go to the ballet for free -- but many people had to wait decades to receive an apartment or replacement parts for their dilapidated Ladas. Imagine the chagrin of Venezuelans today as the government stopped the expensive practice of virtually giving away goods to the people (7 cents per gallon of gasoline!). And finally, I just saw a report that China has more billionaires than the US. What does that tell you about distribution of income in China?

I see some of you folks at the gym now and then. A couple of you approached me the other day and asked me about my solutions. They were frustrated that I point out the defeatist nature of warring ideologies without suggesting any remedies. I have to admit that I don’t have any real solutions. But I can say that I wonder if democracy is still a viable system when the voters themselves line up in ideological extremes. We haven’t always been that way in America. How did we get there? And if I am right, is there a path back to compromise and meaningful negotiation among people with different opinions and solutions? No I don't have the answer. Do you? It might be the question of our times! 

Should Obama Nominate a New Supreme Court Justice?

When a really big controversy hits I usually like to give it a month or two to see where things settle. But for this one I couldn’t wait. This one is a beauty.

I watched TV news and saw two parties talking past each other. The Democrats were saying that of course the President should do his Constitutional duty and nominate a replacement for Judge Scalia. Republicans were saying that they have the power in the Senate and would definitely turn down an Obama appointee or simply won’t go to the trouble of acting since it is a fait accompli.

Instead of focusing on the obvious story talking heads have already wasted enough hours to write the definitive almanac on love. Experts continue to discuss and debate the meaning of the remaining months of Obama’s time in office. They debated if he is a lame duck or not. They went on endlessly about the difference between a vote and not having a vote. They talked about Senator Schumer and what he said in 2007 compared to what he said last week. We have heard people analyze court appointees who were denied hearings in the past. Then there is the issue of whether or not today's voters should determine the choice. 

All that discussion is juicy but meaningless for today’s question. What no one seems to want to say is the obvious – we have a President and a majority party that are driven by ideology. Hillary was saying that even if President Obama nominated a moderate and reasonable judge – those darned Republicans would not give her a hearing. But folks – let’s be realistic. Is there a snowball’s chance in Hell that he would nominate such a person? Obama has publicly hated many of the decisions of the current Supreme Court. Remember Citizens United? That case is always and everywhere lamented by Democrats who would love the chance to have it overturned. Obama is being sued by groups who want to overturn many of his presidential directives as well as his prize legislation, Obamacare. Are you telling me that Obama would nominate someone who would threaten liberal progressive values? 

Obama will nominate a justice who will turn the tide of opinion on the Supreme Court. This new justice will allow the liberals on the court to have their sway and by all means the new court will get many chances to support Obama and to tear apart anything those hated Republicans want done  or changed.

So what are good Republicans to do? Basically there is only one thing they can do. They can stall the process so that the next President might not have such clear ideological and political goals. It makes absolutely no sense for Republicans to not use their Constitutional prerogative to turn down anyone the President might nominate. But why waste everyone’s time? So they are just telling the president to hold off. 

This debate has nothing to do with the Constitution and nothing to do with what past presidents have done near the ends of their terms. It is not about democracy. This debate is like everything else going on now – it is about people at the ideological ends pointing fingers and yelling at each other. Us folks in the middle keep shaking our heads and wonder how we got to such a place. Obama and liberals want to preserve the Obama legacy or at least prevent conservative decisions later this year. Thus they want Obama to appoint a progressive friend.  Republicans want to tear apart Obama’s encroachments and move the court in a more conservative direction. They do not want Obama to appoint a progressive friend.

So now we have one more thing for the Democrats and Republicans to argue about in the coming election. Instead of admitting that the Court appointment is a political issue the Democrats will say the Republicans are obstructionists who won’t allow the President to fulfill his Constitutional responsibility. The Republicans will counter that the Senate has a Constitutional duty to not agree to Obama’s nominee.

Does this surprise anyone who lives in a bifurcated America these days? The extremes have taken over and EVERYTHING has become political. Compromise is seen by both sides as a cop out. Each side clings to "It is our way or the highway". Why would appointing someone to the Supreme Court be any different? Pretty soon I will have to choose between a Republican brand of JD and a competing Democratic brand. What a mess. 

2% Inflation -- A Fool's Quest

I wrote a piece on January 19^th about the Fed’s 2% inflation goal mostly saying that the 2% was a ruse – a way to take your eye off the ball. The Fed wants the unemployment rate lower and the economy stronger and the low recent inflation gives them the excuse to keep their pedal to the metal.

But there is more to the story. So let’s beat on the inflation goal again but in a different way. It seems clear why the Fed might want to adjust policy so as to reduce the unemployment rate. Higher unemployment hurts people. Lower unemployment is a sign of a healthier economy. I am not saying that the Fed is good at lowering the unemployment rate, but it seems to make sense that lower unemployment might be a desirable end.

During much of my lifetime, the Fed’s main goal was to reduce pesky inflation. That seemed reasonable too. Inflation is annoying. Ask folks who lived in any country ravaged by 100% inflation. Inflation hurts. Even when inflation hits 5-10% per year few of us like that. But the Fed tossed all that out lately. Their goal is to raise inflation. What? Why would they want to do that?

The answer has nothing to do with inflation or prices. The answer is that low prices might be an indicator of flagging or deficient national demand for goods and services. Influencing sagging spending makes sense but if you are concerned about low aggregate demand then why doesn’t the Fed come clean and say it is trying to raise AD? The answer is that AD is like love. Love is not directly measurable. Does she love me or does she not? We are always guessing about such things. If you want to know if someone loves you then you look at behavior. Apparently the Fed thinks it can look at measured prices to know what is happening to AD.

The problem with looking at inflation to gauge AD is that it simply is not very good for that purpose. For one thing, inflation reflects aggregate supply (AS) as well as AD.  When inflation falls because of increases in AS – then the Fed should not be reacting to that. So if the Fed has no direct measures of love or AD or AS, then inflation can be a dangerous and misleading indicator. When inflation falls is it because AD went down or because AS went up?  It is hard to know and reflexively presuming AD and inflation are the same thing has frequently led to grave policy errors and unnecessary economic suffering.

A second important problem with using inflation as a measure of AD is that inflation is like Steve Martin – wild and crazy. Inflation measures jump around like a kid on a red ant hill. Below I use some inflation data to make my point. The Fed might as well use lighting strikes to measure AD…it is a fool’s game to use inflation numbers.

My measures of inflation today are called implicit price deflators for GDP.  They are published by the Bureau of Economic Analysis and found at bea.gov with the various GDP statistics. Notice in the detailed table below there are inflation numbers for 2014 and 2015 for every component of GDP. This is a very comprehensive measure. It is broader than the consumer price index since it includes inflation rates of prices for things like plant, equipment, and exports. The closest thing to the CPI in this group is the deflator for personal consumption expenditures. 

I said above that inflation numbers are wild and crazy and could not possibly be good proxies for what is happening to AD or anything else. The overall index for inflation (for GDP) was 1.6% in 2014 and then 1.0% in 2015. The Fed would say that the national inflation rate fell and might be a problem if AD fell in 2015 and worsens in 2016. So far so good. But let’s look inside the wrapping of that sausage.

While the prices of consumer goods were falling by 2.9% in 2015 notice that the prices of consumer services rose by 1.9% after increasing by 2.3% in the year before. Note that the inflation of consumer services averaged those two years around 2%. Thus consumer services prices are at the Fed’s spoken limit. By the way, consumer services were approximately 65% of all consumer spending and 45% of GDP. In contrast, wild and crazy durable goods are only 13% of consumer spending and 9 % of GDP.  The durability of future inflation rates are much more associated with the heavyweight consumer services and much less influenced by wildly gyrating prices of consumer durable goods.

The GDP component we call investment includes purchases of capital goods – plant, equipment, software, buildings, and more. While consumers buy residential investment, the rest of these items are generally purchased by businesses. Notice the behavior of prices in this category. While the prices of the nonresidential portion of investment goods barely budged in 2015 (0.2%), prices of newly produced residences rose by 2% after rising by 6% the year before. Finally look at the behavior of both import and export goods.  Prices fell in those categories by 7-8% in 2015 after being pretty flat in 2014.

When you read the first line of the table and see that the US inflation rate fell to 1% in 2015 one might get the impression that the prices of most or all goods and services followed in lock step and somehow national AD must be on the decline. But this could be very misleading since the average masks a lot of different and conflicting changes – each one having a very different implication for AD or AS. Clearly spending on the biggest part of GDP, consumer services, was strong enough to put inflation of consumer prices at the Fed’s goal value. If you add prices of new residences, you get the same result – healthy enough spending to put inflation at 2%.

So what causes the impression that inflation is falling? Clearly sectoral issues that may or may not be AD in origin make the results very muddy. For example, prices of consumer nondurable goods retreated because of gasoline prices. Lower gasoline prices, however, should give consumers more money to spend on other items. Prices of imports and exports figured into much lower prices of those categories. Again, how much do these international changes reflect ongoing AD issues that our within our sphere of influence?

A closer look at inflation numbers suggests a mixture of temporary changes in highly volatile sectors and a mixture of AD and AS impacts. They paint a very unclear picture of how national AD is changing and a poor clue as to what will happen to inflation and AD in the future. The Fed should stop talking about inflation and be more honest about its true goal. The Fed has become Supergirl of modern times. Even the tiniest worry about unemployment or economic weakness sends the Fed into action. This was never the intention of the framers of the Federal Reserve Act and ignores all of the unintended negative impacts and imbalances that such policies have shown time and again.

Table. Inflation as measured by changes in

implicit price deflators of GDP

                                     2014  2015

Gross domestic product	1.6	1.0
Personal consumption	1.4	0.3
Goods	-0.4	-2.9
Durable goods	-2.3	-2.1
Nondurable goods	0.6	-3.3
Services	2.3	1.9
Investment	1.8	0.6
Fixed investment	1.9	0.6
Nonresidential	1.0	0.2
Structures	1.5	-0.5
Equipment	0.7	0.7
IP products	0.9	0.0
Residential	6.1	2.0
Net exports	na	na
Exports	0.1	-4.9
Goods	-0.7	-6.8
Services	1.9	-0.6
Imports	-0.2	-7.7
Goods	-0.5	-8.9
Services	1.2	-1.7
Government	1.8	0.2
Federal	1.6	0.7
National defense	1.4	0.2
Nondefense	2.0	1.4
State and local	1.9	0.0