Don’t Pick- up that $100 bill. It isn’t really there. Defending Efficient Markets

A guy sees a $100 bill on the sidewalk and walks right by it. A Keynesian comes up to him and asks him why he didn’t pick it up. The guy answers that he believes in the Efficient Market Hypothesis (EMH) – and the bill must not be real or someone else would have already picked it up! This joke is a real knee-slapper for academics. It is meant to demean the EMH. This not only shows why academics are not allowed to mingle with normal people but it also irks me that my fellow academics have too much fun beating a straw horse.

Why defend the EMH?  One reason is because it is 95 degrees and Betty will have me doing tasks in the back yard if I don’t pretend to be doing something in my nice cool basement office/laundry room/ junk room.  The other reason is that it needs defending from people who would use this as part of their rejection of markets and capitalism. Some experts believe that our recent financial crisis proves the EMH is wrong.  Even worse, it gives them a high horse to preach for more stimulus and more regulation.  So I would like to give them a little piece of what is left of my mind.

Before getting into the particulars we should take a step back and think about the whole idea of learning and hypotheses. You don’t have to have a PhD  to see the importance of hypotheses. As a young parent you believe that you should keep a close eye on your two-year-old. You have a hypothesis that if you completely ignore your child, a problem could arise – perhaps even something terrible could happen. I remember when we once saw our neighbor’s child on the roof of their house. They blinked one minute and somehow he was on the roof. It scared the crap out of all of us. Hypotheses like this one lead to action items or policy prescriptions. If the hypothesis is true, then you need to have rules for vigilance. You need to be a very active parent. We usually frown on leashes for children but I know of some parents who have resorted to such things.

Financial economists have a hypothesis about the prices of assets like stocks and bonds – and houses. The hypothesis states that the price you observe in the market for GM stock or for the average of all stocks is the result of buyers and sellers searching for all the relevant information, analyzing it, and then using it in their sales and purchases. This is not very sophisticated stuff. It just says we are not a bunch of LAZY LOSERS. Most of us – before we buy a refrigerator or a car or a share of stock – try to figure out what it is worth or at least find some information that would support our buying the item at a particular place and time. Suppose you do a little research and you are ready to buy the latest I-Phone when your mother comes in and says she heard that I-Phones cause pimples. But the Droid does not cause pimples… So you look in the mirror and pop a few – and then make your decision based on all the information.

This is not a crazy hypothesis to say that people try to buy as well as they can! Would you rather assume that most people are really lazy and ignorant and dumb and they just buy stuff regardless of price or other relevant information? I hope not. My father would spin in his urn.

Okay – so people – both buyers and sellers – gather and utilize information when trading various assets. This implies that the current market price, which is determined by the interactions of buyers and sellers, REFLECTS THE STATE OF RELEVANT EXISTING INFORMATION. It makes no sense that people would totally ignore pertinent information that was out there.

Basically this is what the EMH says – that current prices embody current information. It also implies that it is difficult for someone to make gains in the market that are not available to everyone else. If prices register all the current information, then it is difficult for one person to profit from the information.  If the EMH is true, it stands to reason that it is hard to “beat the market”. EMH friends advise me that I should buy an index fund and just hold it. Trying to pick individual stocks and to time the market (buy low and sell high) is virtually impossible if information is abundant.

Another implication of the EMH is that government intervention into markets is unnecessary. If prices are being driven by information flows about fundamental factors, then prices are playing their appropriate roles in a market system. Consider the recent bubble in asset prices. At the time Alan Greenspan did not think the Fed could or should do anything about rapidly rising housing and stock prices. Presently the government doesn’t talk much about a bond price bubble. Why? Because Greenspan and Bernanke believe that asset prices are being determined by fundamental factors.  They may not like these fundamental factors but by their very nature they are not easy to change or remediate with policy.

But notice that if the EMH is wrong, then perhaps phantoms or something or someone terrible is behind price changes and something should be done about it.  This creates a stronger role for government intervention – if the EMH is false. So is it true or not?

One piece of information being used these days is to point to Hedge Funds and to acknowledge that some of them have made a ton of money choosing stocks and timing the market. If you have not already, you should read Sebastian Mallaby’s “More Money than God”.  But just because there are examples of Hedge Funds or other investors who made a lot of money, this does not necessarily disprove EMH. How many Hedge Funds lost money trying to pick stocks and time markets? How many funds made a lot of money trading only to eventually lose it using the very same models and approaches? All it takes is a few very successful and very lucky pickers to get the attention of the press. A few successes do not, however, make a rule. If 10,000 monkeys are given computers and 10 monkeys print out the line – Davidson should receive a Nobel Prize – then would you nominate me for the award next year?   Hopefully the outputs of the 9,990 monkeys would have some sway with you.

Furthermore, the EMH never said that it is impossible for some people to know more than others for a time and it never said it was impossible for unscrupulous people to contrive means to fool the public. The EMH only says that ability to corner the market on information should not go on forever and once information becomes public prices will reflect fundamental forces.  

Finally, there is the paradox that if EMH is true, how is it possible that asset price changes could look so much like bubbles? You have heard all the stories of rapid price appreciation – and people wondering just how long it would keep up. In the meantime, people were buying houses and stocks at prices that seemed drastically out of line with reality. How can a story about rationality and efficiency explain buying $100,000 condos for $300,000?

The answer lies in what you consider to be the appropriate price. Should the appropriate market price consider future expectations?  You are considering buying a nice condo. Last year similar condos were selling for $100,000. Today you learn that oil has been discovered on the property and all condo owners are expected to receive $500,000 in future royalties. What would you pay for that condo today? That lovely little property that was worth $100,000 yesterday is worth more like $600,000 today. Is that irrational? That’s a big change—but it can be explained by expectations about the future. What would the condo be worth if scientists found that the property was being built on top of a former electronic factory and that the land was giving off cancerous fumes?

I hope you are getting the point that the EMH is perfectly compatible with extreme changes in price. Now, let’s apply this to recent events. There were plenty of reasons to explain why housing and stock prices were rising before 2008. No one can know the future so there were many thoughtful discussions that led many people to conclude that the fast pace of house and stock prices made some sense. There were also many people warning that the prices could not sustain such a rapid pace. All opinions were out in the public and all we can say in retrospect is that people operated with an expectation that prices would continue to rise. That expectation made more people willing to buy and willing to buy at a higher price. The expectations were self-fulfilling. At least they were until the correction came. While this suggests that bubbles do pop or corrections do come – this does not in any way disparage the EMH. EMH simply says people use information in transactions. When expectations about the future are strongly and passionately held – this is part of the information. Those prices that today seem so out of pace with reality – were efficient guesses three years ago. They used all the information.

Today we have a different set of expectations and a different and depressed level of prices. These are efficient prices for today’s information. And this leads us to the final point – what can or what should be done. Let’s not throw away the EMH – rather let’s use it to decide what to do. It seems to me that what went wrong were two things. First, regulators didn’t do their jobs. The whole credit chain fell apart as EVERYONE justified their expectations by leveraging in dangerous and illegal ways.  And the regulators let them. Second, policymakers helped to sustain the fundamental factors that led to a desire for more leverage and for higher asset price inflation. Greenspan didn’t see how low policy-induced interest rates induced a desire to take more risk in markets.  The Fed stoked the fires.  And Fannie/Freddie fanned the flames.

Now the expectations are that prices will continue to fall. That means there is a good way and a bad way for policymakers to act now. The bad way is to try to grease the wheels of credit expansion. That just gets up back into the same garlic pickle.  The good way is to approach the fundamentals. People will believe that the worst is over when policymakers earnestly address what was wrong. To do this they need to do sensible things that reduce our need to leverage ourselves beyond our ability to pay.  Regulation and policy should be addressed to sensible use of borrowing by the government and the private sector. Until they do that it is hard to see an end to the current economic slowdown. Now where did that $100 bill go? 

Lilliputians at the helm -- Why we can’t escape this recession

I heard this joke a long time ago – A guy is driving his car in the mountains. As he heads into a sharp turn a person standing next to the road yells to him – “Pig”. The driver is incensed and yells back at him “Jerk”. Immediately after turning the corner he runs right into a pig in the road.

This joke reminds me of our political leadership. They seem to have no ability to communicate. It seems to me that the problem is worse now but maybe it has always been that way. I don’t know but it is making me more and more irritable!

Since my life has been spent thinking about macroeconomics, it amazes me how the current debates about economic stimulus get us nowhere.  Even the pace of the recovery has become politicized. Republicans seem to want the economy to double-dip so they can point their fingers at the Democrat’s whose stimulus policies did not work. Democrats want the recovery to look good but not good enough to stave off another round or two of stimulus.

While economists also join the usual partisan bickering we are inflicted by our inability to say anything that the politicians seem to understand.  Economists are a lot like meteorologists during hurricane season. We have a lot of theory and a lot of data but we still make a lot of errors! When we try to explain our reasoning, the average politician or TV viewer heads to the kitchen for another slice of black forest cherry cake with vanilla ice cream.  Don’t say all that jibberish! Just tell me if a hurricane is going to hit my house! And when!

The lucky thing for meteorologists is that politicians don’t usually act on hurricane predictions!  So we economists duke it out in the Wall Street Journal, the Financial Times, and Fox News.  I knew that would wake-up some of you! J    And yet, the politicians keep saying inane things and then VOTING on real policies that will affect most of us from now until Hell freezes over.

So I am going to give both sides a little advice. First, in all likelihood we are not headed for either a pure capitalist or socialist state in the near future. This is not about extreme states – it is about the best way to permanently exit a recession and a way to return the unemployment rate to something more normal. SO SHUT-UP YOUR SLOGANS AND QUIT CALLING EACH OTHER NAMES. 

Second, this recession IS different. It is not only deep and enduring but it is the result of a perfect storm of myriad forces that took some time to manifest and will take some time to heal – with or without brilliant policy. My neighbor had serious heart surgery recently. He is on the road to recovery but he knows that not every day will be a good one. There will be ups and downs. He must be patient. Healing will take a while. Why then do our politicians pounce on every bounce in the economy – ready to declare a horrible or beautiful new course of policy? Geez guys and gals – the recovery is not going to be smooth or linear. TAKE A BIG BREATHE.  You have an unprecedented amount of stimulus working in the system – don’t add more!

Third – talk to each other. You guys are like rival gangs at a biker bar. The second Big Moe’s elbow accidentally barely scrapes Hot Mary’s elegantly sculptured boob tattoo of a snake eating the head of a winged dinosaur, all hell breaks out.  As soon as Mary screams the Purple Devils and Mauling Marauders weapon-up and go to their respective corners to prepare for the battle. The Democrats are armed with silly slogans about multipliers and a heart full of compassion for the unemployed while the Republicans load up on Barro’s version of rational expectations and strongly expressed love for fiduciary responsibility. You don’t talk to the enemy during the war – you lob stupid bombs at each other until the other finally gives up – i.e. loses the election.

One must wonder if our politicians are not like proverbial warriors who live only for the fight. My guess is that given the special nature of this recession it is going to take some real compromises to get this thing fixed. Consider the compromise story.  Policy has already and will continue to address all of the following issues– stabilizing aggregate demand, financing the aging of the population, correcting imbalances in the distribution of income, regulating the financial sector, reforming healthcare, widening access to green energy, a war on terrorism, immigration policy, and more. It seems to me that a more overt recognition of the complexity of these issues warrants significant compromise on both sides. Yet instead of viewing the whole policy scene as an opportunity for both parties to improve the country, they take each issue piecemeal and try to win the hearts and minds of the voters bit by bit. Surely with all these opportunities for legislation, there is plenty of room for give and take. Both sides could declare victory. But so far, our warriors seem to relish in the fight and grapple for wins on virtually every point of contention. Meanwhile we languish in a seemingly never-ending economic limbo as our politicians play dueling banjos.

Why does common sense seem so out of line with what we observe from our politicians? I think it is because we have really big issues right now and we have really small politicians. While I like today’s movements towards more transparency, right now I long for the good old days when politicians went behind closed doors, drank brandy and smoked cigars, and made deals.  Imagine the scene -- Obama taps his ash, leans across the table and tells John Boehner – I’ll give you two corporate income tax reductions for one extension of job benefits. John smiles and rubs his knee against Nancy Pelosi’s throbbing thigh and says, Okay Nancy, throw in a reduction in capital gains tax and I’ll not only go with the unemployment extension but I’ll give you a new tax on imported oil. Nancy pours her Armenian cognac in John’s lap and says it all sounds good so long as we throw in a few more dollars for education.

Okay, so I drink while I write. But you get the point. We need a new crop of politicians – if you don’t like what you see, then why do you stick with the idea that these bozos in both parties are there to help us? These folks are not helping us and we need to show them the door. We need some political leaders who will stop being warriors and try becoming statesmen. This is a very challenging time. We need better.  

China is #2. China is #99. What should I think?

Today Bloomberg.com published a small article announcing – ta da – that China has overtaken Japan with the second largest GDP in the world, second only to the -  ta da – the USA. We’re number 1, we’re #1. Do the wave now.

Anyway, in the case of China, the numbers are very interesting. For example, the comparison reported today has both China and Japan at about $5 trillion in Gross Domestic Product.

Note that when you compare the GDP across countries, you have to put all country amounts into one currency. This currency is usually the dollar. So the $5 trillion is the result of taking the country’s GDP in its own currency (yen or yuan) and using current exchange rates to convert to dollars. That sounds straightforward enough were it not for the fact that today’s exchange rate might be a little weird. That is, today’s exchange rate might not truly represent the  fundamental market forces that “ought to move it in one direction or another.” Or one might say the exchange rate is out of long-term equilibrium. So being weird they don’t trust it and then put it in jail. Economist’s jail, that is.

With the current exchange rate in jail, experts create a substitute that better reflects fundamental market forces – or at least it better represents changes in relative country prices. If China has a cost advantage and that makes its traded goods prices more competitive than other countries, this leads to a Chinese trade surplus. 

Theory suggests that the value of the yuan should rise to clear that surplus. Thus, an economist would say that the equilibrium value of the yuan is really higher than today’s market value. They call this the PPP (purchasing power parity) exchange rate. I hate to say PPP because every time I type PPP I have to run upstairs to the bathroom. But that’s an old man thing so don’t get off track here.

When we use the PPP estimate of GDP to compare countries, China has been #2 for quite a while.  Go to Wikipedia to see that China’s GDP at PPP is double that of Japan’s. http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)  So while PPP does not change the ranking for Japan and China – it does give a very different picture – in one case the GDPs are the same – in the other case China’s is double that of Japan.

Okay – so one more statistic. Wikipedia also has a table with GDP at PPP per capita. We know China has a lot more people than Japan – so let’s see what happens when we ask how well the average person is doing. In that table, the US comes in 6^th, Japan is 23^rd, and China is 99^th. Yes, China was right behind economic super powers Guyana and Nimibia. Hmmm. http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)_per_capita

So what does all this mean? I don’t really know. Notice how I made this post really short. It would take a very long post to discuss all the economic, political, and astro-physical implications of all this. So I will leave it to my wacko friends to say more.

But I will say this. There are many dimensions to a country’s economic size or might. Naturally a country with the world’s largest population should have a large GDP. But how strong can a country be if its average citizen is extremely poor? And in the case of China, a lot of the goods produced and measured in GDP go elsewhere – so what the average citizen living in China gets is even lower than the reported GDP figures. Clearly it makes sense that the Chinese government would want to improve per capita GDP.  With so many people, this will only push China farther up the ranks in terms of its total GDP produced. To think that a country with roughly four times the population of the US would forever be behind in terms of GDP simply makes no sense. So you go girl!

Finally one more point – I know there are many, many errors in cross country measurement. You can’t really compare the price of oxen in China to those in the US. There are also many problems in determining the value of the PPP exchange rate. But don’t let those measurement problems deter you from my main message in this post. China is a large, poor country with designs to be richer. As they get richer per capita, they will gradually approach and then exceed the GDP of the US.  But they have an even longer way to go before the average person in China will enjoy the income, wealth, and economic freedoms that we have in the US. 

Fairy Tales Can Come True. It can happen to you….blah blah blah

I was going to take the day off but then I read some of the news and if there ever was a time to write a blog post – it has to be today.

One of the best parts of my life was reading bedtime stories to my kids. Now they read them to me. Ha ha. Just kidding. But I did love reading to them. So it occurred to me that some of the fairy tales I am reading now in the press will have a bigger effect on them than Dr. Seuss or the Man in the Yellow Hat.

Fairy tale #1. A matter-of-fact story came out today about Medicare and Social Security funding and how the latter was fine until 2037. The story didn’t use Al Gore’s memorable term, Lock Box, but it did re-conjure-up that illusion. You know what a lock box is, right? Basically it is a physical thing that keeps money in it so that when bills come due you can pay them. Or it can be a physical thing that you bury in your backyard and tell your kids to dig it up when you die. Your kids, not having had a very good education in our failing public schools, will believe that old Dad and Mom have placed some very valuable items in there. Once they dig up the box and clear away the dirt – they will be rich!

Anyway, that’s what most of us think is a lock box. Al Gore made the mistake of likening the balances in the Social Security Trust Funds to a lock box. And that is why Al Gore had to sit in the corner and eat cold porridge. Anyway, imagine that your son digs up your lock box – opens it up – and finds a piece of paper in it. The paper contains a note that says, “honey, we spent all the money on Cognac and we would recommend that you ask your sister for a loan. We do love you very much.”

You think I am kidding. I think not. This year. THIS YEAR the social security tax revenues are not large enough to pay the beneficiaries (old helpless creatures who need Cognac). But the Social Security Trust Fund (SSTF) will make up the difference. What is the SSTF? A large pile of ten dollar bills? Is it a bunch of gold? HA HA – I think not. It is a bunch of paper that means the Federal Government must pay back what it borrowed in the past from the SSTF. The Federal government puts money back into the SSTF – and then they pay it to the retirees. Where does the Federal Government get the money when it already has a very large deficit? It gets it from raising your taxes! There is nothing in the lock box except a note that says the government promises to makes you charge higher taxes! Even worse, the amount in the SSTF – the amount the government borrowed from it over many years – will run out in 2037. The lock box will not only not have money in it – it won’t even have any more I-owe-yous. This means that your taxes will go up more and more and more as we approach 2037. My son will be approximately my age in 2037.

Fairy Tale #2. It was announced that President Obama does not want to take his latest brainy remedy for unemployment through Congress. Instead he can make a Presidential mandate that allows the Fannie/Freddie twins to spit smoke and fire. Or at least Fannie/Freddie will be able to give more mortgages to people without having to deal with all that silly paperwork. What a burden for bankers to ask embarrassing questions like – “could you ever from now to eternity pay us back one red cent you are borrowing for this Italian villa that was recently transported and reconstructed brick by brick in Ellettsville IN?

Okay – we’d love to see people buying more houses. That would be good for the economy. Homes would be built, developers would be able to go on Rhine Cruises, and more workers would get jobs. But geez you guys, how much does the government need to do beyond the lowest mortgage interest rates since Hugh Hefner was a baby? And didn’t the current crisis result mostly from subprime housing loans? Why on this earth would our president want to go down that path again? Why? Because of Fairy Tale #2. He does not have to listen to congressmen wail about budget deficits and debt. Future Fannie and Freddie liabilities can be increased infinitely today without the numbers actually showing up in the official government budget figures. Of course we know that granting loans without scrutiny will lead to government funding of the bad loans – and that will eventually show up in the budget. But these numbers will not be recorded today nor will they show up before Halloween.

THE KING HAS NO CLOTHES, THEY SCREAMED! But it is just a fairy tale. There is a lock box and we shouldn’t worry about social security. We can fix the economy by giving people low-interest loans that do not have to be paid back by the borrowers. I can lose 100 pounds of unwanted fat by taking the latest pill.

Good night kids. Sleep tight and don’t let the bed bugs bite.

Quarter 2 Real GDP – Why does the press prefer to look through mud-colored glasses?

The second quarter Real GDP figure was announced last week and as usual it got a lot of attention. There were many stories written and the general tone of most of them was worrisome – the 2.4% annualized rate of growth in real GDP from the first quarter to the second quarter of 2010, was low for two reasons – it was lower than the 3.7% growth in the first quarter and it was lower than experts predicted.

Of course, that is NOT what many people wanted to hear. It reinforced the idea that we might be headed toward a double dip recession (why is a double dip good for ice cream but not for the economy?) or deflation. The Keynesians shouted – “I told you so” – and many articles were written to the effect that we need even more monetary and fiscal stimulus. All this was based pretty much on one number for one quarter! It’s a little like winning one hand at Black Jack and then emptying your checking account so that you can bet your whole fortune on your sure-to-come gambling earnings!

To be fair, there were a lot of articles written and not all of them read like a Keynesian recruitment poster. So let me try to bring in some other facts that put the 2.4% number in a broader and more positive context. If you go to the following link you can get enough GDP data to build an Egyptian pyramid. http://bea.gov/national/index.htm#gdp

First, the 2.4% was the fourth consecutive quarter of positive growth in real GDP. That means a full year of growth since Q3 2009.

Second, real GDP statistics are revised many times. So the 2.4% is not the last word on Q2 of 2010. To emphasize that this first look at the number is based on incomplete information, it is officially called the Advance Estimate. Q1 2010 real GDP got revised upward from 2.7% to 3.7%. Wowee. That’s a big revision. I hate to tell you this, but the last revision to Q2 2010 will come about five years from now. REALLY. I am not fooling. Before then, you will see at least three updates – in one quarter, two quarters, and in one year. So stay tuned to learn more about Q2 2010.So people were oooing and ahhhing and making policy suggestions based on a number that isn’t much better than a lottery ticket.

Third, you can see a lot of very specific data if you go to the above site and download data tables. For example, we are very concerned about personal consumption spending (PCE). You will see that PCE rose by 1.6% in Q2. That is exactly how much PCE rose – an average of 1.6% per year – during the previous three quarters. So with respect to PCE, it was growing at the same rate as it had been during the recovery. I know we want to it grow faster – but there was no slowdown evident in Q2 PCE.

Growth in consumer spending on services – the largest component of PCE – had it fastest growth in several years. Geez I guess they forgot to mention that in their ugly little story. PCE in real annual dollars was about $9.2 trillion in Q2 and PCE-Services spending was about $6.0 trillion. So PCE-Services is roughly two-thirds of all PCE. That makes it almost half of all of real GDP! Note that consumer spending on durable goods was only about $1.2 trillion in comparison. It is fine to worry about the automobile industry – but we should not let the rear view mirror get in the way of watching spending on consumer services.

What else? One major reason that real GDP slowed a bit in the fourth quarter has to do with how we account for imports. GDP is a measure of domestic production. Because imported goods are not produced in the US, they have to be netted out – subtracted from the GDP sales figures. Imports of goods rose by 35.4% on an annualized basis in Q2. So that explains a lot of why real GDP slowed. But note that while it subtracts from output – it does show a resumption of spending. It shows some optimism about future spending. Of course, if all we do is buy imports and do not increase our spending on domestically produced goods and services, this will not help to increase future real GDP.

Missing in some of these articles was an explanation of residential spending – which rose by 27.9% in Q2. Hmmm – and that was only the second quarter that such an increase occurred in several years. Spending on the production of new residences – spending on newly built houses, apartment buildings, condos, etc – fell by 12.3% in Q1 and by 0.8% in Q4 2009. Someone should have made a big noise about this!!!! But I guess it didn’t fit in with their stupid sky is falling story. Supporting a picture of rising construction spending is that Q2 was the first time that spending on business structures (plant, office buildings, etc) showed any growth in years. It grew by 5.2% in Q2.

Part of the good growth story was a 14.1% growth in exports of goods and a 21.9% growth in business spending on equipment and software.

Some of our economist friends and their buddies in the press saw a glass of bourbon sitting on the bar. They preferred to see it as half empty and unworthy of drinking. While this was no batch of Pappy Van Winkle, it was a glass of hooch worth drinking. It is a shame that even a routine data announcement has to be tainted by such incomplete and biased analysis.

Obama’s Goal to Double Exports – Pie in the Sky?

The President recently expressed a desire to increase US exports to the world by 100% between 2010 and 2015. This seems to be another one of those hopeful goals that doesn’t have much basis in reality. Part of the reason is simple business. The other part is history. Let’s start with history.

The US exported $1.564 trillion of goods and services in 2009. Two-thirds or about $1.038 of the 2009 total were sales of goods and the remaining $526 billion were services. We don’t know what exports will be in 2010 – the benchmark year for the doubling of exports since we barely have first quarter 2010 results. So let’s just use the 2009 number. President Obama is asking the nation to increase exports by another $1.564 trillion in five years. Is that possible?

How much did exports grow during the previous five year period between 2004 and 2009? Answer -- $384 billion. Hmm, that’s only one-fourth of what he is hoping for in the next five years. Keep in mind that between 1995 and 2009 – a fourteen year period – exports only grew by 93%. He wants them to grow by 100% in the next five years. It isn’t like US firms were intentionally slowing things down. Exports grew by double-digit rates in each of the past five years except for 2009 – 10.6%, 12.7%, 12.6%, 10.6%, and -14.6%.

These statistics are based on current prices. They are nominal figures. Luckily the government calculates real counterparts for exports like they do for all parts of Gross Domestic Product. I mention this because the above numbers include price change – something firms and the government have little control over. Global competition will determine prices of international transitions in the next five years. Furthermore, the President’s goal only makes sense in real terms. Meeting the goal by simply raising prices does little to heal the recession or unemployment.

So let’s look at the numbers that are more based on something the President would like to see – more units of output sold – presumably more cars, electronics, and ears of corn.

Real US exports of goods increased by 72% over the last 14 years and by about 17% in the last five years. While exports based on current prices averaged low double-digit increases in most of the last five years, the average annual growth of real exports of goods was more like 8% per year. It would take something more like 18% per year to achieve the President’s goal of a doubling in five years. Over the last 14 years real exports of goods and services increased by 12% one time (1997) but then increased by 2% in the following year.

It might be surprising to you that exports of services have been growing faster than exports of goods. Usually when we think of exports and export goals, we think of goods like auto parts, equipment or food products. Over the last 14 years the category food, feeds and beverages increased by only 31%. Durable goods exports increased by 58%. The real stars of export growth were found in services – Royalties and license fees (116%) and Other private services (197%).

In short, history implies that if the President’s export goal was translated into basketball, he would be asking our Olympic squad to score 200 points per game while holding each opponent to about 45 points.

This brings us to the business side. Our Olympic players have not exactly been sleeping on the job – nor have our exporters. You might not know this but strong export sales has been a goal of federal and state governments for a long time. There are government officials and programs ready with a full slate of assistance to companies large and small who desire to export. While there might be a few new bells and whistles in the way of assistance in Obama’s goal, a company could always go to something like the following web site for federal assistance http://www.export.gov/ If Washington DC is too far from the location of the exporter, they can go to the federal or state office nearest them for help. The Indiana office is in Indianapolis. Every state has a similar federal office. Most states also have state government offices devoted to export assistance. Senator Lugar has a web site for Hooisers which lists many services -- http://lugar.senate.gov/services/links/pdf/Trade_Assistance_Fact_Sheet.pdf Go to the next link and you will find links to export assistance for US firms in almost any country in the world. These are organizations whose feet are planted on foreign soil who are paid by the US or state governments to help US companies export. http://www.buyusa.gov/home/worldwide_us.html

My point is that we are not new to this. There is a ton of really good help out there for companies that want to export. If a company is NOT now exporting it is because its managers don’t see the need to.

So here’s my question to the President – how do you plan to get our players to score 200 points per game? Where’s the meat?

Are you really going to sign free trade agreements? Hmmm – it seems to me that many of your strongest supporters are quite happy that we do not have a conclusion to the Doha Round or the Korea FTA. Are you really going to sign these accords? Your supporters don’t mind the extra US exports that might arise but they have definite strong feelings against opening up the US economy to more foreign competition at home. Sugar – did someone say sugar? Will you stop protecting sugar-growers in America so that South Americans will open their markets to other US goods?

And what are our friends at the WTO going to say about your plan to increase by 100% the exports of the largest economy in the world – the country that still is among the top exporters in the world? Will you abide by WTO rules governing exports? Can you increase US exports by 100% by not disturbing competitive shares of world sales going to Europe, Brazil, China, etc? Will they sign the Doha Round while you are conjuring up a 100% increase in exports to their countries?

Are you going to apply massive pressure on China to buy more US goods? How has that been working so far? What new tricks do you have up your sleeve?

Clearly I think this is a big mistake to try to manipulate exports. So how are we going to get the US back on its feet? The answer is something I have been preaching over and over in my other posts. What we need is the most competitive and dynamic economy in the world. We need firms that are hungry to succeed and are justly rewarded when they do so whether they sell their goods at home or abroad. We don’t need firms saddled with unnecessary regulations and costs. We don’t need firms who hold back because they are uncertain about the future course of regulations and costs. We don’t need firms who are considered the enemy of the worker, investor, and consumer. Firms have their part to play – but the rest of us do too. Let’s quit waving our flags at silly unattainable goals and do something that we will all be proud of when our grandkids start paying taxes. Okay—I am done. Whew. Where did Betty hide the gin?

Stimulus -- you can pay me now or you can pay me later

This post is stimulated by comments I received on the issue of unemployment in the USA. Many of the arguments against further economic stimulus today are phrased in terms of such issues as rising inflation, budget deficits, national debt, and so on. It is easy to ignore these arguments since they sound much less imminent and alarming than a 9.5% unemployment date. It is easy to imagine the horrible plights of unemployed persons and their families. National Debt and rising inflation seem much less important. But it simply isn’t true. What I try to show below is that a fix that leads to an enduring impact on employment and unemployment is what we want. Stimulus packages and extensions of unemployment insurance may not be the best way to get what we want. If stimulus helps a worker keep his or her job for another couple of months but then leads to a time of rising unemployment after that then you might not vote for it. The issue, then, is about unemployment now and later.

The first thing to emphasize is that while government could conceivably hire all or most of the unemployed persons – not many people really want that as the permanent solution. We recognize that firms always have been and probably always will be the main driver of job growth in the USA. Yes, there are plenty of people who believe that government could hire more people or keep them on unemployment insurance longer as a short-term stimulant, so I will turn to that below. But that is, at best, a temporary fix and not the real solution.

Stimulus seems obvious. Since the unemployment rate remains high, the stimulus argument asks that government add more stimulus – or at least not withdraw or reduce the present level of stimulus. Private spending is lacking. Replace the private spending with public spending. This puts income in people’s pockets and replaces the missing demand for goods and services. The increased demand has a multiplier impact as firms hire workers to do jobs, pay them income which they spend, and spreads the benefits to other firms. In the meantime, uncertainty or lack of confidence disappears and firms are more willing to spend on plant, equipment, and capital items. Not only is this intuitive but it is humane. All those unemployed people regain not only jobs but dignity. I may have missed some of the points but I hope I have reproduced the essence of the stimulus argument.

Intuition helps us solve a lot of problems – but it isn’t always right. The world is complicated enough to facilitate difference of opinion. We used to think blood sucking leeches would solve a variety of human health ills. No I am not talking about any of my relatives. Physicians who voiced objections about blood sucking remedies cared about their patients even though they might have been out of step with traditional practice. Economists and others who argue against continued stimulus care about unemployed people. What matters is not the name or party of the arguers – what matters is what really works.

Since I am one who believes continued stimulus is not the best approach right now, it behooves me to focus on the issue of unemployment – and that’s what I have done in past posts. So let me bring together here what I tried to do in the past messages.

The challenge here is that while the pro-stimulus argument is intuitive, the con-stimulus arguments are not. For example, the Cons are usually phrased using an expectations-augmented shifting Phillips curve. Ohhhh crap – not that one again! J Or the Cons get hung up trying to explain future discounted capital budgeting issues. Or they might worry about disincentive effects of higher tax rates. Arrgghhh

I used past posts to get into the nitty gritty of all that technical stuff. Often I lost the forest (unemployment) for the complicated trees. So let me just try to summarize some of the points here with a stronger focus on unemployment.

First is “you can pay me now or you can pay me later.” A stimulus policy might reduce the unemployment rate now but it won’t last. This is exactly what we saw with the expiration of the massive subsidies to buy cars and houses. We mostly shifted future buying into the present. I wrote one post to explain why the USA and the world economy might not be as far as we think from reducing excess capacity. A huge dose of stimulus on top of the past stimulus could lead to a rise in inflationary expectations, increased input costs, a profit squeeze and a higher unemployment rate. We call this phenomenon stagflation. Some folks say we are a long way away from this. But the facts suggest otherwise. Expectations are sensitive and can move in upward direction quickly.

A second part of “pay me now…..” is what the Fed does. If excess capacity starts declining the Fed will start to remove the monetary stimulus and interest rates will rise. The chances are that the Fed might not remove this stimulus on a perfect time table. In addition to stagflation we could have the Fed moving too slowly then tightening demand too much and this could lead to higher unemployment.

Third, in a previous post I documented the size of changes in the federal debt. But the debt is not the ultimate problem – it is just the symptom. If the USA is alone in its ignorance of the implications of high debt and if the USA adds even more to the bloody debt numbers – it will have an impact on people who participate in the credit markets. But it doesn’t stop there. If domestic and foreign participants lose faith in American financial assets and move their money abroad, this will show up as a reduction in the demand for US goods and services and a rise in the unemployment rate. Some economists argue that this could never happen to the US. But their arguments are not based on current realities. Already we see global investors shifting out of dollars into euros and yen.

Fourth, I wrote a silly analogy about Mary and her Twinkies. But the point is that government spending is habit-forming. Once you get the government spending train going – it isn’t easy to slow it down. After the mid-term elections in November, a bipartisan committee will begin to work on a program to address my third point above. An extension of the stimulus program into the rest of 2010 and beyond makes the job of that special commission even harder. This is partly because the past and future stimulus mixes spending whose intent was to quickly increase spending with other spending that’s aimed at America’s special long-term policies with respect o defense, energy, health care, and more. With partisanship so vivid and strong I pity the members of that commission. If we cannot bend the spending line I doubt we will have any better luck with restructuring taxes. This let down in budget courage will simply add to worries about a financial outflow and will increase the unemployment rate. This makes me really hungry for a Twinkie. Do Twinkies go well with Jack Daniels at 10 am?

Fifth are current expectations of the future health of US business. It matters when people discuss whether or not President Obama is pro business or not. Consider all the spending and taxing and regulation policies that will negatively impact business. It doesn’t matter whether you love business or not. If business is going to hire all those folks then you better not throw away the baby with the dirty bathwater. Many of you have been waiting for years or decades for a president who would solve our long run problems in healthcare, energy, global warming, immigration, social security, financial market problems, poverty, and more. But as James Brown would say – Please Please Please – have we thought about the impacts on business hiring decisions as we try to implement all this legislation quickly (before Obama loses his majority in both houses)? If businesses are to create the jobs in the future, one must not rush to judgment and we must answer this question thoughtfully.

Sixth is basic intuition. If the unemployment rate went up because of too much debt and bad debt – it is hard to imagine that the solution to the problem would be even more debt.

Finally, while the intuition is that stimulus could and should work again, there is no real consensus that it will. As I said above, much of what was called a stimulus package was simply an excuse to attack a myriad of problems – whether or not the spending would quickly impact the economy. If Congress could not be trusted to enact real stimulus at the onset of recession, why should they do any better at a time when the economy has been growing by approximately 3% for as much as a year?

In summary, the prospects do not look very good for improving the unemployment situation with more stimulus. We really should be looking elsewhere.

US Debt -- A Mountain or a Molehill?

So much is being said about US debt these days – and much of it is bewildering. What is it? How big is it? Why do we worry about it?

Much of the discussion is now related to what we call the US or the Federal Debt. The Federal Debt is really just one measure of the nation’s debt. It does not include any of the debt of private parties. That is, if you borrow $100 from Uncle Bob or $100,000 from a bank, this is not captured in the Federal Debt. Furthermore, if a US corporation sells a bond to a foreigner, this loan would not be captured in the Federal Debt – though it would be part of the nation’s Foreign Debt or Net International Investment position.

The Federal Debt is really a pretty simple and straightforward concept. It is the Federal government’s debt. Any time the Federal Government spends more than it receives in revenue (we also call that a Federal deficit), the government must borrow money to make up the difference (no it doesn’t send Milton Friedman out in a helicopter to spew money). The government borrows by printing and selling government bonds. Each government bond it sells to cover a deficit adds to the Federal Debt. In any year that the Federal Government has a budget deficit, the Federal Debt increases. Since we usually have government deficits each year in the USA – it is no surprise that the Federal Debt has increased over time.

In 1940 the US Federal Debt was $50.7 billion. By 1982 it reached $1 trillion. Ten years later it hit $4 trillion, and by 2002 it was more than $6 trillion. In 2010 it will reach $13.8 trillion and promises to land at $20 trillion by 2015. Woooowwee – I wish that was my retirement portfolio! Slowdown Wally – it isn’t exactly what it seems.

My Dad used to tell us kids that he could buy a Chinese meal in Brooklyn for the family in the 1930s for 25 cents. I used to tell my kids, that I could buy a six pack of PBR for only $1.25 when I was using a fake ID back in the 1960s. The point is that we need to create some perspective for these debt amounts when we make comparisons over time. Most tables will show the debt in terms of current GDP – the debt is in nominal terms (current prices) and so we use nominal GDP (instead of the more popular and svelte real GDP).

In 1940 the Federal Debt was about 52.4% of the size of nominal GDP. Here are the percents for the other years I mentioned above:

1982 35.3%

1992 64.1%

2002 58.8%

2010 94.3%

2015 102.6%

The upshot is that between 1940 and 1982, the Federal Debt got bigger in $$ terms but did not keep up with growth in output and prices. Federal Debt was a smaller share of the economy in 1982 than it was in 1940. Despite rising to a high of 121.7% in 1946 (MY BIRTH YEAR!) and despite a war in Vietnam and a war on poverty – the Federal Debt’s increase was less than the growth of output and prices!

But since 1982 the debt percent of GDP crept higher and higher – meaning the debt was rising faster than the size of economy. The 64% of the economy commanded by the debt in 2008 before the recession got some momentum was thought to be quite manageable for the US. It was not out of line with debt percentages of other stable countries. The 90% PLUS rate in 2010 is in line with other struggling countries today and that is what much of the talk is about.

But what of the talk? The intuition has to do with payback. If my family debt gets too big, then I won’t be able to pay it back. That is a problem for me and it is also a big problem for the joker who lent me the money. But that sort of talk is about individuals. Can we apply this intuition to countries?

Most of the Federal Debt is simply what Americans owe to Americans. A portion of the Federal Debt is owed to foreigners, but let’s ignore that for a minute. If we have more debt in the USA, then the gross debt might become large but the net debt is zero – because we owe it to ourselves. Tax payers might have a liability worth $1 but the people who bought the bonds have a $1 asset.

That makes Federal Debt seem pretty cool, until we notice a couple things. First, changes in the economy may have non-symmetric impacts on debtors and credits. For example, an unexpected rise in inflation really stings creditors while it makes the debtors feel like partying until 6am with colorful hats and noise makers. So even though the net debt might be zero – the existence of a large gross debt implies that there are many macroeconomic changes that could have very significant and negative impacts on debtors or creditors. Without the large gross debt – those things would be much less disturbing.

Second, while the net debt might be zero, once the gross debt gets large enough to where it might not be possible to pay it off – it could lead to social instability as we grapple with political issues about what to do about debt holders who will no longer receive their contracted interest and principal.

So even if we owed it all to ourselves – there would still be problems associated with a large gross debt. But foreigners do hold some of the US Federal Debt. In 2009 approximately $3.6 trillion of the $11.9 trillion Gross Federal Debt was held by foreigners. The implication is that this makes things a little tougher on a country that defaults – we don’t just owe it to ourselves and bringing in the international ramifications means there might be even more negative implications of a default or restructuring. Owing 30% of the total debt to foreigners makes the size and interpretation of the debt more complicated and interesting.

What makes the numbers even more confusing is that I quoted 94.3% as the Federal Debt percentage for 2010 but I have seen many references to a 60.3% figure. That’s a big difference. Both numbers are correct! That’s because I have been quoting above the Total Federal Debt –while the 60.3% for 2010 is for the Federal Debt Held by the Public. That figure is expected by the Congressional Budget Office to rise from about 60.3% in 2010 to about 66.7% in 2020. It was 30.6% in 2007 before the recession and 27.8% in 2002.

The Federal Debt Held by the Public is less than the total debt because some of the bonds sold by the government are purchased by other government agencies and by the Federal Reserve. While the government is obligated to pay back the Total Debt, it is thought that the Debt Held by the Public is more compatible with market outcomes relative to the debt. But let’s face it, whether you measure in dollars or percents; or you measure gross or net; or you discuss total or the amount held by the public – there is no getting away from the fact that the debt has grown. If the Debt Held By the Public does increase to 66.7% in 2020 it will have grown more than twice as fast as the economy between 2007 and 2020.

Let me stop there. There are so many ways to go from here. Let’s see what the comments bring.

Inflation or Deflation? Part 2

In a previous post -- Inflation or Deflation Part 1 -- I focused on how to read an inflation press release. Now let’s talk more about the issues. Below I try to persuade you that deflation is not a high probability event and reflation might not be as far away as some people think.

If we are going to forecast something, then we need to check it out first. When faced with a choice for an appetizer, will Mikey choose the piled-high gooey nachos or the patiently arranged raw carrots and celery? Not knowing too much about Mikey, it would be good to have an experiment where we watched Mikey 100 or more times and see what he chose. In that spirit let’s see what we know about changes in the CPI rate of inflation. The graph at the St. Louis Fed (http://research.stlouisfed.org/publications/net/page8.pdf ) might be instructive. The CPI graph plots yoy (year-over-year) inflation rates from 1984 to present. You see the inflation rate going above 6% in 1990 and then following a disinflation trend through about 1998 when the inflation rate fell below 2%. Since then you see a reversal of trend – despite some up and down behavior, the general trend shows the inflation rate generally rising from 1998 to 2008 where it almost reached the 6% mark in mid-2008.

Recent behavior, therefore, shows that inflation has the capacity to both fluctuate and to move in general trends for significant time periods. The latest trend was reflation – and the big question is where we are headed from today in 2010. After peaking in mid 2008, we see the only yoy episode of deflation happening in mid 2009—followed by a return to over 2% in 2010. As of May 2010, the yoy rate is about 2%.

With that background, what can you say? What will the data show in the next half year through December 2010? Will we return to reflation similar to 1998 through 2008? Or will we disinflate like we did from 1990 to 1998?

To answer these questions, this one chart isn’t going to be enough. We need to supplement it with data and explanations about cause and effect. This sounds pretty cool to me – but the TRUTH is that inflation is like other economic indicators – it is complicated and the cause/effect factors change over time. What I am saying is that I am not going to be proving anything here. You won’t see any equations or null hypotheses here. This is more like a Rorschach Test – what you see in the picture may be determined more by your own potting training than by my artistic abilities. In this case I am acting as much like a lawyer (shudder) as an economist. A lawyer does not have to prove that his client is innocent – he simply has to use facts and arguments to convince the judge or jury that his client did not, in fact, steal that plane and fly it to a remote Caribbean Island. Dear judge – let me try to convince you about the future course of inflation.

Economists use theory (some people would call this gobbligook) to try to understand inflation. Since this theory topic could be a whole chapter in a long dreary textbook, please excuse me for simplifying. CPI inflation theory is about the causes of changes of the prices of goods and services we consume each month. In a market system, we think that the prices of most goods and services are driven by supply and demand. When demand is rising faster than supply of goods and services, we predict reflation. When supply is increasing faster than demand, then we predict disinflation. If the difference is big enough, this could cause deflation.

Here is a partial but extremely exciting list of things that might cause demand to be rising faster than supply and therefore predict reflation in the near future. Let’s divide the list into demand stuff and supply stuff.

First the demand stuff:

o Fast money growth causes households and firms to want to spend more

o Rising government deficits cause governments, households and firms to buy more

o Rising net wealth cause households to feel wealthier – they spend more

o Firms have been expanding output causing incomes of workers to increase and they spend more

o Consumer confidence is rising causing households and firms to buy more

o The value of the dollar is falling or the incomes of trading partners is rising causing net exports to increase

o Other stuff

Now the supply stuff

o Cost of oil, commodities and other raw materials are rising and causing firms to push costs through into prices

o The value of the dollar is declining raising the price of imported intermediate goods and raw materials.

o Workers and other suppliers expect the economy to improve or inflation to rise so they are asking for higher wages/prices

o Productivity of workers is decreasing causing the cost of output to rise

o Recent legislation is adding costs to business firms

THAT’S A LOT OF STUFF! So let’s focus. We can argue about each or every item on those lists after I post this to the blog site. Let’s focus on one well-known proxy for these factors impacting the demands and supply for goods and services – Capacity Utilization (Cap U). Cap U reflects how intensively firms are using their factories and businesses. When Cap U is high, we think of a factor humming with lots of activity. Lots of shifts are being worked. Some workers are doing overtime. Orders are flying out the doors and trucks are running nice people like us off the road as they hurry to deliver new goods to Best Buy and LaTorre Mexican Restaurant. But when Cap U is low – imagine the cleaning crew whistling as they spend hours dusting off idle machines and slow-moving workers. Not much is going on. Machines and workers are idle.

The below graph of Cap U was taken from the St. Louis Fed. I would point out a few things. First, it is very cyclical. The grey bars show the dates of seven recessions since 1970. In every recession Cap U declined. Look at how much it declined in the 1975 recession. Look at how much it fell between 1980 and 1982. In the recent recession it fell too – as one might expect. Thus, there are disinflationary forces at work in EVERY recession.

Second, notice that the Cap U rate in the latest recession is the lowest of all! While this is true, it is also true that the CHANGE in the Cap U rate has been large but not unprecedented. The rate is low in 2010 because there is a long-term downward trend clearly exhibited in the Cap U. So the meaning of the historically low Cap U is ambiguous with respect to future changes in the inflation rate.

Third, notice that once a recession is over, the Cap U can very quickly return to past higher rates. While it might take a few years to return to previous peak rates – it takes less time to return to normal productive capacity. Normal productive capacity DOES NOT signal future disinflation or deflation.

There is much concern about the weak US economy. No one knows how long the US will remain in recession with low Cap U rates and disinflation. Much depends on that long list of supply and demand factors above. Our US leaders have expressed a strong preference to gamble with inflation by emphasizing the weakness in the economy. I say gamble because we are closer than we think to an increase in Cap U and the latter means that an increase in inflation might be around the corner. But notice that there are many countries who have taken the opposite tack. That is, they prefer not to gamble with inflation. Germany, Canada, and others have weak economic growth too, yet they prefer to err on the side of less stimulus. Their preference is not without some support as I have tried to show here. I would also point out that both Canadian and German beers are excellent.

Sorry but the graph below won't display completely because of my imperfect cut and paste skills! To fee the full graph try this link:

http://research.stlouisfed.org/fred2/graph/?s[1][id]=TCU

AT&T, Barbara Walters, The Economy, and 4th of July

After losing another chunk of wealth this week and reading too many doomsday articles, I was ready to punch a horse when our electricity went out at 2:30 pm on Friday. No one seems to know why a perfectly good pole decided to fall onto our street, taking many lines down with it. No, we folks who live in Bloomington do not have underground utilities (but we do have a mayor and City Council who are very publicly pissed at the governor of Arizona). Luckily the power folks were out here in an instant and restored power within an hour. For Comcast customers, they were lucky too because we saw at least three Comcast trucks out shortly after the incident. But alas, we are AT&T customers and AT&T is still nowhere to be found almost 24 hours later. Yes, we did place many calls and talked to nice Indians in India and we are promised a visit from local repair people. To makes things convenient for us they said they might come between 8 am and noon. It would be lovely to watch Germany today in the World Cup at 10 am but that looks impossible. Maybe we will get to watch Spain later. We will see. Right now we have no TV, no Internet, and no land line. It is a good thing my washer and dryer are not connected to AT&T.

My talk with the consumer disservice people was really fun. We tried all kinds of things but the little red light on my modem kept blinking and blinking and blinking. He was kind and polite and asked me at the end of our 63 minute conversation if there was any more he could do for me. I didn’t respond but later I thought of a lot of really colorful things to say.

The reason I write is because I am really bored and because I was on the front porch watching the grass grow when I thought up a really great analogy for today’s economic misery. Those of you with TV, Internet and telephone might not find this as funny as I do right now, but I appreciate your willingness to hear me out.

So here is Mary. Until a year ago, Mary was the envy of all the girls and some of the boys. She was so slim she could have been an underware model for Victoria Secret. Then without even realizing it, a so-called friend of hers introduced her to the infamous Twinky. Mary was instantly hooked and without going through all the details, let’s just say that a year later Mary gained 80 pounds and was no longer thin enough to be an underware model for Victoria Secret. She didn’t feel very well either so she decided to lose weight.

Mary, being a careful cognitive kind of kid, carefully careened (I know, I know) around the Internet studying all the different approaches to weight loss and settled on a diet which let her eat 100 red seedless grapes a day. She also drank no water. She also skipped her 10 am Twinky. After a few days she dropped 8 pounds. The diet really worked, so she tried it a few more days and lost 7 pounds. Woopee! She was on a roll. All her friends commented on how much better she looked. She spent hours in front of the mirror.

The second week came and Mary was feeling a little weak and sad. She was also having some digestive distress but we won’t go into the details here for the sake of the children. So she decided to add back the 10 am Twinky. I forgot to tell you that she was still eating the other Twinkies at 8 am, noon, 6 pm, and midnight. Some of her friends warned her that her diet was pretty weird and not really a long run solution, but Mary was not about to give up those Twinkies. There must be another way!

The 10 am add-back did make her feel a little better but in the next few days she only lost 4 pounds and she was really despondent. At 4 pounds, it would take months and months to lose enough weight for her to get back into her skin tight revealing Levis jeans. What was Mary to do?

Luckily the national press found out about Mary – Geraldo, Beck and Barbara Walters all came to Mary’s rescue. Geraldo suggested that she get a big bright sign and march outside the Whitehouse to represent Americans and illegals who have been unfairly fattened by the makers of Twinky. Beck thought a thorough reading of Thomas Jefferson would help. Barbara counseled her on TV with very thoughtful empathetic eyebrows. She didn’t actually give her advice but she cried three times.

So there you have it. What was Mary to do? It wouldn’t be fair to deprive her of her regular Twinky. And diets can be SOOOO hard. Exercise is cool but Mary was not going to put on an ugly sweatsuit and ACTUALLY glisten. The US government determined that a commission would be formed to help Mary and the millions of others like her – but it would make no sense to begin meeting until after the November election. Meanwhile, Mary’s rate of weight loss has slowed and reversed. Her blood pressure is rising but the plus is that she has been invited to participate in all the newest reality shows. We understand she might produce a new one – Diabetes Debs.

Just to make sure there is no confusion about the first line of the post – I did not actually punch a horse. I don’t even know a horse well enough to punch. My dog died about 10 years ago and my kids left town years ago. I repeat – no one got punched, kicked or throw out with the dirty bath water. But it is another hour later and no AT&T. I will post this if and when I have access to the Internet Until then I hope you are having a great weekend.

This message is in NO WAY meant to humiliate or denigrate Mary or the Twinky Corporation. If Twinky’s stock value falls tomorrow it is because mean, vicious, did I say mean, selfish, rich, greedy hedge fund managers decided to put a sell or sell a put or whatever. I am barely able to take care of myself much less be responsible for such big things.

Inflation or Deflation? Part 1 – Jets versus the Sharks and Lady Gaga

I intended to write one post about the situation with inflation and deflation but have had tons of fan mail telling me to keep my posts shorter than “Atlas Shrugged.” So let’s call this post Part 1. This post has nothing to do with Lady Gaga but I promised some people I would put her name in my next post.

At the center of the debates about macroeconomic policy today is the question of the future course of prices. One side (or should I say gang – let’s call them the Jets) looks at past money growth and future government deficits in the USA and posits a rise in inflation. Before things get out of hand, the Jets would like to see a more conservative macroeconomic policy. The Sharks, in contrast, see nothing but recession and excess capacity and recommend continued low interest rates and more fiscal stimulus. Some sharks worry about deflation. So, the expected future course of inflation is critical right now. Will we have inflation or deflation?

Given my last post about the complexity of the macro economy it should not be surprising that economists can have such different forecasts of an important economic indicator like inflation. Given the spate of recent news about the slowing world economy and the ensuing decline in stock markets, you might be wondering how I can even say the word inflation…so let’s get to it.

Before we get all sweaty and crazy let’s make sure we use the right terminology. Economists, like astro-physicists and dry cleaners, use a lot of technical lingo. So it won’t hurt to make sure we understand the terminology as it is used to describe changes in national prices. First, when we talk about inflation, we are talking about a percentage change in a price index. There are lots of price indexes (The Richmond Fed has a data table with some of the more popular versions at http://www.richmondfed.org/research/national_economy/national_economic_indicators/pdf/all_charts.pdf#page=34 and the St. Louis Fed has some graphs at http://research.stlouisfed.org/publications/net/page8.pdf .

Most of us are used to following the percentage change in the CPI (consumer price index) and the truth is that most of these other inflation measures are highly correlated to the changes in the CPI. So for most purposes it is okay to focus on the CPI measure of inflation.

Second, articles that report inflation information describe these percentage changes over one-month and/or over one year, yoy (year-over-year). One has to focus and concentrate a lot to get things straight when reading these articles. Just like your weight can vary a lot from week to week, your doctor seems more concerned with how much weight you gained in the last year. Nevertheless, we weigh ourselves every 18 minutes to confirm that the 36 ounce t-bone with mashed potatoes and macncheese really did add a few pounds this week. In May the Bureau of Labor Statistics (press release: http://www.bls.gov/news.release/cpi.nr0.htm ) reported that the CPI fell .1% in April 2010 and then fell by .2% in May but came in at 2.2% and then 2.0% yoy. The former information tells you that the average level of prices fell for two consecutive months but that a whole year of past price change had inflation averaging around 2.0%. So we are keen to see what happens in June – will the one-month rate return to something more normal (it rose by .1% in March of 2010) or will it be negative again? If it is negative again then we might be thinking that the trend is changing. How much will it impact the yoy rate?

Third, you need to know that sometimes the one-month rate – in my example above the decline of .2% in May-- is usually also annualized. That is, they report a number that shows how much that one-month change would amount to if it kept up for 12 months. The annualized rate is NOT the actual change over a year and it is not a prediction – it is a hypothetical to help put one month into an annual perspective. Annualized rates are useful. Suppose Kobe Bryant scores 9 points in the first quarter of an NBA game. Is that a good performance for him? Bryant’s season average this year was 27 points per game. So the 9 points in the first quarter can be “game-ized” to 36 points by multiplying by four quarters. So if he kept scoring at 9 points per quarter, he would score 36 points and be well above his average. So you say – “way to go Mr. Kobe Bryant – you did great in the first quarter.”The -0.2% change I mentioned above for the CPI in May is often multiplied by 12 (yes, compounding is usually ignored) to get an annualized monthly change of about -2.4% per year. The annualized inflation rate for May was approximately -2.4%.

Fourth, articles also report core inflation. Core inflation deals with apple cores. No it doesn’t. I am just checking to see if you are still awake. Economists care about the sustainability of inflation. There are some elements that comprise the inflation index that are bad actors and confuse us about sustainability. Food and housing prices are not very well-behaved. They have a reputation of jumping around unmercifully. All this spasmodic activity hurts the eyeballs for those who read graphs too often and it is misleading as to what the future inflation will be. So we put food and housing prices in the corner – we remove them from the other children – I mean from the other parts of the index. The Core inflation rate, therefore, is less affected by dramatic short-term changes in food and energy and seems more closely attuned to the factors that contribute to a sustainable inflation rate. The CPI less food and energy rose by 0.1% in May, (a 1.2% annual rate) and increased by 0.9% during the past 12 months. If the yoy Core rate were to decline for a few months to reach a rate of about 0.6% yoy, then Mr. Bernanke would stroke his beard and say, Aha – I think we are disinflating.

Am I kidding – disinflating? Children, take out your dictionaries. Disinflation is a frequent phenomenon in the USA – it simply means that the inflation rate is declining. If inflation was 2% last year and 1% this year – that is disinflation. This must be distinguished against datinflation. No I am just kidding again. There is no datinflation – but there is deflation. Deflation means the inflation rate is negative. That does not happen much in the USA. But that is what the Sharks are worried about. Since we are doing vocabulary there is one more term – reflation. The Jets worry about reflation – a rise in the inflation rate.

I had hoped to fully solve the issue of inflation or deflation in this post but alas I see that a few of you have drifted off. Naps are good and I don’t discourage such behavior but it does tell me that I should be napping too. So I will continue all this in my next post. Please stay tuned. In the meantime, review what you learned – inflation, yoy, annualized, deflation, disinflation, reflation, and antidisestablishmentarianism.

Note – For those of you born within the last 40 years or so – there was a musical called Westside Story that premiered in 1957. It is a wonderful love story about a bunch of guys who race around on Jet skis and get eaten by sharks. http://en.wikipedia.org/wiki/West_Side_Story

Getting the Unemployment Rate Down in Uncertain Times

By now you know that I am fond of simple analogies. Economics can be really boring to most people. When I learned macro it was all about five equation systems with reduced form solutions and stability conditions. Multipliers were the rage. I think we had equation-envy – how come nuclear physicists get to have all the fun? So with the help of Paul Samuelson and others, we economists can now bore to tears almost anyone at the best of cocktail parties. Of course, we can become almost orgasmic with our physics friends over a nice pińa colada and the Heisenberg principle. .

Okay, I also love to exaggerate. But there is some truth to this. President Obama understands that VEEP Joey B. and most members of Congress want things laid out plain and simple – unemployment bad; government rescue good. Now you may not be an expert in five equation models, but there is a little bit that macro can add beyond unemployment bad; government rescue good.

When I studied macro we started with the Classical School and subsequently covered Keynes, Keynesians, Unreconstructed Keynesians, Neo-Keynesians, Monetarists, New Classical Economics, Supply –Side Economics, and JoeBidenism. I am just kidding about the last one – but all the rest are real. What was the point? Was it like a religion course where you needed to understand all the religions of the world so you could choose one or more religions that maximized your chances for salvation? I don’t know, but I think all those schools of macroeconomic thought helped us focus on the many reasons why macro and macro policy are so complicated and controversial.

Dr. Smith thinks my fainting spells are caused by a serious internal blood flow issue. Dr Jones thinks I have a mild case of the flu. The body is a complicated thing. It might take time to study the symptoms, how medicines work, and perhaps time for a little exploration inside the body. Finally the two doctors agree on the problem but then they might have different opinions about the remedy. Let’s use drug X or let’s wear compression pants. I don’t know but hopefully you are getting the point. Why should Macro be any simpler than the anatomy of a human body? After all, what we mean by macro is the summary results of all the millions or billions of interactions between buyers and sellers, and investors and renters and workers and executives and Congressmen, and so on.

We usually break down the economy into segments or markets for labor and other inputs, goods and services, money, bonds and other financial, and so on. Decisions in each market respond and react to each other. A financial change impacts interest rates. But since spending on goods depends on interest rates, a financial impact spills over into the market for goods. Firms produce more goods and that has implications for the labor market and employment. And so on. It is fun. Inverting a matrix is really cool too.

Theory helps us understand how these markets and their participants respond to stimuli. The past helps us to understand HOW MUCH they usually respond. It is very complicated – and the outcomes for tomorrow are not always going to be exactly like the results from yesterday. Though we like to think we incorporate everything important in our macro analysis – the truth is that the economy changes over time – and therefore the HOW and the HOW MUCH changes too. Controlling and forecasting the economy is like trying to hit a moving target.

This last paragraph gets me a little closer to the subject of this harangue – unemployment. Our experts keep telling us that unemployment is a lagging indicator (it must have been sleeping in school) and that in this recession, it will be even more lagging. What a laggard! How can that be? Are we suffering from some bad karma (polyester suits of the 1970s?) Why is it so much slower to adjust than in the 2001 recession; than in other recessions?

Well maybe because those past recessions were different from this one. What wisdom you learn here! What is different about this one? First, it wasn’t your usual-run-of-the-mill Main Street induced slowdown in spending. It was not particularly your 1970s supply-side contraction either. While Main Street did get impacted, the onset was a problem in housing markets that spilled over into financial markets…and then to Main Street and the Champs Elysees, Unter Den Linden, Oak Avenue and lots of other streets around the world. Second, this recession which started at the end of 2007 scared the crap (sorry about the four-letter words – please don’t let your teenagers read this) out of most of us and then when the politicians started wringing their hands on television – it REALLY scared the crap out of us. Japan had a similar kind of recession a long time ago – and some experts think they never did permanently exit it. Third, we hosed this fire with a lot of cannons. We doused it with tax cuts, spending increases, and enough money to run China for about 20 years. Most of this effort was aimed at revving up spending by consumers. Let’s buy a few more cars and houses folks. Being a good American, I chipped in heartily to the retail liquor industry – with several large bottles of Jack Daniels. Fourth, we managed to combine all this action with a health care reform, financial reform, and energy policy. The upshot of much of this policy is that some social goals will have been advanced and business and high income people will be asked to pay for it. The debts are staggering.

They can argue all they want – but let’s face it – no one thinks that the combined impacts of all that legislation had much positive impact on employment. Firms have produced and earned a little more but they have not yet felt compelled to hire many new workers. Would you? The economy is complicated and it really isn’t clear that the government improved the situation. Profits have recovered but could not possibly have erased the losses of the past couple of years. In fact, it is clear that the government has imposed some significant cost increases and regulatory burdens on firms. The government has also created an adversarial environment for many business firms – BP is only the latest victim of superficial populist government finger pointing. Of course, when it comes to the housing and financial problems that STARTED all the negative stuff – the government still hasn’t done enough to instill confidence.

What’s the point? The point is that none of this is very simple and we find ourselves in a new situation in which the past is not a lot of help. It reminds me of a pinball game with about 50 balls all careening around the table. How and where it will end, no one knows. The bottom line is that between the past macro shocks, the recent macro policies, and the expected future macro policies – we have a perfect storm of UNCERTAINTY. Unemployment is not going to improve until the uncertainty subsides. We are left with a tantalizing question that I’d love to pose to Keynes – given this environment in 2010, is the solution to reducing uncertainty more government policy or less?