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Friday, April 13, 2012

Brief Summary( Which Turned Long)

The Euro funnel cloud is forming. The bottom line is that many of the banks are now in a worse position than they were before the LTRO, so what to do? This wouldn't be so bad if Spain and Italy weren't still contracting, but they are.

William Dudley speech. Note that the "sustainable growth rate" for the economy is given as 2.25% annually. I still think that's too high, but consider what that assumption implies about federal deficits. Deficits always grow during downturns, and downturns are more frequent when growth rates are low. At that growth rate you would expect one at about every seven or eight years - and that's a minimal estimate.

To keep federal debt from growing faster than the economy over the long run at that sustainable growth level, one would need to limit deficits during expansions to no more than 1.5%. Crikey! To put that in perspective, on a nominal basis US GDP grew about 564 billion dollars in 2011, and debt held by the public grew by about 500 billion more. Real GDP only grew by about 212 billion from Q4 2010 to Q4 2011. Real GDP growth was 1.7% for 2011 on a YoY basis, or 1.6% on a rolling four quarter basis.

Or one could indulge in massive inflation, which would tend to shrink the pre-existing pot of federal debt relative to even real GDP. But don't expect investors to keep putting money into low-priced Treasuries if that happens - the cost of servicing the federal debt would rise dramatically. And consider the implications. Real GDP growth is a much better measure of ability to service debt, so inflating out of it really isn't an option UNLESS it can boost growth sharply and quickly.

US average interest rate in March on marketable securities is 2.187%. From here it may go up a bit. If you induce high inflation for long enough accompanied by real growth, those interest rates will probably double. Because so much of our debt is floated at short maturities, within a few years our average interest rate can double. Now figure this as a percent of real GDP (because you have to pay interest out of real GDP, i.e. taxes, or keep borrowing to pay interest):
floated debt 80% of GDP, average interest rate 2.2% = carrying cost of 1.76% of GDP.
floated debt 80% of GDP, average interest rate 4% = carrying cost of 3.2% of GDP.

So it is hard to see how inflation could boost real GDP. There's not margin in consumer incomes - cost rises are constraining spending and job creation, as B-Dud implies.

This is why investors are freaked out over Spain. It's supposed to reach the 80% level soon. It can't inflate out of debt, but the carrying cost of the debt compared to real GDP is mounting by leaps and bounds.

The only time a high-indebtedness country can really inflate out of debt is if most of its debt is in long term securities, so the inflation of the currency reduces the principal amount of your debt over a few years by much more than the increase in the average interest rate paid. However the cost of doing so is felt for years after the "surprise" inflation. Investors work on the "fool me once, shame on you, fool me twice, shame on me" rule and demand higher interest rates for years after your "surprise" inflation party.

Here is a useful treasury document as of Q1 2012 (fiscal), which contains the maturity profile for US floated debt:

I'm not making this up. The US has too short a maturity profile to be able to inflate our way out of the debt imbalance.

Right now we can get almost free money short term due to the Euro sovereign crisis. Since they are kind of going from bad to worse (proving the old maxim about committees) the US once again proves the prophetic capabilities of certain Canadians.

Approximately 46% of the debt is owed to foreign interests, so a rapid inflation of our currency could cause a massive funding crisis which would jack up interest rates far more than inflation alone would predict.

Thus, the US faces fiscal consolidation, not because we want to do it, but because any other course would make us all much poorer much faster. A paper discussing the situation from March of last year. Note that Spain's short maturity profile as discussed in that paper is one of the reasons why Spanish bonds are coming under so much pressure now. The last paper is very short. The striking difference between maturities at the end of WWII and now combines with the much poorer growth prospects of our current economy to make this a real issue.

So now Krugman and others are in the Leacock camp, but I personally am less confident of divine intervention. After all, the best bargain the Jews were able to work out over a few thousand years was "Here's the rules - you have to at least attempt to follow them and admit it and repent when you don't, or disaster will ensue." Running around and pretending there were no rules always worked out very badly in practice. It's tough to argue with thousands of years of history.

Hopes that the Fed will dash in and throw some money are daunted by March CPI. The "ex-food-and-energy" monthly increase is 0.2 and the annual is 2.3% - by no measure whatsoever has inflation fallen below the Fed target. Twelve month rolling increases are 2.4% for C-CPI-U, 2.7% for CPI-U, and 2.9% for CPI-W (which you have to look up here). The unadjusted one month change for C-CPI-U was 0.6. For CPI-U it was 0.8. For CPI-W it was 0.9. The SA monthly all-items increases are 0.3% for all categories. The Fed need not worry about deflation at this point.

Chinese GDP was reported at 8.1% (over the year). Quarterly 1.8%, annualized quarterly rate about 7.4% which is very much in line with the announced goal. Singapore's over the year was 1.6% (same as US!) The quarterly annualized change was 9.9%. In the first quarter of 2011 it was 19.7%. Singapore had a tough year, with two negative quarters. Japan is doing better, so Singapore ought to have a better year if all other things remain roughly stable.

US Treasury 10s, 7s and 5s are well in play now. This is pretty much a classic trader situation. There is not tons of product, especially on the 10s, so investor sentiment on certain types of economic news will move prices strongly, thus creating volatility, there's an underlying Fed stop-loss, so you don't have to pay for it, and odds of getting negative news from China and/or Europe to support lower yields are quite high. So far just under 2 is the limit, but we could easily have another 10 basis points in there if things get plug-ugly in Europe. Still I wouldn't go in a these prices. This is hot money.

I still don't see a clear path in Europe. The bottom line for the European Central Bank is that it is sitting on tons of yucky collateral. If it returns to bond-buying, it is left as the last-dollar investor. That is not a situation a central bank likes to be in - ECB desperately wants and needs the bailout funds to be buying these bonds to support values. ECB recently relaxed collateral rules again to let more banks participate in the Euro Toss Olympics. Over the short term that helped ECB, but now Mr. Market has turned to bite the hand that fed it, and will continue snapping away at the collateral value, especially since the banks are once more hung out there.

So within a week or two we should see some more talk over getting the next bailout fund underway - if Germany cooperates. That's the big if and the next big issue, because the money has to be committed. It's doubtful that China will buy in big - it doesn't want to be last Euro either.

I wonder what the effect would be if Spain or Italy were to toss all employment rules and restrictions, including minimum wage rules, and go full free market.

Currently they are raising tax + cutting services, which will make everything slow down more.

Instead, pull an Erhard, as in Ludwig Erhard - who removed the price controls and eased taxes in post-war West Germany.

If they had the guts to:
- disallow closed shop unions
- eliminate/outlaw public unions
- throw away restrictions on employment
- revamp the tax code with lower rates but actually enforce it
- expedite creating new business (removal of all fees and charges)

The unions will riot short-term, of course.

But, in the longer term, what have they got to loose? Short term pain as people adjust, followed by long term growth in new industries, and eventually higher tax revenue (with an overall lower tax rate)
"The US has too short a maturity profile to be able to inflate our way out of the debt imbalance."

And then there are TIPS. Introduced in 1997, tied to the inflation rate, and have longer maturities (shortest auctioned is 5 years).

It's not a huge market but it is probably worth mentioning.

In my opinion, the risk of hyperinflation grows as the maturities are shortened and/or more and more things are directly tied to the inflation rate (like TIPS, COLA, and so on).

I'm not predicting hyperinflation within my lifetime*, but it certainly is a risk. It's the ultimate outcome of *not* being able to inflate your way out of a problem.

* At the rate we're going, I may need to consider taking on more risky activities to make sure I die on schedule, lol. Gallows humor! Sigh.
Chris - they probably don't have that much to lose, although they wouldn't go for everything on that list.

Their economy has to restructure anyway - a lot of it was built on a building boom which is decisively over for some time to come. So they need to build new businesses. A flat business tax is the best way to do that.

Any time your unemployment is over 20%, it's time to consider economic sacrilege, if you know what I mean.
Mark - I haven't forgotten TIPS at all, but an even greater economic cost factor would be the COLAs for basic social programs such as SS, DI, etc.

Realistically, that would be far more of an added cost, and it's one that is not avoidable and occurs that year. Last year soda sales declined again. Utilities declined. Bottled water sales rose.

Any time you have the population cost shifting from soda to water, you've got a problem.

Any time you have the population cost shifting from soda to water, you've got a problem.

Speaking of water, I feel like we're in the left side of a sinking box.
I meant to mention that soda prices have not been all that tame.

When I first turned bearish I could get a 12-pack of Coca Cola for $2 (5 12-packs for $10) on sale.

I count myself lucky if I can get it for $2.80 now. That would be a 40% increase.

And for any Coca Cola executives out there who think they've got an economic moat with their new 7.5 ounce cans, I would point out that our last soda purchase consisted of 12 ounce Shasta cans at WinCo, partly out of spite, partly out of cost savings, and partly because their black cherry cola actually tastes pretty good. I may never switch back.
I keep thinking of Gene Wilder in The Producers: There's no way out, there's no way out, there's no way out...
Wow -- this chart (cpi minus ppi-commodities) from Stagflationary Mark is incredible!


It captures, on the household side, why we can't inflate out of this. In short, what they consume will go up more in price than what they produce, with the relationship probably going back to the pre-1980 loooong term average on the chart. The starting point for inflating matters: if wages were at peak relative to gdp; or if they hadn't stagnated for decades; then maybe we could pull it off. In other words, after two decades (80's and 90's) of unprecedented improvement terms of trade, median households should be chock-full of income and wealth. Where did it all go?

a. the top 1%
b. workers in emerging markets
c. expansion of government
d. the Gulf States
e. all of the above
My mistake -- not the "d. Gulf States", as the terms of trade turned against them in the 80's and 90's. And the China/India outsourcing trend did not really get going until the mid-to-late 90's. I guess I'm left scratching my head: households received a huge "dividend" in the form of a (relative) big decline in commodities over twenty years. Where did the money go? I guess Japan and the NIC's for one; they took share before China/India. Oh yeah, and we had NAFTA. Specialization helped as economists predicted, only gains were unequally distributed -- and then some -- to their workers and our wealthy.
David Pearson,

I guess I'm left scratching my head: households received a huge "dividend" in the form of a (relative) big decline in commodities over twenty years. Where did the money go?

June 1, 2010
Spending Power vs. Trade Deficit

We fell off the "normal" path in 1990 and we don't even seem to realize it yet.

Just a theory of course.
David - yes, that Snarky Mark chart explains a great deal, doesn't it?

Snarking with fundamental relationships creates these devastating charts.

As to where it went - it went down the hopper of the trade imbalance.

The ONLY way out for the US is to produce more and consume less, because that has to come back into balance before our economy can really improve. Deflating our currency as long as the economy is so consumption-weighted will just cut real GDP.

The good news is that our economy is rich in natural resources. The bad news is that we are not exploiting them, and our current environmental laws and regulations make it impossible for us to do so.

No economy that has a huge trade imbalance concentrated on consumer goods, a large social welfare share of governmental expenditures, and a structural energy deficit can inflate its way out of difficulties.
Here's a depressing thought:

The twenty-year commodity "dividend" was a nice cushion against the secular trend of a lower middle class standard of living (driven by that trade deficit).

Now that dividend is being reversed, but the secular trend continues.

The question is how to achieve a "landing" to an ultimate lower standard in the least disruptive way possible?

Higher China/NIC wages would help, but that also drives up commodity prices, so it just shifts the imports to the Gulf States.

So we need higher China/NIC wages PLUS a step-function move towards economically-viable energy efficiency. Too bad we didn't start doing the latter in 2002, when the commodity dividend ended. Ten years of war as our only energy policy (aside from Solyndra!). What a waste.
At gas stations and convenience stores locally, 44 oz sodas are 89 cents. That's lower than 15 years ago. And it's either Coke or Pepsi; no other choice. Sneaking in smaller cans might work at supermarket shelves, but apparently pressure is being felt at one retail option. And I agree, the public shifting down from soda to water is a sign of tough times, but hey, it's a healthy choice.
MOM & David,

The tailwinds became headwinds.

If the Fed wants the CPI to grow 2% per year then...

1. When the non-service economy (commodities) inflates less than 2% per year (and/or actually deflates) then the service economy must inflate more than 2% per year. Good times for the service economy! Yay!

2. When the non-service economy inflates more than 2% per year then the service economy must inflate less than 2% per year (and/or actually deflates). Boo! Hiss!

The Fed can't fix structural problems. At best, it can only make the hand basket path less bumpy. In hindsight, did they even accomplish that? We could certainly feel the dotcom and housing bubble bumps, lol. Sigh.
The Fed's response to the dotcom bust was an overreaction due to fear of deflation, because of the size of the dotcom bubble. That fueled the housing bubble.

The most recent CPI indicated it was above the Fed's target 2% rate. That should call for tightening policy.
The handbasket route is not set in stone here. At least two of the structural problems can be addressed pretty quickly; energy and production of consumer goods. The quickest, easiest route is:

1) Drill, baby, drill!
2) Force economic impact statements for EPA rulings
3) Broad corporate/individual tax reform, to include
a) eliminate double-taxation of dividends and share buybacks
b) elminate most loopholes both corporate and individual, and cut rates.
c) eliminate the S-corp structure, convert all S-corps to C-corps, eliminate all punitive taxation of C-corps (such as professional service corporations).
d) no depreciation schedule for capital equipment--immediate deduction
e) eliminate the marriage penalty for high-earners

Taken together, a) and c) have the effect of decoupling the individual rate from business investment, so the top rate matters less. Item d) stops penalizing capital-intensive industries and makes debt less attractive.

There's lots more that could be done, but I think that'd go a long way.

How would you fix the problem of rising American income and wealth inequality?

I bring it up because it seems to me that your third part would add to it.

That's a three-part answer. I apologize for the length.

1) I'm not convinced income inequality per se matters all that much. I suspect that broad improvement in standard of living is much more important, and that income mobility is most important of all (IOW, it's bad if the richest people of one generation are also the richest people of the next 3 generations, or if there is a permanent hopeless underclass.)

2) As a corollary, inequality becomes more a problem of political power than a social problem. Finding ways to counteract the self-reinforcing power of wealth is something that Americans are particularly good at, and we're currently going through another round of that battle as upstart power centers nip at the heels of the LA-NYC-DC axis. As an example, if wealthy people had the absolute ability to set the country's agenda, it would be illegal to own fireamrs by now. Whether you agree with them or not, the NRA has been very successful at aggregating the fears of a broad swath of the populace into real political power. It's hardly time to let down our guard, but it looks to me like citizens have all the tools we need to increase our say in government.

3) How sure are you that the Gini coefficient is meaningful? Punitive taxes drive wealth and income underground. During the 50's, that 3-martini expense-account lunch didn't show up as income, but it sure as heck felt like compensation. And it was a form of compensation that wasn't available to the small businessman who had to pay 90% rates if he really hit it big. Lowering tax rates brings the money out of the woodwork, so to speak, but that doesn't mean the power and influence wasn't already there. I'll also point out that the rise in the Gini coefficient coincides with the rise of Silicon Valley, which largely turned over the Forbes list, which helps out immensely with statement 2).

Reasonable people may disagree here, but after 100 years of failure attempting to address income inequality at gunpoint, perhaps it's reasonable to try something else.
Sorry, one other point:

4) Whether it's good or bad, it's too late. Government intervention to decrease inequality by decreasing wealth is a luxury we can't afford. We're in the car, on the drawbridge, traveling up the ramp, and it's either floor it or go in the water.

Jake & Elwood bridge jump

Reasonable people may disagree here...

I do believe that's true.

The ultimate income and wealth inequality has one CEO pushing one button commanding his fully automated factory from the comfort of his fully automated executive private jet.

What would the economy look like then?

This was my answer.

We've been combining the very best of capitalist market failure and socialist planning failure for at least a decade so far. Just look at the results.

Sound far-fetched?

August 1, 2011
Million Robot March

I'm not suggesting that I have a solution. I don't think anyone really does.
Bonus thought.

The path to get to that point involves CEO pay rising faster than wages overall (which is exactly what we are seeing).
Yet another thought. Sorry!

The survivors of an automated industry should see their income rise.

The CEO is the ultimate survivor.
I would expect CEO pay to rise precipitously. We've made going to jail part of the job description for any publicly-held C-level, so they've got to make their retirement in a couple of years. I know I wouldn't take the job without that kind of money.
I'll address your limiting case of the pushbutton CEO.

Presumably, the fully-automated corporation exists because this arrangement is cheaper than the alternatives, while still commanding the same market. So, in your limiting case the cost of goods sold (including the automated advertising executive and its robotic booth-babes at the annual industry convention) is equal to the raw materials cost plus the annual capital cost of the automation.

The only way the corporation can afford the cost of capital to keep up all this automation is if there is a market for its produced goods. The only way there is a market for its goods is if someone can afford to buy them. Now, along the way to 100% automation, either the former employees of this automated corporation found some other kind of work to do, or there is no work anymore. If there is no work anymore, there is no pay anymore, and the corporation will cease to automate further because it does not have the marginal extra customer to finance the automation. If the corporation is selling its product, then obviously it has customers who are making some sort of income from doing some sort of work.

So maybe the former employees are now all massage therapists, freelance product designers, and Washington lobbyists, but what exactly is wrong with that? Isn't this the world that Star Trek envisioned?

"If there is no work anymore, there is no pay anymore..."

That's my concern and why I believe rising income inequality does matter to the economy as a whole. As you say, things would break long before there is just one worker.

"Isn't this the world that Star Trek envisioned?"

George Jetson worked 9 hour weeks. I guess we better hope median real hourly wages rise by a factor of 4. I just don't see the process that will allow it to happen (other than a rapidly growing food stamp program to fill the gap, sigh).

I don't understand your point here. Are you claiming that if people don't work in mass-market manufacturing, they won't work at all? I see little evidence for that. People are funny--if the basics are produced by machines, then we'll all brag about our hand-crafted custom-designed Italian leather toaster oven. That's the first thing you learn in Econ 101--people have unlimited wants.

I think your point about the constant value of aggregate wages in a mechanizing industry is a valid one. I've certainly known some wealthy farmers. But their surplus kids all moved to the city and became doctors, lawyers, and engineers at the same or higher income level...

That's the first thing you learn in Econ 101--people have unlimited wants.

I grew up in a small farming community. I'm impossible to shop for. I think the best things in life really are free.

But their surplus kids all moved to the city and became doctors, lawyers, and engineers at the same or higher income level...

On the one hand, I earned more than my parents. What you say rings true with me.

On the other hand, I have no children. The trend ends with me. Thanks to the rising cost of raising children I have opted to pass (much like many in Japan once did after their housing bubble began to pop).

I guess we'll just have to see how it all works out.
I think the rich would have full-time servant staffs if they weren't required to send the government extra money for withholding, soc sec, unemployment, etc. Instead, the non-rich have to compete as contractors to multiple rich parties Instead of having a live-in gardener the gardener has to seve multiple customers and find his own housing. Serfdom by another name.
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