To Consume or Not to Consume?

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THAT is the question. In fact, it is the defining question for an exchange economy. Let’s dissect exactly what it means. “To consume” seems fairly obvious, like the question you ask your kid at the dinner table, “Are you gonna eat that?” But “Not to Consume” offers all kinds of confusing options. To not consume means to save. Save for what? To invest? Invest for what? More stuff? Yes, more stuff to consume in the future. There’s really no other option: “Not to consume now” merely means to defer consumption to some indefinite future time period. (If you die before then, your heirs will consume whatever you saved.)

The implications of this simple insight are broad and deep for understanding the economy. How do we know how to choose whether to consume or save? If we go by the simple human weakness of instant gratification, who would save at all? Why put off until tomorrow the pleasures we can enjoy today? Since in many cases we do exactly that, there must be a good reason. Saving has two payoffs: one, it helps us reduce the risk of not having enough consumption goods to survive in the future (that would be eating our seed corn); and two, saving and investing in future production gives us more tomorrow than we give up today (that would be interest on the savings or profits on the investment).

There are two factors that influence how we choose to save and invest. First is our life-cycle needs – when we are young we consume a lot because we are growing and haven’t yet learned how to produce; in middle age we’ve learned to produce in excess of our needs, leading to saving for old-age when we are no longer producing but still need to consume. This is why societies are most productive if they have a demographic bubble in their middle years, as the US has had with the baby boom generation in the 1980s, 90s and 2000s.

The second factor is technology and the opportunities it offers to make a greater return by saving and investing for the future. The recent computer chip/Internet/social media revolution is a good example of this. If one put aside $100 back in the 1980s to buy shares of Microsoft or Apple, one would be a millionaire several times over today. Not a bad return for putting off one nice dinner.

The key that unlocks the economics of this choice between saving and consuming is the interest rate that signals whether the future may give us more consumption than the present consumption we sacrifice. When interest rates are high, we should consume less to save and invest, and when they are low we should consume more, (given all other things equal). So, the interest rate is crucial to making correct economic choices.

The simple insight of choosing between consuming or saving also illuminates the problems we have in the global economy when countries try to consume or save too much. China’s growth rate is falling because the savings rate is too high and its economy depends on selling too much of its product through exports to other countries, like the US, which is discovering in turn that its consumption is too high and savings too low (reflected in our excessive private and public debt). In other words, to sustain economic growth, the Chinese will have to consume more of their own product and Americans will have to produce more of what they hope to consume. Export-driven economic policies have been very popular in helping developing countries like the Asian tigers to grow rapidly – but we can see by this simple insight that the policy is not sustainable over the long run.

This simple question – To consume or not to consume? – is helpful to understanding many of the complex economic issues we face today, especially sustainability. You see, THAT is the real question, because life is certainly not all about consuming more stuff. The most important consumption good we can enjoy is more free time and leisure to enjoy the short lives we have on this earth.

(Read about this topic in greater depth in the book Common Cent$: A Citizens’ Survival Guide. Available at Amazon in eBook or print.)

Blowing Bubbles

Fool me once, shame on you. Fool me twice, shame on me.

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Is the Fed Blowing a New Housing Bubble?

Stagnant real incomes suggest that rising home prices reflect artificially low interest rates.

By EDWARD PINTO

Over the past year, the Federal Reserve has ramped up its policy of quantitative easing, with the result being new stock market highs and surging bond prices. Moreover, housing prices jumped 8%, the biggest annual gain since 2006.

The result is that more than a trillion dollars have been added to the market value of single-family homes. Homeowners are now wealthier and according to what economists call the “wealth effect,” they should be willing to spend more, helping the economy.

But there is another, less sanguine view of the housing recovery. Recent data released by the Federal Housing Finance Agency (FHFA) suggest that the increase in house prices is not being driven by a broad-based improvement in the economy’s fundamentals. Instead, the Fed’s lower rates are simply being capitalized into higher home prices. This does not bode well for the future.

A comparison of FHFA’s conventional home-financing data for February 2012 and February 2013 shows that borrowers bought newly built and existing homes in 2013 for 9% and 15% more respectively than in the previous year. Increases of this magnitude cannot be attributed to higher incomes, as these rose a mere 2% over the last year, just keeping up with inflation. It appears that home prices are being levitated by quantitative easing. Because interest rates were .625% and .90% lower on new and existing homes respectively this year compared with last year, the monthly finance cost to purchase a new home remained the same and went up only 3% for an existing home.

While a housing recovery of sorts has developed, it is by no means a normal one. The government continues to go to extraordinary lengths to prop up sales by guaranteeing nearly 90% of new mortgage debt, financing half of all home purchase mortgages to buyers with zero equity at closing, driving mortgage interest rates to the lowest level in 100 years, and turning the Fed into the world’s largest buyer of new mortgage debt.

Thus, with real incomes essentially stagnant, this is a market recovery largely driven by low interest rates and plentiful government financing. This is eerily familiar to the previous government policy-induced boom that went bust in 2006, and from which the country is still struggling to recover. Creating over a trillion dollars in additional home value out of thin air does sound like a variant of dropping money out of helicopters.

Will history repeat? When it comes to interest rates, whatever goes down must go up.

The average mortgage rate during the first nine years of the 2000s was 6.3% compared with today’s rate of less than 3.5%. If mortgage rates were to increase to a moderate 6% in three years, say, some combination of three things would have to happen to keep the same level of homeownership affordability. Incomes would need to increase by a third, house prices would need to decline by a quarter, or lending standards would need to be loosened even further.

The National Association of Realtors and the rest of the government mortgage complex can be relied on to push for looser lending. The Consumer Financial Protection Bureau recently came out with new rules that would grease the skids for relaxed lending standards, compliments of Fannie Mae, Freddie Mac and the Federal Housing Administration.

Given the continued subpar economic recovery and our past experience with the disastrous impact of loose lending encouraged by federal policies, homeowners would best be cautious about spending their new found “wealth.” Americans have seen this movie before and know how it ends.

China and the dangers of unbalanced growth

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The article below reiterates one of the basic economic truths explained in Political Economy Simplified, which is that growth requires a cyclical balance between consumption and savings; borrowing and investment. China is producing more exports than the world can consume, especially by the de-leveraging developed economies. China’s growth path is essentially too steep to keep up and so will correct to a more sustainable path. This is what happened with the credit bubble in the US as well. China is attempting to turbo-charge both consumption and investment at the same time by excessive borrowing, just like the US did in the 2000s.

Fundamentally, the economy runs on four wheels: consumption, saving, investment and production. If either of these gets out of sync with the others, the vehicle will sputter and crash. Interest rates are normally what keeps it all together, but we’ve been distorting those worldwide for the past two decades. Such mismanagement will demand a reckoning, and more of the same merely delays the inevitable.

From the WSJ:

China Has Its Own Debt Bomb

Not unlike the U.S. in 2008, China is at the end of a credit binge that won’t end well.

 By RUCHIR SHARMA

Six years ago, Chinese Premier Wen Jiabao cautioned that China’s economy is “unstable, unbalanced, uncoordinated and unsustainable.” China has since doubled down on the economic model that prompted his concern.

Mr. Wen spoke out in an attempt to change the course of an economy dangerously dependent on one lever to generate growth: heavy investment in the roads, factories and other infrastructure that have helped make China a manufacturing superpower. Then along came the 2008 global financial crisis. To keep China’s economy growing, panicked officials launched a half-trillion-dollar stimulus and ordered banks to fund a new wave of investment. Investment has risen as a share of gross domestic product to 48%—a record for any large country—from 43%.

Even more staggering is the amount of credit that China unleashed to finance this investment boom. Since 2007, the amount of new credit generated annually has more than quadrupled to $2.75 trillion in the 12 months through January this year. Last year, roughly half of the new loans came from the “shadow banking system,” private lenders and credit suppliers outside formal lending channels. These outfits lend to borrowers—often local governments pushing increasingly low-quality infrastructure projects—who have run into trouble paying their bank loans.

Since 2008, China’s total public and private debt has exploded to more than 200% of GDP—an unprecedented level for any developing country. Yet the overwhelming consensus still sees little risk to the financial system or to economic growth in China.

That view ignores the strong evidence of studies launched since 2008 in a belated attempt by the major global financial institutions to understand the origin of financial crises. The key, more than the level of debt, is the rate of increase in debt—particularly private debt. (Private debt in China includes all kinds of quasi-state borrowers, such as local governments and state-owned corporations.)

On the most important measures of this rate, China is now in the flashing-red zone. The first measure comes from the Bank of International Settlements, which found that if private debt as a share of GDP accelerates to a level 6% higher than its trend over the previous decade, the acceleration is an early warning of serious financial distress. In China, private debt as a share of GDP is now 12% above its previous trend, and above the peak levels seen before credit crises hit Japan in 1989, Korea in 1997, the U.S. in 2007 and Spain in 2008.

The second measure comes from the International Monetary Fund, which found that if private credit grows faster than the economy for three to five years, the increasing ratio of private credit to GDP usually signals financial distress. In China, private credit has been growing much faster than the economy since 2008, and the ratio of private credit to GDP has risen by 50 percentage points to 180%, an increase similar to what the U.S. and Japan witnessed before their most recent financial woes.

The bullish consensus seems to think these laws of financial gravity don’t apply to China. The bulls say that bank crises typically begin when foreign creditors start to demand their money, and China owes very little to foreigners. Yet in an August 2012 National Bureau of Economic Research paper titled “The Great Leveraging,” University of Virginia economist Alan Taylor examined the 79 major financial crises in advanced economies over the past 140 years and found that they are just as likely in countries that rely on domestic savings and owe little to foreign creditors.

The bulls also argue that China can afford to write off bad debts because it sits on more than $3 trillion in foreign-exchange reserves as well as huge domestic savings. However, while some other Asian nations with high savings and few foreign liabilities did avoid bank crises following credit booms, they nonetheless saw economic growth slow sharply.

Following credit booms in the early 1970s and the late 1980s, Japan used its vast financial resources to put troubled lenders on life support. Debt clogged the system and productivity declined. Once the increase in credit peaked, growth fell sharply over the next five years: to 3% from 8% in the 1970s and to 1% from 4% in the 1980s. In Taiwan, following a similar cycle in the early 1990s, the average annual growth rate fell to 6%.

Even if China dodges a financial crisis, then, it is not likely to dodge a slowdown in its increasingly debt-clogged economy. Through 2007, creating a dollar of economic growth in China required just over a dollar of debt. Since then it has taken three dollars of debt to generate a dollar of growth. This is what you normally see in the late stages of a credit binge, as more debt goes to increasingly less productive investments. In China, exports and manufacturing are slowing as more money flows into real-estate speculation. About a third of the bank loans in China are now for real estate, or are backed by real estate, roughly similar to U.S. levels in 2007.

For China to find a more stable growth model, most experts agree that the country needs to balance its investments by promoting greater consumption. The catch is that consumption has been growing at 8% a year for the past decade—faster than in previous miracle economies like Japan’s and as fast as it can grow without triggering inflation. Yet consumption is still falling as a share of GDP because investment has been growing even faster.

So rebalancing requires China to cut back on investment and on the rate of increase in debt, which would mean accepting a rate of growth as low as 5% to 6%, well below the current official rate of 8%. In other investment-led, high-growth nations, from Brazil in the 1970s to Malaysia in the 1990s, economic growth typically fell by half in the decade after investment peaked. The alternative is that China tries to sustain an unrealistic growth target, by piling more debt on an already powerful debt bomb.

Economics in a Nutshell

In this post we will examine a simple formula that reduces complex economic concepts and analysis into easy-to-understand terms. [The following is excerpted from the book, Common Cent$: A Citizen’s Survival Guide.]

Consume now or later?

These four words can help make sense of the macro-economy. First off, all economics is merely derived from simple decisions we make everyday over whether to consume something today, or save and wait to fulfill our consumption needs and desires tomorrow (or a day, a month, a year, or decade later). Think about some of these decisions you make all the time: eat at home this week so you can splurge on a 5-star restaurant meal next month; put off buying a new car or house for a few years so you can afford to get an MBA; put 15% of your income in the bank to save for a down payment on a house; or borrow to buy a car today instead of next year because the interest rates are low and the discount rebates high.

The real economy is generated by millions of these aggregated individual decisions on whether to consume now or later and the exchanges based on those decisions. The real economy can thus be represented by a simple relationship representing the trade-off between present consumption and future, or deferred, consumption. Symbolically we can represent the trade-off as:

Cpresent versus Cfuture or Cp : Cf

We might prosaically call this trade-off our inter-temporal consumption ratio (ICR), which represents all our aggregate economic decisions over whether to consume now or later.

Now, if you’re wondering where savings, investment, interest rates, government spending, taxes, etc., come in, please be patient. Just remember this simple truth: all resources and the production of goods and services are ultimately allocated toward one end: consumption. What we don’t consume today we may save and/or invest for future consumption, perhaps by our descendants, but ultimately everything is consumed. After all, “You can’t take it with you.”

We can demonstrate the relationship to interest rates and economic growth if we take the formulation and express it as a divisor:

Cf / Cp

Think about how an interest rate affects our preferences for future vs. present consumption. A high interest rate will decrease present consumption as we save more and borrow less in order to reap the high returns of the interest received. In other words, we put our money in the bank (or the money, bond, or stock markets) in order to have our wealth grow to allow us to consume more in the future. Conversely, when the interest rate is low, we prefer to consume now because there is less reward for waiting. The ratio as expressed above is positively correlated with the interest rate: if the ratio is high or rising we would expect interest rates to be high or rising and vice-versa.

This ratio is also positively correlated with the growth rate of the economy. If we defer consumption and save and invest in new production, then the economy grows and we have more to consume in the future. China has been growing at double-digit rates for the past generation because the savings rate is estimated to be near 50% of income and the population’s consumption has been deferred. Of course, China has also relied on selling their goods and services to the rest of the world, since they aren’t consuming much themselves. (Obviously, there is a limit to this “export” growth strategy since the whole world cannot simply produce and sell when nobody buys and consumes.)

Let’s try another thought problem: imagine if interest rates go to zero. Would you be a lender? A zero rate means there is no compensation for risk, zero time value of money, and little to be gained from deferring the immediate gratification of present consumption. In the extreme, a zero interest rate implies a willful disregard, or disbelief, in the future. Naturally, when interest rates go to zero, or even negative numbers in real terms,* we expect the anomaly to be short-lived. We should question the Federal Reserve’s Zero Interest Rate Policy, aka ZIRP. Their policy intent is to stimulate present consumption, but at what cost? How concerned about tomorrow are today’s policymakers?

This brings us to the point where we can discuss how different policy options might affect the ICR (Intertemporal Consumption Ratio), which will be the subject addressed in the next post, Economic Policy in a Nutshell.


* Interest rates are expressly in nominal terms, but if inflation is present, the effective real rate may be negative. For example, if the interest rate is 3% and the inflation rate is 5%, then the real rate is -2%. In this case one should borrow to the max and use the funds to buy appreciating real assets, like real estate, collectibles, or precious metals.

The Art of Mountain Climbing

I recently had a conversation with a friend who was cautiously optimistic about the US economy and its growth potential going forward. He cited statistics about corporate profits and a housing recovery and how the US was better off economically than many other countries and regions. He thought we were posed for another growth spurt that would be reflected in higher stock prices.

I agreed with his basic statistical evidence, which offered a snapshot of the distorted present rather than a sound projection into the future, leading me to a bit of a different interpretation regarding the investment risks going forward. I tried to convey my analysis by verbally explaining what lay between here and there. I think it’s easier to explain using the following illustration:

Cliffs2

The US (and world economy) fell partly off a cliff in 2008 and 2009. One problem is that the previous peak was built on the hot air of cheap credit rather than the firm bedrock of economic productivity. Now, the US economy is still stuck at point A on the chart. The policy experts at the Fed and in Washington are desperately trying to prevent us from falling to point C by bridging the chasm between A and B with cheap liquidity, unproductive spending stimulus, and false confidence that pigs can fly.

My friend is looking backward and forward to see how the US economy has rebounded in the past and will eventually return to point B with an upward growth path. My explanation went something like this: In order to get back to gradual, step-wise positive growth (climbing the mountain one step at a time), we first need to adopt prudent mountain climbing skills. In economic terms, this means working, saving and prudently investing in productive activities. To do this we need functioning capital, labor, and product markets guided by accurate prices. Instead, in their attempts to prevent us from falling into the bottomless ravine at point C, our policymakers are inhibiting citizens from pursuing productive activities.  In other words, we can’t fly from point A to B, we have to get back to climbing fundamentals, but under the continued price distortions promoted by the wrong monetary, tax, and spending policies, many people are rationally returning to the speculative behavior that caused the crisis in the first place. Most of our private debts are being transferred to the public sector, which not only means the debts grow (see previous post on debt-driven spending over the past 30 years) but that nobody really has much incentive to watch the cash register: government borrowing and spending just keeps growing without any consideration on whether this is helping real growth and wealth creation.

We have some real world references to point to here. In the 1990s Japan had a real estate and stock market bubble that burst just like we experienced in 2008/09. They adopted the same strategy of excess liquidity and banking bailouts that prevented losses from being reset and resources from flowing back into productive activities. The Japanese have sat at point A and watched point B recede for the past 25+ years.

Another case, just the opposite, is tiny Iceland. Ten years ago Iceland embarked on a fantastic bank-leveraged financial bubble that popped with a bang in 2008. Because they could not borrow and spend their way out of bankruptcy, in a matter of weeks Icelanders went to bed at point A and woke up at point C. The phony wealth creation evaporated with an instant price reset as the Icelandic krona lost more than half its value. But Iceland is now back on a positive growth path climbing back up the mountain of growth founded on hard work and sound financial policy.

As you might have guessed, we are pursuing the same policies as Japan, not Iceland, because we can and the necessary price reset is politically unacceptable. How many of us would willingly see all prices revert to say, 2001? But we really can’t get from point A to B on the backs of flying pigs. In trying to do so we risk two possible outcomes:  one, we create another bubble and a bigger crash which will be unmanageable because the policymakers will have run out of bailout money; or we sit and watch point B recede ever into the future as economic opportunity declines, growth stagnates, and we all grow older.

Deficits, Debt and the Fate of the Dollar

If you have anything to lose, these developments should worry you. Read the following analysis carefully.

Our politicians have made it almost impossible to protect yourself from this risk. The Federal Reserve will distort financial and real asset markets with excess liquidity until the market turns around and crushes it. We see the first signs of dissent from the Midwest banking centers because they are not enthralled by Wall St.-DC financial and political interests. Historically, they have reflected more the interests of Main St., which stands to absorb the brunt of this failed policy.

From the WSJ:

The shivers that ran through the bond market after the budget deal were a signal the Fed ignores at our peril.

By GEORGE MELLOAN

The year-end “fiscal cliff” tax deal sent shivers through the bond market, driving the price of 10-year Treasurys to the lowest level since April. There was a good reason. The stubborn resistance by President Barack Obama and Senate Majority Leader Harry Reid to spending cuts left no further doubts about their lack of interest in the nation’s No. 1 economic problem, massive federal deficits.

The bond-market decline came despite the Federal Reserve’s renewed program to gobble up yet more government debt. Presidents of some regional Federal Reserve Banks are growing nervous about this program, judging from the December minutes of the Federal Open Market Committee, which guides Fed policy. Jeffrey Lacker of the Richmond Fed, Richard Fisher of Dallas and Esther George of Kansas City have been among the most outspoken in voicing fears that continuation of the Fed’s manic buying—now running at $85 billion a month in Treasury and agency paper—will ultimately destroy the dollar. The concerns expressed in the FOMC minutes didn’t cheer the bond market either.

These are signals of dangerous times. Forget about the next Washington dog-and-pony show on the debt ceiling. The bond market will ultimately dictate the future of U.S. monetary and budgetary policy.

Bond markets only obey the law of supply and demand. When the flooding of markets with American debt causes the world to lose confidence in dollar-denominated securities, the nation will be in deep trouble. The only force standing in the way of that now is the Fed’s support of bond prices. But regional Fed presidents are prudently asking how long that can be sustained.

Mr. Obama currently is riding high, pumped up by his success in resisting Republican budget-cutting demands during the “cliff” talks. But the deal he muscled through Congress is a hollow victory. His so-called tax on the wealthy will produce scant revenues. The money sucked out of American pocketbooks by higher payroll taxes will curb consumer demand, further slowing already weak economic growth. Only entitlement reforms, which the president refuses to consider, can shrink the deficit enough to reduce the danger it poses.

The Fed’s worst fear is that despite its long-term commitment to buying up government debt, it will lose control of interest rates. That’s why the early-January upward blip in bond yields was a yellow warning light. If Treasury bond prices decline significantly from the artificial levels that massive Fed purchases have supported, several things will happen, none of them good.

First of all, government borrowing costs will rise, making it even more difficult to control the deficit. Second, the value of the Fed’s gargantuan and growing $2.6 trillion portfolio of Treasury and government-agency mortgage bonds will decline. It won’t take much of a portfolio loss to wipe out the Fed’s capital base. Without capital of its own, it would become a ward of the Treasury, costing the Fed what little independence it has left to defend the dollar.

Even now, the Fed faces a cruel dilemma. It can let bond prices fall and suffer the unhappy consequences. Or it can keep on its present course of buying up more hundreds of billions of Treasury paper. That course inevitably leads to inflation.

Over the past four years, the damage to the dollar has been partly ameliorated by global investors fleeing weak currencies elsewhere for the relative safety of the dollar. But there has to be a limit to how long that will be true. We already are seeing signs of renewed asset inflation not unlike the run-up that occurred in the first half of last decade. Stocks and farmland are up and housing prices are recovering from their slump.

Brendan Brown, London-based economist for Mitsubishi UFJ Securities, reminds us that asset inflation is usually followed by asset deflation, and that’s no fun, as the events of 2007 and 2008 testified. More seriously, a rise in the price of assets often presages a general rise in the prices of goods and services.

Inflation can ultimately destroy the bond market, as it did in 1960s Britain during the government of the socialist Labour Party. No one wants to commit to an investment that might be worthless in 10 years, never mind 30 years.

Throughout history, governments have inflated away their debts by cheapening the currency. That process is well under way through the Fed’s abdication to irresponsible government. If Fed policies continue, another huge tax—inflation—will weigh down the American people. The politicians will try to escape public censure, as they always do, by blaming it all on “price gouging” by producers, retailers and landlords. A substantial cohort of the press will buy into that phony rationale and spread it as gospel.

The Fed’s dilemma is in fact everyone’s dilemma, given the universal stake in the value of the dollar. And all because an American president and a substantial number of senators and representatives don’t understand one simple fact: In the end, the bond market rules.

Middlin’ Class

Apparently newly-elected MA senator Elizabeth Warren has been having trouble defining her policy guidelines to the media. This excerpted from a recent interview:

Reporter: When you mention “middle class,” what numbers are we talking about, in terms of income level?

Warren: It’s not a numbers issue. I know you would expect a very wonky answer for me, you know, about the percentiles. But it’s not.

Reporter: Well, I would, just because that would be how you would expect that something would be written in a bill form. It would be people with income levels here to here–

Warren: When we strengthen education, when we make it possible for kids to go to college, then we strengthen America’s middle class, and that doesn’t need a dollar figure. . . . How about somebody who’s taught school for ten years, and takes off a year to go to graduate school, and has an income of only $4,000 in the year that she’s not teaching? Would you say that she’s fallen out of the middle class? I wouldn’t. It’s a whole lot of characteristics that define the middle class.

In her example, the wonky Ms. Warren unwittingly provides the answer which she seems oblivious to. Politics and policy should not be characterized by WHO we are, whether defined by income or any other identity basis, but by what we DO. The teacher making an investment in higher education is DOING something productive. That’s what policy should be encouraging and rewarding. We can all DO something different under the right incentive structure, but we can’t change WHO we are. The beauty of the American experiment is that it should not matter WHO you are, only what you DO. Makes sense, right, Ms. Warren? Enough of the class warfare.

The consequences of bad tax policy.

Mr. Wynn’s quote below hints at a bigger macroeconomic cost of taxing capital flows. Capital taxes lock up capital flows so they do not get channeled into more efficient investments or into consumption when investment returns and interest rates are low. When the economy is slow, it is essential for capital flows to get channeled into consumption demand. Instead, capital gets locked up in retained earnings and asset speculation, while consumption demand is borrowed from the future with cheap credit. This is exactly what happened during the credit bubble of the 2000s leading up to a massive de-leveraging of debt after 2008 that still plagues our economy. Bad tax policy does not close deficits, it contributes to economic volatility.

As casino magnate Steve Wynn summarized in a recent investor call: “When the taxes on the dividends are too high, then companies don’t distribute, the shareholders don’t get the dividends and Uncle Sam doesn’t get the tax.”

In this era when envy trumps growth, the government is raising taxes on thrift, investment and risk-taking in the name of fairness and to finance more government spending.

From the WSJ:

The Great 2012 CashoutDividends offer a lesson in tax rates and investor behavior.

Perhaps you’ve heard from various economic sages that tax rates don’t matter either to economic growth or taxpayer behavior. Don’t tell that to the companies and individuals who are busy cashing out their investments or paying dividends to get ahead of the Obama tax scythe in January.

Costco, the giant wholesale-club operator, announced Wednesday that it will pay a special dividend of $7 a share before the end of the year. That’s about $3 billion the company will return to shareholders that the feds will only tax at 15% rather than the 39.6% rate scheduled to kick in when the Bush-era tax rates expire next year. For households earning more than $250,000 in 2013, you can add another 3.8 percentage points in tax thanks to the ObamaCare surcharge. Costco’s shareholders approved, sending its stock up about 6%.

We think companies can do what they want with their cash, but it’s certainly rare to see a public corporation weaken its balance sheet not for investment in the future but to make a one-time equity payout. It’s a good illustration of the way that Federal Reserve Chairman Ben Bernanke’s near-zero interest rates are combining with federal tax policy to distort business decisions.

The Journal reports that as of Wednesday morning some 173 companies had announced special dividends, compared to only 72 in the same period a year ago. A recent Bloomberg analysis found that from September to mid-November, 59 companies on the Russell 3000 stock index had declared one-time cash payments to shareholders, four times last year’s pace.

“I find no precedent like this at all going all the way back to the 1950s,” Howard Silverblatt of S&P Dow Jones Indices told the Journal. Then again, there’s no precedent for the Obama Presidency.

Other companies, like the manufacturer Leggett & Platt, are moving up their regular quarterly dividend to be payable in December rather than in January. Wal-Mart did the same last week, moving its expected $1.34 billion dividend payout to this year. Watch for many more to do the same.

Shareholders should enjoy this windfall because the longer-term result of higher tax rates is that fewer companies are likely to pay any dividends, while others will limit their distributions. As casino magnate Steve Wynn summarized in a recent investor call: “When the taxes on the dividends are too high, then companies don’t distribute, the shareholders don’t get the dividends and Uncle Sam doesn’t get the tax.”

Mr. Wynn knows his history. Dividend payouts rose only modestly in the 1980s and 1990s when they were taxed as ordinary income. The Bush tax cut chopped the rate to 15% on January 1, 2003, on the sound economic reasoning that corporate income is already taxed once at the company level. Dividends reported on tax returns nearly doubled to $196 billion in 2003 from $103 billion in 2002. Dividend income hit $337 billion by 2006, more than three-times the pre-tax cut level.

It’s also a good bet that some of the recent stock market volatility is due to investors seeking to realize capital gains at today’s 15% tax rate, before that rate rises to 23.8% (including the ObamaCare surcharge) on January 1. When the capital gains rate last rose, to 28% from 20% as part of the 1986 tax reform, investors also cashed in before the higher rate took effect.

Tax revenue from capital gains in 1986 soared to $52.9 billion, then dropped to $33.7 billion in 1987 and stayed largely flat for nearly a decade. It boomed again after Bill Clinton and Newt Gingrich agreed to return the rate to 20% in 1997.

When government raises taxes on dividends and capital gains, it is lowering the after-tax return on stocks. Share prices will fall over time to adjust to that new rate of return, reducing overall wealth in the private economy, all other things being equal. As for the feds, history suggests they’ll see a capital gains and dividend revenue windfall this year, but then a decline next year even at the higher rate.

It’s the oldest lesson in tax policy: Tax something and you get less of it. In this era when envy trumps growth, the government is raising taxes on thrift, investment and risk-taking in the name of fairness and to finance more government spending. No one should be surprised when there are fewer dividends and capital gains to tax.

Evaluating the Fed’s QE3: Inequality Getting Worse

From John Mauldin’s Outside the Box:

The Hoisington Quarterly Review and Outlook is one of the cornerstones of my reading on where the economy is headed. Van Hoisington and Lacy Hunt do a masterful job of turning data points into cogent, well-argued themes.

This month they waste no time in dissecting the Fed’s recent move to QE3 and similar efforts in Europe, arriving at the conclusion that “While prices for risk assets have improved, governments have not been able to address underlying debt imbalances. Thus, nothing suggests that these latest actions do anything to change the extreme over-indebtedness of major global economies.”

Their expectation: global recession. The only issue left to sort out, they say, is How deep will the downturn be?

They make the interesting observation that with each injection of liquidity by the Fed, commodity prices have surged: “During QE1 & QE2 wholesale gasoline prices jumped 30% and 37%, respectively, and the Goldman Sachs Commodity Food Index (GSCI-Food) rose 7% and 22%, respectively. From the time the press reported that the Fed was moving toward QE3, both gasoline and the GSCI Food index jumped by 19%, through the end of the 3rd quarter.”

The QE picture gets even muddier. The unintended consequence of the Fed’s actions, say Lacy and Van, has been to actually slow economic activity: “The CPI rose significantly in QE1 and QE2 (Chart 1). These price increases had a devastating effect on worker’s incomes (Chart 2). Wages did not immediately respond to commodity price changes; therefore, there was an approximate 3% decline in real average hourly earnings in both instances. It is true that stock prices also rose along with commodity prices (S&P plus 36% and 24%, respectively, in QE1 and QE2). However, median households hold a small portion of equities, and thus received minimal wealth benefit.[MH note: this is the tragedy of modern capitalism – so few participate.]

They proceed to tear apart the wealth effect that the Fed is banking on to restimulate the economy, drawing on several solid studies. They also make the key point that “When the Fed actions lead to higher food and fuel prices, the shock wave reverberates around the world, with many foreign economies being hit adversely. When prices of basic necessities rise, the greatest burden is on those with the lowest incomes since more of their budget is allocated to the basic necessities such as food and fuel.”

Inequality, Power Laws, and Sustainability: Part III

In Part I of this post I discussed power laws and how they describe the distribution of wealth and income. In Part II I explained the basic dynamics of power laws and wealth distributions by offering some simple analogies and models. In this post I will discuss the policy ramifications of inequality.

Power laws in economic exchange markets lead to instability because of the inter-temporal breakdown of the necessary recycling/feedback processes. Let me explain that in English. An economy is a cyclical flow process that feeds back on itself over time. What we produce today we consume today, and save and invest for tomorrow. Tomorrow we expect to reap the rewards of producing, saving, and investing today so that we can repeat the process again and again, gradually accumulating a surplus = a pot of wealth. This is how an economy grows and how each productive member gets rich.

Now, what happens if 20% of the people receive 80% of the success in terms of the returns? How much will they consume relative to the 80% ‘have-nots’ who have to divvy up 20% of the returns? Enough to justify investment in increased production to meet future demand? If 80% of the people are not receiving an adequate return on current production, they have no resources to consume at the same levels in the future, so why would the 20% bother to invest in increased production? Thus, there is an excess of investment funds among the ‘haves’ and a dearth of consumption among the ‘have-nots’, to say nothing of saving and investment for the ‘have-nots’.  (A good historical example of this logic is when Henry Ford discovered that he wasn’t going to sell many cars if the workers who built them couldn’t afford to buy them. Raising wages was also his way ot retaining workers and reducing retraining costs, thereby lowering his long-run labor costs despite the wage increase.)

What results with a power law distribution is a breakdown in exchange between the 20% ‘haves’ and the 80% ‘have-nots’. The ‘haves’ have to reinvest their profits, but where? If there is no realized demand, they must seek other ways to invest. They do this by bidding up desirable real and financial assets, like real estate, collectibles, stocks and bonds, hoping that these will continue to rise in value. This is speculating according to the “bigger sucker” sales strategy. It continues until those asset prices become unrealistic and unsupportable as incomes stagnate even more in the ‘have-not’ group. The end result is a crash in asset values that brings prices and wages down to a level where exchange can restart.

This is an oversimplification, of course, but it outlines the basic problem. As I have explained elsewhere, equilibrium economics cannot solve distributional breakdowns like this. Economic theory only tells us how to restart the growth process.

The initial policy response to this puzzle might be to tax wealth away from the ‘haves’ and give it to the ‘have-nots’. Unfortunately, this will not solve the problem because it only redresses the relative endowments and not the power law process. This might be acceptable if we reiterate the policy endlessly, so that at the end of every year we redistribute wealth, but the problem is that this destroys the wealth creating process (In the US we’re reminded of this strategy every April 15!). The ‘haves’ cease to accumulate assets that can be taxed away, and why would they? The USSR tried this over the 20th century and we know where that ended.

The obvious logical solution is that more than 20% must participate in the share-out of success, but how to do that without killing the goose that lays the golden eggs? The success of market capitalism is mostly reflected in the increasing returns to capital. Think about it: a successful business increases profits by reducing costs as well as expanding. This process reduces labor costs and increases profits to the business owners. Obviously, to survive in a capitalist society, one desires to be a capitalist, not a worker. (It’s not so stark as this, as what is optimal is the right combination of capital and labor. The value of capital is to increase the profitability of our labors. If you doubt this, think about how a 20-something trader on Wall St. can make a seven-figure income. He or she is highly leveraged with risk capital.)

Current tax policy discourages the accumulation of capital for ‘have-nots’ under the false pretense that there is something nefarious about ‘capitalists.’ We see this in the current misguided political attacks by the Occupy crowd. (They have legitimate grievances, but it’s not with the market, it’s with the political corruption of the market.) Policies to mitigate inequality should include the following:

  1. A reduction of payroll taxes on labor;
  2. A reduction of all capital taxes (capital gains, interest, dividends), especially for the ‘have-nots’;
  3. Some form of consumption tax to replace capital taxes, with a high threshold to reduce overburdening the poor who consume a greater proportion of their income;
  4. Gradual substitution of private capital accumulation for entitlements – if one has a large nest egg in retirement, who exactly needs Social Security?
  5. Means-testing for entitlements;
  6. Lower income taxes across the board, retaining some progressiveness;
  7. Higher wealth taxes on real property;
  8. An estate tax with rules that allow for a high tax-free threshold and voluntary distribution of assets below that threshold that would avoid taxes, before or at death. For example, if the tax-free threshold was $5 million, I could distribute my $100 million estate to 20 or more beneficiaries tax-free.

Proponents of both parties and both ideologies will object to many of these ideas, but compare them to the policies we have in place or are being proposed: raise income taxes, especially taxes on capital; no entitlement reforms to speak of; the expansion of a healthcare entitlement; financial regulation that hampers equity investment; government deficit spending with a rising debt-GDP ratio; a zero-interest rate policy that only rewards asset speculators; a Fed’s stated desire to create a “little inflation”; an estate tax that seeks to confiscate capital; additional plans to bail-out homeowners and student loan borrowers (who really thinks it’s a good investment to pay off an overpriced house for the next 25 years?); failed subsidies for alternative energy and higher taxes existing energy supplies, etc., etc. These are all ideas that reinforce the unequal status quo in our society.

The objective should be to create a dynamic opportunity society that rewards hard work, risk-taking, innovation, and merit rather than political influence or economic power. To do this, we need a set of policies that counter the market’s natural power law of skewed distributions that concentrates wealth and income.  The alternative is a dysfunctional society with growing income and wealth inequalities that violates our basic sense of morality and justice.