Health Care Fantasies

A couple of articles today outlining how far apart from reality are the pro and con arguments for different possible reforms. This is going to matter at some point soon, if not now.

Socialized Medicine Has Won the Health Care Debate

The first article, by Sarah Jaffe published in The New Republic, suggests that “socialized” healthcare has won the policy debate. Citing opinion polls (for which all questions display a certain bias), the author claims that the American public favors government-run socialized medicine. (Here’s a good example of survey bias: “Do you favor free healthcare for all?” – How many No’s do you think that question elicits?)

Ms. Jaffe explains away Obamacare’s unpopularity with this, “What people don’t like are the inequities that still prevail in our health care system, not the fact that “government is too involved. …The law didn’t go too far for Americans to get behind. It didn’t go far enough. And while single-payer opponents continue to evoke rationed care, long lines and wait times, and other problems that supposedly plague England or Canada, the public seems well aware that the reality for many Americans is far worse.”

Really?

What’s more, what makes her think that government control removes inequalities rather than make them worse according to different selection criteria?

Finally, she proclaims, “This is now an American consensus. And if socialism is the medicine our system needs, the country is ready to embrace it—even by name.”

At no point does Ms. Jaffe discuss the associated costs, who is going to pay them, and what kind of trade-offs this will impose on citizens and taxpayers. This is an argument motivated by political ideology, not reality.

***

This brings us to the second article, by Sally Pipes in Investor’s Business Daily (this should give us a clue that Pipes actually plans to address money issues).

Sanders’ Single-Payer Fairy Tale

Ms. Pipes first gives us an indication of polling bias: “The idea is … enchanting ordinary Americans. Fifty-three percent support single payer, according to a June 2017 poll from the Kaiser Family Foundation. But this supposed support is a mirage. According to the same Kaiser poll, 62% would oppose single-payer if it gave the government too much power over health care. Sixty percent would reject it if it increased taxes.”

Sen. Sanders estimates that “Medicare for all” would cost an extra $14 trillion over 10 years, while the Urban Institute’s analysis of the plan puts the figure at $32 trillion. Our current annual health spending is $3.2 trillion, so Medicare at minimum would double that spending level, with no viable way to pay for it, with taxes or otherwise.

Medicare for the 65+ crowd is already a deficit buster, so the nation will not be affording such care for the entire population and promises to do so are a dangerous fantasy. We do know what will happen – the “free” care we expect will never be delivered and the politicians who sell such snake oil will be long gone.

The real problem with our health care debates is that they focus solely on distribution and not on the real problem, which is adequate supply. If no one is producing health care goods, what is there to distribute?

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Constitutional Crisis?

The following was a provocative essay published in the NYTimes. Since it touches on the nexus of economics and politics, I deemed it an appropriate topic for this blog.

Our Constitution was not built for a country with so much wealth concentrated at the very top nor for the threats that invariably accompany it: oligarchs and populist demagogues.

No. It wasn’t.

But we can never seem to anchor our attention on the true determinants of economic power. The distribution of wealth is tilted toward those who control society’s primary productive resources. In feudal and agrarian societies it is land; in industrial and post industrial societies it is energy and finance capital; in the information society it is information data and finance capital.

The imperative for a liberal democracy is to democratize land, to democratize finance, and, especially in the 21st century, to democratize big data. There are trade-offs implied (especially the necessary democratization of investment risk), but the objective must be liberty and justice, not national wealth, because sustainable wealth is only derived from liberty and justice.

Aside from economic inequality there is a related but different plague upon the body politic these days. That is the anti-democratic ideology of identity politics and multiculturalism. These ideologies probably arose as a response to the frustration of economic inequality and power that demanded a division into victims and victimizers. The victimizers, of course, were corporate, white, and male, while the victims were all other identity groups not so defined: ethnic and racial minorities, women, LBGTs, etc.

But a constitution based on compromise through participation cannot possibly manage identity groups based on biology and genetics.  There is no compromising our biological identity, there are only zero-sum battles with winners and losers. Thus, the rule of the victimizers must be torn down, though it cannot end there. Coalitions of identity groups do not hold together after the common enemy has been vanquished, so they turn on each other until we see the complete Balkanization of democratic polities.

We will need to solve both these problems – economic inequality and identity Balkanization – in order for our democracy to restore itself and guarantee liberty and justice for all. Unfortunately this professor, and most of our political leaders in the oligarchy, don’t really have any promising ideas about how to go about that.

There are other things the Constitution wasn’t written for, of course. The founders didn’t foresee America becoming a global superpower. They didn’t plan for the internet or nuclear weapons. And they certainly couldn’t have imagined a former reality television star president. Commentators wring their hands over all of these transformations — though these days, they tend to focus on whether this country’s founding document can survive the current president.

But there is a different, and far more stubborn, risk that our country faces — and which, arguably, led to the TV star turned president in the first place. Our Constitution was not built for a country with so much wealth concentrated at the very top nor for the threats that invariably accompany it: oligarchs and populist demagogues.

From the ancient Greeks to the American founders, statesmen and political philosophers were obsessed with the problem of economic inequality. Unequal societies were subject to constant strife — even revolution. The rich would tyrannize the poor, and the poor would revolt against the rich.

The solution was to build economic class right into the structure of government. In England, for example, the structure of government balanced lords and commoners. In ancient Rome, there was the patrician Senate for the wealthy, and the Tribune of the Plebeians for everyone else. We can think of these as class-warfare constitutions: Each class has a share in governing, and a check on the other. Those checks prevent oligarchy on the one hand and a tyranny founded on populist demagogy on the other.

What is surprising about the design of our Constitution is that it isn’t a class warfare constitution. Our Constitution doesn’t mandate that only the wealthy can become senators, and we don’t have a tribune of the plebs. Our founding charter doesn’t have structural checks and balances between economic classes: not between rich and poor, and certainly not between corporate interests and ordinary workers. This was a radical change in the history of constitutional government.

And it wasn’t an oversight. The founding generation knew how to write class-warfare constitutions — they even debated such proposals during the summer of 1787. But they ultimately chose a framework for government that didn’t pit class against class. Part of the reason was practical. James Madison’s notes from the secret debates at the Philadelphia Convention show that the delegates had a hard time agreeing on how they would design such a class-based system. But part of the reason was political: They knew the American people wouldn’t agree to that kind of government.

At the time, many Americans believed the new nation would not be afflicted by the problems that accompanied economic inequality because there simply wasn’t much inequality within the political community of white men. Today we tend to emphasize how undemocratic the founding era was when judged by our values — its exclusion of women, enslavement of African-Americans, violence against Native Americans. But in doing so, we risk missing something important: Many in the founding generation believed America was exceptional because of the extraordinary degree of economic equality within the political community as they defined it.

Unlike Europe, America wasn’t bogged down by the legacy of feudalism, nor did it have a hereditary aristocracy. Noah Webster, best known for his dictionary, commented that there were “small inequalities of property,” a fact that distinguished America from Europe and the rest of the world. Equality of property, he believed, was crucial for sustaining a republic. During the Constitutional Convention, South Carolinan Charles Pinckney said America had “a greater equality than is to be found among the people of any other country.” As long as the new nation could expand west, he thought, it would be possible to have a citizenry of independent yeoman farmers. In a community with economic equality, there was simply no need for constitutional structures to manage the clash between the wealthy and everyone else.

The problem, of course, is that economic inequality has been on the rise for at least the last generation. In 1976 the richest 1 percent of Americans took home about 8.5 percent of our national income. Today they take home more than 20 percent. In major sectors of the economy — banking, airlines, agriculture, pharmaceuticals, telecommunications — economic power is increasingly concentrated in a small number of companies. [Don’t we need to discuss why before we embark on solutions?]

While much of the debate has been on the moral or economic consequences of economic inequality, the more fundamental problem is that our constitutional system might not survive in an unequal economy. Campaign contributions, lobbying, the revolving door of industry insiders working in government, interest group influence over regulators and even think tanks — all of these features of our current political system skew policy making to favor the wealthy and entrenched economic interests. “The rich will strive to establish their dominion and enslave the rest,” Gouverneur Morris observed in 1787. “They always did. They always will.” An oligarchy — not a republic — is the inevitable result.

As a republic descends into an oligarchy, the people revolt. Populist revolts are rarely anarchic; they require leadership. [See Trump AND Sanders.] Morris predicted that the rich would take advantage of the people’s “passions” and “make these the instruments for oppressing them.” The future Broadway sensation Alexander Hamilton put it more clearly: “Of those men who have overturned the liberties of republics, the greatest number have begun their career by paying an obsequious court to the people: commencing demagogues, and ending tyrants.”

Starting more than a century ago, amid the first Gilded Age, Americans confronted rising inequality, rapid industrial change, a communications and transportation revolution and the emergence of monopolies. Populists and progressives responded by pushing for reforms that would tame the great concentrations of wealth and power that were corrupting government.

On the economic side, they invented antitrust laws and public utilities regulation, established an income tax, and fought for minimum wages. On the political side, they passed campaign finance regulations and amended the Constitution so the people would get to elect senators directly. They did these things because they knew that our republican form of government could not survive in an economically unequal society. As Theodore Roosevelt wrote, “There can be no real political democracy unless there is something approaching an economic democracy.”

For all its resilience and longevity, our Constitution doesn’t have structural checks built into it to prevent oligarchy or populist demagogues. It was written on the assumption that America would remain relatively equal economically. Even the father of the Constitution understood this. Toward the end of his life, Madison worried that the number of Americans who had only the “bare necessities of life” would one day increase. When it did, he concluded, the institutions and laws of the country would need to be adapted, and that task would require “all the wisdom of the wisest patriots.”

With economic inequality rising and the middle class collapsing, the deep question we must ask today is whether our generation has wise patriots who, like the progressives a century ago, will adapt the institutions and laws of our country — and save our republic.

Ganesh Sitaraman, a professor at Vanderbilt Law School, is the author of “The Crisis of the Middle-Class Constitution: Why Economic Inequality Threatens Our Republic.”

QE Pains and Gains

Reprinted from Bloomberg.

The Unintended Consequences of Quantitative Easing

Asset inflation doesn’t have to be bad. Flush governments could invest in education and infrastructure.
August 21, 2017, 11:00 PM PDT

Quantitative easing, which saw major central banks buying government bonds outright and quadrupling their balance sheets since 2008 to $15 trillion, has boosted asset prices across the board. That was the aim: to counter a severe economic downturn and to save a financial system close to the brink. Little thought, however, was put into the longer-term consequences of these actions.

From 2008 to 2015, the nominal value of the global stock of investable assets has increased by about 40 percent, to over $500 trillion from over $350 trillion. Yet the real assets behind these numbers changed little, reflecting, in effect, the asset-inflationary nature of quantitative easing. The effects of asset inflation are as profound as those of the better-known consumer inflation.

Consumer price inflation erodes savings and the value of fixed earnings as prices rise. Aside from the pain consumers feel, the economy’s pricing signals get mixed up. Companies may unknowingly sell at a loss, while workers repeatedly have to ask for wage increases just to keep up with prices. The true losers though are people with savings, which see their value in real purchasing power severely diminished.

John Maynard Keynes famously said that inflation is a way for governments to “confiscate, secretly and unobserved, an important part of the wealth of their citizens.” Critically, inflation creates much social tension: “While the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at the confidence in the equity of the existing distribution of wealth.”

Asset inflation, it turns out, is remarkably similar. First, it impedes creative destruction by setting a negative long-term real interest rate. This allows companies that no longer generate enough income to pay a positive return on capital to continue as usual rather than being restructured. Thus the much-noted growth of zombie companies is one consequence of asset price inflation. Thus also the unreasonable leverage and price observed in real estate, with the credit risks it entails for the future.

Second, it also generates artificial winners and losers. The losers are most found among the aging middle class, who, in order to maintain future consumption levels, will now have to increase their savings. Indeed, the savings made by working people on stagnant wages effectively generates less future income because investable assets are now more expensive. The older the demographics, the more pronounced this effect. Germany, for instance, had a contraction of nearly 4 percent of gross domestic product in consumer spending from 2009 to 2016.

The winners are the wealthy, people with savings at the beginning of the process, who saw the nominal value of their assets skyrocket. But, as with consumer inflation, the biggest winner is the state, which now owns through its monetary authority, a large part of its own debt, effectively paying interest to itself, and a much lower one at that. For when all is accounted for, asset inflation is a monetary tax.

The most striking similarity between consumer price inflation and asset inflation is its potential to cause social disruption. In the 1970s workers resorted to industrial action to bargain for wage increases in line with price increases.

Today, the weakened middle class, whose wages have declined for decades, is increasingly angry at society’s wealthiest members. It perceives much of their recent wealth to be ill-gotten, not resulting from true economic wealth creation [and they are correct], and seeks social justice through populist movements outside of the traditional left-right debate. The QE monetary disruption almost certainly contributed to the protest votes that have been observed in the Western world.

The central banks now bear a large responsibility. If they ignore the political impact of the measures they took, they will exacerbate a politically volatile situation. If, on the other hand, the gains made by the state from QE can be channeled to true economic wealth creation and redistribution, they will have saved the day.

This is entirely possible. Rather than debating how and how fast to end quantitative easing, the central bank assets generated by this program should be put into a huge fund for education and infrastructure. The interest earned on these assets could finance real public investment, like research, education and retraining. [That’s fine, but it does little to compensate for the massive transfer of existing wealth that is causing the political and social dislocations, such as unsustainable urban housing costs.]

If the proceeds of QE are invested in growth-expanding policies, the gain will help finance tomorrow’s retirements, and the government-induced asset inflation can be an investment, not simply a tax.

The Bubble Economy

This is where the easy credit goes. A slush fund for Wall St. and Silicon Valley…

Full article here.

Money, money, money: Silicon Valley speculation recalls dotcom mania

Venture capitalists and private equity investors keep the bubble going with their millions

by Rana Foroohar

Financial Times
July 17, 2017

…It’s a bubble that is different — but the same — as the last time. In 2000, start-ups like pets.com were able to go public and jack up share prices even as they were losing hundreds of millions of dollars. The digital ecosystem has since grown, changed and deepened. Today it is harder for companies to receive funding just by sticking “.com” behind their names.

But now, as then, you do not necessarily need profits or paying customers to draw investor interest but rather “users” in a hot market niche. Compelling narratives develop around these sectors (wearables, electric cars, the “sharing” economy). Companies send market signals about their own “value” with announcements that play off these narratives, for example, Uber’s $680m purchase of self-driving truck firm Otto).

Venture capitalists and private equity investors keep the bubble going by buying into it at higher and higher valuations. The smartest ones guarantee their own success by taking rich advisory fees along the way and exiting before disaster via the secondary market for private shares. And this is, as behavioural economist Peter Atwater recently pointed out to me, unusually liquid thanks in part to central bank-enabled easy money.

The virtual money, generated by valuations that are based as much on narrative as fact, is used to salaries: it can cost upward of $2m in cash and stock options to recruit a driverless-car engineer in the Valley. These then distort the price of property, services and labour. You’ll weep when you see the prices of depressing ranch-style homes off Highway 101, which runs through Silicon Valley. The whole cycle is straight-up “madness of crowds”, as described by Charles Mackay in 1841.

It’s the Fed, Stupid!

A Messaging Tip For The Donald: It’s The Fed, Stupid!

The Fed’s core policies of 2% inflation and 0% interest rates are kicking the economic stuffings out of Flyover AmericaThey are based on the specious academic theory that financial gambling fuels economic growth and that all economic classes prosper from inflation and march in lockstep together as prices and wages ascend on the Fed’s appointed path.

Read more

Book Review: Makers and Takers

Makers and Takers: The Rise of Finance and the Fall of American Business by Rana Foroohar

Crown Business; 1st edition (May 17, 2016)

Ms. Foroohar does a fine job of journalistic reporting here. She identifies many of the failures of the current economic policy regime that has led to the dominance of the financial industry. She follows the logical progression of central bank credit policy to inflate the banking system, that in turn captures democratic politics and policymaking in a vicious cycle of anti-democratic cronyism.

However, her ability to follow the money and power is not matched by an ability to analyze the true cause and effect and thus misguides her proposed solutions. Typical of a journalistic narrative, she identifies certain “culprits” in this story: the bankers and policymakers who favor them. But the true cause of this failed paradigm of easy credit and debt is found in the central bank and monetary policy.

Since 1971 the Western democracies have operated under a global fiat currency regime, where the value of the currencies are based solely on the full faith and credit of the various governments. In the case of the US$, that represents the taxing power of our Federal government in D.C.

The unfortunate reality, based on polling the American people (and Europeans) on trust in government, is that trust in our governmental institutions has plunged from almost 80% in 1964 to less than 20% today. Our 2016 POTUS campaign reflects this deep mistrust in the status quo and the political direction of the country. For good reason. So, what is the value of a dollar if nobody trusts the government to defend it? How does one invest under that uncertainty? You don’t.

One would hope Ms. Foroohar would ask, how did we get here? The essential cause is cheap excess credit, as has been experienced in financial crises all through history. The collapse of Bretton Woods in 1971, when the US repudiated the dollar gold conversion, called the gold peg, has allowed central banks to fund excessive government spending on cheap credit – exploding our debt obligations to the tune of $19 trillion. There seems to be no end in sight as the Federal Reserve promises to write checks without end.

Why has this caused the complete financialization of the economy? Because real economic growth depends on technology and demographics and cannot keep up with 4-6% per year. So the excess credit goes into asset speculation, mostly currency, commodity, and securities trading. This explosion of trading has amped incentives to develop new financial technologies and instruments to trade. Thus, we have the explosion of derivatives trading, which essentially is trading on trading, ad infinitum. Thus, Wall Street finance has come to be dominated by trading and socialized risk-taking rather than investing and private risk management.

After 2001 the central bank decided housing as an asset class was ripe for a boom, and that’s what we got: a debt-fueled bubble that we’ve merely re-inflated since 2008. There is a fundamental value to a house, and in most regions we have far departed from it.

So much money floating through so few hands naturally ends up in the political arena to influence policy going forward. Thus, not only is democratic politics corrupted, but so are any legal regulatory restraints on banking and finance. The simplistic cure of “More regulation!” is belied by the ease with which the bureaucratic regulatory system is captured by powerful interests.

The true problem is the policy paradigm pushed by the consortium of central banks in Europe, Japan, China, and the US. (The Swiss have resisted, but not out of altruism for the poor savers of the world.) Until monetary/credit policy in the free world becomes tethered and disciplined by something more than the promises of politicians and central bankers, we will continue full-speed off the eventual cliff. But our financial masters see this eventuality as a great buying opportunity.

The Guardian view on central bankers: growing power and limited success

I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment.

– John Maynard Keynes

This editorial by The Guardian points out the futilities of current central banking policy around the world. Unfortunately, they only get it half right: the prescience of Keynes’s first sentence is only matched by the absurdity of his second sentence. Calculate the marginal efficiency of capital? Directing investment? Solyndra anyone? The captured State is the primary problem of politicized credit…

Reprinted from The Guardian, Thursday 25 August 2016

To find the true centre of power in today’s politics, ignore the sweaty press releases from select committees, look past the upcoming party conferences – and, for all our sakes, pay no mind to the seat allocations on the 11am Virgin train to Newcastle. Look instead to the mountains of Wyoming, and the fly-fishers’ paradise of Jackson Hole.

Over the next couple of days, the people who set interest rates for the world’s major economies will meet here to discuss the global outlook – but it’s no mere talking shop. What’s said here matters: when the head of the US Federal Reserve, Janet Yellen, speaks on Friday, the folk who manage our pension funds will take a break from the beach reads to check their smartphones for instant takes.

This year the scrutiny will be more widespread and particularly intense. Since the 2008 crash, what central bankers say and do has moved from the City pages to the front page. That is logical, given that the Bank of England created £375bn of new money through quantitative easing in the four years after 2009 and has just begun buying £70bn of IOUs from the government and big business. But the power and prominence of central banks today is also deeply worrying. For one, their multibillion-pound interventions have had only limited success – and it is doubtful that throwing more billions around will work much better. For another, politicians are compelling them to play a central role in our politics, even though they are far less accountable to voters. This is politics in the garb of technocracy.

Next month is the eighth anniversary of the collapse of Lehman Brothers. Since then the US central bank has bought $3.7tn (£2.8tn) of bonds. [Note: We’re going on $4 trillion of free money pumped into the financial sector, folks] All the major central banks have cut rates; according to the Bank of England’s chief economist, Andy Haldane, global interest rates are at their lowest in 5,000 years. Despite this, the world economy is, in his description, “stuck”. This government boasts of the UK’s recovery, but workers have seen a 10% drop in real wages since the end of 2007 – matched among developed economies only by Greece. Fuelling the popularity of Donald Trump and Bernie Sanders is the fact that the US is suffering one of the slowest and weakest recoveries in recent history. In April, the IMF described the state of the global economy as “Too Slow for Too Long”.

Having thrown everything they had at the world economy, all central bankers have to show is the most mediocre of score sheets. When it comes to monetary policy, the old cliche almost fits: you can lead a horse to water, but you cannot make it avail itself of super-low interest rates to kickstart a sustainable recovery. Two forces appear to be at work. First, monetary policy has been used by politicians as a replacement for fiscal policy on spending and taxes, when it should really be complementary. Second, major economies – such as Britain after Thatcher’s revolution – have become so unequal and lopsided that vast wealth is concentrated in the hands of a few who use it for speculation rather than productive investment. QE has pushed up the price of Mayfair flats and art by Damien Hirst. It has done next to nothing for graphene in Manchester. [Does it take a rocket scientist to figure this out?]

All this was foreseen by Keynes in his General Theory: “I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment.”

Eighty years on, it is time those words were heeded by policymakers. In Britain, that means using state-owned banks such as RBS and Lloyds to direct loans to those industries and parts of the country that elected and accountable politicians see as being in need. Couple that with a tax system that rewards companies on how much value they add to the British economy, and the UK might finally be back in business.

The State, run by the political class and their technocrats? Yikes!!! Will we ever learn?

ZIRP Perps: Fed

 

Bill Gross Says a $10 Trillion Economic Supernova is Waiting to Explode

With massive losses for bondholders.

“Bond king” Bill Gross did not mince words Thursday when he called out a problem in the credit markets that could have catastrophic consequences.

In a tweet though his firm, Janus Capital JNS 2.59% , Gross asserted that the spread of negative interest rate policy though central banks around the world will cause the record-breaking $10.4 trillion of negative-interest-rate sovereign bonds on the market to “explode one day.” 

Gross has often noted that negative interest rates could lead to a credit bubble with massive damages to bondholders. Here’s at least part of the reason why:

Negative interest rates have been adopted by stunted economies in Japan and parts of the eurozone in a bid to promote spending where more conventional policies have failed. The policy effectively causes bondholders to pay the issuer if they hold it to maturity. But demand for the bonds is still growing. That’s because there are positives to buying bonds with negative interest rates—they generally promise lower risk. Banks in the euro currency bloc are also piling in as a result of higher capital requirements. And since yields have an inverse relationship to price, demand has helped push down yields.

“Unconventional monetary policies, regulatory risk mitigation by banks, and a flight to safety in global financial markets have all contributed to the ongoing rise in the amount of sovereign debt trading with a negative yield,” head of macro credit at Fitch, Robert Grossman, wrote in a note earlier this month.

While some investors are trudging through lower yields, others investors have been driven to riskier and/or higher yielding areas—such as U.S. treasuries and longer maturity bonds. But should yields rise, investors holding such bonds could also face massive losses.

Goldman Sachs released a note to clients earlier this month, estimating if U.S. interest rates rise by 1% (noting that the rate is currently 0.25%), bondholders could lose $1 trillion as the value of the underlying bond falls and yields rise, hitting securities with longer maturities the hardest. That exceeds the losses from mortgage-backed bonds during the financial crisis.

Gross, who runs the $1.4 billion Janus Global Unconstrained Bond Fund, is not the only major investor to decry negative interest rates. DoubleLine’s Jeff Gundlach called the policy “the stupidest idea I have ever experienced,” Reuters reported, while BlackRock’s Larry Fink wrote in his most recent letter to investors: “Not nearly enough attention has been paid to the toll these low rates—and now negative rates—are taking on the ability of investors to save and plan for the future.”

bond bubble

Disconnects

…between central bank policies, economic growth and unemployment. Stockman distinctly and colorfully explains why we are experiencing 1-2% growth these days. I’m not sure any of the candidates for POTUS have a good answer for this…It’s a sad commentary on our intellectual and political leaders.

Losing Ground In Flyover America, Part 2

In fact, the combination of pumping-up inflation toward 2% and hammering-down interest rates to the so-called zero bound is economically lethal. The former destroys the purchasing power of main street wages while the latter strip mines capital from business and channels it into Wall Street financial engineering and the inflation of stock prices.

In the case of the 2% inflation target, even if it was good for the general economy, which it most assuredly is not, it’s a horrible curse on flyover America. That’s because its nominal pay levels are set on the margin by labor costs in the export factories of China and the EM and the service sector outsourcing shops in India and its imitators.

Accordingly, wage earners actually need zero or even negative CPI’s to maximize the value of pay envelopes constrained by global competition. Indeed, in a world where the global labor market is deflating wage levels, the last thing main street needs is a central bank fanatically seeking to pump up the cost of living.

So why do the geniuses domiciled in the Eccles Building not see something that obvious?

The short answer is they are trapped in a 50-year old intellectual time warp that presumes that the US economy is more or less a closed system. Call it the Keynesian bathtub theory of macroeconomics and you have succinctly described the primitive architecture of the thing.

According to this fossilized worldview, monetary policy must drive interest rates ever lower in order to elicit more borrowing and aggregate spending. And then authorities must rinse and repeat this monetary “stimulus” until the bathtub of “potential GDP” is filled up to the brim.

Moreover, as the economy moves close to the economic bathtub’s brim or full employment GDP, labor allegedly becomes scarcer, thereby causing employers to bid up wage rates. Indeed, at full employment and 2% inflation wages will purportedly rise much faster than consumer prices, permitting real wage rates to rise and living standards to increase.

Except it doesn’t remotely work that way because the US economy is blessed with a decent measure of free trade in goods and services and virtually no restrictions on the flow of capital and short-term financial assets. That is, the Fed can’t fill up the economic bathtub with aggregate demand because it functions in a radically open system where incremental demand is as likely to be satisfied by off-shore goods and services as by domestic production.

This leakage through the bathtub’s side portals into the global economy, in turn, means that the Fed’s 2% inflation and full employment quest can’t cause domestic wage rates to rev-up, either. Incremental demands for labor hours, on the margin, are as likely to be met from the rice paddies of China as the purportedly diminishing cue of idle domestic workers.

Indeed, there has never been a theory so wrong-headed. And yet the financial commentariat, which embraces the Fed’s misbegotten bathtub economics model hook, line and sinker, disdains Donald Trump because his economic ideas are allegedly so primitive!

The irony of the matter is especially ripe. Even as the Fed leans harder into its misbegotten inflation campaign it is drastically mis-measuring its target, meaning that flyover American is getting  an extra dose of punishment.

On the one hand, real inflation where main street households live has been clocking in at over 3% for most of this century. At the same time, the Fed’s faulty measuring stick has led it to keep interest pinned to the zero bound for 89 straight months, thereby fueling the gambling spree in the Wall Street casino. The baleful consequence is that more and more capital has been diverted to financial engineering rather than equipping main street workers with productive capital equipment.

As we indicated in Part 1, even the Fed’s preferred inflation measuring stick——the PCE deflator less food and energy—has risen at a 1.7% rate for the last 16 years and 1.5% during the 6 years. Yet while it obsesses about a trivial miss that can not be meaningful in the context of an open economy, it fails to note that actual main street inflation—led by the four horseman of food, energy, medical and housing—–has been running at 3.1% per annum since the turn of the century.

After 16 years the annual gap, of course, has ballooned into a chasm. As shown in the graph, the consumer price level faced by flyover America is now actually 35% higher than what the Fed’s yardstick shows to the case.

Flyover CPI vs PCE Since 1999

Stated differently, main street households are not whooping up the spending storm that our monetary central planners have ordained because they don’t have the loot. Their real purchasing power has been tapped out.

To be sure, real growth and prosperity stems from the supply-side ingredients of labor, enterprise, capital and production, not the hoary myth that consumer spending is the fount of wealth. Still, the Fed has been consistently and almost comically wrong in its GDP growth projections because the expected surge in wages and consumer spending hasn’t happened.

growth chart

Statistical Fixations

Martin Feldstein is nowhere near as excitable as David Stockman on Fed manipulations (link to D.S.’s commentary), but they both end up at the same place: the enormous risks we are sowing with abnormal monetary policies. The economy is not nearly as healthy as the Fed would like, but pockets of the economy are bubbling up while other pockets are still deflating. There is a correlation relationship, probably causal.

The problem with “inflation targeting” is that bubble economics warps relative prices and so the correction must drive some prices down and others up. In other words, massive relative price corrections are called for. But inflation targeting targets the general price level as measured by biased sample statistics – so if the Fed is trying to prop up prices that previously bubbled up and need to decline, such as housing and stocks, they are pushing against a correction. The obvious problem has been these debt-driven asset prices, like stocks, government bonds, and real estate. In the meantime, we get no new investment that would increase labor demand.

The global economy needs to absorb the negative in order to spread the positive consequences of these easy central bank policies. The time is now because who knows what happens after the turmoil of the US POTUS election?

Ending the Fed’s Inflation Fixation

The focus is misplaced—and because it delays an overdue interest-rate rise, it is also dangerous.

By MARTIN FELDSTEIN
The Wall Street Journal, May 17, 2016 7:02 p.m. ET

The primary role of the Federal Reserve and other central banks should be to prevent high rates of inflation. The double-digit inflation rates of the late 1970s and early ’80s were a destructive and frightening experience that could have been avoided by better monetary policy in the previous decade. Fortunately, the Fed’s tighter monetary policy under Paul Volcker brought the inflation rate down and set the stage for a strong economic recovery during the Reagan years.

The Federal Reserve has two congressionally mandated policy goals: “full employment” and “price stability.” The current unemployment rate of 5% means that the economy is essentially at full employment, very close to the 4.8% unemployment rate that the members of the Fed’s Open Market Committee say is the lowest sustainable rate of unemployment.

For price stability, the Fed since 2012 has interpreted its mandate as a long-term inflation rate of 2%. Although it has achieved full employment, the Fed continues to maintain excessively low interest rates in order to move toward its inflation target. This has created substantial risks that could lead to another financial crisis and economic downturn.

The Fed did raise the federal-funds rate by 0.25 percentage points in December, but interest rates remain excessively low and are still driving investors and lenders to take unsound risks to reach for yield, leading to a serious mispricing of assets. The S&P 500 price-earnings ratio is more than 50% above its historic average. Commercial real estate is priced as if low bond yields will last forever. Banks and other lenders are lending to lower quality borrowers and making loans with fewer conditions.

When interest rates return to normal there will be substantial losses to investors, lenders and borrowers. The adverse impact on the overall economy could be very serious.
A fundamental problem with an explicit inflation target is the difficulty of knowing if it has been hit. The index of consumer prices that the Fed targets should in principle measure how much more it costs to buy goods and services that create the same value for consumers as the goods and services that they bought the year before. Estimating that cost would be an easy task for the national income statisticians if consumers bought the same things year after year. But the things that we buy are continually evolving, with improvements in quality and with the introduction of new goods and services. These changes imply that our dollars buy goods and services with greater value year after year.

Adjusting the price index for these changes is an impossibly difficult task. The methods used by the Bureau of Labor Statistics fail to capture the extent of quality improvements and don’t even try to capture the value created by new goods and services.

The true value of the national income is therefore rising faster than the official estimates of real gross domestic product and real incomes imply. For the same reason, the official measure of inflation overstates the increase in the true cost of the goods and services that consumers buy. If the official measure of inflation were 1%, the true cost of buying goods and services that create the same value to consumers may have actually declined. The true rate of inflation could be minus 1% or minus 3% or minus 5%. There is simply no way to know.

With a margin of error that large, it makes no sense to focus monetary policy on trying to hit a precise inflation target. The problem that consumers care about and that should be the subject of Fed policy is avoiding a return to the rapidly rising inflation that took measured inflation from less than 2% in 1965 to 5% in 1970 and to more than 12% in 1980.

Although we cannot know the true rate of inflation at any time, we can see if the measured inflation rate starts rising rapidly. If that happens, it would be a sign that true inflation is also rising because of excess demand in product and labor markets. That would be an indication that the Fed should be tightening monetary policy.

The situation today in which the official inflation rate is close to zero implies that the true inflation rate is now less than zero. Fortunately this doesn’t create the kind of deflation problem that would occur if households’ money incomes were falling. If that occurred, households would cut back on spending, leading to declines in overall demand and a possible downward spiral in prices and economic activity.

Not only are nominal wages and incomes not falling in the U.S. now, they are rising at about 2% a year. The negative true inflation rate means that true real incomes are rising more rapidly than the official statistics imply. [Sounds good, huh? Not quite. Read Stockman’s analysis.]

The Federal Reserve should now eliminate the explicit inflation target policy that it adopted less than five years ago. The Fed should instead emphasize its commitment to avoiding both high inflation and declining nominal wages. That would permit it to raise interest rates more rapidly today and to pursue a sounder monetary policy in the years ahead.

inflation-vs-employment

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