Tuesday, May 30, 2017

Do We Need a Bigger Pot?

You planted your lovely Japanese Maple in a nice pot and it flourished – at least for a while. So you added some fertilizer and moved the plant to a sunnier location. That helped but only for a while. Your neighbor suggested JD but you didn’t agree. Other friends suggested you try moving it to a bigger pot.

The economy is not so different from the Japanese Maple. When growth slows, we want to do something to restore healthy growth. It is not always obvious which is the best remedial path to follow. So we will always have some difference of opinion as to how to proceed. History helps us think about these competing policy ideas.  

Macro has a history of policy preferences. Before the 1940s arrived, we had no strong preferences for active policy and we preferred to let the markets work. Adam Smith’s invisible hand would heal the economy. As policy makers stood by, it was believed that prices and wages would fall enough to restore weak demand to stronger levels. Competition and markets would ensure growth in the longer term.

The Great Depression shook that theory. Despite large reductions in wages and prices, the economy did not return quickly to its former strength. John M. Keynes was among a number of economists whose theories supported a stronger role for government in rehabbing a sick economy. While Keynes was not a big fan of monetary policy, he did believe that fiscal policy could be used to kickstart a weak economy. If people were too pessimistic about the future to spend, then the government could spend or perhaps induce people and companies to spend through tax breaks.

This was the start of Keynesian aggregate demand policy. It was notable for three reasons. First, it gave a stronger role and perhaps an obligation for government to intervene when an economy was in recession or headed for one. Second, it was very specific that the intervention had something to do with reviving flagged demand for goods and services. Third, other followers of Keynes were less negative about monetary policy and added monetary policy to fiscal policies as acceptable government macroeconomic tools.

This approach to macroeconomic policy became the status quo until the late 1960s and 1970s when we experienced a series of supply shocks and a run of stagflation. Increasing AD was not the remedy for this disease, since a policy to get people to buy more would worsen inflation. And worse yet, with inflationary expectations high and rising, any increase in spending would cause even more supply shocks and stagflation.

What to do? Nixon threw up his hands in frustration and landed on wage and price controls as the solution. Even Spiro Agnew knew that wouldn’t work. The controls were stopped in 1974 after three frustrating years of failure. We were eventually treated to a remedy in the early 1980s when the Fed stopped AD and inflationary expectations in their tracks with 20%+ interest rates. We had two recessions as a result. Lesson: don’t let AD get out of the corral. Getting it back in is too painful.

Reagan and Thatcher wondered if there was an easier way to combat stagflation. And they hit upon aggregate supply policy. The idea is that sometimes a weak economy is not primarily caused by reluctant consumer spending, but rather by uncertain business firms who don’t want to take risks involved with producing more. It’s not easy to tell what is causing an economy to slow. But clearly there are times when uncertainty of business firms is what is mostly responsible for low levels of employment and output.

Depending on which famous economist you bribe, he will tell you that AS policy is either the best thing since sliced bread or worse than a Syrian Bar Mitzvah. But the sad truth is that the concept has been thoroughly trashed by people who refer to AS policy as a Trojan Horse, Voodoo, or Trickle-Down Economics. You would never give your kid any of those names. The challenge is that AS policy is aimed to increase the incentives of business firms to produce. So instead of AS policy directly impacting your ability to spend, it starts by stimulating firms with the idea that they will then produce more and probably hire more workers and then they will spend like the Tuna after winning the lottery.

So what about now? The situation now is that AD policy was tried, and it is out of bullets. The Fed has kept interest rates at zero so long that interest no longer impacts spending decisions. Of course, old fools like me are constrained from spending because the interest earnings of our retirement accounts are producing very little spending power. And if monetary policy is out of bullets, fiscal policy did about all it could to give us cash for clunkers and now the government is in debt with all projections showing the nation’s debt situation getting worse and worse. Don’t count of the usual fiscal policy to get spending roaring again.  

So if AD policy won’t work, what are we left with? Yup, we are pretty much left with the Voodoo. I think AS policy is worth the risk. Maybe it won’t directly and immediately improve the distribution of income. But most of us would be more than happy to have growing job opportunities and rising incomes. Okay, maybe all those rich business executives will gain more than I will from an AS Policy – but right now many people would be pretty happy to just get a job and/or a fat raise.

AS policy is like making the pot bigger. The plant already has too much fertilizer on it. The roots need some room to grow. This might not lead to a miracle but tax reform, deregulation, and a number of other AS policies can lead to more economic capacity and growth. AD will follow. So will our incomes. 

Tuesday, May 23, 2017

The Fed and the Feds

Add an “s” to a word and it becomes plural. Simple. One JD tastes good. Two JDs taste even better. There is no real confusion. The meaning of “s” is pretty clear. The same goes for the possessive “s”. That one is Larry’s JD. The “apostrophe s” is pretty clear. That is my JD and not yours.

But add an “s” to the word Fed and you get chaos. The Fed is the Federal Reserve, the central bank of the USA. The Fed is not your typical branch of government. For years, I taught that the US Fed is independent of the US government. It is not a part of the administrative, legislative, or judicial elements of the government. Ms. Yellen and the board of the Fed make important decisions about monetary policy without approval from any of those branches. It is true that the Fed itself and its administrators are created/confirmed by the government, but once in office they pretty much do what they want to do.

If you add an "s" to Fed you get the Feds. The Feds are the government, or in this discussion today, the US Treasury Department. The Treasury carries out the financial aims of the President and Congress. When government spends more than it receives in revenues, the Treasury sells government bonds or borrows from the public. That government budget deficit is what accumulates into a large national debt when the government continually spends more than it takes in. 

The confusion between the Fed and the Feds arises because they both play in a sandbox called the bond market. The Fed buys and sells already outstanding government bonds (and a few other things) as a means to carry out its monetary policy. The Feds (the Treasury) sell brand-spanking new bonds to finance the government's annual deficits. 

There was a time when the Fed was required to buy government bonds from the Feds. But in March 1951 an agreement between the Fed and the Treasury called “The Accord” let the Fed buy Hondas. Just kidding. The Accord said the Fed could no longer buy bonds from the US government. This freed the Fed from being a lap dog to the Treasury and gave it more independence to pursue its preferred monetary policies. 1951 is also known by some as the day rock 'n' roll was born. 

What a relief to not have to buy all those government bonds. Life would be easier for the government if the Fed just printed money and gave it to the government to spend willy nilly. But the Accord said no way. The government would have to find real suckers to buy all those bonds.

Are you art history majors keeping up? Great! This story has an ending. Ms. Yellen and Treasury Secretary Mnuchin run away to Ukraine together and lived happily ever after. Just fooling with you again. But there is a conclusion here about interest rates.

While the Accord agreement prevents the Fed from buying bonds from the Treasury, it does let them buy them from Pete and Charlie. You might have read that the Fed has a ton of government bonds. Experts use fancy phrases like the “Fed’s balance sheet” but those of us who got Cs in accounting know that means the Fed owns enough bonds to paper the entire Great Wall of China. They bought those bonds because the government sold them to the public and this flood of bonds caused interest rates to rise. Since the Fed hates it when interest rates rise, they bought these bonds from the market (not from the Treasury). The Fed's intent was to stabilize the government bond market and keep interest rates lower than a limbo stick at a Gary Coleman convention. 

Thus, the Fed has a lot of government bonds despite the Accord.

What the Fed does with this gargantuan pile of bonds in weeks ahead is why I wrote all that stuff above. The Fed could simply sell the bonds. Just as you advertise that you have a rusted patio chair to sell, the Fed can let the world know it wants to sell its government bonds. Since the Fed has a lot of bonds, this announcement would send bond prices plummeting and interest rates soaring. While the Fed is looking to normalize interest rates, they don’t want them soaring. So selling a bunch of their bonds too quickly is not in the cards. 

Even if the Fed sells them gradually, markets are not stupid. There are a lot of bonds.
One smart cookie noticed that many of these bonds are maturing. That is, the Fed will receive a final payment from the government and the bonds will disappear. But that is not the whole story. Where does the Treasury get the money to pay off these maturing bonds? Since the government has a whopping deficit, it can only get the money by selling even more bonds. As they do that action, interest rates would  rise and the Fed would buy more bonds from Charlie and Pete. Hmmm – an action by the Fed to reduce its bond holding causes the Fed to hold more bonds. Dern. No cigar here.

So for sure the impact of the Fed reducing its balance sheet will be upward pressure on interest rates. Whether the Fed sells its portfolio tomorrow or the next day, whether they sell the bonds or simply not renew them, the result is the same. Higher interest rates! What is the moral of the story?

A doughnut store opened across the street, and you gained 100 pounds. Despite your protestation and decision to drink one less JD per day, you are in for quite a challenge to restore normalcy.

You can swear off doughnuts but that just makes you hungrier. So long as the store is there and you don’t like hunger, you will not lose much weight.

The government has huge deficits and debt. That’s the candy store. The Fed hates 
owning all that debt but it also hates what happens when they sell it or don’t buy more of it. That's the Fed getting fat. 

The process of returning to financial normalcy starts with a government that balances its budget. It also goes with a Fed that attends to its monetary policy goals and adheres to both the wording and spirit of the Accord. The Fed is not the problem. The Feds are the problem. If government stops having large deficits then monetary policy is easier. It won't matter if the government sells short-term bonds or long term bonds. A balanced budget means they won't be selling much of either. Ms Yellen can then go fishing. 

Tuesday, May 16, 2017

Lord of the Flies

Lord of the Flies is a book I read in high school. It is fiction. Experts say it is about loss of innocence and about the constant conflict between savagery and civilization. Heavy stuff. I was thinking about Lord of the Flies because I keep searching for explanations for current political behavior.

Maybe it was Lord of the Flies that formed me. Maybe it was Atlas Shrugged. Maybe I am giving away more about myself than I should. I also loved Hesse's Magister Ludi. But the point is that today we are suffering from an age of optimism. How can one suffer from optimism, you ask? 

Optimism is good. But we can suffer from optimism after events start to shake our foundations. In Lord of the Flies, an airplane carrying schoolchildren crashes on a deserted island. The children are very civilized English kids. But it doesn’t take long for the tea and crumpets to disappear and for raw human behavior to take over.

Which made me think about today. We are optimistic. We think of ourselves as being sophisticated and mature. We know we are much better than those savages that lived hundreds of years ago. We go to school for many years and we become experts on things. We can afford to buy and read books. We give money to worthy charities. We value finding balance between work and play. We take time to worry about those who are less fortunate than ourselves, and we devote time and thought to helping them.

We do all this because we can. We are not living in caves, and we are not constantly threatened by beasts lurking outside our caves. Productivity allows us to work less, and labor saving devices let us manage our non-work lives with minimal effort. We don’t have to grow our own food, and we don’t usually make our clothing.

We are incredibly civilized and nice. Think about politics and government in the US. In the past eight years, we devoted ourselves to equality and fairness. Okay, maybe we didn’t get any medals for achievement but the Obama administration and the Democratic Party reminded us continually about the unfairness that remains in our modern and rich society. And today as we discuss healthcare, tax reform, and government debt, we cannot escape expectations that any and all reforms be fair and not abandon those with lower incomes.

I am not complaining. I am just describing what is. We are a very optimistic, caring society. Those little English boys came from a very caring society before their plane crashed on that fictional island.

What then brought out their savage sides? The savagery arose when the society they used to know vanished and was replaced by fear and uncertainty. Living on a deserted island isn’t easy. It is downright scary. Living right before the great recession was not so bad. Economic growth, employment, and wages were good. Income inequality worsened but overall we felt pretty good.

But then the recession pulled the rug out from under us. Like landing on a far-away island, we “landed” on a new economy full of perils.  And worse than the actual dismal economic effects were the thoughts that our economic system had failed us. Every time the government added a new stimulus package and/or a new regulation, they sent out a message that said, "Times have changed for the worse, we don’t know where this is heading, and we are going to have to do very extreme things to save the day. But don’t worry, the government is here to save us all."

If that isn’t scarier than a plane wreck and a deserted island, then I don’t know what is. Obama’s team was cool as they went about turning this country upside down. Whether it was cars for clunkers or some crazy Dodd-Frank program that took a wrecking ball to small banks, they plowed ahead to forge a new world.

This is not to criticize either the Bush or Obama administrations. It is meant to be a description of what we have been through since 2008. Bam, there you are on a deserted island that only mildly resembles your previous home and bam, people start trying to fix things.

The result in Lord of the Flies was horrible. As the boys grappled with life-threatening issues, the worst of their personalities came to the surface. As the US economy struggles to regain its balance, we are seeing the same kinds of things. It’s not just our political leaders. It is all of us. We thought we were sophisticated but to me, it isn’t sophisticated to treat your friends and neighbors with disregard at best, rudeness at worst. 

Sadly, Lord of the Flies resolved nothing. The book ends when the boys are rescued by adults. They go back to being boys again. How is our book going to end? Who is going to save us from ourselves? When will we be able to go back to not walking on eggshells whenever we discuss current economic policies? When will we kiss and make up?

Tuesday, May 9, 2017

Lesson 17 Interest Rates

Everyone knows what an interest rate is. But today the interest rate is more talked about than Howard Stern’s new personality. The Fed has a new policy to increase interest rates, yet interest rates go in the opposite direction. Is this a Putin plot to control the US economy? Maybe, but it is also true that most of us don’t know squat about interest rates, so let me waddle into the fray and try to make us all experts. I also explain why I think US rates will rise, and the prediction is not mainly the result of Fed policy.

There are more interest rates out there than new expensive bourbons. Dang, even Washington State is making bourbon. That should really infuriate our Kentucky friends. Interest rate is a phrase that means if you let someone have some of your money for a while, they will give it back with a little bonus. Consider my savings account at the local credit union. I gave them several thousand dollars, and I got 18 cents back in interest this month. Not all financial assets are that crappy thankfully, but in today’s financial scene, we talk about interest rates being very low. You can earn interest on savings accounts, short-term government bonds, long-term government bonds, private bonds, and so on. 

In macro, we talk about things like national output, the price level, the wage level, and so on, even though we know there are many different goods and types of labor. So it is with interest rates: we often refer to “the interest rate” even though we know there are many of them out there. So my first order as macro blogger-in-chief today is to say that the 10-year US government bond is often used as a statistical indicator of the US interest rate. Today that rate is at about 2.3%. To put that rate into perspective, it achieved a high in the early 1980s at 15% and as recently as 2007, it peaked at more than 5%. So it is pretty clear that at 2.3% interest rates are very low today. If you buy a bond for $100 then you would expect to receive roughly $2.30 in interest over the course of a year. That will not buy you one espresso mocha at Peet’s.

So why is the interest rate so low today? Why is the Fed having trouble raising it? And what explains the future course of interest rates? Wow – lots of questions.

Let’s address the various things that impact interest rates. If you lend money to a company, they are going to use it to improve the company. So if prospects are good for companies, they are very apt to be borrowing. Suppose a company borrows money to expand the capacity of one of its manufacturing plant. If prospects suggest a 5% return on money they borrow, then they don’t mind paying 3% to borrow the money. So a major factor affecting interest rates is optimism about the future economy. The more optimistic firms are, the more they are willing to pay for funds. The more pessimistic they are, the less they are willing to pay to borrow.

A second factor is inflation expectations. Paying back a loan takes time. The lender receives these payments and that constitutes their return. If the prices for goods and services rise during the payback period, the lender receives dollars that are worth less in terms of goods and service. Thus, at the beginning of the loan, it behooves the lender to anticipate future inflation. Imagine if they think inflation will reach 100%. A 4% interest rate would be lame. Maybe 104% would be better and would protect them from the expected inflation. So we say that today’s interest rates have an inflation premium. The higher expected inflation is, the higher is the interest rate.

What else affects the interest rate? A third factor is risk. Risk relates to the expectation of the lender receiving no payments. That is, if the economy tanks sometime in the future, then the lender gets nada. The riskier the economic environment is, the more the macro risk rises and the more lenders want today in the way of an interest rate.

That’s a long list of factors affecting the interest rate – optimism about business prospects, inflation expectations, and risk. What else? The general idea of supply and demand as it impacts bonds points to other factors like returns in the stock market, real estate, insurance policies, and foreign assets. One has choices in holding assets. Instead of owning bonds which give you a rate of return, you could also choose to have stocks, real estate, savings accounts, and similar assets from other countries. Thus, anything that makes these other assets relatively more attractive will reduce the demand for bonds and raise the interest rate. For example, if interest rates begin to rise in Europe, investors might sell US bonds so as to buy more European bonds. This would lead to a rise in the interest rate in the US.

Finally there is the Fed. Usually the Fed tries to impact short-term interest rates but quantitative easing suggests they attempt to influence the entire term structure of rates from short to long-term.

I probably have forgotten something but you can see the list of things that could impact the US interest rate is pretty long.

Anyone who wants to think about the interest rate today or in the future has to grapple with all these factors. What do you think about these?
US business confidence?
Inflation expectations?
Macroeconomic risk?
Stock market gains?
Relative desirability of real estate, life insurance products, banking products?
Interest rates abroad?
Fed policy ?
Price of JD?

Here is my quick outlook. As the distance from the great recession widens, the world economy is going to continue to slowly improve. Along with these improvements will come more optimistic assessments of US economic growth.

Worries over long-term changes in labor force participation and productivity will remain but will be lessened. As these worries recede aggregate demand will get even stronger and the result will be higher employment, wages, and inflation.

While I am not predicting a resumption of very high economic growth, I am projecting a more positive response than is now envisioned. With the Fed slightly more worried about inflation, their policies combined with the more sanguine macroeconomic outlook will produce a clear cycle of rising interest rates. Since the US will likely be leading this global parade, our higher interest rate will spill over to higher rates abroad and will create international impacts that will raise US rates even more. 

I hesitated about going further but no economist makes a prediction without covering his butt. Nations are prone to making horrible policy choices. It will take some doing but a general recognition that new policies will be inherently bad for economic growth could lock us into interest rate purgatory for a long time. The US, China, the EU, and several other places need to keep their collective foot on the growth pedal. Stupid stuff will keep it all low --  interest rates, economic growth, investment spending, productivity growth, and labor participation. Focus on the growth ball, guys. Plain and simple. Interest rates will go up and we will enjoy it. 

Tuesday, May 2, 2017

Marching for Science is Like Marching for Air

According to the Wall Street Journal, the March for Science last week “drew tens of thousands to more than 500 rallies world-wide.” The organizers proclaimed the purpose was because of attacks on science.

I am not sure how people can attack science. And where are these bleeding hearts when people tell the same stupid economist jokes every time I show up at an event? People attack economics all the time but no one really seems to care. And what about meteorology? How would you like to be a weather forecaster at the annual gathering of Florida Flood Insurers?

What is this thing called science that people braved inclement weather and dog poop as they strutted their stuff in 500 places around the globe? It seems to me what these people really want has little to do with saving science and everything to do with promoting their own agendas. So let’s get into it.

Science is an elusive topic. Most of us discuss it by describing its characteristics or elements. For example, hard sciences include biology and chemistry. Defending biology and chemistry is a little like promoting spinach and kale. Yuck. Or you might discuss science by mentioning microscopes or lab coats. While all that helps one get closer to describing science, the truth is that such an approach is at least incomplete if not very misleading. You can know a lot of biology and/or walk around in a cool lab coat but neither brings you much closer to the definition of science.

Science is elusive but simple. Science is anything that uses the scientific method. That’s all there is to knowing the definition of science. Tuna, wake up. This is getting more exciting.

Using terms like “the scientific method” is a lot like talking about diminishing total factor productivity. It sounds technical and difficult. But the scientific method is way cooler than disco music. It is like the air we breathe – it is right there in front of us making life better and easier. It’s very practical and useful.

Here is my list of steps involved with defining the scientific method:

1.    Pose a problem – e.g. people drive too fast
2.    Think up a reasonable explanation for that problem – people love the excitement of going fast
3.    Study the problem – when police officers give people speeding tickets, have them ask the people why they were speeding. Sir, were you speeding because it was exciting, or are their other reasons why you were speeding?
4.    Compile the data from a sufficient sample of speeders and draw a conclusion – 10% of the people said they speed because of the excitement. 90% said they speed because they forgot to look at their speedometer. We can reject excitement as the main cause of speeding. 
5.    Solve the problem – suggest that all highways present signs that say “Drivers, please look at your speedometer more often.”
6.    Keep studying the problem to see if the solution worked.
7.    If you aren’t satisfied with the degree of problem remediation, go back to step 2.

Wasn’t that fun? But that’s all there is to the scientific method. It works for all sorts of problems and questions. That’s what makes it so cool. Because you use science does not mean you will always get things right. But it does say you will always strive to get improvement.

What is also notable is that scientists NEVER (am I yelling?) say they proved something. They ALWAYS say they either rejected or failed to reject a reasonable explanation for a problem. In the above example, we rejected the importance of thrill seeking in speeding. We did not reject the importance of driver attention. But we didn’t prove anything because the next study may find a new outcome – yup, distracted driving might be more important as a cause of speeding in your next scientific study. And then there is always JD.

In a nutshell, the scientific method never really ends for any important problem because we assume that important problems are complicated and because the world changes over time. The number of truly immutable scientific laws are very few. The Law of Gravity is one of them. That baby works well nearly all the time. But much of what we call science and cause and effect are temporarily held conclusions and truths. That means we expect that they will need to change and be revisited.

If that is science, I don’t really know anyone who is trying to stop scientists from doing their thing. The group behind the March for Science seemed to implying that some people don’t believe the facts, models, and predictions about climate change. But that seems odd – because the true basis of science is to be skeptical. The true foundation of science is knowing that models are incomplete and static, data are notoriously fallible, and truths are both durable and fleeting.

Unfortunately what I hear in the March stuff is asking that people not be skeptical about today’s models. They are asking people to stop questioning. They want folks to support them in taking a political position.

One more point. What is good today is that real scientists are studying climate change and environmental issues. These people are asking the right questions, and I am optimistic that their hard work will produce a better world.  I realize that a slow pace of policy remediation has its risks – but so does rushing to conclusions. Let’s let the scientists duke it out in an open and competitive scientific space without interference from either the political left or right. Only then will we eventually get the best results. I don't see how marching does much to accomplish that.