Author Archive

“We owe it to ourselves” is not a solution to the debt crisis

Saturday, October 12th, 2013

One problem with the argument that “we owe the skyrocketing debt to ourselves, so we can limit the impact”: each of those debts represents a promise to pay someone. If we can’t pay as agreed, the impact is severe. For example, if we don’t pay Grandma the $20K/year in Social Security because we can’t, and instead we only pay her $10K, that creates a problem. Alternatively, if we pay her $20K but we’ve driven monetary inflation (and skimped on the COLAs) so that it only buys $10K worth of goods, that still creates a problem. Piling on more promises now won’t change what Grandma’s going to get in real long-term value. The only thing that’s going to save Grandma is if someone else doesn’t get what they were promised… Now we have to repeat the same argument for everyone who was promised something — bottom line, we face a political vicious cycle for years to come.

Adding more to the debt without generating real GDP improvements will only aggravate the vicious cycle. And the data shows that the debt piled on since 2000 or so has done precious little to boost GDP, but represents an enormous number of promises relative to that GDP.

It is true that there are ways to break promises gently, rather than defaulting brutally, but the root problem is that our governments (at all levels) have, in aggregate, made far more promises than can realistically be kept. Politically it makes a big difference how you do it, but in practical terms the outcome is bad no matter what. There will be massive financial haircuts and broken expectations.

Furthermore, a political process, rather than a rational process, is going to decide who gets the worst cuts. This is not a recipe for peace and prosperity in a vicious-cycle political climate.

Even worse, the exaggerated promises are now so blatant that the government is losing credibility. As the promises lose credibility that creates all kinds of political and economic issues, because people here, and worldwide, will modify their behavior if they don’t think we can deliver.

Putting it all together, the problem is here and now, and aside from the immediate crises the risk of something catastrophically bad happening is rising exponentially. Papering the problem over with politically palatable platitudes isn’t a panacea.

There needs to be structural economic reform. The government needs to prioritize wants vs. needs, and we as a nation need to find better ways to direct labor to where it can generate genuine improvements in well-being.

Ten Ways NOT to Govern a Superpower

Tuesday, September 17th, 2013

1) Reward criminals and incompetents, rather than punishing them, but only when lots of money is involved.

1) Pass legislation exempting some sectors of the economy (e.g. medical industry) from antitrust laws, and prohibit trade that would allow local prices to equilibrate with the global market. Make Americans pay 2x to 10x as much as anyone else for the same products and services!

1) Allow arbitrary “ChargeMaster” bills to be charged to customers who cannot even see the prices beforehand! Most healthcare expenses could be paid out of pocket if the bills actually reflected necessary costs rather than bloat.

1) Pass legislation that requires people to pay for services they do not need, or else pay taxes for being healthy instead. Thus forcing everyone to feed the insane insurance industry, creating insane incentives and tying up millions of people in paperwork jobs that add no economic value.

1) Pass legislation that no one even has time to read, let alone understand. Then fail to address legitimate issues arising from the unpalatable special-interest garbage that was in the bill.

1) Don’t pass a budget each year. Just let everything run on autopilot until something egregiously bad happens.

1) Each election cycle, reelect the same people who created the current problem. Keep them lying to us while failing to address crucial national issues, yet endlessly feathering their cronies’ nests at our expense.

1) Fail to protest when the government exceeds its constitutional authority.

We get the government we deserve. The Constitution will only live if those who believe in it stand up to defend it!

P.S. Yes, all ten of these are ranked #1. I couldn’t decide which of them made me feel most ashamed to be an American.

P.P.S. Yes, there are only 8 items on the list of “ten”. If you feel like protesting that, you might also consider protesting your local politicians, who routinely promise far more than they deliver, and whose decisions have a much greater impact on your life and your future than this blog comment!

The real Fiscal Fiasco is the debt per taxpayer

Friday, August 30th, 2013

Over at Capital Gains and Games, Stan Collender reports that the FY14 planning in Washington has gone from “Budget Bedlam to Fiscal Fiasco“.

Although he’s right, I’d like to add that the real fiasco here is that our elected leaders persistently fail to address the fundamental problem: the government’s debt cannot continue to increase forever in real, inflation-adjusted, hours-of-workers-pay terms.

Instead, we have over $100,000 in national debt per taxpayer (not counting state debt, underfunded pensions and so on). And we have neither a rational budgeting process nor a rational debt-limitation plan.  Following the methodology of the “Congressional Budget Office” and adding some sanity per Cyniconomics, we can expect in 20 years to have $300,000 in debt per taxpayer (after adjusting for inflation! in 2013 dollars!), and it just gets worse from there. Something’s gotta give. And screwing over Social Security recipients (who are funded by a dedicated tax) isn’t an option. Neither is taking away grandma’s medical care.

The problems is that people want to apply accounting cuts, when what is needed is a deeper rethinking of the structure of the U.S. economy. How can we make America more efficient and more productive?  What can we do to create a stronger tax base, with lower wasted effort, and maintain a carefully prioritized set of vital government functions?

One proposal: It’s entirely possible to have an effective government that is substantially more affordable than what we currently suffer, but it does require goring some sacred cows, primarily in the medical-waste sector. That sector is normally referred to as “healthcare”. But the cost per outcome is at least twice what other nations pay, and arguably as much as 10 times what is reasonable. So most of the expenditure is indeed wasted. Therefore we must indeed call it the medical-waste sector, pending future reforms.

Now, I’m not talking about cutting Medicare outcomes, or destroying the quality of life of senior citizens. We all know from personal experience that healthcare in this country is a bureaucratic and financial disaster. Hospitals, exempt from antitrust laws and often facing no competition, waste money and overcharge everyone. The insurance system creates deluges of time- and money-wasting paperwork for no benefit other than shifting costs in Byzantine ways.  And medications cost far more here than overseas, even for identical quality.  This has all been thoroughly documented (e.g. by Steven Brill in Time). Furthermore, there is a lot of emerging evidence that many medical procedures, with modern technology, can actually be purchased directly by consumers, from competitive providers for a small fraction of the hospital/insurance system’s sticker price. Given all that, it ought to be possible to deliver the same quality of life at much lower cost.

So I’m proposing that we change the laws regulating the medical sector. The medical industry should eliminate the B.S. pricing, live with the same antitrust laws as the rest of the business world (which need to be properly enforced, but that’s another article). We need to eliminate confidential price-fixing agreements. Pills and procedures of equivalent quality should have only one price worldwide (modulo taxes), and be subject to competition among different providers – not arbitrary “chargemasters”. And the whole structure of “insurance” is wrong, leading to endless, needless paperwork that adds no value to anyone’s life.

If we thoroughly restructured that industry, it would enable (over perhaps a decade) millions of workers to gradually shift into new occupations, ones which actually increase human well-being at reasonable cost, and thus add true economic value rather than merely “GDP”. And we’d have both a more-affordable government and greater overall wealth in society.

This isn’t the only sacred cow that ought to be slaughtered, it’s just the largest.  The Giant Squid has many tentacles, and not all of them are on Wall Street.

It’s not as though there’s a choice here. Our alternative as taxpayers and citizens, if we fail to meet the clear need to reform the government and the economy, is to toil away under that ever-increasing federal mortgage, and pray the bill never comes due. But it will. And even in the meantime, we will all suffer a reduced standard of living, because our nation is run with horrifically low efficiency.

“Tornado Warnings” for the stock market? Can we? Should we?

Wednesday, June 5th, 2013

When those with expert knowledge detect that a potentially calamitous event threatens, but they aren’t sure, human nature runs in two directions. We are torn between wanting to issue a warning so that folks can take precautions, versus wanting to keep everyone calm to prevent the damage that could be caused by mass panic.

Meanwhile, those being warned are faced with their own difficult choice. Do they ignore the warning, accept the risks, and go about business as usual? Do they drop everything and take shelter or flee for safety? What level of precaution is appropriate?

Consider first the case of actual tornados. According to Wikipedia, early forecasters were banned from making actual tornado warnings, because of the fear of public panic.

According to NOAA data, tornado warnings have been about 70% accurate since the mid-1990s. Now, we need to be careful when measuring “accuracy”, because even when a tornado warning correctly predicts a tornado touchdown, the tornado doesn’t touch everyone in the warning area. And even if a tornado doesn’t touch down, the severe thunderstorm can still do damage with high winds, hail, and heavy rain leading to flash floods.

But despite not being a perfect warning system, we know that the warnings (a) provide people with valuable time to take shelter, (b) do not disrupt activities excessively, and (c) save lives when tornadoes do touch down and wipe out buildings and vehicles. The issue with mass panic has been addressed through decades of careful public education in tornado-prone areas, training people to react appropriately.  People have come to accept and value the warning system, most recently in Oklahoma City where 16 minutes’ advance notice saved thousands of lives as the mile-wide EF5 tornado (an extremely bad one!) wiped out thousands of buildings. The warning didn’t prevent the tornado, but the community will recover much more quickly because they reacted well.

But now consider a warning that might, by itself, trigger human reactions which bring about the calamitous event that it is warning about! What if, whenever it is issued, it causes a certain part of the business community serious damage, while saving others from grave harm? And of course it is going to cause anxiety among those who are warned, and people don’t like that unless it’s really justified.  This is the situation one faces when considering a “Tornado Warning” system for the stock market.

There is a stock market “measurement” (technical indicator) which has a 30-year record of making predictions which have a 77% accuracy in anticipating a market decline of 5% or more. Let’s call any 5% decline a “market tornado”. The measurement does not predict every “market tornado”, but it has triggered before all the really bad tornadoes (with drops in the DOW of 20% or more) and nearly all of the “medium size” ones (10% or more).

Note that in a “market tornado”, as with a real tornado, the damage is far greater in some places than in others. Thanks to inflation and growth, the market as a whole recovers eventually, just as communities repair their damage after real tornadoes. But in a 5% “market tornado” decline, some stocks will fall much farther than the average, just as some homes suffer more damage than others in a real tornado. And if the market tornado is bad enough, some stocks get destroyed (bankruptcy) if the company isn’t in good financial condition, just as weaker houses get destroyed by very bad real tornadoes.

However, unlike in a tornado, a “stock market tornado warning” induces more people to try to sell, which tends to push prices down, and that might exacerbate the market decline that the warning is all about. Businesses involved in the market will be damaged by loss of customers, decline in revenue from remaining customers, and potentially losses on their own trading positions.  We must expect the psychology of market participants to be deeply resistant to warnings which cause them immediate harm, even if the warning provides a prudent opportunity to prevent the harm from being far worse! (For some reason I’m reminded of the scene in Jaws where the shark is spotted and the warning is issued, but the folks running the beaches refuse to spread the word because they don’t want to scare people having fun… and lose profits…)

On the other hand, perhaps when a market has run up too far, a “Market Tornado Warning” might actually mitigate the subsequent inevitable correction?  Perhaps with proper public education, market participants could simply take precautions, rather than panicking?  A warning gives those caught “offsides”, overextended on leverage, a chance to pull in their positions, helping the market to be less overextended and less at risk of a deep crash. Those looking to buy in might hold back a bit, expecting a dip in prices ahead. By slowing the rally and creating a pool of folks willing and able to “buy the dip”, the market tornado might be far smaller than it would otherwise have been. This would stabilize the market, by preventing so many from buying too soon and then becoming sellers at the worst time for all.

In addition, with a reasonable warning system, businesses catering to market participants would have a chance to issue polite warnings that actually help their clients. They would have to accept that some short-term damage to portfolios is very likely, but they would have a critical window of opportunity to work constructively to minimize that damage. And that could also minimize the risk of deep damage to the business.

Perhaps, when the market is due for a correction, the warning actually allows the correction to take place in a less-damaging manner?  That is a tantalizing thought, because the horrific economic damage created by deep market declines affects millions or billions of people…

Oh, and the name of that “Market Tornado Warning” technical indicator?  It’s usually referred to as the Hindenburg Omen.  I believe that’s a poor choice of name, since the name alone induces more panic than it should.  And the indicator itself isn’t perfect and could probably be made better. But more about the Hindenburg later…

Today’s Payrolls Data Worse Than Spinmeisters Say

Friday, May 3rd, 2013

The Monthly payrolls data from the BLS shows, over the past year:
* About 1.9 million more jobs, but only a 1.3% increase in jobs
* Job growth is about the same as working-age population growth (not getting ahead)
* Also, 0.4 million (20%) of the new jobs are only part-time. Part-time jobs are increasing at a faster rate than full-time jobs. (Definitely not getting ahead).
* For those working, average weekly earnings are only up 1.6%, only about the same as official inflation. (Most definitely not getting ahead.)

In most previous years this report would have been abysmal, but I guess this month we’re just glad the sky isn’t falling again… yet…

A possible vicious cycle due to flawed CPI measurements?

Tuesday, March 19th, 2013

Some good folks at the Atlanta Fed’s “Macroblog” recently posted a discussion about the imputed rent of being a homeowner and how housing costs are treated in the consumer price index. Owner’s Equivalent Rent is the answer. The Macroblog article describes a trend-vs-cycle decomposition of OER and a comparison of that with actual home prices. The comparison is far from persuasive.

I have long been skeptical of OER, and propose a simpler hypothesis: the CPI determination of OER is flawed. One might then be concerned that this bad OER measurement distorts the CPI, and that this could lead to serious macro consequences due to the widespread use of a bad CPI.

And indeed, if one takes time to read how OER is actually determined, one is not heartened. The quote is below. The bottom line is that some owners are SURVEYED and asked their OPINION about what their house WOULD rent for, if they rented it! I am flabbergasted by this, because in my experience owners’ responses are horribly biased, and not at all reflective of actual rental market conditions. Owners are usually not market participants. Many owners haven’t even looked at renting for years, decades, etc. Why would someone who emphatically chooses not to participate in the rental market have any expertise on what their home might rent for?  THERE HAS TO BE A BETTER WAY TO MEASURE 24% of the CPI! (The fact that this isn’t being done, despite the weight and importance of this part of CPI, is a significant “tell” that no one in a position to make a difference genuinely cares about getting anything factually right in economics…)

Here is the quote, from the link given in the article cited above:

” ‘ … Owners’ equivalent rent of primary residence (OER) is based on the following question that the Consumer Expenditure Survey asks of consumers who own their primary residence:

“If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”

… From the responses to these questions, the CPI estimates the total shelter cost to all consumers living in each index area of the urban United States. ‘ “

Now, what happens when a flawed OER distorts the CPI?  Consider the present… There is widespread evidence of ongoing declines in actual housing rental prices right now, in multiple markets nationwide but especially those in the Southwest. The mechanism appears to be this:

  1. Investors seeking higher yields send credit to firms investing in rental real estate.
  2. Firms purchase foreclosed housing (depressing inventory while inflating sales rates and prices and creating “housing boom” headlines).
  3. Firms convert housing to rental property in hopes of earning cash flow from rent and capital appreciation from future price increases.
  4. Rental market is glutted as a result of this reaching for yield, and much of the rental inventory goes unrented.
  5. Investor-driven glut of homes-for-rent depresses rents, even though purchase prices are rising.
  6. Homebuilding firms see rising sale prices and start building even more homes.

However, since median wages are not increasing and total full-time-equivalent employment is lagging badly, the sustainable household formation rate does not appear sufficient to absorb large amounts of additional housing. The current low-interest-rate environment appears to be distorting investment into housing in an unsustainable way.

So we’ve got a lot of poorly invested credit, a glut of rental homes, and another unsustainable building “boom” which is likely to lead to another “bust”.

And of course the OER metric currently being reported fails to capture this effect. (Similarly, during the housing bubble, OER badly lagged the market bubble and held the CPI artificially low, preventing policymakers from raising interest rates early enough to stop the bubble before it became a disaster.)  Even worse, if OER did capture the current “rental bubble” effect, it would appear deflationary (falling rents lower the CPI), suggesting that the “cure” would be to push credit even harder…

The CPI and other consumer-price inflation metrics are supposed to serve as crucial counter-cyclical signals to the Federal Reserve that interest rates need to change.  But the OER portion of CPI was in fact pro-cyclical (or at least neutral) for both the original housing bubble and the new emerging “rental housing bubble”!  Since OER makes up such a large fraction of CPI, this effect is a huge distortion on U.S. monetary policy.

But I suppose, if we carry on down this path for a decade or so, the U.S. can eventually end up with Chinese-style vacant cities of our own! (Or at least vacant neighborhoods… or just millions more vacant structures…)

“Beating Buffett” Blog is full of B.S.

Wednesday, October 31st, 2012

I know it’s better to ignore it when “someone is WRONG on the Internet”, but I can’t help myself this time:

I recently ran across a new blog called “Beating Buffett”.  I think Beating Buffett is a great concept, and it’s among my own personal benchmarks as an investor.  However, BeatingBuffett.com is definitetly not a great blog and will not go into my bookmarks unless its performance improves significantly.

Case in point: Among the posts visible today (though posted on October 10) is one about Annaly Capital Management.  The article claims that “Annaly Capital significantly underperformed the S & P 500 over the past 3 years in the best possible macro-environment. What will it do when things turn ugly?”

The article then plots a chart of NLY’s stock price, using a cherry-picked time period to show a net loss over 3 years, and totally ignoring the huge dividend payouts from Annaly.

In point of fact, a more assessment of NLY vs. the S&P 500 ($SPX) must include the total return of both. The chart below does this and shows that NLY has held its own and at times done better than the S&P 500. This chart correctly captures the reality that NLY pays out around $0.50/share quarterly, a much higher dividend yield that the S&P 500.

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Disclaimer: I don’t own NLY directly, though I may have some through a mutual fund, but even I know that to assess an investment over a 3-year horizon what matters is total return, not share price.

If you want to “Beat Buffett”, you’d better do so on a total return basis over time, and after taxes!

Why we will not “build our way to prosperity”

Friday, December 23rd, 2011

There have been some comments on analyses that “We’re going to need a LOT more houses” lately.

The analysis presents a plot of housing starts vs population, since 1960, showing that current starts are at a series low.

Using the ratio of starts to population is not the correct metric for understanding the likely future path of housing starts.  It’s true that housing starts are currently historically low, and population remains high, but there are reasons why the Flow (housing construction) could remain low for some time, if there’s too much durable Stock (existing housing units) and persistent low demand for said stock (due to demographic changes).

The construction need is determined primarily by two flows: changes in household size, and population growth — not by population. 100% of population growth needs housing, whereas only 1% of population stock needs to be rebuilt each year, assuming a given home lasts 100 years.  Assuming stable househould size, if population growth previously averaged 2-3% of population, but today averages only 0-1% due to declining birthrate and reduced immigration, that cuts the need for new housing and reduces the required number of starts by 2/3 to 3/4.

Furthermore, in recessionary conditions, household formation drops and household size increases.  With median household size in the range 2 to 3 persons, a change of just +0.1 person per household results in a -3 to -5% change in the required housing stock, equivalent to 3-5 years of replacement production.  This effect can therefore be even larger than the population growth effect.

Household size and population growth were both quite high in the 1960s (when the available data series started, the Baby Boom was peaking).  The decline in household size since the 1960s drove much of the demand for housing but is not sustainable.  If we previously ran a population growth of 2%/year and it is now 0%/year or even slightly negative (as in Japan, Russia, China, Europe…), and if household size is trending back up, we might not need any new homes at all for as long as household size trends upward.

So to me, it’s not at all clear when we’ll need to build more houses.  (If it were clear, investors would flock to homebuilder stocks, would they not?)

Towards an Activist Federal Reserve

Tuesday, February 15th, 2011

I’m still thinking about the Macroblog post last week on Inflation Confusion, which said in part:

“When food prices rise or oil prices rise, people are right to feel in some sense worse off, because they are. And if you are tempted to call that “inflation,” I understand.  But for policy purposes, the distinction between cost of living increases and inflation as a deterioration in the generalized purchasing power of money is critical.”

If that distinction is really so critical, shouldn’t policymakers utilize inflation metrics which explicitly focus on prices other than consumer prices?  If in fact monetary policy wants to focus on something other than ensuring a stable cost of living for the median consumer, why is the public emphasis of policymakers always on the CPI?  Furthermore, why did these policymakers explicitly ignore huge warning flags such as house prices grossly above historical norms (2005-2007), stock market valuations grossly above historical norms (1998-2001), and rapid expansion in money and credit at rates vastly greater than underlying GDP (1982-2008)?  Policymakers who actually cared about monetary inflation should’ve taken away the punch bowl a lot sooner in each instance.  The fact that they did not gives the impression that policymakers were in fact focusing only on the cost of living, ignoring the distinction claimed above. (The other commenters at that post also critiqued this distinction.)

Now, the current inflation angst may also be partly about displaced budget frustrations.  For many groups of people — the unemployed, the underemployed, those re-employed at lower wages, workers facing state and federal wage freezes and endless, inevitable budget cuts, and retirees whose savings/CD income has been crushed by low interest rates while Social Security hasn’t budged, to name a few — there are plenty of reasons to be worried that a deflating income won’t stretch to meet inflating goods prices… especially when debts have to be repaid as well.  So even if the goods prices aren’t inflating much, the income deflation and debt burdens are bad enough.

At the end of the day, however, the real problem in restoring prosperity isn’t about inflation, it’s that we need to restructure both the economy and the government.  We need to get more people producing genuine goods and services, things that really make the nation a better place to live in.  We need to shift workers away from wasteful and even counterproductive activities.  And we need to face the reality that for decades to come, there are going to be more retirees and probably fewer workers to provide for them all.  We need political leaders willing to roll up their sleeves and do some serious work, not simply grandstand for narrow constituencies while exempting themselves from the laws they write for the rest of us.

But, going back to the Inflation Confusion post, we see no evidence of an Activist approach to running the Federal Reserve.  Instead, we see this quote from Atlanta Fed president Dennis Lockhart:

Monetary policy is a blunt instrument without the capacity to systematically influence prices in targeted markets.

The good leader appears to forget that the Federal Reserve, and the government more generally, have all manner of policy tools at their disposal, and some of these are quite sharp.  For example, the Federal Reserve has a tremendous amount of regulatory discretion. Used judiciously, this tool could not only clean up terrible financial institutions, it could “systematically influence prices in targeted markets”. As just one example:  had the Federal Reserve bothered to enforce reasonable lending standards in 2004-2007, they certainly could have “systematically influenced prices in targeted markets”, namely the price of housing in the bubble states, where the most egregiously bad lending took place.  That would have been painful at the time, since no one wants to take away the punch bowl and be blamed for starting a recession.  But such a policy would have prevented the far greater economic pain we have suffered since 2007, including most recently the current inflation problem.

Is there a similar policy tool, which might inflict some economic pain now, but which will prevent far greater pain down the road?  I think there is!  Here are a few policies we could pursue that might hurt now, but would clearly fix things that are out of balance, and should help us later:

First, we should persuade all trading partners to float their exchange rates over the next 2 years. Keeping the dollar misaligned relative to our partners subsidizes their economic development at our expense.  But we cannot afford to subsidize the economic development of the rest of the world for much longer.  Another problem with misaligned exchange rates is that capital flows out of the U.S., while debt remains.  This is not stable and the imbalance needs to be unwound. The current monetary inflation is a step in the right direction, but more needs to be done to increase savings rates and reduce debt-to-money-supply ratios within the U.S.

Second, we need to return to policies which encourage genuinely productive investment and reduce the national addiction to debt marketed as “credit”. At the moment we have a tremendous amount of malinvestment… we have a horrifically unproductive health care sector… we have a financial sector which appears to have been a net drag on the economy for a decade… and we have too much debt relative to tangible value. In fact, to rewrite the classic line by Churchill, it may be that we have reached a point where “never in human history have so many people owed too much, to too few“.Third, we need to bring the national and state government budgets back into balance at a level, relative to GDP, which is consistent with the middle of the historical range. As with any budget pruning exercise, a lot of worthwhile, very reasonable activities will have to be cut back or terminated in order to allow higher-priority, more worthwhile activities to continue.  No major budget category should be spared.

It’s ridiculous that we spend more on defense than the rest of the world combined. And we spend far too much relative to our GDP.  While our soldiers deserve our support when we send them into harm’s way, perhaps we are putting too many in harm’s way, for too little gain?  How ironic would it be if, in Egypt, the protesters achieve more in a month than the entire U.S. military (with trillions of dollars) achieved in a decade in Afghanistan?  But perhaps more importantly, it’s impossible to claim that the entire defense budget is “essential”, so let’s prune the nonessentials. And ridicule anyone who claims that the whole budget is essential to national survival. We will have to accept some consequences, but we have to live within limits again.

It’s even more ridiculous that we spend far more on health care (as a share of GDP) than any other major nation, and yet we get worse outcomes.  Social security needs to be updated for modern life expectancies, but it could include another lower-payout “early option” for those who are forced into medical retirement before the median age. And it could include a phaseout for those who have millions of dollars in assets, hundreds of thousands in income, and clearly don’t need welfare for the elderly.

And finally, a huge swathe of “discretionary” spending is in fact discretionary. Some of it is prudent investment, so it’s unfortunate that Congress is tackling this last part first, because I think it’s the hardest to fix.  There are too many details, and in proportion I think there’s less fat in this part of the budget, so I fear they’ll never get to the health care sector where the bulk of the budget problem lies.

Looking at these 3 policy approaches, what role could the Federal Reserve play?

First, the Fed could stop subsidizing congressional overspending.  As has been said, the national debt isn’t created by the Fed, it’s created by Congress. But Congress wouldn’t be “enabled” to borrow so much, if the Federal Reserve were to stop monetizing it — and especially not if the Fed began to raise interest rates to fight inflation, thus raising the cost to Congress of being in debt.  We should all be horribly ashamed that our great nation has gone from “tax and spend” (which I recall was a really bad thing in the 1980s!) to “borrow and spend”, and now we’ve reached “print and spend” within just 30 years. There’s a natural size for the government, above which bad things happen, and everyone should quit trying to make the government bigger than that size.  We should be debating what fits inside the government’s slice of the pie, and working to grow the pie for everyone — not borrowing to make the government’s slice bigger now at the expense of painful repayments later.

Second, the Federal Reserve could cease tacitly supporting financial fraud, clean up the banking sector, and bring to light as many cases as possible where bankers lent foolishly (or even criminally) and are now broke. Does the Federal Reserve represent the financial industry as a whole, or just a few of the most troubled banks?  If the former, then among the latter, those responsible for the destruction of national and shareholder wealth need to face punishment, not be silently rewarded.  We need to get to the same “never again” mindset that policymakers adopted in the late 1930s, and institutionalize that mindset so the reforms will stick for as long as possible.  The banks which get with the program and clean up their business could be rewarded… and if necessary, the others could be cleaned up through aggressive regulation, if the Fed learned how to lift its little finger.  It’s time to recognize that the system is more than a collection of parts, and indeed that those parts which are incorrigibly broken must be replaced.

Third, the Federal Reserve needs to start lobbying for, and implementing, systemic financial limits. To reduce debt levels relative to GDP, a good start would be to reduce financial leverage limits.  For every borrower there is a lender, and there are currently too many lenders willing to lend too much relative to GDP. At the moment the marginal utility of debt appears to be quite low, particularly in the housing sector, so a reduction in bank leverage might not have as much of an impact as it would if this policy were implemented in the depths of a recession or during a raging credit-starved economic boom.  This could be a golden opportunity, in fact.

The goal must be to get to sustainable economic growth, not “growth at any cost”, and certainly not “the illusion of growth because we neglect to measure inflation adequately”…

Inflation: Why might it be worse than the CPI data?

Tuesday, February 15th, 2011

There was a nice post on “The Inflation Disconnect” at MacroBlog by the good folks at the Federal Reserve Bank of Atlanta last Friday.  (This was following up on an earlier post on “Inflation Confusion“.) They explained how the Federal Reserve attempts to keep an eye on inflation in many ways besides looking at the Consumer Price Index data.

As a comment there, I suggested the following three (really 4) possible “inflation disconnects”, three ways in which the Federal Reserve’s view of inflation might differ from grassroots realities, that were not covered in the MacroBlog article (though the first is alluded to in the comments there):

(1) Inflation in necessities hits the poor much harder than the rich. In recent decades, Per Capita GDP has been skewed to the high side by changes in income distribution. The median income has not done as well. The basket used in the computation of the various CPIs doesn’t do a very good job of representing the budget impacts of the current price changes on lower-income vs. upper-income folks.  When rent, gas, food and clothing are the bulk of your budget, it doesn’t really matter if the CPI stays low because computers and digital toys are getting cheaper and property prices are declining… you still have to choose between paying rent, getting to work, having servicable clothes and eating.

(2) Inflation as measured by the CPI has a very large fraction allocated to “owner’s equivalent rent”, which is very badly measured.  From 2004-2008 the OER totally missed the housing bubble, which was an inflationary disaster for anyone trying to buy a home with traditional financing.  More recently, declines in OER have offset some of the inflation in other areas, particularly food and fuel. But for those consumers who either own homes outright (no mortgage) or who bought a house in the bubble (with nontraditional financing), the decline in home values is a negative, not a positive.  The inclusion of OER in the CPI is grossly disconnected from the budgetary realities of these households.

(3) It might be worth questioning whether the REIN approach of surveying business leaders provides an unbiased view of price changes and inflationary trends. Business leaders profiting from low interest rates can hardly be expected to give answers which would lead the Federal Reserve to raise interest rates!  (Note that this doesn’t mean anyone is intentionally being misleading; there are plenty of examples where even very conscientious people will, without thinking about it, give misleading answers — if their incentives are misaligned.) Even if one doesn’t go that far, based on recent economic history it’s clear that a lot of business owners (especially in finance) have no clue what is actually going on in their business, and they may in fact be as ignorant as the Federal Reserve about price changes being implemented at much lower levels. In particular, there is a fair amount of evidence that businesses have been passing on higher costs by changing product size & volume without changing the “price” on the package. Do the leaders of those businesses actually report such changes via REIN?

(4) Bonus item:  One thing the REIN group does not provide is a representative sample of consumers.  Given the importance of accurate inflation data to policymaking, and given the resources available to the U.S. Government and Federal Reserve, why isn’t there a “household survey” of consumers regarding their budgets and inflation perceptions, to complement the CPI and the REIN “establishment survey”?  In other words, shouldn’t there be a reporting structure analogous to the monthly payrolls report, which captures the perspective from multiple sides of the market?