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The more government spends, the worse it gets


The federal budget numbers for September, released today, didn't show anything encouraging. Revenues came in on the weak side, and the fiscal 2011 deficit was almost exactly $1.3 trillion, second only to the record-setting $1.4 trillion in fiscal '09. Using my estimates for Q3/11 GDP growth, I figure that federal spending is currently running at almost 24% of GDP. If we don't slow the growth in discretionary spending and reform entitlement programs, then the blue line is almost sure to go higher in the future.

What struck me most while updating my numbers and charts was the chart above, which compares spending as a % of GDP to the unemployment rate. There are things like automatic stabilizers (e.g., unemployment insurance) that push spending up when the economy weakens, thus automatically boosting spending relative to GDP, but the extremely close correlation between the two lines since 2008 begs for a better explanation. With no proof, unfortunately, I'm sorely tempted to say that huge increases in government spending only serve to weaken the economy, and that's why a big increase in the relative size of government correlates so well to an exceptionally high unemployment rate. Corollary: cutting back on the size of government would boost the economy and lower the unemployment rate. If the big boost in spending only weakened the economy, then cutting back on spending should help.

Retail sales and supply-side economics



Today's release of September retail sales data may be old news by now, and retail sales aren't what drives economic growth, but they sure don't paint a picture of an economy on the cusp of recession. Indeed, the strength of retail sales—which are up 8% in the past year and have now surpassed their 2008 high by 4.5%—is impressive given that 7 million fewer people are working today than at the pre-recession peak. Yes, with 5% fewer people working, we are collectively spending almost 5% more. That is a testament to the worker productivity that has occurred in the past 3 years, and the degree to which businesses have become leaner and meaner and more profitable. Government transfer payments may be helping out, of course, but most of the big "stimulus" money is now water under the bridge, with little or no lasting effect on jobs or permanent incomes, which are the main determinants of spending. A good portion of this growth in sales has got to be due a genuine improvement in economy, even though we are still way below where we should be.

As a supply-sider, I consider retail sales to be a reflection of the underlying growth fundamentals of an economy, not the principal driver of that growth. Too many people these days are insisting that what we suffer from is a lack of aggregate demand, but that gets things backward. Supply-siders understand that it's not about how demand creates more jobs—it's how more and better jobs are what create demand. If there's a chicken and egg argument here, it's that supply comes first (supply being the result of investment and work creating jobs and output) and demand follows. Or to paraphrase the great French economist Say: "supply creates its own demand."

The reason Obama's "stimulus" plans haven't worked is that in grand (and mistaken) Keynesian tradition, they have focused on stimulating demand, not on stimulating supply. As the late Jude Wanniski used to say, "we can't spend out way to prosperity." Prosperity comes only from more work, smarter work, more and better computers, more entrepreneurs, more efficient companies, and more risk-taking. Redistributing income from the rich to the poor, in the belief that the poor are more likely to spend it than the rich, and thus more likely to "stimulate" the economy, is just plain nonsensical. If anything good has come out of pouring $1 trillion of "stimulus" money down the drain, I would hope it will be understood as a failed experiment in Keynesian economics.


The continued strength in retail sales also shows that consumers in aggregate can spend more even as they deleverage. In the chart above, note that households' debt burdens (consumer and mortgage debt payments as a % of disposable income) have declined dramatically since just before the recent recession, by about 20%. This is the biggest effective deleveraging of the household sector on record. In a sense, you could say that, based on this chart, the consumer debt bubble has burst, and we are back to levels that in the past have served to launch significant economic recoveries (e.g., 1983, 1995). Of course, some portion of this deleveraging is the result of massive defaults on mortgage debt, but it still shows that debt can be cut back dramatically without causing an economy to shrink.

For more on how debt works (how more debt doesn't create money or new demand, and therefore less debt doesn't destroy money or demand), see my July post titled "Debt musings and misconceptions." This has great relevance not only to how the U.S. economy has survived a massive deleveraging largely intact, but also to how it is not inevitable that the Eurozone must implode just because the Greeks have little choice but to default on their debt. Debt does not create demand, nor does it create growth (it can facilitate growth, but not create it out of thin air), and wiping out debt therefore does not necessarily wipe out demand. The money that the PIIGS borrowed and squandered is gone: the Eurozone economy has already paid the price of its bad investment decisions and bad spending decisions. Wiping the debt slate clean, which must happen at some point, could well prove to be the catalyst for stronger growth in the future, not the death knell of the global economy.

Finally, today's retail sales number is one more in a growing list of statistics that have thrown buckets of cold water on the notion that the U.S. economy is sick and about to slip into another recession. The bond market, which only two weeks ago was priced to the expectation that the entire global economy was going down the drain, has only just begun to wake up to the fact that pessimism has gotten way out of line with reality.


Export growth continues strong



August trade figures released today show that exports continue to grow at strong double-digit rates. More and more of our output is being exported; exports now account for about 14% of U.S. GDP, up from less than 10% at the end of 2001, and less than 4% in the early 1970s. This can only be a healthy development.



Claims still show no evidence of a double-dip



Not much news on the unemployment claims front, except that the series continues to show no evidence at all of the economy being on the cusp of, or entering, another recession. On a seasonally adjusted basis (top chart), claims remain near the low end of their range so far this year; on an unadjusted basis (bottom chart), claims actually rose by 66K in the latest week, but that was fully anticipated by the seasonal adjustment factors.

Romney is wrong about China

I watched most of last night's Republican debate. A few things were obvious: Perry is in over his head and no longer stands a chance; Cain continues to float up in standing; Gingrich was born to be an elder statesman, but not President; Paul is too dogmatic; and Romney is clearly the frontrunner.

Most of what Romney said I agree with, with two huge exceptions: his stance on China and his advocacy of lower capital gains taxes for the middle class.

Romney said that "if he were elected president he would immediately launch a combative relationship with Chinese leaders and attack their currency and trade policies." I wouldn't mind seeing him elected, but I sure hope that before he takes office, someone tells him he is dead wrong on China.

I sense that these words resonated with a lot of folks, and that's very unfortunate. Romney's great weakness as a leader is that he is a slick politician who crafts a message that he thinks people like to hear. He may understand a lot about how businesses and economies work, but he has no grounding at all in trade policy.

For those who disagree, let me first say there is a huge body of research, backed by sound economic theory, that says that free trade is an unmitigated good: no exceptions. Second, let me note that imports from China are such a small part of what we buy that trying to correct our supposed trade imbalance with China can't possibly be worth the risk of starting a trade war with such an important trade partner.

Goods and services from China accounted for only 2.7% of U.S. personal consumption expenditures in 2010, of which less than half reflected the actual costs of Chinese imports. The rest went to U.S. businesses and workers transporting, selling, and marketing goods carrying the "Made in China" label. Although the fraction is higher when the imported content of goods made in the United States is considered, Chinese imports still make up only a small share of total U.S. consumer spending.

Third, let me quote from the excellent Don Beaudreaux, who, in an open letter to Romney, demolished Romney's position using simple logic:

... you complained that Beijing pursues policies that make Chinese products less expensive than American products.
I overlook the fact that, because only 2.7 percent of Americans’ personal consumption expenditures are on goods and services produced in China, 97.3 percent of the goods and services bought by American consumers obviously are less expensive to Americans than are Chinese-made equivalents.
Instead, let me here go to the heart of your argument and accept your presumption that party A harms party B if A offers to sell goods or services to B at prices lower than what it would cost B to produce those goods or services himself.
Accepting this presumption, I’m obliged to advise you that you can make yourself and your family better off by styling your own hair. Your current stylist obviously does a fine job – strong evidence in support of my suspicion that that stylist has pursued policies that make it less costly for you to use his or her styling services than it would be for you to design and maintain your coiffure yourself.

If that's not enough, because you think that it's China's subsidizing of its exports that is harmful to us, consider this open letter written by Boudreaux to Robert Samuelson:

You argue that we Americans are harmed by foreign subsidies that lower the prices of our imports (“Our one-sided trade war with China,” Oct. 7). But why? Why are we harmed by these lower-priced imports if (as I know you agree) we benefit from imports whose prices are lowered by natural market forces?
In both cases, some U.S. workers lose jobs. And in both cases, not only does Americans’ cost of living fall, but, also, opportunities are thereby opened in America for the creation of new industries and new opportunities that would otherwise be economically out of reach. In America, absolutely nothing about jobs lost to imports whose prices are made lower by foreign subsidies distinguishes them from jobs lost to imports whose prices are made lower by natural market forces.
If you’re skeptical of my claim, ask first: Would you oppose the successful private efforts of a Chinese physician to invent an inexpensive pill that safely and completely cures people of cancer? I’m sure not, despite the fact that such a pill would destroy many American jobs – from those of physicians to hospital orderlies. Now ask, would you oppose the successful efforts of the Chinese government to subsidize the invention and production of such a pill for export to America?
The logic of your position is that such subsidies would hurt Americans and, therefore, Uncle Sam should retaliate with measures to protect us from the scourge of such a low-priced cancer-curing pill.
But honestly, would Americans really be made better off by retaliatory tariffs that prevent us from buying this pill – or that force up the price of this pill to levels sufficient to protect the jobs of oncology physicians, nurses, and other health-care workers? If you (rightly) suspect that the answer is no, then you should realize that your case for retaliatory trade restrictions against whatever goods Beijing might now subsidize for export is without merit.

I would also refer skeptics to my post "Pity the Chinese" from last October, in which I note that China is the losing party in our trade relationship:

They sell us mountains of cheap goods, then turn around and invest most of the proceeds (equivalent to our trade deficit with China) in U.S. Treasury securities. We get the goods, and we get to keep the money. Then we devalue the dollar, and they lose on their investment. Why we would want them to stop doing this is beyond me, though if I were a Chinese citizen, I would be furious with my government for directing such massive quantities of my country's export earnings to Treasuries.

As for Romney's preference to further steepen our already-very-progressive tax code, by giving those who earn less than $200,000 a reduced capital gains tax rate, let me say that I am fed up with politicians discriminating among us on the basis of race, ethnic origin, or income, or whatever. Income redistribution of the kind Romney is advocating is morally wrong (think Robin Hood), and it does nothing to strengthen our economy or advance living standards in general. In fact, it most likely harms the economy by creating perverse incentives that distort the allocation of the economy's scarce resources. Furthermore, steepening the tax code further only makes it more difficult for those who are climbing the income ladder, since it creates very high marginal tax rates.

UPDATE: I think it's appropriate here to include a few words from Art Laffer, who adds weight to the argument against raising taxes (which also applies to not lowering taxes, or increasing the progressively of the tax code) on upper income earners:

It has become an article of faith among the proponents of “soak the rich” policies that the wealthy are somehow immune to tax rate hikes. We hear a lot of cynics arguing that increasing tax rates from 35 to 39.6 percent won’t affect the behavior of hedge fund managers and CEOs, since these high achievers are allegedly out to win status, not just an income.
As usual, these critics have things exactly backwards. It’s the poor and middle class who are largely unresponsive to income tax rate changes. The person who punches the clock at a 9-to-5 job has few options when tax incentives change. Upper income earners, on the other hand—particularly entrepreneurs—have much more leeway to change the timing, location, and composition of their income. To give a simple example, a blue collar worker can’t easily strike a deal with his boss to take his pay for calendar 2012 as a lump sum payment in December 2011, to avoid a looming tax rate increase. But businesses engage in analogous arrangements all the time. That’s why we see the Laffer Curve give its most pronounced effects when it comes to changes in the capital gains tax rate.
It’s ironic that so many of Obama’s supporters deny that income tax incentives can influence behavior. After all, most of them are ardent supporters of a carbon tax to reduce carbon emissions to fight the threat of climate change. For some reason, in this context they understand full well that when you tax an activity, you get less of it. Well, the same applies to earning income. When you raise the marginal tax rate on the most productive members of society, expect less output, fewer jobs created, and a smaller bounce in tax receipts than a naïve static analysis would have suggested.

Big and welcome reversal


This chart shows the fairly significant reversal in two indicators of fear that has occurred this month: the Vix Index (orange), and the 10-yr Treasury yield (white). The chart bellow combines these two into one, the Vix/10-yr ratio:


Obviously, something big has happened since Oct. 3rd, which marked the peak in the Vix/10-yr ratio and the recent low in the S&P 500. The Eurozone sovereign debt crisis has not been resolved, not by a long stretch, so what is it? Two things: 1) economic data that show the U.S. economy is still growing, and in fact might be picking up a bit after a very depressed first half (e.g., unemployment claims, private sector payrolls, rail shipments, capital goods orders), and 2) indications that the Eurozone debt crisis is not getting worse and might possibly have a solution down the road. Reason #2 might not sound very convincing, but I think it does mark an important inflection point. After all, as I have been noting for awhile, since markets were priced to an "end-of-the-world-as-we-know-it" scenario, then anything short of that, even just a hint that conditions might be sort of stabilizing or improving just a tiny bit, would have to be very good news in a relative sense.

In short, markets were braced for an outright catastrophe, and now that seems doubtful. That's not to say the future looks rosy—on the contrary, we still face strong headwinds and likely setbacks on the road to a painfully slow recovery. To really get optimistic, we'll need to see real austerity measures (such as those adopted by Ireland), tax reform (lower and flatter tax rates, coupled with fewer deductions and a broadening of the tax base), entitlement reform (e.g., a privatization of social security, higher retirement ages, and market-based healthcare reform), and central banks willing and able to take bold steps to reverse their quantitative easing as the demand for money falls back to its pre-2008 levels. That comprises my wish list of things to hope for over the next 2 years, and I think they are doable.

TIPS update


This chart shows the entire history of the real yield on 10-yr TIPS. I've overlaid it with valuation parameters which make sense to me. TIPS are very different from ordinary bonds, since they trade based on real yields, not nominal yields. There is no limit to how high nominal yields can rise, especially if there's lots of inflation to contend with. But there is a practical limit to how high real yields that are guaranteed by the U.S. government can go. Ultimately, the real yield on TIPS is highly unlikely to ever exceed real growth expectations for the U.S. economy, otherwise TIPS would become an absolutely compelling alternative to just about any other asset class. For example, try to imagine how any asset class could beat a risk-free, U.S. government-guaranteed, real yield greater than 5% for 10 years? Can't be done. So as real yields approach or exceed 2.5-3%, then TIPS become very attractive since on a risk/reward basis they are highly competitive with just about any asset.


But while there is for all practical purposes a limit to how high TIPS yields can rise, there is no reason that they can't continue to fall, or become negative. In fact, as the chart above shows, real yields on TIPS maturing in less than 8 years already are in negative territory. Buy a 10-yr TIP today and over the next 10 years your total return will only be whatever the increase in the consumer price index proves to be. But anything less than an 8-yr TIP and you will receive less than the increase in consumer price inflation. A negative real yield simply means that the effective nominal yield on TIPS will be less than the future rate of inflation.


This next chart shows the nominal yield on 10-yr Treasuries, the real yield on 10-yr TIPS, and the difference between the two, which is the market's break-even, or expected annual inflation rate over the next 10 years. It's extremely important to note that the state of the Treasury market today is very different from what it was at the end of 2008, even though 10-yr Treasury yields are just as low now as they were then. At the end of 2008, 10-yr nominal yields briefly touched a low of 2%, but 10-yr TIPS yields were almost 2% as well, which meant that the market was expecting zero inflation for the next 10 years. Today, the difference between 10-yr nominal and real yields is 2%. That adds up to an expectation that consumer prices will rise by about 22% over the next 10 years.

In other words, the panic that struck at the end of 2008 was in part due to the market's belief that monetary policy was so tight as to preclude all thought of rising prices, as well as the widespread fear of a deep global recession or depression. It's dramatically different today, however, because the Fed and most other major central banks have made it clear that they will do whatever is necessary to avoid even the hint of deflation. Zero or negative inflation is not an option. Today's panic only extends to the outlook for growth. 10-yr TIPS are trading at a real yield of almost zero because the market fears that the outlook for economic growth is absolutely dismal. But buyers of TIPS and Treasuries today have almost no doubt that inflation will be about 2% per year for the foreseeable future. Put another way, if you worry about deflation, then you will shun TIPS and prefer Treasuries instead. (The same holds for inflation-adjusted bonds in the Eurozone, where break-even inflation expectations are also in the neighborhood of 2%.) A deflationary monetary error is not among the things that markets worry about today, and that, at least, is a source of some comfort. It's all about the outlook for Eurozone growth, it's not about central banks being too tight or too loose.

This analysis leads us to the following conclusions. If the economic outlook improves, then it is highly likely that both TIPS and Treasury yields would rise. 10-yr TIPS yields simply could not remain at zero if the market becomes more optimistic about the economy's ability to grow. If the economic outlook improves and inflation expectations rise, then Treasury yields would rise by more than TIPS yields. Put another way, if you expect the economy to have even the slightest chance of growing in the years to come, then you will find both TIPS and Treasuries to be very unattractive. If you expect the economy to eke out at least some degree of growth and if you expect inflation to rise, then you had better be prepared to see TIPS prices fall (since real yields would rise), even as rising inflation improved the effective nominal yield on TIPS.

Beware the safety of Treasuries



These charts show the extreme volatility in the yield on 30-yr Treasuries in the past several years (below) and days (top). Since Oct. 4th, long-term T-bond yields have risen from 2.7% to 3.1%, a rather extraordinary move that has slashed the price of the long bond by almost 8% from last week's high. (How's that for a risk-free investment?) It's looking a lot like we have seen a major reversal of the panic that last week drove yields down to levels that implied the onset of a global recession/depression. Yields are still very, very low, however, and still priced to very dire assumptions about the U.S. economy's ability to grow. But T-bonds are far from being safe investments, even with the approach of Operation Twist. In the end, it's all about Europe and whether Europe goes down the drain and drags everyone with it. If Europe just manages to survive, long-term bond yields have plenty of room to rise, and prices to fall.

Shipping activity shows strong gains


Mark Perry has some good background on this. I'm adding my chart to the mix since it shows both total expenditures and an index of shipping activity. Activity is up 7.5% in the year ending Sept. '11, while expenditures are up 15%. Expenditures have risen much faster than shipments since the recent recovery began, suggesting that freight companies are enjoying some decent pricing power. The strong rise in shipping activity in the past year and in recent months is one more sign that the U.S. economy is not on the cusp of another recession, and the strong gains in expenditures belie even the hint of deflation. On the contrary, economic activity and cash flows are definitely improving according to these figures.

One more tribute to Steve Jobs


Today, Apple's market cap exceeded Microsoft's by $135 billion. Since Jobs returned to Apple in 1997, Apple's market cap has grown by as much as Microsoft's market cap has declined from its early 2000 high. The numbers speak for themselves. This has got to be the greatest David vs. Goliath story in corporate history.

Volatility update


Fear—emanating primarily from Europe—continues to be the big driver in most markets around the world. Today that fear eased a bit as talk out of the Eurozone pointed to more serious steps being taken to deal with the sovereign debt crisis. The Vix declined, and equity prices rose in lockstep.



Here's a closeup look at the Vix Index over the past six months, and since early 2008. The good news is that we haven't scaled new heights of fear since the latest round of the crisis erupted in early August. The bad news is that the Vix remains quite high, fear is still intense, and to date there has been no definitive resolution to the crisis.

Good friend Ashby Foote today noted that this crisis is not at all like a "Black Swan" event that catches the world totally by surprise. That reminded me once again of my post comparing Europe's sovereign debt crisis to Los Angeles' "Carmageddon". When looming losses stare the world in the face for 18 months, people take notice and act. The world has had plenty of time to brace for a Greek default, beginning early last year. When it finally happens, I would be surprised if markets deteriorate further; they might even rally, happy to have eliminated the uncertainty at last. Angelenos went into Carmageddon weekend convinced that they faced a nightmarish gridlock; instead, there was hardly any traffic to speak of.