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Couldn't resist posting this. Your typical smartphone now includes a built-in computer, TV, CD player, DVD player, stereo, still camera, video camera, video editor, photo editor, darkroom, phone, typewriter, calculator, radio, inertial guidance system, GPS, complete maps of the world, global library, encyclopedia, interpreter, newspapers, magazines, photo albums, rolodex, video games, multiple listing services, accounting services, remote controls, barcode scanner, portfolio management, stock ticker, travel agency, medical reference library, stargazer, mail-order catalogs, flight simulator, textbooks, math tutor, alarm clock, weather station ... . This would have been inconceivable just 10 years ago. HT: Mark Perry.

SNAP is out of control

The Food Stamp program (officially know as the Supplemental Nutrition Assistance Program, or SNAP) was created in 1969. That year there were only 2.88 million people enrolled (1.4% of the population), and their monthly benefits were $6.63. Today the number of people receiving Food Stamps has exploded to over 47 million (15% of the population), and the monthly benefit is $134. In 43 years, the size of the program has increased 1,450% (an annualized growth rate of 6.6%, more than double the rate of growth of the economy), and the cost has increased by 315,000% (an annualized growth rate of over 14% per year). If this is not an example of a government program begun with good intentions but now out of control, I don't know what is.

There is plenty of blame to spread around here, but the worst of the outsized growth of this program started about 10 years ago.


The above chart shows the number of people receiving food stamps since the program's inception. Note that there were two periods of exceptionally fast growth since then: 1970-75, and 2002-2012. From 1975 through 2001 the number of people receiving food stamps did not go up at all. I'm willing to ignore the rapid growth in the first six years of the program, since it likely has a lot to do with getting the program up and running and spreading the word about its availability. From the late 1970s through the late 1990s, the program functioned pretty much as one would expect: adding people during recessions, when times are toughest and unemployment rises, and shedding people during recoveries, as unemployment declines. But over the past 10 years the program has just grown and grown. Since the end of the 2001 recession, the number of people receiving food stamps has increased 173%, or 9.5% per year.


This next chart shows total spending on the SNAP program. Since the end of the 2001 recession, the cost of this program has surged by 345%, or 14.5% per year. That's so far out of line with growth in the economy (1.7% per year annualized) and inflation (2.2% per year annualized) that it simply screams for attention. Monthly benefits have increased at an annualized rate of 5.4% over this same period, more than twice the rate of inflation.

Has the economy deteriorated in the past 10 years by enough to justify the enormous growth in the size and cost of this program? I don't see how it could have. But I can see how the uncontrolled growth of this program has contributed to the generally slow growth of the economy over the past decade. As government grows, and as the number of people who depend on government grows, the private sector gets squeezed and the percentage of people of working age who want to work declines. Federal government spending relative to GDP has grown from 18.3% at the end of 2001 to 22.8% today; that's a 25% increase in the relative size of the federal government in just 11 years, and the bulk of that increase takes the form of transfer payments, such as food stamps. The percent of the population working or wanting to work has declined from a high of 64.7% in 2000 to 58.8% today.

 Soaring spending on food stamps is just one small part of an expanding entitlement state in which each person working ends up supporting more and more people who are not working.

Needless to say, this is not a formula for a strong economy.


This chart shows monthly data (which is not available prior to late 2008) for the past four years. The number of people receiving food stamps has jumped by 53%! If there is any silver lining in this otherwise very dark cloud, it is that the growth in the number of people receiving food stamps has slowed significantly in the past year or so.


In April 2009, a 17% increase in monthly benefits (from $114.67 to $132.21) gave a significant boost to the overall cost of the program, which has increased 70% in just the last four years (14% per year).

It's time to blow the whistle on SNAP. No government giveaway of this magnitude can happen without significant fraud and corruption, and anecdotal evidence of that abounds. What really needs to happen, however, is a complete re-examination of the underlying premises and objectives of this program. When government hands out food stamps to almost 1 out of every 7 inhabitants of this country, something is very wrong. This was never part of the original intent of the SNAP program, and government was never supposed to become such a huge part of people's everyday lives. If we can't fix this, the economy will only get weaker and weaker with time.

Reading the market tea leaves: lots of bad news is priced in

As the world waits to see how politicians figure out how to avoid the looming "fiscal cliff," nerves are on edge. Even though the risks of failure perhaps might not be high, the consequences of failure could be very serious. Moreover, politicians might avoid the fiscal cliff but still implement policies (e.g., sharply higher tax rates on small businesses, the engine of jobs growth) that could hamstring the economy.

Now is a good time to look once again at key market indicators that can help us understand how much bad news is already priced into the market. As I see it, the market is already braced for an unpleasant outcome to the fiscal cliff negotiations. That's not to say that we should expect an unpleasant outcome, but rather to say that should the outcome be unpleasant, that would not necessarily be bad news.


The above chart compares the real yield on 5-yr TIPS to the running 2-yr annualized growth rate of real GDP. The underlying premise of the chart is that government-guaranteed real yields that are available for purchase in the TIPS market can tell us a lot about the market's expectations for real economic growth. If I buy a 5-yr TIPS bond today, I have locked in a risk-free real rate of return of -1.4% per year for the next 5 years. Don't be quick to dismiss the importance of this; TIPS prices are not distorted. The spread between 5-yr TIPS real yields and 5-yr Treasury nominal yields is just over 2%, which means that the market is expecting the CPI to average about 2% per year for the next 5 years, and that is not unreasonable at all, considering that the core CPI has risen at an annualized rate of 1.7% over the past 5 years, and the CPI has increased at a 2.1% annualized rate over the same period.

Apparently the market is quite content to lock in a guaranteed loss of purchasing power with TIPS. I think that only makes sense if you accept that the market is willing to do this because there is a lot of fear out there that buying and holding any riskier asset is likely to mean real returns in coming years that are disappointingly low. By inference, if the market expects real returns on risk assets to be very low (perhaps even negative) over the next 5 years, then the market also expects the real growth of the economy to be very disappointing. That's precisely what the above chart shows: the current level of TIPS yields is consistent with real GDP growth that is close to zero over the next 5 years. That could be variously interpreted of course: it might mean 2 years of recession followed by 3 years of a moderate recovery, or it could be just total stagnation.

Note how in the chart real TIPS yields do a pretty good job of tracking the growth rate of the economy over the past 15 years. When economic growth was robust in the late 1990s, TIPS yields were very high; and with growth rates slipping to the current 2%, TIPS yields have declined.


And it's not just the bond market that is pessimistic. As the chart above shows, the stock market's confidence in the stability of earnings has also tracked the real yield on TIPS. As the real yield on TIPS has fallen over the years (shown here inverted), the earnings yield on the S&P 500 has risen (and the market's PE ratio has fallen). Why would the market today be priced to an earnings yield of 7.3%, when real yields on TIPS are -1.4%? The only way that makes sense is to accept that the market is demanding a very high equity earnings yield today because it expects earnings to be much lower tomorrow. If the market had any confidence at all in the stability of earnings going forward, then PE ratios would be higher (at least above their long term average of 17) and earnings yields would be lower—at least below the current 4.5% yield on BAA corporate bonds.


CDS spreads tell the same story. Credit default swaps are a very liquid market and a very good indication of the market's confidence in the future health of the economy. CDS spreads today are at the same level they were just prior to the onset of the Great Recession. The market is obviously concerned that default risk is relatively high, and that only makes sense if the market also worries that the economy might experience another recession. 5-yr high-yield bonds are trading with yields that are 6 percentage points higher than 5-yr Treasuries because the market thinks that there is a significant risk that corporate defaults will be troublesome in the years ahead, and that is only likely to happen if the economy is very weak.


When 10-yr Treasury yields are trading at extremely low levels (these bonds have almost never been so expensive), it's a safe bet that the world is very risk-averse.


And it's not just the U.S. that is in trouble, according to market expectations. As the above chart shows, sovereign yields in the U.S. and Germany are converging on the yields of that paragon of miserably slow growth, Japan. The market is behaving as if the world's major developed countries are going to be experiencing the same stagnate growth as Japan, which has suffered zero net growth since the end of 2006 (as compared to 4.4% growth in the US over the same period) and annualized growth of only 0.7% over the past 10 years (as compared to 1.6% in the US over the same period). Note also, for comparison purposes, that 5-yr real yields on Japanese inflation-indexed bonds are -0.6%. Negative real yields and extremely low nominal yields all point to one thing: a market that expects agonizingly slow growth to prevail—much slower than we have seen in recent years.


If extremely low 10-yr Treasury yields are symptomatic of miserably low real growth expectations, and if the Vix index is a good proxy for the market's level of fear, then the ratio of the Vix index to 10-yr Treasury yields (shown in the chart above) is a good indicator of how worried the market is about  the future level of growth. The Vix/10-yr ratio has spiked during every major crisis in the past few decades, and although it is significantly lower today than it was at the height of the 2008 meltdown—when the market fully expected a global financial market collapse and years of depression and deflation—it is still extremely high by historical standards. In short, this indicator suggests that the market is quite fearful of another recession.



Finally, the above charts show how investors are voting with their feet. Equity mutual funds continue to experience heavy outflows, while bond funds continue to experience strong inflows. This is a picture of a market that is very worried about the future and very concerned about seeking shelter.


If there is one thing out of place in this picture of a market obsessed with concerns about growth, it is swap spreads. Swap spreads have been excellent coincident and leading indicators of the fundamental health of the financial market and of the economy. As the chart above shows, swap spreads rose well in advance of each of the last three recessions, and declined well in advance of the onset of recoveries. Today swap spreads are unusually low, which is telling us that the fundamentals of the economy are not in the least shaky. Systemic risk—actual risk as perceived by market participants—is very low. The wheels are not about to come off this economy. The best explanation for why so many indicators point to troubles ahead but swap spreads say everything is fine, is that the market is very worried about something that has not yet even begun to happen. And it might not happen, either, if swap spreads are still good leading indicators.

In short, as I see it, the market is priced to lots of bad economic news that has yet to hit the tape. The market may end up being right, of course, but there are reasons to think that the market may be too pessimistic. At the very least we know that the market has had plenty of time to work itself into a frenzy of concern, since there is no shortage of things to worry about: political gridlock in Washington, a president who is anti-business and anti-wealth, trillion-dollar deficits for as far as the eye can see, a Middle East in turmoil, a huge increase in regulatory burdens, the onset of ObamaCare—which promises wrenching adjustments for one-sixth of the nation's economy, millions of underwater mortgages, and monetary policy that is far advanced into uncharted territory, to name just a few. It should not be surprising or controversial to discover that, in a time bad news is in plentiful supply, that the market is priced to pessimistic assumptions.

If you're worried about the future, you have plenty of company. If you're seeking refuge and protection, it's extremely expensive. The world is braced for lots of things to wrong. As I mentioned last August, it might make sense instead to worry about something going right.

Inflation update

Today's October CPI report was unsurprising, showing inflation at the consumer level running at just over 2%. However, from a long-term perspective, inflation is averaging about 2.5% a year. That's not particularly troubling, until you realize that the Fed has been trying as hard as possible to push inflation higher.


The above chart plots the consumer price index on a semi-log scale. As the dotted line shows, the index has been rising at a 2.5% annualized rate over the past 10 years, with occasional periods of above- and below-trend growth. (A similar chart using the core CPI would show that inflation has averaged about 2.1%.) The Fed's inflation target is 1-2% growth in the core Personal Consumption Deflator, and that measure of inflation tends to run about 0.5 percentage points below the CPI. So what the Fed has accomplished in the past decade is to deliver inflation at the upper end of its target range.

There is absolutely no sign here of any deflation, and that is very significant given the prevailing belief at the Fed that weak economic growth poses a risk of deflation. We've had the weakest recovery ever in the past several years, with the economy slipping well below its potential and well below its long-term growth path. The chart below documents this:


In fact, this recovery has effectively shattered three long-cherished beliefs shared by many economists (though not by supply-siders): 1) that increased government spending can stimulate growth; 2) that accommodative monetary policy can stimulate growth, and 3) that weak and below-trend growth is deflationary.

Government is not as all-powerful as statists would have us believe. The Fed can't pull its monetary levels and fine tune growth, and Congress can't borrow and spend and expect that to create jobs. If there's any mystery here, it is that inflation has not proven to be much higher given the degree of monetary stimulus that has been applied already by the Fed. I've explained why that is the case here.

We haven't seen worrisome inflation yet, but that's not to say it won't happen going forward. There is a large degree of monetary uncertainty in the world, and that helps explain why gold is still trading in the stratosphere and the dollar is very close to its weakest level ever. Moreover, it's a testament to the inherent dynamism of the U.S. economy that it has managed to grow 2% a year for the past three years in spite of huge monetary uncertainty and in spite of the threat of a massive hike in future tax burdens (courtesy of four years of trillion-dollar deficits)

These musing beg the question: if fiscal stimulus doesn't work (and it most likely hurts rather than helps the economy), and if monetary stimulus doesn't work (since it only adds to the uncertainties), then why does Congress want to keep the pedal to the metal on fiscal policy, and why does the Fed want to add even more monetary stimulus? I'm reminded of the definition of insanity: doing the same thing over and over and expecting different results. Questions such as these are a big reason why economic growth remains lackluster.

A more enlightened fiscal policy would focus on reducing, rather than increasing government spending, and a more enlightened monetary policy would focus on reducing, rather than increasing monetary stimulus.

Until policymakers see the light, it's very slow and steady as she goes, with a chance of higher inflation on the horizon.

This is not necessarily bad for the stock market, however, since I continue to believe that both stocks and bonds are priced to the expectation that growth will be very weak or even negative in the years to come.

Retail sales update

After a surprisingly strong September report, October retail sales came in a bit below expectations (-0.3% vs. -0.2%) and September sales were revised down slightly. The net result is that sales are still in an uptrend, and consistent with an economy that continues to expand, albeit relatively slowly.



The top chart shows the level of nominal retail sales, which have risen at a 6.2% annualized pace since their March 2009 low. The bottom chart shows the inflation-adjusted level of sales, which have yet to break into new high territory.

Higher taxes on the rich would barely dent the deficit

On the eve of negotiations over the looming "fiscal cliff," here's a look at the current status of the federal budget and projected deficits, using the latest October figures released today.

Obama says it is critical that the rich pay higher taxes, and he has long argued that it was the Bush tax cuts which put us in this mess, since the rich aren't paying their "fair share." The Republicans say it is critical that we avoid raising tax rates on anyone, since higher tax rates would jeopardize the health of the economy. As the numbers show, higher tax rates on the rich would make only a small difference to the projected deficit, since the health of the economy and the level of federal spending are by far the major determinants of the deficit.


This first chart puts the federal budget in the proper long-term perspective, measuring spending and revenues as a percentage of GDP. Spending is still well above its post-War average (22.9% vs. 19.3%), whereas revenues are only slightly below their post-War average (15.9% vs. 17.3%). If you assume that post-War averages are the norm, then 72% of the current budget deficit of 7% of GDP is due to excess spending, and 28% is due to a revenue shortfall. It's important to note here that federal revenues exceeded their post-War average from 2005 to 2008 despite the Bush tax cuts. Those same tax rates are delivering disappointing tax revenues today because of a shortfall of jobs and the fact that our economy is about 10-12% below its potential output. It's the shrunken tax base, not lower tax rates, which is responsible for today's revenue shortfall. A healthier economy and faster jobs growth would do much more to close the deficit than any amount of higher tax rates on the rich.


The chart above plots the running 12-month total of nominal federal spending and revenues. Two rather surprising revelations are apparent. First,  after surging in 2008 and 2009, federal spending growth has slowed to a crawl, thanks mainly to Congressional gridlock and the unwinding of automatic stabilizers (e.g., fewer people collecting unemployment insurance). Second, revenues have surged by $446 billion since hitting a low in early 2010, without any increase in tax rates and despite a two-year payroll tax holiday, mainly because an expanding economy, rising corporate profits, and the addition of 5 million new jobs have expanded the tax base. Even if the economy were to continue growing at a measly 2% rate, there is every reason to think that revenues would continue to rise without the need for higher tax rates. Raising tax rates, however, might weaken the economy further, and that would make it much more difficult to generate higher tax revenues.


The chart above shows the impressive reduction in the federal deficit as a percent of GDP that has occurred over the past three years—from a high of 10.5% in late 2009 to the current 7%. If nothing changes and current trends were to continue (spending growth of 3% per year, revenue growth of 7% per year, and nominal GDP growth of 4% per year), the deficit would decline to approximately 6% of GDP by the end of next year, and return to its long-term historic average of 2% of GDP in seven years. Nobody's taxes need to be raised, and nobody's spending needs to be cut—the U.S. economy is already on a glide path to the restoration of fiscal sanity. Washington: are you listening?

But if anything is likely to change in a big way in coming years, it is increased entitlement spending, particularly under ObamaCare and Social Security. This is what should be getting the priority these days, not tax rates.

I happened on a Bloomberg News article this morning (which for some reason I am unable to find on the web) that reinforces my point that the shortfall in revenue today is not due to tax rates that are too low, but rather due to a weak economy:

... boosting taxes for the wealthiest 2 percent would bring in $58.1 billion in fiscal year 2013, according  to Bloomberg calculations based on data from the [left-leaning] Tax Policy Center. The CBO estimates the government's finances will show a shortfall of $1.04 trillion, assuming almost all the tax increases and automatic spending cuts that are slated to take effect next year are totally averted. 
"It's not very much, but it is a step in the right direction," Roberton Williams, a senior fellow at the nonpartisan Tax Policy Center in Washington, said in a telephone interview. "In order to close half the budget deficit by raising taxes on the rich, you would have to raise their tax rate up to about 90 percent. That's not going to happen."

According to some estimates I've seen, if Obama gets his request for higher income, dividend, capital gains and estate tax rates rise for those making more than $250K per year, that could raise up to $120 billion to federal revenues next year, assuming no adverse consequences for economic growth. That's not an assumption I'm comfortable making, but nevertheless the revenue gains that might result from boosting tax rates for the rich are still a relatively small fraction of the total projected deficit.

Greg Mankiw uses data from the Tax Policy Center to make the point that putting a cap on total deductions could raise significant revenue from the rich without increasing their marginal tax rates, and that is important since it avoids creating a disincentive to additional work and investment:

According to the Tax Policy Center, if we cap itemized deductions at $50,000 and keep tax rates as they are today, we would raise $749 billion in tax revenue over ten years. Moreover, according to the TPC's distribution table, 96.2 percent of the extra revenue would come from the top quintile, with 79.9 percent from the top one percent.

Given today's political realities, the best outcome of the "fiscal cliff" negotiations, from my perspective, would be an agreement to meaningfully reduce future spending on entitlements, extend the current tax structure for at least another year or two, and put a cap on total deductions. This would reinforce the fiscal sanity glide path (i.e., slow growth in spending coupled with continued expansion of the tax base), and give politicians and markets plenty of time to notice that the U.S. federal budget outlook is not nearly as bad as most seem to believe.

If the "fiscal cliff" negotiations end up being driven by political considerations rather than economic realities, higher tax rates on the rich would only increase the odds that the economy is likely to continue growing at a sub-par pace (i.e., growth that is insufficient to return the economy to its full potential) for the foreseeable future. That would be a very unfortunate conclusion to such an important policy debate.