Main menu

Some things never change

As Democrats and Republicans face off over what to do about our trillion-dollar deficits—raise taxes or cut spending?—I can't resist posting this page from the New York Daily News, dated Nov. 4th, 1949. This debate is as at least as old as I am.

(click to enlarge)

I provided some important and worthwhile long-term perspective on this issue a few weeks ago.

Monetary policy update

With today's release of the Core PCE deflator (the Fed's preferred measure of inflation), I thought I would update some monetary policy charts. Core inflation is relatively benign at 1.6% over the past year, but it is substantially higher than the short-term rates the Fed is targeting, and that results in negative real borrowing costs. Real short-term borrowing costs are the best way to measure how "easy" or "tight" monetary policy is. By this measure, the Fed has never been so easy for so long.

The chart above shows the real Fed funds rate, calculated by using the Core PCE deflator. There are several things to note, most important being the see-saw nature of Fed policy. Fed tightening was likely the proximate cause of every recession in modern times, and it was almost always done in response to rising inflation. The Fed typically starts easing as recessionary conditions develop, and stays easy for the first few years of a recovery. But after being easy for several years, inflation typically picks back up, to be followed a few years later by Fed efforts to tighten once again. We are currently in the longest period of negative real borrowing costs. It would not be surprising to see inflation start to pick up in the next few years, to be followed by a recession a few years later.

This next chart overlays the slope of the yield curve on the first chart. Note that the yield curve slope tends to move inversely with monetary tightenings and easings. Recessions typically follow the point at which the Fed tightens policy by enough to invert the yield curve.

If there is one comforting message here, it is that monetary policy does not pose any threat to the economy. Indeed, policy is quite easy, as it almost always is during the early stages of a business expansion. Put another way, if we experience a recession in the next year or so, it will not be because the Fed has tightened too much. There is absolutely no shortage of money in the system these days.

What the Fed is doing is to actively encourage people to borrow money. Borrowing money at or near the funds rate to buy anything that is likely to rise in price even just a few percentage points a year is likely to be a profitable speculation. Leveraged investments, in other words, are almost a license to print money in this environment, and the Fed is all but guaranteeing that this will be the case for the next several years.

The good news is that investors can benefit from leveraged investments. The bad news is that this diverts capital from other areas of the economy that might be more promising. The Fed is promoting speculation, not long-term investment with this policy. Similarly, Fed policy is punishing savers in order to reward borrowers. This does not help the economy grow, and it likely is one of the reasons that growth has been disappointingly slow in recent years.

Three under-appreciated GDP facts

Everyone knows that the economy is weak, and that this recovery has been the weakest ever. So weak that the Fed believes it is going to have to keep interest rates at zero and continue buying bonds by the bushel for the next several years. So it is rather surprising to look inside today's third quarter GDP revision and discover three under-appreciated areas of strength: nominal growth last quarter was the strongest in over 5 years, inflation is running above the Fed's target, and corporate profits are extremely strong.

As the above chart of quarterly GDP shows, in the third quarter the economy posted its fastest rate of nominal growth in over 5 years. The last time nominal GDP grew by more than Q3/12's 5.55% pace was the second quarter of 2007, when it registered 6.5% annualized growth. On a nominal basis, Q3/12 growth was a good deal better than the 4.0% average pace of quarterly growth since the current recovery started in mid-2009. And at 2.7%, real growth in the third quarter was comfortably better than the 2.2% average for the current recovery. Despite almost universal gloom, last quarter stands out as one of the best in the current recovery.

The above chart shows the quarterly annualized rate of inflation according to the GDP deflator, the broadest measure of inflation available. The latest reading for the third quarter was 2.8%, and that is above the Fed's professed inflation target of 1-2%. Taken together, both growth and inflation in the third quarter were non-threatening. So why is the Fed still panicked? 

What worries everyone, of course, is that the economy has fallen way behind where it could have been if this recovery had been a normal one, and if the economy's potential growth rate track were the same as it has been for most of the past 50 years. With an output gap (see above chart) of as much as 13%, there aren't enough jobs to bring the unemployment rate down to healthy levels. The Fed wants to close the actual/potential GDP gap since that will increase jobs and reduce the unemployment rate.

The question everyone should be asking is whether monetary policy is capable of accomplishing such a feat.  Is the economy struggling because there is a shortage of money? Can zero interest rates on cash convince small businesses to hire more people? No one really knows, but neither has anyone ever argued that monetary policy was an effective tool for generating real growth. The Fed is in uncharted territory, with regards to the magnitude of its quantitative easing efforts and the scope of its policy objective.

The chart above compares total after-tax corporate profits (as calculated by the Bureau of Economic Analysis) to the level of nominal GDP. The two y-axes are calibrated so that both show a similar range. Note how strong profits have been during this recovery, and over the past decade. The growth rate of profits appears to be tapering off, but profits are still up 4% over the past year.

As this next chart shows, corporate profits have displayed unprecedented strength in this recovery. Never before have profits been such a big percentage of GDP (with the exception of last year's fourth quarter). 

This chart of PE ratios is constructed using the S&P 500 index (normalized) as a proxy for the value of all corporate businesses (the P), and the after-tax corporate profits measure shown in the preceding two charts for the E. PE ratios by this measure have rarely been lower, even though profits have never been stronger.

For purposes of comparison, the chart above shows the traditional measure of the PE ratio of the S&P 500 index, using trailing 12-month reported earnings. Both this chart and the one above it tell the same story: PE ratios are substantially below their long-term average, despite record-setting profits. The only explanation for this anomaly is that the market apparently believes that the current level of profits is not sustainable, and that profits will likely revert to their mean (e.g., 6% of GDP) in coming years—which would entail a huge decline in nominal terms.

The chart above compares total corporate profits to nonfinancial domestic corporate profits. which make up about half of total profits. This shows that the strength of corporate profits is broad-based, since both measures have increased by a similar order of magnitude in the current recovery.

This last chart compares corporate profits to global GDP. Here we see that profits are not unusually high at all, and not much different from their long-term average. This casts doubt on the need for, or the likelihood of, a big, mean-reverting decline in profits in coming years, and that further suggests that the market may be much too pesssimistic about the outlook for profits. U.S. companies now make a much larger percentage of their profits from overseas, and that is to be expected since the world has become much more integrated and many foreign economies are experiencing exceptional growth (e.g., India, China). The global marketplace has expanded much more rapidly than the U.S. economy, and U.S. corporations are benefiting from that expansion. Over the past decade, U.S. exports have grown 40% more than U.S. GDP.

So two puzzles remain: if corporate profits are so strong and there is little reason to expect them to collapse, why are PE ratios so low, and why aren't corporations using those profits to boost GDP by investing in more plant, equipment, and personnel?

I'm compelled to note here that total after-tax profits of U.S. corporations have averaged about $1.3 trillion per year since the recovery began in mid-2009, and that this happens to be almost identical to the annual federal budget deficit over the same period. Think of it this way: corporations have generated over $4 trillion in profits during the recovery, and substantially all of those profits have been borrowed by the U.S. government to finance what for the most part has been a huge expansion of transfer payments and a shortfall of tax collections (due to the output gap and the reduced level of employment).  Corporations may not have directly funded the federal deficit, but the funds they have saved and supplied to the credit markets, being fungible, have in effect found their way into Treasury notes and bonds. Since the U.S. government is highly unlikely to be able to spend $4 trillion as productively as corporations could, much of the money has, in a sense, been squandered. Collectively, we have not spent those funds in a very productive manner, so it is not surprising at all that the recovery has proved to be unusually weak.

Of course, that still leaves unanswered the question: Why aren't corporations using their profits to expand? The only sensible answer to that is that there is still a great deal of uncertainty about the future, which in turn stems from 1) the possibility that taxes on capital could increase dramatically in coming years, 2) the fact that Obamacare imposes significant new taxes on many people and significantly higher costs on small businesses, 3) the strong likelihood that regulatory burdens will be increasing, especially with the implementation of Dodd-Frank, and 4) concerns over the ability of the Federal Reserve to reverse its massive quantitative easing program in time to avoid a significant increase in inflation. All of these represent uncertainties, higher costs, and headwinds that weigh on any business' decision to put capital at risk.

In the end, the story boils down to this: government spending is a tax, and too much of it can smother an economy's growth potential. Japan is the prime example. Having engaged in massive deficit-financed public sector spending over the past few decades (enough to make ours look tame by comparison), it is not surprising that Japan's economic growth has been much weaker than ours.

We must find ways to reduce projected federal spending, especially on entitlements, if this economy is going to regain its former luster.

The Laffer Curve is alive and well in the UK

The Laffer Curve (a stylized version of which is shown above) is a very simple statement about the relationship between tax rates and tax revenues. For example, the Laffer Curve says that tax rates that are too high can result in reduced revenues. The UK has just proved that this is true. A few years ago, the UK raised the top tax rate on those making more than £1 million to 50%. The result? Tax collections from millionaires fell by £7 billion. Many millionaires (perhaps as many as two thirds) left the country, while others figured out how to reduce their reported income.

Here are the facts:

In the 2009-10 tax year, more than 16,000 people declared an annual income of more than £1 million to HM Revenue and Customs.
This number fell to just 6,000 after Gordon Brown introduced the new 50p top rate of income tax shortly before the last general election.
George Osborne, the Chancellor, announced in the Budget earlier this year that the 50p top rate will be reduced to 45p from next April.
Since the announcement, the number of people declaring annual incomes of more than £1 million has risen to 10,000.
Last night, Harriet Baldwin, the Conservative MP who uncovered the latest figures, said: “Labour’s ideological tax hike led to a tax cull of millionaires."
Far from raising funds, it actually cost the UK £7 billion in lost tax revenue.

To further explain the Laffer Curve: We don't know the actual shape of the Laffer Curve (the red portion of the chart above), but we do know where three points on the curve lie: if tax rates are zero, tax revenues obviously will be zero (#1); if tax rates are 100%, tax revenues will also be zero, since no one will be willing to work (#2); and there is a tax rate "C" that maximizes revenue (#3), because it minimizes tax evasion, maximizes the incentives to work and invest, and strikes the most efficient balance between the size of the public and private sectors, thus boosting overall economic growth and increasing the tax base. Furthermore, we know that in the region "A" of the curve an increase in tax rates will lead to reduced revenue, while in region "B" an increase in tax rates will lead to increased revenue.

As Jean Baptiste Colbert once said, "The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.”

This is what the fiscal cliff negotiations now underway in Washington are all about: Will higher rates on the so-called "rich" produce increased tax revenues or not? The Democrats say they will, believing that we are in region B of the Laffer Curve, while the Republicans say they won't, believing that we are in region A.

As a supply sider, and in my experience, I think politicians too often underestimate the impact of taxes on people's incentives to work and invest. In fact, when the CBO projects the budget impact of proposed changes to tax rates, it explicitly ignores the dynamic effect of changes in tax rates, assuming that an increase in tax rates will always produce a proportionate increase in tax revenues. The UK has just proved that you can't always assume this will be true. Higher tax rates do reduce people's incentives to work harder, save, and invest, and that can lead to a weaker economy and a smaller tax base. Moreover, higher tax rates can lead to increased tax evasion, or to increased tax avoidance activities.

The UK's experience with raising taxes on the rich provides a timely lesson for our politicians in Washington. We would all be much better off if they avoided higher tax rates on the rich, and instead focused on simplifying the tax code (by eliminating or limiting deductions, loopholes and subsidies), reducing taxes on business wherever possible (consumers are the ones that ultimately pay the bulk of corporate taxes), and reducing spending, particularly on entitlement programs.

Confidence is up, but it's still very low

"Consumer confidence in U.S. reaches highest level in more than four years," reads the headline today. But as this chart shows, confidence is still very low; it's about as low as it was during the recessions of 1990-91 and 1980-82. But of course it's the change on the margin which is important, and that change is positive. Things are improving, even though the economy is still miserably weak.

Meanwhile, capital goods orders—a proxy for business investment—are down over 6% this year, although they have stabilized and even increased a bit in the past four months. This underscores the fact that the economy is weak, but it's not collapsing. A recession is not inevitable. Taken together, these charts also are consistent with the view that the strength in the equity market is not being driven by optimism, but rather by a gradual decline in pessimism.

Housing update: prices continue to firm

According to the Case Shiller indices of housing prices, the housing market has been consolidating for the past three years, and that comes after 3 years of the most brutal collapse in home prices in modern times. Altogether, the housing market has undergone six years of intense adjustment. With prices stabilizing (and even going up in some markets) and housing starts up fully 65% since early last year, there's ample reason to think that we've seen the worst, and that the housing market is now getting back on its feet. 

Both of these indices of housing prices show year over year gains: the Case Shiller index is up 3%, and the Radar Logic index is up 5%. Moreover, both indices are relatively unchanged for the past three years. 

From a longer term perspective, housing prices appear to have come back down to earth in a big way. Over the past 25 years, housing prices have risen only 15% more than rents, and that seems quite reasonable considering that 30-yr fixed rate mortgages have fallen from over 9% in 1987 to only 3.5% today. It's not a stretch to say that housing has never been more affordable. If anything is holding back the market now, it's the fact that banks are still risk-averse in their lending practices, and regulators have also tightened lending rules.

Gold looks expensive

Here are some charts that put the current price of gold ($1750/oz.) in perspective.

In nominal terms, gold is very close to its all-time high of $1900/oz. Since its low of $254 in early 2001, gold has risen at a compound annual rate of 17.8%. That's almost hard to comprehend, until you compare it to AAPL, which has posted an even more incredible 42% compound annual growth rate over the same period.

In constant dollar terms, gold today is below its all-time high set in early 1980. But relative to the average real price of gold over the past 100 years, gold is trading at a premium of 230%.

It's not a coincidence that periods of strongly rising real gold prices have corresponded to periods in which Federal Reserve monetary policy was "easy," and falling real gold prices only occurred when the Fed was "tight." When individuals perceive that the Fed is oversupplying dollars to the world by keeping real interest rates very low, they tend to react rationally, seeking out and paying a premium for gold for its ability to maintain its purchasing power over long periods. In contrast, when money is tight and real interest rates are high, gold loses its luster as investors prefer financial assets.

This chart compares gold to a basket of non-energy industrial commodity prices. Note that gold and commodities tend to track each other over time. But note also that the right-hand y-axis of gold prices spans a range of 250 to 2000—a difference of 8 times—while the left-hand y-axis of commodity prices spans a range of 200 to 800—a difference of only 4 times. Gold prices have been far more volatile than commodity prices.

When we compare gold prices to crude oil prices, however, the two are very close to their long-term average relationship, in which one ounce of gold buys about 19 barrels of oil. Using Arab Light crude prices, the ratio today is one ounce to 15.4 barrels, which means that gold is a bit cheap relative to crude. But that is mainly due to the fact that Arab Light crude is trading at a substantial premium (about 27%) to American crude as traded on NYMEX because of geopolitical concerns. The ratio of gold to NYMEX crude is a little less than 20 today. On balance, let's just say that gold and crude oil are trading fairly close to their long-term average relationship.

If the Fed continues its massively accommodative monetary policy, gold prices conceivably could move higher. But I think that would require some evidence that inflation is picking up, and that evidence is still lacking. In my view, gold is essentially priced to a significant increase in inflation already. The premium that investors are willing to pay for gold today (defined as the amount by which today's price exceeds the average historical real price) is almost as much as it was in early 1980, when inflation had already attained double-digit levels.

By this same logic, if the Fed were to even suggest that it is contemplating a reversal of its quantitative easing (which could be accomplished by raising the rate it pays on reserves, or by draining reserves), then gold would be quite vulnerable to losses. Gold today is a very expensive inflation hedge.