Thought Offerings

The Ultimate Job Guarantee Implementation: Can we Achieve Zero Wasted Labor AND Zero Material Waste Simultaneously?!?

2012-01-14T01:37:00.003-05:00

Discussion in the MMT blogosphere has focused recently on the "Job Guarantee" (also known as "Employer of Last Resort", "Transition Job", or to some, "Workfare".) The concept is that everyone should have the option of a federally funded but locally administered minimum wage job. The economic motivations include (1) achieving loose "full employment" even when there is insufficient aggregate demand (spending) to create private sector jobs for everyone who wants one, and (2) enhancing macroeconomic price stability (low and stable inflation), and (3) raising the long term productivity of the economy. Job Guarantee (JG) proponents are among those who consider mass involuntary unemployment to be an enormous waste of willing human labor, resulting in many direct and indirect costs to society. And even Ben Bernanke has said:

"Long-term unemployment imposes severe economic hardships on the unemployed and their families, and, by leading to an erosion of skills of those without work, it both impairs their lifetime employment prospects and reduces the productive potential of our economy as a whole."

One of the recurring topics of JG debate is "what would all these people do?" Some commenters have a variety of constructive answers to this question, while others suggest than any job tasks chosen by the government (even local government, as opposed to Congress) would be a "boondoggle." I am not familiar enough with the academic research and modeling to weigh in with strongly held opinions for or against the JG concept in general (though I lean strongly toward giving it the benefit of the doubt), but this post will outline a concrete JG idea I have not seen described elsewhere. There are aspects of the idea I find highly compelling, but I expect some people may hate it.

First, some brief context. Modern economies have major problems with their environmental sustainability. One of these problems is that they have evolved to treat natural resources as an "input" to human activity and accepted a large waste stream as an "output", as though the economy were the center of reality. There have always been some observers warning that economies exist WITHIN the natural environment, not APART from it, and economies must adapt to function in a sustainable closed-loop way just like natural ecosystems -- where the output of every system of production and consumption is ultimately an input to another such system. Here is a diagram from zerowaste.org reflecting the current economic system's material flows:

Here is a diagram reflecting the conceptually ideal zero-waste closed loop system:

Three of the major problems with the current system as shown in the first diagram are external costs, that is, costs borne by society at large:

Land fills consume finite land (for which available locations are diminishing), and can be unpleasant and costly to administer.
Garbage incineration contributes to air pollution that adversely effects health, and consumes many materials that might have had better forms of reuse.
The economy's raw material input requirements are larger than would be necessary if we reused more of our waste stream. In addition, the methods we use to extract new raw materials typically have large external costs as well (e.g., habitat destruction and pollution from mining). These external costs go down when we reuse more materials.

What if the role of job guarantee work was to "intercept" the not-currently-recycled part of the waste stream with the goal of reclaiming recyclable, reusable, and organic (compostable or biofuel-ready) materials to the maximum extent possible? Source separation (such as separate curbside bins) should certainly still be encouraged wherever possible to create pre-separated streams of recyclables, organic waste (yard and food scraps), and general trash, however many localities don't do any separation at all, and even general trash streams will inevitably contain recoverable waste. So a JG zero-waste program would focus specifically on reducing the waste streams that are currently going to landfills or incinerators.

The pie chart below shows the composition of the 250 million ton annual waste stream in the US, of which only 34% is currently recycled! (Source: EPA). That 66% currently going to landfills and incinerators contains extraordinary amounts of valuable material! Separating it further would be labor intensive work, and would probably not be profitable for individual companies extracting only the materials they could sell for more than the cost of labor. But, the job guarantee concept isn't intended to be "profitable" in such a narrowly focused sense!

An underlying presumption in this idea is that the more human labor is available for sorting, separation, and dis-assembly of complex items, the higher would be the percentage of the waste stream that can be reclaimed for new uses. There would likely be diminishing returns in adding new labor as separation of reusable materials approaches 100% of the waste stream -- since some portion of the waste stream may be too complex or contaminated for separation -- but this also means a potentially huge number of JG workers could be usefully employed, so the JG program could be exclusively focused on this goal! Here is a purely speculative graph of this labor vs output relationship (I have no detailed knowledge of the waste industry, so this could be inaccurate!):

Of course, automation should be used in waste stream separation to the maximum extent possible, and we shouldn't abuse "cheap" labor if there are reasonable automation options available! Single-stream recycling facilities already have impressive technology for separation of material types, and technologies for processing "dirty" trash streams appear to be advancing too! But based on my limited knowledge, even these advanced "dirty" processing facilities still require some human labor in the sorting process, and may also be too expensive for many municipalities. We are probably still decades away (I'm guessing!) from sophisticated enough computer vision and robotic dexterity to achieve everything a human can in this type of process.

I expect this to be a controversial suggestion, in part because of the "trash" association and concerns about human dignity (perhaps this is an inherently bad idea!) but I'll run through some of the pros and cons I can think of. Here are some advantages:

Job guarantee workers would be providing an obvious-to-all public service with broadly shared benefits, because the waste stream is produced by just about everyone, and the negative externalities being reduced would otherwise be suffered widely also. With other JG roles sometimes suggested by commenters (reading to the elderly, planting trees in parks, removing graffiti, etc) there might be concerns by voters about jobs benefiting some demographics more than others, or about potentially poor choices of projects in general. But everyone benefits from a zero material waste economy!
If a program of this type intercepted the part of the waste stream not already being reclaimed, it would not compete with the private sector or charities (or perhaps very minimally). Presumably this work is too labor intensive to be cost effective for private industry, but cost effectiveness (with the typical narrow definition of a single entity's cash flow) is not the goal of the job guarantee.
It is inherently local (which is one of the MMT design choices for implementing a JG), because waste streams are produced everywhere people live and work!
The financial costs of waste handling are often already paid for by municipalities (source).
The savings in materials-flow-related external costs alone (pollution, landfill space, and raw material inputs to the economy) could significantly offset the program's "costs" in terms of wages paid to JG workers (not that a JG program should be required to be provably "profitable" to be considered a success).
After also accounting for the benefits to society of reduced involuntary unemployment (e.g., reductions in mental illness, crime, family breakdown, soup kitchen spending, safety net transfer payments, etc) such a program would look even more cost effective!
It would scale easily with the ever-changing size of the JG's buffer pool of workers. If the economy booms and the JG pool shrinks and there is no fiscal adjustment made by federal government to increase the pool (potentially needed if inflation were accelerating), then more of the waste stream will simply end up in the landfill or incinerator as is the practice today. Thus "zero" waste would be an exaggeration, but the waste reduction might still be large. Conversely, if the economy contracted and the JG pool of workers grew large, perhaps the sorting process could focus on reclaiming a much larger percentage of the waste stream, possibly even with extra time to break down and disassemble complex waste into component parts. What would the "typical" size of the JG pool of workers be? At least one MMT economist has suggested it might average around 3% of the work force.
Waste sorting and separation jobs would be easily filled by unskilled labor, consistent with the "hiring off the bottom" goal of the JG.
A job guarantee is widely recognized as setting a floor on economy-wide wages. However, it might also set a floor on conditions. Some commenters have expressed concern that having too many jobs viewed as "easy" in a JG (reading, tutoring, etc?) could be a problematic competitive force attracting workers from private sector jobs to the JG. An assumption in this thinking is that society relies on some industries in which the work can't be made "fun" and "easy" and while there should certainly be safe and humanitarian working conditions enforced, those industries' attempts to pay enough to retain workers might result in problematically large shifts in private sector wage structures, potentially raising the general price level by enough to force the nominal JG wage too far below a "living wage" to be politically acceptable. Thus, for better or worse, waste stream handling as a choice of JG program would be likely be seen by voters as not setting an overly "cushy" floor for work conditions.
Waste handling is a large enough problem that it might (?) be able to absorb ALL JG workers (even if that represents 3% or more of the work force).
Waste handling is a national and global problem so best practices could be shared widely across implementations.
Such a program might be able to piggy-back on some existing infrastructure.
Such a program might not be seen by voters as "make work" (see CETA-related quote here), and thus have higher political feasibility than some JG suggestions?

Here are some potential drawbacks:

There could be a large social stigma for JG workers handling society's waste in this way. But would it be worse than the social stigma of unemployment? And might society's notions of dignity be able to evolve? After all, one of nature's waste handlers, the scarab (a type of dung beetle), was considered sacred in Ancient Egypt...
Concerns may arise about the moral hazard for households and businesses in knowing that someone will "clean up after them." But with a national emphasis on good practices in sustainability, hopefully there could be ways to minimize this. And certainly manufacturers and such whose waste output is already regulated should continue to bear a higher responsibility (enforced by regulation) for minimizing their waste streams. (Often this process turns out to be profitable for them anyway.)
Such a program might not be "transitional" enough -- does it adequately prepare workers for transition to the private sector when a job becomes available? I don't know, and I'm not sure how favorably it would compare in this respect to other job types suggested for unskilled labor in JG programs.
Could the potential for unsanitary organic waste (dirty diapers!), sharp metal or glass, hazardous chemicals, etc make it too dangerous? Are there standards for hazmat suits and assistive tools and technology that would suffice? Even assuming so, there would need to be some sort of externally administered inspection process to ensure safe working conditions.
Could such work inherently lead to repetitive stress injuries? I'm not sure how highly repetitive such sorting tasks would be given the nature of a mixed waste stream -- it could include some interesting dis-assembly of a big variety of items (toys, electronics, furniture, etc) into their component pieces. Perhaps every certain number of hours would involve a shift in the "creative project" room designing and building the [mini-]pyramids for the 21st century and other art out of the waste not useable for other applications!
Separability of materials might be too difficult if organic waste can cause too much contamination... but this might be addressed with larger source separation initiatives (curbside food and garden waste containers) along with a willingness to send unrecoverable bags or clumps of trash to the landfill-bound conveyer.
Energy use for sorting, transportation, and reuse might be more of a limiting factor than the needed human labor. If getting the separated materials back into the industrial production stream in a useable form required too much energy, such a project might not be popular (at least until further strides are made in renewable energy). Of course, the organic waste stream may itself be an energy source given ongoing innovations in waste-to-energy technology.
Some new infrastructure (facilities and equipment) might be required. This could actually be beneficial to the economy if there was enough spare economic capacity to build and produce what was required within putting undesirable upward pressure on prices.

Aside from the drawbacks above and whatever else I've overlooked or gotten wrong, this almost seems too good to be true! What do you think?

To repeat, the high level aspiration outlined here is to "kill two birds with one stone" by matching the goal of reducing human labor waste (involuntary unemployment) with the goal of reducing other external costs currently borne by society. This post focused on the "other external costs" related to materials flow and associated environmental sustainability, but are there other large-scale external costs a JG could potentially address?

What are the lessons of CETA? (a 1973 US jobs program)

2012-01-13T14:15:00.006-05:00

Last May I ran into a reference to a jobs program started in 1973 called CETA (Comprehensive Employment and Training Act) that at its peak employed more than 700,000 people. At the time I searched the major MMT blogs as well as the papers I could find on Job Guarantee / Employer of Last Resort policy and implementations, and I didn't find any discussion of it. I posted comments asking about it on a couple major MMT blogs, but no one weighed in at the time. It occurred to me given the recent JG discussions to ask again, and a search in my feed reader hasn't uncovered any new references to it. (Disclaimer: my lack of results could be entirely my failure to search thoroughly enough.)

Overview from wikipedia: “a United States federal law enacted in 1973 to train workers and provide them with jobs in the public service… The program offered work to those with low incomes and the long term unemployed… The intent was to impart a marketable skill that would allow participants to move to an unsubsidized job. It was an extension of the Works Progress Administration program from the 1930s. The Act was intended to decentralize control of federally controlled job training programs, giving more power to the individual state governments.”

An opinion writer at politicsdaily that had came up in my quick search results said: “That was the crux of the policy dilemma: The voters did not want make-work and the unions did not want real work.” And, “CETA employees did perform useful work — from asbestos removal to assisting in libraries and senior citizen centers.” And, “Following the questionable gospel that state and local governments always know best, CETA programs were decentralized.” And, “But the problem with CETA was not that it embodied Big Government, but that it was not big enough.”

The program sounds like it shares a number of characteristics with the Job Guarantee as proposed by primary MMT authors, and it's more recent than the Great Depression work programs that people often mention in comments. So, what did it do right? What did it do wrong? What are the lessons learned? Why is it not being used as an example in these discussions, or mentioned by primary MMT authors? (Perhaps it has been and I've just missed it). Was it successful for its size (despite not being an unlimited offer of work positions at the policy wage, as proposed under a JG) but just not big enough to matter? Were there major unintended consequences that weren't addressed? Was it ultimately sabotaged on ideological grounds by free market fundamentalists? Did the voters and the unions reject it on the grounds quoted above? Anyone know or have useful links that I've overlooked?

UPDATE 1/15/2012: Corrected the first paragraph. It had falsely referenced Jimmy Carter as associated with the start of this program (either I mangled the notes I took a year ago or the original source I found was wrong -- I should have caught that presidential year mistake -- oops!)

Kaldor on Money Supply Endogeneity

2012-01-11T15:11:00.001-05:00

Some of my posts starting in October 2010 (the most recent one is here, with some conceptual graphics) have focused on the endogeneity of the money supply independent from the broad Post-Keynesian observation that loans create deposits. That is, the dynamism of the economy (largely courtesy of the financial sector) seemingly allows households and businesses on aggregate to self-determine their portfolio composition -- i.e., how much "money" they hold -- independent of both government policy and private debt levels.

Whether due to lack of familiarity or considered relative unimportance, there seems to be very little attention to this dynamic in the MMT-oriented econoblogosphere, even among the "primary" MMT bloggers when they discuss QE. If money supply endogeneity were only about loans creating deposits, then one should still expect to see QE changing broad money supply from whatever trend(s) it was already on, since QE isn't generally assumed to change people's propensity to borrow or their rate of deleveraging. Here are two updated charts of the MZM (Money Zero Maturity) measure of broad money supply:

Money supply did not grow as much as the QE operations alone would suggest. The actual trends are very volatile (probably having to do with uncertainty and liquidity preference during recession and expanding financial assets in line with a growing economy during economic growth) and so it's difficult to say anything conclusive other than that QE did not provide a 1-to-1 increase or obviously "shift" the trend lines while active.

Ramanan recently posted two great quotes from Nicholas Kaldor's The Scourge Of Monetarism (Oxford University Press, 1982). First, via Ramanan (emphasis mine):

"As it is, a highly developed banking system already provides such facilities on an ample scale, since it is prepared to accommodate the public’s changing demand between different types or financial assets by altering the composition of the banks’ assets or liabilities in a reverse direction. If the non-banking public wishes to switch its holding of gilts for interest-bearing bank deposits, the banks are ready to supply such deposits at the minimum of inconvenience, and at the same time to place their surplus funds into the gilts which were previously held by the public. Similarly the banks provide easy facilities to their customers for switching balances on current accounts into interest-bearing deposit accounts, or vice versa. Hence, while the annual increment in the total holding of financial assets of the private sector (considered as a whole) is nothing more than the mirror-image of the borrowing requirement of the public sector (in a closed economy at any rate), neither the Government nor the banks can determine how much of this increment will be held in the form of cash (meaning notes and current deposits) and how much in the near-equivalents to cash (such as interest-bearing demand deposits) or in various forms of public sector debt. Thus neither the Government nor the central bank can control how much or the total financial assets the public prefers to hold in the form of ‘money’ on one particular definition or another."

Kaldor certainly appears to have these concepts mastered (including financial sectoral balances) and this was 1982! It's amazing to me that virtually none of this could "rub off" onto the economics mainstream over a period of three decades! Ramanan quotes more interesting details from Kaldor in a second post (follow the link to read it).

This seems to me largely consistent with dynamics I've postulated. A copy and paste from my last post's summary of mechanisms:

Overview of Ways the Private Sector Can Reduce "Unwanted" Broad Money Supply:
Replace loans (which create money) with non-bank borrowing (which does not create money) independent of total debt levels. Examples of non-bank debt include corporate bonds, peer to peer loans, securitized loan pools, housing agency debt, etc. Most of this post focused on this mechanism.
Induce less bank lending by changing aggregated propensities to borrow. For example, many reports indicate a record number of cash buyers have been supporting the housing market. Logically, if there is an "excess" of deposits in the economy, then investors who would rather own other assets may outbid other potential buyers of those same assets who would have bought using debt. Thus, while QE's added money supply in this case doesn't eliminate existing bank loans, it serves to reduce the number of houses bought using bank loans, while at the same time other loans are continually being paid down. The net effect is that bank lending moves to a lower level than it would have been at had QE not occurred. Those who lost the bid for houses (who would otherwise have bought with a bank loan) might rent from the investors instead, so this point does not imply that QE will cause some to have no place to live.
Banks can sell assets (treasuries, loans, etc) to the rest of the private sector. A net decrease in assets in this way causes a net decrease in broad money supply. To see how this works, visit the Macroeconomic Balance Sheet Visualizer, and choose the operation "Bank Loan" followed by "Bank Loan is Securitized" (which is one way banks sell assets to the non-bank sector).
Banks can fund themselves with a higher portion of non-deposit liabilities (e.g., bonds) instead of deposit liabilities. This results in less broad money supply. As I understand it, this was part of the dynamic that RSJ described in this post.

I'm not sure whether I'm odd to find this stuff fascinating or whether my descriptions are not clear and/or don't seem credible (and I admit I still may have some things wrong!). It may just be that this is clearly less important than topics on "fixing" the economy's current primary problems. But I've considered putting together a mini step-by-step visualization on EconViz on this topic (when I can get to it) -- if anyone would find this beneficial in clarifying these interactions, please say so.

The US Becoming Japan... not in the way you may think!

2012-01-11T13:33:00.000-05:00

It has become common in recent years to suggest that the US is headed the way of Japan, with the implication being that Japan has been an economic failure in recent decades. (I starting expecting in the early 2000s that the US would follow Japan, also, but for some right and some wrong reasons). Last year and again today I've highlighted the huge degree to which Japan's economic performance is a story about demographics and the confusion about nominal versus real in the context of periodic mild deflation.

However, by failing to adequately support US economic growth (that is, incomes and employment) in the wake of the "Great Recession", policy makers may yet find a way to send us down Japan's path:

"A sharp decline in fertility rates in the United States that started in 2008 is closely linked to the souring of the economy that began about the same time, according to a new analysis of multiple economic and demographic data sources by the Pew Research Center." -- In a Down Economy, Fewer Births

and

U.S. population grows at slowest rate since 1940s

So, poor economic growth could become a self-fulfilling prophecy via the demographic channel itself!

Of course I'm exaggerating for effect. The drop off in US fertility rate (about a 7% fall from 2007 to 2010) is not yet anywhere near large enough to give the US a demographic outlook like Japan's... plus there are long lags in demographic effects, and other factors such as immigration rate. And according to Eamonn Fingleton the reasons for Japan's demographics are quite different:

"The story begins in the terrible winter of 1945-6, when, newly bereft of their empire, the Japanese nearly starved to death. With overseas expansion no longer an option, Japanese leaders determined as a top priority to cut the birthrate. Thereafter a culture of small families set in that has continued to the present day."

"Japan’s motivation is clear: food security. With only about one-third as much arable land per capita as China, Japan has long been the world’s largest net food importer. While the birth control policy is the primary cause of Japan’s aging demographics, the phenomenon also reflects improved health care and an increase of more than 20 years in life expectancy since 1950."

Nevertheless, if US policy makers were to sabotage the US economy further by actively imposing austerity, we might yet follow in Japan's economic path (or worse) but in a different way than typically suggested!

I should also note that I'm not suggesting that higher population growth rates are inherently better, just that they contribute to economic growth (for better or worse). I recognize the planet's finite resources are being strained, but I am also a mild optimistic regarding our ability to accelerate "radical resource productivity" with the right fixes to the political system and the current massive problems of externalized costs.

Myths about Japan's Stagnation Revisited

2012-01-11T00:53:00.001-05:00

Almost a year ago I posted two graphs and some comments on Real GDP Per Capita and Myths about Japan's Stagnation. I had realized that demographic factors and mild deflation played a different role than the conventional wisdom which held that they are each merely a factor in Japan's supposed "malaise". It turned out that demographics and the difference in real versus nominal growth entirely account for the illusion that Japan has suffered two lost decades. That is, real GDP per capita growth for the US and Japan since 1980 are remarkably similar, with one [longish] period of meaningful divergence. Here are the same graphs repeated from my post last year:

Annual Growth of Real GDP Per Capita in the US and Japan (1980-2009)

Annual Level (Indexed) of Real GDP Per Capita in the US and Japan (1980-2009)

Recently there has been some discussion among higher profile bloggers on this topic:

The Myth of Japan’s Failure by Eamonn Fingleton
Japan, Reconsidered by Paul Krugman
Japan's Lost Decade: All Too Real by Matthew Yglesias
Japan had one lost decade, but not two by Noahpinion
More On Japan (Wonkish) by Paul Krugman
The Japan Story by CEPR

Noahpinion may have read my previous post because he or she used my first graph above without changing the file name I had chosen.

I won't discuss all these posts in detail and there are points in each I disagree with.

However, Paul Krugman's second post contains a graph of Japan's Log Real GDP per working-age resident. I had myself been interested in the per-working-age-resident data as compared to the per-capita data, since changes in the participation rate (partly due to demographics) could cause the two to differ, but hadn't gone to the trouble of getting the data. Unfortunately Paul Krugman starts at 1990 rather than 1980 and so I'm not sure his conclusion tells the full story:

"This picture suggests that the Japanese economy was indeed depressed for about 16 years, and deeply so after the slump of the late 1990s. But it may have returned to more or less potential output on the eve of the current crisis."

Look at my second graph (above) and you can see the extraordinary growth in the late 1980s in Japan. Was this growth "above potential"? Was Japan somehow borrowing from the future in the 1980s, and are the Austrians correct that slower growth in the 1990s to undo the "excesses" and get back to the trend line must be an inevitable outcome? (I do think the answer is closer to "no" than "yes", but don't have all the answers for how/why).

Is the correct framing Krugman's, i.e., that Japan stagnated from 1990 onward and didn't return to the potential growth trend line for a decade and a half? Or is the more accurate framing that Japan's growth accelerated above trend line in the 1980s and took a decade to revert to the trend line? (In a mostly smooth fashion, excepting the unfortunate 1997-ish austerity, rather than a crash and depression!)

I believe MMT shows how the "hangover" theory of economic growth is wrong (as opposed to asset prices, which MMTers generally agree must be allowed to adjust after bubbles pop). This is because it is always possible for the flow of national income to be sustained by government deficits or net exports even if the leakage to private sector savings increases. Perhaps there was a massive inventory effect from overbuilding of real estate in the 1980s, requiring less building in the 1990s. Should that or other dynamics have pushed unemployment so low as to cause accelerating inflation? Glancing at some graphs it appears Japan's late 1980s unemployment got down to around 2%, with inflation rising to around 4%. What would have happened if the economy hadn't slowed after 1990? Would inflation have accelerated upwards uncontrollably? It doesn't seem obvious that it would, but I don't know the answers.

If not an "overbuilding" dynamic or a labor force participation dynamic (not yet investigated), then perhaps the majority of the late 1980s surge can be explained by a huge above-trend rise in productivity. If so, is there any implication that productivity will inevitably grow below trend after such a surge? It doesn't seem like such a reversion should be inevitable, but perhaps there are dynamics specific to the types of productivity improvements in Japan in that time frame that would provide more answers.

Comments and insight are welcome.

I'll split a few more observations on demographics into a separate post to keep this from getting too long.

New EconViz Blog & Survey Results

2011-11-22T14:01:00.001-05:00

Thanks to those of you who have tried out the preview draft version of the How the Economy Works Visual Tutorial and submitted feedback! (And thanks Tom for the extra traffic from your post).

I have created a dedicated blog for EconViz.org on which I'll announce major content and functionality updates to that site. Feel free to subscribe to the RSS Feed if you are interested in seeing what unfolds there and perhaps giving further feedback. So far there are two posts -- an introduction, and the results of the mini-survey I included at the end of the tutorial.

My goal is to keep up occasional posts on this blog on macroeconomics topics outside of concept visualization -- hopefully more frequent than they have been recently! But neither will be a high volume blog any time soon.

Public Service Announcement for Google Reader users: If like me you were driven crazy by the huge amount of wasted screen space in the "refresh" to Google Reader a few weeks ago, I recommend the Google Reader Demarginfier script (works with the Greasemonkey browser add-on).

Concept Visualization and Macroeconomics

2011-11-16T14:45:00.000-05:00

Across many theoretical subjects, it seems that much more effort has been spent on data visualization than on concept visualization. There are a number of good reasons for this, but I think concept visualization is still behind where it should be (at least in the educational material I've been exposed to).

Macroeconomics is a subject extremely well suited to conceptual visualization, yet the majority of the educational material on the web seems to be text-centered (other than supply-demand curves and the occasional simple diagram or balance sheet). While equations such as “GDP = C + I + G + ( X – M )” provide precision and rigor and aren't even mathematically complex, their inclusion in content (for example, blog posts) necessarily narrows the potential audience.

As most readers know, my first attempt at concept visualization for macroeconomics was the Macroeconomic Balance Sheet Visualizer. However, it did not appear to be as accessible to newcomers as I'd initially hoped. So I've been working on something intended for a broader audience.

Design goals include:

Anchor as much of the verbal content to visual representations as possible, to reduce ambiguity and help illustrate concepts
Be as concise as possible while covering the most important core concepts
Have the core content be beginner friendly, but have additional details available just a click away at each step along the path for those who want more
Use a web site rather than blog format, so the content can be evolved and improved in-place over time

While the content and illustrations are very far from complete (think of it as an evolving framework still in the rough draft stage), I think it's crossing a threshold where it could be worth having available to the public while work on it continues. (There's a chance I will take it offline again for a while if I get the impression it may do more harm than good in its current form).

My “to do” list is enormous for it... there is much much more that can be done graphically as well with better verbal coverage of concepts. It simply takes time... And you'll also have to excuse the amateurish graphics, for now.

That said, it's very useful to get feedback to help prioritize the “to do” list, plus you may have creative suggestions that aren't on my list! Also I hope you'll help keep me on track with direct and honest feedback (including negative reactions) if you think parts of it are heading in the wrong direction, or I've messed up or left out important things! If you do choose to try this new visualizer and respond, you can give anonymous feedback directly from a link at the bottom of each page in the tutorial, or you can post comments to this blog post, or email me.

And if you're just learning MMT and are short on time, you may want to just wait for a future improved version rather go through what's there now, since it's full of gaps and placeholders.

Here it is:

http://econviz.org/how-the-economy-works-visual-tutorial/

P.S. I do still have a good sized list of potential topics for this blog too, but have still been giving the EconViz stuff priority for the time being, so please excuse the silence.

Looking for a Volunteer

2011-08-25T14:20:00.001-04:00

As previously mentioned, I've been gradually working on a new MMT-inspired visual tutorial on how the economy works. (It is completely separate from the macroeconomic balance sheet visualizer). My hope has been that integrating an animated flow diagram alongside the verbal explanations would make the concepts accessible to a broader audience than those willing to read and digest a typical MMT blog post.

I have a partial "proof of concept" working, though it's still too rough, ugly, and incomplete to release into the public wilds of the internet.

I would value high level directional feedback on what is working well and what isn't. Please email me privately if you'd be willing to take a look and give feedback. It could be especially helpful if you are either:

someone who has experience attempting to explain MMT to others, or
someone who is learning MMT and still trying to get up to speed on the core concepts.

Thanks!

A Visual Guide to Endogenous Money and the Failure of QE

2011-06-22T16:37:00.004-04:00

I've wanted to do a more comprehensive post on the dynamics of endogenous money and the private sector's response to large exogenous events such as quantitative easing, but for now this post will be another incremental update to my previous posts on the topic from October and April. As stated previously, it's possible I've reached some incorrect conclusions, however my interpretation of a piece of Post-Keynesian Circuitist literature I was referred to suggests to me that these ideas are on the right track.

Basic QE Mechanics

Some people have read that the direct mechanics of Quantitative Easing only increase bank reserves but not deposits (broad money supply). That is true only in the narrow case where banks are net sellers of bonds from their own balance sheets to the Federal Reserve. But the evidence suggests banks have not drawn down their net bond assets in this way since QE began (the Fed has bought over $2 trillion in bonds!), and that the primary sellers are non-banks. To see why the immediate mechanical result of this is for QE to increase bank deposits (and thus broad money supply), please visit the Macroeconomic Balance Sheet Visualizer and run the operation "Quantitative Easing (Variation 1 - Households Sell)". Also, see this guide from the NY Fed:

"When the Fed buys an asset, the effect on the broad money supply depends on who sold the assets and what they do with the funds they receive. If the seller is a bank, reserves go up, but broad money only increases if the bank responds to the increase in its reserves by lending more to households and businesses. If the seller is an investor other than a bank, reserves go up, and broad money also goes up in the first instance as the seller's bank puts a sum equal to the amount it receives from the Fed into the seller's bank account. But if the seller uses the money to pay down debt, the broad money supply declines again by the amount of the debt repayment. As of early 2011, the behavior of the broad money supply, economic activity and inflation all suggested that recent money growth had not been excessive."

The guide mentions the well known idea that the broad money supply increase resulting from QE has been muted due to debt repayment, but as my past posts have indicated, I think that's only half the story.

Actual Broad Money Supply Changes During QE

The first graph shows broad money supply as measured by MZM (Money Zero Maturity), the second graph shows the year on year change.

It's not obvious that either QE program had a direct impact on the broad money supply trends, even though they should have if you consider only the direct mechanical results of the Fed buying bonds, and don't consider any private sector response! Of course it is difficult to tell for sure, as the money supply changes for lots of reasons besides just QE (e.g., it generally expands during economic growth, but perhaps also during times of uncertainty).

So where did part of the roughly $2 trillion in "money" that replaced bonds go? Did it only "disappear" to the extent that the private sector wanted to pay down debt? I've argued that it disappeared INDEPENDENTLY of whatever level of desire there was to pay down debt, and that the money supply growth that did occur would have occurred to almost the EXACT SAME DEGREE even if QE had not happened. In other words, money supply grew because the private sector "wanted" a larger money supply as part of its aggregated portfolio preferences.

A Visual Guide to Money Supply Endogeneity

First, consider the general situation in which bank loans expand the broad money supply. The "Bank Loans" and "Bank Credit" bars are the same size by identity because loans create deposits:

Next, consider what happens during Quantitative Easing in terms of the immediate mechanical result. Broad money supply expands, "backed" by an increase in excess reserves held by the banking system:

The private sector controls all quantities with white labels. Excess reserves, with a yellow label, is the only quantity here fully controlled by government! The light yellow label on Required Reserves indicates partial control. Banks lend first and look for needed reserves later, and the Federal Reserve's open market operations ensure that reserves sufficient to meet reserve requirements will automatically become available (either as a result of the Fed buying/selling treasuries as part of OMO, or via loans from the Fed). So the quantity of Required Reserves adjusts in response to changes in the quantity of Bank Loans, and the government only controls the size of Required Reserves if it changes the rules.

Lastly, consider how the private sector can work to "undo" the change in money supply imposed by QE, without having to alter its borrowing desires!

One of the reasons bank loans can be replaced by other forms of borrowing (perhaps with a lag?) is that when you look inside the aggregates, the economy is very dynamic under the surface. There are always some households and companies borrowing new money, others making debt repayments and others completely paying off debt.

Some bank loans may be repaid early and replaced by non-bank borrowing, but in general there is always new borrowing being done, even when the big picture is one of deleveraging.

When there is "excess" money and investors would rather hold bond assets, those investors will likely outbid banks in the contest to fund new borrowing needs. That is how the mix of bank debt versus non-bank debt can be affected. Even unconventional borrowing markets may play a part in this, such as "peer-to-peer" lending (going to family and friends for a loan instead of to the local bank). Another example of non-bank borrowing is new corporate equity issuance — perhaps angel investors and the like are outbidding banks on meeting funding needs, too.

Overview of Ways the Private Sector Can Reduce "Unwanted" Broad Money Supply:

Replace loans (which create money) with non-bank borrowing (which does not create money) independent of total debt levels. Examples of non-bank debt include corporate bonds, peer to peer loans, securitized loan pools, housing agency debt, etc. Most of this post focused on this mechanism.
Induce less bank lending by changing aggregated propensities to borrow. For example, many reports indicate a record number of cash buyers have been supporting the housing market. Logically, if there is an "excess" of deposits in the economy, then investors who would rather own other assets may outbid other potential buyers of those same assets who would have bought using debt. Thus, while QE's added money supply in this case doesn't eliminate existing bank loans, it serves to reduce the number of houses bought using bank loans, while at the same time other loans are continually being paid down. The net effect is that bank lending moves to a lower level than it would have been at had QE not occurred. Those who lost the bid for houses (who would otherwise have bought with a bank loan) might rent from the investors instead, so this point does not imply that QE will cause some to have no place to live.
Banks can sell assets (treasuries, loans, etc) to the rest of the private sector. A net decrease in assets in this way causes a net decrease in broad money supply. To see how this works, visit the Macroeconomic Balance Sheet Visualizer, and choose the operation "Bank Loan" followed by "Bank Loan is Securitized" (which is one way banks sell assets to the non-bank sector).
Banks can fund themselves with a higher portion of non-deposit liabilities (e.g., bonds) instead of deposit liabilities. This results in less broad money supply. As I understand it, this was part of the dynamic that RSJ described in this post.

Implications

Why does this matter? To the extent that these dynamics really occur as described in my three posts so far:

This shows in even stronger terms why Quantitative Easing as practiced so far (targeting quantities rather than prices) has had no meaningful effect other than on sentiment. QE truly was a placebo.
It lends even more power to the concept that money is always debt and can NOT be modeled like a commodity. Its quantity is extremely dynamic and subject to the portfolio desires of the private sector. IS/LM curves and the like are not relevant. One of the arguments by the Fed was that QE would increase deposits in portfolios relative to the supply of available bonds and provide a bid under other assets due to "formulaic" institutional portfolio investing, but the premise of persistently expanded money supply and reduced longer duration assets appears to be false.
It lends even more weight to the idea (frequently argued by MMTers) that interest rates are determined independently of borrowing demand, and thus that there can be no financial crowding out of the private sector when the government issues debt! Economy-wide interest rates truly are anchored to the short term Fed Funds rate plus expectations of future rate settings. (Not that the market can always consistently estimate future rate settings!)
Conventional wisdom is that one goal of QE was to help the banking system. Ironically, QE may have hurt banks more than it helped them! The banking system seems to operate as a private sector lender of last resort, and by triggering a shift to additional direct (non-bank) lending, QE seems to have reduced the role of banks in the economy, and thus reduced their potential to accrue earnings from loans!

UPDATE 6/23/2011: Made a few minor edits for clarity, and added Implication #4. Also, here are the two previous related posts:

Some Thoughts on US Economic Growth

2011-06-22T12:11:00.003-04:00

Here is an updated chart from a previous post (Real GDP Growth in the US and Japan: A Closer Look at Consumption, Government Spending, Net Exports, Investment, and Inventories).

US: Contributions to Percent Change in Real Growth Domestic Product (2005/Q1 - 2011/Q1)

(click to enlarge)

Note that 2010-2011(Q1) does not look all that different from 2005-2007!

I don't know where to from here. I think a "double dip" is very possible but if I had to guess, I don't think a new recession is the most probable scenario in the near term. But that depends on difficult factors to predict such as whether current US congressional antics really are only short term theater as many allege, and the potential size of negative demand shocks from the rest of the world (China, Europe, other various housing bubble countries like Australia and Canada, etc).

I believe a common mistake is to consider high oil prices to be one of the drags on growth. Rising oil prices are certainly a drag on growth, but stable oil prices (once lagged effects of previous changes have dissipated) are growth neutral, as I understand it. Even the generally excellent Calculated Risk might have gotten this wrong in a recent outlook post where he says "Also the recent decline in oil and gasoline prices will help, although $100 oil is still a drag on the economy." However he could be correct if he considers a drag on the economy to be a separate phenomenon from a drag on economic growth. (If you think I'm the one who's gotten this wrong, please let me know!)

Similarly, deleveraging is not a drag on growth unless the rate of deleveraging increases. Deleveraging is just one determinant of the household savings rate. A stable household savings rate is growth-neutral. However, deleveraging does reduce the likelihood of a falling savings rate and the associated boost to GDP growth that such a shift would provide. So in terms of current economic growth (i.e., ignoring impacts on future growth), steady-state deleveraging is the absence of a positive rather than an actual negative.

Note that this post only focused on GDP growth... clearly we still have crisis levels of unemployment and underemployment that policy makers should be actively working to address!

Further Evidence that the Private Sector Fully Controls the Money Supply and QE Doesn't "Work" as Advertised

2011-04-21T18:03:00.001-04:00

In October, I wrote a post titled How the Loan/Bond Choice Helps the Private Sector Self-Determine the Money Supply — AND Yet Another Reason QE is a Non-Event for the Economy. To give a brief summary, it described my thoughts on the inter-relational dynamics between debt, money supply, and Quantitative Easing, as follows:

There are two high level ways that borrowing occurs in the private sector — bank loans, and all other forms of borrowing, i.e., bond issuance, securitization, peer to peer lending, etc.
When there is an "excess" of short duration assets (primarily money) held by the private sector, the holders of those assets will be eager to lend it out, and thus acquire a higher yielding asset. The money supply remains unchanged.
When there is no "excess" of money to lend (i.e., portfolio preferences are satisfied with the current levels), then banks will have a higher propensity than non-bank lenders to fulfill the economy's current borrowing needs, because they can lend an [almost] unlimited amount, independent of their level of money/reserves. (Their only limit on lending to worthy borrowers, and it is temporary, is how much equity capital they can raise). Bank lending increases the money supply, so from a macro perspective, banks could be considered the private sector's lender of last resort.
By choosing the relative proportion of the two type of borrowing, the private sector is able to choose its portfolio mix of long duration assets and short duration assets (money), independently of the actions of the federal government, and [mostly] independently from the desired level of private sector borrowing!
When the Federal Reserve conducts Quantitative Easing, it buys long duration assets (treasury bonds, etc) out of the private sector, and gives the private sector short duration assets (money balances) instead.
If the private sector is not happy with this new portfolio mix resulting from QE, it likely has the power to "undo" the change over time via shifts in the proportion of bank loans versus other types of lending that it uses!

If the balance sheet impacts of bank lending, non-bank lending, and quantitative easing are not familiar to you, please play with the Macroeconomic Balance Sheet Visualizer — it is a graphical web-based tool, now with a step-by-step walk through mode.

Possible Evidence from a Post-Keynesian Expert that this Theory may be Correct

In the comments of my previous post, commenter Ramanan helpfully linked to a PDF from Marc Lavoie, one of the leading Circuitists. Circuitists (also known as horizontalists) are one "school" of theory within Post-Keynesian economics, and they share most of the same concepts as Modern Monetary Theorists. In section 9.3.1, Lavoie seems to describe the same dynamic that I have attempted to describe. Here is an excerpt:

"...for apparently the demand for money and the supply of credit are determined by two independent mechanisms. In the Lavoie and Godley (2001-2002) model for instance, the demand for credit, at the end of the period, depends on the part of investment expenditures which has not been financed by retained earnings and new equity issues..."

"...the decision by households to hold on to more or less money balances has an equivalent compensatory impact on the loans that remain outstanding on the production side."

While Lavoie only mentions "equity issues", I have seen evidence elsewhere that he uses that term as shorthand to describe any non-bank borrowing mechanism employed by a firm, i.e., his reference to "equity issues" is supposed to also encompass bond issues and some other types of liabilities.

For reasons that are unclear to me, some MMT authors repeatedly claim that QE does not add to the broad money supply. While it is true that if the primary dealers sell their own treasuries to the Fed, then only base money supply is affected, this scenario is too limited given the size of QE to date. As I understand it, primary dealers frequently act as an intermediaries to facilitate QE buying assets from the larger private sector. But if the private sector can react relatively quickly enough via the mechanisms described here to "undo" the money supply changes, then the money supply data won't show any bulge in broad money supply resulting from QE! (And of course there are other factors impacting the money supply at the same time, primarily a desired deleveraging within the private sector, so it is probably not possible to disentangle these different dynamics when looking at the data.)

Evidence in the Recent Data for the QE in the United States

In the last post on this topic, I showed a graph of Japan's bank and non-bank borrowing. While inconclusive, it suggests that Japan's Quantitative Easing from 2001-2006 may have caused a relative decrease in bank-based borrowing as compared to non-bank borrowing, which could add to evidence of the theories above.

Below is a graph of US borrowing from Q2 2004 to Q1 2011.

Effects of US Quantitative Easing on Bank Lending Compared to Total Borrowing:

(click to enlarge)

The red line shows the annualized percentage change in bank loans and leases, by quarter. The green line shows the annualized percentage change in total private sector debt (from the Z.1 report, which is not yet available for Q1 2011). The blue line shows the annualized percentage change in non-financial private sector debt (since the private sector's debt has many layers that could overwhelm the other trends, I thought it worth separating financials out.) I have not subtracted bank loans out of the total debt data, so the shape of the blue and green lines is slightly impacted by the shape of the red line (though the absolute amount of bank debt is around $7 trillion versus around $41 trillion for total private sector debt, so crossover impact is not huge).

Notice how bank loans declined substantially faster than total debt after the first round of Quantitative Easing started! The gap between the red line and the blue line is probably the most relevant. Despite tracking closely to each other until late 2008, they diverged significantly starting in 2009, perhaps as the private sector favored non-bank lending on a relative basis over bank lending, in order to "shed" the excess money supply imposed by quantitative easing!

The second round of quantitative easing is smaller in magnitude, and the data so far only covers the start of QE2. However, in Q4 2010 the gap between the red and blue lines appears to begin widening again. Will that effect continue? I would guess so, but I could ultimately prove to be wrong.

It is also not clear how big the lag effects in this process are. Also, the changes in bank loans versus total debt diverged most significantly in the middle of QE1, and the gap narrowed partially before QE1 ended. It could be that other dynamics that I am unaware of provide a more accurate explanation than what I suggest here.

Anecdotal Evidence

While it's far from scientific or conclusive, and I don't follow the details of specific financial markets, I occasionally see anecdotal evidence of the private sector's increased eagerness for non-bank lending. For example:

Junk Borrowers Turn Tables on Investors With Looser Terms: Credit Markets: "...debt sold this week included a condition that allows the company to call 10 percent of the bonds at 103 cents on the dollar in each of the first four years... [The borrower] is trying to lock in low interest rates while getting the flexibility to repay debt any time, as it would with a loan..."
Subprime Bonds Are Back
[Maybe] recent increases in venture capital activity? (If true, it would be an example of equity issuance rather than bond issuance, but with a similar macroeconomic effect.)

PostScript / Technical Note

In generating the chart in this post, I discovered the importance of using the percent change bank loan data as prepared by the Federal Reserve in its H.8 release whenever possible, instead of starting with the absolute levels of loans. The latter's level jumps around too much due to balance sheet consolidations, acquisitions, etc, while the percent change data appears to be adjusted to remove this effect, if I am understanding it correctly. Details are on the about page and notes page.

Real GDP Per Capita and Myths about Japan's Stagnation

2011-04-12T14:15:00.008-04:00

While addressing some myths about Japan, Bill Mitchell posted some graphs of contributions to real GDP. His graphs cover the same data I graphed last August -- the contributions of Consumption, Investment, Government Spending, and Net Exports toward inflation-adjusted economic growth. (A minor difference is I separated Inventories and other Investment in my graphs). Bill also usefully added in Ireland while emphasizing the negative effects of austerity on growth. Visuals such as these make it obvious that investment falls under austerity -- it doesn't rise on a supposed swell of increased business confidence that austerity proponents often claim will be triggered!

While I've been guilty of parroting some myths on Japan myself in years past, it has been enlightening to put more effort into reviewing the data for myself. Here is a graph I have been meaning to post for quite a while:

Annual Growth of Real GDP Per Capita in the US and Japan (1980-2009)

The blue line is for Japan, the red line for the US. It is quite astonishing how close in both magnitude and direction US and Japanese growth have been, when adjusted for population changes! The main divergences are Japan's burst of higher growth in the late 1980s, and its austerity-driven recession in the late 1990s. Once you adjust real GDP growth for changes in population, what you are left with is largely productivity growth. There are other factors that affect the level of GDP (and important things like employment!) but they have less effect on year-on-year growth rates once the adjustment has occurred.

Japan's famous deleveraging primarily meant a higher savings rate than before the deleveraging (corporate rather than household, in Japan's case), with the main effect being a one time shift downward in GDP level (but not growth). After the GDP shift caused by a savings rate shift, future and ongoing GDP growth is impacted by other factors such as whether aggregate demand is sufficient to bring growth back near potential growth, but Japan may have been a success story in this area! However, its success in achieving this real per-capita GDP growth may have been more a result of the falling household savings rate over the last couple decades than of government fiscal (or monetary!) policy.

Japan's stagnation myths (some people blame too much government spending, others too little!) derive in part from two sources of confusion -- real growth versus nominal growth (Japan has a low and sometimes negative rate of inflation) and GDP growth versus per capita GDP growth (Japan has a low-to-negative population growth trend).

Of course, real GDP growth (absolute rather than per-capita) does affect valuations of financial markets and real estate, since those valuations rely on the size of future earnings streams. Japan's asset markets have famously failed to "recover." To the extent that other nations follow in Japan's demographic footsteps, there will be some downside surprises in asset market returns in the medium to long term for many advanced nations...

UPDATE (same day):

To supplement the year-on-year growth chart above, here is a graph of the actual levels of per capita real GDP indexed for Japan and the US. Japan's surging growth in the late 1980s that accompanied its stock market and real estate bubbles did put it above the US trend, but the levels converge again before year 2000.

UPDATE 5/23/2011: After reading a post by Bill Mitchell today that appeared to contradict the findings in this post, I initially wondered whether I had erred by using the FRED2 data for Japan in which the real per capita GDP data is converted to 2009 US dollars at purchasing power parity. (i.e., perhaps this incorporated exchange rate effects as well.) However, today I extracted the appropriate source data from Japan's cabinet office and generated my own graph using yen-denominated values, and the trend line is identical to the FRED2 data I used. In other words, the trend lines for per capita GDP growth for the US as measured in dollars and Japan as measured in yen still are remarkably consistent with each other, just as this post initially showed. The main divergences in the two trends are in the time periods of roughly 1987-1990 and 1997-2000.

It turns out (based on my own graphs from the source data) that Bill seems to have accidentally switched the labels on the two lines in his second graph, so his nominal and real GDP per capita lines for Japan are reversed.

Nonfinancial Corporate Earnings: Could They Keep Falling Until the Economy Passes Through Another Recession?

2011-03-30T14:58:00.001-04:00

While I ponder aloud whether this is a healthy stock market for investors (as opposed to momentum traders), this will be my second post on the topic, following the last post that graphed long term trends in earnings.

I tend to avoid analyses that take the form of "whenever A happened in the last B years, then C occurred at least D percent of the time." Much of the time this indicates data mining to validate a favored conclusion, whether bullish or bearish. While this post risks getting closer to that territory than I'd like, I'm going to avoid actually calculating percentages and such and keep it vague and qualitative! I have no clear conclusions, I simply found the data interesting.

Here is a graph of nonfinancial corporate business profits after tax (NFCPATAX) and financial corporate business profits after tax (CP minus NFCPATAX) from the national accounts data, generated via FRED2.

Nonfinancial profits (the blue line) fell a nontrivial amount in Q4 2010. Have they peaked for this expansion? Or was there a special one-time event (such as an expiration of tax-friendly legislation) that explains it?
Look at the historical pattern of past occurrences of nonfinancial profits first starting to fall. If the drop was nontrivial in size, nominal nonfinancial profits continued to fall and only reversed course once a recession had occurred and was reaching its end! This process seemingly can take several years to occur (e.g., especially in the late 1990s).
The most obvious exception to the pattern is in the mid 1980s — a large drop in earnings was later followed by resumed earnings growth, with no recession.
Financial profits (the red line) in the period leading up to and through recessions have acted quite differently than nonfinancial profits. In the 1991 and 2001 recessions in particular, financial profits kept growing, largely unfazed by recession! This perhaps had a lot due to with the rapid growth in household debt as well as the steeper yield curve due to the Fed lowering rates.

Here is the same data ending in 1992, so that the vertical scale for the earlier years is more visible:

The pattern of nonfinancial profits peaking in nominal terms months or years before recession occurs seems similar but less pronounced than in the later periods. Note that I am intentionally graphing nominal profits in all cases, rather than a ratio such as to GDP. This is because stock prices are likely more sensitive to nominal profits than profits ratios.

A natural question for an investor would be, what are the implications for stock prices?

Here is a graph of nonfinancial corporate profits and the value of the S&P 500 index:

Does the point at which nonfinancial earnings peak represent an "overvalued" stock market price, given that recession often follows within a few years? It appears that in many cases, the stock market continued to rise after earnings peaked, and the eventual stock market low during recession wasn't always lower than the stock price had been at the time of that prior peak in earnings. Thus, waiting to buy stocks wouldn't necessarily have provided a lower entry point in the future. There are of course exceptions, for example the most recent recession taking stock prices well below their price at the time of the prior peak in nonfinancial earnings.

I can suggest no insights from this data regarding the eventual impact on stock prices even if the current contraction in nonfinancial earnings continues. The future direction of financial sector earnings may turn out to be a key determinant of the outcome. Plus, as is well known, valuation multiples expand and contract independently from changes in earnings.

Here is the same data repeated but only up to 1992, so the vertical scale for the earlier years is more clear:

Stock Market Earnings Trends: What Happens This Decade?

2011-03-24T14:11:00.002-04:00

What is the outlook for US stock market returns over the coming decade? There is no shortage of commentary on this topic, and I don't have any unique answers, but I thought I would share two graphs.

A lot of market commentary suggests the stock market is overvalued on the basis of measures such as stock market capitalization to GDP, Shiller's CAPE (10 Year Average Inflation-Adjusted PE ratio), Tobin's Q, etc. But for any elevated ratio, a reversion to the mean can occur via a combination of falling numerator and/or rising denominator. For example, GDP could grow rapidly while stock market valuation grows slowly, allowing the ratio of market cap to GDP to mean revert without a fall in earnings and stock prices. But how likely is the numerator to fall? That is what would most concern a medium to long term investor.

One prediction in particular that caught my attention was Robert Shiller's suggestion that the S&P 500 will be around 1430 in the year 2020. With the S&P 500 currently around 1300, that represents roughly a 10% total increase (not annual!) over a decade. Robert Shiller is known for recognizing both the dot-com bubble and housing bubble long before most people, so he is worth listening to.

Here is a chart of trailing 12 month reported earnings created from Shiller's spreadsheet, from 1871 through Q3 2010:

The green exponential trend line shows the long term earnings trend. Current earnings have rebounded quickly to well above the trend line. If earnings oscillate around this trend line as they have done historically, they should be centered around roughly $60 in 2020! At a 15 valuation multiple, that only represents an S&P 500 index value of 900 (a 31% decline!) However, this trend is for real (inflation adjusted) earnings, so the nominal level of earnings and corresponding S&P 500 valuation would be somewhat higher assuming continued positive inflation.

But what about the most optimistic case from the perspective of the stock market? What if we are in a sustainable new era in which the recent extraordinary corporate margins, earnings to GDP, etc, can be maintained indefinitely? The next graph shows the same trend line since 1980 but for nominal reported earnings. The red portion of the line is the estimated forward earnings from Standard & Poors S&P500 spreadsheet as of today, which is important because expected earnings represent what the market valuation is currently priced for, i.e., earnings of $90-$95.

This trend line shows the nominal earnings trend reaching the $90-$95 level around 2020. So current earnings and forward estimates are ten years ahead of "schedule"! This second graph seems to align with Shiller's suggestion of an S&P index of 1430 in 2020 (with a 15 valuation multiple, earnings would be $95).

The key question for a stock market investor is what happens to that earnings line over the next decade: does it remain above trend line (not impossible, if you look at the late 1990s period), does it crater again as in 2008-2009, or does something else occur?

This graph shows the extent to which nominal earnings can fall: a 35% fall from 1989-1991, a 54% fall from 2000-2001, and a 92% fall from 2007-2009 . So history shows that a falling numerator is not uncommon, i.e., reversion to mean not exclusively driven by a rising denominator. If falling earnings is a reasonably probable scenario, the next question is, when? With labor cost pressures low and held down by high unemployment, and rising commodities costs representing a possibly more manageable percentage of most cost structures, is a contraction in GDP the only thing that could meaningfully reduce earnings?

Comments are welcome.

Updated Macroeconomic Balance Sheet Visualizer

2011-02-17T15:38:00.000-05:00

Around a year ago, I wrote a blog post about the draft copy of the macroeconomic balance sheet visualizer I had set up, and got some useful feedback (thanks!) At the time, I said:

"If you are learning this like me, I recommend you skip this until an updated version is ready, otherwise you could be unnecessarily misled or confused. I will post another blog entry when a more polished version is ready — both more accurate, and with added features, usability, more accessible step-by-step walkthrough, etc."

Since then, various knowledgeable folks have looked at it, and to the best of my knowledge what's there is correct. (I know the text descriptions still have room for improvement and better precision, which will come over time, but hopefully any issues are minor — let me know if that's not true!)

In the last few weeks especially (apologies for the full year it's taken!), I've made some batches of updates, including:

Layout improvements.
A "Replay Operation" button.
Mouse-over text descriptions for each asset, liability, and equity block (e.g., reserves balances of the banking system).
Step-by-step walk-through mode to give visitors who are at a loss for how to start a concrete way to be led through each operation in turn. (And it avoids the "Invalid Operation" message that you get if current balance sheet states don't support a particular operation.)

So if you heeded my warning and held off before, please give the tool a try now and see if it helps you:

Macroeconomic Balance Sheet Visualizer

While I still have a few ideas to work on and improvements to make (especially for the walk-through mode), if you have concrete suggestions for how the visualizer might be further improved, I'd love to hear from you in comments!

I am also still occasionally working on the macroeconomic flow visualizer that I hope will be comprehensible to a wider audience, but my time and progress on it to date have been much less than I'd hoped. So, more on that later, maybe.

How the Loan/Bond Choice Helps the Private Sector Self-Determine the Money Supply — AND Yet Another Reason QE is a Non-Event for the Economy

2010-10-27T16:49:00.008-04:00

NOTE: Just to be clear, this post does not describe any established theory. It was intended as a thought exercise to elicit feedback (with no results so far). What it describes may or may not be accurate — it does seem logical to me, but I am not an expert on the banking system.

UPDATE 11/11/2010: Thanks to commenter Ramanan for pointing out that the concepts in this post overlap to some degree with existing Post Keynesian / Circuitist work, such as by Marc Lavoie.

UPDATE 4/28/2011: If you read this post and are interested in further details including a graph of QE's impact on bank versus non-bank lending in the US, please also read this more recent post.

Two fundamental types of lending enable the private sector to borrow money. The first type is bank loans, which "create money". The second type is other lending in all its forms, in which a lender (typically not a bank) lends existing money to a borrower. Sometimes loans of existing money are directly between two entities, for example a household buying a bond issued by a corporation. Other times they go through a lending intermediary that pools together loans, for example securitized loan pools sold to investors, or Fannie Mae and Freddie Mac with their mortgage assets and "agency debt" liabilities. There is even a fledgling peer-to-peer lending industry that can involve either direct person-to-person loans or intermediary loan pools.

This post will explain how an economy with both forms of lending on offer allows the private sector to partially self-determine the broad money supply (i.e., according to its preference for holding liquid short-duration assets), semi-independently of the amount of private borrowing it desires. I have never seen this idea explained elsewhere before, so please comment below if you have seen it addressed elsewhere, or if you think my logic is incorrect.

One important conclusion of this is observation is that if the government attempts to force the private sector on aggregate to hold a larger quantity of money (short duration assets) than the private sector wants, then the private sector, given enough time, will counter the government's action by shifting from bank loans to non-bank loans (e.g., bonds), thus eliminating the increase in the money supply. Conversely, if the government offers insufficient short duration assets, the private sector will tend to favor bank loans (with their associated money creation) over non-bank loans, until the money supply increases enough to satisfy the private sector's liquidity desires.

However, this conclusion only holds to the extent that bank loans and other debt such as bonds can be used interchangeably to fulfill the needs of prospective borrowers. Clearly this is not entirely true, and substitutability between the two types may be limited by regulations, refinance cost frictions, or other factors. For example, investors may take some time to trust securitized loan pools again, and households can only borrow from banks, they can't issue bonds! (Though if peer-to-peer lending were to grow sufficiently, this limitation might be overcome...)

This conclusion also has implications for what to expect from quantitative easing. QE is nothing more than an asset swap that replaces long duration assets held by the private sector with new short duration assets (issued by the central bank). Modern Monetary Theory (MMT) authors have been saying this for years, and Paul Krugman has finally figured it out too. So, given enough time after quantitative easing and small enough frictions and impediments between the two types of lending, we should expect to see a relative reduction in bank lending (via money creation), and relative increase in other forms of lending (without money creation) as the private sector tries to eliminate its excess short duration assets ("money") by shifting into longer duration assets (e.g., newly issued bonds).

Thus yet another reason QE is a non-event for the real economy! Other authors have already shown that it will not cause any increase in bank lending (the money multiplier is a myth for today's currency systems!) But will QE even reduce long term interest rates? There is little evidence that it will. Long term rates rose during the Bank of England's recent QE program. James Hamilton, a frequently linked to traditional economics professor, summarizes estimates of the effects of Fed's QE at less than a 20 basis point reduction in long term yields, a trivially small amount that may also represent coincidence.

In fact, an implication of the theory explained above is that QE could actually accelerate the shrinking of banks' loan books, and aside from fee income from banks facilitating other types of bond-like lending, banks could actually be hurt by QE via the loss of expected loan income as loans are packaged into securities for yield-hungry investors or refinanced into bonds.

Japan's Experience

Does history show any evidence of this effect? Japan first experimented with a form of quantitative easing from 2001-2006. Here is a graph showing two types of liabilities summed up for Japan's private sector — loans and "securities other than shares" (which I am assuming are largely longer-duration liabilities such as bonds, but I am no expert on Japan's national accounts data and could be wrong on this).

(click on graph for a larger version)

Funding via "securities other than shares" (bonds, etc?) (red line) jumped to positive growth during the QE period, even amidst ongoing contraction in bank loans (blue line). If deleveraging was ongoing, absent other factors, shouldn't it have been ongoing in both categories? It seems this data might lend some support for the idea that a forced increase in money might be counteracted by the private sector favoring bond-like lending over bank loans to reduce the balance of unwanted money in the system.

Technical Explanation of the Trade-off Between Bank Loans And Non-Bank Lending

First let's look at the difference between a bank loan and other forms of lending, then at how interest rates are determined. The following images are snapshots from a slightly edited (for demonstration purposes) copy of my Macroeconomic Balance Sheet Visualizer. You can try the "Bank Loan" and "Private Bond Issued" operations there yourself, as well as the "Bank Loan Is Securitized" operation (not shown here).

Bank Loan — Balance Sheets Before Lending Occurs:
(the "Households" balance sheet below represents the borrower)

Bank Loan — Balance Sheets After Lending Occurs:

Private Bond — Balance Sheets Before Lending Occurs:

Private Bond — Balance Sheets After Lending Occurs:

Discussion of Balance Sheet Change Details:

As you can see, loans create deposits (this is widely misunderstood, as people assume that banks lend out reserves, which is not true). Because of the way the central bank ensures sufficient reserves in the system to satisfy reserve ratios (though these ratios don't even exist in many countries), the only limitation to bank lending is finding enough credit-worthy borrowers and meeting capital ratio requirements. The capital requirements dictate how much balance sheet equity a bank must have relative to its loan assets, since such equity is a "cushion" for absorbing losses. Banks can generally raise more capital as needed if there are worthy borrowers, so this is no limitation either beyond the very short term.

Comparing bank loans versus other bond-like lending:

In both cases, the borrower's balance sheet adds a new short duration asset (money) and a new long term liability (loan or bond).
In both cases, the lender's balance sheet adds a new long duration asset (loan or bond).
For a non-bank lender, adding the long duration asset requires giving up a short duration asset (money).
For a bank lender, adding the long duration asset requires adding a short duration liability (bank deposits, which are money for the depositor).
In both cases, total private sector debt is increased.
Only in the case of bank lending is the broad money supply increased.

So the KEY difference from a lender perspective is that bank lending requires accepting a new short duration liability, while non-bank lending requires giving up a short duration asset.

What interest rates would banks offer on loans compared to rates offered by non-bank lenders? In both cases, interest rates have to be sufficient to cover credit risks (i.e., the risk of borrowers defaulting on their debt) and inflation and interest rate risks. On top of this, a bank lender has to price in the ongoing cost of the new liability (paying interest to the depositor), while the non-bank lender has to price in the opportunity cost of the foregone short duration asset (money). At any given point in time, both these costs will be the same, since both the liability and the foregone asset pay interest at the current deposit rate on offer by banks. So, based on these factors alone, bank lenders and non-lenders should offer comparable interest rates to borrowers at any given point in time.

So which would "win" in lending to prospective borrowers? At times when there is a surplus of short duration assets (bank deposits) in the system (i.e., "too much money"), some non-bank lenders will be more eager to trade short duration assets for longer duration assets, and will likely bid down the lending rate and out-compete the banks. This will limit the increase in the money supply as non-bank lending doesn't create money. Conversely, at times when there is a deficient amount of short duration assets in the system, non-bank lenders will want to hold onto the deposits they have, so they will not match the lower lending rates offered by banks, and will thus let banks extend the loans to borrowers, thereby increasing the money supply. Loans would keep beating out bonds until the money supply had increased to a point of equilibrium (i.e., the amount of money desired by depositors on aggregate to meet their liquidity preferences). In this way, the ability of banks to "create money" when they lend provides an interest rate anchor for the economy (a sort of private sector "lender of last resort"). And because of this, the private sector has some control over the broad money supply, independent from the amount of debt it issues.

And if the suggestion just above is correct (i.e., that bank loans help anchor long term interest rates independently from the supply of long and short term assets), it may help in explaining why even a post-QE reduction in private sector long duration assets may not have any meaningful impact on bond prices and yields. (Generally it is argued that reducing the supply of something increases its price.)

Of course the whole dynamic posited here would probably be a "medium term" thing, not instant, as it would take time for shifts between types of lending to occur, so in the short term, none of this may apply.

What do you think? Is this (A) logical (B) flawed, or (C) an amateurish summary of some existing theory in finance or economics?

UPDATE: I had intended to also mention the theory that QE will drive up asset prices (stocks, housing, etc). This post does not address that directly, but to the extent that a shift away from bank loans occurs and counteracts the increased "unwanted" money supply, some of the driver for such an effect on asset prices might disappear (in the medium term).

Rock Beats Scissors, Automatic Stabilizers Beat Debt Deflation...

2010-09-21T14:11:00.000-04:00

I've been tracking the borrowing trends from the Z.1 Federal Reserve Flow of Funds report since last summer. Here is the Q2 2010 update:

Total US Government and Private Sector Borrowing Relative to GDP (Quarterly 2003 - 2010/Q2)

(click on graph for a larger version)

Total borrowing (blue line) has been positive again for the last two quarters, with government borrowing (red line) increasing and private sector borrowing (yellow line) contracting less slowly.

US Borrowing by Sector (Quarterly 2003 - 2010/Q2)

(click on graph for a larger version)

Government and the financial sector between them dominate all other sectors with respect to their effect on the overall trend.

Why do these graphs matter? For several reasons discussed in past posts... This is one way of showing that clearly the government is NOT crowding out the private sector in the debt markets, given how high total borrowing has been in the past. Fortunately this point has become obvious to most observers over the last year. Another is that it shows in rough terms the magnitude of the government support for the economy (much of it driven by automatic stabilizers) in the context of the peaking and collapse of a private sector credit bubble. (There are better ways to look at the government's role, as I admit the borrowing data is only a crude proxy).

With respect to the post title, it's not a given that debt deflation won't yet emerge (for example, if GDP double dips and private creditors are allowed to suffer more losses than they did in 2008, but we are missing smart policy to limit contagion). But Great Depression severity debt deflation has clearly been averted so far for a variety of reasons, a major one of which is stronger automatic stabilizers.

On the last update, I noted some ongoing questions, such as the extent to which the negative private sector rate of borrowing reflects a voluntary paying down of debt versus involuntary factors like defaults. In the past there has been evidence of each. However, several bloggers have recently cited this WSJ Real Time Economics post. It notes that in the last two years, mortgage debt and consumer credit have contracted at a 2.3% annualized rate. But after removing the effect of defaults, the contraction rate is only 0.08%! While that suggests defaults are the dominant factor, they note at least a little room for frugality taking place as well: "Defaults happen even in normal times, and are typically offset by even stronger growth in new mortgage and consumer loans. By holding their debts steady, consumers are actually being a lot less profligate than usual."

Real GDP Growth in the US and Japan: A Closer Look at Consumption, Government Spending, Net Exports, Investment, and Inventories

2010-08-31T16:32:00.001-04:00

In a previous post on the historical "stocks" of wealth in Japan and the US, I promised a post on the flows, i.e., aggregate income (GDP). I imagine someone must have posted versions of these before but for some reason I haven't come across them (just charts for recent quarters). Here are three longer-term charts followed by some comments.

Japan: Contributions to Percent Change in Real Gross Domestic Product (1981 - 2008)

(click on chart for a larger version in a new window)

US: Contributions to Percent Change in Real Gross Domestic Product (1980 - 2009)

(click on chart for a larger version in a new window)

US: Contributions to Percent Change in Real Gross Domestic Product (2005/Q1 - 2010/Q2) (SAAR)

(click on chart for a larger version in a new window)

Technical Note: The US data appears inconsistent if you compare the quarterly chart to the annual one. This is unmodified data directly from BEA's site so I have not introduced errors. It appears their annual data uses an average value of each flow (GDP, consumption, etc) for within each labeled year, rather than the end of year value. This would explain why, for example, the change in GDP for 2008 appears to be flat (i.e., 2008 average compared to 2007 average, rather than comparing end of year values) while the quarterly data confirms the plunge that was taking place in the second half of 2008.

Some Comparative Observations on Japan's Post-1990 Balance Sheet Recession and the US Post-2007 Balance Sheet Recession

Real GDP
Despite slowing in the early 1990s, real GDP in Japan only contracted in a single year — 1998 (at least, up until the 2008 global financial crisis). So far the US will only have experienced [just over] a year of actual contraction, though it was deeper. There is of course still the risk of "double dip", i.e., renewed contraction.

Household Consumption
Household consumption made a positive contribution to growth in Japan in every year except 1998, despite slowing after 1990 from over 2% to below 1%. In the US, consumption's contribution has been negative five out of six quarters starting in Q1 2008, but has since been positive in the quarterly data. Even if it remains positive in future quarters and years (TBD), it seems likely that ongoing deleveraging will cause the rate of increase to be smaller than the roughly 2% rate in the housing-bubble-and-home-ATM 2000s, which was in turn slower than the 1990s rate that ended at over 3% annually in the "new economy" tech bubble years.

Japan's household consumption was likely also supported by the fact that the household savings rate fell from around 13% in 1990 to around 3% in 2006. The US household savings rate is around 6% now, and unlikely to match Japan's decline (as it would have to go quite negative!). So it remains to be seen whether government deficits (boosting income) instead provide sustainable support for household consumption growth.

Direct Government Spending
Note that the measure shown is direct government spending, investment, and inventories, so it may be significantly less than the total government deficit during the same period. Hence these charts don't show the effect of the government giving the private sector more money to spend as it [the private sector] chooses, through lower taxes, larger transfer payments, etc.

Government spending growth represented about 0.5% to 1% of annual real GDP growth through most of the 1980s in Japan, and this increased a bit to over 1% in 1992 and 1993, likely in response to the deflating stock and real estate bubbles. (Were there large fiscal stimulus packages during these years?) Perhaps government spending going negative in 2007 is what helped tank the Japanese economy by 1998 — Richard Koo has mentioned pressure at that time to reduce government deficits and that this of course made the situation worse! The mid 2000s in Japan actually saw direct government spending contracting mildly each year.

In the US, government spending has grown every year except 1993, though at generally less than 0.5% of GDP it is not huge relative to other growth factors. Looking at the post-2007 recession and crisis response spending, the contribution is surprisingly small, at less than 1% in all but two quarters, and sometimes even negative! Part of the explanation is that this total includes state and local governments which have contracted to offset some of the federal spending, but the other possible partial explanation is that the Japanese may have been more aggressive in post-asset-bubble direct government stimulus spending (again ignoring tax cuts and other ways of government sustaining demand).

Investment
Private sector investment includes residential housing construction, commercial real estate, software, equipment, and other capital formation.

In Japan's late 1980s bubble, private investment contributed between 1.3 and 3.4 points to GDP growth each year. After slowing in 1991, it contracted for three years, taking almost 2 points off GDP in 1992 and again in 1993. 1998 saw a similar contraction.

In the US, investment was usually over 1% in the 1990s, but made a surprisingly small contribution to GDP in the mid 2000s housing bubble years (not much more than 1%, so much less than Japan's bubble-era investment). However, contracting private investment was the biggest contributor to falling GDP in late 2008 and early 2009. Late 2009 and the first half of 2010 have seen large a large bounce back in investment, perhaps reflecting the depth of the decline. Where might it go from here? I'll save that for a future post on outlook, but there is no obvious answer based on these charts alone.

Inventories
Changes in private sector inventories are the primary driver of typical recessions and business cycles (if inventories are increased by too much as optimism gets ahead of reality, the recession allows the inventories to be drawn down, but reduces income to manufacturing and other contributions to inventory growth during the recessionary period). But in balance sheet recessions arising from debt-fueled asset price bubbles, inventory effects are dominated by other factors, particularly private investment. This is evident in the Japan chart from 1990-1993 and the US quarterly chart in 2008 and early 2009.

To compare to more typical recessions, look how much larger the green (inventories) is relative to the yellow (investment) in the US in 2001, 1982, and 1980.

There has been a huge inventory rebuild in the US in Q3 2009 through Q2 2010, so this effect will likely fade and be more neutral going forward (though with risk of renewed contraction in the immediate quarters ahead if the rebuild was too large or consumption falters further).

Net Exports
One common statement about Japan is that they are an "exporting nation" and that this sustained them after 1990 and prevented a depression. But this chart shows that in the 1990s, changes in net exports were sometimes positive and sometimes negative, and did not dominate the trend in GDP growth at all. However in the 2000s net exports have made a moderate and steady contribution to growth every year from 2002-2007.

Through most of the 1990s and 2000s in the US, changes in imports and exports exerted a mild drag on growth (i.e., imports rose faster than exports, as an increasing amount of income was spent on imported goods and services). This is a little surprising for the 2001-2005 period, as the dollar was falling most of that period. A deeper dive into the data could answer this, but on the surface it seems the growing demand for imports exceeded the increased competitiveness of exports. Perhaps China's currency peg was a dominant reason. Since 2007, growth in net exports has provided some positive support for US GDP growth.

Summary
This was a limited comparison narrowly focused on one type of data set (contributions to real GDP) and not tied into historical accounts of the timing of recessions, government stimulus, etc. I'd welcome a bit more elaboration in comments on the real world factors that contributed to the GDP growth trends for each country and time period (or any other insights into the data), if anyone is inspired.

As a future project, perhaps I'll eventually correlate these charts with changes in private sector debt and changes in government deficits.

International CPI Trends: No Deflationary Spirals Evident So Far

2010-08-26T15:27:00.000-04:00

While the US deflation risks seem to dominate discussion on the blogs I follow, there has been ongoing talk of the international deflation risks, especially for other housing bubble countries. The talk intensified in late 2009 as Ireland and Japan both experienced intensifying deflation. Discussion again picked up in spring to early summer of this year in the context of the anticipated deflationary pressures that austerity measures would bring to countries within the European Union.

Here's a long due update on price levels graphs for various housing bubble countries (the US, Australia, UK, Ireland, and Spain). Out of interest, I also include Japan, Iceland, Greece, and the EU27 area, as each has played a prominent part in crisis headlines over the last couple years.

Here are the actual price levels (not rate of change):

(click on chart for a larger version in a new window)

Price levels in Japan and Ireland appear to have bottomed out around January of this year.
The US suffered the biggest decline in 2008 and has yet to reach its previous price level peak.
The remaining countries have continued an upward price level trend, each to a different degree.

I had to stop including three-month rate-of-change graphs, as a lack of seasonally adjusted price level data for Europe made the result way too volatile to be useful. But here is the year-on-year inflation rate graph, i.e., the rate of change of the price levels above:

(click on chart for a larger version in a new window)

Inflation in the UK and Australia currently seems to be flattening out in the 3% range.
Inflation in Greece has kept rising and is over 5%.
Inflation in the US is falling.
Inflation in Spain and the EU27 region is around 2%, with the trend unclear.
Japan and Ireland both have a moderating level of deflation, moving toward flat line (this is more visible in the prior price level graph).

Will any countries within the EU experience a deflationary spiral as some commentators warn? It seems unlikely. Will they experience falling inflation and eventual possible mild deflation, following the Japan (and perhaps US) path? Maybe in some cases, but absent acute crisis conditions (a possibility), these price trend changes seem to take years to unfold. In addition, actual house prices don't seem to have corrected nearly as much in other countries as in the US (measured relative to incomes and rents). In the US house prices peaked around five years ago and while we have continued disinflation we don't yet have sustained deflation.

Here is the exact same graph zoomed out to a larger Y-axis scale to show Iceland in full:

(click on chart for a larger version in a new window)

Iceland is the extreme outlier of the group, with the inflation rate peaking over 20%, and falling continuously in the last year and a half. I don't know all the reasons for Iceland's experience, but currency changes must be a large factor. In 2008 its currency value crashed to less than half of its previous level against the dollar, as shown in this ISK to USD chart:

(click on chart for a larger version in a new window)

And as of 2008, it was more dependent on imports than most countries, with their value measured at around half of Iceland's GDP (via Google Public Data):

(click on chart for a larger version in a new window)

Deflation Watch (July 2010): Still Disinflating Japanese Style, Actual CPI Deflation Probably Not Imminent

2010-08-19T16:58:00.002-04:00

Three months of negative month-on-month CPI prints (a trend which broke in July) have generated an absolutely astounding amount of deflation commentary in the econoblogosphere! The Japanese-style-deflation-in-the-US meme has certainly reached critical mass in at least some circles...

I decided this month to finally update my charts. The format carried over from my original post comparing historical deflationary episodes overdoes the Great Depression comparison, despite being useful at the time (a year ago, negative year-on-year CPI reports had prompted a renewed surge in deflation chatter).

Some Relevant Current Articles

My list of relevant links has grown long, and in the interest of actually publishing a chart update today with the latest data, I'll save the links for a later post. (Some others are even labeling their posts "deflation watch" as well!)

Post-Bubble Consumer Price Index Trends: Current US (post-2007) versus Japan (post-1989) versus the US Great Depression (post-1929)

(click on chart for a larger version in a new window)

The above chart shows the actual price levels for the three commonly discussed post-asset-bubble deflationary episodes. Here are the year-on-year inflation rates for the same time periods:

(click on chart for a larger version in a new window)

Rather than attempting to align all three episodes of data at a CPI peak, they are instead now aligned at the dates that wealth (i.e., asset values such as real estate and equities) peaked. The goal is to compare the effects of the post-asset-bubble deflationary forces on the actual consumer price level trend in each case. I considered a few other possible alignment points, such as the peak in private sector borrowing (as debt-fueled asset bubbles tend to be the largest). However the peak private sector rate of debt-growth before the Great Depression was actually in 1925 (!), and overall the peak in balance sheet wealth seemed the most logical choice. The main reason for this choice is that falling asset values (along with a post-bubble consumer mentality) typically induce a higher attempted private sector savings rate, which will typically cause an aggregate demand deficiency and lead to downward pressures on prices and wages. Some charts of balance sheet wealth in the US and post-bubble Japan are in this previous post. The rough peaks I used (these are not terribly precise) for the charts were November 1929 for the Great Depression, mid 1989 for Japan, and mid 2007 for the US.

Key Observation: The US price level is currently following a similar path to Japan's experience (though slightly more rapid than Japan, still very far from the Great Depression experience), and it took many years of disinflation before Japan experienced sustained (mild) deflation. That said, the downside economic risks are much larger in the US today than in Japan post-1989. A number of factors still threaten a faster move through disinflation to deflation for the US today, including but not limited to:

Higher unemployment in the US today than 1990s Japan
Risk of negative global demand shocks due to such factors as deflating global housing bubbles (real estate prices in many countries are still nearer peak than trough by price/earnings and price/income measures).
Anti-deficit political pressure that threatens reductions in US fiscal policy spending
A low likelihood of any non-government sector (household or business) driving growth by reducing its savings rate significantly (Japan's consumers provided just this boost to demand by reducing their savings rate from around 15% in 1990 to under 5% by the early 2000s)

Still, it's probably premature to expect US deflation in the immediate months ahead.

Trends in Consumer and Producer Price Index Levels (CPI & PPI, Seasonally Adjusted)

(click on chart for a larger version in a new window)

The chart above shows various CPI and PPI measures, aligned at 100% on July 2008 when the CPI peaked. It is intended to help in comparing the trends in absolute price levels (not rate of change). For example, crude materials (PPI) and energy (CPI) are clearly more volatile than finished goods (PPI) or headline or core CPI, but you can see at times (especially late 2008) how they can drag the other indexes around.

Annualized 3-Month Rate of Change for Components of US Consumer Price Index, Seasonally Adjusted

(click on chart for a larger version in a new window)

This chart shows the short term (three month) rate of change of the components of CPI, to help identify underlying inflationary and deflationary forces within the overall CPI basket. Many components are quite volatile despite being seasonally adjusted.

A surprising number of components (food, housing, recreation, and overall headline) are showing a flat (0%) three month rate of change. But shelter (a subset of housing I have separated due to its importance) has broken its deflationary trend and continues with positive inflation! I am still looking for a good explanation (Calculated Risk has commented a little but is also unsure of details). If this continues, it removes a lot of the near-term deflationary impulse on the overall index, and perhaps actual lasting CPI deflation is still years away like Japan's was (or perhaps even not at all).

16% Trimmed CPI

The 16% trimmed mean CPI (generated from the Cleveland Fed site) removes the most extreme monthly price changes, and is still falling after only a brief interruption in the trend:

(click on chart for a larger version in a new window)

Deflation Watch (May 2010): Headline Deflation Is Back!

2010-06-17T16:40:00.003-04:00

April and May brought a renewed decline in the headline consumer price index, however it is not yet clear whether this trend is ready to stick. And curiously (and a little unexpectedly) rents seem to have stopped falling, at least for now.

Some Relevant Current Articles

Have Residential Rents bottomed? - Calculated Risk says "There is some evidence that apartment rents have bottomed ... at least temporarily." And from the BLS: "The indexes for both rent and owners' equivalent rent were unchanged in May."

Warren Mosler on oil prices (from March, but still relevant to the medium term trend):

"With supply following demand, as with any monopolistic arena, it looks like the world crude oil balance remains very much neutral leaving the Saudis in full control as swing producer where they set prices and let quantity adjust to market demand. Stable crude prices with 0 interest rates, high excess capacity and low aggregate demand should keep inflation at bay indefinitely, with productivity increases making deflation the greater risk."

Consumer Price Index Trends: Great Depression versus Today through May 2010 (US)

(click on chart for a larger version in a new window)

I should note that this chart isn't intended to show we are following the Great Depression path, as we are clearly not (more details in the original deflation post), so perhaps a new chart is in order in the future.

However, it is looking like the headline CPI (red line) has been changing direction and may not make it back to the peak level from July 2008!

Annualized 3-Month Rate of Change for Components of US Consumer Price Index, Seasonally Adjusted (April 2006 - May 2010)

(click on chart for a larger version in a new window)

The three month trend in CPI has gone negative for the first time since late 2008! However, transportation (dominated by energy prices) at -6.9% (annualized three month rate) and apparel at -3.6% (annualized three month rate) seem to be the primary drivers of the latest deflation. Housing (and its subset category, shelter) seem to have stopped declining, at least in recent months. The other components are all in positive (but sub 3%) inflation territory, with varying levels of volatility. Will we stay in negative price change territory? It seems likely the drag from energy prices will come to an end, so the answer is far from certain in the short term, though the overall dis-inflationary trend is nowhere near over.

Price Index Changes: Great Depression CPI versus Current PPI through January 2010 (US)

(click on chart for a larger version in a new window)

Slowing in China, austerity in Europe, and the peaking of housing bubbles in countries such as Australia, Canada, and the UK could all contribute to a sustained end to rising commodity prices.

16% Trimmed CPI

The 16% trimmed mean CPI (generated from the Cleveland Fed site) removes the most extreme monthly price changes, and is still falling after only a brief interruption in the trend:

(click on chart for a larger version in a new window)

CPI in Japan (Jan 1980 - Jul 2009)

From previous posts, for reference: "The peak of Japan's CPI occurred in October 1998, almost eight years after the stock market peaked, and Japan's notorious mild deflation has been in effect since then. A multi-year disinflation (of core CPI) leading to sustained mild deflation is one possible outcome for the US.

(click on chart for a larger version in a new window)

Q1 Charts of Total Borrowing: Involuntary Deleveraging via Defaults, or Frugality?

2010-06-15T17:29:00.001-04:00

I've been tracking the borrowing trends from the Z.1 Federal Reserve Flow of Funds report since last summer. Here is the Q1 2010 update:

Total US Government and Private Sector Borrowing Relative to GDP (Quarterly 2003 - 2010/Q1)

(click on graph for a larger version)

The contraction in private sector borrowing (yellow line) appears to be in a declining trend. Total borrowing (combined private and public sectors) has gone marginally positive!

US Borrowing by Sector (Quarterly 2003 - 2010/Q1)

(click on graph for a larger version)

The largest component of the private sector is the financial sector, and its contraction in borrowing (purple line) has been getting smaller, though at a slower rate. Notably, business borrowing (dark green line) was roughly flat in Q1 after contracting for four consecutive quarters. But home mortgage borrowing is contracting faster than before.

What best explains the private sector's negative borrowing rate? And why is the rate of decline getting smaller? In my last update I linked to some data that suggested "consumers haven't actually been paying down credit card debt since Q1 2009 — they've actually continued to add to debt, whether out of necessity or choice — so the overall contraction since then has been all due to charge-offs." Credit card debt is only one kind of borrowing, but it is likely correlated with consumer attitudes toward debt and therefore future trends in borrowing.

Edward Harrison, always a worthwhile read, is continuing to question whether consumers have really found frugality. In his latest post on the topic, he concludes: "Bottom line: people don’t change unless they are forced to do so. Americans are as spendthrift as ever. Wait until the economy hits a rough patch – and then we can talk about the demand for credit."

Many other commentators (myself included) have tended to assume that consumers are becoming more frugal after being burned by debt-driven asset bubbles and would both choose to incur less new debt and to pay down existing debt faster than before. This is the multi-year deleveraging process that so many expect. There is evidence to suggest this is occurring, but also conflicting evidence suggesting that defaults, not voluntary repayments, explain the primary trend. Understanding this dynamic is key to understanding likely economic outcomes and whether this is truly a non-temporary balance sheet recession as described by Richard Koo. Thoughts? Evidence I've missed?

New developments can of course change current attitudes and behaviors. Household wealth stands a good chance of declining again due to (a) a resumed decline in housing prices as the effects of the absolutely enormous government support for the housing market diminish somewhat, and (b) potential further drops in stock prices (more on that another time). Might lower asset prices (and especially directionally declining asset prices) lead to an increased frugality?

It would be tremendously useful in understanding macro trends to have government data like we have now in the Z1 and other reports, but disaggregated into various household wealth and income tiers. Such data could go a long way to distinguishing between trends driven by economic stress versus trends driven by choice. Unfortunately I don't know of any source of such data (and it would likely by necessity be collected from small sample sets, anyway).

Shadow and Flame

2010-06-15T15:25:00.000-04:00

"Moria! Moria! Wonder of the Northern world! Too deep we delved there, and woke the nameless fear."
— Glóin from The Lord of the Rings 2 II The Council of Elrond

"The dwarves delved too greedily and too deep. You know what they awoke in the darkness of Khazad-dum... shadow and flame."
— Saruman

Apologies to non-Tolkien fans, but this example of life imitating art/literature struck me when I first read about the Deepwater Horizon explosion and oil spill. Tolkien powerfully captures the clash of nature and industry as one of the recurring themes in his Lord of the Rings trilogy, and tragically this disaster has some uncanny parallels. For those not familiar with the story of the Lord of the Rings, when the dwarves delve "too greedily and too deep" they awaken a Balrog, a demon of shadow and flame, and it proves too powerful to overcome. After much loss of life, the magnificent underground city and mining operation is abandoned.

Of course, the evidence is that this incident was avoidable, whether or not the driver was "greed" or a dysfunctional and reckless corporate culture (BP had an astonishing 760 egregious willful citations at refineries versus 1 for other companies in the same period!) . Yves Smith has provided solid coverage over recent weeks, and yesterday excerpted a letter sent from the government to BP: "In effect, it appears that BP repeatedly chose risky procedures in order to reduce costs and save time and made minimal efforts to contain the added risk." (much more via the link).

A guest post by George Washington and a link highlighted by Yves Smith both get into the possibility of undisclosed damage to the system and the threat of an accelerated flow of oil with no credible way to contain it at the well site. A knowledgeable commenter on Yves' site concludes "the relief well has to work. They will have to keep trying until they intersect the well."

If you need a less alarmist perspective, think of the oil spill relative to the Gulf of Mexico as "ONE raindrop in 10 olympic sized swimming pools" (and better mandate all wildlife to cease swimming or landing in the vicinity of said raindrop until further notice!) I suppose this is a bit sarcastic but I actually find it a worthwhile data point as food for thought, despite believing it to be rather misleading.

What To Expect From This Blog

2010-05-24T16:05:00.000-04:00

I realize I haven't posted in a couple months, so I thought that a short status post might be valuable. The brief summary is that you are likely to see continued sporadic posts here in the future, though probably less often than before (not that they were ever frequent!) I'm less likely to do updates every month/quarter of certain series of posts I've been covering, though I will make an effort to update them when the data changes in a noteworthy way. For example, the deflationary CPI trend is now becoming apparent to more and more observers and bears revisiting. Remember, Japan's deflation took years to arrive after its asset bubbles peaked. Other past topics likely to be revisited include Modern Monetary Theory, flow of funds data and borrowing trends, macroeconomic and market outlook, stock dividend trends, deflation outside the US, etc. New topics won't be frequent but I do have some some in mind.

I didn't exactly plan to have an economics blog (I'm an engineer, for one thing). I initially set it up as an easy platform to share my macroeconomic and market outlook, distilled from much reading in the econoblogosphere, with a select set of real life acquaintances. However, I subsequently found myself becoming dissatisfied with some gaps in my knowledge and with some of the third party commentary I'd been reading, so I decided to do more digging in raw data myself, wherever possible, rather than only relying on the commentary and analysis of others. And at times the data has seemed worth sharing. I hope some have found it useful — this site has 60+ RSS subscribers via Google Reader (and I don't know how many in other readers) — a small number, especially given that many probably don't read all their feeds, but not zero!

Other than general time constraints, the other reason for the shortage of posts lately is I've been putting a little time into attempting a second macroeconomic visualization that I hope could have broader value, if successful, than the last one (which I know still needs further updates). So if I make progress on it, look for a future post introducing it.

As a bonus for reading this far, and so as to include some actual economic content, here is a chart from an April presentation by Richard Koo that I think is useful and have not seen posted elsewhere:

It's the first actual "picture" of the so-called reverse-square-root-sign recovery that I recall seeing, and nicely shows two things. First, that the "Lehman Shock" probably did contribute to a collapse in confidence and GDP beyond that attributable to the Minsky-style private debt dynamics alone (though contagion and adverse feedback loops were certainly a real risk that could have kept GDP on its downward path, even so). Japan's GDP never fell this dramatically, even after its own giant asset bubbles popped. Second, it shows the uncertain future with respect to the degree of ongoing private sector deleveraging versus government fiscal stimulus.

Total Borrowing Still Contracting at a Stable Rate in Q4 2009 ($577 billion annualized)

2010-03-11T15:18:00.005-05:00

The Z.1 Federal Reserve Flow of Funds report is out for Q4 2009. Here are some updated graphs:

Total US Government and Private Sector Borrowing Relative to GDP (Quarterly 2003 - 2009/Q4)

(click on graph for a larger version)

US Borrowing by Sector (Quarterly 2003 - 2009/Q4)

(click on graph for a larger version)

The trend has been somewhat consistent over the last three quarters, with the size of government borrowing almost offsetting the contraction in private sector borrowing, which has been largest (as a percentage of GDP) in the financial sector. However, it seems the financial sector's rate of negative borrowing is shrinking, a trend which bears watching. Home mortgages, consumer credit, and business debt all show continued contraction, but there is no way to know which way their trends will go from here. A lot may depend on the future path of housing prices, which most likely aren't completely done falling. But it's possible there could be some surprises, for example Felix Salmon observes (and EconomPic charts) that consumers haven't actually been paying down credit card debt since Q1 2009 — they've actually continued to add to debt, whether out of necessity or choice — so the overall contraction since then has been all due to charge-offs.

In rough terms, I think these graphs show:

Fears of "massive" government debt supply driving up interest rates to any dangerous degree are misplaced. Government bonds (plus shorter duration instruments) are replacing disappearing private sector assets. (See further discussion of outlook for treasuries here).
Government deficit spending (a lot of it via the automatic stabilizers) has helped sustain incomes in the face of defaults and attempted private sector deleveraging, thus preventing a worse outcome to date. Of course, there is a lot that can still go wrong.

Some past posts discuss these graphs in more detail: