A quick thought on a Paul Krugman article

Paul Krugman writes lots of interesting articles and blog posts on economics.  He recently commented on the trade policies of Donald Trump and his critic Mitt Romney.

See: http://www.nytimes.com/2016/03/07/opinion/when-fallacies-collide.html?partner=rss&emc=rss

Dr. Krugman says : "In fact, a worldwide trade war would, by definition, reduce imports by exactly the same amount that it reduces exports."

This property of trade is a bit short on its completeness.  This is simply stating that an export from one country is imported to another country.  Such a tautology is necessary, but hardly helpful in understanding trade.  Unfortunately, this leaves out the balance of trade of a single country, which is what is really important to that country.  The problem is with what is advertised as “trade” actually is is not trade.  Rather, it is a multi-currency purchase and sale system where each country buys from another in its own currency which is then exchanged for a global reserve currency, such as USD, and then exchanged to the seller’s currency.

By this mechanism imports and exports of a country are decoupled.  A country can choose to import and not export by simply making foreign purchases with currency.  Or, in the opposite extreme, a country can choose to export and not import by simply taking foreign currency for its goods.  More likely the trade is nearly balanced, or goes off to one side for a period of time as with the US where it imports more than it exports and has done so for decades.

But, what’s the long term effect of a trade imbalance?  Don’t imports have to equal exports over the long term?  Why would a country continue to sell to another for long periods of time, i.e. many decades, if it only gets foreign currency for its products?  What would happen to a country that maintains a balance of trade deficit for decades?  Wouldn’t trading partner nations simply stop selling to it after some time?  Well, the US may soon be able to answer this question.

So, what is wrong with moving toward a balance of trade by imposing tariffs when trade imbalances exist for long periods of time?  Wouldn’t that have the needed effect of reducing imports to be more in line with exports?

Increasing inequity impeeds growth and causes deflation

Much has been written and commented on about inequity in recent years.  From the Occupy movement to the current campaign of Bernie Sanders.  Inequity has become a rallying call for many Americans who see the system as not benefiting them, while a few appear to reap all the gains of a growing economy.  Interestingly, no one that I've seen seems to have connected the growth in inequity to slow growth and deflation.  I would be interested in finding others that have examined this issue.

First a few definitions so we agree on what we're discussing.  Growth is the total change rate in real value of production in the economy, and is usually expressed as the change in GDP.  The measure of growth is thus truly economic as the effect of inflation (or deflation) is removed from the value.  Inflation (or deflation) is the change rate in the nominal price of a set basket of goods and services.  So, that the actual goods and services received are the same and the change in the total price is measured.

The increasing nature of inequity that is a driver of slow growth and deflation.  This is tied to long term debt that people have incurred over the previous decades.  This primarily includes mortgages and student loans, but some other debt like auto loans may also contribute.  When these debts were incurred decades ago the distribution of incomes was skewed more toward what we call the middle-class.  Workers in the economy brought home a greater percentage of the GDP compared to the highest earners in the economy.  These are the so called "1%" who's share of GDP has grown significantly over the last few decades as has been documented in many places.

The effect of a higher relative income in past decades is that people took on long term debts with the expectation that their incomes would continue to grow as they had for the previous decades.  When incomes failed to keep rising as they had in the past, i.e. inequity increased, people thought is temporary and took on yet more debt to maintain the life styles to which they had become accustomed.  Eventually, the lack of rising incomes and growing inequity led to an inability to pay the monthly payments on those large debts, and crisis ensued. 

This phenomena of growing inequity continues today with wages growing slowly relative to the economy and long terms debts slowly being paid down to levels that can be supported by the new expectation of future incomes.  These effects are deflationary for two reasons: first, the basket of goods and services that is used to measure inflation are mainly comprised of the very items that these middle-class members consume.  So, perhaps at better label would be "middle-class inflation" for what is measured.  Second, people are paying down their long term debt and have little additional money to spend on these goods and services, so their is little demand pricing pressure to push prices up.  Perhaps if the measures of inflation included more high luxury goods then the reported inflation would be rising at a faster rate that is more inline with the desires of policy makers.  In this case goods such as trendy art, super yachts, and mega-mansions would need to be included in the rate.

Growth suffers for similar reasons.  The distribution of goods and services planned for production still reflects the demands of the middle-class from years ago.  So, with the inability of this class to consume at a higher level with their constrained incomes growth stagnates.  To remedy this situation manufacturers can shift quicker away from producing middle-class goods and services to those that are consumed by the "1%".  Or we can simply wait for deflation to reduce the price of goods for the middle-class to a level where their incomes will allow them to consume more.  The economy is shifting toward a new steady state of lower relative incomes.  Until that new state is achieved the effects will be observed as low growth and deflation (or low inflation).

In any case, it is the lack of demand from middle-class consumers that is limiting both growth and causing deflation (or low inflation).  A shift in incomes from the "1%" back to the middle-class, as was the condition decades ago, will allow the middle-class to consume more.  This will have the twofold effect of raising prices as consumers compete to buy goods and services, thus eliminating deflation, and increasing growth as the increase in demand and subsequently prices will spur manufactures to increase production to satisfy that increasing demand.  This will contribute to a virtuous cycle of increased employment as manufactures hire to increase production which will in turn increase incomes which will in turn increase demand.

Tackling inequity is central to fixing the economy.  Fixing the economy is central to fixing the financial problems.  Changes to Federal government policies is central to both.

Adam Smith on a Progressive Tax

Adam Smith thought about many things in economics, and taxes were an important area of concern.  He discussed quite extensively the kinds of taxes that governments could raise and what effects each would have on the the economic and financial sectors.  He also had opinions on the proportion of taxes that the various segments of society should pay.  In particular what the wealthy should contribute, and he decidely did not agree with the "flat tax" arguments being bandied about in recent years.  From Wealth of Nations:  "It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion."[1]  In this instance, Smith is talking about property tax in particular, but it does not take a great leap to see that this sentiment generalizes to all forms of wealth and income.

Smith clearly understood that the wealthy benefit quite extensively from their situation in society, and that contributing a greater fraction that others to taxes would not harm them in the least.  He also appears to suggest that they should contribute more because they can afford to pay more, while greater taxes on people of more modest means would have an adverse effect on their standard of living.  This also suggests that the wealthy should contribute more because they benefit from the system so greatly that they should be willing to do more than others to support and propagate this system.

So, flat taxers take head, Adam Smith is not a supporter!

[1] http://www.gutenberg.org/files/3300/3300-h/3300-h.htm

Oh, USA regarding China, your sincerity is incredible

We are endlessly barraged by comments from lawmakers, pundits, the press, etc. about the problem of the rise of China's economic and military might.  They seem to think that this happened in a vacuum, and is now just appearing without warning.  One wonders where they have been since Nixon's trip?  Could this be one of the most incredible feats of insincere lamenting in history?  Perhaps these same folks haven't noticed that it has been US policy for decades to build up China's technological might by transferring US education, US advanced technology, and US manufacturing companies to China.  How else do they explain the rise of China?

When Nixon visited China in 1972 the economy was that of a large but an unremarkable undeveloped nation with a second rate military.  But, his visit started the opening of trade for which US companies were clamoring.  The mere thought of a billion new consumers and low cost workers must have driven financiers and corporate managers to a frenzy!  They, of course, wasted no time in taking advantage of this new opportunity.  The following decades saw the transfer of thousands of US manufacturing businesses to China, along with their jobs, and just as importantly their technology.  This has likely been the greatest completely voluntary surrender of economic and sovereign capability in history.

The Chinese played this game for all its worth.  They insisted on the transfer of valuable technology in exchange for the right to open manufacturing operations in China.  They also insisted on the formation of joint ventures with Chinese companies in these transferred operations so that Chinese managers and support professional services would rise with the manufacturing capability.  The Chinese, unlike their US counterparts, were working with the goal of increasing the capabilities of the Chinese nation and people.  China sees a greater, endless China as the goal.  US leaders seem to have forgotten about the US as a sovereign, self sufficient nation as the founders had envisioned.  Indeed, given their manifest lack of concern for the future of the US, one wonders who are they working for?

So, now that China has set up advanced universities to teach the next generation state of the art technology and management, built up a modern infrastructure that is the envy of the world, established a broad industrial base, and secured access to a vast amount of world resources, why would anyone be surprised that they take the next obvious step and enhance their military might and presence in the world?  This certainly was inevitable to anyone who wasn't sleeping.

Perhaps this serves a purpose in itself?  China is the new bogeyman for the US to raise the alarm over.  Thus, the US military must rotate to the Pacific to protect US interests in the region from the US created Chinese military.

Perhaps the folks who press this agenda don't see a powerful China as a problem at all?  In spite of saber rattling over disputed islands, and aircraft incursions and encounters, the Alibaba IPO went off without a hitch on the US stock market.  An amazing occurrence if one thinks about this a bit.  Why would a Chinese company want to list on a US market?  Doesn't China have a market?  Doesn't Alibaba need funds in Chinese Renminbi to pay its Chinese workers and debts?  Currencies are now completely exchangeable and fungible in other currencies.  Its like having one world currency where there are no actual sovereign nations ;)

Apparently, as long as the business continues unimpeded and finananciers and corporate managers are making big profits, the effects of manufacturing and job loss, massive trade deficits, and military adventures are mere annoyances and distractions.  So, leaders and pundits, let's stop the lamenting and congratulate each other on "job well done!"  All goals were accomplished, so shouldn't you be celebrating?

What's changed since the start of the financial crisis?

It's been seven years since the start of the financial crisis (an estimate of course as the actual start dates of these kinds of things are always a bit subjective).  We'll take the start of the crisis as being in August 2007 "when BNP Paribas terminated withdrawals from three hedge funds citing "a complete evaporation of liquidity"[1].

What has changed?  For the better?  For the worse?  Or not at all?

US National Debt:  This certainly has gotten worse.  In August 2007 it stood at:$8.9trillion but by June 2014 it had ballooned to: $17.5trillion [2].  That's almost double the amount in only seven years!  So, what did Uncle Sam spend our money on during that period?  Well, a big part of it turns out to be bailing out the banks.  As of 2011 the total amount of funds disbursed by the government to the banks was: $4.76trillion [3].  Most of the rest was due to continued government spending during a time of economic depression that lowered tax receipts.  In essence the government was hit with a double whammy by the crisis in that it had to keep spending through running deficits and it chose to bail out the major banks which were almost certainly going to otherwise fail.

Labor:  No improvement here.  Participation rate is still headed down, and the employment/population ratio which plunged during the official recession period has hardly budged at all  [4].

So, all those folks who lost their jobs don't appear to be back in the labor force.  Of course, that's only a problem for these folks if they say its a problem.  If they took early retirement or are happy to be out of the labor force then this is OK.  But, I suspect that many in this group are out of work involuntarily and would like to get a good job.  For these folks the depression continues.  In May 2014, 3.4 million were long-term unemployed and 7.3 million were involuntarily part-time employed [9]. Fortunately for the national debt, the wise people in Washington decided to end the long term unemployment benefits for many of these non-workers.  Not so good if you're on the receiving side.

Stock Market:  The S&P 500 was $1433.06 on July 30, 2007 and is trading around $1977 as of this writing on 7/1/2014.  The bailouts certainly helped the markets, particularly since the S&P500 hit a low of $683 after the crisis began.

Regulation: The main government regulatory response to the crisis was the passage of the Dodd-Frank Act which imposed some minor requirements on banks.  In addition, greater capital requirements were imposed on banks, a designation of "systematically important" was created for the biggest banks, and some form of plan for an orderly liquidation was to be created for these banks [5].  But the overall response was quite limited given the enormity of the crisis.  Nothing on the scale of the response to the Great Depression was even under consideration.  No "Pecora Commission" was created to properly investigate the causes of the crisis.  Few were brought to account for their actions.  In other words, other than an increased requirement for reserve capital, banks could pretty much go back to what they were doing before the crisis.  Though their actions will certainly come under greater scrutiny than before, and their apatite for risk is slightly diminished, at least until they can find ways of once again shifting the risk to other parties.

Trade: Once seemingly bright spot in this is that the trade deficit dropped from the pre-crisis level of $-705billion in 2007 to a low of $-383billion in 2009 and was $-476billion in 2013. Interestingly, exports actually grew over this period, with the exception of one year, from $1.65trillion in 2007 to $2.28trillion in 2013.  Total trade has expanded dramatically from $4.0trillion in 2007 to $5.0trillion in 2013[7].  So, the crisis has been good for trade.

Housing: As usual, Bill McBride has collected some great data and created some useful graphs.  The Core Logic Housing Price Index peaked at around 200 in 2006 before the crisis began, or perhaps a better description is that it is part of what tripped the crisis release mechanism, bottomed in 2011 to 2012, but has been moving up for the last several years. 

Is this good or bad?  Well, depends on which side you're on.  If you are a homeowner with a big mortgage or a seller then this is good, if you're a buyer then this is bad.  More importantly is the "rentier" aspect of home prices.  That is, what fraction of the price represents actual construction costs, and what fraction represents aspects of speculation?  That is, the price of the land and price of older buildings?  A market that is good for homeowners is one where the land is essentially free and the price of the house almost entirely represents construction costs.  The fraction of home price that is land rose from 32% in 1984 to 50% in 2006 [10], a clear indication of the speculative boom in housing, and incidentally, evidence that the Fed was quite aware of this.

Once significant improvement in the housing market is the fraction of mortgages that are seriously delinquent has dropped dramatically from the high in early 2010 and continues downward.  A simple extrapolation shows that by the beginning of 2016 this rate should be back to pre-crisis levels.  This is an indication that homeowners are getting their finances back into order.

What does this mean for the future?  What's there to prevent another crisis?  The supporters of current policies believe that the added regulation and reserve requirements are sufficient to prevent another catastrophe like the crisis we're still digging out from.  I'm less sure as many of the same risky behaviors that caused the crisis are now rearing their ugly heads once again [8].  The rules of the game determine the play.  And the rules of this game have shifted dramatically over the last few decades to allow risky financial behavior by banks, businesses, and consumers that previously was considered unacceptable.  The inevitable outcome is the ongoing financial crisis.  A return to the regulations and policies which led to decades of growth and stability is a prudent action for the future of the nation.


[1] https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932010
[2] http://www.treasurydirect.gov/NP/debt/current
[3] http://www.sourcewatch.org/index.php?title=Total_Wall_Street_Bailout_Cost
[4] http://data.bls.gov/pdq/SurveyOutputServlet
[5] http://www.ritholtz.com/blog/2012/05/regulatory-reform-since-the-financial-crisis/
[6] https://en.wikipedia.org/wiki/Pecora_Commission
[7] See table on: http://bea.gov/newsreleases/international/trade/tradnewsrelease.htm
[8] http://www.nytimes.com/2013/04/19/business/banks-revive-risky-loans-and-mortgages.html?pagewanted=all&_r=0
[9] http://www.bls.gov/news.release/empsit.nr0.htm
[10] http://www.federalreserve.gov/pubs/feds/2006/200625/200625pap.pdf

The "death tax" is as American as apple pie

The estate tax, or "death tax" as its critics call it, is an essential aspect of the American republic.  Indeed, it's an essential aspect of any republic.  Recall that essential means something can't exist without whatever is that essential thing, which is exactly what I mean; a republic cannot exist for long without a meaningful estate tax.

Several premises of the American republic were: that the aristocracies of Europe were not serving the interests of the vast majority of the people, and that the people have inherent rights that are not being recognized by the ruling class of aristocrats.   That the people were capable of governing themselves and only through this self government were the people able to ensure that their rights were defended.

Now what exactly is an aristocracy?  To the casual observer it appears that it is a system of interrelated families that have members who have titles which grant them a certain status.  And that the members inherit these titles at birth, so you have to be born into the system.  That's a pretty closed system.  These are all true, but are really not the foundation or the causes of the aristocracy, rather these are the symptoms.

An aristocracy is primarily a system of inherited wealth.  Wealth brings power and influence, so that those with great wealth have much of both, and when they band together their share of both grows markedly.  This group, by necessity, is a very small fraction of the population, perhaps less than 0.01%.  This very small group wields enormous control over the lives of the rest of the population.  This group may not act in the best interests of the majority of the population, so some rational for the legitimacy of their actions needs to be enacted.  That mechanism is the idea of hereditary aristocracy.  A system which cannot be breached from the outside due to its inherent closed nature.  Thus, the population is led to believe that the right of the aristocracy to rule is natural and permanent.  But of course it's not.  Each title and ceremony and right were crafted by those in power to solidify their power, so much so that they appear to be an essential part of the the state.

What do the rest of the population think of this?  Inevitably, the aristocracy will take actions that will disadvantage the rest of the population.  Some of the people will recognize this and be unhappy with the situation.  They will band together and take action when the opportunity arises to change the situation.  The American revolution was just such an opportunity.  The result was a republic "of the people, by the people, for the people".  The challenge then is to prevent the formation of a new aristocracy that can overturn the republic.

The key to preventing the formation of a new aristocracy is to prevent the passing down of inherited wealth from generation to generation.  That is, to prevent the creation of what people rightly call dynasties.  The very word dynasty refers to an aristocratic structure.  So what is the best way to prevent the passing of great wealth and the formation of dynasties?  The inheritance or estate tax.

This single essential need, of preserving the republic, is rationale enough to defend the estate tax from the endless challenges of those who think it unfair, or big government, or punishing success, or whatever other argument du jur.

So, I repeat, a meaningful estate tax that prevents the passing of great fortunes from generation to generation is an essential aspect of a republic.  

"Fordism" used to be the norm

"Fordism" is the economic philosophy that widespread prosperity and high corporate profits can be achieved by high wages that allow the workers to purchase the consumer goods they produce, such as automobiles, furniture, clothes, etc.  Named for its creator and biggest proponent the industrialist Henry Ford, who understood the paradox of workers producing goods that they could not afford themselves, which was the prevalent state of the economic system in the US when Ford started his automobile production.  Ford understood that such a system is self-limiting in that the few who had all the wealth could not possibly spend it all, thus the distribution of work product, i.e. the goods and services produced, would progressively shift to an overall inefficient application of labor and resources, and a state of perpetually high unemployment would exist.  Fordism also includes the shift to specialized mass production which made for large quantities of inexpensive goods that appeal the the worker rather than the luxury buyer.  But mass production also brought undesirable working conditions of intense concentration to the work and at the same time boredom.  Conditions which made these jobs hard to keep properly filled.

Without Fordism, there would not be the production of large quantities of middle class goods and services such as small homes, economical cars, reasonable furniture, home goods, clothes, and food.  Instead, the production would shift to small amounts of esoteric luxury items and services for a tiny fraction of the population, where each item or service took significant labor to produce.  These are things like elaborately ornate embroideries, and home finishes which require hand applied elaborate details, watches meticulously crafted by hand, extreme luxury and performance cars, exquisitely prepared meals at exclusive restaurants, and services like personal chefs, legions of gardeners, house keepers, butlers, etc. to maintain immaculately manicured homes.  In other words, fewer customers for Ford's cars and for the myriad of other mass produced goods from the factories of America.  However, Ford was no opponent of luxury and fine goods, rather he thought that there was a limit to the need for these and beyond this limit they became harmful to the greater economy.

Employers benefit from Fordism in two ways, first, with high wages the employer has the pick of the most stable and most efficient employees, resulting in high productivity, high quality work, and low turnover.  Secondly, the workers earn more income than previously, so they can purchase more goods and services at higher prices, the very goods and services which they produced, resulting in increased sales for the employer.  This results in a virtuous cycle of rising incomes, motivated workers, low unemployment, and rising consumption driving rising sales and profits.

Fordism is a formula for maximal employment and having the economy functioning at its expected potential.  Indeed, Fordism raises the expected potential of the economy faster than it would have risen otherwise because the incessant demand it creates induces producers to increase productivity through efficiency and innovation faster than they otherwise would have attempted.  Producers are forced down this path of growth because no other path is available to meet the demand.  In other systems, there is no increase in demand as efforts of employers are aimed at reducing wages which allows for a greater profits at the same price, and the belief that more workers could then be hired to meet demand at the same price.  But this reduction in wages does not increase demand as the total amount of wages is the same.  It simply means that the workers share the same amount of goods as today, but have fewer per worker.

Fordism is a nationalist system, therefore it has one problem.  It needs to be all encompassing at the national level.  All entities which interact in the system must be susceptible to the principles of Fordism for this system to work.  Fordism could be a global system, but all nations must adopt its principles for this to happen.  At the national level this can be ensured by two necessary mechanisms; first, all regions of production must come under the same rules and opportunities as existed in the Midwest manufacturing belt where Fordism started.  This is what happened all over American as production expanded through the mid-twentieth century.  Manufacturers in the West, East, and South were forced to adopt Fordism or lose their workers to those who did.  The second is to enforce a balance of trade with other nations and to provide for the protection of high wage, high tech, high value added industries.  This is what happened in America until the mid-1960s, which is coincidentally when problems in the US economy and financial situation started to occur.  And this is what Germany does today, which helps explain its thriving production economy.

Starting in the early 1970s, the US abandoned Fordism by shifting to globalization.  Globalization is by definition anti-nationalism.   This shift promoted unbalanced trade which left massive trade deficits of unsettled trade accounts, and free-floating currencies which were no longer backed by real goods and services (the abandonment of Bretton-Woods in 1971).  The result was that goods were imported from foreign nations where wages were kept artificially low compared to the US through currency manipulation and a lack of trade settlement.  US manufacturing jobs which relied on Fordism's high wages were shipped overseas.  Wages fell in the US and the standard of living of Americans with it.

Therefore, it is highly likely that resurrecting traditional American trade policies will lead to a similar resurrection of Fordism and the American standard of living.

PS  Apparently Fordism is making a bit of a comeback.  Here's a quote from a recent article by Robert Reich [1]

"For one thing, a higher minimum wage doesn’t necessarily increase business costs. It draws more job applicants into the labor market, giving employers more choice of whom to hire. As a result, employers often get more reliable workers who remain longer – thereby saving employers at least as much money as they spend on higher wages.

A higher wage can also help build employee morale, resulting in better performance. Gap, America’s largest clothing retailer, recently announced it would boost its hourly wage to $10. Wall Street approved. “You treat people well, they’ll treat your customers well,” said Dorothy Lakner [2], a Wall Street analyst. “Gap had a strong year last year compared to a lot of their peers. That sends a pretty strong message to employees that, ‘we had a good year, but you’re going to be rewarded too.’

[1] http://robertreich.org/post/78130228939

[2] http://www.bloomberg.com/apps/news?pid=webport_news&tkr=MCD:US,PFE:US,WMT:US&tkr2=WMT:US&sid=a2ZJ55vwtY3Q