savings

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Wolf Knows Better. I know He Does

What am I supposed to make of this?

Martin Wolf, someone whose work I always pay attention to, flubs it and leaves us with a partial picture.  That’s unlike him.  Perhaps it was the editing?

In any case the notion that the UK needs to generate more savings, which is what Wolf is arguing in his recent Financial Times article, needs a slight augmentation in his basic analysis. 

The problem begins when he says that “Investment is financed by savings”.  This is a very un-Wolf like statement.  He is as aware as we are that savings do not cause investment.  This is simply one of those accounting identities that sometimes confuses people into imagining causation where there is none.  This unfortunate sentence then opens the door for the avoidance of the sort of deeper thinking we associate with Wolf.

For instance, whilst the causation does not run savings-to-investment, we could argue that there is causation in the other direction.  Investment in productive projects creates flows within the economy that do, or rather can, create savings.

What’s missing in the article is the relationship between consumption and the availability of productive projects worthy of investment.  Strong levels of consumption provide profitable investment opportunities.  That’s how investment decisions are made.  Banks are willing to provide financing for such projects.  Their credit risk assessment tells them they will get repaid from the profits of projects based on solid consumption prospects.  Banks will create the cash to fund such projects.  That’s the happy advantage of our banking system.  We can invest without having any savings.  

In turn, consumption relies on strong income flows throughout the economy.  The more people who have disposable income available to spend on new or additional products the more productive projects will exist.  

So the virtuous cycle Wolf would like to bring into being has its beginnings in the availability of that disposable income.  Not in the stock of savings.  High levels of savings, in the absence of strong consumption, simply creates a pile of useless financial assets floating around various Wall Street and City of London balance sheets.  

And here’s where we can fault Wolf most of all: the distribution of disposable income throughout the economy really matters when we want to stimulate consumption.  A highly unequal distribution creates the problem I just mentioned.  Since the accumulated spending power is highly concentrated in an unequal society there will inevitably be lower overall consumption.  Such a society will under-consume relative to its apparent wealth and income.  A few people with high levels of spending power is not equivalent to more people each with less spending power.   Wolf doesn’t mention this.  

To jump start a poor performing economy where both savings and investment are languishing at unacceptable levels — which is Wolf’s diagnosis of the current UK economy — the policy solution is to distribute purchasing power more evenly throughout society.  Get cash into the hands of people who will spend it rather than tuck it away into financial assets that produce no future increment to our national wealth.

Inequality is not some academic issue beloved only of left of center activists.  It is a factor that has immediate impact on the real economy.  And analysts like Wolf need to make it part of their discussion when they are presenting arguments about depressed levels of savings.

We can give him the benefit of the doubt this time.  After all his focus was on how to develop programs to stimulate savings.  

Then again, can we?  His idea that the UK needs to raise the “forced” savings rate from its current level would simply, in the immediate future, depress consumption.  That would reduce the number of productive projects worth investing in and depress investment from its already too low level.

See what I mean?

What am I supposed to make of this?

Let’s be generous: bad editing.  Surely the Financial Times knows better.

Doesn’t it?

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Weekend Round Up

It’s been a busy week. Particularly for sundry European leaders. Here’s a few suggestions for your consideration over the weekend.

Are stock markets really that stupid?

The extraordinary jump in the world’s various bourses at first sight of the Euro “solution” was out of proportion to the likely success of said solution. Actually it isn’t really a solution at all. It is a heavily disguised punt. None of its key features are what they seem. The haircut on the debt is voluntary. A hair cut is a great idea: let’s face it the Greek debt is nowhere near as valuable as the numbers the banks are carrying on their balance sheets. I would guess it’s worth about 20% of that carrying value. Nonetheless a 50% hair cut gets us closer to reality. The problem is that the hair cut is voluntary. There is no enforcement.

Why not?

Because to make the hair cut involuntary would open the door to the deal being called a default – as it it isn’t already. That is an odious word in the fantasy land of banking. A default would trigger all sort of doomsday activity, most of all in the credit default swaps market. The banks, you see are all terribly clever: they take on risk assets in order to make a profit from the risk, but then insure themselves against any losses from that risk by buying credit default swaps. Which they naturally buy from other banks. So the risk is shunted about within the banking system and ends up … who knows where? The world’s regulators have let this “pass the buck” activity grow so far out of control and undocumented properly to boot that everyone is terrified of what would happen were the banks to start making claims on this insurance. The losses implied by the hair cut could rumble about the system and destabilize banks in every corner of the globe. So no one wants to trigger a default, lest we unleash a second coming of the Lehmann debacle.

Here’s the silliness of this: the banks would thus have to book larger losses. Or at least those whose risks are properly offloaded. So, why in heaven’s name would they voluntarily take a hair cut? They would end up worse off.

But no one wants the hair cut to be involuntary.

Oh, what a tangled web the banks have us caught up in.

A second part of the Euro solution is it’s rescue fund. Hitherto that fund has been far too small to cope with the bail out of debtor like Italy – the world’s third largest issuer of sovereign debt. It can cope with small fry like Greece, but not the bigger nations now being sucked into the Euro collapse vortex. As the markets slowly realized this, the orthodox view became the rescue fund needed to top a trillion Euros. For some reason this magic number was seen as sufficiently large that it could act as a firewall: the crisis would crash against that bulwark and then ebb away as investors realized there was enough cash to keep the market alive.

So, hey presto, the negotiators conjure up a fund of over one trillion. The market heaves a gigantic sigh of relief and rages upwards. But. That magical figure is an illusion. It is the result of a proposal rather than a check arriving. The proposal is to – get this – leverage up the existing fund. Yes the bulwark against the debt crisis is the same leverage trick that sank Lehmann.

Whether the private sector can produce the debt implied in this plan I doubt. Especially when the furor dies down.

Meanwhile the most glaring deficiency in Europe – the lack of a clear lender of last resort – goes unaddressed. That means, in my view, the crisis will perk back to the boil as the next few months go by and everyone realizes that continent wide austerity is making debt problems worse

Governments cannot create jobs, but they can destroy them.

Poor Krugman. He’s beside himself this morning. I sympathize. The Republicans, whose mantra has been that the government cannot create jobs through spending – rubbish, but let’s ignore that for now – are apoplectic at the thought of all those job losses implied by cuts to defense spending.

Say what?

I admire the Republicans for having the nerve even to try this particular example of contorted mental gymnastics. It takes a very special mind to reason that defense spending is somehow not the same as any other kind of government spending. The thought is this: when the government hires a teacher, that is not job creation. When the government hires a soldier, that is most definitely job creation. More to the point: paying to build a school does not add to the economy and does not employ people. Building missiles does both. Ugh.

This twisted thinking sets a new low standard for even our political class. Yet here we are: the Republican leadership is all atwitter over the enormous damage to our unemployment problem were we to cut the offense defense budget. Just think of all those unemployed missile makers and generals. The horror. But slashing police, firefighters, and teachers from the payroll, which is what cutting domestic government spending amounts to, is somehow just fine.

There are words to describe this nonsense, but I defer using them for fear of hurting your ears.

Consumers to the rescue!

Well no, but if you are a breathless stuffed-shirt cable television expert it sounds nice to say so.

Today we learned why, or at least how, the third quarter GDP figures were as strong as they were. Don’t forget I don’t consider them strong at all. It turns out that in September, consumers spent way more than they earned. The savings rate dropped to 3.6%, it lowest since late 2007, while personal incomes rose a miserly 0.1%. Meanwhile consumer spending jumped 0.6%.

That doesn’t look like a sustainable trend to me. It looks very much like an end of summer blip.

It isn’t exactly rocket science to argue that spending cannot outstrip incomes for too long before we find ourselves back in a debt created mess again. Given that all signs indicate households are still trying to cut debt and not acquire it, the September reversal in the savings rate should be an aberration.

The implication is that the uptick in the GDP consumption category, which as you may recall was the biggest single reason for what growth we saw in the third quarter may ebb away as winter arrives. This means the other categories within GDP will have to take up the slack. Since none appear likely to do so, I think it fair to predict that the third quarter is not the start of a steady increase in activity, but is, more likely, simply another bump in a long list of such bumps along a stagnant road.

Which is what I have been trying to argue all along.

One last thing:

Back to Europe …

Fitch, one of the top rating agencies, says the Euro deal is good for Europe.

This means the deal is almost certainly not good for Europe.

Recall that Fitch, like the other ratings agencies, told us that those Mortgage Backed Securities were just amazing. Their brilliant analysis led them to go along with the magic wand trick that turned sub-prime into, not just prime, but AAA prime assets.

These people cannot be trusted to turn a calculator on correctly, let alone actually use one properly.

This is one group of folks whose recent body of work indicts their professional standing. It calls into question their ethical standing too, but that I will leave alone for now. Suffice to say Wall Street is hardly center of virtue.

But you know that already.

Enjoy the weekend.

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Historic Fog

Ugh.

The numbers are just horrible. We have wandered off into the desert and will not return for years. Here’s why:

  • Household debt is still way too high. It is well down from its peak of about 130% of disposable incomes, and is now “only” 115%. But that compares with an average of around 75% for the last few decades of the last century. Something tells me that we are still retrenching furiously. That undermines aggregate demand. That is why underemployment is a feature of the economy we will not eliminate any time soon.
  • One result of the retrenchment is the lack of consumer spending. America is a consumerist nation. It has built its economy around private consumption. But we have never seen such a prolonged period of practically zero growth in consumption as we are currently living through. This is a first for post-war America. Our elites have no answer. They are fumbling. All their policies fail to match up with the historic fog we are in. We have had thirteen straight quarters of weakness in consumption, and while those debt levels are where they are households are likely to keep a tight lid on spending.
  • Savings are deplorable. Despite the retrenchment and the reduction in spending rates, households are having a hard time saving. Yes the savings rate is up somewhat from its derisory levels during the years of illusion, but it is less that half what it was back in the latter part of last century. And things are getting worse: one of the great shifts of the decades of illusion was the movement of risk from businesses and government onto households. The shift from defined benefits to defined contributions is one example: it exposed millions of households to a risk they had never shouldered before and are not well equipped to deal with. As the baby boomers approach retirement they are realizing how short they are in terms of invested cash. With the slump in home values depriving them of wealth too – albeit paper wealth – this is the first American generation since World War II, to be faced with an urgent need to save instead of spend. An unintended consequence of privatizing all that risk is to bring upon us the end of the consumer boom. By putting the onus onto their employees, businesses have reduced the spending power in the economy and thus cut their sales prospects. That means the endless short term focus on profit is going to end up as a longer term loss.
  • The shift of risk to households would have been ameliorated had wages risen to compensate for the risk. But they didn’t. Businesses have tried to have their cake and eat it too. They cut their own risk by trimming benefits, but they have kept wages flat too. Indeed real wages have fallen by 1.6% over the last year. This is also historic: this is the first recovery ever, where seven quarters in wages have not risen. There is no way that consumption can rise if wages are held flat. No way, unless, that is, consumers are not inclined to pile up debt. And, as I have already said, they are not so inclined.
  • This accumulated freeze up of the consumerist spigot is having an enormous impact on smaller businesses. Not only are bigger businesses slashing costs in order to boost profits – this cuts into small business sales since they usually occupy a lower rung on the supply chain – but small business sales direct to consumers are being radically reduced. The National Federation of Independent Business, a small business trade group, has just released its survey of its members: the majority are freezing hiring in anticipation of lower sales volumes. Yes fewer are reducing payrolls too, but, for the first time in almost a year, they are not hiring either. The number one one concern amongst small business is the lack of sales. High taxes and government red tape – a perennial gripe of small business owners ranks third.

Even if we ignore the continuing instability of our financial sector – too big to fail will come back to haunt us sooner rather than later – this list of issues is not one that is easily solved. These are intractable and long term in nature. They imply a very significant shift within the economy – away from consumerism … but towards what?

Some people argue we need to pump our manufacturing up again, but this is a long term solution also and worldwide competition is ferocious. Plus it is not at all clear what we would manufacture. Does this approach portend trade wars? The imposition of tariff walls? The phrase “industrial policy” gets bandied about, but where do we invest? And, even if we back winners, who is going to buy all these domestically produced goods if we have shifted from a consumerist economy? The implication is that we are headed more towards a German, Japanese, or Chinese style export driven economy. Who, then, will take our place as consumer of last resort?

If the American economy is in a historic fog, and if our policy makers have only a set of policies built for the old style consumerist days, it seems clear that a decade of stagnation and frustration is the more likely prognosis.

And on the policy set: neither major party, no business group, and few if any academics, have yet been able to articulate anything new. They all appear to be in denial of the shifts I have outlined. Their prescriptions have all been tried and all have failed at least once. The last ten years have been a spectacular flop: we cut taxes with an historic verve only to debilitate government and produce no visible boost in growth. Wages stagnated. Profits soared. Debt became the only way most Americans kept up with rising costs. The years of illusion ended with a thud when we hit the wall and our banks imploded. The clean up, and the return to sanity, like those days after any binge, will be longer and grayer than it might have been had we recognized the pathetic emptiness of the ideas that led us so far astray.

Historic fog indeed.

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And Slower We Go

The news this week has been mediocre at best. That’s the most optimistic I can get over the data released yesterday and today. Manufacturing activity is now slowing down from the peaks of early this year, household incomes are flat, consumption has hit a wall, disinflation gathers pace, and savings are way too high.

Not good.

It is very clear that the second quarter, which as a whole was way down on the previous couple of quarters, ended on a very soft note. More a whimper in fact.

Not good at all.

We could still survive without another downturn, the Fed certainly seems to think so, but there are increasing signs of unease in the credit markets: bond prices are beginning to signal the need for help if we are to avoid that dreaded ‘double dip’.

Consumption, Incomes, and Savings:

Personal incomes ground to a halt in June, with a zero change over May. This is the first time in a year that there has been no growth in personal incomes, and the report came as something of a shock: most people were expecting growth of around 0.2%. Worse still, the figures for both April and May were revised downward, indicating that the weakness in June had set in earlier. The real damage to incomes came from private sector wages which declined 0.1% in June. Whether this is a portent of deflation we cannot yet tell, but it is an ominous sign that the economy is failing to achieve any private sector momentum.

Naturally this slowdown showed up in consumption spending which was also virtually flat for June, with growth of only 0.1% after adjusting for inflation. The only bright spot was in durable goods – high ticket, long lived products – spending. Since durable goods are notorious for being susceptible to cycles, June’s modest strength suggests to me that consumers were making purchases they had been postponing for a while. It will be interesting to see whether the trend develops or fades later in the year. Other sectors of demand, for non-durable goods and services, were both weak and in line with incomes.

This lack of spending had an impact on savings. The savings rate rose to 6.4% in June, and May’s rate was revised up from 4.0% to 6.3%. Consumers are clearly hunkered down in fear, which is, of course, the root cause of all our troubles.

As long as consumers, and businesses, fail to spend, the economy will sputter to a halt. There is enough energy out there at the moment to keep things in the black, but a few more months of this tentative nature and we can no longer guarantee GDP growth. The limit will probably be reached in late fall or early winter. Only then will we know whether the economy can pull out of this dive without slipping into another contraction.

Inflation:

The ongoing slowdown in the rate of inflation – aka disinflation – continues. Consumer prices fell 0.1% in June, if we exclude the more volatile things such as energy and food costs, it was unchanged. This brings the rate of inflation for the past twelve months down to 1.4%, well below the Fed’s target of a 2.0% ceiling. And the trend is downward.

This is simply not good news.

As I have argued here before we appear to be getting all too close to outright deflation, which is something we want to avoid at all costs.

Deflation is pernicious. It reduces consumption because people put off buying things in order to wait for lower prices. While that may appear to be a good thing – lower prices seem to be beneficial – it actually undermines the economy by sucking consumption out and overemphasizing savings. This is exactly the Japanese syndrome, where an economy becomes entirely dependent on outside assistance for its survival. The Japanese unwillingness to spend has not been a disaster only because other countries, notably the US, have been willing to do so. Left to its own devices the Japanese economy cannot sustain a healthy level of employment because the Japanese themselves simply don’t spend their incomes. What growth there has been for the last two decades has been driven by exports.

Not only does deflation undermine consumption, but it has the same effect on investment. Businesses are perpetually driven to postpone major expansion because their expectations of future sales are shrinking, not growing. So there is no incentive to build more factories or employ more people.

Lastly deflation also undermines the credit markets. On the surface it looks as if the losses suffered by borrowers – they have to pay back loans with money whose purchasing power is far greater than that they borrowed – would be offset by the profits to lenders. But this is not true. Prospective debtors realize that they would experience this loss in wealth every time they borrow, so they simply stop borrowing. This cramps growth, and it leaves lenders with cash unused. Since that cash is rising in value simply by being unlent, the entire banking system grinds to a halt. The economy ends up being awash with cash that no one wants to use.

The only time deflation is a benefit is during periods of immense productivity gain, when the fruits of new technologies drive down prices of some goods and thus release spending power for application on other goods or services. A prolonged burst of productivity is, in fact, the only way that long term living standards can be increased. This is as long as the increased productivity finds its way into wage growth and not simply profits. If we reflect on the state of US manufacturing or agriculture, a major reason that we employ far fewer workers in those sectors has been the enormous increase in productivity of the remaining workers. This productivity gain comes from the use of new technologies and the substitution of machinery for human labor. There is, of course, a point at which no amount of capital substitution can offset the existence of low labor costs elsewhere. This latter point is why China now dominates world manufacturing: its workers earn about 3% of the wages of their US counterparts. That advantage is so large it cannot be overcome. Naturally this dichotomy will change through time as Chinese workers seek to raise their standard of living and demand a greater share of the profits now being reaped by Chinese capitalists.

Ironically, such a shift in Chinese wage rates would then flow into the US as higher prices and return us to an inflationary rather than deflationary path.

Until then deflation seems to be our emerging issue.

Parenthetically, the world credit markets are fairly screaming this point at the moment. For all the recent talk of inflation fears and the need to tighten government spending because the bond market ‘expects’ or ‘wants’ balanced budgets, the evidence is exactly the opposite. More and more it looks as if the bond markets are concerned over renewed recession. The damage done to asset values by weak or declining GDP is greater than that done by huge government borrowing. The credit markets realize this and are pricing bonds and other assets accordingly. Bond rates, far from crying out for restrictive budgets, are calling for more effort to stave off recession.

Not that we could tell from the words of officials who all seem to have fallen into the worst kind of groupthink. It is now fashionable to be a deficit hawk and call for stringent and punishing cuts. No matter what the cost to growth and wealth. We are now intent on passing along a diminished economy and highly damaged opportunity as our legacy.

Presumably because we lack imagination.

Manufacturing:

The Institute of Supply Management report on manufacturing activity also points to a slow down. But not a downturn. The ISM index stood at 55.5% in July which is the fifteenth month in a row that the index has been above the magic 50% mark. Any reading above 50% points to expansion – more than half respondents indicating that they are adding to production in response to demand. So that is good news, but it is moderated by the fact that July’s reading is down from prior months. Activity was down from the early part of the year. We will have to wait to see if this downturn is maintained in light of the sluggish consumption figures I mentioned above.

What is clear is that this decline will feed into business expectations and act as a break on employment. A couple of weak months of data and businesses will be forced into a ‘wait and see’ approach as they plan for next year.

And that will generate more hesitancy. Which will lead to lower growth.

As I said: this week’s news has been mediocre at best.

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Spending and Manufacturing: Good News

We are now receiving a string of reports all pointing in the same direction: the economy is perking up. The recovery is now well under way. That doesn’t mean, unfortunately, that we are experiencing the usual post-recession surge, instead we appear to be making steady headway across the board.

The news can be summarized briefly:

Consumer spending keeps on ticking upwards. March’s rise of 0.3% suggests that there is enough momentum to carry the first quarter GDP increase into the current quarter. The numbers for February had been a concern – spending grew a mere 0.1% – and we had to wait for these march figures to see whether the steady growth seen since last November was faltering. The year end data was muddied by various aspects of the stimulus package, with things like the ‘cash for clunkers’ program potentially stimulating demand at the end of last year by bringing it forward from this year. That concern appears unjustified, so we can now project a reasonably healthy rate of spending for the next few months.

This is especially true as the income figures are also showing signs of a return to health. Wages and other forms of income are picking up across the board. This is not a statement about per-hour wages or pay scales, but rather is a reflection of the slight increase in hours being worked, and the very slight turn around in the labor markets. This evidence is very good news: it signals the turn in aggregate incomes we need if growth is to become self-sustaining and not dependent upon the stimulus. This is the first month for quite a while where incomes have risen in all sectors. Obviously we are moving away from the bottom of the cycle.

Also buried in the report is the news that taxes are rising. This, of course, reflects the increase in income. As total wages start to grow again the tax take at both the local and Federal level will also recover. The reason this is important to note is that it will start to relieve the deficits that riddle governments all across the nation. Lost in all the blather and hype about the ‘catastrophic’ deficits has been the simple observation that as unemployment grows the total wage bill within the economy slumps. That means there is less taxable income. This, in turn, drives the government deficits up. Naturally as the cycle turns back to the positive the opposite effect takes hold and deficits start to shrink without any spending cuts or tax increases being made to close the gap.

I have mentioned this before, but it bears repeating: the current Federal deficit consists of three large pieces. The stimulus accounts for a small part. The loss of tax revenues due to the cyclical downturn accounts for a larger part. And the Bush era tax cuts account for the largest part. As the economy recovers we will get rid of the first two of these, leaving us with the third to correct. Unfortunately the size and extent of the Bush tax cuts was sufficient to knock a vast hole in the government budget, so fixing that problem will need equally large counter measures. Once the recovery is well set getting the budget back to a fiscally conservative posture will require getting rid of the Bush policies which were extremely de-stabilizing. I expect a mix of tax increases and spending cuts – including in defense – to be part of next year’s budget planning.

Economics being what it is, today’s good news contains the germ of future problems. The increase in consumer spending has meant that saving dipped. This is not good. Over the medium term the economy needs to be de-levered. Debt needs to be severely reduced. Consumers will have to control spending in order to make sure that their debt doesn’t reflate back to the dangerous levels we saw during the bubble. March’s figures saw savings going the wrong way, very slightly, so this is a trend we will need to keep an eye on over the summer months.

The other good news today is that the Institute of Supply Management Index for manufacturing activity showed a larger than expected increase in April. It rose to 60.4%, from 59.6% in March. This is the highest level the index has reached since 2004 and was a much stronger result than most people had been forecasting. Evidently manufacturing is bouncing back well. More to the point seventeen of the eighteen industries covered by the survey reported increased activity which tells us that the growth is widespread and not dependent upon a specific sector. Just as a reminder: any reading on this index of over 50% tells us that industrial activity is growing, so last month’s reading is a very strong one, and suggests that we are fast approaching the point at which jobs will become more abundant.

So what do we make of this news?

That the recovery is both well under way and is taking root right across the economy. The worst is now well behind us. The next issues we face are all to do with risks to growth: the impact and timing of the Federal Reserve’s expected tightening of rates being high on that list. If we see reports like today’s repeated over the next few weeks – say into July – then the pressure to raise rates will increase dramatically. Right now I see no reason for a rate increase. Even with all this good news growth has yet to be firmly established to the degree that it needs to be tamed. Having said that the debate about higher interest rates is bound to begin soon.

Meanwhile let’s enjoy the good news.

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