June 29, 2011

Job Creation: Why There’s None; What Should be Done

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:46 PM by Robert Barone

It is clear to everyone that the economic vitality of the U.S. is based on jobs.  Since its peak in late ’07, the U.S. has lost between 6.8 and 7.0 million jobs (depending on which employment survey you consult).  Despite record deficits, spending, various stimulus schemes, and money printing programs, jobs are not being created at a pace that results in a falling unemployment rate.  And, there is a lot of evidenced that the official unemployment rate (the U3 series) seriously understates the issue.  In his latest press conference, as QE2 is about to end, Fed Chairman Bernanke appears to be befuddled as to why the U.S. economy is softening.  The Obama Administration’s release of 30 million barrels of oil from the Strategic Petroleum Reserve (just over one day’s usage) with prices already retreating certainly appears to have an element of desperation in it, aimed, perhaps, at the 2012 election.  For sure, after trying everything in the Keynesian playbook, no one with any policymaking power seems to have a clue about how jobs get created.

The Problem: Deteriorating Balance Sheets

Demand, of course, is the key.  If demand rises, employment will eventually follow.  And it is not corporate America that is in need, as they stand around with record levels of cash looking for something to do with it.  But, middle America, the heart of the consumption machine, is in trouble.  We know that real wages have been stagnant since the late ‘90s and that the economic boom of the early part of the last decade was induced by debt and artificially low interest rates.  But, besides stagnant wages, the biggest issue for Americans is their deteriorating balance sheets.  Since the largest item in their asset base is their home, the relentless downward march of property values is simply debilitating to the net worth of a significant percentage of Americans, and this is likely the most significant factor in the stagnation of consumption despite the record level of stimulus.  As an aside, the Fed’s QE2 program did raise the level of equity prices, but only a small segment of America benefitted.  So, we’ve recently seen a rise in luxury retail sales, but little else.  If we leave things as they are (unlikely in an approaching election year), because of the binge of Alt-A mortgage lending in ’06, 2011 is seeing the beginnings of another wave of defaults.  Five years is the magic number written into those mortgage notes.  At the end of five years, principle payments begin.  For a property already underwater, a doubling of the monthly payment simply induces default.  So, if nothing changes, the U.S. has at least 18 more months of high foreclosure activity and declining property values.

Pent-Up Demand

Looking back at the employment data, in mid-’06, there were 7.7 million construction workers.  Today, there are 5.5 million.  Doing the math, of the 7 million lost jobs from the ’07 peak, 2.2 million (31%) are in construction.  The fact is, U.S. periods of economic expansion have always been accompanied by high employment in the construction trades.  In addition, there is a multiplier effect both when jobs are created or lost as jobs in other ancillary industries (like home furnishings) are positively or negatively impacted to say nothing of jobs created simply as support (services etc.).  After four years of the lowest level of construction activity on record, a level we know is below replacement and certainly below the needs of a rising population, with families moving in together and college graduates remaining in their parents’ homes, there has to be a huge pent-up demand for housing.  But, no one will buy while prices are falling, and prices will continue to fall while foreclosures remain near record levels. One key to job creation, then, is stable or rising home values.  That would result in rising sales and would stimulate construction employment with its attendant job multiplier.

Extend and Pretend

Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff have completed several studies examining the aftermath of balance sheet recessions.  In a recent interview with Investors Business Daily (“Slow Growth Normal For Post Fin’l Crisis Recoveries”, Norm Alster, 5/23/11), Vincent Reinhart said that in Japan, for example, “the banks were allowed to carry bad assets on their books at inflated values”.  As a result, “property prices have declined for 20 years”.  Reinhart concludes that “the government’s willingness to let banks carry bad debt rather than force them to take losses tends to stretch out the process of deleveraging.  When you let banks carry their assets at high values relative to their market values, it freezes that market”.  His prescription: “Recognize the losses … take the hit”.

We have a 20+ year example with Japan, 3+ years in the U.S., and now, Europe is about to embark on a similar path with the “extend and pretend” game with Greek debt.

Prescription

Here is a 4 step prescription to stop the downward spiral in home prices, renew consumer confidence, increase consumption, and create jobs, all without additional spending.

  1. All real estate notes held by Financial Institutions (“FI’s”) must be written down to appraised values (i.e., marked to market).  Much of this has already taken place as regulators have examined the books of the FIs.  Pools of mortgages trading in the secondary market have had their prices adjust to the reality of the market place.  The larger FIs have already raised capital.  To some extent, the plethora of short sales in which the FIs do not require deficiency payments is occurring because the assets have already been written down and the FI has already taken the hit.
  2. The asset write-downs have been causing failures among those smaller FIs that have no access to the capital markets.  This is costing the taxpayers in the form of fewer choices, and since the FDIC fund has been depleted and assessments on FIs have risen, consumers are paying higher prices for their financial services.  The following was tried in the ‘90s during the S&L crisis, and mostly worked, failing only when government reneged.  I am talking about the establishment of a special regulatory asset category into which the losses from the asset write-downs are placed.  Such an asset (think of it as similar to goodwill) can be amortized over a fairly long period, say 10 or 15 years.  Thus, from a regulatory perspective, the capital of the institution is not depleted immediately.  Because liquidity is the most important part of an FI, GAAP insolvent institutions can operate and remain open indefinitely.  We saw this in the 80s in the S&L debacle, and it is true today for many FIs (including, perhaps some in the SIFI {“Systemically Important financial Institutions”} category, and definitely some large European institutions) that don’t recognize the true value of their assets.  Under this scenario, no taxpayer funds are expended. (Such a scenario can also play well with the SIFIs which are being pressured to have higher levels of capital since they pose systemic risks.)
  3. With assets written down, in order to qualify for the special regulatory asset category, FIs must now reduce the balances owed by the mortgagors to appraised value and offer the residential borrower a 30 year fixed rate or a 5/1 ARM (borrower’s choice) at market rates. (Congress must also extend the provision that such debt forgiveness is not a taxable event.) I can even postulate a scenario in which the borrowers must share in any “profits” with the FI if the property sells for more than the written down mortgage note value.  Some financial institutions, like JPMorganChase (“JPM”), have already done such note reductions with some of the loans they “bought” from Washington Mutual (“WaMu”) when they “purchased” WaMu in an FDIC assisted sale.  [Having bought these assets at pennies on the dollar, accounting rules will not let them write the assets “up” to their true market values.  So, last year, JPM reduced the mortgage notes to the borrower on some of the WaMu assets to an estimated market value still above the book value, while, at the same time, raising the interest rate.  A win-win.  The note holder could now sell the home at market value, and, if they didn’t, JPM got an enhanced interest return on the asset.  Once sold, JPM gets to write-up the asset from its book value to the reduced mortgage note value.]  The result of such a program would be a rapid fall in foreclosure activity.  Properties could be sold without a short sale.  Without foreclosure activity, prices would stabilize, even rise.  With their balance sheets now stable to rising, consumers and small businesses would have more confidence, and the pent-up demand for homes and other properties would appear.  New construction would occur.  JOBS would be CREATED.
  4. One more missing piece.  When a home with an underwater mortgage note sells for appraised value, the selling homeowner has no equity with which to purchase another home, even with a good job, good credit scores, and acceptable expense ratios.  In a recent article (Barron’s “The Next Mortgage Bombshell”, 6/25/11) author Jonathan Laing indicates that the big three private mortgage insurers, PMI, Radian, and MGIC, likely have insufficient capital to survive the current housing depression.  Enter FNMA (“Fannie”), FHLMC (“Freddie”) or their successor(s).  The original concept of Fannie and Freddie was to provide liquidity to the mortgage market, not to become the dominating forces.  Becoming mortgage insurers would accomplish the original intent.  And no taxpayer dollars would have to be expended if the mortgage insurance is properly underwritten.  By insuring the top 10%-20% of new mortgages, those underwater homeowners who sell are now able to repurchase, and FIs can issue new loans with a 10%-20% equity cushion, just like in the old days.

Almost none of this is new.  In the search for solutions to the jobs issue, at least this attacks the problem – the deterioration of middle America’s balance sheet.  And it won’t cost the taxpayer a single dollar.

 

Robert Barone, Ph.D.

June 27, 2011

Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

 

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June 27, 2011

Bernanke: Failure, or Just Delusional?

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:47 PM by Robert Barone

In his June 7th speech, Fed Chairman Ben Bernanke stated, “the best way for the Federal Reserve to support the fundamental value of the dollar in the medium term is to pursue our dual mandate of maximum employment and price stability, and we will certainly do that.“.

It is instructive to take a look at the actual Federal Reserve goals, as well Bernanke’s results in pursuing those goals.

Goals of Monetary Policy (emphasis added)

“The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Mar­ket Committee should seek ‘to promote effectively the goals of maxi­mum employment, stable prices, and moderate long-term interest rates’.  Stable prices in the long run are a precondition for maximum sustainable output growth and employment as well as moderate long-term interest rates. When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are undistorted by inflation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living. Moreover, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inflation—and the need to guard against such losses—are minimized, households are encouraged to save more and busi­nesses are encouraged to invest more.” (http://www.federalreserve.gov/pf/pdf/pf_2.pdf)

Let’s look at the results of Bernanke’s economic “fine tuning”(using data from the St. Louis Fed’s database, starting in February, 2006, through April 2011), and see if he has successfully pursued this mandate.

Definition of STABLE (from the Mirriam-Webster dictionary)

a : firmly established : fixed, steadfast <stable opinions>

b : not changing or fluctuating : unvarying <in stable condition>

c : permanent, enduring <stable civilizations>

Stable Prices?

Stable prices are one of the Fed’s primary mandates.  In the table below, take a look at what has happened to the prices of items in a typical U.S. consumer’s budget since Ben took the reins:

Feb ’06 – April ’11

Items in a Typical Budget

% Change

Food and Beverages

16.54%

Water and sewer and trash collection services

31.88%

Rent of primary residence

13.82%

 Housing

8.68%

Fuels and Utilities

11.93%

Apparel

4.83%

 Medical Care

20.11%

Gasoline (all types)

65.12%

Transportation

23.36%

Tuition, other school fees, and childcare

29.28%

Recreation

2.87%

It is easy to play with the weightings of the above prices, and see how individual budgets would be impacted.  Regardless of the method used to look at prices, it is clear that Bernanke has not been successful at maintaining price stability since taking over as Fed Chairman.  Mandate not accomplished.

Maximum or Full Employment

Finding a strict definition of maximum employment is impossible.  Many economist give different estimates, ranging from 2-7%.  The standard Unemployment Rate most often used by the Fed is currently at 9.1%, up 90% since Bernanke started.  The more inclusive (realistic) U6 number stands at 15.8%, up 75% in the same period.  The Civilian Participation Rate has declined 2.87% to 64.2%.  This is the lowest level the U.S. has seen since March, 1984.  The decline amounts to 8,946,844 fewer Americans in the labor force.  Had they not dropped out because of a lack of jobs, the “official” unemployment rate would be significantly higher.  While we can debate the meaning of the term maximum employment, it is clear that the jobs data has deteriorated considerably since Bernanke took the reins at the Fed.  Mandate not accomplished.

Moderate Interest Rates

While not stated in Bernanke’s recent address, the Fed’s website also posts “moderate interest rates” as a stated goal.  While we cannot definitively say what constitutes “moderate”, we do know that both short and long-term interest rates are near all time lows.  It is safe to assume that near record low rates are not “moderate”.  Further, when  interest rates are artificially held below the rate of economic growth,” financial repression” is occurring.  Many bright folks have commented on how the zero interest rate policy (ZIRP) is destructive to savers and misallocates resources.  It is safe to say that this mandate has not been accomplished.

In conclusion, it is evident that Ben Bernanke is failing his mandates.  We believe it must come down to one of the following reasons:

  1. Bernanke does not know how to achieve his mandates;
  2. The policy tools employed don’t work;
  3. He does not have the ability to implement policies that would work;
  4. He is not trying to achieve his mandates;
  5. He has goals other than his legal mandates;
  6. He does not look at the data, and believes he is succeeding.

We will leave it up to our readers to make their own conclusions.

Matt Marcewicz

Robert Barone, Ph.D.

June 17, 2011

Matthew Marcewicz is an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative of Ancora Securities, Inc. (Member FINRA/SIPC).  Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

June 24, 2011

Two Soft Patch Views

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 4:38 PM by Robert Barone

There are two views on the softening economic data that began in April and has continued unabated.  The majority view is that the U.S. (and world) is in a “soft patch”, similar to the one that occurred last summer.  The disasters in Japan have caused supply chain disruptions which are blamed, along with $4/gallon gasoline, for the economic slowdown.  The view is, now that the supply disruptions are ending and gasoline prices are on the decline, consumption will expand thus ending the soft patch.

The minority view, and the one that I espouse, sees howling headwinds which threaten to turn the soft patch into outright recession.  What follows is a discussion of those headwinds.

  1. Employment is one of the two biggest issues facing the U.S. today even if one believes that the 9.1% unemployment number is accurate.  The headline Establishment Survey data is beset with issues from unstable seasonal factors to significant upward bias from an arcane birth-death business formation model which automatically adds approximately 50,000 jobs per month, as the Bureau of Labor Statistics believes that there are significantly more small businesses being created than are being closed.  Apparently, these folks haven’t left the Washington, D.C. area for the last couple of years. (See the work of John Williams at Shadow Government Statistics.)  It is more likely that the U6 unemployment rate (15.8%) is closer to reality.  The recent fall we have seen in the “official” rate from 9.8% in November to 9.1% in May appears to be more due to a falloff in layoffs than a rise in hiring.  Over taxation and over regulation are often cited as reasons businesses won’t hire, and I suspect this is partly true.  But, it appears that lack of demand and credit availability are the bigger culprits.  Data show that real wages have been flat to down since 1997, and that the expansion of ’02-’08 was based on debt alone, a condition that won’t occur again anytime soon.
  2. The other big issue in America today is mortgages.  More than 28% of them are underwater in the U.S.  On top of that, in ’06 at the height of the housing insanity, financial institutions were issuing 100%+ loans with negative amortizations for the first 5 years at variable interest rates.  Today, 5 years later, many such loans must begin full amortization, more than doubling the mortgage payments.  The vast majority of these will default.  Thus, we have at least 18 more months of significant foreclosure activity, falling home prices, and, as a result, continued low levels of new construction activity which used to be a significant economic driver.  The continued downward pressure on home prices will weigh heavily on consumer sentiment, consumer balance sheets, and consumption levels.
  3. According to David Rosenberg (Gluskin-Sheff), while QE2 certainly caused equity prices to rise, the wealth created in the past 8 months in the equity markets benefitted those least impacted by the slow economy, while the ongoing losses in home values hit middle America and the ordinary consumer much harder.  Without the payroll tax decrease at the beginning of the year, Rosenberg asserts that consumption would have declined in the first quarter.
  4. There are several news stories daily regarding state and local finances.  Either there are announced layoffs or workers are accepting lower wages, lower benefit levels, or must contribute more heavily to those benefits.  That leaves much less discretionary spending.  All levels of state and local governments are cutting spending.  A similar drama, of course, is now playing out in Washington, D.C.  The current soft patch will not be met with additional government spending or, according to the Fed, QE3.
  5. Remember, the soft patch of the summer of ’10 ended with the QE2 stimulus and additional deficits with the extension of the Bush tax cuts.  The result was at least $600 billion of money printing to purchase the Treasury Notes required by the deficit.  In addition, the sub-par recovery to date has been supported by the most massive fiscal and monetary stimuli in history.  Without such additional support, either through additional deficit programs or QE3, the soft patch could easily turn into outright recession.
  6. Like its predecessors in Japan and the U.S., the European debt crisis will be a long-term drag on world consumption.  No matter what the outcome is for Greece and the other weaklings in the European Union, the European banks are stuck with a lot of underwater sovereign debt.  There has even been some negative impacts on the U.S. muni market as one European bank, Dexia SA, a large insurer of U.S. muni debt, is overly exposed to Greek bonds resulting in rising yields on those U.S. muni issues.  The experience of Japan for the past 20 years and that of the U.S. for the past 2, along with the now famous  research of Rinehart and Rogoff, strongly suggests that, when banks hold impaired assets that aren’t recognized in their financial statements, lending dries up.  The current Dexia situation is a good example.
  7. And so it is in the U.S. as lending continues to disappoint.  Commercial and Industrial loans at U.S. commercial banks peaked in October ’08 at $1.6 trillion and fell to $1.2 trillion by last October (or by nearly 25%).  Since then (as of May) they have risen 4.3%, but most of that was due to student loans with federal guarantees.  The banks all comment that there is really no loan demand.  Clearly, large cap corporations have excess cash on their balance sheets, and they all use the credit markets for their borrowing needs.  That means that small and medium size businesses that must borrow from a financial institution either don’t want to borrow or don’t qualify under current bank lending standards.  In either case, since small business drives employment, the lack of lending is not a good sign.
  8. The only really good sign has been large cap corporate profits.  But even these are worrisome.  Having grown at double digit rates since the doldrums of ’09, forecasts of profit growth are now migrating to single digits with a downright negative tone to guidance going forward.  And, speaking of the markets, Treasury yields have fallen dramatically over the past 4 months.  The 10 year Treasury yield has fallen below 3% from 3.72% in February and 3.57% in April.  Usually, the bond market sees the correct direction of the economy before the equity market.  Bonds seem to be indicating more than just a “soft patch”.
  9. Lastly, recent statements by Fed Chairman Bernanke, usually the biggest cheerleader in Washington, D.C., and Fed Governor Dudley indicate that they see trouble ahead.  Dudley recently said that “the recent disappointing data suggest that downside risks to the outlook have increased”, and he specifically mentioned a) high oil and commodity prices, b) declining home prices, c) slowing consumer spending, and d) aggressive government spending cuts or tax increases.  In a June 7 speech, Bernanke was downbeat about the economy and sounded somewhat frustrated.  “Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established,” he said.  If these guys are worried, I think we all should be.

Conclusion

There are so many headwinds that the most rational view appears to be that the “soft patch” will likely turn into recession.  Employment and Housing are not improving; there is negative stimulus emanating from all levels of government, and, because this is a balance sheet recession, the economy has not responded well to massive stimulus. Lending in the U.S. has disappointed, and the European debt crisis will turn the lending spigot off there as well.  Corporate guidance has turned negative, and the bond market is indicating economic issues ahead.  Finally, the Fed itself is worried.  Initially, there won’t be QE3.  But, I suspect that, if a recession begins to unfold, we will see a QE3 and more fiscal stimulus.  The dollar will weaken further.

Robert Barone, Ph.D.

June 17, 2011

Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

 

June 13, 2011

The Concept of Inflation as a Measure of Standard of Living

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:19 PM by Robert Barone

There is a debate in financial circles as to whether or not we even have inflation, and, if we do, should we even worry about it.  As expected, the chief monetary and fiscal officers of the federal government deny that inflation is a problem or that their policies have anything to do with it.  This was reaffirmed by Chairman Bernanke in his talk to The International Monetary Conference on June 7.  St. Louis Federal Reserve Bank economists, Chen and Wen, in a recent paper1 using data from prior oil shocks, conclude that while such oil price shocks had significant “inflationary” impacts in the 1970s and in the early 1980s, today, rapidly rising oil prices appear “to have only transitory effects on headline inflation and virtually no impact on measures of underlying inflation”.

Statistical Proof

Much of the debate centers around semantics and the “meaning” of the word “inflation”.  If you adopt one meaning, as Chen and Wen do, then inflation is not an issue.  If you happen to believe that inflation in the U.S. is actually measured by the “core” CPI numbers reported by the Bureau of Labor Statistics (BLS), then you, like our government leaders, shouldn’t be concerned.  However, despite the fact that Chen and Wen conclude that inflation is not a problem (at least relative to the price of oil), in a footnote there is an admission that their conclusions are based upon their definition of inflation.  “Although the effect on inflation [of oil price shocks] is transitory, the effect on the price level is not, because inflation is defined as the rate of change in the price level, not the price level itself” [emphasis added].  An appropriate interpretation of this is that we can have high inflation in the sense of high permanent prices, but we shouldn’t worry about it because it will disappear as soon as the underlying cause disappears.

The Standard of Living Concept

On the other hand, if your definition of inflation is a concept that measures, not prices alone, but “standard of living”, then the rest of this blog may be relevant to you.  Under the “standard of living” definition, the general price level can actually be falling but “inflation” can be an issue if incomes are falling faster than prices, and, thus, the standard of living is declining.

In his 1937 book, Seven Kinds of Inflation – and What to do About Them, Richard Skinner identifies four kinds of “absolute” inflations and three kinds of “relative” ones.  Absolute inflations include:

1.  Rising prices of fixed income securities

2.  Rising prices of land, equity securities and business values

3.  Rising short-term interest rates

4.  Rising general prices and living costs.

Today’s definition of inflation as measured only by the CPI only captures item 4, but we all recognize items 1 and 2 and refer to these as “asset bubbles”.  Relative inflations include:

5.  Growth in debt compared to wealth

6.  Growth in interest charges compared to income

7.  Growth in living costs compared with income.

Everybody now recognizes that item 5 describes the last two decades, and it appears that, with rising costs of vital food and energy commodities, item 7 would appear to apply today.  As debt costs rise, like those in Greece, we know that item 6 is also real.  So, of the seven kinds of inflation described by this 1937 work, we easily recognize six of them.  Of those six, two are commonly referred to as “asset bubbles” (items 1 and 2), and three are recognized as economic problems, but not categorized as inflation (items 5, 6 and 7).  Only one, rising general prices and living costs (item 4) is, today, actually called “inflation”.

Who is Right?

As could be expected and briefly described above, the government (Geithner, Bernanke) is in the camp that denies that inflation is a real issue.  They will defend this position as long as they have an argument that is even mildly credible.  And there are a whole set of well respected economists who believe that inflation isn’t an issue to worry about.  David Rosenberg (Gluskin Sheff), for example, believes that deflation is a bigger threat because of stagnant real incomes, high debt levels, and significant balance sheet issues for America’s consumers due to the real estate depression.  On the other hand, there are those pro-inflationists who point to $4/gallon gasoline and rapidly rising food prices, which they blame on QE1 and QE2, as proof positive that inflation is rampant.  So, who is right?

Actually, both are.  Rosenberg’s “deflation” is a “standard of living” concept.  One might categorize it as close to Skinner’s “relative” inflation concept (item 7 above – incomes not keeping up with prices), while the pro-inflationists are referring to one of Skinner’s “absolute” inflation concepts (item 4 above – rising general prices and living costs).

Cost-Push Inflation

Cost-push inflation is the kind that some American’s may remember from the 1970s.  Cost-push inflation is generally caused by input factor “shortages”, usually labor.  These could be real shortages or contrived shortages. They are real if the economy is operating at full or near full employment.  And the mild inflation we experienced in the early part of the last decade could possibly be attributed to such shortages.  In the 1970s, they were contrived.  At that time, unions were much stronger than today, and they could tie wage increases to an increase in the CPI measure.  As companies raised prices to protect profit margins from increasing wages, another round of wage increases resulted.  A vicious cycle had been created, one that could occur even when the economy was not operating with full employment.  Thus, the term “stagflation” was born.

We clearly do not have this type of inflation today.  First, unions represent a much smaller percentage of the employed labor force.  And, the industries in which they are strong are all either struggling (e.g., autos, or government employees) or are highly cyclical (construction and transportation).  Unions, today, do well just to hold wages and benefits at current nominal levels, and, most are making concessions.

Asset Bubbles

The next type of inflation, asset bubbles, has little to do with capacity constraints or restricted production inputs.  This generally occurs when a particular asset or class of assets begins to rise in price usually due to some basic economic change (innovation, government policy etc.), and early players in the bubble make “easy” money.  A large swath of the public is attracted to the game and asset prices are bid up to a crescendo peak, with each player having little use for the asset itself except to “flip” it for a quick profit.  Such bubbles always end in disaster for the late entrants, and oftentimes for those who weren’t even playing.  The recent U.S. housing bubble and the dot.com bubble are two good examples.  Some say that QE1 and QE2 has turned the current equity market into another such bubble.  That remains to be seen.

Currency Depreciation

Depreciation of the currency relative to other currencies is another significant source of inflation.  This source could be significant for a country that imports a large amount of vital commodities and other goods and services.  The U.S. falls into this category with large importations of oil and manufactured goods.   The work of Raphael Auer2, another Fed economist (Dallas), indicates that because of the volume of Chinese imports and their resultant weight in American’s inflation indexes, the appreciation of the Yuan would “substantially alter the competitive environment on many U.S. markets and consequently lend to widespread inflationary dynamics”. Thus, as the dollar falls in value, the dollar cost of imported goods rises.  And, since the dollar is the world’s reserve currency, and most international trade is done with dollar payments, dollar weakness is a significant source of inflation.  With real wages stagnant and median household income down to 1997 levels in real terms, the increases in the prices of energy and imported manufactured goods have lowered the standard of living for most Americans.

Conclusion

In conclusion, “inflation” in the standard of living sense is clearly a problem today.  Unlike cost-push inflation, this is not a self-feeding spiral.  So, the statements of government officials, like Geithner and Bernanke, that proclaim that the “inflation” is “temporary”, are not exactly false, but they are misleading.  This “temporary” inflation will end when the dollar stops falling in value.  But, when will that happen?  That will happen when the financial repression of interest rates and money printing by the Federal Reserve ends and a real solution to the structural fiscal deficit is crafted.  Given the nature of politics in the U.S., those events may still be a long way off.  Unless there is some international disaster that causes a run to the dollar as a safe haven (a phenomenon that appears to be getting weaker and weaker), the “temporary” time frame may be significantly longer than the rhetoric implies.

The price of gasoline can, and as of this writing, has moved downward from its $4/gallon level, due mainly to falling demand. But, because of dollar weakness, it is unlikely to fall to where it was a year ago.  And, even if the dollar’s value stabilizes, all this means is that prices stop rising, not that they return to their lower levels.  Clearly, without commensurate rises in wage and income levels, the standard of living will continue to fall.

It is a disservice to Americans to assure them that “inflation” is “temporary”, and therefore not a policy issue when there is ample evidence that the very policies of the government (money printing and uncontrollable deficit spending) are the root causes of the declining standard of living and are unlikely to be reversed anytime soon.

Robert Barone, Ph.D.

June 7, 2011

1Mingyu Chen and Yi Wen, Oil Price Shocks and Inflation Risk, Federal Reserve Bank of St. Louis, June, 2011.

2Raphael Auer, “Exchange Rate Pass-Through, Domestic Competition and Inflation: Evidence from the 2005/2008 Devaluation of the Renminbi”, Working Paper No. 8, Federal Reserve bank of Dallas, January, 2011.

Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.  He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

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