February 12, 2014
In countries where central banks are printing money, such as the US, UK, eurozone, and Japan, deflation is the fear. On the other hand, inflation is high in countries where central banks have followed more traditional policies, like Brazil (official inflation 5.9%), India (11.5%), Indonesia (8.4%), and Turkey (7.4%). One explanation is the carry trade. Because the central banks of the developed world promised low rates for the long term, the liquidity created by those central banks found its way into the economies of the emerging markets (EM) (read: borrow at low interest rates, invest at high ones). Unfortunately, most of those funds did not find their way into capital investment in those markets, but was instead used for consumption, which has played havoc with EM trade balances. When the demand side (usually measured by GDP) outstrips the supply side (potential GDP), inflation occurs. Now that the bubble in EM countries, caused by excess liquidity in the developed world, is starting to burst — investors no longer believe the carry trade will last much longer — what will become of all of that liquidity?
On February 4, the Congressional Budget Office (CBO), a supposed non-partisan government agency, released a shocking report, “The Budget and Economic Outlook: 2014 to 2024,” projecting that over the next 10 years the Affordable Care Act, commonly referred to as Obamacare, would reduce future employment rolls by more than 2.3 million. Overlooked in that report is the CBO’s projection that “potential” GDP in the US will be much slower over the next 10-year period than it has averaged since 1950; this in an age of innovation where rapid change is considered normal. The CBO says that “changes in people’s economic incentives caused by federal tax and spending policies set in current law are expected to reduce the number of hours workedâ€¦” and “that estimate largely reflects changes in labor hours worked owing to the ACA [Affordable Care Act].”
In the US, if the current gap between real GDP and potential GDP closes (and the so-called “slack” in the economy disappears as the CBO projects it will), then, just like in the EMs, any growth on the demand side of GDP above potential GDP, ends up, by definition, as inflation.
There are a many measures that indicate that the economy is much closer to its potential than is generally assumed. One such measure is the fact that, despite record levels of cash flow (used mainly for stock buybacks or dividends), for the past five years, corporations have not reinvested in their plant and equipment. According to David Rosenberg (Gluskin-Sheff), the average age of the capital stock in the US is almost 22 years, an average not seen since 1958. Given the fact that the cost of capital is near an all-time low, there is something holding back such investment. Rosenberg speculates that it is likely found in overregulation and the uncertainty regarding tax policy. An old and aging capital stock implies a much lower growth rate of potential GDP than in the past when the capital stock was younger.
The second issue is the labor force. While the December and January Establishment Survey disappointed the markets (December’s survey reported 75,000 jobs added; January saw a gain of 113,000), nobody is talking about the Household Survey. This is the survey from which the “official” unemployment rate is calculated. While more volatile that the Establishment Survey, the Household Survey showed gains of 143,000 jobs in December and a whopping 638,000 in January. When combined with other surveys (NFIB) which show that 23% of small businesses have at least one open position that they cannot fill (a six-year high according to Rosenberg), and that there is a sustained uptrend in voluntary quits, it would appear that the Establishment Survey is the outlier and that the labor market is quite tight.
If, indeed, the CBO is correct and potential GDP growth will slow over the next 10 years due to Obamacare, a tight labor market in conjunction with old capital stock will only exacerbate that situation. Since the financial crisis, the unemployment rate has fallen from 10.0% in October ’09 to 6.6% in January ’14, a 3.4 percentage point decline. During that period of time, the annual GDP growth rate has been about 2.4%. After the recession of the ’90s, to get the unemployment rate to fall 3.4 percentage points (from 7.8% to 4.4%), it took an annualized GDP growth rate of 3.7%. The lower GDP growth required to reduce the unemployment rate implies that the gap between actual and potential GDP is either small or nonexistent.
The aging of the capital stock, lack of new investment, and the tightening labor market indicate that resources are in short supply, which means that there is a strong probability that any semblance of robust economic growth will be accompanied by inflation. Adding to such pressure is the liquidity sloshing around the EM world. If it finds its way home, as appears to be happening, unless much of it goes into new capital formation (which is unlikely given the current regulatory and tax regimes), we are likely to see growing inflationary pressures much sooner than is currently priced into the financial markets.
February 4, 2014
There is no doubt that the gap between the rich and the middle class and poor has widened in recent years. And the most recent studies confirm a continuation of that trend with capital gains playing a major role.
What is ironic is that public policies — some long practiced, some new, — contribute significantly to the problem. Recognizing and fixing such policy issues, however, is easier said than done.
In this post, I will discuss three such policies: 1) The asset inflation policies of the Fed; 2) The policy that significantly understates inflation; and 3) The policies that strangle lending to small business. There are many other public policies, such as work disincentives, that also have an impact, but I’ll discuss them another time
Since the financial crisis, the Fed, through its “quantitative-easing” policies, has relied upon the “wealth effect” via equity asset price inflation to combat the so-called deflationary forces that had built up in the economy.
Each time a QE policy ended, there was a big decline in equity prices. Those declines prompted another round of QE.
As indicated above, capital gains have played a major role in the recent growth of the income gap. Those gains also played a major role in the dot.com and subprime bubbles of the recent past.
In his Jan. 29 missive to clients, David Rosenberg of Gluskin Sheff, a wealth-management firm, said that “if we were to replace the imputed rent measure of CPI (consumer price index) with the actual transaction price measure of the CS-20 [Case Shiller home price index], core inflation would be 5.3% today, not 1.7% as per the ‘official’ government number…”
John Williams (www.shadowstats.com) indicates that, using the 1990 CPI computation, inflation in the U.S. was 4.9% in 2013; using the 1980 computation method, it was 9.1%.
Those of you old enough may remember that in 1980 the then new Fed Chairman, Paul Volker, began to raise interest rates to double-digit levels to combat an inflation that was not much higher than the 9.1% of today (if the 1980 methodology is used).
Over the years the Bureau of Labor Statistics has changed the computation method for CPI, in effect, significantly biasing it to produce a much lower inflation rate.
In a post I wrote last September (“Hidden Inflation Slows Growth, Holds Down Wages,” TheStreet.com, 9/13/13), I showed how the growth of wages earned by middle-class employees has hugged the “official” inflation trend.
If that “official” inflation trend understates real inflation by 3% per year (the difference between Williams’ computation using the 1990 methodology and 2013’s “official” rate is 3.1%), over a 20-year period, the real purchasing power of that wage would fall by more than 80%.
That helps to explain why both husbands and wives must work today, why the birth rate is falling and why the income gap is widening.
Once again, changing the inflation measurement problem is easier said than done. In the U.S., Japan, the U.K and the eurozone, debt levels are a huge issue. Lower inflation rates keep interest rates low, allow new borrowing (budget deficits) at low rates and keep the interest cost of the debt manageable (at least temporarily).
Also, a low official rate keeps the cost-of-living adjustments for social programs — Social Security, Medicare and government pensions — low. As a result, Social Security, Medicare and pension payments are significantly lower than they otherwise would be. Returning to the older, more accurate inflation measures would truly be budget busting.
Constraints on Small Business Lending
One of the reasons that the economic recovery has been so sluggish is the inability for small business to expand. Since the financial crisis, much of the money creation by the Fed has ended up as excess reserves in the banking system (now more than $2.3 trillion).
Small businesses employ more than 75% of the workforce. So, why aren’t banks lending to small businesses?
In prior periods of economic growth, especially in the 1990s and the first few years of the current century, it was the small and intermediate-sized banks that made loans to small businesses in their communities.
Today, for many of the banks that survived the last five years, there are so many newly imposed reporting and lending constraints (Dodd-Frank) and such a fear of regulatory criticism, fines or other disciplinary action that these institutions won’t take any risk at all. In earlier times, the annual number of new community bank charters was always in the high double digits.
But, since 2011, the FDIC has approved only one new bank charter that wasn’t for the purpose of saving an existing troubled bank. Only one!
In effect, the federal regulators now run the community banking system from seats of power in their far away offices.
Small businesses cannot grow due to the unavailability of funding caused by overregulation and government imposed constraints. This holds down the income growth of much of the entrepreneurial class and is a significant contributor to income inequality. Of the policies discussed in this post, this would be the easiest to change.
There is definitely a growing income gap, but, much of it is the result of public policy. New elections or new legislation won’t fix these policies. The first step is recognition. But, as I’ve pointed out, many of these policies are rooted in the fabric of government.
There is little desire on the part of those comfortably in power to recognize them, much less to initiate any changes.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Contact Robert Barone or the professionals at UVA (Joshua Barone and Andrea Knapp)
are available to discuss client investment needs. Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.