Changing Dance Partners

October 14, 2018

by Steve Stofka

This week’s stock market activity helps us remember some simple rules of investing. Many of us confuse mass and weight. Mass is the resistance of an object to a change in speed or direction. Weight is the force of gravity on that object. Using this model, let’s compare the masses of stocks and bonds. On Wednesday, when stocks fell over 3%, the price of a broad bond composite barely moved.

Bonds act like a big cruise ship, more resistant to changes in wind and wave than a sailboat. The cruise ship’s progress is ponderous but predictable. Stocks behave like a sailboat which moves in a zig-zag fashion, changing directions to cope with wind and wave. Sometimes, the sailboat makes a lot of progress in calm waves with a favorable wind. November 2016 through January 2018 was one such period when stocks made steady progress.

On the previous Wednesday, October 3rd, a “rout” – a half-percent drop – in the bond market indicated a global unease. A half-percent move in the stock market occurs weekly. The last half-percent drop in the bond market was on March 1st 2017, eighteen months ago. Let’s look at that incident to help us understand the pattern.


Post-election, the stock market rose for three months, then plateaued for two weeks following that bond rout. Bonds drifted slightly lower and then, on March 15, 2017, charged higher by .6%. Within a few days, stocks lost 2-1/2%. On May 17th, bonds again surged, and stocks fell 2%.

The gigantic size of the bond market dwarfs the stock market. An infrequent daily shift in the pricing of the bond market signals a long-term recalculation of future risks and profits in both the bond and stock markets. When large shifts in the bond market happen frequently, stock investors should pay attention. Between Thanksgiving 2007 and the end of that year, the bond market experienced ten days of greater than 1/2% price swings! It signaled confusion and was a warning to stock investors that rough times were coming.

The bond market’s YTD price loss of 4% marks the probable end of a multi-decade bull market in bonds. The bond market is so stable that a small loss of 4% can mark the largest loss in decades.

We are seeing a change in dance partners. As an example, the stocks of high growth companies rose 20% from February lows. That was almost twice the gains of the SP500 broader market. Many of these are small and medium size companies whose growth is hampered by the greater cost of borrowing money in an environment of rising interest rates. The owners of growth stocks wanted to take some profits this past week but could not find buyers at those high prices. In the past week, prices of those stocks fell 8%. Cushioning the fall of some stocks is the large stockpile of cash – $350 billion – that U.S. companies have stockpiled for buybacks of their own stock. Some of that money was put to work in Friday’s recovery.

The U.S. stock market has been the one of the few bright spots in a global marketplace that has turned down this year. This week begins the reporting for the 3rd quarter earnings season so we may see more price swings in the days to come.

Consumer Credit

It is very iniquitous to make me pay my debts; you have no idea of the pain it gives one. – Lord Byron

October 7, 2018

by Steve Stofka

The total of all consumer loans, excluding mortgages, is almost $4 trillion. The Federal government owns $1.5 trillion of that total, most of which is student loans, which have tripled in the past decade. According to the Dept. of Education, 11% of student loans are in default, three times the credit card default rate and more than ten times the auto loan default rate (Note #1).

Over a five-decade period, the stock market has risen when consumer credit rose. Below is a chart of consumer debt outstanding as a percent of GDP (Note #2).


This a decade long indicator, not a timing tool. Notice that the ratio of credit to GDP (blue line) rises during recessions (shaded gray) when GDP, the bottom number in the fraction, falls. When the recession is over, credit falls as people fall behind in their payments, loans are written off, etc. Now GDP starts rising again while the top number, credit, is falling.

Auto loans make up 28% of outstanding consumer credit and currently have less than a 1% default rate. If we adjust the total of consumer credit by the extraordinary growth in student loans, auto loans make up 39% of total consumer credit (Note #3). We saw a similar percentage in the mid to late 1980s when savings and loans aggressively extended auto loans and mortgages. In the late 1980s and early 1990s, a third of all S&Ls failed.

Typically, people do not count vehicle depreciation in their budget, but they should, just as businesses do. Example: the average yearly take-home pay is $52K. Let’s say the average car, new and used, is $24K and depreciates $2400 a year (Note #4). Let’s say that the average person saves about $2400 a year to make the math easy. The $2400 that goes in the savings bank is simply offsetting the $2400 in depreciation. There is no savings.

In addition to depreciation, many of us don’t include the cost of inflation in our budget. Six years from now, a replacement car, new or old, could cost an additional 15%. Without adjusting for these “hidden” costs, we may think we are getting by. Over time, however, we add these hidden costs to our credit balances. We put less down on the next car and get longer auto loans. The average loan length is now 5-1/2 years. As soon as we are done paying off one car, it is time to get another (Note #5).

The economy is strong, and it needs to stay strong so that households can pay back their loans. The ultra-low interest rates of the past decade have reduced the monthly debt payments for many. For the past two years they have leveled at 5.6% of disposable personal income, the mid-point of the past forty years. For every $20 that a person takes home, they are paying $1 to service their consumer debt. The average yearly debt service payment would be about $3000 on a $52K take-home pay.

In response to the strong economy, the Federal Reserve has been raising interest rates to a more normal range. The 30-year mortgage rate just hit 5% this past week. Rising interest rates raise the monthly payments and reduce the loan amounts that borrowers can qualify for.  Many younger workers are unfamiliar with a world of normal interest rates.  They will have to learn a new math.



1. Student default rates . Default rates reported by the credit agency Experian .
2. More detail on consumer credit here at the Federal Reserve ()
3. I made the adjustment by subtracting $1 trillion in Federal student loans from the current total of credit. This pretends that Federal loans grew 15% in the past decade, not 300%.
4. The average amount financed on a used car is $17,500 (FRED series DTCTLVEUANQ). New car loans average $29,800 (FRED series DTCTLVENANM).
5. A buyer of a new car holds it for 71 months according to Auto Trader.



Amy Finkelstein is a MacArthur genius award recipient who studies trends in health care. Proponents of Medicaid expansion projected that lower income families would better control and plan their medical care under Medicaid. Instead they have used the ER even more.  She found that people visit the ER more, not less. Although families report better health and more confidence in their financial security because of Medicaid expansion, measureable health outcomes have shown no change. WSJ article (paywall) is here. Her citations on Google Scholar.


Inflation Measures

“Everyone is entitled to his own opinion but not to his own facts.” – Sen. Daniel Patrick Moynihan

September 30, 2018

by Steve Stofka

The above quote has been attributed to the former Senate Majority Leader. People repeat the quote when discussing a contentious subject. We are often convinced that we have the facts when our facts may indeed be arbitrary. Let’s take the case of real or inflation-adjusted income. Has the average real wage declined or risen in the past decades? The calculation depends on which measure of inflation we choose.

There are two measures of inflation, the Consumer Price Index (CPI) and the Personal Consumption Expenditure Price Index (PCE). The CPI relies on surveys of what consumers buy. The PCE is based on surveys of what businesses sell (Note #1). The CPI uses a fixed basket of goods, regardless of changes in the prices of items in a basket. If the weekly basket of goods includes two pounds of ground beef, that two pounds never changes in response to lower prices. It is static. The PCE does adjust for price changes. If the price of a pound of ground beef went down thirty cents, the PCE calculates that a family bought a bit more ground beef and a little bit less chicken, for example. It is a dynamic measure.

People drive fewer miles and buy more fuel-efficient cars as the price of gas increases BUT only after a certain dollar amount. Our purchasing patterns are both static and dynamic. Because we are creatures of habit, our buying patterns are resistant to change. Within a certain price range, we will continue to buy the same items. Outside of that range, we do make changes because we want to optimize our choices.

In the past forty years the CPI has calculated an annual rate of inflation that is over ½% higher than the PCE rate. That small difference compounded over forty years amounts to 23%. That large difference tells two very different stories. Using the CPI, the average worker has lost a few percent in inflation adjusted hourly wages. Using the PCE, on the other hand, the average worker has enjoyed real gains of 20% in the past forty years (Note #2).

Our most volatile disagreements are in areas where facts are difficult to observe. The household survey data that underlies the CPI is unreliable because people living busy lives are not accurate journal keepers of their daily purchases. On the other hand, surveys based on business sales are inaccurate because people stock up on items whose prices decline.

Even when facts are readily verifiable, the interpretation of those facts varies with context. In arriving at our version of the meaning of those facts and their context, we subtract a lot of observable data.  We must filter reality because we cannot manage such a large amount of information. Because we filter our perceptions, eyewitness testimony is unreliable. Although our perceptions are inaccurate, we must act on those perceptions and hope that they are accurate enough. That same reasoning guides economists, politicians, and those in the social and physical sciences. We would all have more constructive discussions if we understood the imperfection of our perceptions.



1. The Difference between CPI and PCE {Federal Reserve}

2. Using the average hourly wage for production and non-supervisory employees.

The Crack in the World

Ignorance has one virtue: persistence. – John Kramer, Blythe

September 23, 2018

by Steve Stofka

Ten years ago, the financial world cracked. Job losses during the first eight months of 2008 were definite signs of recession, but this correction to an overheated housing market had been expected for two years. In July 2008 came the news that June’s job losses had eased. The average duration of a post-WW2 recession was eight months, so the correction was nearing an end. More worrying were the high gas prices, which had topped $4 per gallon. Beginning in mid-July, the stock market rose more than 5% and traded in a consolidation level through August.

In early September, the market lost 3% when August job losses worsened. Within a week, the market recovered those losses and closed on Friday, September 12th at the consolidation level it had been at during August. Over that weekend, the Federal Reserve, U.S. Treasury and other banking agencies tried to arrange a rescue of the investment firm Lehman Brothers.

On September 15th, the world learned of the firm’s collapse. Within hours, the market lost almost 5% of its value, more than the market may gain or lose in a year. In busy urban areas, people stopped to stare at the market’s extraordinary volatility displayed on storefront TV screens. There were more such days to come. Over the next two weeks of turbulent price swings, the market stabilized at its mid-July low, closing September just below 11,000.

What stabilized the market in those closing days of September? On September 30th, the N.Y. Times reported that the Securities and Exchange Commission (SEC) might suspend a newly implemented FASB international accounting standard SFAS 157 (Note #1 and #2). This accounting rule required financial institutions to value loans and other assets on their books at market value, not by the present value of future cash flows (Note #3). In turbulent markets, when raw fear is the auctioneer, market prices do not reflect the future value of assets.

After a TARP bill (Note #4) failed to pass Congress on the first go, there would be another attempt by the end of the first week in October. Neither the Congress or the administration could summon the political will to temporarily suspend the accounting rule. The TARP bill that President Bush signed on Saturday, October 3rd, required only that the SEC study the accounting rule.

Investors ran for the exits. The financial carnage may have happened in September, but the market implosion happened in October. In seven consecutive days in early October, the Dow Jones Industrial Average lost almost 23% of its value (Note #5). Did an accounting standard cause the financial crisis? No, but it did intensify negative investor reaction to the financial crisis, which exacerbated the crisis in a negative feedback loop.

In early March 2009, after the market had lost 40% of the value it had in early October 2008, the FASB announced that they would modify the standard a month later (Note #6). By the time that modification was implemented on April 9, 2009, the SP500 had risen 20%.

Could the Bush administration have eased the response to the crisis? Yes. Did accounting standards cause the financial crisis? No. Can we expect another crisis sooner rather than later? Yes. Central bankers and Federal agencies that supervise the banking system cannot fully monitor modern credit markets in real time. When the horses are spooked, regulators sitting in the driver’s seat may hold the reins but have little control of the panicked animals.

Investors who maintain some balance in their savings portfolio can weather these market catastrophes. 50% market falls have occurred only three times in the past fifty years (Note #7). Investors with long time horizons can afford to take a less balanced approach.


1. The FASB is a privately held international organization that sets accounting standards. Fair Value Accounting standard SFAS157 (“mark to market”) is one of their standards, implemented in 2006. An explanation of the standard from FASB in May 2008, before the crisis.

2. Suspension of the SFAS 157 standard would have allowed banks to report higher profits and relieve some of the capital pressures on bank balance sheets. Sept. 30th NY Times article.

3. FDR suspended mark-to-market accounting in 1938. See this March 2009 article for a  review of the issue.

4. TARP – The Troubled Asset Relief Program was a compilation of many programs designed to support the automotive, housing and financial industries. On page 11, a reminder of the corruption of Wall Street and the incompetence in Washington. “In March 2009, after receiving $170 billion in federal bailout money with another $30 billion pending, AIG announced a $165 million bonus payout to executives. Despite the bailout and the U.S. government having ownership control, AIG management thought it was prudent to pay executive bonuses in a financially struggling company. The U.S. government lacked the oversight to assure efficient use of taxpayer bailout funds.”

5. The sharp fall in October was the second sharpest decline since World War 2. The leader is the October 1987 crash, when the market lost 28% in four days.  What about the dot-com bust? Over 2-1/2 years, the market lost half its value but there wasn’t a decline of more than 20% during that market fall. The strongest decline began in February 2001 and took 34 trading days to lose 18%.

6. An article from the Harvard Business Review in November 2009.

7. 50% market falls: The gas crisis of 1973-74, the dot-com bust of 2000 – 2003, and the mortgage and financial crisis of 2007-2009. Less severe falls came in 1966, 1969-70, 1977-78, 1982, 1987, 1990, and 2011. These were all more than 20% drops in market value.



In mid-2016, the inflation-adjusted price of the SP500 index finally rose above its price at the start of the century. The price has risen 25% since then.


Not Trading

“It takes a lot of time to be a genius. You have to sit around so much, doing nothing, really doing nothing.”― Gertrude Stein

September 16, 2018

by Steve Stofka

As the U.S. market grinds higher, emerging markets are in bear territory, off 20% from their highs at the beginning of the year and selling at 2007 prices. After nine years of recovery, the U.S. economy is in the late stages of the cycle. Warnings of an impending market fall will come true at some point. If the market falls in 2020, those who called for a fall in 2014 will say, “See, I called it. Buy my book.” This year, hedge funds, the smart money, have underperformed index funds, the dumb money. For several years, passive index funds have outperformed active fund managers, a phenomenon that some warn will lead to a catastrophic meltdown when it happens.

For the average retail investor, it is difficult to beat buy and hold. An investor who bought the SP500 index 25 years ago would have earned 9% per year in price appreciation alone. Adding in dividends would have raised the annual gain to 9.58%. That is what is called a “Buy and Hold” (BnH) strategy. It’s not a strategy. It’s a strategy of no strategy, and yet it is surprisingly difficult to consistently beat a no-brainer no-strategy like BnH over several decades. The stock market earned this while riding through two downturns that erased half of the market’s value. Even a middle of the road strategy of 60% stocks and 40% bonds earned 8.3% annually during the same period.

Traders develop rules that work in one decade, but don’t work in the next. A strategy that worked well in the years 1998-2007 didn’t work well in the period 2008-2017. Why? Because they were two different time periods, with different events and circumstances (Note #1).

Here’s a rule that could have earned an investor twenty – yes, twenty – times BnH in the period from 1960-1993. The rule did not work in any timing frame other than daily. Each morning at the open, buy the SP500 index if the previous day was up, sell if it was down. Huge profits even after trading costs (Note #2). 1993 – 2018? It was a losing strategy. It would have been better to do exactly the opposite – sell after an up day and buy after a down day.

Every year thousands of people will shell out good money for a winning strategy that promises to best the market. Most strategies don’t beat the market consistently. Those that do are guarded like the nation’s gold at Fort Knox and are not shared. For the rest of us, the winning strategy is a few rules: save money and invest in a balanced portfolio that is appropriate for our age and needs in the next five years.



  1. From 1998-2007, an emerging market index fund (VEIEX) earned 15.08% annually. From 2008-2017, that same fund earned 1.13% annually. For the combined twenty-year period, the annual gain was 7.87%.
  2. Until the SPY exchange traded product was created in 1993, there was no product that enabled a retail investor to trade daily and frequently. Mutual funds that mimicked the index restricted the frequency of trades. I used the daily SP500 index numbers as though there had been such a product created in 1960.

The Reputation of Money

To be respected, authority has got to be respectable. – Tom Robbins

September 9, 2018

by Steve Stofka

Most nations create their own money, a super power of the modern state. The politicians and central bankers of each country have the responsibility to maintain the reputation of its money. Each nation is both the creator and net seller of its money, able to lower but not raise its comparative value. To raise that value, each nation depends on others to be net buyers of its money.

Nations carefully study the behavior of each other’s central banks. Argentina cut interest rates in January 2018 even though the country was experiencing high inflation. This action was the opposite of good central banker behavior, and hurt the reputation of the Argentine peso, which has lost half its value since January. Money traders suspected that the Argentine central bank had become captive to political control. Few trusted a politician with money super powers.

The reputation of a nation’s money rests on the steadiness of its tax revenues. As I have noted before, revenue from the sale of nationalized resources acts as a tax. Those commodity revenues do not build a money’s reputation as much as the tax revenues from the economic production of a nation’s people and businesses.

A nation can print its own money at little cost. A greater supply of anything, given a constant demand, lowers the price of that thing. The real cost of printing money is borne by the nation’s people and businesses who use that money for daily exchange. As a money’s value declines, that loss of value acts as a sales tax on each money unit exchanged. Let’s call that the king’s tax. This undeclared tax revenue does not build a money’s reputation.

A nation supports the reputation of its money by using its super powers with restraint. When a nation receives most of its tax revenues from its own internal production, that is a sign of a healthy economy, with a reasonable monetary and fiscal policy. When the king’s tax (inflation) and commodity resource revenues exceed half of a nation’s revenue, the value of its money becomes like two day old bread.

A nation’s money rises in reputation when it is bought, and there are two reasons for buying a nation’s money: 1) buying goods and services from that nation, and 2) loaning money to the governments and businesses of that nation. In 2017, China, the United States and Germany were the top exporters, putting their currencies in demand (Note #2). Loans to borrowers in emerging markets are often priced in U.S. dollars, the current reserve money of the world. If the money in that nation loses its value against the dollar, the borrowers effectively pay a king’s tax as they make their loan payments (Note #1). Typically, a nation will blame the tax on rapacious money dealers.

A nation’s money reputation relies on several factors that a nation can control: inflation, tax revenue and the source of that revenue. A nation is judged on its current and historical behavior with money and debt. Its political structure and the independence of its central bank are important factors as well. On an international stage, its money must compete with other nations in all these categories. Call it the daily beauty contest – no swimsuits.


1. EMB is a basket of emerging market debt priced in USD ( It is off 5% from its high at the beginning of the year and pays a dividend of 4.6%. Its annual return for the past ten years was 6.5%, the same as a long Treasury ETF like TLT. A broad bond index fund like Vanguard’s BND earned 3.8%.

2. Germany uses the Euro, not its own national currency. In 2017, China exported $2.35 trillion, the U.S. $1.55T and Germany $1.45T. Visual Capitalist picture graph. The site is a picture book for curious minds. Here’s one on the biggest employer in each state. For southern states, the answer is Wal-Mart. Universities and health care systems are prominent employers in many states.

Related: The U.S. owes $6.2 trillion to the rest of the world. China’s share of that debt is $1.8 trillion. The U.S. holds $125 billion in foreign reserves, similar to the amount Turkey holds. As the world’s reserve money, the U.S. holds enough foreign reserves to counter any distortions in currency markets.



In a survey of 5000 workers, Gallup found that only 51% had a single full-time job.  36% were gig workers.

Since 1991, real purchase only house prices have gone up 1.7% annually. FRED series HPIPONM226S / PCEPI, index 3/1991 = 100. Real rents and owner equivalent rent (OER) nationally have gone up 8/10ths percent annually. This is about half the rate of home price growth. Urban residents must pay an extra price. In Denver, rental prices have gone up 1.9% annually since 1991. OER has risen 1.7% annually. No doubt, California cities have even higher annual growth rates than national averages. Owner Equivalent Rent is a BLS-calculated rent that a homeowner pays themselves for use of the residence. This includes mortgage, repair and maintenance costs on the home.

The Force of the Fed

To some extent, the Federal Reserve considers itself government. Other times, when it serves, it considers itself not government. – Philip Coldwell, President FRB Dallas 1968-74

September 2, 2018

by Steve Stofka

The nations of the world are the gods of Mt. Money, most of them with central banks who administer the credit and currency of each nation. Like the ancient Mt. Olympus of Greek lore, there is competition and a hierarchy among the gods. Currently the U.S. is the top god of Mt. Money.  Central banks manage credit by changing the interest rate, or price, that they will charge the demi-god banks within the nation’s borders. The banks, however, do not perfectly distribute the intentions of the central bank. Acting as intermediaries, the banks filter monetary policy and have a more direct effect on the economy. In this intermediary role, banks control the draining of Federal taxes generated by the economic engine.

In the U.S., the Federal Reserve (Fed) is the central bank of the Federal government, an independent agency created by Congress which has given it two targets: promote full employment and stable inflation. To meet those goals, Fed economists must gauge the strength of the economy, a difficult task, and estimate an ideal state of the economy, an even more difficult task.

Each August the Federal Reserve holds an economic summit at Jackson Hole in Wyoming. The newly appointed head of the Federal Reserve, Jerome Powell, is the first non-economist leading the central bank in 39 years. His paper (Note #1) is plain spoken and illustrates the difficulty of reading an economy in real time. As such, I think he will be a gradualist, someone who advocates measured moves in interest rates unless there is a more abrupt shift that requires a stronger policy tonic.

Powell uses the analogy of a sailor steering the waters by reading the stars. The waves and weather can make real time observations unreliable, yet the sailor must make decisions that steer his course. Optimizing employment is one of the two missions that Congress has given the Federal Reserve. The Fed must make a real-time estimate of what they think is the optimum or natural rate of unemployment (NAIRU) and adjust interest rates to help align the actual unemployment rate to the natural rate. Powell presented a chart that compares the actual rate of unemployment to NAIRU as it was estimated at the time, and the “hindsight” NAIRU as economists now calculate it. (Note #2) The speech balloons are mine.


On page seven, Powell writes that, in the past, the central bank “placed too much emphasis on its imprecise estimates of [NAIRU] and too little emphasis on evidence of rising inflation expectations.”

Note the final word – expectations. Measuring what will happen is especially difficult because it has not happened. Probability methods can help but an economy has many more inputs than a dice game. One category of estimates are surveys of guesses about what will happen in the future, but these overstate actual inflation [Note #3]. A second category uses market prices. One method uses the price that buyers are willing to pay for a Treasury Inflation Protected Security (TIPS) (Note #4) In my July 22nd post, I introduced another market method – the net flow of money into the economic engine (Note #5)

Credit expansion has been poor since the Financial Crisis. The Fed cannot force banks to increase or decrease their loan portfolios by changing interest rates. In the years following the Financial Crisis, the Fed was frustrated by this inability, called “pushing on a wet noodle.” Interest rates are the carrot. The stick is a complex regulatory process that raises or lowers asset leverage ratios to encourage or discourage lending (Note #6).

The Fed manages credit flow through asset sales and purchases. While the central banks of other countries can buy stocks and commodities, the Fed is limited to buying debt, including foreign currencies, from its member banks (Note #7).

The Fed has the extraordinary power to purchase or sell the reserves of its member banks without their consent. Like the Fed, you or I can increase the reserves of a bank by depositing money in the bank (Note #8). What we can’t do is lower those reserves by writing our own loans. However, credit card companies, who are underwritten by banks, do provide us with a line of credit that we can draw on by using our cards. During the Financial Crisis, credit card debt jumped $50B, or 15%, because card holders reduced their payments by that much. In response, credit card companies reduced credit card limits by 28% (Note #9). While the Fed encouraged banks to loan, the behavior of consumers and businesses did the opposite. Consumers and businesses were more powerful than the Fed.

The banks administer or filter Fed policy in their interactions with consumers and businesses. If a bank must pay higher interest for its funds, then it will charge higher interest rates for consumer and business loans. Interest is the price for a loan. When the price rises, the supply for loans rises (banks make more profit on the spread) but demand for loans falls. The reverse is not true, as the data of the past decade has shown. When the price falls, the supply of loans falls while the demand increases.

Less credit expansion results in a slower economic engine, which generates less Federal tax revenue. For the engine to run properly, the internal pressure must remain stable. Inflation is one gauge of that internal pressure. The annual growth in Federal tax revenue must be equal to or greater than the inflation rate. When it is not, the engine begins to stall. In the graph below, I’ve charted the annual growth in Federal tax revenue less the inflation rate. Note the periods when this metric dropped below zero. In most cases, recession follows. Look at the right side of this chart. There has never been a time when the reading is so far below zero without a recession. That is a cautionary note.


The Fed must look through the fog of the future before it deploys its money super powers. In the face of this, the Fed must act with humility and a practical caution. Once it has decided on a strategy, the banks modify its implementation because they obey three masters: the Fed, their customers and their stockholders. Actual monetary policy becomes not the work of a select few in the Federal Reserve but an emergent composite of policy force and practical friction.


1. Powell’s speech is 14 pages double-spaced with several pages of charts and references.

2. For thirty years, from 1955 to 1985, the gap between the real-time estimate of NAIRU and the hindsight estimate is 1-1/2%, an error of 25%. In the 1990s economists’ models were more accurate. The estimate of NAIRU and its validity is debated now as it was in 1998 when Nouriel Roubini referenced several views on the topic.

3. A one-page Fed article on survey and market methods of measuring inflation expectations.

4. A one-page Fed article on long-term inflation expectations using the implied rate of TIPS treasury bonds – currently it is 2.1%. Vanguard article explaining TIPS bonds.

5. The net flows of credit growth, federal spending and taxes precedes inflation by several months (July 22 blog post).

6. Credit growth has been flat for the past decade as I showed in this July 15th post.

7. In conjunction with the Treasury, the Federal Reserve may buy foreign currencies to correct disruptive imbalances in interest rates. A NY Fed article explaining the process.

8. When we deposit money in a bank, its reserves, or cash balance, increases on the asset side. It incurs an offsetting liability of the same amount because the bank owes us money. We have, in effect, loaned the bank money. When so many banks collapsed before and during the Great Depression, people came to realize the true nature of depositing money in a bank. The banks could not pay back the money that depositors had loaned them. The creation of the FDIC insured depositors that the money creating powers of the Federal government would stand behind any member bank. My mom grew up during the Depression era and passed on the lessons learned from her parents. She would point to the FDIC Insured decal on the bank window and tell us kids to look for that decal on any bank we did business with in the future.

9. Credit card companies lowered limits. See page 8. Oddly enough, this Fed study found “we have little evidence on the effect of such large declines in housing wealth on the demand for debt.” Page 9. NY Fed paper written in 2013.

Tax Brawl

Taxation with representation ain’t so hot either – Gerald Barzan

August 26, 2018

by Steve Stofka

The debate over taxes focuses on the size of national programs, and the Federal taxes collected for those programs. In the past fifty years, state and local government (SLG) taxes have risen to equal the burden of Federal taxes. Despite this rise, SLGs must increase tax revenues to meet obligations and historic growth rates. Republicans control most states and will turn to property and sales tax for the additional revenue.

Fifty years ago, SLG tax receipts were half of all Federal tax receipts, including Social Security. For every tax dollar a worker sent to Washington, he sent fifty cents to his SLG. During the past decade, the SLG tax share has averaged ninety cents.


In the engine model I first introduced in July, Federal taxes were drained from the economic engine. Because SLGs do not have super powers to create money, their taxes stay within the engine and grease the gears. 72% of SLG taxes are under the category of mandatory business production – they are levied on goods and services received by the taxpayers. These include property, sales and business taxes and a plethora of licensing fees. A family who cannot pay their property taxes loses their home. Sales taxes are mandatory at the time of purchase. When SLG taxes are high, households must work more hours or cut expenses to meet the burden. Unlike Federal taxes, higher SLG taxes can force families to work more and increase GDP (Note#1).

For the past thirty years, SLG taxes have grown 6.6% each year, 1-1/2% above the 5.2% annual growth in spending. In the past ten years, tax receipts have grown at half that rate – 3.2%, barely above the 3.0% growth in spending. SLGs have not saved enough to meet the pension benefits and medical care promised the Boomer generation. SLGs will need to raise revenues, cut spending or both.

23% of total SLG tax receipts are taxes collected on personal income. Taxes on business income make up an additional 5%. Sixty years ago, those personal and business shares of the SLG tax pie were 7% and 3%.


Republicans oppose raising taxes, especially income taxes, and they control the legislatures in 32 states. In 26 of those states, they control the governorship as well (Note #2).  Democrats have total control of only six states, one of them California, where income and sales tax make up a whopping 50% of state revenues (Note #3). Many SLGs will cut spending and raise additional revenue through higher property and sales taxes and licensing fees. This lowering of the income tax share will move the mix of income and production taxes to the model of sixty years ago when production taxes were 87% of total SLG tax receipts.

In 2017, single family homeowners averaged $3300 in property taxes. Some states like Colorado have low property taxes averaging only $2000 (Note #4). Personal property taxes have averaged almost 7% annual growth during the past thirty years. Expect 8 – 10% annual growth in the next decade and a population shift to those states which can curb the growth of their taxes. Angry homeowners and taxpayers are sure to kick up a ruckus at City Councils and State Legislatures around the country.


  1. In 2007, Christina and David Romer analyzed the effect of tax changes on GDP. They found that a 1% exogenous tax increase resulted in a 2 – 3% reduction in real GDP. They classified tax changes implemented for long-term growth as exogenous. Here is a one page summary of the PDF.
  2. One of several sources on Republican dominance of state legislatures. The Hill.
  3. Income and sales tax make up 50% of California’s tax revenues (CA Research Bureau)
  4. Denver Post article on property taxes



NYT had an article on senior scams this week. Because those older than 50 own 70% of deposit balances, they are prime targets of fraud. This was novel: a retired IT pro who thought he was working from home as an employee gave his new “employer” his bank information so that his paycheck could be direct deposited. Common scams: Check fraud is still common, as are overpayments and other excuses to get you to give up your bank account information. Only you should be initiating such a transaction.

Vanguard’s projections of expected returns for various asset classes over the next ten years. Domestic stocks 3.9%. Bonds 3.3%



Taxes – the Necessary Good

Taxes shall be levied according to ability to pay. – Franklin D. Roosevelt

August 19, 2018

by Steve Stofka

In the aggregate taxes are necessary and beneficial to everyone. Because Federal taxes act as a drain from the economic engine, they are different from state and local taxes. How those taxes are levied is a matter of policy debate, but they are necessary for the survival of a nation’s government and its economy. Revenue from natural resource production that is owned by a national government acts as a tax. Failing to understand that concept weakens and cracks governments around the world.

The inability to create money constrains state and local governments (Note #1). Taxes paid act as income for goods and services received from those governments. The Federal government has no such constraints. It does not need tax income as such. Rather, it must drain taxes to offset the amount of spending that it pumps into an economy. Inflation, the chief measure of extra money in an economy, rises when the Federal government doesn’t drain enough in taxes. As inflation rises, people turn to goods and service exchange that is not recorded and not taxed. The underground economy tries to offset the hidden tax of inflation.

As Venezuelans flee the runaway inflation in their country, they are running from too much spending and not enough taxation. Yes, it is counterintuitive. Venezuela owns the world’s largest reserve of oil. The net revenue from that oil competes with the taxes that a private oil company would pay to the government. The national government “owes” itself the tax revenues that it would have collected from a private company. Oil production has declined from 2.4 million barrels per day in 2008 to 1.2 million barrels in 2018 (see Note #2). Corruption and incompetence are the chief causes of the decline. Net oil revenue has declined by 95% from the bull market levels of the mid-2000s. Because the national government has not been paying their taxes, inflation has exploded the economy.

Because national politicians begin their careers in local politics, they regard a nationalized resource (NR) as a source of income, not an economic drain. That drain must be kept open through spending in oil infrastructure, training and transportation. In Venezuela, 2016 gross oil revenues were 20% of GDP and a net of less than 5% (see Note #3). Inflation taxes 100% of an economy. Because NR revenue acts as a pressure relief on inflation, that 20% portion of GDP affects 100% of the economy. A lack of understanding of the nature of a NR led to the crisis and decline of Great Britain in the 1970s, China in the 1960s and 1970s, and Zimbabwe in 2008.

How should a national government levy taxes on the taxpayers within the economy? FDR suggested “ability to pay.” For the past one hundred years we have measured ability to pay by income. Is that a good measure? French economist Thomas Piketty suggests that assets are a better measure. Local governments use this method to collect property taxes. Consider a retiree with $500K in liquid assets, who is taxed on $10K in interest and dividends earned each year. Clearly, the retiree’s assets are a better indication of his ability to pay. Should Congress abolish the income tax and tax people and corporations a multiple of what they pay in property taxes on their primary residence or business locations? Those living in high tax suburban and ex-urban areas might move toward lower-taxed urban areas. Would suburban areas actively recruit businesses to widen their tax base and lower property taxes? An intriguing thought.

Tax levies are the subject of endless debate because people cannot agree on what constitutes a fair tax. In the aggregate, the pressure reducing function of taxes benefits everyone, but is especially beneficial to those with less income. Should a national government impose a head tax on everyone? It could. That would amount to $15,000 per person this year, more than some families make. How does a national government extract tax money from its poor? It doesn’t. From 1958 – 1962, China forced taxes out of poor farmers in Mao’s Great Leap Forward (Note #4). Millions starved as a result.

Everyone should contribute equally to shared benefits, but practicality triumphs over principle. The survival of the national government becomes paramount. Some form of redistributive taxation must ensue. How to shape that redistribution? A government could take all the wealth of the ten richest people in America and still be short $3.8 trillion (Note #5). All the debate falls between total equality and total unfairness, and neither accomplishes the task of draining enough taxes out of the engine. A government could spend nothing: no defense, no research, no border or shore protection, no pension, medical or education spending. That’s a government in name only, and not for long. Other governments will want to capture control of that country’s resources.

The vast middle of the debate is an endless variety of proposals of “fairness” in both taxing and spending, a debate that has changed little since Cicero argued for his proposals in the Roman Senate in the first century B.C.E. What is not debatable is that a nation’s taxes must be roughly guided by its spending. A nation like Venezuela, which taxes half of what it spends, was headed for an economic tsunami of high inflation and inevitable collapse.

The debate is important. Just as it did in Rome two thousand years ago, consolidated party power corrupts. Because the current Presidency and House are held by the same party, we can expect a strong growth rate of net input, spending less taxes, and the data confirms the prediction. Net Federal input in the first full year of the Trump administration, April 2017 – March 2018, grew at a record-breaking annual pace of 19.6%, far above the sixty-year average of 8%. However – because Federal input has been so low this decade, the Federal government must continue this torrid pace of input in 2018 and 2019 just to reach the 8% average.

Republicans have held the House for the majority of the past three decades. Neither party agrees with the other party’s priorities, so the Republican strategy has been simple. They talk fiscal discipline and curtail Federal spending during Democratic administrations so that Republicans can spend big on their priorities when they have the Presidency. The Democrats did this for forty years when they held the House from 1954-1994 and will do so again when they have their next Congressional “run.”

To sum up: taxes are good, in general, but bad in the particular. No nation’s leader has stood on the world stage and said, “To tax or not to tax, that is the question.” For a nation and its economy, “to tax” is synonymous wtih “to be.”



1. Before the Civil War, each state controlled banking within its border (National Bank Act). For a deeper dive into state financing, try this Brookings Institute article.

2. A background paper on Venezuela oil (PDF). Crude oil production in the first quarter 2018 fell to 2.19 million barrels, a thirty-year low (Reuters). The Venezuela government spends more than 40% of GDP but collects only 20% in taxes (Statistica). During the 1997-2006 oil bull market, net revenues to the Venezuelan government averaged $20B per year (background paper above). Last year it was less than $1B. On August 20th, Venezuelans will lose their gasoline subsidies and pay a competitive price for gasoline (PDVSA article).

3. Gross oil revenue in 2016 was $48B, 20% of GDP of $236B (Reuters article). Exxon Mobil had a net profit of 6.5% in 2011. Venezuela would greatly benefit if the oil production was owned privately and paid 25-30% in income and other taxes.

4. Frank Dikotter was one of several historians afforded access to People’s Party records of the Great Leap Forward. He wrote an exhaustive account of human folly in Mao’s Great Famine .

5. Richest people in America  – Wikipedia 


Gold is down more than 10% in the past few months. BAR is a gold ETF launched in the past year. As an alternative to GDL and IAU, it has the lowest expense ratio at .2%. Here is a June 2018 article on the ETF.

Taxes – A Nation’s Tiller

Printing money is merely taxation in another form. – Peter Schiff


August 12, 2018

by Steve Stofka

The Federal government does not need taxes to fund its spending, so why does it impose them? Taxes act as a natural curb on the price pressures induced by Federal spending. Taxes can promote steady growth and allow the government to introduce more entropy into the economic system.

During World War 2, the Federal government ran deficits that were 25% of the entire economy (Note #1) and five times current deficit levels as a percent of the economy. Despite its monetary superpowers, the government imposes a wide range of taxes. Why?

Using the engine model I first introduced a few weeks ago (Note #2), taxes drain pressure from the economic system and act as a natural check on price inflation. During WW2, the government spent so much more than it taxed that it needed to impose wage and price controls to curb inflationary pressures. Does it matter how inflation is checked? Yes.

When price pressures are curbed by law, people turn to other currencies or barter. During WW2, the alternative was barter and do-it-yourself. Because neither of these is a recorded exchange of money, the government collected fewer taxes which further increased price pressure in the economic engine. After the war was over and price controls lifted, tax collections relieved the accumulated price pressures. As a percent of GDP, taxes collected were 50% more than current levels.

For the past fifty years, Federal tax collections have ranged from 10-12% of GDP, but they are not an isolated statistic. What matters is the difference between Federal spending and tax collections, or net Federal input. During the past two decades Federal input has become a growing share of GDP.


During the past sixty years, that net input has grown 8% per year. The growth rates have varied by decade but the strongest rates of input growth rates have occurred when the same party has held the Presidency and House. Neither party knows restraint. The lowest input growth has occurred when a Republican House restrains a Democratic President (Note #3).


Let’s compare net Federal input to the growth of credit. As I wrote last week, the Federal government took a more dominant role in the economy in the late 1960s. By the year 2000, net Federal input grew at an annual rate of 10.3%, over one percent higher than credit growth. During all but six of those years, Democrats controlled the House and the purse. During those forty years, inequality grew.


During the 1990s and 2010s, government should have increased its net input to offset the lack of credit growth. To increase input, the government can increase spending, reduce taxes or a combination of both. When GDP growth is added to the chart, we can see why this decade’s GDP growth rate has been the lowest of the past six decades. It’s not rocket science; the inputs have been low.


A universe with maximum entropy is a still universe because all the energy is uniformly distributed. At a minimum entropy, the universe exploded in the Big Bang. Too much clumping of money energy provokes rebellion. Too little clumping hampers investment and interest and condemns a nation to poverty. As an act of self-preservation, a government adopts redistributive tax policies. Among the developed nations, the U.S. is second only to France in the percent of disposable income it redistributes to its people (Note #4).

A nation can either tax its citizens directly, or add so much net input that it provokes higher inflation, which taxes people indirectly through the loss of purchasing power. Of the two alternatives, the former is the more desirable. In a democracy we can vote for those who spend our tax dollars. Inflation is both a tax and an unmanaged redistribution of money from the poor to the rich. How so? Credit is money. Higher inflation rates lead to higher interest rates which reduce access to credit for lower income households, and give households with greater assets a higher return on their savings.


1. Federal Income and Outlays at the Office Management and Budget, Historical Tables

2. The “engine” was first introduced in Hunt For Inflation, and continued in Hunt, Part 2 , Engine Flow , and Washington’s Role.

3. Federal spending less tax collections grew at a negative annual rate during the Clinton and Obama administrations. Both had to negotiate with a hostile Republican House in the last six years of their administrations.

4. “U.S. transfer payments constitute 28.5% of Americans’ disposable income—almost double the 15% reported by the Census Bureau. That’s a bigger share than in all large developed countries other than France, which redistributes 33.1% of its disposable income.” (WSJ – Paywall) The OECD’s computation of the GINI coefficient is based on disposable personal income, which is calculated differently in the U.S.


Average GDP growth for the past sixty years has been 3.0%. The average inflation rate has been 3.3%. The 60-year median is 2.6%. The average inflation rate of the past two decades have been only 2.1%.

A good recap of the after effects of the financial crisis.