Interest Rate Ceiling

June 23, 2019

by Steve Stofka

After the Federal Reserve meeting this week, traders are betting on a cut in interest rates in July and the market hit all-time highs. Is a cut in interest rates warranted at this time? Such an action is usually taken in response to weak employment numbers, a decline in retail sales or sluggish GDP growth. Let’s review just how good the economy is.

Unemployment is at 50-year lows. The percent of people unemployed more than fifteen weeks is near the lows of the late 1990s. At almost 18 million vehicles, auto sales are near all-time highs. Real retail sales continue to grow more than 1% annually. In the first quarter of this year, real GDP growth was over 3%. Ongoing tariffs may cause real GDP to decline one percent but a growth rate above 2% is above average for this recovery after the financial crisis.

Corporate profits have been strong. In fact, that may account for the volatility of the past two decades. The chart below is after tax corporate profits (CP) as a percent of GDP. The multi-decade norm is in the range of 5-8% but the past twenty years have been above that trend except for the plunge in profits and GDP during the GFC.

Companies have paid part of those extra profits as dividends to shareholders who tend to be cautious pension funds or older, wealthier and more cautious individuals.  Some profits have been used to buy back shares and boost the return to existing shareholders.

Despite the above average profits, investors still have a strong thirst for lower yielding government debt. Why? The Federal Reserve has kept interest rates below a market equilibrium, which is currently about 3.8%, far above the current 2.4% federal funds rate (Note #1). As with any price ceiling, the below-market price creates a shortage. In this case, the shortage is in the capital investors want to supply to governments to meet the demand for capital. Consequently, investors have been searching for alternative substitutes or near-substitutes. That distortion is being reflected in stock market prices.

Despite a strong economy and corporate profits, the SP500 has gained less than 5% from its peak high in February 2018 after the passage of the 2017 tax cuts. Including dividends, the SP500 has gained just 5.7% in 16 months. If we turn the clock back a few weeks to the end of May, the total return of the SP500 during the past fifteen months was a big, flat zero. Those gains of the past sixteen months have come in the past three weeks on the hope and the hint of rate cuts.

An intermediate bond ETF like Vanguard’s BIV has returned 5.2% in the same period. On a scale of increasing risk 1-5, with 1 being a safe investment, BIV is rated a 2. The SP500 is rated a 4. Investors buying the broad stock market have not been rewarded for the additional risk they are taking.  How long will this situation persist? For as long as the Fed keeps a price ceiling on interest rates.

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Notes: A popular model of equilibrium interest rates is the Taylor rule proposed in 1993 by John B. Taylor, a member of the Council of Economic Advisors under three presidents. The Atlanta Fed has a utility that calculates the current rate and allows the reader to change the parameters. Click on the graph icon, accept the default parameters and the utility graphs the equilibrium rate and the historical Fed funds rate.

The Federal Risk Reserve

June 16, 2019

by Steve Stofka

What if the federal government offered competitive products that help individuals and businesses manage risk? Today, the government insures many Americans through a variety of programs and a potpourri of agencies. I am proposing that the government do more risk management through a separate and independent agency like the Federal Reserve.

Well, doesn’t the financial industry already act as a risk broker? It does – and it doesn’t. It picks the risks that it wants to broker – and leaves those it doesn’t want to the government. The 1986 S&L crisis, the 1987 stock market crash, the 1998 Asian financial crisis, the 2002 Enron crisis and the 2008 financial crisis indicate that Wall Street is not an efficient risk manager.

Let’s look at some common risks that the government already manages. The federal government insures mortgage risk through an umbrella agency called the Federal Housing Finance Agency, or FHFA (Note #1). Financial companies do not want the risk of loaning money to people for thirty years at a low fixed rate. Why? People’s circumstances and the housing market change over such a long period of time. Finance companies might prefer a shorter time period – say five years – so that they could renegotiate the terms of the mortgage. Many mortgages are bundled by banks and mortgage companies, then sold to investors with guarantees from the government.

The government manages the risk of poor asset management by its member banks. In the late 1920s, the onset of the Great Depression caused the failure of many banks and millions of people lost their life savings. Who would insure a bank against its own lack of judgment or improper management? The government became the insurer of last resort when the Federal Deposit Insurance Corporation (FDIC) was created in 1933 (Note #2).

There were a lot of bank failures during the 2008 financial crisis. Through the FDIC, the federal government handled the transition of each one. No depositors lost money. California, Georgia, Florida, Illinois and Minnesota have each had more than twenty failures in the past decade (Note #3).

Bank failures since 2007

In many cases, the FDIC stepped into a failed bank at closing time on Friday evening, closed the institution and fired the management. Over the weekend they did a thorough accounting of the bank’s assets and liabilities, packaged and sold the bank’s performing loans to another bank which re-opened the following Monday under a new name. Nothing to worry about here, folks. Go on about your business. The FDIC has proved itself an efficient and prudent risk supervisor.

The government manages the risk of natural disasters. Insurance companies are reluctant to cover damage from “acts of God.” Homeowner’s insurance does not cover flooding, for example (Note #4). If they did, it would be prohibitively expensive. Instead, the government insures flood damage through the National Flood Insurance Program (Note #5). Because the program is subject to much political influence, it lacks fiscal prudence. The program’s greatest expenses are recurrent repairs to structures in areas that are prone to flooding, but the program can not charge the premiums reflecting those increased risks. An independent agency with a long-term outlook would act less rashly.

Employee risks are managed by state and federal government agencies which deploy government funds to pay unemployment claims. For employees injured on the job, private insurers are reluctant to pay for replacement wages for an injured employee. Even after medical bills are paid, the employee may need retraining after the injury – an additional expense that private insurers want to avoid. Furthermore, employers wanted to avoid the risk of being sued by their employees for unsafe working conditions. Many states have Workmen’s Compensation programs that are either government agencies or independent agencies set up by law (Note #6).

The federal government manages health risks. It plays a large role in the health insurance market and in the health delivery market through the Medicare, Medicaid and tax subsidy programs. The federal government pays almost half of all health care costs in the U.S. through these programs (Note #7).  In 2017, this amounted to 8% of the entire GDP of the country.

In summary, the federal government is already heavily involved in insuring risk. Private industry has taken the gravy and dumped the risks that they don’t want to insure on the government. If the government assumed some of the lucrative insurance products, it would help offset the costs of these other risks. Let’s get government in the capitalism business. Let an independent government agency start offering some competitive financial insurance products and see if they can attract some market share.

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Notes:

  1. Federal Housing Finance Agency encloses several formerly independent government finance agencies
  2. History of the Federal Deposit Insurance Corporation
  3. The map of bank failures is from the FDIC site
  4. Homeowner’s insurance and the distinction between flooding caused by wind (may be insured) and that caused by rain (not insured). Allstate
  5. National Flood Insurance Program
  6. Workmen’s Compensation Insurance

The Voting Market

June 9, 2019

by Steve Stofka

One hundred years ago, Congress passed the 19th Amendment giving women the right to vote (Note #1). Despite the ratification of the amendment, many African Americans and those from Asian countries faced barriers to voting (Note #2). During the 18th and 19th centuries, America and other developed nations denied women civil and legal rights through marriage and coverture laws (Note #3). Some Islamic nations like Saudi Arabia continue to exclude women from the rights enjoyed by men.

Two-hundred thirty years ago, the Declaration of Independence stated a natural right that all people are created equal.  Unlike our sentiments, 18th and 19th century Americans regarded natural rights as separate from legal and civil rights. When drafting the 14th Amendment following the Civil War, Republicans based their case for black citizenship on natural rights. Such a strategy, however, strengthened the claims of women who wanted the right to vote. Republican lawmakers added Section 2, which specified male persons (Note #4).    

Human societies have a long history of restricting the freedoms of some members of their society. Why? There’s a profitable payoff. The American Medical Society restricts the number of doctors who can be licensed. The result is that American general practitioners enjoy the highest earnings among all nations – double the average of developed countries (Note #5).

Established suppliers of a product or service enjoy less competition and greater profits if they can convince lawmakers to restrict entry into that market. Hundreds of occupational licensing laws reduce the threat of more competitive pricing and cost consumers billions of dollars (Note #6). Older people may remember the Blue Laws preventing the conduct of some business on Sunday (Note #7).  Most Blue Laws today concern the sale of alcohol on Sunday but some states, including Colorado and some Midwest states, prohibit the sale of automobiles on Sunday. Most banks are closed on Sunday, but some states have begun to relax those rules (Note #8). Post Office branches used to offer savings accounts, but these were discontinued in the 1960s (Note #9). To help those who are largely unbanked, post offices could start offering simple banking services again (Note #10).

Each vote is a lottery ticket to choose who has political power. Most votes cancel each other out so there is an incentive for those with similar voting preferences to join forces to make voting easier for their group and difficult for those with different preferences.  

The first debates between Democratic contenders for the 2020 election begin this month. In the coming year, watch for even more strategies designed to restrict or liberalize voting. The election officials in some counties will not operate enough polling places so that lines are long, and voting is inconvenient for some of its citizens, particularly for those who are likely to vote the Democratic ticket. Some states will have vigorous voter registration drives to draw in more voters for the Democratic ticket.

To counter these efforts, Republican lawmakers in some states have passed laws making it more difficult to validate last minute registrations (Note #11). They argue that the integrity of the vote is their only concern and they point out that many Republican led legislatures have implemented DMV registration to make registration easier. Several states are instituting registration at social agencies as well (Note # 12). Democratic organizations characterize any restrictions as voter suppression.

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Notes:

  1. Background on 19th Amendment
  2. Citizenship and voting restrictions in the first half of the 20th century
  3. Marriage and coverture laws denying women the right to own property separate from their husbands
  4. Drafting the 14th Amendment
  5. Comparison of doctors’ earnings
  6. Occupational Licensing laws
  7. Blue Laws
  8. Banks open on Sunday
  9. US Postal Service savings accounts
  10. Proposals to have postal service offer banking services
  11. Laws to restrict voter registration
  12. 36 states are taking steps to modernize voter registration

Budget Perspective

June 2, 2019

by Steve Stofka

How does your spending compare with others in your age group? Working age readers may compare their budgets with widely published averages that are misleading because they include seniors as well as those who are still living at home with their parents or are going to college. Let’s look at spending patterns classified by working age consumers 25-65 and seniors whose spending patterns change once they retire.

The Bureau of Labor Statistics collects data on consumer behavior by conducting regular surveys of household spending (Note #1). These surveys provide the underlying data for the computation of the CPI, the Consumer Price Index. Social Security checks and some labor contracts are indexed to this measure of inflation.

The BLS also provides an analysis of consumer purchasing by household characteristics, including age, race, education, type of family, and location (Note #2). Spending and income patterns by age contained some surprises (Note #3). The average income of 130,000 people surveyed in 2017 was $73K. Seniors averaged $25K in Social Security income. Younger workers aged 25-34, the mid-to-late Millennials, earned $69K, near the average of all who were surveyed. Following the Great Financial Crisis, this age group – what were then the early Millennials in 2010 – earned only $58K, so the growing economy has lifted incomes for this age group by 20% in seven years.

Home ownership is around 62% for the whole population, but far above that average for older consumers. 78-80% of people 55 and older own their own homes. More than 50% of those have no mortgage but too many seniors do not have enough savings. In many states, property taxes are the chief source of K-12 education funding and older consumers have the fewest children in school. Older consumers on fixed budgets resist higher property taxes to fund local schools and they vote in local elections at much higher rates than younger people. Since 2000, per pupil spending has grown more than 20% but most of that gain came in the 2000s.  In the past twelve years, real per pupil spending has barely increased (Note #4). Below is a chart from the Dept. of Education showing per pupil inflation adjusted spending.

Graph link: https://nces.ed.gov/fastfacts/display.asp?id=66

Saving is an expense and working age consumers aged 25-65 are saving 9-12% of their after-tax income, twice as much as the 5.6% average. Wait – isn’t saving the process of not spending money? How can it be an expense?  Call it the imaginary expense, as fundamental to our life cycle as i, the imaginary square root of -1, is to the mathematics of cyclic phenomena. Let’s compare today’s savings percentage with the panic years of 2009-10 just after the financial crisis. Workers in the 25-34 age group – who should have been spending money on furniture and cars and eating out – were saving 20% of their after-tax income (Note #5). That age group will probably carry the lessons – and caution – learned as they began their working career after the financial crisis.

Workers 25-65 spend 28-32% of their after-tax income on housing. Until they are 65, people spend a consistent 12% of their income on food, both at and away from home. Seniors spend less on food but most of that change is because they spend less money eating out at restaurants. Working age consumers spend more on transportation than they do on food – a consistent 15% of after-tax income.

People 65 and older are entitled to Medicare but they spend more on health insurance than working people and the dollar amount of their spending on health care rises by 50%. As a percent of after-tax income, seniors spend 15% while people of working age spend about 6%. Ouch. I’m sure many seniors are not prepared for those additional expenses.

Those of working age should compare their budget averages to other workers, not to the national averages, which include older people and those under 25. Summing up the major expense categories: workers are averaging 30% for housing, 15% for transportation, 12% for food, 11% for personal insurance, pensions and Social Security contributions, 10% for savings and 6% for healthcare.

As Joey on the hit TV show Friends would often say, “So how you doin’?”

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Notes:

  1. Explanation of Consumer Expenditure Survey
  2. Consumption patterns – list Table 1300
  3. The most recent detailed analyses available are for 2017.
  4. Dept of Ed data
  5. Spending and income levels for those aged 25-34 2009-2010.