Month: August 2019

The Association – A Split

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August 25, 2019

by Steve Stofka

A few things before I continue the saga of our mountain community. Bond yields have sunk to remarkable lows as the prices of those bonds climb higher in response to global demand for safe assets. Governments have borrowed trillions since the financial crisis, yet there is not enough debt to meet demand.

The private market created a huge supply of “safe” assets called Collateralized Debt Obligations, or CDOs, based on house mortgages. When the housing market imploded, it left a big hole in the market for safe assets. As countries around the world have adopted capitalistic market structures, the living standards of millions of people have improved and that has led to more savings in search of safe investments.

The U.S. still pays a positive interest rate on its debt and that is attracting a lot of foreign capital to our country – capital that is driving down the interest rates on our savings and pension assets. Unlike some other countries, capital moves freely across U.S. borders. It doesn’t wait in crowded spaces behind chain link fences.

Donald Trump’s family business relies heavily on borrowing, and most of that has come from a single source, the German firm Deutsche Bank. No other bank is willing to risk capital on a family business with a history of failure. The family’s business depends on the free movement of capital across national borders, yet Trump himself is adamantly opposed to the free movement of labor across borders.

Capital requires a legal framework of property rights protection, a robust banking system capable of servicing that capital, and a political system that protects the profits generated by investment from graft and corruption. Labor requires a social framework in addition to a legal system that enforces basic personal rights. Capital comes to this country because we spend a lot of money to nurture and protect it more than some other countries. Labor comes to this country for the same reasons – a higher return on their effort, an educational system that nurtures their families, a social and legal system that offers some protections.

“They’re taking our jobs!” some people complain of immigrant labor, yet few Americans are affected by an immigrant labor force that takes mostly lower paying jobs. The flow of capital into our country creates a competition that affects many more Americans – anyone who has a savings account, a pension fund, a 401K, an IRA. Where is the outcry against foreign capital?

Let us return to those dear souls who inhabited an abandoned mining town. In last week’s story, they had formed a homeowner’s association which created Money, Debt, and traded with another community called the Forners.

The board of the homeowners’ association complained often about the expense of handling the Money that it had created. The association decided that it would be more efficient to reduce the use of paper Money. It gave each homeowner a bank account and a Money shredder which scanned and tabulated the Money that each homeowner shredded. Homeowners didn’t have to go to the community center when they needed to pay another homeowner or the association. When they did receive Money, they deposited it in the shredder, which added the amount to their balance. When they wanted to pay someone, they tapped some buttons on their shredder and the amount went from their account to the other homeowner’s account. Paying their monthly homeowner fees was so much more convenient.

A homeowner called Mary decided to re-open the old restaurant, but she would need more Money than she had. What to do? The association could print the Money and loan it to her. Mary would put up 10% of what she needs, and the association would print the other 90%.  She would pay the money back over time with interest. One of the homeowners asked, “How will we be paid if we do work for Mary’s restaurant?” Someone answered, “With the same Money that you get paid when you work for the association.”

That was acceptable to everyone. With the extra Money earned by fixing up Mary’s restaurant, several other homeowners put down deposits and opened businesses with loans from the association (Note #1). The association held a mortgage on each business, but the business owner decided how to run the business and received the profits from the business.

When Stan’s business failed, the homeowners discussed what to do. Stan had spent the printed Money that the association had loaned him, so the Money had not disappeared. Like all the printed money, it was spread around the community. The effect of Stan’s business failure was the same as if the association had started the business, hired people to do work, paid them and then closed the business after a time. The printed Money went out into the community but never made it back to the association in the form of loan payments. Someone said, “There is extra Money in our community because Stan’s business loan won’t be paid back.”

They agreed that this was so but what to do about it? They all had some extra Money because of Stan’s business loan. “What if more businesses fail?” someone asked. “What will we do with all the extra money the association has printed?”

“Prices will go up,” someone else said. “That’s what happened last time.”

“If more businesses failed, I would be more careful and buy less stuff,” another offered. Several heads nodded. “I’d deposit some extra Money in the shredder.”

“Well, that doesn’t make the Money go away,” someone argued. “The money is still in your bank account with the association.”

“But prices won’t go up because people are spending less Money, isn’t that right?” someone asked. That was the confusing part. The last time there was extra Money, prices went up. But in this case, prices were likely to go down if more businesses failed and there was extra Money.

Someone stood up and said, “I’ve got the answer. When we all worked fixing up Stan’s business, the Money was exchanged for our labor and supplies. Since the Money was exchanged for goods and services, there is no extra Money.”

Someone else countered, “What if we all started businesses, borrowed Money from the association and we all failed? There would be a lot of extra Money.”

The other person answered, “Yes, the amount of circulating Money would be suitable for a thriving community. Too many people with a lot of Money and nowhere to spend it would drive up prices. But just one or two business failures has such a small effect that it is negligible.”

They decided to continue printing and loaning money but formed a loan committee whose job was to review an applicant’s business plan before loaning the money.

Bob, the community’s propane dealer, bought his supplies from the Forners. One month, the Forners got very angry at the whole community and would not sell propane to Bob. He contracted with another community for propane but there wasn’t enough for everyone’s needs. Bob raised the price of propane then began rationing propane by selling only to those who were in line at his station at 6 A.M. After two hours, he shut off supplies until the next day. Some homeowners threatened Bob and so he had to hire a few people for extra security (Note #2).

Mary used a lot of propane for cooking, so she had to spend several hours each day buying propane. Naturally, she raised prices to account for the additional time and higher price of propane. Homeowners ate fewer meals at Mary’s and she had to let go of several employees.

As prices rose, some homeowners who had bought association debt at low interest rates began to complain. “We loaned the association money at 5% interest and prices are going up at 10% a year. We’re losing money!”

Everyone agreed that this wasn’t fair, but no one knew what to do about it. Should they cancel the old debt and reissue debt at higher interest rates? That would lead to higher homeowner fees for everyone. “You want us to pay extra so that your interest income will keep up with inflation? Why should I take money out of my pocket and put it in yours?”

Tempers flared. “I’m not loaning this association money ever again,” complained one homeowner and several stormed out of the clubhouse. True to their word, these homeowners would not renew their loans to the association unless it paid much higher interest rates. After several months, the Forners resumed propane deliveries but a vicious cycle of higher prices had started. Homeowners had to pay higher association fees and wanted more money for their labor to pay those higher fees. No one knew how to fix the situation.

“We need to charge high interest rates on the Money we print and loan to homeowners for their businesses and homes,” a board member said.

“Are you crazy?!” Several complained. “Rates are already too high. People can’t afford to start businesses or buy a home!”

“We need to raise them so high that it will hobble the economy for a while,” the board member said. “That’s the only way to bring prices down. It won’t take long.”

It took much longer than anyone anticipated, and the economy declined for almost two years. This period of higher prices followed by high interest rates caused a divide among the homeowners – between those who relied on the association for services and help during hard times, and those who formed a deep distrust of the association (Note #3). No one fully understood how deep the divide would grow.

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Notes:

  1. The process where loans generate income for others which generates more loans is called the Money Multiplier in economics.
  2. In the 1970s, two gas embargoes led to similar circumstances.

This is a retelling of the high inflation of the late 1970s, followed by nose-bleed interest rates that caused back-to-back recessions in the early 1980s. The recession of 1981-82 was the most severe since the 1930s Depression.  

The Homeowners’ Association

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August 18, 2019

by Steve Stofka

Two quick asides before I get into this week’s topic. A cricket perched on the top of a 7′ fence. It drew up to the edge of the top rail, learned forward, raised its rear legs as though to jump, then settled back. It did this twice more before jumping 8′ out then down into a soft landing on some ground cover. How far can crickets see, how often do they injure a leg if they land incorrectly and do they get afraid?

The bulk of the personal savings in this country is held by the top 20% of incomes, and it is this income group that received the lion’s share of the 2017 tax cuts. It’s OK to bash the rich but that top 20% probably includes our doctor and dentist. Before you start drilling or cutting me, I want to make it perfectly clear that I was not criticizing you, Doc.

In 2016, the top quintile – the top 20% – earned 2/3rds of the interest and dividend income (Note #1). Due to falling interest rates over the past three decades, real interest and dividend income has not changed. Real capital has doubled and yes, much of it went to those at the top, but the income from that capital has not changed. That is a huge cost – a hidden tax that gets little press. The real value of the public debt of the Federal Government has quadrupled since 1990, but it pays only 20% more in real interest than it did in 1990 (Note #2). Here’s a graph of personal interest and dividend income adjusted to constant 2012 dollars. Thirty years of flat.

Ok, now on to a story. Economists build mathematical models of an economy. I wanted to construct a story that builds an economy that gradually grows in complexity and maybe it would help clarify the relationships of money, institutions and people.

Let’s imagine a group of people who move into an isolated mining town abandoned several years earlier. The houses and infrastructure need some repairs but are serviceable and the community will be self-sufficient for now. The homeowners form an association to coordinate common needs.

The association needs to hire lawn, maintenance and bookkeeping services, and security guards to police the area and keep the owners safe.  How does the association pay for the services?  They assess each homeowner a monthly fee based on the size of the home. How do the homeowners pay the monthly fee?  Each homeowner does some of the services needed. Some clean out the gutters, others fix the plumbing, some keep the books and some patrol the area at night. They work off the monthly fee.

How do they keep track of how much each homeowner has worked? The association keeps a ledger that records each owner’s fee and the amount worked off. The residents sometimes trade among themselves, but it is rare because barter requires a coincidence of wants, as economists call it. Mary, an owner, needs some wood for a project and Jack has some extra wood. They could trade but Mary doesn’t have anything that Jack wants. He tells Mary to go down to the association office and take some of her time worked off her ledger and credit it to Jack’s monthly fee. Mary does this and they are both happy (Note #3).

As other owners learn of this idea and start trading work credits, the association realizes it needs a new system. It prints little pieces of paper as a substitute for work credits and hands them out to owners who perform services for the association. These pieces of paper are called Money (Note #4).

The money represents the association’s accounts receivable, the fees owed and accruing to the association, and the pay that the association owes the owners for the work they have done. Then the association notices that there are some owners who are not doing as well as others. It assesses an extra fee each month from those with larger homes and gives that money to needy homeowners.  These are called transfers because the owners who receive the money do not trade any real goods or services to the association. In this case the association acts as a broker between two people. Let’s call these passive transfers. We can lump these transfers together with exchanges of goods and services.

Then some people from outside the area start stealing stuff from the homeowners. The association needs to hire more security guards, but homeowners don’t want to pay a special one-time assessment to pay for the extra guards.

Instead of printing more Money, the association prints pieces of paper called Debt. Homeowners who have saved some of their money can trade it in for Debt and the association will pay them interest. Homeowners like that idea because Money earns no interest and Debt does. The association uses the Money to pay for the extra security guards.

But there are not enough people who want to trade in their Money for Debt, so the association prints more Money to pay the extra security guards.

Let’s pause our story here to reflect on what the words inflation and deflation mean. Inflation is an increase in overall prices in an economy; deflation is a decrease (Note #5). Inflation occurs when the supply of money fuels a demand for goods and services that is greater than the supply of goods and services. Ok, back to our story.

So far so good. All the Money that the association has printed equals a trade or a passive transfer. Let’s say that the association needs more security guards and no one else wants to work as a security guard because they can make more Money doing jobs for other homeowners. The association makes a rule called a Draft. Homeowners of a certain age and sex who do not want to work as security guards will be locked up in the storage room of the community center.

Now there’s a problem. Because the association has taken some homeowners out of the customary work force, those people are not available for doing jobs for other homeowners, who must pay more to contract services. This is one of several paths that leads to inflation. To combat that, the association sets price controls and limits the goods that homeowners can purchase. After a while, the outsiders are driven off and the size of the security force returns to its former levels.

Now all the extra Money that the association printed to pay for the security force has to be destroyed. As homeowners pay their dues, the association retires some of the money and shrinks the Money supply. However, there is a time lag, and prices rise sharply (Note #6).

Over the ensuing decades, there are other emergencies – flooding after several days of rain, a sinkhole that formed under one of the roadways, and a sewer system that needed to be dug up and replaced. The association printed more Debt to cover some of the costs, but it had to print more Money to pay for the balance of repairs. Because the rise in the supply of Money was a trade for goods and services, inflation remained tame.

There didn’t seem to be any negatives to printing more Money, so the homeowners passed a resolution requiring that the association print and pay Money to homeowners who were down on their luck. These were active transfers – payments to homeowners without a trade in goods and services and without some offsetting payment by the other homeowners.

So far in our story we have several elements that correspond with the real world: currency, taxes, social insurance, the creation of money and debt and the need to pay for defense and catastrophic events. Let’s continue the story.

With the newly printed Money, those poorer homeowners could now buy more goods and services. The increased demand caused prices to rise and all the homeowners began to complain. Realizing their mistake, they voted on an austerity program of higher homeowner fees and lower active transfers to poorer homeowners.

Because homeowners had to pay higher fees, they didn’t have enough extra Money to hire other services. Some residents approached the association and offered to repair fences and other maintenance jobs, but the association said no; it was on an austerity program and cutting expenses. Some residents simply couldn’t pay their fees and the problem grew. The association now found that it received less Money than before the higher fees and Austerity program. It cut expenses even more, but this only aggravated the problem.

Finally, the association ended their Austerity program. They printed more Money and hired homeowners to make repairs. Several homeowners came up with a different idea. There is another housing development called the Forners a few miles away. They are poorer and produce some goods for a lower price. The homeowners can buy stuff from the Forners and save money. There are three advantages to this program:

  1. Things bought from the Forners are cheaper.
  2. Because the homeowners will not be using local resources, there will be less upward pressure on prices.
  3. The homeowners will pay the association for the goods bought from the Forners and the association will pay the Forners community with Debt, not Money. Since it is the creation of Money that led to higher prices, this arrangement will help keep inflation stable.

As the homeowners buy more and more stuff from the Forners, the money supply remains stable or decreases. After several years, homeowners are buying too much stuff from the Forners and there is less work available in the community. As homeowners cannot find work, they again fall behind in paying their monthly fees.

Several of those in the association realize that they don’t have enough Money to go around in the community. There is a lot to do, and the homeowners draw up a wish list: repairs to the roads and helping older homeowners with shopping or repairs around their home are suggested first. A person who is out of work offers to lead tours and explain the biology of trees for schoolchildren. The common lot near the clubhouse could use some flowers, another homeowner suggests. I could use a babysitter more often, one suggests, and everyone nods in agreement. I could teach a personal finance class, a homeowner offers. Another offers to read to homeowners with bad eyesight and be a walking companion to those who want to get more exercise.

Everyone who contributes to the welfare of the community gets paid with Money that is created by the association. What should we call the program? One person suggests “The Paid Volunteer Program,” and some people like that. Another suggests, “The Job Guarantee Program” and everyone likes that name so that’s what they called it (Note #7).

So far in this story we have two key elements of an organized society:

  1. Money – a paper currency created by the homeowner association.
  2. Debt – the amount the association owes to homeowners (domestic) and the Forners (international).

Next week I hope to continue this story with a transition to a digital currency, banks and loans.

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Notes:

  1. In 2016, the top 20% of incomes with more than $200K in income, earned more than 2/3rds of the total interest and dividends. IRS data, Table 1.4
  2. In 2018 dollars, the publicly held debt of the Federal government was $4 trillion in 1990, and $16 trillion now. In 2018 dollars, interest expense was $500B in 1990, and is $600B now.
  3. In David Graeber’s Debt: The First 5000 Years, there is no record of any early societies that had a barter system. They had a ledger or money system from the start.
  4. In the Wealth of Nations, Adam Smith – the “father” of economics – defined money as that which has no other value than to be exchanged for a good. This essential characteristic makes money unique and differentiates paper money from other mediums of exchange like gold and silver.
  5. An easy memory trick to distinguish inflation from deflation. INflation  = Increase in prices. DEflation = DEcrease.
  6. The account of the increased force of security guards – and its effect on prices and regulations – is the simple story of money and inflation during WW2 and the years immediately following. The process of rebalancing the money supply by the central bank is difficult. Monetary policy during the 1950s was a chief contributor to four recessions in less than 15 years following the war.
  7. A Job Guarantee program is a key aspect of Modern Monetary Theory.

The Skittish Market

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August 11, 2019

by Steve Stofka

I had some whole hazelnuts left over and left them out for the squirrels. They smelled them, tried to bite them, gave up and buried them in the ground. No surprise there. Squirrels bury food. But that got me to wondering. Do hazelnuts soften after a few weeks in the ground? If so, then that might be an indication that squirrels have some primitive notion of future time. I buried a few hazelnuts in the garden and dug them up this week. Still as hard as they were when I put them in there.  Maybe two weeks is not long enough.

We bury money, not nuts. We put it in banks and other institutions called “financial intermediaries” and hope that our savings grow into a big money tree over time. Our bank, mutual or pension fund sends us statements every month or quarter and tells us how big our tree has grown. Financial advisors caution us not to go out and look at our money tree every day. Why? Because sometimes the wind comes and breaks a few branches.

This past Monday was a bit windy. In response to escalating trade tensions, the Chinese yuan weakened in the global money market, and the Chinese central bank did not intervene as the exchange rate dipped below a key number of 7 yuan to the dollar. President Trump accused the Chinese of manipulating their currency because they had taken a free market approach much like the U.S. does. That’s the upside down world we live in now. If the Chinese don’t manipulate their currency, they are guilty of manipulating their currency.

The popular Dow Jones index dropped 3%.  How much is that? A little perspective might help. The financial crisis began when investment firm Lehman Brothers went bankrupt on September 15th, 2008. The stock market dropped 4.4%. A dip below a key number in the money exchange rate between China and the US was all it took to drive the market down a remarkable 3%. In short, the market is extremely sensitive right now to information. Don’t look at your money tree. Some of the branches have been broken.

How do the banks and pension funds grow our money trees? They loan the money out to people and businesses who need it. Unlike nuts and seeds, money doesn’t grow when left in the ground. Growth during the past decade of recovery has been slow but unemployment is at 50-year lows so demand for consumer credit is high – credit card rates are the highest in 25 years – over 17% (Note #1).

Here’s a graph showing credit card rates (the blue dots) and the prime rate (red line), the rate that banks charge their best business customers.

Here’s a chart of the spread or difference between the two rates. Notice that the spread decreases a few years before a recession actually occurs or banks get increasingly worried about a recession. Banks were already telegraphing their fears two years in advance of the 2008-09 recession.

As you can see, the current spread is increasing, not decreasing. Banks are not worried about getting paid because the economy is strong, and people are working. Credit card defaults are near all-time lows (Note #2). Interest rates are the price of money – the price of time. Banks are confident that they can raise their prices for people who want to borrow money.

Less than two weeks ago, the Fed cut interest rates for the first time in a decade. Chairman Powell cited concerns about global growth and warned that the market should not expect further cuts unless data justified such action. He called the ¼% rate cut a mid-course correction.

Conflicting signals – the “yes, buts” – drive market volatility higher. The economy is good. Yes, but the global economy is weakening.

Wage growth is slow. Yes, but unemployment and delinquencies are very low. Housing costs are through the roof and people won’t be able to keep up their payments. Yes, but annual increases in housing costs for the whole country are only 2-1/2 to 3%, the same as they were for most of the 90s and early 2000s (Note #3).

The yield curve recently inverted, meaning that short term rates are higher than long term rates. Yes, but workers in the retail industry are particularly vulnerable and their real weekly earnings are still rising (Note #4). The yes, buts.

As children we were told to go to sleep and we may have said, “yes, but I saw a spider on the ceiling, and I don’t want it to eat me while I’m sleeping.” It’s just a trick of the light, now go to sleep. “Yes, but I heard a mouse under the bed. What happens if it gets under the covers?” That’s just the wind outside, now go to sleep.

Not once did we worry before going to sleep, “Yes, but what about my piggy bank?” That’s what some of us do as adults. “Yes, but what if the financial crisis comes again and uproots my money tree and carries it up into the sky?” we ask. Close your eyes, now. Don’t listen to the market noise. It’s only the wind. Don’t look under your financial statement every minute for mice and bugs.

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Notes:

  1. Highest credit card rate in 25 years
  2. Credit card delinquency, FRED series DRCCLACBS
  3. Housing costs, FRED series CPIHOSNS
  4. After adjusting for inflation, median weekly earnings of full-time retail workers have risen 10% since the end of the recession. Annual earnings of $33,000 (in 2018 dollars) are far below the median $45,000 for all workers.

The Interest Rate Curve

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August 4, 2019

by Steve Stofka

I was doing some work on various 1930s Depression era programs and ran across this precursor to Social Security call the Townsend Old-Age Revolving Pension. You can read more about it at the Social Security website in the notes below (Note #1).

The idea was to give people 60 years and older $200 a month. Pretty cool, I thought. Then I checked the BLS inflation calculator and found out that $200 at that time was equivalent to $3900 a month! That’s almost 2-1/2 times the average $1,461 a month that current Social Security recipients receive. The program was to be funded by a 2% national sales tax somewhat like the VAT tax in Europe. Seniors loved the program. They would be receiving twice what an average working person received each month.

A bill was introduced in Congress to adopt this plan; when the proponents of the program appeared at a Congressional hearing, it became apparent that they had not done any research on the amount of taxes needed to fund the program – more than half of the entire federal budget. The idea was shelved but inspired the creation of the Social Security program a few years later.

A unique feature of the plan was that recipients had to spend the money every month or lose whatever they did not spend. As the economy slowed down in early 2008, the Bush Administration sent out tax rebates to everyone in the hopes that the increased spending would stimulate the economy. A 2008 consumer confidence survey indicated that only a third of people spent the rebate (Note #2), but a 2009 Congressional Budget Office analysis indicated a higher percentage (Note #3).

In Obama’s first months in office after the 2008 Financial Crisis, the issue was a hot topic among policymakers and economists. The government could send out another round of rebate checks to people, but it couldn’t make them spend it to stimulate the economy. The Fed had cut interest rates to near 0%. What else could it do?

In an April 2009 NY Times op-ed, the prominent economist Greg Mankiw discussed a proposal that one of his students offered (Note #4). Essentially, the scheme was to announce a lottery that would invalidate 10% of all money. The nominal cost of holding money would go from 0% to -10%. By nominal, I mean excluding inflation which was zero or negative in early 2009. In advance of the lottery, people would want to hold as little money as possible. Would they spend it, or deposit it in the bank?  In today’s digital economy, most of us do not hold as much money as we did several decades ago. Would such a scheme encourage people to spend more?

I remember reading a suggestion at the time that the government should send credit cards to taxpayers instead of checks. The thinking was that people would have to spend the rebate instead of being saved or paying off debt. However, money is fungible, or interchangeable. After receiving my credit card loaded with $600, for example, I could pay my utilities or rent with that and put $600 in my savings account. I have spent nothing extra, which is what the government wants me to do.

If government can’t force people to spend money, then the government must spend the money directly to stimulate the economy during a downturn. But that leaves it to Congress to decide what to spend the money on and that is a long and difficult process of debate and competition for political and economic power.

It has been more than ten years since the financial crisis. That’s ten years of some very smart and experienced people trying to think of solutions to the next crisis, whenever it comes. No one has been able to come up with a workable solution. I think that’s why the Fed announced a small decrease in the prevailing interest rate this week. In the face of some weaker manufacturing data in this country and around the world, they are trying to steer the economy away from any rocky shore. 

Have policymakers unwittingly crafted a financial world that can no longer cope with the normal downs in a business cycle? There are imbalances that build up during an expansion. A downturn is a correcting mechanism. After ten years, the Fed hasn’t been able to raise rates to a normal 3-4%. Because developed countries around the world have large debts that they must service, central banks are pressured to keep interest rates low.  The low rates entice companies to borrow money to buy back their own stock to make their future earnings more attractive to equity buyers. The low rates fuel robust credit growth among consumers who feel more confident in the future as stock prices continue to rise. The money spent spurs more growth. Eventually, the growth rate of employment and house prices and credit slows to zero. Then comes the downhill part. I think the Fed knows that the brakes on this economy are not working very well and are taking us down a road where the downhill might be more gradual. I hope.

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Notes:

  1. The Townsend Old-Age Pension program
  2. A preliminary analysis 2008 tax rebate
  3. A CBO analysis of the 2008 tax rebate
  4. Greg Mankiw’s NY Times op-ed “It May Be Time for the Fed to Go Negative.”