Month: February 2023

An Evolving Society

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February 26, 2023

by Stephen Stofka

Our political conversation often features a dispute over the role of government in our lives. Role is a shorthand word for recognition, powers, legal authority, and mutual responsibilities of government. In the U.S. this debate occurs on multiple levels: 1) the role of the federal government to the states, 2) the role of state governments to cities, 3) the role of all three levels of government to the individual. Supporting these roles are the customs and beliefs of our society.

To understand the development of society, I break it into three phases of political economy. The first is tribalism, a society built on honor. Members of the tribe are expected to accept their status and recognize the status of others. Any disruption to this network of status within the tribe is perceived as a threat to the tribe itself. A second type of society called feudalism is based on obligation. Each member belongs to a class within the society and each class has an obligation to those of other classes. A third type of society called capitalism is based on individual property claims that are tradeable. In the U.S. this set of economic and financial relationships is paired with a democratic political regime based on non-tradeable rights like life, liberty, and the pursuit of happiness as stated in the Declaration of Independence. Claims are tradeable, rights are non-tradeable.

Using this framework, socialism would be a hybrid of feudalism and capitalism. Socialist principles describe obligations to each other as a way of reaching equality and equity. Laws under a socialist regime establish government as an agent who can trade property claims for individuals as a means of meeting those obligations. Governments can redistribute resources through space, from one region to another, or across time, from one generation to another. The Social Security program is an example of such an intergenerational transfer.

Property claims depend on information to establish the claim and facilitate the trading of those claims. However, trading relies on an asymmetry, or uneven level, of information or expectations between buyer and seller. Asymmetry of information is different than misinformation, the transmission of information which someone knows not to be true in order to persuade someone else to do something without physically forcing them. This is where democratic politics, the system of non-tradeable rights, must be separated from economics, the system of tradeable claims.

Democratic politics relies on some degree of misinformation to persuade people to vote for a candidate. A candidate who holds an unpopular position on an issue will not reveal that true conviction if they think voters will reject them because of that position. Republican representative George Santos can misrepresent himself and his background to get elected but not commit criminal fraud.

On the other hand, economic transactions founded on misinformation and misrepresentation are classified as fraud. Carlos Watson, the founder of Ozy Media, can make several misrepresentations and be arrested for criminal fraud (Palma & Nicolaou, 2023). Our capitalist system emphasizes tradeable property claims and the right of contract. Our democratic system punishes transgressions against the capitalist system of contract. Votes cannot be traded legally and our political system rarely exacts criminal penalties for violations of election law.

Article 1, Section 8 of the Constitution gives Congress powers over tradeable property claims. These involve the powers
1) to tax
2) to borrow money and pay debts on behalf of all the states
3) regulate interstate commerce,
4) establish rules for bankruptcy, when property claims become forfeit,
3) control of the creation of money used to make exchanges,
4) regulation of the weights and measures of tradeable goods
5) the granting of copyrights, patents and trademarks which establish tradeable property claims (see Johnson, 2009 in the footnotes).

After specifying some regulatory control over tradeable property claims, the Constitution then grants power to Congress to regulate non-tradeable rights. These involve what economists call public goods. These include
1) Naturalization, the claim to non-tradeable rights as a citizen, including the right to vote.
2) the lower courts that address violations against both rights and claims,
3) the mechanisms for providing a common defense to protect both claims and rights from outside interference and intrusion,
4) the rules of international relations, conduct of war and treatment of prisoners,
5) establishing and administering a central capitol district.

There are two approaches to constitutional interpretation. Conservatives regard it as an instruction manual and employ two analytical techniques grouped under textualism, a close reading of the law, and originalism, understanding the text in the historical background when a law was written. Free market enthusiasts believe that the federal government should have a minimum role in the economy. The framers gave the federal government broad powers over the legal tools that facilitate economic exchange but not the regulation of outcomes. Therefore, the Congress has only those powers listed in Article 1, Section 8, as above.

On the opposite end of the political spectrum are those who interpret the Constitution as software code that needs to be maintained to meet the needs of those who use it. They rely on one phrase at the beginning of Section 8 – provide for the…general welfare of the United States – as a justification for expansive federal authority and redistributive programs. Which is it – instruction manual or software code?

These two political camps may have different perspectives on the scope of government authority but the farm bill is a big spending tent where both camps meet. Spending under this annual bill benefits both farms and individual households. The bill provides price supports to farmers, many of whom are politically conservative. The large scope of the farm bill also includes food support for low income households, addressing the concerns of those who have a more expansive view of the role of government. Democracy is a big tent of competing values and conflicting interests as messy as a finger-style Texas barbecue.

These political and economic debates evolve rather than resolve, and they evolve through conflict. The superior arms of those who believed in individual property rights conquered tribes founded on the principle of group property rights. As those tribes were confined or exterminated in some cases, the debate has been silenced. Technological improvements in farming made feudalism impractical and unprofitable. We are no longer debating the mutual obligations of peasant workers and the propertied lords granted their lands by the king. Our current system will evolve through conflict as well.

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Photo by Eugene Zhyvchik on Unsplash

Johnson, S. (2009). The invention of air: A story of science, faith, revolution, and the birth of America. Riverhead Books. This is an engaging book about Joseph Priestley and his influence on seminal thinkers of the 18th and 19th century, including Benjamin Franklin, John Adams and Thomas Jefferson. Priestley publicized his experiments and methods to advance the state of scientific knowledge. He believed that patent rights interfered with progress and the natural human instinct to share knowledge.

Palma, S., & Nicolaou, A. (2023, February 23). Ozy Media founder Carlos Watson arrested on fraud charges. Financial Times. Retrieved February 24, 2023, from https://www.ft.com/content/0669ff08-05d8-4a99-bdec-30f89d59acd6

A Labor-Output Ratio

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February 19, 2023

by Stephen Stofka

When analyzing the economies of some developing countries, economists refer to a “resource curse,” a commodity like oil or minerals that a country can sell on the global market. In a developing country, that commodity may become the main source of foreign currency, used to pay for imports of other goods. The extraction of that resource requires capital investment which usually comes from outside the country. If the production of that resource is not nationalized, most of the profits leave the country.

There are a few big winners and a lot of losers. This uneven ratio promotes economic and social inequality. Political instability arises as people within the country want to get a hold on those resources. Some politicians promise to use the profits from the resource to benefit everyone but those who seize power benefit the most. Political priorities determine economic decisions and the production of that resource becomes inefficient.

A key factor in the “resource curse” is that its contribution to GDP is usually far above its contribution to employment. If a mining sector accounts for 2% of employment but contributes 10% to GDP, the ratio of employment / GDP % equals 2%/10%, or 0.2. Ratios that are far below 1 do not promote a healthy economy. Industries that are closer to a 1-1 ratio will produce a more well rounded and vibrant economy because employed people spend their earnings in other sectors of the economy – a diffusion effect. Some economists might say that a low ratio means that capital is being used more efficiently and attracts capital investment. However, that efficiency comes at an undesirable social and economic cost.

 Let’s look at some examples in the U.S. The construction industry contributes 3.9% to GDP (blue line in the graph below) but accounts for 5.1% of employment (red line). Notice that this is the opposite of the example I gave above. The 1.31 ratio of employment/GDP is above 1, meaning that the industry employs more people for the direct value that it adds to the economy.  Construction spending includes remodels and building additions but does not include maintenance and repair (Census Bureau, n.d.). In the chart below, look at how closely GDP and employment move together. The divergence in the two series since the pandemic indicates the distortions in the housing market because of rising interest rates. Builders have put projects on hold but employment in the sector is still rising because of the tight labor market.

The finance sector’s share of the economy has grown since the financial crisis yet employment has remained steady – or stuck, depending on one’s perspective. The great financial crisis put stress on banks, big and small, but the government bailed out only the “systemically important” banks, leaving smaller regional banks to fend for themselves. The larger banks absorbed many smaller banks, leading to a consolidation in the industry. That consolidation and investments in technology helped the sector become more efficient. The ratio is about 0.75, above the 0.2 ratio in the example I gave earlier. I labeled the lines because the colors are reversed.

Retail employs a lot of people relative to its contribution to GDP. The ratio is about 1.65. Does that mean retail is an inefficient use of capital? Retail sales taxes pay for many of the city services we enjoy and take for granted. Retail is the glue that holds our communities together.

The manufacturing sector employs fewer people in relation to its GDP contribution. It’s ratio is 0.77, about the same as finance.

As I noted earlier, the mining sector is capital intensive with a high ratio of GDP to employment. This sector includes gas and oil extraction. In the U.S. that ratio averages about 0.33 but it is erratic global demand. Look at the effect during the pandemic. In our diversified economy, the mining sector contributes only a small amount, like 2%. In a developing country like Namibia in southern Africa, mining accounts for 10% of GDP. In the pandemic year, the demand for minerals declined and Namibia’s economy fell 8%.

Lastly, I will include the contribution of health care, education and social services, which contribute 7.5% to GDP but employ almost a quarter of all workers. Since the financial crisis and the passage of Obamacare, this composite sector contributes an additional 1% to GDP. These sectors include many public goods and services that form the backbone of our society. The 3.0 ratio is the inverse of the mining sector.

To summarize, the construction, retail, health care and education sectors have a ratio above 1. They employ more people for each percentage unit of output. The finance, manufacturing, mining, oil and gas sectors have ratios less than 1, employing fewer people per percentage unit of output. For readers interested in the GDP contribution of other industries, the Federal Reserve maintains a list of charts, linked here [https://fred.stlouisfed.org/release?rid=331].

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Photo by Camylla Battani on Unsplash

Census Bureau. (2019, April 15). Construction spending – definitions. United States Census Bureau. Retrieved February 16, 2023, from https://www.census.gov/construction/c30/definitions.html

U.S. Bureau of Economic Analysis, Value Added by Industry: Construction as a Percentage of GDP [VAPGDPC], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VAPGDPC, February 12, 2023.

U.S. Bureau of Labor Statistics, All Employees, Construction [USCONS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USCONS, February 12, 2023.

U.S. Bureau of Labor Statistics, All Employees, Total Nonfarm [PAYEMS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PAYEMS, February 12, 2023.

I will not do a complete reference for each series. Here’s the identifiers for each series: Finance Value Added – VAPGDPFI. Employment in finance – USFIRE. Construction employees – USCONS. Retail Value Added – VAPGDPR. Retail Employees – USTRADE. Manufacturing Value Added – VAPGDPMA. Manufacturing Employees – MANEMP. Education, Health Care, Social Services Value Added – VAPGDPHCSA. Employment is a composite of 4 series. Mining Value Added – VAPGDPM. Mining Employment – CES1021000001

Price Paths Rejoin

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February 12, 2023

by Stephen Stofka

Divergent paths rejoin. This week’s letter revisits a correlation between movements in oil prices and the general price level. On July 10th of last year, I noted a divergence between the change in oil inflation and price inflation. The chart graphed the change – or momentum – in oil and price inflation, not the inflation itself. Transportation is a fundamental component and cost of our economy and companies must factor in shifts in price momentum in their pricing decisions. Here’s that chart.

At the time I had thought it likely that the change in broad price inflation – the red line in the chart – would moderate toward the momentum change in oil prices, the blue line. It did. Here is a chart with the most recent data through the end of 2022.

As I was writing last July, the momentum in general price inflation had already peaked and would start declining throughout the rest of the year. Think of momentum as a strong dog on a leash. Where it pulls, general price inflation will follow. Here’s a monthly comparison of inflation and its momentum.

At just a hint that inflation was moderating, the broad market began a rally in late October but it fizzled out in early December for a few reasons. The labor market was strong despite the Fed’s interest rate hikes and market participants correctly anticipated another 0.75% rate hike. In addition, Christmas retail sales were slow, increasing the likelihood that earnings gains would decrease. The broad market has rallied 7% since the beginning of the year.

A last note for those of you who are working on taxes and reviewing your portfolio, the investment advisor Edward Jones (2023) has a nice chart titled Investment Performance Benchmarks at the bottom of the page showing the 1, 3, and 5-year returns on various asset classes within the cash, bonds, and stocks categories. Despite the 18% drop in large cap stocks last year, the five-year performance is 9%, close to the decades long averages. The tech sector lost almost 30% in value last year but its 5-year return is almost 16%. During volatile years, relatively passive investors should keep their sights on the long-term averages.

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Photo by Jens Lelie on Unsplash

Edward Jones. (2023, January 24). Quarterly Market Outlook. Quarterly Market Outlook | Edward Jones. Retrieved February 9, 2023, from https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/quarterly-market-outlook

Money As Wave

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February 5, 2023

by Stephen Stofka

This week’s letter is about money, a peculiar thing invented by people that has no intrinsic value unless exchanged between people. Unlike other goods, the consumption of money satisfies no human wants. Price is the thing on the left side of an equation. On the right side can be a physical quantity like a haircut or a quart of milk, or a less physical good like the satisfaction of a debt owed, or the title of ownership to a car. Money is the equal sign of that equation, the channel that connects the price information to real goods and services.

Many goods have two types of value – subjective and objective. A tomato’s subjective value depends on the needs, preferences, and resources – the circumstances – of the consumer. These circumstances vary with time. A consumer who is hungry and who likes the taste of tomatoes values a tomato more than a consumer who is not hungry or who doesn’t like tomatoes. The subjective value depends on a consumer’s resources. A consumer with a fridge can preserve a tomato longer and might value a tomato more than someone who has no cool place to store a tomato. A further element of subjective value is the intended use for the good. A consumer who wants to eat a fresh tomato might have different quality standards than someone who wants to puree the tomato for a soup or sauce.

The second type of value is objective, an intrinsic value of the good itself – the nutrients and calories a tomato provides, the chemical changes that it undergoes, the pests that the tomato harbors within its skin. Just as the circumstances of the consumer vary with time, the benefits or dangers of a good’s consumption can vary with time.  

Like the values of goods, the value of money has a subjective and objective component. The objective component is a decay in the exchange value of money on the left side of millions of exchange transactions. Economists measure thousands of prices each month and determine an average weighted price for a set of goods – a consumer price index. The annual, or year-over-year, percent change in that index is called inflation. It compares this month’s price index with the price index one year ago. Economists also measure the change in that percent change and the two sometimes get lumped together by the financial press. Inflation is like the odometer in a car. If I travel 50 miles in an hour, I have averaged 50 MPH but it is the speedometer that tells me my current speed, not the average over an hour. Too often the arguments on social media mix the two together. Imagine getting pulled over by a patrol car for speeding and explaining to the officer that your average speed for the past 15 minutes has been less than the speed limit. The officer cares only about your acceleration – the near instantaneous speed.

The value of money has a subjective component that depends on the user’s circumstances. Today-Money is that which is needed to satisfy current needs. Future-Money is savings. As prices go up, people tend to hold more money as a percent of their income to pay for living expenses. If a household spends 90% of their income on current needs, then much higher inflation rate might cause them to spend 100% of their income on expenses. A higher income household might spend only 60% of its income on expenses. The effect of inflation is lower for higher income households.

Savings is an exchange between two people in time, between a person today and that same person in the future. “You got to pay you,” we may be told when encouraged to save some of our paychecks. The first you is Today-You. The second you is Future-You, who will be grateful that Today-You was prudent. Future-You does no work yet enjoys all the sacrifices that Today-You makes, the extra work, the enjoyment of things not consumed in order to save. Future-You is truly the child of Today-You.

The financial system facilitates the exchange of money-value through time. In countries with a poor financial system, people place their savings in things, animals and children whose work or usefulness will provide for a person when they become less vigorous in their old age. A child may grow up with the moral and financial burden of having to care for their parents. In these pastoral societies, a child is considered a form of wealth.

Children in an area far from home or in a foreign country are expected to send a substantial part of their paychecks home to their parents or extended family. This moral burden drives young people to immigrate to another country where they can earn more money. Part of their earnings form the international flow of remittances which increased by almost 5%, according to the Migration Data Portal (2023). India, Mexico, and China were the top recipient countries in 2022, accounting for $310 billion of the $690 billion in remittances. This sum does not include informal or illegal transfers of goods and services between countries.

Money acts like a radio wave, conveying price information about the relative values of goods and services. It requires institutions to broadcast and relay that wave as it travels around the globe and through our lives.

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Photo by Pawel Czerwinski on Unsplash

Migration Data Portal. (2023, January 6). Remittances. Migration data portal. Retrieved February 3, 2023, from https://www.migrationdataportal.org/themes/remittances. The portal was established in 2016 as a data repository founded under the auspices of the United Nations. It collects central bank data through the World Bank and IMF.