The Pause in the Cycle

March 26, 2023

by Stephen Stofka

This week I’ll look at things that are hard to measure and their effect on our lives. Much of human activity is recursive, meaning that the outcome of one action becomes the input to the next iteration of that same action. When we get nervous we may breathe fast and shallow which changes our body chemistry increasing our anxiety and we continue breathing fast and shallow, amplifying the effect. Because of that cyclic process prominent thinkers like Aristotle, Adam Smith, David Ricardo, Karl Marx, and Joseph Schumpeter, among others, have proposed circular models of human behavior.

The 19th century economist David Ricardo modeled the industrial process as a profit cycle. Increasing or decreasing profits mark the division between two phases of the cycle. The first phase is a series of more and higher –

rising profits,
more investment,
leading to more output,
an increased demand for labor,
a rise in wages,
a rise in population and consumption,
an increasing use of less efficient inputs,
higher prices,
then higher interest rates,
and lower profits.

The decline in profits signals the end of the expansion and begins the downward phase, a cycle of less and lower of each of those elements – less investment, output, less demand for labor, lower wages in aggregate, etc. Ricardo assumed that workers received subsistence wages so an individual worker might not work for wages any lower. Like his friend Thomas Malthus, Ricardo assumed that higher incomes would lead to an increase in population. In the early 19th century, less efficient inputs meant less fertile land. As our economy has transitioned to become almost entirely service oriented, the less efficient inputs are labor. It is difficult for a hairdresser or therapist to become more productive.

Since the pandemic companies have been rewarded for raising prices, a strategy Samuel Rines, managing director of the research advisory firm Corbu, called “price over volume” on a March 9th Odd Lots podcast. With this strategy, companies like Wal-Mart keep pushing prices higher, willing to accept lower volume as long as total revenue and profits are higher. After-tax corporate profits (CP) have risen more than 40% from pre-pandemic levels, according to the Federal Reserve.

In Ricardo’s model of the profit cycle, higher prices lead to higher interest rates as investors increase their demand for money to take advantage of the higher prices. In our economy, the Fed controls the Federal Funds interest rate that other rates are based on. As prices continued to rise, the Fed began to lift rates and has raised them more than 4% in the past year. As the Fed raises rates, bank loan officers tighten lending standards, beginning with small firms (DRTSCIS) and credit card loans (DRTSCLCC). The FRED data series identifiers are in parentheses. In the past year, banks have increased their lending standards by more than 50% for small firms and 43% for credit card loans. However, all commercial loans have increased by 15% in the past year and delinquency rates have not changed since the Fed started raising rates. This is part of Ricardo’s model. Investment does not decrease until profits decline. Profits (CP) still grew at 2.25% in the 3rd quarter of 2022. We are not there yet.

In the 4th quarter of 2022, real GDP grew at less than 1% on an annual basis. We won’t have an estimate of 1st quarter numbers until the 3rd week of April but employment remains strong. Since 1980, the population adjusted percent change in employment goes negative or approaches zero just before recessions. In the chart below, notice how closely the employment (blue line) and output series move in tandem. The red line is the annual percent change in real GDP.

We may be approaching the pause point but the point of decline could be six months to a year away. Although the Fed let up on the “gas pedal,” raising rates by ¼% rather than ½%, they showed their commitment to curbing inflation as long as the employment market stays strong. If the Fed had not raised rates this past week, they would have set expectations that they were done raising rates. For now we can look for these signs that the expansion of the business cycle in Ricardo’s model is coming to a close.


Photo by Lukas Tennie on Unsplash

The Money Treadmill

March 19, 2023

by Stephen Stofka

Inflation is a cat’s cradle of mechanisms and motivations as mysterious as time, a simple and puzzling concept that controls our lives. Our minds are caged by this thing that is objectively invariant – a second is a second – but experienced so differently by each of us. It begins when we are very young and ask a parent when we can go to the beach or an amusement park. “Next week,” we are told, and our eyes glaze over. How far away is next week? Albert Einstein was the first to understand time as a distance. Stephen Hawking, one of the most fertile minds of the last century, wrestled with the beginning of cosmological time.  Many of us struggle to knit two concepts together – time and money. To many of us the net present value of a future flow of moneylooks like something inside of a tangled ball of fishing line.

Several banks blew up recently because they mismanaged their exposure to time risk. Inflation is the experience that time is moving faster than our money. It’s like our money is running on a treadmill when someone starts increasing the speed of the treadmill. The Fed cannot directly affect the speed of the treadmill so it raises interest rates, the equivalent of adding weight to our money. More often than not, the Fed damages the treadmill, sending the economy into recession.  

I’ll include some background on the relationship between inflation and interest rates. Irving Fisher was an influential economist in the early half of the 20th century whose ideas continue to influence economic thinking. Several of these are the Quantity Theory of Money, a way of computing a price index, and a hypothetical relationship between inflation and unemployment that later became known as the Phillips Curve. Fisher hypothesized that interest rates rise in a lockstep response to inflation – an idea known as the Fisher Effect. Fisher reasoned that lenders would demand higher interest rates if they anticipated that a dollar would buy less in the future. For the same reason, depositors would demand higher interest rates on their savings. Fisher died in 1947, just after World War 2. In the decades after his death, the data did not support a simple one-for-one relationship between interest rates and inflation.

Despite the lack of a simple relationship, the Fed has limited tools to achieve – by law – two counterbalancing targets, full employment and stable prices. For several decades, its policy objective has targeted a 2% inflation rate as a quantitative mark of stable prices. To counter inflation, the Fed initiates a Fisher Effect by being the first bank to raise the interest rate it pays to all the other banks. The reasoning is that banks will charge higher interest on their loans to cover the higher cost of their funds. That should slow loan demand. Secondly, the Fed reasons that banks will raise the interest rate they pay on deposits. A higher rate should induce people to save more and spend less, thus slowing down the treadmill.

Fisher’s Quantity Theory of Money (QTM) is built on the assumption – an “if” – that interest rates stayed constant. Since interest rates were lowered to near zero during the financial crisis in 2008, there has been little movement in interest rates. This became a natural experiment that Fisher had imagined – a world where interest rates remained constant. As the Fed pumped more money into the economy during the 2010s, the QTM predicted that prices would rise. They didn’t. Just as economists had discovered that the relationship between interest rates and prices was complicated, so too was the relationship the quantity of money and prices.

Banking is the art and discipline of managing the speed and weight of money when an individual bank has no control over either the speed or the weight. Anything that stays still for long becomes invisible or at least minimizes their risk. Cats instinctively know this as they wait still and patient in the hope that a wary bird will relax its guard. The long lack of movement in interest rates tempted those at Silicon Valley Bank to take concentrated risks based on the assumption that interest rates would continue to stay low.

Retail investors are cautioned not to load up on long-term bonds just to get a higher interest rate return. From October 2021 to October 2022 Vanguard’s long-term bond index BLV lost almost 30% in value. Professional bankers broke that cautionary rule. Former Fed Chairman Alan Greenspan admitted his mistake in judgment as the 2008 financial crisis unfolded: “I made a mistake in presuming that the self-interests of … banks … were such that they were best capable of protecting their own shareholders and their equity in the firms.” By holding interest rates low for so long, some banks lost their sense of prudent risk management. The cat pounced.

This experience should guide our own choices of investment, savings and risk management. We can be lulled into thinking that some factor in our lives will stay constant. Some factors are personal – a job, a marriage, our health and the health of our family. Some factors belong to the wider community we are a part of – the local economy, the housing market and the weather. Other factors are macro – interest rates, inflation, state and federal policies. We can do what Silicon Valley Bank did not do – diversify.


Some have likened the run on SVB to the D&D model presented in a 1983 paper. Douglas Diamond and Philip Dybvig (D&D) won the 2022 Nobel Prize for their model demonstrating the efficiency and appropriateness of government deposit insurance. Douglas Diamond was interviewed this past Tuesday on the podcast Capital Isn’t. Diamond says that the bank run on SVB was not like the ones they presented in their model. In that model the depositor base was much wider and diverse, more like a random sample than the depositors of SVB who were primarily businesses in the tech industry.

Photo by Sven Mieke on Unsplash

Paradoxes in Savings

March 12, 2023

by Stephen Stofka

Paradoxes in Savings

The week’s letter is about the relationship between savings and inflation. On Tuesday, Jay Powell, the Chairman of the Fed, announced that they would continue raising rates to get inflation under control. The market dived a few percentage points. There are no shortage of explanations for persistent inflation. Despite an inflation rate above 5% for the past year, the employment market remains strong, a puzzle to economists. I will take a look at how changes in savings affect inflation.

There are times when we coordinate our behavior for apparent reasons. The weather and seasons synchronize the activities of farmers. The harvest comes at a particular time and farmers need to rent more harvesting equipment, storage capacity, rail cars and trucks for transporting their crops. Suppliers are on a different time schedule than their customers.  Supplying anything takes planning, investment and time.

Suppliers rely on the fact that buyers coordinate their buying decisions according to the seasons. Clothes, gardening and Christmas gifts are easy examples. Forty percent of homes are sold during the spring months. Except for big purchases, a buying decision takes less planning and this can create anomalies that suppliers are not prepared for. Sometimes it is a popular toy at Christmas or a clothes style made popular by a celebrity.

What causes asset buyers to coordinate their behavior? The economist John Maynard Keynes was particularly interested in that question. He attributed the phenomenon to “animal spirits,” an infectious rush of pessimism or optimism that affects the prices of assets first, then spreads to the purchases of goods. Normally, some of us are saving more than usual for something, while some of us are spending that savings, or borrowing to buy things. There is a balance of savers and borrowers. However, sometimes a general prudence causes everyone to save more than average and what emerges is a paradox, the Paradox of Saving. If everyone saves, then economic activity declines, unemployment rises, people spend down their savings and the economy finds a new equilibrium at a much lower growth rate.

In the spring of 2020, a surge of Covid deaths in Italy and New York City prompted the closing of many businesses. City morgues were overwhelmed, forcing hospitals to rent refrigerated trucks to store the bodies. The NY health department supervised several mass burials. Residents in rural areas who were unable to catch their breath were flown to distant hospitals with the equipment and personnel capable of bringing the patients some relief. Because many workers had abruptly lost their income, the government issued relief payments to households throughout the country. With many entertainment venues closed, many of us increased our rate of savings. Below is a graph of the quarterly change in the personal savings rate.

The savings rate shot up 15%, a historic rise. Even during the high inflation of the 1970s, the savings rate rose by only 2.5% in 1975. Such an abrupt change in savings did have an effect on prices. When the change in the savings rate is negative, people are buying stuff with their savings. Companies could take advantage of supply chain bottlenecks and raise prices. This helped make back what they had lost in profits in 2020. The quarterly change in prices began to rise, as the red line in the chart below indicates. Note that inflation is the annual, not quarterly, change in prices.

Look on the right side of that chart and you will see the blue savings line turning positive. A steadily higher savings rate should exert some calming effect on prices. I then ran a statistical regression on the annual change in both prices, i.e. inflation, and the savings rate for the past 35 years. The effect of a 1% rise in the savings rate is about a 1% decrease in the inflation rate and explains 21% of the movement in inflation.

What can you do with this information? Quick erratic changes in savings have an effect on prices. Immediately after 9-11 there was an abrupt rise and fall in savings but the change was much less than the pandemic shock, which was truly historic. In 2008 came another shock, an abrupt shift in savings and an accompanying rise in prices in the summer of 2008 before the Lehman meltdown in September and the economy tanked in the 4th quarter of 2008. These changes in savings rates don’t occur very often, but when they do we should pay attention.


Photo by Johannes Plenio on Unsplash

The Money Cycle

March 5, 2023

by Stephen Stofka

This week’s letter is about money and a natural resource like water. The nature of money, its origin and history have long been a subject of lively debate. What similarities and differences does money have with water? Does an analogy help uncover some less apparent characteristics of money? I’ll start with the three purposes of money that every economics student learns: a medium of exchange, a store of value and a unit of account. Coincidentally, water has three phases, gas, solid and liquid, and in each of those phases has some of the characteristics of money. The quantity of money can expand. The volume of water in all its phases is fixed.

Ice stores the energy of water the way that money stores value. As freezing water locks together in a crystal lattice, it becomes its own container. Oddly enough, most ice exhibits a hexagonal form, an efficient material transformation in response to changes in temperature. Only 2.5% of the world’s water is freshwater and most of that is locked up in glaciers. Money’s store of value is contained within assets.

In Part 5, Chapter 3 of the Wealth of Nations, Adam Smith noted that people tend to hoard their capital, to lock it away from a government which has little respect for individual property – what he called a “rude state of society.” If merchants and manufacturers have confidence in a government, they are willing to lend it money because the debt of that government can be traded in the market as though it were money. It is an interest bearing money. He lamented the fact that too many governments borrowed money to finance war and taxed people to build infrastructure. He suggested that governments do the opposite – borrow as much idle capital as possible to enhance the productivity of a country and tax people to finance wars. There would be less war and more progress.

Like money, water vapor is a medium of exchange between sky and ocean, between sky and earth. It is in constant motion within the atmosphere because its density quickly changes in response to changes in heat. It carries the water from the ocean and drops it onto the land in a conveyer belt system called the hydrological cycle. When all the earth came together in one supercontinent called Pangea 250 million years ago, water vapor transported little moisture from the oceans to the interior of the vast continent and the land was mostly desert (Howgego, 2016). When businesses around the world closed their doors at the onset of the pandemic in March 2020, we became very aware that our society, not just our economy, depends on a cycle of exchange.

Money is a unit of account, a common denominator to add up all the various goods and services in an economy. We add up tons of wheat and corn and millions of hours of labor in terms of money. . While we often think of fractions as “this divided by that,” economists understand fractions as “this in relation to that.” A social scientist might question whether it is a good idea for people to think of their labor in relation to money, the common denominator. Sadly, our society judges our worth to society in relation to that common denominator, money.

Water has a density like money has a purchasing power. Water is at its most dense – its weight per unit of volume – at 39°F and that benchmark is standardized at 1 in the metric system. The density of water at 39°F is like the benchmark price that economists use when they compute real GDP. Its volume expands as it gets colder or hotter than that temperature, so it’s density declines. The most measurable changes come at higher temperatures; at 200°F, the density is .963. We often use the language of heat when talking about inflation. The economy is overheating, for example. When there is hyperinflation¸ society itself begins to change state, just as water does at the boiling point.

Changes in the market value of our assets can have a material effect on our sense of safety. We work hard and save only a small portion of what we earn. When the value of an asset declines, it seems to melt away as though it were a block of ice on a sunny day. We may get a sense of helplessness or anxiety similar to the feeling we have when we lose electricity and worry that we will have to replace all the food in our fridge.

Readers may have other insights into money based on this water analogy. Just as equations can expose relationships that we did not understand before, analogies can do the same.


Photo by Ryan Yao on Unsplash

Howgego, J. (2016, July 14). Travel back in time to the most extreme desert and monsoons ever. New Scientist. Retrieved March 3, 2023, from