Author: sgstofka

A Home Is a Magic Wallet

Leave a comment

April 7, 2024

by Stephen Stofka

In this week’s letter I will explore the various roles that housing plays in our lives. Last week I showed the divergence of household formation and housing supply during the financial crisis. Home builders responded to the downturn in household formation by building fewer homes. Because the recovery after the crisis was slow, the demand for housing did not pick up until 2014. It is then that a mismatch between housing demand and supply started to appear in the national and some local home price indices. This week I will examine the demographics of homebuyers and sellers in recent history and the secret life of every homeowner as a landlord. A home is a magic wallet where money flows come and go.

Data from the National Association of Realtors (NAR) indicates that the median age of home sellers has increased from 46 to 60 since 2009. I will leave NAR data sources in the notes. In the four decades between 1981 and 2019, the median age of home buyers rose by twenty years, from 36 in 1981 to 55 in 2019. The median age of first-time buyers, however, increased by only four years, from 29 to 33. In 1981, the difference in age and accumulated wealth between first-time buyers and all buyers was only seven years. Now that difference has grown to 22 years. First-timers typically buy a home that is 80% of the median selling price of all homes.

In the past four decades, there has been a divergence in wealth between older and younger households. The real wealth of younger households has declined by a third since 1983 while households headed by someone over 65 have enjoyed a near doubling of their real wealth in thirty years. Accompanying that imbalance in growth has been a shift in capital devoted to housing.

The Federal Reserve regularly updates their estimates of the changes in household net wealth. The link is an interactive tool that allows a user to modify the time period of the data portal. The chart below shows the most recent decade of changes in wealth. The lighter green bars are the changes in real estate wealth for households and non-profits and show the large gains in real estate valuations during the pandemic. The blue bars represent equity valuations and demonstrate the volatility of the stock market in response to any crisis, large or small.

The Fed’s data includes various types of debt as a percent of GDP. Twenty years ago, household mortgages were 11-12% of GDP. Today they are 19% of GDP, a huge shift in financial commitment to our homes and neighborhoods. A city average of owner equivalent rent (FRED Series CUSR0000SEHC) averaged an annual gain of 2% during Obama’s eight- year term, 2.8% during Trump’s term, and 6% during the first three years of Biden’s term. Biden has little influence on trends in housing costs, but the art of politics is to use correlation as a weapon against your opponent. People feel the change in trajectory as a burden on their households.

The Bureau of Labor Statistics calculates owner equivalent rent by treating a homeowner as both a landlord and renter. Property taxes, mortgage payments, interest, maintenance and improvements to a home are treated as investments just as though the owner were a landlord. The BLS uses housing surveys to determine the change in rental amounts for different types of units. A sample of homeowners are asked how much they would rent out their home but this guess is used only to establish a proportion of income dedicated to rent, not the actual changes in the rental amounts for that area, as the BLS explains in this FAQ sheet.

Let us suppose that a homeowner has a home that is fully paid for. If the house might rent for $2000 a month and monthly expenses are $500 a month, that would represent $1500 per month in implied net operating income for that homeowner, an annual return of $18,000. A cap rate is the amount of net operating income divided by the property’s net asset value. If similar homes are selling for $450,000 in that area, the homeowner is making 4% on their house’s asset value, slightly less than a 10-year Treasury bond (FRED Series DGS10, for example).

Long-term assets compete with each other for yield, relative to their risk. A property is a riskier investment than a Treasury bond, so investors expect to earn a higher yield from a property. Before the pandemic, 10-year bonds were yielding between 2-3%. Landlords could charge lower rents and still earn more than Treasury bonds. As yields rose for Treasury bonds, property investors must charge higher rents to earn a yield appropriate to the risk or sell the property and invest the money elsewhere.

When we own an asset that provides an income, it is as though the asset owes us. When a home declines in value, we feel a sense of loss. When the housing market turned down in 2007-2008, homeowners expected to get a similar price as the house their neighbor sold in 2006. They used that sale price to determine what their house owed them. In order to get the listing, a real estate agent would agree to list the home for that higher amount, but the property would get few offers. After a period of time, the seller would cancel the listing and wait for the “market to turn around.”

Earlier I noted the dramatic rise in mortgage debt as a percent of GDP. At one-fifth of the economy, that debt represents capital that is not being put to its most efficient use because most homeowners do not regularly evaluate the yield on their homes as professional investors. A higher percent of capital devoted to housing will help sustain higher housing costs and pressure household budgets. I worry that an inefficient use of capital will contribute to a pattern of lower economic growth in the future, stifling income growth. The combination of these two pressures will make it difficult for younger households to thrive. The generational gap will widen, adding more social and political discord to our national conversation.

/////////////////

Photo by Towfiqu barbhuiya on Unsplash

Keywords: mortgage, housing, owner equivalent rent

Notes on median age of sellers: 2009 data is from the NAR and cited in a WSJ article (paywall). Current data is from the NAR FAQs sheet. Jessica Lautz, an economist with NAR, reported the four-decade trend in home buyers. Median home prices of first-time buyers is from a 2017 analysis by the NAR. The comparison of older and younger households comes from a 2016 NAR analysis.

Notes on Federal Reserve data:  The change in mortgage debt as a percent of GDP is in the zip file component z1-nonfin-debt.xls, in the column marked “Noncorporate Mortgages; Percent of GDP.”

A Home Is More Than a Home

Leave a comment

March 31, 2024

by Stephen Stofka

This week’s letter is about housing, the single largest investment many people make. The deed to a home conveys a certain type of ownership of physical property, but the price reflects a share of the surrounding community, its economy, infrastructure, educational and cultural institutions. We purchase a chunk of a neighborhood when we buy a home.

These are network effects that influence demand for housing in an area. They are improvements paid for by tax dollars or business investment that are capitalized into the price of a home. Take two identical homes, put them in different neighborhoods and they will sell for different amounts. When elements of this network change, it affects the price of a home. Examples of negative changes include the closing of businesses or an industry, a decline in the quality of schools, the presence of graffiti or increased truck traffic. Positive changes might include improved parks and green zones, better schools and alternative transportation like bike lanes and convenient public transportation.

Zoning is a critical tool of a city’s strategic vision. Zoning controls the population density of an area, the available parking and the disturbance from commercial activities. Many cities have some kind of long-term plan for that vision. Los Angeles calls it a General Plan. In Denver it is called Blueprint Denver (pdf). Homes built in the post-war period in the middle of the twentieth century were often smaller. They feature a variety of building styles whose distinctive character and lower prices invite gentrification. As properties are improved, their higher appraisal values bring in more property tax revenue from that city district and the process of building an improved neighborhood network begins.

A representative for that district can argue for more spending on public amenities to enhance the neighborhood. This further lifts property values and increases tax revenues. Developers get parcels rezoned so that they can convert a single-family property into a two-family unit. This may involve “scraping” the old structure down to its foundation, then expanding the footprint of the structure to accommodate two families. As this gentrification continues, there is increased demand for rezoning an area to allow the building of accessory dwelling units, or ADUs, on a property with a single-family home. Here is a brief account of a rezoning effort in Denver in 2022.

In the past decade, the 20-city Case-Shiller Home Price Index (FRED Series SPCS20RSA) has almost doubled. The New York Fed has assembled a map with video showing the annual change in the index for the past twenty years. Readers can click on their county and see the most recent annual price change. Millennials in their late twenties and thirties feel as though some cruel prankster has removed the chair just as they started to sit down. Analysts attribute the meteoric rise in prices to lack of housing built during and after the financial crisis fifteen years ago.

Each generation faces a set of crises that stifle their ambitions. In the 1970s, just as the first Boomers were entering their late twenties, mass migration from the eastern U.S. to the western states and high inflation doubled home prices in some areas within just a few years. The decade is a comparison tool as in “How bad is it? Well, it’s not as bad as the ’70s.” The 1980s began with high interest rates, the worst recession since the Great Depression and high unemployment. Boomers had to buy houses with mortgage rates over 10%. Following that recovery was another housing scandal and the savings and loan crisis that restricted any home price growth. A homeowner who bought a home in 1980 might have seen no price appreciation by 1990. Gen-Xers who bought a home during the 2000s had a similar experience, leaving some families underwater or with little equity for a decade. Equity growth from homeownership helps support new business start-ups.

Despite the insufficient supply of affordable housing, there are more homes than households. In the graph below are the number of homes (orange line) and households (blue line) as a percent of the population. The difference is only a few percent and contains some estimate error, but represents many more homes than the number of households.

Graph showing homes and households as a percent of the population.

Household formation, the blue line in the graph above, is a key feature of the housing market. In 1960, 3.4 people lived in each household, according to the Census Bureau (see notes). By 1990, that number had steadily declined to 2.6 persons and is slightly under that today. The supply of homes naturally takes longer to adjust to changes in household formation. That mismatch in demand and supply is reflected in home prices.

During the financial crisis household formation declined as unemployment rose. Home prices fell in response to that change in demand for housing and a come down from the “sugar high” of easy credit and sloppy underwriting. The percent change in the Home Price Index, the red line in the graph below, fell below zero, indicating a decline in home prices, an event many homeowners had never experienced. The fall in home values crippled the finances of local governments who depended on a steady growth in the property taxes based on rising home values.

Graph containing two lines: 1) the percent difference between homes and households as a percent of the population, 2) the home price index. There is a large gap where the two series diverge during the financial crisis.

The thirty-year average of  the annual growth in home prices (FRED Series USSTHPI) is 4.5% and includes all refinancing. We can see in the chart above that the growth in home prices (red line) is near that long-term mark. However, rising wages and low unemployment have encouraged more household formation, the rising blue line in the first chart. Those trends could continue to keep the growth in home prices above their long-term average. Millennials with mortgages at 6-7% are anxiously waiting for lower interest rates, a chance to refinance their mortgages and reduce their monthly payments. Strong economic growth and rising incomes will continue to put upward pressure on consumer prices, slowing any decisions by the Fed to lower interest rates. These trends are self-reinforcing so that they take a decade or more to correct naturally. Too often, the correction comes via a shock of some sort that affects asset prices and incomes. Millennials have endured 9-11, the financial crisis and the pandemic. “Go ahead, slap me one more time,” this generation can say with some sarcasm. The challenge for those in each generation is to try harder and endure.

Next week I will look at the cash flows that a property owner receives from their home investment.

////////////////////

Photo by Scott Webb on Unsplash

Keyword: interest rates, mortgages, mortgage rates, housing, households

Notes on series used in the graphs. The total housing inventory is FRED Series ETOTALUSQ176N divided by Total Population Series POPTHM. Total Households is TTLHHM156N divided by the same population series. These are survey estimates so some of the difference between the two series can be attributed to a normally distributed error. The all-transactions Home Price Index is FRED Series USSTHPI. The FRED website is at https://fred.stlouisfed.org/

No Man’s Land

Leave a comment

March 24, 2024

by Stephen Stofka

This week’s letter continues a look at taxes. This week the House passed a series of six spending bills that will avert a partial government shutdown. A majority of Republicans voted against the measure and Marjorie Taylor Greene, the bombastic representative from Georgia, filed a motion to remove Mike Johnson, the current House Speaker. It is unlikely to come to a vote because Republicans have only a one-member majority in the house after Mike Gallagher (R-WI) announced his early departure from Congress. A vote for a new speaker risks the chance that Democrat Hakeem Jeffries (D-NY), the current Minority Leader, might win the vote and become Speaker.

Most Republicans in the House and Senate have taken a “no-new-taxes” pledge called the Taxpayer Protection Pledge. The Americans for Tax Reform (ATR) database lists 191 members of the House and 42 members of the Senate who have taken the pledge. They have committed to not raising income tax rates. Additional tax revenues that arise from eliminating a tax deduction or loophole must be dedicated to lower taxes, according to the ATR’s FAQ page. Republican representatives implicitly committed themselves to increasing deficits but that is an unpopular political stance. They pledged to reduce spending but not military spending, the largest discretionary category in the budget. They pledged to reform entitlement programs like Social Security,  Medicare and Medicaid, but rural Republican voters repeatedly rejected such reforms because they depend on those programs. Each time Republican members of Congress stepped away from the issue to save their political hide.

Many conservative members of Congress protest the social spending programs that crowd out other priorities. In 2010 defense spending was over 5% of GDP, more than twice the percentage of the state and federal spending on Medicaid. Defense spending has been reduced to 3.6% of GDP and Medicaid spending has grown to 3.2% of GDP. I will leave the series and chart links in the notes. As a share of GDP, Medicare has grown from 0.5% in 1967, two years after the program was enacted, to a current level of 3.6%.

The trustees are projecting a per capita growth rate of 5.4% and the program is now almost half funded by general tax revenues. Dedicated payroll taxes and cost sharing by Medicare recipients were supposed to fund the program entirely. Democrats want to raise taxes to shore up underfunded entitlement programs they instituted last century when they had filibuster proof majorities. Republicans view these higher taxes as a moral hazard, a reward for Democrats’ excessively optimistic promises and poor planning.

Voters in rural counties form a strong Republican base but depend on state spending and taxes from urban taxpayers to support the infrastructure central to their local economies. The growing of grains and vegetables, and the raising of animals requires natural resources that include land, water and food. Highways and utility lines in sparsely populated counties connect farmers and ranchers to their markets. Despite gains in efficiency, the farming and ranching industries are less efficient than industrial production. Crops and animals do not pay taxes. People do.

Elected officials must play a game with their constituents. Politicians in state legislatures could enact a head tax on dairy cows and beef cattle to cover the cost of those direct and indirect costs. Federal officials could enact a pollution tax on cattle and chickens whose concentrated effluent contaminates interstate waters. However, such taxes would raise the prices of milk and beef in grocery stores. Officials are hesitant to enact specific taxes like that because such taxes arouse voter anger and risk a politician’s career. Lawmakers prefer to fund such costs with general tax revenues. The costs appear as line items on a state or federal budget that is hundreds or thousands of pages long and disappear in the thicket of words.

The private economy is not capable of supporting the current social and defense spending at this level of taxation. Neither political party wants to compromise on their priorities and the interest expense on the debt will grow, exacerbating the tensions between both political parties. That interest is now 3.5% of GDP, about the same as defense and Medicare spending. That interest is entirely funded by a deficit. We are borrowing to pay the interest on the debt we have accumulated.

The blue line will continue to rise, pushing the orange line upward as well. The political parties will stay entrenched in their ideological bunkers, creating a daily drama covered by mainstream and social media whose coverage incentivizes posturing rather than compromise. Just as Britain did in the inter-war period a century ago, we are steadily losing resilience, ready to falter at the next crisis.

////////////

Photo by British Library on Unsplash

Notes on social programs: Defense spending is series FDEFX at the FRED database. Medicaid is series W729RC1. Medicare is W824RC1. Each series link is a percentage of GDP.

Taxes and Investment

Leave a comment

March 17, 2024

by Stephen Stofka

This week’s letter is about the effect of tax revenues on government, on the economy and the role that taxes play in our lives. Tax revenues are the income of a government at all levels – federal, municipal and state. Those revenues fund the courts and prisons, the police, the roads and cultural institutions that connect people together, yet no one wants to pay them. The essence of a tax is a private payment for a public benefit. Few object to the opposite, a public payment for a private benefit when they are on the receiving end of such a subsidy.

Regardless of the amount that people pay in taxes, they feel that they have a right to complain about any good or service that a government provides. It’s in the Constitution. First Amendment – freedom of speech. For those who work in a democratic government, the unpopularity of taxes presents an existential conflict. Paul Samuelson (1947) pointed out the difficulty of designing a purely lump-sum tax or subsidy. A lump-sum tax is like a head tax, a fixed amount of tax regardless of a person’s circumstances. Under such a system, the wealthiest and poorest person pay the same amount of tax. This violates a sense of proportionality that is a guiding ethical principle.

A fixed single rate of tax answers concerns of proportionality. As an example, many districts enact a set rate for residential real estate. However, states have been reluctant to adopt a single or flat rate of income tax. In 1987, Colorado was the first state to adopt a single tax rate, according to the Tax Foundation. Other states were slow to follow Colorado’s lead and less than a quarter of the states have adopted a flat tax rate. Revenue and proportionality are not the only concerns. By its nature, a democratic government is not fair. People elect representatives who will maximize their benefits and minimize their taxes. Politicians naturally want to lighten the tax load of regular voters. In a flat tax system like the one in Colorado, politicians have amended the definition of taxable income to benefit some taxpayer groups at the expense of other groups. Pension income like Social Security and state retirement plans is not subject to state income tax.

The federal government and the majority of the states enact a graduated income tax that penalizes effort at the margin. An employee who works an occasional day of overtime may be surprised by the additional taxes taken out of that additional pay. Payroll software treats that extra amount as though the employee worked overtime every week, increasing the annual income used to calculate the tax rate on that additional income.

Republican politicians routinely champion their principle of low taxes. The justification for the tax cuts in the 1980s was based on an idea put forth in 1974 by the economist Arthur Laffer who drew an inverted curve on a napkin to illustrate the idea that higher tax rates might lead to lower tax revenues. Despite repeated evidence that lower tax rates lead to lower tax revenues, Republicans have clung to the idea. In the graph below, I have charted federal tax revenues as a percent of GDP. They do not include Social Security taxes.

According to the theory behind the Laffer Curve, lower taxes should spur more investment, more output, higher incomes and higher tax revenues. As we see in the graph above, tax raises led to higher revenues soon after they were enacted. Tax cuts did not. Believers in the theory claim that the cuts can take several years to work but this makes it hard to identify causality. In the graph below, I have added in investment as a percent of GDP.

The Bush tax cuts in 2001 certainly helped arrest the decline in investment following the “dot-com bust.” However, too much of that investment went into residential housing and led to the housing boom that preceded the financial crisis. Those tax cuts expired in 2010 and both investment and tax revenues improved. That raises the question: did higher taxes in 1993 and 2010 produce more investment? On principle, it seems unlikely. Following the 2017 tax cuts known by their acronym TCJA, investment again reversed a decline but had little effect on tax revenues. The rise in revenues as a percent of GDP was due to the fall in output as a result of the pandemic.

According to the neoclassical economist’s narrative, savings provide the source of investment. Taxes reduce savings and therefore reduce investment. Italian economist Pietro Sraffa (1932) reiterated a point made by Sir Dennis Robertson that savings were an inducement to more investment as well as a source of investment. Investment occurs in the period before consumption. People have money to save for two reasons. The first is that their incomes increase from new investment in production. Secondly, there are not enough goods in the marketplace to induce them to spend that extra income. The mismatch in supply and demand gives companies pricing power. Investors rush in to take advantage of the additional demand and the flow of new savings gives banks the confidence to make more loans.

For the past thirty years, federal revenues excluding social security taxes have averaged 17% of GDP. For that same period, the government spent 18.6% of GDP. The deficits have been persistent because the federal government consistently spends more than it taxes, an analysis confirmed by the Congressional Budget Office in a recent report. Republican lawmakers try to choke tax revenues to “Starve the Beast” – the beast being the size and reach of the federal government. To Democratic policymakers, our society needs constant remodeling, so they always have a plan for extra tax revenue. Neither party seems willing to resolve this political push-me-pull-you and the public has become used to deficits. There is always one more war to fight, one more wrong to right.

/////////////////

Photo by Kelly Sikkema on Unsplash

Keywords: tax cuts, investment, taxes

Samuelson, Paul Anthony. (1947). Foundations of Economic Analysis. Harvard University Press.

Sraffa, P. (1932). Dr. Hayek on money and Capital. The Economic Journal, 42(165), 42. https://doi.org/10.2307/2223735

The Conflict in Policy

Leave a comment

March 10, 2024

by Stephen Stofka

This week’s letter continues my analysis of the many roles of the federal government, comparing spending, tax revenues and the federal debt that has accumulated since 9-11. Governments accumulate debt by spending more than they collect in tax revenues. Farmers, businesses and households appreciate the subsidies and support from government but resist paying the taxes to fund those programs. The private marketplace depends on government funding of nascent technologies that may take decades to commercialize. Examples include the internet, the development of semiconductors, lithium batteries and the funding of pharmaceutical research. Investment in military readiness has spurred advancements in aerospace and satellite technology, the GPS that connects our phones and the Kevlar clothing that protects our soldiers and police officers. Critics may ridicule a government investment in solar manufacturer Solyndra, but it was also heavy government funding that provided the cash flow for SpaceX and Tesla.

In last week’s letter I showed that private investment and government spending and investment both averaged about 18% of GDP over the past three decades. A closer look at those two series shows how they complement and compete with each other. In the graph below, private investment dipped from 19% of GDP in 2006 to below 14% in 2009. As a percent of GDP, government spending and investment took up some of the slack.

As many people lost their jobs, they became eligible for Medicaid or food stamps. Both of these programs are included in government spending because the programs directly or indirectly provide people with goods or services. The graph above does not include increased unemployment insurance payments during the recession. These are included in government transfers since this is money, not services, transferred from the government to individuals. Policymakers refer to this combination of support programs as automatic stabilizers, providing assistance to households during hard economic times.

A recent analysis by the Congressional Budget Office (CBO) found that these automatic stabilizers were not “key drivers of debt over the long-term.” The federal debt was growing because government spending was increasing at a faster pace than revenues. The chart below shows spending and revenues for the past thirty years in a natural log form to portray the trends of change more clearly.

For most of the past three decades, revenue growth, the orange dashed line in the graph above, lagged government spending, the blue line. Note that this revenue series (FRED Series FYFR) does not include Social Security taxes. The growth in government spending showed some moderation only during Obama’s term and that was the worst time to slow the growth of government spending and investment. The Great Recession of 2007-2009 was the worst economic downturn since the 1930s Depression, surpassing the pain of the back-to-back recessions of the early 1980s.

Biden was vice-President during that recovery and was determined not to repeat that mistake in the aftermath of the Covid-19 pandemic. Although the Democratic majorities in the House and Senate were slim, unified government helped the effort to pass the Inflation Reduction Act and the CHIPS Act. Both pieces of legislation committed government funds to support investment in clean energy development and semiconductor manufacturing. Such commitment spurred private investment in the energy industry. In 2023 field production of crude oil surpassed 2019 levels, according to the Energy Information Administration (EIA). They report that natural gas output was up 2% in the first year of Biden’s term, then accelerated to 5% growth in 2022 and 2023 following Russia’s attack on Ukraine.

Despite big increases in the deficit after 9-11, and an accumulated debt of $22 trillion held by the public, the interest share of GDP has remained below the levels of the 1990s. In 2001, China was admitted into the World Trade Organization. As imports from China increased, we paid for them with U.S. Treasury debt, helping to keep interest rates low for most of the past two decades.

Unlike individuals and corporations, governments can buy their own debt. Unless a majority of that debt is sold in the private marketplace, there is no independent evaluation of the creditworthiness of that debt. At the end of last year, 65% of the total Federal debt was privately held, the highest percentage since 1997 (see notes). Including the Treasuries held by independent Federal Reserve banks, the percentage is close to 80%. A recent report from the Center for Strategic and International Studies (CSIS) calculates the percentage of debt held by two of our largest trading partners, China and Japan, at 5.8%. The wide ownership of U.S. debt validates it as a low-risk financial instrument.

The global financial system depends on tradeable sound securities. When the financial crisis undermined confidence in mortgage securities, private investment declined sharply, and it would do so again if investors doubted the soundness of Treasury securities. The recent CBO report points out a weakness in public policy that the Congress must resolve or risk damaging the credit of U.S. securities. 1997 was the last year when Congress submitted a budget by the deadline, according to the Congressional Research Service. When is the moment when the private debt market loses hope that Congress can match its spending and revenues? No one can forecast a stampede to safety but in hindsight many will claim to have seen the exit signs.

///////////

Photo by Manki Kim on Unsplash

Keywords: investment, debt, interest, Treasuries, government spending, taxes, automatic stabilizers

According the March 2024 Treasury bulletin, total Federal debt was $34 trillion. $21.7 trillion was privately held – about 65%. See Table OFS-2 of the March bulletin. Privately held debt plus $5.2 trillion of Treasuries held by independent Federal Reserve banks constitute Federal Debt Held by the Public (FRED Series FYGFDPUN) and is close to 80% of total federal debt. For a thirty-year series of the public’s portion of total debt, see https://fred.stlouisfed.org/graph/?g=1hYFV. Until the 2008 financial crisis Federal Reserve banks held less than 10% of total debt. During the pandemic, that share rose to 21%. At the end of 2023, the share was 15.4%.

The Role of Government

Leave a comment

March 3, 2024

by Stephen Stofka

This week’s letter is about the federal government, its expenses and the role it plays in our lives. As originally designed in 1787, the federal government was to act as an arbiter between the states and provide for the common defense against both Indians and the colonial powers of England, France and Spain. James Madison and others considered a Bill of Rights unnecessary since the powers of Congress were clearly set forth in Article 1, Section 8 of the Constitution. However, they agreed to attach those first ten amendments to the ratification of the Constitution to soften objections to a more powerful central government (Klarman, 2016, p. 594). After the Civil War, the federal government was given a more expanded role to protect citizens from the authoritarianism of the states. The authority to do so came from the amendments, particularly the recently ratified 13th, 14th and 15th additions to the Constitution (Epstein, 2014, p. 15).

After the Civil War, the Congress awarded pensions to Union soldiers, their widows, children and dependent parents. In 2008, there were still three Civil War dependents receiving pensions! (link below). This program indebted future generations for the sacrifices of a past generation. Aging soldiers sometimes married young women who would help take care of them in return for a lifetime pension until they remarried. The provision of revenues for these pensions provoked debate in Congress. In the decades after the Civil War, the federal government’s primary source of revenue was customs duties on manufactured goods and excise taxes on products like whiskey. Farmers and advocates for working families complained that this tax burden fell heaviest on them, according to an account at the National Archives. There were several attempts to enact an income tax, but these efforts ran afoul of the taxing provision in the Constitution and courts ruled them invalid. Fed up with progressive efforts to attach an income tax to legislation, conservatives in Congress proposed a 16th amendment to the Constitution, betting that the amendment would not win ratification by three-quarters of the states. Surprisingly, the amendment passed the ratification hurdle in 1913. In its initial implementation, the burden of the tax fell to the top 1% so many disregarded the danger of extending federal power. Filling out our income tax forms is a reminder that our daily lives are impacted by events 150 years in the past.

In the decade after the stock market crash of 1929, the government extended its reach across the generations. Under the Franklin D. Roosevelt (FDR) administration, the newly enacted Social Security program bound successive generations into a “pay-go” compact where those of working age paid taxes to support the pensions of older Americans. The government assumed a larger role in the economy to correct the imbalance of a free-market system which could not find a satisfying equilibrium. This expanded role of government and the writing of John Maynard Keynes (1936) helped spawn a new branch of economics called macroeconomics. This new discipline studied the economy as a whole and a new bureaucracy was born to measure national output and income.

Students in macroeconomics learn that the four components of output, or GDP, are Consumption, Investment, Government Spending and Net Exports. In its simplest definitional form, GDP = C+I+G+NX. In the American economy each of these four components has a fixed portion of output. Net exports (FRED Series NETEXP) are a small share of the economy and are negative, meaning that America imports more goods and services than it exports. The largest share is consumption (PCE), averaging 67% over the past thirty years. Government spending and investment (GCE) and private investment (GPDI) have averaged an 18% share during that time. Because these two components have an equal share of the economy, more government spending and taxes will come at the expense of private investment. This helps explain the intense debates in Congress over federal spending and taxes. Federal investment includes the building of government facilities, military hardware, and scientific R&D. I have included a link to these series in the notes.

The Social Security program is as controversial as the pensions to Civil War veterans and their survivors. The long-term obligations of the Social Security program are underfunded so that the program cannot fully meet the promises made to future generations of seniors. The payments under this program are not counted as government spending because they are counted elsewhere, either in Consumption or Investment. They are treated as transfers because the federal government takes taxes from one taxpayer and gives them to another taxpayer. The taxpayer who pays the tax has less to spend on consumption or saving and the person who receives the tax has more to spend on consumption or saving. However, those transfer payments represent already committed tax revenues.

The chart below shows total transfer payments as a percent of GDP. Even though they are not counted in GDP, it gives a common divisor to measure the impact of those payments. The first boomers born in 1946 were entitled to full retirement benefits in 2012 at age 66. In the graph below those extra payments have raised the total amount of transfers to a new level. After the pandemic related relief transfers, total transfers are returning to this higher level of about 15% of GDP. I have again included government spending and investment on the chart to illustrate the impact that the federal government alone has on our daily lives. In one form or another, government policy at the federal level steers one-third of the money flows into the economy.

For decades, the large Boomer generation contributed more Social Security taxes than were paid out and the excess was put in a trust fund, allowing Congress to borrow from the fund and minimize the bond market distortions of government deficits. Outgoing payments first exceeded incoming taxes in 2021 and Congress has had to “pay back” the money it has borrowed these many years. To some it seems like a silly accounting exercise of the right pants pocket borrowing from the left pocket, but the accounting is true to the spirit of the Social Security program as an insurance program. Paul Fisher, undersecretary of the Treasury, quipped in 2002 that the US government had become “an insurance company with an army” but the quip underscores public expectations. Workers who have been paying Social Security taxes their entire working life expect the government to make good on its promises.

We are mortal beings who create long-lived governments that act as a compact between generations. We argue the terms and scope of that compact. What is the role of government? The founding generation debated the words to include in the Constitution and even after the words were on the page, they could not agree on what those words meant. The current generations are partners in that compact, still debating the meaning of the text of our laws and the role of government in our lives.

///////////////////

[20240303Government.jpg]

Photo by Samuel Schroth on Unsplash

Civil War pensions – a National Archives six page PDF https://www.archives.gov/files/calendar/genealogy-fair/2010/handouts/anatomy-pension-file.pdf

Data: a link to the four data series at FRED https://fred.stlouisfed.org/graph/?g=1hxIK. There is a small statistical discrepancy, and that series is SB0000081Q027SBEA.

Social Security: Notes on the adoption of a 75-year actuarial window used by the trustees of the Social Security funds to assess the ability of the program to meet its obligations. https://www.ssa.gov/history/reports/65council/65report.html. In 2021, the Congressional Research Service published a three-page PDF explainer for the choice of a 75-year term.

Epstein, Richard Allen. (2014). The classical liberal constitution: The uncertain quest for limited government. Harvard University Press.

Keynes, J. M. (1936). The general theory of employment interest and money. Harcourt, Brace & World.

Klarman, M. J. (2016). The Framers’ Coup: The Making of the United States Constitution. Oxford University Press.

Crystal Ball

Leave a comment

February 25, 2024

by Stephen Stofka

This week’s letter is about the public’s expectations of inflation. The interest rate setting committee of the Fed indirectly controls the borrowing costs on our mortgages, credit cards and auto loans. The committee pays attention to public expectations of inflation because we respond now to what we see as potential threats. A fear of “making a mistake” in a job interview can make us nervous, increasing the chances that our behavior will decrease our chance of securing that position. A consumer who expects higher gas prices next year may buy a more fuel efficient vehicle this year.

Consumers must anticipate their future circumstances and income when they decide between different consumption bundles. Should they spend more on housing and live closer to work or get more house for their dollar and have a longer commute? Invest time and money in college, including the loss of income while attending school. Consumers must decide how much to spend and how much to save. Despite the difficulty of such decisions, many consumption choices are made on a shorter time scale than the suppliers who provide those goods and services. To survive, a business must live in the future, anticipating the trends of customer behavior that shape demand for its products or services. Since the pandemic, the shift to work at home has hurt many downtown businesses that depend on foot-traffic. There aren’t enough office workers to support some types of businesses.

In his General Theory published in 1936, John Maynard Keynes gave a prominent role to investor expectations. John Muth (1961) presented a more formal model that he termed “rational expectations.” In the 1970s, Thomas Sargent and Robert Lucas developed more extensive models to understand how people responded to the stagflation of the 1970s. The formation of expectations is an important economic variable and remains a hotly debated topic among economists.

Each month the New York branch of the Federal Reserve surveys a rotating sample of 1300 people to gauge their expectations of overall price changes as well as principle expenses like housing, food and gas (questionnaire pdf here). The Fed provides data on the past decade of surveys which allows us to assess changes in public expectations. As I explored this data with graphs, I was surprised at how closely expectations conformed to a textbook model that students are taught in an intermediate macroeconomics class. Macro is hard because there are few natural experiments to test theories and models. The pandemic led to a series of events that provided such a natural experiment.

I’ll begin by comparing actual inflation to public expectations of inflation a year earlier. The first graph is actual inflation and the predictions of that inflation from a year earlier. From 2014 to 2020, the median value of expected inflation, the blue line, stayed anchored in the 2.5% to 3% range even when actual inflation, the orange dotted line, was below that. Lower inflation was not a threat to people’s pocketbooks so there was little reason to revise their estimates downward. We have a well-studied risk aversion, meaning that we place greater weight on loss than we do on gains. In this case, lower than expected inflation is a gain. Economists and the general public were both caught off guard when inflation surged higher in 2021.

As soon as inflation rose above long-term averages, as it did in 2021, survey respondents revised their estimates of next year’s inflation. Higher inflation is a threat to our finances, so we pay greater attention. However, survey respondents based their estimates of next year’s inflation on this year’s actual inflation. Is that a good estimating procedure? Maybe not, but estimating trends requires knowledge, practice and error checking to improve our skills. Many times we use shortcuts, called heuristics, instead. I will leave a textbook explanation of the formation of inflation expectations in the notes.

How do we survive using shortcuts? One of those shortcuts is our degree of uncertainty. There are fewer traffic accidents at roundabout intersections because they introduce a degree of uncertainty that causes us to be more cautious. The median percent of uncertainty jumped in March 2020 when pandemic restrictions were announced. When Biden took office a year later uncertainty remained at this elevated base. As the economy reopened in the spring of 2021, supply disruptions became apparent. “When are you going to get more of these in stock” was met with “We don’t know. They’re on a boat somewhere in the Pacific.” While people sat at home during the pandemic, they bought a lot of goods from online retailers like Amazon. The reopening of service-oriented businesses caused another price shock as the economy transitioned from goods-heavy back to one that relied heavily on services.

The peak of uncertainty occurred in mid-2022, shortly after the Fed began a series of consecutive interest rates increases that would lift the benchmark lending rate by 5%. The uncertainty of survey respondents decreased in reaction to the Fed’s intention to keep increasing rates until rising inflation was tamed. I’ll zoom in on the past three years of uncertainty and the Fed’s “get serious” campaign of interest rate increases.

Despite criticism of the Fed, its intentions were credible to the public. Expectations are as difficult to measure as animal pheromones but they are real. They cause responses. Surveys are an imperfect gauge of expectations but they will have to do until someone invents an expectarometer that detects the mental disturbances in the sub-ether caused by expectations. That’s a world similar to Philip K. Dick’s Minority Report and I’m not sure we want that.

////////////////////

Photo by Jan Huber on Unsplash

Keywords: federal funds rate, inflation, expectations

Note on inflation expectations: A textbook explanation is

πet = (1- θ)π̅  + θπt-1, or in words
πet   is current expectations of future inflation,
π̅   is average inflation,
θ is the weight people give to recent inflation πt-1 (Blanchard, 2017, p. 162).
From 2014-2020, survey respondents gave little weight to recent inflation, such that θ was close to 0 and expectations of inflation were close to a long-term average. As soon as inflation rose above the long-term average, θ went quickly to 1, resulting in an equation that looked like πet = (1-1)π̅ + 1π̅t-1   which simplifies to the most recent reading of inflation.

Blanchard, O. (2017). Macroeconomics (Seventh ed.). Boston, MA: Pearson Education.

Muth, J. F. (1961). Rational Expectations and the Theory of Price Movements. Econometrica, 29(3), 315-33512

Changing the Rules

Leave a comment

February 18, 2024

by Stephen Stofka

This week’s letter continues to take a historical look at survey data. Every July the polling organization Gallup publishes a mid-year assessment of sentiment toward political institutions like Congress and the President, and the civic institutions that help bind our society together. These include our schools, the medical system and organized religion. Institutions are a set of rules and relationships, of rights and responsibilities. The company provides historical tables of these surveys that show a declining trust in our institutions.

Graphing the positive responses against a background of seminal events like 9-11 and the start of the Iraq war reveals the volatility of the public’s confidence in the president. Over 50% of respondents to Gallup’s survey  expressed a “great deal” or “quite a lot” of confidence in George Bush before and after 9-11.  His ratings fell  sharply after the invasion of Iraq. The justification for the war collapsed when the public learned that there were no WMD, or weapons of mass destruction, in Iraq. By the end of 2006, positive sentiment was just 25%, less than half the results at the start of the Iraq war. In 2007, the Bush administration committed troops to ensure security in the capital city of Baghdad and this helped turn the momentum of the war. The success of this strategy called the surge helped lift confidence in the president. Notice that confidence in Biden’s presidency is about the same as the confidence in the Bush presidency in 2006.

According to Ballotpedia, 94% of Congressional members are re-elected yet survey respondents have a low confidence in Congress as an institution. On a bipartisan vote 22 years ago, Congress authorized the Iraq war. Within a year, confidence ratings sank and have never recovered. Today positive sentiment is less than 10%. The rules of both the House and Senate are designed to let a few key people in either body control the flow of legislation to the floor of each chamber. Party leaders are more concerned about their own power and reputation than the voices of the people who elected the members of the House and Senate. Almost 250 years after fighting the British over taxation without representation we have lots of taxation and little effective representation.

Medical

The Affordable Care Act (ACA) was supposed to restore public confidence in our very expensive and bloated medical system. Judging by the responses to this Gallup survey question, the creation of this bureaucracy in 2010 has had little effect on the public’s confidence in the system as a whole. Many of the provisions in the act known as Obamacare rolled out slowly and the marketplace for insurance did not open until the beginning of 2014. When the online public exchange opened, its inability to handle the surge of applicants was a humiliation for the Obama administration. Despite the improving functionality of the public exchange and the greater access to health insurance, there was little effect on public confidence. In the initial months after the Covid-19 shutdown, confidence spiked but fell again to its former level the following year.  

Schools

Gallup’s 2020 survey of confidence in schools also saw of surge of support that declined to a pre-pandemic average the following year. The decline in confidence began after the onset of the Iraq war and continues to this day. At 26%, positive sentiment is only two-thirds of the level at the start of the Iraq war and matches a low set during Obama’s second term.

Banks

At the height of the housing bubble in 2006, almost 50% of survey respondents expressed strong confidence in banks. In the following two years, confidence plummeted and has barely recovered in the 15 years since.  This lack of confidence may explain the growing support for a digital currency alternative like Bitcoin.

What is the takeaway? A declining confidence in institutions can spark a revolution just as it did in the Progressive era a century ago. As people become discontent with the rules that govern their daily lives, they look to change the institutions that embody those rules. The people within those institutions are regarded as corrupt. Groups turn to violence in an attempt to restore the integrity of those institutions as they perceive it. In the years leading up to World War I, there were hundreds of bombings of prominent buildings and frequent riots to protest working conditions for adults and children, as well as living conditions within America’s growing cities. People were beaten and jailed for wanting freedoms that we now take for granted. Sixty years ago Bob Dylan wrote The Times They Are A-Changin’, heralding an era of protest and reform in the 1960s. This may be another seminal moment when people will demand a change in the rules because the old rules are serving so few.

/////////////////

Photo by Sean Pollock on Unsplash

Keywords: Congress, President, schools, banks, medical, healthcare

Survey Signals

Leave a comment

February 11, 2024

by Stephen Stofka

This week’s letter takes a detour toward political polling. NBC News recently posted a story summarizing its latest opinion poll on the overall state of the country and the favorability of presidential candidates. Hart Research Associates regularly conducts this poll for NBC News and asks the question “All in all, do you think things in the nation are generally headed in the right direction, or do you feel that things are off on the wrong track?” One of the reporters at NBC News was kind enough to post the survey data on a central repository, and included in Hart’s survey data were the results of past surveys. A visual depiction of those survey trends contradicted some of my beliefs.

For a decade, the majority of survey respondents regularly answered that they don’t like the direction the country is going. More than half of these surveys were conducted among registered voters only and it doesn’t matter who the President is. The wrong track responses outnumber those who think the country is on the right track. In the graph below I’ve charted a four survey average to smooth the trends in the results. The orange dotted line is the percentage of those who answered wrong track. The blue line indicates those who answered right direction. Less than 10% of respondents have a mixed opinion or are not sure and I did not include those responses in the graph.

Toward the end of Obama’s second term, the percentage of wrong direction responses declined to about 55% before Trump took office in January 2017. From there, the survey responses became increasingly pessimistic. In the final year of Trump’s term negative sentiment shot up in reaction to the pandemic and it kept rising during Biden’s term. The percentage of those with a negative outlook this past month is over 70%, but just a few percent higher than a peak toward the end of Obama’s second term.

Favorability

Given such pessimism about the direction of the country, it is no surprise that a President’s favorability ratings rarely exceed 50%. Survey respondents were routinely asked to rate their feelings toward several public figures. Although both Biden and Trump are subjects of this question for more than a decade, I focused on the responses while both men were in office. The survey has five categories of feelings, from very positive to very negative. I chose just the two favorable categories, very positive and somewhat positive. A chart of the response numbers indicates stark differences in the trend of feelings toward each person. I’ll begin with Joe Biden.

In the first few months of Biden’s term, the sum of positive responses increased from 44% to 50%. Although the Democrats had a political trifecta, their majorities in the House and Senate were slim and prevented passage of controversial legislation like comprehensive immigration reform. The realities of the political process dampened the ardor of progressives who hoped for reforms in immigration, as well as education and child care. The level of moderate feelings, those who answered they were somewhat positive toward Biden, remained anchored at about 20%.

Unlike Biden, the percent of respondents with very positive feelings toward Trump continued to grow during Trump’s term. His disruptive style won him more appeal from ardent supporters than he lost among moderates. Trump’s overall favorability increased slightly during his term from 38% to 40%. Unlike Biden, Trump has a zealous voter base which affords him room to make reckless political postures.

In contrast, Biden’s support is more tempered and results oriented. After an initial positive rating among half of respondents in the early months his very positive ratings in this survey dropped by almost half. The passage of the Inflation Reduction Act in August 2022 helped revive his favorability ratings but the bloom faded after the Republicans won a slim majority in the House a few months later. For Democratic voters, policy choices trump party and person loyalty. With little prospect of further legislative gains in a divided Congress, voter enthusiasm waned.

Party loyalty has long been a central characteristic of Republican voters. Like an operator switching a train track, Trump has steered that loyalty to himself as a person. As such his favorability has been more resilient. In November 2018, midway through Trump’s term in office, the Democrats won the House Majority. Just before Christmas, the Republican-led Congress and Trump were unable to pass an Appropriations bill or a Continuing Resolution. The federal government shut down all non-essential services for a month, the longest government shutdown on record. Trump’s favorability ratings should have taken a hit.

Unlike Biden, Trump’s favorability increased in reaction to the shutdown and the swing of power in the House to Democrats. A wing of the Republican Party, fervent and defiant, continue to fight for control of the party and its agenda. Trump is their champion. The party has evolved from a party holding the political center – think of Mitt Romney – to a reactionary movement of None of the Above. No taxes, no immigration, no Obamacare, and no restrictions on guns to name some prominent issues. Nikki Haley, a Republican challenger to Trump, lost the Nevada primary to a candidate on the ballot named None of these candidates.

After the January 6th riot at the Capitol, fervent support for Trump waned. By June of 2023, survey responses of  very positive had dropped by half to a low of 17 and his total positive sentiment was less than Biden’s numbers. His success in the upcoming election will depend on whether he can re-engage strong sentiment among Republican voters.

These polls demonstrate the strength of Trump’s support in the party. Those in the Republican caucus are afraid of a primary challenge that will cost them their seat. In 2014, the Republican House Majority Leader, Eric Cantor, lost a primary to a Tea Party challenger who received a boost from conservative media. Trump wields a big trumpet and blows it daily. As any parent of a two-year old knows, saying no is easier than making choices that involve compromise. With only a slim majority in the House, loyalty to Trump has made it difficult for Republicans to pass any legislation in the House. Republican congressman Chip Roy from Texas worries that his party will have few accomplishments to attract voters in the upcoming election. However, voters in the coming election will likely cast a rejection vote as in Not Trump or Not Biden. The media will be bombarded with even more negative advertising than usual. Grab a big box of popcorn and settle in.

//////////////

Photo by Emily Morter on Unsplash

Keywords: election, survey, opinion poll, ratings, favorability

Producer and Consumer Prices

Leave a comment

February 4, 2024

by Stephen Stofka

This week’s letter is about the inflationary spurt that began a little over two years ago. The causes of the inflation have been a controversial topic among economists and political commentators. Some blame Biden and the Democrats for enacting a third round of stimulus shortly after he took office. That’s fiscal policy on the hot seat. Some target monetary policy, blaming the Fed for leaving interest rates at a pandemic low near 0%. In this letter, I will focus on a price signal that the Fed could have treated with more importance. A combination of the two is more credible. Republicans hope to make inflation and the immigration crisis at the southern border central issues in this year’s election campaign.

I’ll begin with two measures of changes in consumer prices. The Consumer Price Index, or CPI, is a headline gauge of inflation that reflects current price changes. Because Fed policy must anticipate price changes, it uses a  a less volatile index called the PCEPI, or Personal Consumption Expenditures Price Index. I’ll call it PCE. The CPI is based on a static basket of goods that the average family might buy each month. Households adapt to changing prices where they can but the CPI methodology does not measure that. Nor does it measure costs paid by someone other than the members of a household. To address those weaknesses, the PCE measures the actual spending choices that households make. The PCE includes expenses like health care benefits that an employer provides. The Cleveland branch of the Federal Reserve has a deeper dive on the differences between the two measures.

The oldest price index, first charted in 1902, is based on a measure of prices that producers and wholesalers receive at both the intermediate and final stages of production. In the final demand phase, a product is going to be sold to a consumer. In the intermediate stage a producer sells a product to another producer as a component in their product. Each month the BLS surveys thousands of companies to compile the wholesale prices on most of the goods sold in the U.S. and 70% of traded services. The agency then builds hundreds of indexes to measure the changes in those prices. The Producer Price Index, or PPI, is a headline composite of those indexes. As you can see in the graph below, the PPI is more volatile than the PCE measure of consumer price inflation. Government subsidies can increase the prices that suppliers receive with little impact on consumer prices. The PPI is more responsive to changes in transportation and distribution costs.

Despite its volatility, the PPI is regarded by the Fed, Congress and the administration as an advance indication of movements in consumer prices, according to the BLS. It indicates producers’ forecast of consumer demand and reflects economic stress and global supply pressures. However, wholesales prices may not be a reliable forecast tool of consumer inflation if the economy is weak and households cut back on their spending where they can. In the recovery years following the financial crisis in 2008, real GDP did not rise above 3% until the end of 2014. Unemployment finally dipped below 5% in the spring of 2016.

In 2021, the PPI indicated a developing surge in wholesale prices that would become apparent in consumer prices by the following year. But the economy still had not fully opened and unemployment did not fall below 5% until the fall of 2021. Would the pandemic recovery follow the sluggish trend of the recovery after the financial crisis? The Fed waited, preferring to keep interest rates low to support the labor market. In the graph below I’ve charted both the PCE and PPI over the past eight years. I’ve marked out the beginning of Biden’s term in the first quarter of 2021 and the Fed’s tightening that began in the spring of 2022.

The PPI (dotted orange line) had already reversed higher before Biden took office. As we can see in the chart above, the Fed did not enact stricter monetary policy until the PPI had peaked. In hindsight, the Fed was late to respond to surge in prices but Congress has given the Fed a dual mandate to maintain stable prices and full employment. During times of economic stress, those two objectives can indicate contradictory policies. During the initial months of the pandemic in 2020, five million people left the work force. In early 2020, the participation rate for the prime work force aged 25-54 stood at 83%. By the fourth quarter of 2021, the rate was still only 82%. 1.5 million workers had still not returned to the labor force. During a severe crisis like the pandemic, the Fed has trouble balancing those two objectives of stable prices and full employment. If they raised rates too soon, they could have damaged a recovery in the labor market.

While the general price level has come down in the past year, the inflation beast is not dead. There is still a residual inflation energy in some intermediate goods. Had the pre-pandemic price trends continued for the past four years, we might expect prices to be 8 to 10% higher than they were at the start of 2020. The prices of a number of goods have stabilized at levels far above their pre-pandemic levels. Meats are 32% higher after four years. Natural gas prices (WPU0551) have declined from the highs of last winter but are 38% higher than pre-pandemic prices. Residential electric power (WPU0541) and gasoline (WPU0571) are up 25% in four years. LPG gas is up 28% in that period. The prices of paper boxes (WPU095103) are up the same amount. Paper (WPU0913) is up 25%. The prices of bakery goods (WPU0211) are up 22% and still rising.

Despite promises made during the upcoming presidential campaign, the general price level is not going to return to its pre-pandemic level no matter who is president. The pandemic shook up the global economy, raised the general price level and there is no going back. A U.S. president may have their finger on the button of an arsenal of destruction but they have little influence on the producer prices of goods sold around the world. A hindsight analysis can identify policy winners and losers made by both the Trump and Biden administrations. The Fed and other central banks waited too long to respond to a worldwide inflation. Finally, the lessons learned from this pandemic will not all be applicable to the next global crisis.    

////////////////

Photo by Ian Taylor on Unsplash

Keywords: PCE, PPI, wholesale prices, consumer prices, inflation

Note: In April 2022 the Fed began raising its key interest rate by .25% or more each month.