Author: sgstofka

Home Prices and Monetary Policy

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July 30, 2023

by Stephen Stofka

This week’s letter is a proposal for an alternative measure to guide the Fed’s monetary policy. In 1978, Congress passed the Full Employment and Balanced Growth Act which gave the Fed a dual mandate – giving equal importance to price stability and full employment. The Canadian central bank has a hierarchical mandate with price stability as a priority. As with most Congressional mandates, the legislation left it up to the agency, the Fed, to determine what price stability and full employment meant. The Fed eventually settled on a 2% inflation target. Full employment varies between 95-97% and is hinged on inflation.

For its measure of inflation, the Fed relies on the Bureau of Labor Statistics (BLS) who conducts monthly surveys of consumer expenditures.  The BLS compiles a CPI based on the its price surveys of hundreds of items. The Fed prefers an alternative measure based on the Consumer Expenditure Survey, but the weakness in both measures is the complexity of the methodology and the inherent inaccuracy of important data points.

According to the BLS, housing costs account for more than a third of the CPI calculation. Twenty-five percent of the CPI is based on an estimate of the imputed rental income that homeowners receive from their home. This estimate is based on a homeowner’s response to the following question:   “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” How many owners pay close attention to the rental prices in their area?  The BLS also surveys rental prices but tenants have six to 12 month leases so these rental estimates are lagging data points. The BLS tries to reconcile its survey of rents with homeowners’ estimates of rents using what it admits is a complex adjustment algorithm. 

The BLS regards the purchase of a home as an investment, not an expenditure so it must make these convoluted estimates of housing expense. There is a simpler way. Buyers and sellers capitalize income and expense flows into the price of an asset like a house. The annual growth in home prices would be a more reliable and less complex measure of inflation. Federal agencies already publish monthly price indexes based on mortgage data, not homeowner estimates and complex methodology. An all-transactions index includes refinancing as well as purchases. Bank loan officers have a vested interest in monitoring local real estate prices so their knowledge is an input to the calculation of a home’s value when an owner refinances.

The Federal Housing Finance Agency (FHFA) publishes the All-Transactions House Price Index based on the millions of mortgages that Fannie Mae and Freddie Mac underwrite. From 1990 – 2020, home prices rose by an average of 3.5% per year. A purchase only index that does not include refinances rose almost 3.9% during that period. As an aside, disposable personal income rose an average of 4.6% during that period.

The Fed does not need authorization from the Congress to adopt an alternative measure of inflation to guide monetary policy. As its strategy for price stability, the Fed could set a benchmark of 4% – 5% home price growth, near the 30 year average. If house prices are rising faster than that benchmark, monetary policy is too accommodating and the Fed should raise rates. Since the onset of the pandemic, home prices have risen 11% per year, three times the 40 year average. This same growth marked the peak of the housing boom in 2005-2006 before the financial crisis. The Fed did not begin raising interest rates until the spring of 2022. Had it used a home price index, it would have reacted sooner.

The annual growth in home prices first rose above 4% in the second quarter of 2013. The Fed kept interest rates at near zero until 2016, helping to fuel a boom in both the stock market and housing market. Since 2013, house prices have stayed above 4% annual growth, helping to fuel a surge in homelessness. Let’s look at several earlier periods when using home prices as a target would have indicated a different policy to monetary policymakers at the Fed.

In 1997, the annual growth of home prices rose above 4% and remained elevated until the beginning of 2007 when the housing boom began to unravel. In 2001, home prices had risen almost 8% in the past four quarters but the Fed began lowering its benchmark Federal Funds rate from 5.5% to just 1% at the start of 2004. The Fed was responding to increasing unemployment and a short recession following the dot-com bust. Near the end of that recession came 9-11. By lowering rates the Fed was pushing asset capital that had left the stock market into the housing market where investors took advantage of the spread between low mortgage rates and high home price growth.

In 2004, home price growth was over 8% and accelerating. Had the Fed been targeting home prices, it would have acted sooner. However, the Fed waited until the general price level began rising above its target of 2%. In the 2004-2006 period, the Fed raised rates by 4%, but it was too late to tame the growing bubble in the housing market. In 2005, home prices grew by 12% but began responding to rising interest rates. By the first quarter of 2007, home price growth had declined to just 3.3%.

The Fed models itself as an independent agency crafting a monetary policy that is less subject to political whims. However, the variance in their policy reactions indicates that the Fed is subject to the same faults as fiscal policy. If the Congress is crippled, then the Fed feels a greater pressure to react and is helping to fuel the boom and bust in asset markets. Let’s turn to the issue of full employment.

The condition of the labor market is guided by two surveys. The employer survey measures the change in employment but does not capture a lot of self-employment. The household survey captures demographic trends in employment and measures the unemployment rate. The BLS makes a number of adjustments to reconcile the two series. The collection of large datasets and the complex adjustments needed to reconcile separate surveys naturally introduces error.

The labor market has experienced large structural changes in the past several decades. Despite that, construction employment remains about 4.5 – 5.5% of all employment so it is a descriptive sample of the condition of the overall market. Declines in construction employment coincide with or precede a rise in the unemployment rate. In the past 70 years, the construction market has averaged 1.5% annual growth. During the historic baby boom years of the 1950s and 1960s, the growth rate averaged 2%. The Fed might set a target window of 1.5% – 2.5% annual growth in construction employment. Anything below that would warrant accommodative monetary policy. Anything above that would indicate monetary tightening. In 1999, the growth rate was 7%, confirming the home price indicator and strongly suggesting that fiscal or monetary policy was promoting an unsustainable housing sector boom.  

If the Fed had adopted these targets, what would be its current policy? The FHFA releases their home price data quarterly. The growth in home prices has declined in the past year but was still 8.1% in the first quarter of 2023. However, the S&P National Home Price index tracks the FHFA index closely and it indicates a slight decline in the past 4 quarters. Growth in construction employment has leveled at 2.5%, within the Fed’s hypothetical target range. The combination of these two indicators would signal a pause in interest rate hikes. This week, the Fed continued to compound its policy mistakes and raised interest rates another ¼ percent.  

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Photo by Rowan Heuvel on Unsplash

Prices and Values

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July 23, 2023

by Stephen Stofka

This week’s letter is about prices and two dynamic values, a use value and an exchange value. These two values can help us compare assets if not goods. I’ll review a short history of thinking on price and value. How does the passage of time affect different types of assets? Lastly, how sensitive are some assets to investor temperament?

The insights of prominent thinkers in the past can inform our perspective. Richard Cantillon (1680-1734) was a financier whose keen understanding of human exuberance enabled him to make a fortune in the stock market bubbles of the South Sea and Mississippi System. He argued that there was an intrinsic value to a commodity that was the sum of the inputs, land and labor (capital was included in land). The ratio of supply and demand as well as “humors and fancies” explained the variance between market price and intrinsic price. In a well-organized society, the market price and the intrinsic price tracked each other closely.

Writing a few decades later, Adam Smith would refine the classification of prices further. A market price included the rent of the land, the worker’s wages and a capitalists’ profit. A natural price was the average of market prices and a price that a customer expected to pay when going to market. Finally, there was an exchange price, a measure of purchasing power. Writers of that time distinguished between commodities, or subsistence goods, and goods of an artisanal nature, affordable only to those in the middle and upper classes.

In Book 1, Chapter 4, Smith distinguished the two meanings of the word value. The first was a value in use, the “utility of some particular object,” whose value is consumed. Utility depends on the person, their circumstances and preferences and cannot be measured. The second is a value in exchange, the “power of purchasing other goods.” Commodities like a pound of corn have both a use value and an exchange value but Smith made it clear that the use value of a commodity does not anchor its exchange value. He noted that many goods which have a high use value like water have a low exchange value, and those with a high exchange value like diamonds have little or no use value. Smith spent the following three chapters exploring the connection between exchange value and price.

As he compared standards of living in different ages and countries, from neighboring France to the American colonies, Smith was looking for a yardstick, a standard of measure. Economic institutions today compile extensive price and income indexes to compare prices across time and countries. Smith had limited manpower – himself. He chose a laborer’s toil as “the only standard by which we can compare the values of different commodities at all times, and at all places.” He was careful to note several caveats. It was “difficult to ascertain the proportion between two different quantities of labor” and the “real price of labor is very different upon different occasions” and in more advanced societies. Regardless of prices or the value of gold and silver in England and the American colonies, he could compare the purchasing power of laborers in each country doing similar work.  

Smith’s grand thesis was that greater specialization of labor increased productivity and fostered economic progress. Within this framework, people would more frequently exchange their labor rather than consume the goods their labor produced. For Smith, labor was an “exchangeable value,” not some value inherent in a commodity. He used it to construct a measure of purchasing power. Almost a century later, Karl Marx would distort this yardstick of purchasing power into a qualitative claim that the labor input to a commodity was the intrinsic value of the commodity. Anything above that value was an exploitation of workers by capitalists, according to Marx.

Let’s extend this analysis to asset, which I will divide into two types: those that derive an exchange value based on ongoing operations and those that don’t. Ongoing operations can be likened to a use value because something is consumed in that operation, a depreciation. There is an explicit or imputed flow of income whose discounted value influences the market value of stocks and bonds. Time-sensitive financial instruments like stock options act like insurance and are very much anchored by ongoing activity and the expectations formed from those operations. The market value of real estate may rely on scarcity, like a collectible, but the scarcity aspect contributes to expectations of future income that the real estate can earn. Therefore, its market value is also anchored by operations.

Collectibles are an asset without any ongoing operation. They derive their market value from their scarcity or uniqueness. A painting may bring pleasure in the viewing but the enjoyment of that pleasure does not consume the painting. Time, yellowing and dust may introduce a depreciation expense but time usually increases the market value of the painting.  Money can be a collectible but only if it is rare. Digital currencies behave very much like collectibles but there is nothing to hang on a museum wall. For traders, the chief attraction of crypto is the possibility of future trading gains. Unlike stocks, crypto does not represent ownership in operating profits. Unlike bonds, crypto is not a purchase of someone’s debt. Unlike real estate, crypto does not generate any cash flows from its use value.

Some assets with little ongoing use value have volatile valuations because their chief use value is the hope of future trading profits to the holders of the asset. Their use and trading values can collapse suddenly as though they were a time-sensitive financial asset. Being alert to that imminent collapse helped Richard Cantillon make a fortune. Investors in such assets must remain nimble.

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Photo by Sean Stratton on Unsplash

New Technology, New Laws

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July 16, 2023

by Stephen Stofka

This week’s letter is about the impact of the internet and digital technologies on our laws. New technologies introduce new connections between people and institutions. What was once separate when a law was written becomes joined under the new technology. Advocacy groups emerge to pressure policymakers to shape new laws and regulations that incorporate a recent technology.

Over twenty years ago, the increasing volume of internet sales not subject to sales tax challenged the meaning of tax nexus. This was a retailer’s physical presence within a state that required it to collect sales tax on purchases and remit those collections to the state. The Sales Tax Institute has a nice explainer on the various types of nexus and the history of court decisions on the topic. Several characteristics of cryptocurrency have challenged policymakers and legal interpretations.

On Thursday, the stock of the Coinbase exchange shot up 25% on the hope that it will prevail in its attempt to operate outside SEC regulations, those that govern conventional market exchanges and securities brokers. A month ago the agency had charged Coinbase for operating as an unregistered securities exchange. On Thursday, a district court judge in a case involving another blockchain ruled that crypto assets were not securities in many cases. The judge cited the Howey test, a 1946 Supreme Court decision that set forth characteristics that defined a security. This past March an article at Coin Telegraph explained the history of the Howey test.  The key phrase in the Howey decision is that an investment contract is “an investment of money in a common enterprise with profits to come solely from the efforts of others.” Is crypto a “common enterprise” whose profits come “solely” from the efforts of others?

The judge’s ruling strengthens the argument by some that crypto has many characteristics of a collectible, which is not considered a security. Classifications rely on shared as well as distinguishing characteristics. Anomalies challenge classification the way that the platypus challenged biologists’ definition of a mammal. Advocates of crypto claim that it is a trustless system of exchange but let’s examine that claim.

A barter transaction between two people is the only exchange that does not involve a third party in some way. Trust is an implied intermediary in an exchange between two parties. Crypto or cash, there is some third party involved in a transaction. Our cash money may read “In God We Trust” but our trust is really in the Federal Reserve, an agency of the U.S. Government. Crypto exchanges have a fiduciary duty to the owners of the crypto coin the exchange holds. That fiduciary duty invites government regulation and it will be a battle of advocacy groups to shape the laws that create those regulations. This week Coinbase may be confident that it will prevail against SEC regulation but there will be an ongoing effort to impose some regulation to protect owners of crypto. As policy is shaped over the coming years, crypto owners can expect that crypto exchanges will experience similar abrupt reevaluations.  

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Photo by Earl Wilcox on Unsplash

Group Affirmation

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by Stephen Stofka

This week’s letter is about the digital currency proposed in a 2008 paper penned by someone or some group writing under the pseudonym Satoshi Nakamoto. The two problems that Nakamoto’s proposal targeted have been mitigated by other means. That may explain why there has not been wider adoption of digital currencies as a transaction medium.

Although the idea of a digital currency has gained a fervent loyalty in the public, that was not the intended audience. As electronic payments became a greater share of global payments, chargebacks plagued both merchants and banks. By 2010 electronic payments were 8% of global payments. In a decade, they were an estimated 16%, according to a report from McKinsey and Company, the world’s top consulting firm.

The proposal was a method to “make non-reversible payments for non-reversible services” as Nakamoto stated in the introductory paragraph. I won’t dive into the details of the chargeback-to-transaction ratio but it was a much bigger problem in 2008. By 2017, the chargeback-to-transaction ratio was still 3.76% but has fallen to 1.52% by 2021, according to Midigator. I will refer interested readers to two reports published by Midigator, a subsidiary of Equifax, the credit reporting company. The first is the 2022 report on chargebacks and a 2020 explainer of the Rapid Dispute Resolution system used by participating banks and merchants.

The second problem the paper addressed was the minimum amount set by banks and merchants for debit and credit card transactions. In 2008, a common minimum was $5. Today, many merchants will process a transaction of less than $1. Apple routinely charges customers $0.99 per month for additional cloud data storage.

Cash payments solve a verification problem in transactions between strangers. Cash is a non-reversible exchange of money for goods or services. Transactions without cash involve some form of I.O.U. – a check or debit card, or a credit card. The customer gets the good or service. How can the merchant trust the customer’s I.O.U.? This requires a verification process of the customer’s identity and a commitment by a third party like a bank to pay the I.O.U.

The marginal cost to send one more email or one more http request to a web server is nearly zero. The spread of email in the 1990s exposed millions of people to dishonest actors who could send thousands of emails at little cost. A small number of computers could send thousands of counterfeit http requests to a server to overwhelm its resources in a Denial Of Service (DOS) attack. A countermeasure was to require a proof of honest intent by having the computer show some proof of work. An honest agent would do the proof of work to gain access to the server. Such a scheme would frustrate a dishonest agent trying to make repeated attempts to overwhelm a server’s resources.

Nakamoto proposed a currency based on a proof-of-work system rather than trust in a central agency. In a peer-to-peer network, verification is done by consensus. If each voter were defined as an IP address, a malicious actor could simply accumulate a lot of IP addresses then legitimate a fraudulent transaction. To combat that problem, Nakamoto proposed that a voter be defined by CPU, not IP address. Any actor who could amass enough computing power to defeat the system would find it more profitable to use that power to honestly make new digital coin.

Digital currencies have evolved beyond their original purpose. Nakamoto’s currency was designed to combat flaws in electronic payment systems that presented problems for merchants and bank intermediaries. Since 2008 the industry has developed other methods to reduce or resolve chargebacks and fraud. Meanwhile, Nakamoto’s proposal has become a favored security for some investors. Its adoption as a collectible like investment has introduced a pricing volatility that subverts its original purpose as a non-reversible payment, a digital form of cash.

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Photo by Bryan Goff on Unsplash

Keywords: Nakamoto, crypto  

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Honesty, Power and Crypto

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July 2, 2023

by Stephen Stofka

This week’s letter is about lying and some types of lies, the key part they play in our society and the steps we take to uncover and counter lying. This week’s picture by David Clode on Unsplash is that of a butterfly wing, not an owl.

Like many animals, humans survive by signaling. A growl, the curl of a tail or a frown on a face are forms of signaling. Lying is a signaling tool that we use to get something we want. We may want protection from some threat so we lie. We may want approval from others so we lie. Lies come in several colors. Lies told for some social or public purpose are called white lies. In the 1969 Frazier v. Cupp decision, the Supreme Court ruled that the police could make false statements to gain a confession. These are known as blue lies. There are red lies told to hurt someone or their reputation. We tell green lies to gain some financial advantage.

People are so good at lying that public agencies and private companies spend billions per year to prevent fraudulent claims. As Jennifer Pahlka (2023) noted in her book Recoding America, policymakers will spend far more than a $1 to prevent paying out $1 of a fraudulent claim even if it means that legitimate claimants have to wait longer to receive their benefits. Policymakers are rarely as responsive to people’s needs as they were during the pandemic. In a rush to serve millions of people laid off during the pandemic, many fraudulent claims flooded state unemployment offices. According to an indictment filed in May, recently elected Congressman George Santos (R-NY) was one of those who made a fraudulent claim with New York State and received $24,000 while already employed.

Politicians like Santos attract news coverage but it is not clear that they are any more dishonest than the population in general. It is true that those who are uncomfortable with lying are cautioned not to run for office. Lying is an accepted tactic to confound the opposition, gain a policy foothold or some electoral advantage. Within a democracy, the electoral process is a competition of lies and boasts that political scientists call branding. There is no “truth in advertising” standard that politicians must adhere to when they run for office. It is the voters who must beware when they “buy” whatever ideological concoction a politician is selling. The voters are supposed to act as a giant sieve, straining out the fabrications, the incompetent and crackpots. It is not a perfect system.

The Bitcoin algorithm was designed to “crowd-source” property claims, spreading the verification process to the many nodes in a historical transaction chain. Yet the 15 year history of Bitcoin and other digital currencies has been punctuated with episodes of large scale fraud. According to a Justice Dept. investigation, in 2011, customers of Bitcoin exchange Mt. Gox learned that most of the bitcoin stored on the exchange had disappeared. Over a three year period, Russian hackers with unauthorized access to the exchange’s server had stolen most of the Bitcoin stored there. Dishonesty 1, digital security 0.

Forms of digital communication like email allowed scammers to send a lie for a fraction of a penny, far below the cost of bulk mailing. The Federal Trade Commission reported that consumers lost $8.8 billion to fraudsters in 2022. Money transfers, both legitimate and criminal, happen with the flip of some ones and zeroes. Digital currencies can be stolen at far less personal risk than holding up a physical bank so it is surprising that more crypto is not stolen each year. CNN reported an estimate that $3.8 billion worth of digital currency, most of it DeFi, not Bitcoin, was stolen in 2022. That’s just 0.45% of the $840 billion in the market cap of cryptocurrencies at the end of 2022, as tracked by Coin Gecko. The technology that underlies digital currencies could be adapted to verify other forms of transactions.

A century from now, we may put digital currencies in the same historical bucket with the worthless stock certificates of hundreds of railroads and mines issued in the 19th and early 20th century. History is littered with broken dreams destroyed by deceit. Dig down to the ideological foundations of digital currency, however, and there is an enduring idea that will outlast whatever the current form of digital currency trading and transfer. That idea is as old as the Constitution – checks and balances. Money is information and information is power. Unless that power is checked, it accrues into an autocratic regime or an economic monopoly. Digital currency represents a yearning for a check on the accumulation of economic and political power. That idea will not go out of fashion.

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Photo by David Clode on Unsplash

Keywords: honesty, crypto, Bitcoin,

Pahlka, J. (2023). Recoding America: Why government is failing in the Digital age and how we can do better. Metropolitan Books, Henry Holt and Company.

The Money Information Network

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June 25, 2023

by Stephen Stofka

This week’s letter is about money, both conventional and digital, prompted by the news that Argentina’s yearly inflation just passed 100%, 25 times the U.S. rate of inflation reported a week ago. Let’s not confuse money and the banking system. Money exists within a banking system. The regimes, or set of rules, that govern that system are fluid but the institutions that manage that regime have evolved over centuries. The pillars of international institutions rarely crumble suddenly.

On Monday June 19, Bitcoin’s 24 hour volume was $10B, almost 2% of its $513B market cap. M1, the measure of transactional money like cash and checking accounts, was $18.6 trillion, about 36 times the market cap of bitcoin. Bitcoin’s algorithm changed the nature of money hoping that the adoption of Bitcoin would bypass the hegemony and inequities in the global banking system.

Satoshi Nakamoto, the pseudonym of the developer of the Bitcoin algorithm, understood the informational nature of money. Let’s explore that informational model. Economics students learn the three roles that money plays: a unit of account, a medium of exchange, and a store of value. The banking system manages a network of information databases. That’s the store of value function. That information is denominated in various currencies, the unit of account function. As a medium of exchange, access to that information is mostly guarded by a banking system that manages permissions. Our credit or debit card number is a password into that exchange.

Within this database model, cash is a permission-less and anonymous public information source that can be exchanged freely and (usually) confers a property right with that exchange. However, the availability and flow of cash is managed by central banks.  Satoshi designed Bitcoin to take advantage of those two characteristics of cash and avoid the negative aspects of central management, including the risk of inflation. To avoid a central gatekeeper, Bitcoin’s algorithm introduced a lot of nodes as gatekeepers. Those nodes formed a path of past exchanges which verified the existence of the funding source for an exchange.

Some entity had to keep a digital record of those exchanges, however. That has become a vulnerability in digital currencies because the exchange is also a broker, facilitating trades within its own exchange. Conventional securities are traded in an environment where the exchange, like the New York Stock Exchange, and the broker, like Vanguard, are entirely separate. Not so with digital currencies and that presents an opportunity for mismanagement and fraud. The implosion of the FTX exchange owned by Sam Bankman-Fried is a recent example. Until digital currencies can separate their broker and exchange functions, they are vulnerable to these shenanigans. Yes, the banking system is subject to mismanagement and fraud but the gatekeeper, the government, provides some recourse.   

Bitcoin is like a set of Christmas lights with many bulbs. If one goes out, a circuit may not complete and a transaction between two parties be recognized on both ends of the exchange. The banking system is like a network of traffic lights in a city. Traffic lights are permissions. Should one go out, a policeman will likely show up to manage those permissions and direct traffic. There is no recourse when a node in a digital currency block goes out or an exchange produces tokens to cover its trading losses.

Nations are their own banks and their security and welfare depend on that status. Wikipedia lists more than 150 central banks among the 195 countries in the world. The adopters of bitcoin and other digital currencies dreamed big but cannot overcome the political advantages of such a system. The dream of one-world currency may be destined for the same graveyard where the one-world government envisioned in the 1990s went to die. The hope that digital currency embodies will live on.    

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Photo by Aedrian on Unsplash

Keywords: bitcoin, money, banking

Great But Not Perfect

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June 18, 2023

by Stephen Stofka

This week’s letter is about the political movement to remove books from schools and libraries that reveal the uglier parts of American history. Any society makes mistakes, historical debts that never be paid and the succeeding generations are reluctant to shoulder the burden of those mistakes. A truly great people acknowledge those flaws and adopt policies that ameliorate some of the suffering caused by those mistakes. Some who shout the loudest that America is great are more concerned that America appears great than contributing to America’s greatness.

For some groups in America, the nation was never great. Some laws kept people out of restaurants, bathrooms, schools and other public places. American customs and federal policy kept some Americans from living in certain neighborhoods – the process of redlining in real estate. Some customs kept some Americans from jobs and credit because of their religion or skin color. These restrictive laws have been repealed or found unconstitutional but the customs and sentiments live on.

In 1705, Bernard Mandeville (1795) published The Fable of the Bees: or Private Vices, Public Benefits, an eleven page poem and commentary about a thriving beehive. When some bees complain about the many vices of their neighbors in the colony, the god Jove grants their wish and makes everyone virtuous. Bars are closed for lack of business, prices fall to an honest level, debtors pay their debts, and most lawyers are put out of business. Criminals are either hanged or set free and the jails closed. The jailers and attendants are put out of work. Many locksmiths and blacksmiths are idled because no one needs security locks or bars. Without vanity, the now contented bees no longer want clothes and other accoutrements that signify their civic stature, and this causes much industry to be idled. As the bees leave the hive, it collapses.

A prosperous society emerges from both the virtues and the vices, Mandeville claimed. Preachers assailed Mandeville’s criticism of good Christian virtues. That a good could come from vice was a heresy at the time of the book’s publication in the early 18th century. Mandeville described an emergent vitality and wisdom in the interplay between vice and virtue, contradicting the Christian teaching that wisdom was received from God’s or from reading the ancients.

Mandeville’s thoughts inspired David Hume, a giant of 18th century philosophy, and Adam Smith, the founder of the study of economics. Both were keen observers of human behavior, empiricists who believed that a variety of perspectives promoted vitality in a society. In time Adam Smith would develop the concept of the division of labor, that greater specialization improved productivity and promoted economic growth. Specialized trades can only develop and flourish in areas with large populations. Competition and diversity were the key to this outlook.

In another camp of political philosophy were Rousseau, Kant, Hegel and Marx, idealists who believed that a uniformity of rules and circumstances was the key to social improvement. A rigid adherence to norms that curbed people’s greed and self-centeredness was the key to a flourishing society. Policy proposals that ban books and public behaviors fall into this camp.

The Declaration of Independence and the U.S. Constitution embody this conflict between the idealists and empiricists. The Declaration of Independence espoused an idealistic uniformity like “All men are created equal.” Governments were allies to the individual’s pursuit of happiness. In contrast, the U.S. Constitution was an act of pragmatic bargaining to form a more powerful alliance between diverse colonies. In the text (Article 1, Section 2) of that bargain, slaves were to be counted as three-fifths of a person and the Congress could not regulate the importation of slaves for twenty years (Article 1, Section 9). Article 4, Section 2 preserved a universal right of ownership of a human being regardless of which state that human being was located. Governments promoted the happiness of some at the expense of others.

If we are a great nation and a great people, we teach our children about the good, bad and ugly truths that formed the backbone of this nation. There is a lot of each. Teach it all. A great people stand up in the daylight of truth. They pick up their legal tools and their steel tools and they get to work fixing the ugly, not burying it. They don’t drape themselves in flags and blather slogans. They put on their work clothes because building strong institutions and repairing ugly is hard work.

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Photo by Tom Hermans on Unsplash

Keywords: Constitution, Declaration of Independence, history, book bans

Mandeville, B. (1795). The fable of the bees: Or, private vices, public benefits. Printed for C. Bathurst and others. Available free from https://books.google.com/books/about/The_Fable_of_the_Bees.html?id=I7JlAAAAMAAJ&printsec=frontcover&source=kp_read_button#v=onepage&q&f=false

Bank Money and Hard Money

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June 11, 2023

by Stephen Stofka

This week’s post is about money and Adam Smith (2009), the author of the Wealth of Nations, a book that authors sometimes refer to by its acronym – WON. In 2026, it will be the 250 year anniversary of the publication of that work and Smith remains the most cited author in economics literature, according to Avner Offer and Gabriel Söderberg (2019), authors of The Nobel Factor. Smith lived in an age of a metallic or hard currency standard, but one with an active trade in paper or “bank” money. In Part 1, Chapter 4 of WON he attributed the debasement of hard currencies to the “avarice and injustice of princes and sovereign states.” We will see why he thought so.

Smith noted the chief flaw of hard currencies, particularly in an era of increasing industry. The supply of those metals depends on the success of mining operations and the fortunes of ships carrying the metals across the seas. There is either not enough hard currency to support the number of transactions in a country of increasing industry, or there is too much of the metal currency during economic downturns. Paper or bank money acted as a substitute for hard currency. In Part 2, Chapter 2, Smith notes that the exchange of bank money was mostly between wholesalers, not between dealers and consumers. In an age when the revenue of a country depended largely on excise taxes on particular goods and property taxes on landowners, the flow of taxes was mostly between the wealthy and the state.

Like most substitute goods the value of bank money rose when there was a shortage of hard currency, falling again when there was an adequate supply of gold or silver coin. A prince or state stabilized the value of paper money by allowing or stipulating the payment of taxes in paper money. Smith admired the resilience of the working class, a sentiment not shared by others in the higher social classes. When the American colonies drafted their Constitution, only those of means were allowed to vote because they were the primary source of direct government funding. The founders paid little recognition to those on the lower rungs of the socioeconomic ladder who paid few taxes directly to a government.

The working class paid taxes in three indirect forms: 1) higher prices on goods, 2) lower compensation for their labor, and 3) inflation. In an open letter written about 1780, American founder Benjamin Franklin remarked (https://founders.archives.gov/documents/Franklin/01-34-02-0156) that the printing of vast quantities of paper money to fund the American war against Great Britain had caused an explosive hyperinflation. In less than five years, 60 dollars of American paper currency had become equivalent to one dollar in gold. As Smith noted, a country abandons a hard currency standard as soon as it goes to war so that it can fund the war without increasing taxes.   

The developed countries of the world have realized Smith’s vision. Diverse economies with a lot of specialization promote growth. Less developed countries share a common characteristic – the economy is very reliant on agriculture. The growth of the retail trade in developed countries necessitates the increasing use of bank money. Hard currency is neither reliable nor convenient. Smith might attribute the persistent inflation of bank money not to an oversupply of paper money but to a shortage of hard currency. In growing economies, that shortage promotes deflation, benefitting those who have at the expense of those who have not. That is the injustice of hard money.

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Photo by Zlaťáky.cz on Unsplash

Keywords: Adam Smith ,gold coin, silver coin, hard currency, bank money

Malthus, T. R. (1989). An essay on the principle of population. Cambridge: Cambridge Univ. Pr.

Offer, A., & Söderberg, G. (2019). The nobel factor: The prize in economics, social democracy, and the market turn. Princeton University Press.

Smith, A. (2009). Wealth of Nations. New York: Classic House Books.

Fiscal Cliffs

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June 4, 2023

by Stephen Stofka

This week’s letter is about household debt and income. First I’ll touch on the latest news in the debt ceiling debacle. In a late Thursday session, the Senate passed a debt ceiling bill 63-36 and the President is expected to sign it before Monday, the day when Treasury Secretary Janet Yellen said the country would start delaying or defaulting on payments. There were few significant cuts to social and military spending, the biggest contributors to the nation’s rising debt. The CBO’s recent outlook estimates that the debt will rise by almost 50% in the next decade.

Although the issue is laid to rest until 2025, neither side is willing to pass a law that voids the 105 year old debt ceiling law. Since the passage of the 17th Amendment in 1913, only the Democratic Party has ever held a filibuster proof 60 vote majority in the Senate. For Republicans, the debt ceiling is a critical bargaining chip to undo Democratic spending priorities. When Democrats had a filibuster proof majority in 2009-2010, they could have undone the debt ceiling law but chose other priorities like Obamacare and banking reform. In 2021, ten Republicans joined Senate Democrats to bypass the 60 vote filibuster threshold and permit a vote to raise the debt ceiling, the Hill reported. Last year, Janet Yellen asked Democrats to lift the debt ceiling while they held majorities in both chambers of Congress but Chuck Schumer probably didn’t have the votes in a narrowly divided Senate.

The latest report on household debt from the New York Federal Reserve (2023) reveals some interesting trends in mortgage debt. During the pandemic, the surge in mortgage originations was particularly strong among those with the best credit scores of 760 and above.

Those with the greatest house buying power are now “locked” into historically low interest mortgages below 4%. How low is 4%? The 50 year average of the 30-year fixed mortgage rate is 7.74%, according to Trading Economics. An entire generation was accustomed to very low rates after the financial crisis. Those low mortgages will create a resistance to sell that will likely dampen the housing market for a decade to come. A $400,000 mortgage at 4% costs $1900 per month. At a 6.5% rate that same monthly payment covers only a $300,000 mortgage. How many people will be willing to downsize into a more affordable mortgage?

In the past 15 years, Americans have reduced their debt load to a level less than their disposable income but how long can that continue? For the past 20 years, real disposable personal income per household has grown at only 1% annually, half of the rate of growth from 1982-2002. (Disposable income is what remains after taxes). In the graph below, that is the blue line. That same income series per job, not household, has grown at 1.25% annually (red line), down from 1.5% annual growth in the previous 20 year period. I’ve charted the two series on a log scale to demonstrate the different growth rates. The difference indicates that those with higher paying jobs have enjoyed higher growth of after tax income for the past two decades. The two series show the cumulative effect of favorable tax policies for those with higher incomes.   

Because the growth of household income is tepid, families are more likely to increase their debt burden. In a decade this could provoke a credit crisis similar to the great recession 15 years ago. Republicans are fiercely resistant to higher taxes on the top income earners and equally resistant to any reductions in military spending or agricultural supports. Democrats continue to promote social programs without the additional tax revenues to support that spending. A higher federal debt level will reduce the federal government’s capacity to support families when the next crisis arrives.   

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Photo by Leio McLaren on Unsplash

Keywords: fiscal cliff, public debt, household debt, mortgage, disposable income

Federal Reserve Bank of New York. (2023, May). Quarterly report on household debt and credit. https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2023Q1

U.S. Bureau of Economic Analysis, Real Disposable Personal Income [DSPIC96], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DSPIC96, June 2, 2023. Other series shown are Total Nonfarm Payroll (PAYEMS), the Census Bureau’s estimate of  households (TTLHHM156N)

The Crack in Our Windshield

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May 28, 2023

by Stephen Stofka

This week’s letter is about debt, both public and household. Since 9-11, the public federal debt  has grown five times. The causes include costly wars in Iraq and Afghanistan, a global financial crisis followed by a slow recovery, tax cuts passed under the Trump administration and a once-in-a-century pandemic. Ten percent of the $32 trillion debt was added during the first three months of the pandemic. As the deadline approaches when the government will not be able to make timely payments to vendors and bondholders, we ask why do we have this thing called a debt limit?

Denmark is the only other country in the world to require an approval of a debt limit after the spending has been approved. Their legislators raised the limit so high that it might be a century before the issue comes up again. That leaves only the U.S. in the world where a debt limit debate is a threat. Neither party wants to repeal this century old law because it has the potential to be a powerful negotiating tool. It allows one party to negate or modify the funding priorities that the other party passed in the last legislative session. This is a game of chicken played for high stakes.

Some have criticized the Biden administration for not starting negotiations sooner. However, the House did not put anything on the negotiating table until they passed a bill on April 26th, just a month ago. Given the fractured Republican caucus, it was not clear that Speaker McCarthy could get a bill passed in the House. French Hill, R-Ark., told Roll Call “The whole purpose of this is to compel the president to negotiate — and to demonstrate to Washington, D.C., that Kevin McCarthy has the votes to raise the debt ceiling.” Four House members defected and the vote barely squeaked by at 217-215. Although George Santos, R-NY, is facing prosecution for fraud, money laundering and theft of public funds, McCarthy has allowed him to keep his seat at a time when every vote is crucial.

In 2011, the Republican House balked at raising the limit but the only legislation they could pass was an affirmation that they would not raise the limit without some unspecified spending cuts. Republicans were unable to agree on terms that they could pass in the House. Despite that, President Obama made the mistake of negotiating with Speaker John Boehner, and the two struck a so called Grand Bargain. Lacking anything in written legislation from the House, a bipartisan committee in the Senate came up with a different proposal and Obama tried to negotiate a compromise between the two versions with Boehner. Boehner could not get any changes past the most conservative members in his caucus. According to Politico reporter Tim Alberta (2017), the staff of Jim Jordan, R-OH, had been working secretly with outside groups to sway enough House members to vote against Boehner’s bargain. Jordan apologized but the incident exacerbated tensions between the warring factions within the Republican House. As Vice-President at the time, Biden would have learned a valuable lesson. Get something in writing before starting negotiations.

In contrast to the growth of the public debt, the growth in household debt has decreased since the financial crisis and the housing bust. The chart below compares the two types of debt, public and household, in two 13 year periods before and after the financial crisis.  

From 1994-2007, the public debt (GFDEBTN) grew 5% per year while household debt rose 8.7% annually. As a percent of disposable income, household debt jumped from 78% at the end of 1994 to 124% at the end of 2007. Chiefly responsible was the doubling of mortgage debt (HHMSDODNS) during the first seven years of the 2000s. Lax underwriting standards allowed families with poor credit scores of less than 620 to secure mortgages. Millions lost their homes during the housing bust, banks tightened lending standards and Americans were forced to go on a credit diet.

Since the financial crisis, American household balance sheets have improved. Household debt has grown by only 2.2% per year, about half the growth rate of personal income (DSPI). As a result, debt as a percent of disposable income had fallen to 91% at the end of 2022. The public finances have not fared as well. Although federal tax receipts, including FICA taxes, have increased 8% annually, expenditures and social benefit payments have outpaced tax receipts, resulting in a 7.2% annual increase in the public debt since the end of 2009.  

This week David Leonhardt (2023) with the New York Times presented a graph of voter policy preferences derived from recent polls. The fiscal liberals in both parties outweigh the fiscal conservatives, a trend sure to promote the growth of the public debt. In the 2011 debt limit duel, Republican leaders like Paul Ryan championed privatization of Social Security and cutting back on benefit programs. In the decade since, neither of those proposals are popular with the party’s base. Instead McCarthy will appeal to the social conservatives in the party and insist on work requirements for benefit programs. As Leonhardt notes, the fight for Democrat and Republican swing voters is taking place in the quadrant of voters who are socially conservative but fiscally liberal, nicknamed the “Scaffles.”

The government’s spending becomes household income in some form or another, an accounting identity that joins the growth in public and household debt. Our economy, laws and regulatory framework promote financial crises and exacerbate social problems. Policymakers, economists and social scientists can debate the causes, extent and severity of the problems but acknowledge the reality.  We may discover that our experiment in governance does not scale as our population grows and congregates in cities, as our technology advances and we become accustomed to greater energy use. The spread of mass communication and social media since World War 2 has exacerbated rather than resolved our ideological and cultural differences. The growth of our public debt indicates that we expect more from our government than our economy or political framework is able and willing to pay for. Like a crack in our windshield, it will continue to grow.

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Photo by Ivan Vranić on Unsplash

Keywords: public debt, household debt, mortgage debt, debt limit

Alberta, Tim. 2017. “John Boehner Unchained.” POLITICO Magazine. https://www.politico.com/magazine/story/2017/10/29/john-boehner-trump-house-republican-party-retirement-profile-feature-215741/ (September 27, 2022).

Federal Reserve Bank of New York. (2023, May). Quarterly report on household debt and credit. https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2023Q1

The various FRED data series used in this post were HHMSDODNS Mortgage Debt, HCCSDODNS Consumer Credit Debt, GFDEBTN Public Debt, DSPI Disposable Personal Income.

Leonhardt, D. (2023, May 25). Ron DeSantis and the “scaffle” vote. The New York Times. https://www.nytimes.com/2023/05/25/briefing/ron-desantis.html