Author: sgstofka

Paradoxes in Savings

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March 12, 2023

by Stephen Stofka

Paradoxes in Savings

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

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

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

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

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

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

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

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

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Photo by Johannes Plenio on Unsplash

The Money Cycle

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March 5, 2023

by Stephen Stofka

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

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

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

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

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

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

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

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

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Photo by Ryan Yao on Unsplash

Howgego, J. (2016, July 14). Travel back in time to the most extreme desert and monsoons ever. New Scientist. Retrieved March 3, 2023, from https://www.newscientist.com/article/mg22730300-600-travel-back-in-time-to-the-most-extreme-desert-and-monsoons-ever/

An Evolving Society

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February 26, 2023

by Stephen Stofka

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

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

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

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

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

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

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

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

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

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

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

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

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Photo by Eugene Zhyvchik on Unsplash

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

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

A Labor-Output Ratio

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February 19, 2023

by Stephen Stofka

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

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

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

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

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

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

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

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

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

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

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Photo by Camylla Battani on Unsplash

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

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

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

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

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

Price Paths Rejoin

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February 12, 2023

by Stephen Stofka

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

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

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

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

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

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Photo by Jens Lelie on Unsplash

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

Money As Wave

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February 5, 2023

by Stephen Stofka

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

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

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

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

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

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

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

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

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

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Photo by Pawel Czerwinski on Unsplash

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

Political Horses in Harness

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January 29, 2023

by Stephen Stofka

This week’s letter is about the debt ceiling. It has been ten days since Janet Yellen, Secretary of the Treasury, began using “extraordinary measures” to pay federal obligations as the nation waits for Congress to raise the debt ceiling. The U.S. is the only country in the world that requires legislative authorization of its debt after the legislature has already authorized the spending, then appropriated the money for that expense.

Each year, the federal government and each of the states conducts an annual appropriations process that allocates money to each state or federal department or agency. By law, states must balance their budgets – in a pro forma manner, at least. They sometimes employ accounting mechanisms to defer expenses to a later year or accelerate revenues into a current fiscal year to achieve that balance. The federal government does not have a balanced budget constraint but Congress does occasionally play a dangerous game of budget “chicken” when it wants to send a message to the other party.

Political parties are ever conscious of their branding and each claims to be a good financial steward of the public’s taxes. Each claims that the other party is irresponsible. Paying the interest on the debt takes funding from other programs without doing anything. While this may be true and the interest on the debt is rising, it is less than 2% of GDP, far below the 2.5% – 3% of GDP during the 1980s and 1990s.  

The press, politicians and public argue over who is responsible and whether to cut programs or increase revenues. When Republicans are out of power, as they are now, they call for spending cuts. Democrats call for revenue increases, particularly higher taxes on the rich. When Republicans were in power from 2017-2019, they increased the deficit each year, ending 2019 with a deficit of almost $1 trillion. In 2020, the deficit was $3.1 trillion. A month after the 2020 election was over, Congress added another $920 billion for Covid relief. The Trump administration added $6.5 trillion to the debt, or 21% of today’s total debt of $31 trillion.

Shortly after Mr. Biden took office in January 2021, Congress passed the American Rescue Act which provided another $1.9 trillion in relief. The two relief packages before and after the start of Biden’s term added up to $2.8 trillion and was responsible for the entirety of the 2021 deficit of $2.775 trillion. The Republican House will pin the blame for the debt on the Biden administration and programs like Social Security and Medicare. When a party is out of power, they can indulge in what is called position-taking. The firebrand rhetoric is popular with the Republican base and, since there is no possibility that those programs will be cut, politicians can claim to be prudent or for small government. When a party is actually in power, politicians have to be careful with political blustering. Their constituents are more likely to think that such cuts are possible and will vote them out of office.

For forty years, the Republican party has run on a theoretical assumption that tax cuts will spur enough economic activity that the increased tax revenue will more than pay for the cuts. There is no evidence supporting that claim but claims do not need evidence to be effective at raising funds and winning votes. For almost sixty years, Democrats have touted federal social programs as a path to greater equality and equitability.

In any game of chicken, the danger is that neither side gives in. Relying on estimates of income tax revenue in the next few months, some economists project that Secretary Yellen can continue to take ever more extraordinary measures until June. At the last big debt limit showdown in 2011, people argued over the constitutionality of the Treasury printing a $1 trillion coin and handing it over to the Federal Reserve to cover any expenses, including interest payments and bond redemption. This year, the idea is again a popular debating point on social media.

Like the filibuster, the debacle of the debt limit debate continues because each party wants to have power yet check the other party’s power, a dilemma that neither can escape. They are two horses harnessed together pulling the wagon of state. With reins in hand, the public is under the impression that it is driving the wagon but it is not. The parties pay attention only to the harness that binds each to the other.  

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Photo by Jacek Ulinski on Unsplash

Investing, Not Gambling

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January 22, 2023

by Stephen Stofka

This week’s post is about expectations, investing and gambling. After last year’s slump in asset prices, investors may be disappointed in the recent performance of their portfolio. A 60/30/10 (U.S. stocks/bonds/cash) had a 3-year return* of 3.65%. A 5-year return was 5.53%, according to Portfolio Visualizer (2023).  Investors tend to weight losses more than they do gains. Following portfolio losses during the financial crisis, many investors turned to more conservative assets, selling their beaten down stocks at a low. Following this past year’s selloff in both bonds and stocks, investors might be tempted to shed both. Let’s take a look at the averages.

Only three years out of the past fifteen has a balanced portfolio had a negative return. When a stock fund loses 35% in a year, investors can feel the loss so deeply that they liken stock investing to gambling. A gamble is a win or lose event with a high return and a low probability of winning, a probability so low that it outpaces any winnings I might get. For example, if I could bet a $1 and win a million, that is a 1,000,000 to 1 leverage. But my chances of winning might be 1 out of 300,000,000. Take that probability and turn it upside to get its inverse of 300,000,000 to 1. Compare that to the leverage and the ratio is 300 to 1. The gambler is at a distinct disadvantage. That’s how lotteries raise money for parks and common areas and how casinos stay profitable.

A prudent portfolio is not a win or lose bet but a series of erratic steps, the familiar model of the random walk. In any year, our expectations should be guided by historical averages, not the last erratic step. In the fifteen years since the year of the financial crisis, the average of the annual returns of a 60/30/10 portfolio, rebalanced annually, was almost 7.2%. (Note: this is slightly higher than the annualized growth rate). A more conservative 50/40/10 asset mix averaged 5.6%. Last year’s portfolio loss of 15.55% was unusual and not likely to be repeated. Investors who were spooked by market losses last year risk losing positive gains in the following years if they let one year’s return dictate their allocation targets.

Losses in both the stock and bond markets last year made rebalancing counterintuitive. In a simplified model, bonds go up when stocks go down. To rebalance, an investor sells some bonds and buys stocks, selling high and buying low. Likewise, when stocks climb, bonds show a negative return. For twenty years, Callan (2023) has charted seven asset classes and their returns, demonstrating the wisdom of asset diversification. In 2021, a mix of large and small cap stocks returned about 21% while a mix of domestic and foreign bonds fell 3-4%, depending on the mix. Rebalancing toward a target allocation, an investor would have sold some stocks and bought bonds. In 2022, both stocks and bonds had approximately similar negative returns. An investor may have found that their allocation changed little except that the cash portion of their portfolio might have grown a bit.

An unusual year like 2022 can distract or confuse an investor’s strategy. A casino or lottery wants to draw our attention to the unusual event – the win – and away from the average – the loss. If gamblers were to focus on the averages, few would play. Investing is the opposite of gambling and our focus should be trained on the averages.

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Photo by Kaysha on Unsplash

*CAGR – compound annual growth rate

Callan. (2023, January 16). Periodic table. Callan. Retrieved January 21, 2023, from https://www.callan.com/periodic-table/ Note: this chart ranks the annual returns of seven asset classes for the past twenty years. Go to the web site, then click the PDF link for the free chart.

Portfolio Visualizer. (2023). Backtest portfolio asset class allocation. Portfolio Visualizer. Retrieved January 20, 2023, from https://www.portfoliovisualizer.com/backtest-asset-class-allocation

Employment Curves

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January 15, 2023

by Stephen Stofka

For millennia people have claimed a power of divination by various methods, including the casting of bird bones on the ground, the magic of numbers or certain word incantations. As the New Year begins, there is no shortage of predictions for 2023. Will the Fed taper its rate increases now that inflation has moderated? Will the U.S. go into a recession? Will falling home prices invite a financial crisis like the one in 2007-9? Will bond prices recover this year? Other animals see only a few moments into the future. We have developed forecasting tools that try to time-travel weeks and months into the future, but we should not judge a tool’s accuracy by its sophistication.

Statistics is a series of methods that constructs a formula explaining a relationship between variables. Each data point requires a calculation, a tedious task for human beings but a quick operation by a computer. Before the introduction of the computer in the mid-20th century, investors used simpler tools like the comparison of two moving averages of a time series like stock prices. These simple tools are still in use today. An example is the MACD(12,26) trend that compares the 12-day and 26-day moving averages, noting those points where the short 12-day average crosses the long 26-day average (Stockcharts.com, 2023). We can apply a similar technique to the unemployment rate.

In the chart below I have graphed the 3-month and 3-year moving averages of the headline U-3 unemployment rate. The left side of each column faintly marked in gray marks the beginning of a recession has noted by the NBER (2023). These beginnings roughly coincide with the crossing of the 3-month (orange) above the 3-year (blue) average. With the exception of the 1990 recession, the end of the recessions is near the peak of the 3-month orange line, after which unemployment declines. Today’s 3-month average is well below the 3-year trend, making a recession less likely. However, except for the pandemic surge of unemployment, the 3-month average is quite low and has been below the 3-year average for the longest period in history.

I did not do any laborious trial and error of various averages to find a fit. I chose these periods because they fit my story, something I wrote about last week. A 3-year average should provide a stable long term trend line of unemployment. A 3-month average should reflect current conditions with some of the data noise removed. The crossing should capture an inflection point in the data.

The low unemployment rate implies that workers have more wage bargaining power but wage increases have lagged inflation, robbing workers of purchasing power. If inflation continues to decline in 2023, some economists predict that wage increases may finally “catch up” and surpass the inflation rate.

There are two trends that have weakened the wage bargaining power of workers. Since World War 2, an economy dominated by manufacturing has transitioned to a service economy with lower average wages. In that time, the percent of workers employed in agriculture fell from 14% to less than 2% as production and harvesting became more mechanized. The labor market has undergone structural changes that may invalidate or weaken the lessons of earlier decades.

Since WW2, self-employment has declined. Half of those employed now work for large companies with 500 or more employees (Poschke 2019, 2). Few are unionized and able to bargain collectively for wages. According to the Trade Union Dataset (2023), most European countries enjoy much higher trade union participation than in the U.S. where only 10% of workers belong to a union. Large American companies enjoy a wage-setting power that smaller companies do not have and this enables them to resist wage demands. American workers do not have enough wage bargaining power to make a significant contribution to rising prices. Stock owners, able to move money at the stroke of a computer key, hold more bargaining power.

To keep their stock prices competitive, publicly traded companies must maintain a profit margin appropriate to their industry. Investors will punish those companies who do not meet consensus expectations. Company executives rarely take responsibility for falling profit margins. Instead, they blame rising wages or material costs, shifting consumer tastes or government regulations. Interest groups like the U.S. Chamber of Commerce, a private lobbying organization funded by the largest companies in America, champion a narrative that inflation is the result of rising wages, not rising profit margins. Like any interest group, their job is to assign responsibility for a problem to someone else, to convince lawmakers to act favorably to their cause or industry. The Chamber has far better funding than advocates for labor and it uses those funds to block policies that might favor workers.

There are economists and policymakers who still believe in the Phillips Curve, a hypothetical inverse relationship between unemployment and inflation. High unemployment should coincide with low inflation and high inflation with low unemployment. Shortly after Bill Phillips published his data and hypothetical curve, Guy Routh (1959), a British economist, published a critique in the same journal Economica, pointing out the flaws in Phillips’ methodology. The chief flaw was Phillips’ lack of knowledge about the labor market itself. Despite that, American economists like Paul Samuelson, who favored an activist fiscal policy, liked the implications of a Phillips Curve. Policy makers could fine tune an economy the way a car mechanic tuned a carburetor.

In the past year, some economists and policymakers have advocated policies to drive unemployment higher and wring inflation out of the economy. Despite rising interest rates, the labor market has been strong and resilient. In January 2020, Kristie Engemann (2020), a coordinator at the St. Louis Fed, explored the debate about whether this relationship exists or not. For the past five decades, the “curve” has been flat, a statistical indication that there is no relationship between inflation and unemployment. Policymakers will continue to cite the Phillips Curve because it serves an ideological and political purpose.

We don’t need statistical software to debunk the Phillips curve. In the chart I posted earlier, there were several points where the 3-month average unemployment rate was near or below 4%. These were in the late 1960s, the late 1990s, and the late 2010s. The inflation rate was 3%, 2.5%, and 1.4% respectively. If the Phillips Curve relationship existed, inflation would have been much higher.

As our analytical tools become more sophisticated we risk being fooled by their power. With a few lines of code, researchers can turn the knobs of their statistical software machines until they reach a result that is publishable. We should be able to approximate if not confirm our hypothesis with simpler tools.  

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Photo by Augustine Wong on Unsplash

Engemann, K. M. (2020, January 14). What is the Phillips curve (and why has it flattened)? Saint Louis Fed Eagle. Retrieved January 13, 2023, from https://www.stlouisfed.org/open-vault/2020/january/what-is-phillips-curve-why-flattened

National Bureau of Economic Research. (2022). Business cycle dating. NBER. Retrieved January 13, 2023, from https://www.nber.org/research/business-cycle-dating

Poschke, M. (2019). Wage employment, unemployment and self-employment across countries. SSRN Electronic Journal, (IZA No. 12367). https://doi.org/10.2139/ssrn.3401135

Routh, G. (1959). The relation between unemployment and the rate of change of money wage rates: A comment. Economica, 26(104), 299–315. https://doi.org/10.2307/2550867

Stockcharts.com. (2023). Spy – SPDR S&P 500 ETF. StockCharts.com. Retrieved January 13, 2023, from https://stockcharts.com/h-sc/ui?s=spy  Below the price chart is the MACD indicator pane.

Trade Union Dataset. OECD.Stat. (2023, January 13). Retrieved January 13, 2023, from https://stats.oecd.org/Index.aspx?DataSetCode=TUD

U.S. Bureau of Labor Statistics, Employment Level [CE16OV], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CE16OV, January 11, 2023.

U.S. Bureau of Labor Statistics, Employment Level – Agriculture and Related Industries [LNS12034560], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LNS12034560, January 11, 2023.

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Price Illusion

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January 8, 2023

by Stephen Stofka

This week’s letter is about price illusions. The past two weeks I have written about the need to sort through past events to find the lessons. The past is a teacher, not a goal. Those who idealize and revere the past must eventually be swept down the drain of time. During this week’s struggle to elect Kevin McCarthy as House Speaker, the more conservative members of the Republican Party voiced their desire to return the country to the past of more than a hundred years ago when the population of 112,000,000 was a third the current size. Instead of learning from the past, we often use elements of history to tell a story. We discard events that do not fit our narrative. Historical analysis serves political interests. Asset analysis suffers from similar distorting strategies.

Technical analysis studies price movements with little regard for the circumstances that prompted the supply and demand, the buying and selling that underlie those movements. I will pick a few such variants at random. Elliott Wave theory bases its interpretation of price movement on the Fibonacci sequence of numbers. Beginning with 1, 1 this number series is constructed from the sum of the previous two numbers in the series. Thus 1 + 1 = 2, 2+1 = 3, and so on. This simple rule produces a sequence found in plant growth and the development of nautilus shells, for example.

Elliot Wave analysis claims that price movements come in waves. Understanding the current position within a wave can help an investor predict subsequent price action. The system is famously prolific in its prophecy, indicating several interpretations. It is better suited to a post hoc narrative. An investor can believe that if they just got better at interpreting the waves, they could time their buying and selling. As the physicist Richard Feynman said, “The first principle is that you must not fool yourself, and you are the easiest person to fool.”

Another technical system relies on the recognition of price trends, identifying those to follow and those that signal a likely reversal. These are visual and geometric, full of rising wedges, head and shoulders price patterns, double tops and bottoms. Much human behavior is repetitive, tempting an investor to perceive a pattern then extend it into the future. The repetition hides the recursive or evolutionary nature of human thinking. Inertia, Newton’s First Law of Motion, may apply to inanimate objects but not to human behavior. Biological systems have built-in dampeners that counteract a stimulus. Without repeated stimulus, the formation of any possible pattern decays.

Price behaves like a biological organism, not an inanimate object. We can see beautiful symmetries in graphical chart analysis but each pattern formation has a unique history. Price is the visible point of a response to events, needs and expectations. Price is a story of people. George Soros, a highly successful investor, constructs a predictive story, then watches price only as a confirmation or refutation of the story. If Soros thinks his story is not unfolding as he predicted, he exits his position.

In school we encountered various branches of mathematics where we were given formulas and plotted data points or intersections, the solutions to a set of equations. Statistics is the reverse of that process. We are given data sets and try to derive formulas to explain relationships within the data. A data set might be the test scores of students before and after the initiation of a certain curriculum. We may represent the test scores on a graph, but the scores reflect a complex set of individual behavior and circumstances, institutional policies, cultural background and economic resources. A statistical analysis tries to include some of these aspects in its findings. A student population is likely more homogenous than the companies in the SP500 stock index who represent a variety of industries. Just as test scores cannot fully explain the efficacy of a school policy or curriculum, asset prices do not reflect the complexity of a day’s events. In our longing for predictability and our fondness of patterns, we prefer analysis that explains price action as a rational sequence of responses to economic, political and financial events. Much financial reporting is happy to oblige.

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