Author: sgstofka

Alliances in Political Parties

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July 7, 2024

by Stephen Stofka

This week’s letter continues my look at expectations and alliances, focusing on several junior elected Representatives as foot soldiers in an ideological and egotistical battle for political control. Congressional candidates who successfully challenge an incumbent in their own party attract the most attention. Running for office requires as much perspiration as aspiration and upsetting an incumbent requires both in large doses. Challengers are often funded by special interest or advocacy groups outside a district who are more concerned with defeating an incumbent than in promoting a new agenda. Seniority is power in Washington. A newly elected Congressperson with no seniority has less influence and bargaining power. They must work harder to help their constituents with problems in the Washington bureaucracy.

A newly elected Representative must learn to understand and navigate a complex web of seniority rights, relationships and personalities within the party. In Washington, the party leaders manage their party’s representatives as political assets in a game to control policymaking and promote their own power. Leaders use committee assignments as tools of control and inducement. Each Representative has a distinct style and demeanor that appeals to some groups of voters more than others. Party leaders hope to use that to broaden the party’s appeal.

Every three to four years, the Pew Research Center produces a typology of nine voting groups (PDF) in this country. These include Committed Conservatives and Faith and Flag Conservatives on the political right, and Democratic Mainstays and Progressive Left on the other side of the aisle.
Establishing a sympathetic tie with one or more of these groups helps each Representative meet fundraising goals set by the party. The report highlights the divisions within each party as well as those between the parties.

Despite the divisions within each party, allegiance to party is stronger than it has been in 54 years, according to a Pew Research analysis of the 2020 election. Only six states have split representation in the Senate – one Republican and one Democrat Senator. In most states, voters choose their Senators and President from the same party. Ninety percent of voters chose the same party in 2016 and 2020, leaving just a small fraction of uncommitted voters that each party hopes to woo.

Strong party allegiance makes it difficult for a Senator to compromise with their colleagues across the aisle. Special interest groups can fund a challenger, portraying a Senator’s compromise to reach consensus on legislation as a cop-out, a betrayal of principles. Our Constitution emerged as the result of many fractious debates. The convention was closed to public view to allow bargaining by the delegates without them having to worry about protecting their reputations during those debates. Secrecy certainly comes with caveats, but bargains are best brokered in back rooms, out of public view.

In each party the senior members do much of the bargaining while the junior members are expected to rally sentiment and bring in their allotted share of contributions from special interest groups and top donors. Representatives Lauren Boebert and Marjorie Taylor Greene rode MAGA sentiment to win Republican primaries in 2020. Greene represents Georgia’s 14th district, rated a strongly Republican R+22 district in the Cook Partisan Voting Index. Like Trump, Greene is a rule breaker, tossing aside customs of decent behavior for a Representative. Examples include using personal insults in a committee hearing, screaming at Democrats outside the Capitol building,  and attacking fellow Republican Lauren Boebert in a committee hearing. Her forceful and strident approach has been an effective strategy in her district.

In a district with a more moderate political voting record, an incumbent may have to temper their political posture. Like Greene, Lauren Boebert has portrayed herself as a disruptor and a combative Christian but her distinctively un-Christian behavior led many Republicans to abandon her in the 2022 election against a moderate Democrat. Her Colorado 3rd district is rated only R+7 in the Cook Partisan Voting Index. To avoid defeat in the upcoming 2024 election, Boebert moved to the 4th district which leans more heavily Republican. Both have low effectiveness scores but they bark loudly, and each party needs both barkers and bargainers.

In 2018, Alexandria Ocasio-Cortez, dubbed “AOC”, upset a long-time Democratic incumbent of New York’s 14th district (D+28). The heavily Democratic district allows her the latitude to further a progressive platform with less concern about a challenge from a moderate Democratic candidate. Just north of AOC’s district is Yonkers, a suburban county north of New York City. In 2020, Jamaal Bowman rode a progressive wave to unseat a 32-year incumbent Democrat. This 16th district is a strongly Democratic D+20 as ranked by the Cook Partisan Voting Index. Both AOC and Bowman have higher legislative effectiveness scores than Boebert and Greene, and are adept at attracting media attention without the histrionics that Boebert and Greene employ. Having sponsored two bills that became law, Bowman has the best record of all four yet lost his primary re-election this summer because of remarks he made about Israel’s conduct of the war against Hamas in Gaza.

National special interest groups as well as those in each Congressional district can make or break a candidate. They supply a candidate, or their challenger, with resources and funding, as well as a “banner” issue that can incentivize voter turnout in a primary election with typically low voter participation. In Bowman’s case, the Zionist lobbying group AIPAC led a historic fundraising campaign that supported Bowman’s challenger, according to Politico.

The political struggle is within each party as much as it is between the two parties. One party champions family and a political system called liberalism that prioritizes individual freedom, and advocates restraints on state power to protect those freedoms (O’Neil, 2021, p. 113). The other party promotes social democracy, a hybrid political-economic system founded on liberalist principles of private property and free markets but with an emphasis on community beyond the nuclear family and the well-being of individuals within community. Next week I will look at the role of the judiciary in this ideological struggle.

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Photo by Kelly Sikkema on Unsplash

Keywords: political-economic system, legislative effectiveness, special interests, primary election, political typology

O’Neil, Patrick H. 2021. Essentials of Comparative Politics. New York, NY: W.W. Norton & Company.

Legislative Effectiveness Scores: For each legislator, the Center for Effective Lawmaking produces an effectiveness score that includes the introduction of legislation, whether a bill made it through committee, was moved to the general chamber for a floor vote and whether the bill became law. A legislator’s score is compared to a benchmark score based on whether the party was in the majority or minority. Party leaders typically have scores in a range of 2 to 8.

 In the House session ending in January 2023, Lauren Boebert had an effectiveness score of .292. Marjorie Taylor Greene has a score of .117. AOC had a score of .739 and Bowman was .801.

The Party Swamp

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June 30, 2024

by Stephen Stofka

This week’s letter is on expectations and alliances. After separating voters into two parties, alliances within each of the parties coalesce to form intra-party squabbles. These alliances can form despite radically different approaches to managing problems: analytical and instinctual. Voting for the same candidate might be a person with an instinctive dislike of government and a business owner who estimates the impact of that candidate’s policy preferences on a company’s bottom line. These two different approaches also produce conflict.

In past weeks I have distinguished between expectations and anticipations, the first being more analytical and the second more imaginative or instinctual. The two work symbiotically in our individual lives but that symbiosis becomes outright conflict in a group. Some prefer a more analytical approach to discussing and solving problems while others rely on their gut, their moral compass. Individuals participating in that debate want to convince others to adopt their perspective and values. Perspective evolves over our adult lifetime and its purpose is to protect our values which have evolved since childhood. Attacking a person’s perspective can be perceived as an attack on their values, so we are resistant to persuasion. A variation of a 17th century quote goes, “A man convinced against his will is of the same opinion still.” The trick to persuasion is to insert your argument into another person’s perspective like a key and let them turn the key.  

In the Democrat Party, the center left contends with the radical left who weaponize shame. Advocates of DEI funding and mandates within all public institutions honestly believe that such training will moderate or eliminate racist attitudes. The majority of U.S. colleges and universities require students to take these non-credit classes to graduate. For students with a heavy academic schedule and work commitments, the burden of that mandate multiplies a student’s stress. Those within and without the academic community debate the conflict between these mandates and academic freedom.

Those favoring more spending on affordable housing disagree with voters in the party who prefer the personal space buffer that R-1 Single Family Home zoning gives residents. Proponents of free needle exchange must overcome fears that such tolerance will introduce a moral hazard that promotes more rather than less drug use. Supporters of more resources for  immigrant housing, job and medical services encounter principled opposition from those who are mindful of the resources and money that must be diverted from other programs. Should the needs of newcomers take higher priority than those of long- time residents, particularly the descendants of those African-Americans brought to this country centuries ago? Party leaders struggle to manage these ideological conflicts because these issues permeate the leadership ranks as well.

The Republican Party is more dominant in the ex-urban and rural parts of each state. Party leaders and candidates express strong support for religious faith as a cornerstone of American society. According  to Pew Research, Republicans attend church more often than Democrats or Independents but the majority of Republican voters do not attend church weekly. Like Democrats and Independents, a third of Republicans rarely step inside of a church. Those who believe that public institutions should be secular confront those who think religious principles and doctrine offer the only sound foundation to good governance. A person supporting their argument with Bible verses may truly believe that they are taking an analytical approach. In their belief framework, the Bible is history, recorded by various authors or sources but inspired by God himself. To those devotees, the Bible is fact, not an arbitrary assembling of oral traditions and myths. Two Republican voters, each with very different religious beliefs, practices and priorities still vote for the same candidates and issues. Leaders within the party must negotiate a compromise between Christian compassion and checkbook constraints.

Immigration is a key issue on ideological lines even though most immigrants initially settle down in urban areas where political sentiments skew Democratic. When the labor market is strong in the U.S. relative to other countries, that acts as a draw to legal and illegal immigration. The emphasis is on the “relative to other countries” part. A mismatch in labor market demand between the U.S. and neighboring countries is an important contributor to immigration flows. The strong economy in the late 1990s and early 2000s attracted a surge of immigrants, far more than today’s levels when adjusted for population.

 A recent analysis by the Federal Reserve estimated that restrictive immigration policies from 2017 to 2020 made it moderately more difficult for employers to fill job vacancies.  Farmers and ranchers, a strong Republican cohort, have long lobbied for changes to the H-2A “guest worker” program that would help them meet seasonal worker demand. The number of slots for foreign workers is not enough to meet demand and the application process is burdensome. Employers have similar complaints about the H-2B program for non-agricultural workers, and are heavily used by janitorial and landscaping services. Regardless of the impact of restrictive immigration policies on their businesses, owners may still vote for a candidate who promotes an immigration crackdown.

Jobs and sustainable wages are the cornerstones of family support, individual self-respect and autonomy. Those in rural areas are keenly aware that urban areas offer a more developed communications and transportation network that attracts companies, jobs and talent. For the past several decades, small to medium-sized manufacturing has migrated to foreign markets which offer lower labor costs. The influx of immigrants is yet another potential threat to community stability and resources. Long established immigrants who came to the U.S. through a legal process may not feel welcoming to those who have jumped ahead in the immigration line. Β Β For decades, rural areas have fought to retain businesses and develop more jobs at a sustainable wage. Those who advocate more government spending on infrastructure to attract businesses clash with those having an ideological preference for laissez-faire markets.

Candidates within each party search for and exploit the shifting alliances within their party’s voters. Challenges to incumbents emerge not from the other party but from a primary election by a candidate in their own party. Primary elections attract only a small percent of party faithful whose political passion gives their small numbers a lot of leverage within the party. Fringe candidates with less funding can appeal to special interest groups to further an agenda with a dedicated party base. A candidate can appeal to a single-issue like abortion, immigration, or project a no-nonsense, get-tough persona and attack an incumbent who compromised on a piece of legislation. A Representative must learn to manage different sets of alliances: those in their district and state, and those in Washington. Next week, I will look at several Representatives and how they have navigated relationships of political power within their party.

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Photo by Ryan Noeker on Unsplash

Expectations and Elections

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June 23, 2024

by Stephen Stofka

This week’s letter begins a series on the shaping of Americans’ expectations by the election system. The structure of U.S. political institutions and election rules favor a two-party system that channels voter choice and identification. In this system there are unlikely alliances as voters are corralled into one of two political pens. Voters may feel like the patrons of the Olympia Restaurant, whose meal preferences were bluntly diverted by John Belushi to the only meal choice the restaurant served – cheeseburgers, chips and Pepsi (1978 SNL YouTube clip).  Despite an election cycle that is far longer than those in Parliamentary democracies, voters have less choice, and it is no surprise that average turnout in a U.S. Presidential election is only 60%. In a 2001 election in the U.K. that same percentage of turnout was a hundred year low for the Brits (Clark 2021). In America, party platforms and policy aims are as immaterial as the menu items at the Olympia Restaurant.

The U.S. was set up as a republic of thirteen colonies for their mutual benefit as stated in the Preamble to the Constitution. It is those colonies, now numbering fifty states, who elect the President through the Electoral College. The College was an arcane compromise between those who favored a popular vote and those who wanted the state legislatures to elect the President. The Federalists at the Constitutional Convention hoped that the Electoral College would act as buffer between public passion and the power of the Presidency. At the Constitutional Convention, the Antifederalists objected to the Electoral College but could not offer a more acceptable alternative (Klarman, 2016, p. 367). They argued that a majority of electors was unlikely in a nation of such diverse interests and most Presidential elections would be decided in the House, effectively sidelining the public voice. Their fears were confirmed in the 1800 and 1824 elections.

In each state, the two parties choose a slate of electors for their Presidential candidate. A vote for a candidate is a vote for that candidate’s electors, not the President. In most states, the candidate that gets the most votes in that state gets awarded all of that state’s electors, a winner-take-all system. A Presidential election is a composite of fifty elections that rewards each party for incremental gains as a path to national power. Each party tries to control a state legislature, which constructs the districts within the state and writes some election rules that exclude certain people from voting. Many voting districts are gerrymandered to ensure victory for the party who draws the electoral map (O’Neil et al., 2018, 114). The party in power partitions the voters to maintain the party’s power in the state. Thus, the two parties curb any but the most incremental changes in political power.

Control of a state legislature gives a party greater power in choosing a President. The Constitution gives each state a lot of discretion in the conduct of their elections for national office. Article 1, Section 4 states:

The Times, Places and Manner of holding Elections for Senators and Representatives, shall be prescribed in each State by the Legislature thereof; but the Congress may at any time by Law make or alter such Regulations, except as to the Places of chusing [sic] Senators.

However, the Constitution makes a special provision for a Presidential election. Article II, Section 1 states:

The Congress may determine the Time of chusing[sic] the Electors, and the Day on which they shall give their Votes; which Day shall be the same throughout the United States.

The word “may” indicates an optional power for Congress, not the specific duty conveyed by the word “shall.” May appears only 33 times in the Constitution while shall appears 192 times. This careful wording acknowledged a certain degree of state autonomy even in Presidential elections.

The contentious 2000 Presidential election first introduced the terminology red states and blue states to refer to those states which were reliably Republican or Democrat, respectively. The phrase has become so popular and often used that it seems decades if not centuries old. There are twenty reliably red states, twenty reliably blue states and ten states that lean toward one of the parties or are toss ups. The concerns, interests and perspective of a Democrat voter in a red state are effectively silenced. The same for a Republican voter in a blue state. Voters are like the crowd at a football game. They do not control each team’s strategies or the rules of the game. The framers constructed a system that separates political power and fosters incremental policymaking. There are no “Holy Mary” passes, only a grinding ground game to further the progress of one’s policy goals. Only special interest groups have the ear of the leaders on each political team and are able to achieve their objectives (O’Neil et al., 2018, 125). Marginalized by the two parties, many voters become disinterested, and the control of power becomes increasingly consolidated in a small number of political party operatives and special interests.

That undemocratic result is by design. In a long election cycle, a smaller pool of dependable voters makes the marketing of candidates and ideas less expensive. There simply is not enough money to fund many closely contested state elections so the parties try to construct voting districts that minimize those types of elections. In a two-party system that limits choice, each party appeals to alliances of socioeconomic status, alliances of regional interests, alliances by tradition and those by race, or at least a shared history of grievance. The different expectations and anticipations of the voters within those alliances can make those connections fragile. More on that next week.

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Photo by Erik Mclean on Unsplash

Keywords: Constitution, Electoral College, election, red states, blue states

Clark, D. 2021. β€œVoter Turnout in the UK 1918-2019.” Statista. https://www.statista.com/statistics/1050929/voter-turnout-in-the-uk/ (July 9, 2021).

Klarman, Michael J. 2018. The Framers’ Coup: The Making of the United States Constitution. New York, NY: Oxford University Press.

O’Neil, Patrick H., Karl J. Fields, and Donald Share. 2018. Cases in Comparative Politics. 6th ed. New York: W.W. Norton & Company.

Expectations and Anticipations

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June 16, 2024

This week’s letter continues my study of expectations, focusing on the political aspect. While some economists have treated expectation and anticipation as synonyms (the Stockholm school, for one), I want to distinguish between the two. Expectation is planning for or projecting into the future from an observation point in the present. Anticipation is visionary, an imaginative leap into the future in which some event or state has already happened. Anticipation is intuitive; expectation is calculating.

Anticipation invokes our identity and biases as well as our imagination. Political campaigns often target our sense of anticipation with negative advertising that impugns the candidate, then implies that a vote for such a character is an association with that candidate. Imagine how bad things would be if such a person were elected. Do we really want to be associated with someone like that? At a 2008 Presidential debate between Republican candidate John McCain and Democratic candidate Barack Obama, McCain defended Obama’s character against the innuendo spread by right wing TV and talk radio personalities. Much as we deplore negative political advertising, it is effective.

In the game of chess, each player strategizes to take the other’s king. Getting to the other side of the board first does not win the game. One achieves victory by the opponent’s loss. Elections like those in the U.S. are similar to baseball or football. Preventing the opposing team from scoring will not win the game. The victorious team must also make a score. The winner must get more points than the loser, a typical characteristic of a race, which is why our type of elections are called first past the post voting. What makes an election different than a 100-yard dash are the battle tactics employed to weaken an opponent’s efforts to score votes. Successful campaigns strive to get there first while persuading voters to vote NO on their opponent. Campaigns target two separate processes we use to make choices.

One axiom of rational choice theory in economics is a completeness of preferences – that people are able to weigh the costs and benefits of two options and choose the option that maximizes their self interest. We choose an option that provides what we think will give us the most utility. Yes, we make mistakes, but the errors are random. Behavioral economists have challenged the assumption that our choices are rational, pointing out biases that introduce systemic, not random, error in our choices. Losses have a greater impact on our senses than equal gains. Options may be too complex to evaluate fully before making a choice, so we rely on instinct.

 In Chapter 8 of his book, Optimally Irrational, Lionel Page (2023) discusses the debate and presents several examples that test the axiom. Given two grocery lists, could you pick the best option? Consider there might be twenty or more items on the list and a grocery store carries thousands of items. How could any person decide the best option? This past week, after checking out my groceries, I picked up what I thought was the receipt that had fallen out of my pocket. With a glance, I knew it was not mine because there were a few items on the list that I would never buy. I realized then that I could choose between two random grocery lists in less than a minute. I would scan the list for things that I definitely did not like or want. The list that had the fewest of those would be my choice.

When we do have difficulty making choices, it is because we are trying to choose the best, not the worst, option. Page cited (p. 101) an episode of the Big Bang Theory where Sheldon had difficulty choosing between two computer game consoles. He had approached the problem in a very analytical manner typical of Sheldon and was unable to choose. The shortcut, or heuristic, of decision-making that we use in our daily lives is not finding the best, but establishing the worst of two options. We know our dislikes more than our likes because our dislikes amplify the cost of our decisions, helping us choose the cheaper option with less deliberation. Secondly, identifying the worst alternative makes it more probable that we can live with our decision.

A successful political campaign structures its rhetoric to take advantage of this shortcut in decision making. Just before the 1980 election, candidate Ronald Reagan posed a question to President Carter at an October debate: Are you better off than you were four years ago? Despite the word “better” in the question, this was an “identify and reject the worst” choice using both rational expectations and more imaginative anticipations. On the one hand were the empirical realities of high inflation and unemployment, and the energy shortages that voters had experienced during Carter’s term. Voters could form expectations based on that data. Reagan’s term as Governor of California during the 1960s gave voters some basis to form a rational expectation of a Reagan term. However, much was left to voters’ imaginations to construct a post-hoc, or after the fact vision of a Reagan term. This was the anticipation instinct at work. The question helped turn a Β close race into a landslide victory for Reagan.

Some voters may not have a clearly defined worst or judge two candidates to be equally worse. Each may have one or two repulsive personal characteristics, political alliances or policy stances. To appeal to those voters, a political campaign offers hope that their candidate will maximize a voter’s income, personal freedom, autonomy or other circumstance like the health of the community a voter lives in. The negative approach targets the cost calculation that voters make. The positive approach appeals to the benefit calculation, but the negative approach is the more powerful. The disadvantage of the negative approach is that it can persuade voters to abstain from voting. In a national campaign for President, a voter’s abstention is neutral, but a lack of turnout can be a decisive factor in local races where a small number of voters can be the tipping point of a political victory.

I hope I have made a clear distinction between expectations and anticipations. When a person stands in the present and plans ahead for some state or event, she is expecting. When a person stands in an imagined future and looks back at an event, she is anticipating. I will take a closer look at the unintentional political alliances between voters as a result of the symbiosis between expectations and anticipations.

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Photo by Ahmed Almakhzanji on Unsplash

Keywords: campaign, election, choice, anticipation, expectation

Page, L. (2023). Optimally irrational: The good reasons we behave the way we do. Cambridge University Press.

Key Expectations

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June 9, 2024

by Stephen Stofka

This week’s letter continues my exploration of the role of expectations. They coordinate the supply, demand and price relationships that form the web of our economic and financial lives. They shape our voting patterns, and alter our behavior in interactions with others. If we expect a police officer to be hostile, we are defensive. That reaction will affect the behavior of the officer, increasing the chance that the encounter will be hostile. Expectations cause us to behave in ways that confirm and amplify our expectations, aggravating undesirable circumstances.

Expectations and yearnings act symbiotically within us but there is a distinction between the two. Expectations are a calculation; yearnings are a desire. “I think that” is an expectation. “I hope that” is a yearning. A woman may yearn to have a child, but she expects to have a child within a period of time. A yearning knows no time or logic. We expect a certain range of compensation for the type of work we do, our skill level and experience. Business coaches encourage people to visualize and enhance their good attributes to raise those expectations. Business owners expect their capital to earn a certain percentage of profit as compensation for the risk, planning and skill that a successful business requires.

Consumers expect a certain range of prices for many frequently bought goods and services. The price of meat may be more or less than average in a week, but the price will not be $100 a pound for ground beef. We may have no price anchor for infrequent purchases like replacing a hot water heater. A few hundred dollars or a few thousand? A search in a browser can help with an average price of approximately $2100 to help a homeowner evaluate quotes from a plumbing contractor.

In the U.S., the pricing of medical care is treated as a catastrophic event like a house fire. The connection between price and medical care has been cut so that patients may not know beforehand the price of a procedure. A browser search for the cost of a colonoscopy indicates an average cost of $2200, close to that of a hot water heater, coincidentally, but medical providers do not quote a price. Prices are negotiated between health insurance companies and a network of medical providers. The negotiated price may be a fifth of the stated list price. If patients have health insurance, the only price visible to them is a co-pay. The prospect of higher medical costs next year does not incentivize us to seek care now at a lower price. Colonoscopy prices going up soon? Let me book one now! However, as costs increase, workers negotiate for better benefit packages that cover the anticipated higher costs.

In our economy, workers play a dual role of producer and consumer. The monthly labor report and retail sales report captures the importance of these roles, and the release of these reports move markets. In the core labor force age range of 25 to 54, four out of five people are working or looking for work, according to the latest labor report. The largest generation in this demographic are the Millennials, born between 1981 and 1996. They produce the most and buy the most so their expectations steer the economy. Job openings as a percent of total employment indicate a historically robust labor market. Recent reports indicate that openings are returning to pre-pandemic levels.

Job openings as a percent of total non-farm employment

Despite the strong demand for labor, post-pandemic inflation has taken a bite out of gains in median earnings. Biden assumed office as earnings gains turned negative. Despite legislation meant to promote investment and support the labor market – the Inflation Reduction Act – the decline in real earnings did not turn positive until 2023.

Real earnings equals real purchasing power. Late Millennials reaching their early thirties expected to be able to settle down and buy a house. Older Millennials in their forties who expected to trade up to a different home are frustrated by high home prices and interest rates. Political power in our system is captured by the interests of older voters, particularly the Boomers. Less than one out of four in this generation is working (FRED series here). They want to reduce their tax costs, and preserve or enhance the government benefits they feel they have earned after a lifetime of working.

This week, David Leonhardt, editor of the N.Y. Times Morning Newsletter, pointed out a poll indicating strong support for many policies initiated by the Biden administration. Most of the public’s attention is directed to controversial issues like immigration, the war in Gaza and American support for Ukraine in their continuing war against Russia’s invasion. The pandemic focused the public’s attention on Trump’s chaotic governing style. His behavior defied expectations and his supporters became accustomed to excusing or rationalizing his actions. A majority voted for Biden as a return to normalcy in the recovery from the pandemic.

People vote their expectations, and those expectations strongly influence voters’ assessments of the economy even before a candidate has taken office. A candidate needs to offer a clear set of new expectations that manifest the yearnings of a majority of voters. Has either candidate made the connection between voter expectations and yearnings? Next week I will look more closely at the political aspect of expectations.

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Photo by Jan Tinneberg on Unsplash

Keywords: prices, growth, earnings, inflation

Invisible Expectations

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June 2, 2024

by Stephen Stofka

This week’s letter continues a topic from last week, our expectations of inflation. The high inflation of the 1970s prompted a lot of debate on this topic, and I will try to cover a portion of those ideas. Hypotheses regarding the formation of expectations influence monetary policy and the manner in which the Fed raises interest rates. Different policy approaches reach across the country into the pocketbooks of many Americans. They can mean the loss of many jobs or few jobs, or the viability of buying a home.

The University of Michigan conducts a monthly survey of consumer sentiment in a rotating sample among 500 participants. Respondents are asked to estimate the rate of inflation for the next twelve months (see here, p. 5). Inflation is a rise in the average price of all goods but in casual conversation, we often use the term loosely to refer to a rise in prices of the goods and services that have the most impact on our lives. Each of our estimates are biased but an average of many estimates should approximate a comprehensive survey of the prices of many goods. This BBC five-minute video explains this phenomenon known as The Wisdom of the Crowd when many people try to estimate the number of jelly beans in a mason jar.

The blue line in the graph below is the headline CPI that tracks a basket of goods and excludes expenses like the employer portion of health care insurance. The Fed pays more attention to the PCEPI, the green line in the graph below. That methodology is based on actual expenditures in various sectors of the economy, including employer paid health insurance. Notice how closely the average estimates of inflation approximate this broad measure of price movement. In the April 2024 survey, expectations averaged 3.2%, a big decrease from over 5% in 2022 but a slight rise from 2.9% in March.

How do we form inflation expectations? There are two hypotheses, and they are distinguished by how errors occur in our expectations. Adaptive expectations was a predominant hypothesis until the 1970s. It holds that we revise our forecasts up when actual inflation is higher than we expected, and down when inflation data indicates that our forecast was too high (Blanchard, 2017). Imagine that we are offered a discount at the doctor’s office if we guess our weight within three pounds. We base our guess on a previous weight reading. If it is too low, we lose our discount so the next time we revise our guess higher. Under this hypothesis, our expectations are very much guided by past experience and our forecast errors are systemic. To tame high inflation, monetary policy must act like a shock that induces a recession and alters the expectations of investors and consumers.

In August 1979, during the Carter administration, Paul Volker assumed the position of Fed chair. In October, the Fed raised interest rates 1.5%, then lowered by a half-percent in November, then raised them again by a half-percent in December. In those three months, sales of new one-family homes (HSN1F) dropped 25%. A few months later, in the spring of 1980, came another interest rate shock of a 3.5% increase over two months and new one-family homes sank by 38%. They did not begin to recover until the spring of 1982. This cattle prod approach to taming expectations was influenced by the adaptive expectations hypothesis.

Statistical tests done in the early to mid-1970s showed that we paid much more attention to ongoing conditions than previously thought. This contradicted the notion that our expectations relied mostly on past experience. Two economists, Robert Lucas and Thomas Sargent presented a rational expectations hypothesis claiming that we form the best inflation forecast we can with the information available to us. Rational does not mean perfect. Errors in our forecasts are random and arise from unseen shocks (Humphrey, 1985). The critique against this hypothesis was that people were too naΓ―ve or uninformed to form rational expectations. Information frictions blurred the distinction between rational and non-rational (Angeletos et al, 2021).

 Over the past several decades, the rational expectations hypothesis has guided policymaking at the Fed. If the Fed presents a convincing policy commitment to steer inflation toward a particular target, investors will change their behavior in accordance with their belief in the Fed’s commitment. Economist Roger Farmer (2010) has called them self-fulfilling beliefs and devotes a section of his book to rational expectations. Under this regime, the Fed uses steady, incremental rate increases and consistent policy statements to “corral” expectations like a trained sheepdog persistently badgering a flock of sheep to guide them into a holding area. By guiding expectations, monetary policy can tame high inflation without necessarily producing a recession. This has been dubbed a soft landing.

In the spring of 2022, the Fed under Chairman Jerome Powell raised rates a half percent a month, a steady rate to let everyone know that the Fed was serious. From the spring of 2022, the number of new one-family homes did not fall. That was the rational expectations hypothesis at work. The Federal Reserve as sheepdog. As with any comparison, there are a number of other factors. My point here is that ideas about people’s motivations and behavior make a concrete difference in the lives of ordinary people.

We respond to high inflation with behavior that can exacerbate inflation. Next week I will look at several scenarios that illustrate why the Fed is concerned about managing consumer and investor expectations.

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Photo by Hassaan Here on Unsplash

Keywords: housing, interest rates, monetary policy, adaptive expectations, rational expectations, inflation

Angeletos, G.-M., Huo, Z., & Sastry, K. A. (2021). Imperfect macroeconomic expectations: Evidence and theory. NBER Macroeconomics Annual, 35, 1–86. https://doi.org/10.1086/712313

Blanchard, O. (2017). Macroeconomics (Seventh ed.). Boston, MA: Pearson Education. p. 337. This is an intermediate economics textbook.

Farmer, R. E. A. (2010). How the economy works: Confidence, crashes and self-fulfilling prophecies. Oxford University Press. This book contains succinct descriptions of various economic theories that have influenced policy and is aimed toward the general reader.

Humphrey, Thomas M., The Early History of the Phillips Curve (1985). Economic Review, vol. 71, no. 5, September/October 1985, pp. 17-24, Available at SSRN: https://ssrn.com/abstract=2118883

Cause and Effect

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May 26, 2024

by Stephen Stofka

This week’s letter is about the causes of inflation. Inflation can be easily described as a mismatch between supply and demand but that is a tautology that does not explain how the mismatch occurred. For hundreds of years, scholars and academics have identified various components of inflation’s causal web but identifying a primary cause has inspired enthusiastic debate. In the past century, economists have built sophisticated mathematical models which failed to predict a subsequent episode of inflation or predicted an inflation that did not occur. Economic models predicted that large government support during the financial crisis fifteen years ago would lead to higher inflation. It did not. Some economists were surprised at the extent and strength of the inflationary surge following the pandemic. In hindsight, turning off the world’s economic supply engine for even a short time was likely to have a strong effect on prices.

In The Power of Gold, Peter Bernstein (2000) recounts the causes that sixteenth century scholars gave for the persistent inflation in Europe during the 1500s. Those factors included “the decline of agriculture, ruinous taxation, depopulation, market manipulation, high labor costs, vagrancy, luxury and the machination of businessmen” (p. 191). Five hundred years later, most factors are relevant today in an altered form. With more sophisticated analytical tools, economists have developed a better understanding of these causal influences but that understanding has not led to better inflation forecasting. These factors can be grouped into those that affect supply or demand. Missing from that list was war, a common cause of inflation that distorts both supply and demand.

Prior to the severe cooling of the Little Ice Age in the 1600s, England and northwest Europe experienced a cooler climate that affected harvests. In an economy that relied mostly on agriculture, a poor harvest, or decline in agriculture was a supply constraint that pushed up prices. The demand / supply relationship is a fraction that helps explain a change in price. A lower supply, the denominator in that fraction, equals a higher price. Repeated waves of the plague and other general pandemics led to a depopulation that reduced the work force and pushed up the subsistence wages paid to workers. Employment in the U.K. has still not recovered from pre-pandemic levels, contributing to slightly higher inflation in the U.K. compared to the U.S.

High labor costs are the essence of a cost-push theory of inflation. When there is not enough supply of labor, workers are able to command higher wages. In many businesses, labor is an employer’s highest cost. Because employers markup all production costs, that markup increases the rise in prices. If employees get an extra $1 wage and the employer marks it up 50% to cover operating expenses, required taxes, fixed investment and profit, then the price will rise $1.50. The additional wage income will increase demand, resulting in a wage-price spiral that further exacerbates inflation. Any policy that reduces the supply of labor can be included in a cost-push theory of inflation.

Vagrancy, or homelessness, was a new phenomenon in the 16th century as Europe emerged from the feudal system in which workers were bound to the properties they cultivated. Policies that tolerated idleness of any sort reduced the work force and gave workers more bargaining power. Scholars of that century would be puzzled by modern day unemployment insurance which “rewards” workers for idleness. The mathematics of probability and risk that makes any insurance program feasible was barely in its infancy. By the late 17th century, Blaise Pascal and Pierre de Fermat had developed probability analysis, giving pools of underwriters gathered in coffee houses near London’s Royal Exchange the mathematical tools to sell insurance policies on many risky events (Bernstein, 1996, 63, 90).

Ruinous taxation consisted of import taxes and the debasement of hard metal currencies by the sovereign as a substitute for taxation. Import taxes on necessary commodities increased production costs, creating a cost-push effect. To repay debts incurred during war campaigns, rulers debased the currency by mixing base metals with gold or silver. In the 4th century B.C., Dionysius of Syracuse in Sicily had all the coins in his kingdom restamped to double their value so he could pay his debts (Bernstein, 2000, 48). Monetarists claim that an excess supply of money is the root cause of inflation. The economist Milton Friedman, never one to equivocate, stated flatly that inflation was “always and everywhere a monetary phenomenon.” In the Wealth of Nations, Smith (1776; 2009) noted that gold discoveries in the Americas had driven prices higher in England. A higher supply of money of any form will increase demand so this root cause is a subset of demand-pull theories of inflation.

Popular and scholarly opinion often points an accusing finger at the business class, whose conspiratorial machinations are thought to be responsible for rising prices. Historian Barbara Tuchman (1978, 163-165) described the power that merchants had acquired as the Third Estate under feudalism in 14th century France. Because many merchants were free citizens of a town and not subject to the rule of a noble, they enjoyed wealth and privileges like that of nobles, and at the expense of the workers who regarded them with scorn and envy. In Part 1, Chapter 10 of the Wealth of Nations, Smith wrote “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” Responding to the global inflation following the Covid-19 pandemic, some op-ed writers and Twitter threads were convinced that collusion by business interests was the primary cause of the inflation.

The reasoning and analysis by thinkers of centuries past did not include the role of expectations in fostering and feeding inflation. Expectations are a key part of some prominent models because supply and demand operate on different time scales. The companies that make up the supply chain must anticipate the level of demand for a product or service before the demand manifests. Each year, the risk of being wrong increases in an economy marked by technological change and rapidly evolving tastes. Inflationary expectations needs a bit more space and will have to wait until next week. Have a good holiday weekend!

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Photo by Elias Kauerhof on Unsplash

Keywords: expectations, money, taxation, unemployment, supply, demand, cost-push, demand-pull

Bernstein, P. L. (1998). Against the Gods, the Remarkable Story of Risk. John Wiley & Sons.

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

Tuchman, B. W. (1978). A Distant Mirror: The calamitous 14th Century. Alfred A. Knopf.

Price Waves

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May 19, 2024

by Stephen Stofka

This week’s letter is about our perception of inflation and the uncomfortable feelings we experience at higher-than-expected changes in prices. We notice price changes relative to the goods and services we experience and purchase in our daily lives. If the water is rising under our boat, we reason that the water is rising under all boats. We may have a good understanding of local conditions but a less accurate picture of underlying trends in a national economy. Economists understand the term on a macro level, when most people experience rising prices in the bundle of goods they buy. Inflation is a rise in the average of all prices for consumer purchases and often reflects price changes throughout the supply chain. To gather this information, the Bureau of Labor Statistics and the Census Bureau interview households and businesses from around the country each month. The monthly report on inflation may confirm our intuitive sense of changing prices or it may challenge our own appraisal. With all those resources and data, why do economists argue over the causes of inflation? In either case, we experience high inflation as a loss of purchasing power, and that sense of loss is magnified by the particular attention we pay to losses.

The Federal Reserve and most central banks around the world try to keep inflation at about 2% per year. That rate is thought to compensate for measurement error and a rise in the quality of goods. Our tendency to ignore small changes is evident in other areas of our lives. The 410-mile journey west on I-70 through Kansas is almost flat, yet in that span there is gain in elevation of 3258 feet (calculations in notes). Expectations play a key role in the decisions that people and companies make. Central bankers want small changes in the average price to play a negligible role in those decisions. Claude Shannon wrote that if what happens tomorrow is what happened today, then there is no new information. Our attention is piqued by news, or new information, so that we tend to pay attention to deviations from that average. The average becomes our environment. Statisticians recapture this human tendency when they standardize or normalize an average by setting it to 0, called a z-score.

We integrate quality improvements into our expectations so that gradual improvements are little noticed. In 35 years a 2% annual improvement in the quality of a product or service will result in a doubling of its quality. The reliability, safety, efficiency and performance of cars today are vastly superior to the cars in the 1970s. In 2020, the price of a new car was about 50% higher than in 1980, an annual price increase of less than 2%. I will leave the series identifier in the notes.

The quality of cars has increased far more than the increase in price. During that time, control of many systems within a car transitioned from mechanical control to precise electronic control, improving fuel efficiency. The quality of tires improved, reducing the number of flats that forces a driver to the side of the road. Air conditioners perform better and do not need to be recharged every few years because the seals leak. In 1980, the design of a car transferred too much of the impact of a crash to the driver. Today, a car is designed to absorb and distribute those physical forces. Seat belts protect the passengers from being thrown about during an accident, while front and side airbags cushion a violent change in direction. Quality has improved by at least twice the 50% increase in price.

During the high inflation of the 1970s, the real weekly earnings of wage and salary workers (LES1252881600) fell, as shown in the chart below. The term real means inflation-adjusted. In an age when families paid their monthly bills by check or money order, rapidly increasing costs sometimes meant that there was not enough money to pay all the bills. Although the recent surge in inflation has invited comparisons with the 1970s, workers’ earnings have outpaced inflation in this past decade and shown real gains.

If wage gains are rising faster than prices, why do consumer sentiment surveys not reflect this economic reality? Economist Paul Krugman had a short and helpful op-ed on the sentiment gap in recent surveys. Consumer purchasing power has increased since the pandemic, but consumer sentiment has declined by an amount comparable to the Great Recession in 2007-2009 when purchasing power decreased. He shows evidence from other surveys that one’s political party affiliation is strongly correlated with changes in consumer sentiment. People who usually vote Republican are optimistic about the economy when a Republican is President. Democrats express positive feelings when a Democrat is in the White House.

Political alliances are easily exploited via social media, whose use has skyrocketed since the Great Recession began at the end of 2007. Negative news and negative views proliferate on social media because we have a tendency to pay more attention to bad news. In the newspaper business, the rule was “If it bleeds, it leads.” Taking advantage of this human tendency, anonymous accounts on social media post total fabrications in order to get views. Higher views earn more revenue from ad placement, turning bad news into good news for the poster. News that gives the reader a sense of uplift or empowerment can be treated as “Pollyannish.” What other factors might account for the discrepancy between sentiment and reality? One aspect might be a rising standard of living.

Just as the quality of cars has increased, so has our standard of living in general. Families today are used to a higher standard with more conveniences than was typical fifty years ago. More conveniences equals more bills. These include monthly cell phone costs, TV and cable subscriptions, and higher electrical costs to run all the new appliances, computers and entertainment devices we have today. Some homeowners may experience fees for trash pickup or parking fees that were not typical in decades past.

Higher prices feel like a loss to us, and we pay attention to losses more than we do the wage gains. Economists Daniel Kahneman and Amos Tversky (1977) invented behavioral economics when they presented compelling evidence that our decisions are not always rational, that we weigh gains and losses on different scales. This challenged the conventional view that people’s choices were fundamentally rational, that bad decisions or poor choices were due to errors in judgment or a lack of information. Kahneman and Tversky asserted that irrational decisions were systematic rather than random error. Our tendency to measure gains and losses with different yardsticks can help explain why we become accustomed to improvements in our lives so that they escape our attention. Losses challenge our survival more than wins so we give losses our greater attention.

We survive by reacting promptly to threats. Children are taught to curb this natural impulse, to use their words, not their fists when responding to the behavior of other young children. We do not hit the butcher in the grocery store because the price of a steak has gone up 20%, but we might feel a bit of anger or resentment toward some nameless cause of the higher price. Even though inflation is part of our economic environment, it is not like the weather, we reason. Human decisions cause inflation so someone is responsible. However, the cause is more likely to be a composite of human behavior, of natural biases in how we process and react to information. That would make each episode of high inflation a unique blend of circumstance and policy decisions unlikely to be repeated in the future.

Economists, ever on a quest to find the Holy Grail, to understand the underlying process of high inflation, cannot admit the singularity of each episode. Next week, I will explore some of the factors that contribute to episodes of high inflation. Until then, watch Monty Python and the Holy Grail.

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Photo by Tadeu Jnr on Unsplash

Keywords: monetary policy, Prospect Theory, inflation

Bernstein, P. L. (1998). Against the Gods. John Wiley & Sons. In Chapter 16, Bernstein explores the ideas in Prospect Theory proposed by Kahneman and Tversky.

Kahneman, D., & Tversky, A. (1977). Prospect Theory. an Analysis of Decision Making under Risk. https://doi.org/10.21236/ada045771.

The index on new car prices is https://fred.stlouisfed.org/series/CUUR0000SETA01 The series identifier for the used car price index is CUSR0000SETA02.

Journey through Kansas: Kansas City on the eastern border is 909′ in elevation. Burlington, CO, at the western border of Kansas is 4167′, a rise of 3258′, or 0.617 miles. Dividing Hays, KS on the west side of Kansas is 2018′, a rise of 1000 feet. The state is 410 miles wide so the 1000′ gain in elevation is only .05% per mile. The 3000 gain in elevation is .15% per mile, a grade that feels flat to us.

Our Perception of Risk

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May 12, 2024

by Stephen Stofka

This week’s letter is about our perception of investment risk, and the subjective and objective aspects of risk evaluation. Our journey will take us several hundred years in the past and several decades into the future. The triennial survey of consumer finances indicated that less than half of people nearing retirement have $100,000 in liquid financial assets like savings accounts, stocks and bonds. Half of all working households have no savings, leaving them vulnerable to specific circumstances or a general economic shock. In our 20s, retirement looks remote with many years of work ahead of us. As we near retirement, we look in the other direction, to the past, and wish we had saved more. We confront the reality that we feel today’s needs more urgently than tomorrow’s possibilities. A $100 saving has a $100 impact on our current consumption but is only a faint light compared to the many thousands of dollars we will need in the future. We may not understand the underlying mechanism of saving.

We rely on what is visible to our senses to develop a flow of causality. We press on our car’s gas pedal and go faster, convinced that our action is adding more fuel to the engine. What the pedal controls is not fuel, but the air flow leading into the combustion chambers of the engine. The increased flow of fuel occurs in response to the change in air pressure. Prior to the 1980s cars used carburetors and mechanically employed this process called the Bernoulli principle, the idea that faster moving air induces a lower air pressure, a vacuum effect that sucks fuel toward the engine. Today’s fuel injection systems use air flow sensors that direct a computer to adjust the fuel flow. So, what does this have to do with risk?

Bernoulli’s principle is named after Daniel Bernoulli, the son of a noted Swiss mathematician and the nephew of Jacob Bernoulli, a 17th century mathematician who developed foundational concepts in probability like the Law of Large Numbers. Jacob maintained that people perceived risk in two ways. The first was an objective measure, an estimate of the probability of some event. The second was a subjective measure that depended on each person’s wealth, an inverse relationship. The first is visible, like the pressing of a gas pedal. The second is less visible, like the change in air pressure. Imagine that two people agree to flip a fair coin for a $100 bet. Person A has $1000 in her pocket; person B has $200. The loss or gain of $100 represents only 10% of A’s wealth, but 50% of B’s wealth. Even though the chance of winning or losing is the same for each person, they perceive the outcome differently. Peter Bernstein (1998) presents an engaging narrative of Jacob’s ideas in his book Against the Gods. His trilogy of books on the history of investing, risk and gold will inform and entertain interested lay readers.

Jacob may have identified one subjective element in each person’s evaluation of risk, but a person’s stock of wealth is not the only basis for a subjective estimate of risk. There are retired folks with accumulated savings of a million dollars who keep their money in savings accounts or CDs because they perceive the stock and bond markets as risky. A $10,000 loss in the stock market is only 1% of a million-dollar wealth yet some people perceive that loss in absolute dollars, magnifying the effect of a $10,000 loss. They regard the stock and bond markets as different versions of a casino. That same person might give $10,000 to a grandchild for college or to help buy a car, reasoning that there is an exchange of something that a person values for the $10,000. A person has no sense of receiving anything when their stock portfolio shows a $10,000 decrease. The stock market should have to pay an investor for using her investment, not the other way around. Such perceptions are confirmed during crises when the stock market loses 50% of its value.

Is an investment in the stock market like putting a quarter in a slot machine? Another perspective: an investor is like an investment company selling insurance to the stock market. A century of data shows that the probability of a loss in the stock market in any specific year is about 25%, according to an article in Forbes. In 70 years, the SP500 has doubled every seven years on average. An insurance company relies on Jacob Bernoulli’s Law of Large Numbers and diversification to manage risk. An investor, like any insurance company, will experience losses in some years. In last week’s letter (see note below) I wrote about surplus as a key dynamic factor in market transactions. In most years, an investor with a surplus of funds can “sell” those funds to the market and reap a gain.

Like risk, values in the stock market are based on both objective and subjective components. Sales, profits, dividends and efficiency help anchor a stock’s price movements as objective measures of value. Price responds to changes in these variables. Objective measures also include the variation in a company’s stock as a precise measure of uncertainty. There are various less precise but objective measures of economic and financial risk. Subjective measures include an investor’s need for liquidity, the ability to turn an investment into cash without impacting the price. An investor’s wealth can act as a cushion against fear of loss, a subjective measure discussed earlier.

Index funds have grown in popularity because they take advantage of Jacob Bernoulli’s Law of Large Numbers. By owning partial shares in many companies, an investor reduces the risk exposure to the variation in the fortunes of one company. The SEC might open an investigation into the ABC company, or the company loses an important overseas market, or the company reveals that the profit margins on some of its popular products are decreasing. To an index fund investor, a 10% decrease in that company’s stock price may be barely noticeable. The investor still has a risk of a change in general conditions, like a pandemic, but has dramatically reduced the risk of local conditions specific to one company.

Investors in Bitcoin do not act as an insurance fund for Bitcoin companies who mine Bitcoin. The miners have the surplus and are the sellers of Bitcoin. In the secondary market, the sellers of access to the digital currency market are the two dozen or so ETFs that allow investors to buy interest in a fund that owns bitcoin. Price movement is like a tailless kite flying in a breeze, responding mostly to price forecasts, a characteristic of some derivatives markets. The only objective measure of value and risk is the number of Bitcoin in circulation and the reward for mining new Bitcoin. Bitcoin’s price movement has a high volatility greater than 50% because there is little economic activity that anchors the variation in Bitcoin’s price. Despite the high volatility, an asset manager at an ETF fund makes the case for investing a few percent of a portfolio in a bitcoin ETF. As in our earlier example, the loss or gain depends on the current state of one’s savings.

Understanding the two aspects of risk perception, the objective and subjective, can help us manage our personal risk profile. Through research or the advice of a financial consultant we can understand the objective measures of portfolio risk but there are subjective elements unique to our personal history and disposition. The fear of having to be in a long-term care facility may influence our yearning for safety, regardless of our current health. A parent or relative may have had a similar experience and our primary concern is the protection of our portfolio value. We may feel fragile after the loss of our entire savings in a business venture. We can only become comfortable with our apprehensions by becoming familiar with them.

Next week I will look at our perceptions of other significant factors in our lives, particularly inflation.

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Photo by π“΄π“˜π“‘π“š 𝕝𝔸𝕀 on Unsplash

Keywords: stocks, bonds, risk, investment

Bernstein, P. L. (1998). Against the Gods: the Remarkable Story of Risk. John Wiley & Sons.

In last week’s letter I wrote about surplus as a key dynamic factor in market transactions. A seller of a good or service has a surplus which it values less than the buyer. However, the seller’s cost, including opportunity cost, is more than the cost to the buyer. These two ratios of benefit and cost find an equilibrium in the market that depends on the type of good or service and general conditions.

https://etfdb.com/themes/bitcoin-etfs/

https://www.vaneck.com/us/en/blogs/digital-assets/the-investment-case-for-bitcoin/

The Role of Surplus

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May 5, 2024

by Stephen Stofka

This week’s letter begins a series of subjects related to income and consumption. I will start with income, how we get the money to buy the goods and services we consume. A first-year course in microeconomics conveniently and simplistically divides the world into consumers and producers. In their textbook titled Microeconomics, Krugman and Wells (2018) explore the subject of labor as a factor of production in Chapter 19 at the end of the book. Since most of us work for forty to fifty years, the subject could be introduced to students in one of the early chapters. John Maynard Keynes, schooled in neoclassical analysis as a student of Alfred Marshall, criticized this framework because it ignored many of the flows in an economy. In a modern economy, we implement our choices with an exchange of money. Where did the money come from?

An entrepreneurial attitude to work is this: we either work for money or money works for us. If we work for money, money is our boss. If money works for us, we have a responsibility to direct it and manage it well. In that framework, money is a factor of production, the capital we use to realize goals for ourselves and our family. I was first introduced to this notion of money working for me when I was a child, and my folks opened up a savings account for me. I was amazed that my birthday money did chores just like a real person and got an allowance called interest. As the money got bigger, it worked harder and got a bigger allowance. What an amazing system!

Adam Smith, the first economist, analyzed the exchange of goods and money as a system. In the Wealth of Nations, Smith (1776; 2009) emphasized that the key to a developing economy was the subdivision of tasks to become more productive. Higher productivity created a surplus of a good or service so that the producer was willing to trade with someone else who wanted that good or service. In Chapters 2, 3, and 4 of Part 1 he repeats the point that this imbalance of supply and demand provides the energy to an economic system. In an often-cited example, Smith recounted the efficient production of a pin factory where each worker is assigned just one step in the production of a pin. An economy grows as the division of labor becomes more complex.

In Part 5 of the book, Smith predicted that the increasing division of labor would lead to greater prosperity but unevenly distributed. “For one very rich man there must be at least five hundred poor,” he wrote. Such inequality could lead to violent anarchy because the “avarice and ambitions in the rich” clashed with the “hatred of labour and the love of present ease and enjoyment” by the poor. A sovereign government had a responsibility to keep order and protect people from each other. Secondly, it should provide public works and institutions that distributed the benefits of a growing economy to more people. A road or port does not provide enough benefit to any one person or group to justify its expense, but such public projects raise the productivity and standard of living for many. Smith saw this improved public welfare and private security as key features that distinguished England from less-developed economies. To Smith, government was an intermediary between parties just as money was an intermediary of exchange.

A cost-benefit analysis of an exchange of surplus reveals some interesting ratios. A seller with a surplus of a good values the benefit from the good less than the buyer does. On the other hand, the cost to the seller includes the opportunity cost of not producing something which would earn a higher price from a buyer. The commitment of capital or time to producing a good or service requires a choice between alternative uses of that capital or time (see notes for measurement of opportunity costs). Presumably, the ratio of benefits equals the ratio of costs. If not, there is less motivation for exchange between seller and buyer. A less developed economy like Brazil generates less surplus so there is less inducement to make economic trades and money circulates at less than a third of the speed that it does in the U.S. (Notes).

The concept of surplus helps us distinguish different types of exchange. When two people trade services, they trade their labor, which has no surplus as such. To barter their labor, buyer and seller must match the type of good or service to be exchanged. To each party, the benefit must equal the cost, a hindrance to exchange. In an economy promoting the production of surplus, the benefit and cost are unequal to each party, but the ratios of benefits and costs are equal. Matching is easier and there are more trades.

Can we apply this analysis to the exchange of securities? The seller of a security like Apple’s stock does not have a surplus because she produces Apple stock for sale. She is motivated to sell because she thinks it might go down in price, and the benefit she receives from the sale is greater than the cost if she held onto the stock. The buyer thinks the security might go up in price, so his benefit is also greater than the cost. The key to this transaction is the broker who produces trades for sale, the matching of security transactions. The benefits to the buyer and seller of the stock are greater than the benefit to the broker. The broker’s cost, including the opportunity cost, is greater than either the buyer or seller of the security because the broker could always make more in commission by facilitating a different type of trade.

A year ago, I spent a few months studying the dynamics of a developing country in Africa. Because there was a lack of surplus in some parts of the economy, I came to appreciate the key role that surplus plays in our lives. In the coming weeks, I will try to understand various aspects of our working lives through these ratios of seller and buyer costs and benefits and how those ratios are influenced by surplus.

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Photo by Adam Jang on Unsplash

Keywords: securities, stock, cost, benefit

Krugman, P. R., & Wells, R. (2018). Microeconomics (Fifth). Macmillan education.

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

Brazil Money Velocity: In the third quarter of 2023, M1 velocity for Brazil was .35, meaning that money circulates a rate that is a third of GDP output. The same velocity in the U.S. was 1.5, more than four times the rate. Brazil M1 measure is MANMM101BRM189S. Final demand, a measure similar to GDP, is  BRAPFCEQDSMEI. There was not a current measure of M2, a broader measure of money often used in the U.S. The series for M1 velocity is M1V.

Physics Imbalance: Coincidentally, an imbalance in electron fields causes atoms to bind together in an exchange of electrical charge. Khan Academy has a short explanation with graphics.

Opportunity cost: this is a fundamental concept in economics, yet economists disagree on how it should be measured. In 2012, Potter & Sanders justified four different answers economics graduate students gave to the calculation of opportunity cost found in an introductory economics textbook.

Potter, J., & Sanders, S. (2012). Do economists recognize an opportunity cost when they see one? A dismal performance or an arbitrary concept? Southern Economic Journal, 79(2), 248–256. https://doi.org/10.4284/0038-4038-2011.218