Commercial Mortgages

April 25, 2021

by Steve Stofka

They’re at it again. Thirteen years ago, the financial crisis originated in RMBS, residential mortgage-backed securities. Now banks and investment companies have been packaging CMBS, mortgage-backed loans on office and retail space, not residential, properties. Most of these loans are backed by or facilitated by the Small Business Administration and other government agencies. Who will pick up the tab when some of these loans default because of the pandemic? The same people who picked up the tab for the financial crisis – taxpayers. Even if the direct cost of bailouts is repaid, the loss of economic output and incomes is a crushing blow to many Americans.

Next month, the Federal Reserve will release its semiannual Financial Stability Report a comprehensive examination of the assets and lending of America’s financial institutions. Their last report in November 2020 was based on nine months of data, six months after Covid restrictions began. Concerning the Fed were several trends that were far above their long-term averages.

High yield bonds and investment grade quality bonds were almost double long-term trend averages (Fed, 2020, p. 17). High-yield bonds are issued by companies with low credit quality. Well established companies with good credit issue bonds rated investment grade. These are attractive to pension funds and life insurance companies who need stability to meet their future obligations to policy holders. Many companies took advantage of low interest rates during the Covid crisis. 60% of bank officers reported relaxing their lending standards; that same practice preceded the financial crisis in 2008. Will we eventually learn that commercial property evaluations were overvalued, just as house prices were generously valued before the financial crisis?

Many commercial mortgages are backed by commercial real estate (CRE) and packaged into CMBS, commercial mortgage-backed securities. The Fed noted that “highly rated securities can be produced from a pool of lower-rated underlying assets” (p. 51). This was the same problem with residential mortgages. CMBS are riskier than residential mortgages and delinquencies on these loans have spiked (p. 27). The Fed devoted most of their TALF (below) program in 2020 to CMBS (p. 16). 

Before the election last year, more than 70% of those surveyed by the Fed listed “political uncertainty” as their #1 concern (p. 68). 67% listed corporate defaults, particularly small to medium sized businesses. Respondents were from a wide range of America, from banking to academia. Only 18% of respondents were concerned about CMBS default. Simon Property Group (Ticker: SPG), the largest commercial real estate trust in the U.S. fell by almost 50% last spring. Although it has recovered since then, its stock price is still 20% below pre-pandemic levels.

Who thinks that the market for commercial space, retail and office, will return to pre-pandemic levels? Vacancy rates have improved, but even hot markets like Denver have a 17% direct vacancy rate (Ryan, 2021), near the 18% vacancy rate during the financial crisis, and far above the 14% during a healthy economy. 25% of space in Houston, Dallas and parts of the NY Metro area is vacant.

The stock market is convinced that the economy will come roaring back. In total, investors may be right but I think there will be some painful adjustments in the next year or two. The Covid crisis has diverted the habits of people and companies into new channels, and the market has not priced in that semi-permanent diversion. I would rather not wake up to another morning like that one in September 2008 when we learned that the global financial world was on the brink of disaster. I hope that the Fed report released in a few weeks will show a decrease in some of these troubled areas.

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Photo by John Macdonald on Unsplash

TALF – Term Asset Backed Securities Loan Facility

Federal Reserve System (Fed). (2020 November). Financial Stability Report. Retrieved from https://www.federalreserve.gov/publications/files/financial-stability-report-20201109.pdf. (Page numbers cited in the text are the PDF page numbering, six pages greater than the page numbers in the report).

Ryan, P. (2021, April 20). United States Office Outlook – Q1 2021, JLL Research. Retrieved April 24, 2021, from https://www.us.jll.com/en/trends-and-insights/research/office-market-statistics-trends

The Wrong Medicine

August 23, 2020

by Steve Stofka

During this pandemic, the Federal Reserve has been supportive of the asset markets and the government’s stimulus and relief programs. It’s immediate response was to lower interest rates, a boon for home buyers. This week we learned that home sales had rebounded 25% in July and are up 7% over last year at this time. Low interest rates have benefited homebuyers but penalized savers and pension funds who must generate a current income flow from their savings base.

During the 1930s Depression, the economist John Maynard Keynes argued that, because people want to hoard during a downturn, a central bank should maintain an interest level sufficient to induce people to deposit their money in banks (Keynes, 1936). Government-insured savings accounts helped solve that confidence problem. Keynes’ language and sentence construction are laborious, leading some people to think that Keynes argued for a policy of ultra-low rates during economic declines. He did not. Low interest rates are not a Keynesian solution.

Despite the low rates, the amount of savings has doubled since the financial crisis in September 2008. There is a distinctive change in savings behavior at that important point.

With a savings base of $11 trillion, every 1% decrease in interest rates is a transfer of income of $110 billion from savers to borrowers. Who is the largest borrower? The government. Aren’t low interest rates good for businesses? No, Keynes argued rather unartfully in Chapter 15. Borrowing is a long-term decision, and subject to error. When interest rates are particularly low, like 2%, there is no wiggle room for error in the expectations of businesses who might borrow. For homebuyers, expectations of future business conditions are a small factor.

During an economic decline, people and businesses are guided more by short-term decisions. When interest rates are low like today, banks don’t want to lend because they aren’t confident in the flow of deposits to maintain their liquidity. Banks need that flow of deposits to meet the outflow of money when they make loans (Coppola, 2017). Entrepreneurs are reluctant to borrow for expansion because they are not confident in the accuracy of their long-term expectations. They borrow to pay back more predictable future obligations, particularly current and future stock grants to their key employees. Borrowing money to fund stock grants does not create jobs but helps inflate stock prices.

Keynes badly underestimated the political forces that guide a central bank’s decision making. As it did a decade ago, the Federal Reserve has lowered interest rates to near-zero, the opposite of Keynes’ prescription. Low interest rates do not benefit bank stocks, which have declined by 25% and more. A select group of technology stocks are booming as people consume more digital services at work and play. Borrowing by businesses jumped in response to the CARES act but many businesses kept those borrowed funds liquid to avoid insolvency during this crisis. We can expect slow growth as consumers and businesses continue to make short-term decisions, and asset markets are warped by central bank policy.

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Notes:

Photo by Christina Victoria Craft on Unsplash

Coppola, F. (2017, November 01). Bank Capital And Liquidity: Sorting Out The Muddle. Forbes Magazine. Retrieved August 15, 2020, from https://www.forbes.com/sites/francescoppola/2017/10/31/bank-capital-and-liquidity-sorting-out-the-muddle/

Keynes, J. M. (1936). The general theory of employment interest and money (p. 124). New York, NY: Harcourt, Brace & World.

The Long and Short Run

August 16, 2020

by Steve Stofka

Gold is at an all-time high. Like wheat and other commodities, it pays no interest. Gold’s price moves up or down based on expectations about the value of money used to buy gold. If inflation is expected to increase, the price of gold will go up. Eight years ago, after several rounds of quantitative easing by central banks, gold traders bet that inflation would rise. It didn’t, and the price of gold declined by a third.

Since mid-February, the U.S. central bank has pumped almost $3 trillion of liquidity into the economy (Federal Reserve, 2020). Numbers like that hardly seem real. Let’s look at it another way. The overnight interest rate is so low that it is essentially zero – like gold. People around the world regard U.S. money and Treasury debt as safe assets – like gold. Imagine that the central bank went to Fort Knox, loaded up 1.5 billion troy ounces of gold – about 103 million pounds – in gold coins and dropped them on everyone in the U.S. There are about 190,000 tonnes (2204 lbs./tonne) of gold in the world, a 70-year supply at current production. A helicopter drop of gold would be almost 47,000 tonnes, or 25% of the world supply. It would take five C-5 cargo planes to haul all that.

Milton Friedman was an economist who believed in the quantity theory of money. His model of money and inflation held “inflation is always and everywhere a monetary phenomenon.” If the growth of money was greater than the growth of the economy, inflation resulted. The data from the past decade has refuted this model. Former chairman of the Federal Reserve Ben Bernanke noted that the evidence suggests that economists do not fully understand the causes of inflation (C-Span, 2020, July). He was including himself in that group of economists because he had been an advocate of that model (Fiebiger & LaVoie, 2020).

What has the Federal Reserve and the government done to navigate the difficult path created by this pandemic? Helicopter Money for businesses and consumers. Lots of toilet tissue, so to speak. No reason to hoard, folks. There’s plenty. They have followed the first of John Maynard Keynes’ prescriptions for a downturn. The government should spend money. Why? It is the only economic actor that can make long-term decisions. Everyone else is focused on the short term.  Keynes badly mis-estimated the short-term thinking of politicians, particularly in an election year.

Will the flood of money cause inflation as gold bugs assert? Some point to the recent rise in food prices as evidence of inflationary forces. However, the July Consumer report indicates only a 1% annual rise in prices, half of the Fed’s 2% inflation target. The rise in food prices this spring was probably a temporary phenomenon. It suggests that the Fed is fighting deflation, as Ben Bernanke noted this past April (C-Span, 2020 April).

Since March, government spending has helped millions of American families stay afloat during this pandemic. Congress has gone home without extending unemployment relief and other programs. Many families are being used as election year hostages by both sides. House Democrats put their cards on the table three months ago. Republicans in the Senate and White House have dawdled and delayed. Faced with a chaotic consensus in his own coalition, Senate Majority Leader McConnell has largely abdicated control of the Senate to the White House and the wishy-washy whims of the President.

We return to where we began – gold. It is neither debt, equity nor land. As a commodity, only a small part is used each year. It has been used as a medium of exchange and a store of value. Except for a few years during and after the Civil War, gold held the same price from 1850 until the 1929 Depression – $20.67. In the long run, longer than a person’s retirement, gold is good store of value. In the ninety years since the Great Depression began, the price of gold has grown 100 times. Yet it is still lower than its price in 1980. The U.S. dollar does not hold its value over several decades, but it is predictable in the near-term. In a tumultuous world, predictability is valuable. The dollar has become the new gold.

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Photo by Lucas Benjamin on Unsplash

C-Span. (2020, April 7). Firefighting. Retrieved August 12, 2020, from https://www.c-span.org/video/?471049-1%2Ffirefighting (00:21:15).

C-Span. (2020, July 18). Ben Bernanke and Janet Yellen Testify on COVID-19 Economic Inequities. Retrieved August 12, 2020, from https://www.c-span.org/video/?473950-1%2Fben-bernanke-janet-yellen-testify-covid-19-economic-inequities (01:35:20)

Federal Reserve. (2020, July 29). Recent Balance Sheet Trends. Retrieved August 12, 2020, from https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

Fiebiger, B., & LaVoie, M. (2020, March 4). Helicopter Ben, Monetarism, The New Keynesian Credit View and Loanable Funds. Retrieved August 12, 2020, from https://www.tandfonline.com/doi/abs/10.1080/00213624.2020.1720567?journalCode=mjei20

The Two 10%

August 9, 2020

by Steve Stofka

In the past three months the stock market has been on a tear. The last time we’ve seen such a rise? 1938. People are day trading on the Robinhood platform. Hop aboard the gravy train and party like it’s 1999, near the height of the dot-com bubble.

According to the Federal Reserve, the top half of households in this country own 99% of the stock market. The top 10% own a whopping 87% of the market. So why do many news outlets broadcast updates on the stock market  every hour?

Share of Equity Ownership by Wealth Percentile

A second group of 10% is unemployed, according to the unemployment report released Friday. House Democrats passed a $3 trillion bill in May. Republicans and the White House have been worried that too many Americans are going to get fat and lazy if the federal government continues to support the unemployed with extra benefits. They have fought among themselves about a stimulus package, and 15 Republican Senators – half their caucus – don’t want to do anything more for the American people. The Senators who are up for election this year do want to pass something but want to appear frugal at the same time – a difficult task.  

The richest 10% are doing fine. This week the NY State’s Attorney General announced a suit to terminate the non-profit status of the NRA and dissolve the organization. Their investigation has been going on for more than a year. In September 2019, House Ways and Means Committee member Brad Schneider revealed several allegations against NRA executives (2019). Whether the IRS had already begun an investigation at that time is unclear.  The NRA has paid exorbitant expenses for their executives, including Wayne LaPierre, the public spokesman and VP of the organization. These include homes, yachts, and private jets for them and their families. The executives billed the “expenses” to the NRA’s ad agency, Ackerman McQueen, who then submitted bills with little detail to the NRA, which paid the ad agency.

Dues to the organization have been declining since Donald Trump was elected president. Gun manufacturers have relied on scare tactics to sell their products and have been big supporters of the NRA. Since the election of Trump, sales have declined. Two years ago, the oldest gun manufacturer, Remington, declared bankruptcy. As NRA revenues fell, the abuses came to light when the organization fell behind on payments to the ad agency. Influential members devoted to the mission of the organization have been appalled at the corruption.

Mr. Trump has signaled his support for the organization. Like all Presidential hopefuls, his financial affairs came under scrutiny. The Trump Foundation was later dissolved because of the same self-dealing practices.

The top 10% are always doing fine because they pay an army of lawyers and accountants to legally dodge the rules. Every week, Mr. Trump’s comments indicate how little he knows about any of the laws of this country because the laws don’t apply to him. He is part of the 10% that owns the stock market. When those markets came under stress a few months ago, the Federal Reserve stepped in with massive infusions of liquidity to preserve the assets of that 10%. They are the fire department for the rich.

Who will come to rescue the homes and families in the unfortunate 10% whose extra UI benefits have ended?  

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Notes:

Photo by Fritz Benning on Unsplash

Schneider, B. (2019, October 09). NRA’s Actions “Absolutely” Raise Questions on Tax-Exempt Status Testifies Non-Profit Tax Expert. Retrieved August 08, 2020, from https://schneider.house.gov/media/press-releases/nra-s-actions-absolutely-raise-questions-tax-exempt-status-testifies-non-profit

Event and Response

March 15, 2020

by Steve Stofka

The response to an event is part of the event. While driving on the highway this week, I listened to an NPR report on the relatively few deaths from the COVID-19 virus. I passed under a sign telling me that almost 600 people died in my state last year in auto accidents. The number of deaths nationally was almost 39,000. In 2019, we had almost 20% fewer fatalities than 2002 even though we drove 20% more miles during the year (CDOT, 2020). Cars are safer now because the government set safety standards for car manufacturers. Our institutions are strong. We tackle thorny problems and fix them. Was the reaction to this virus a bit too strong?

On Friday, the death toll from the virus climbed to 50. During the winter flu season of 2017-18, the CDC estimated 70,000 deaths (CDC,2020). That’s over 1300 per week. 50 didn’t seem so bad. One person on Twitter thought this panic buying of toilet paper was all silly. Then he went into his grocery store and the shelves were empty of Twix, his comfort chocolate. A bit of black humor. We may need more humor in the weeks to come.

Despite the mortality from flu each season, the world community has built a collective herd immunity to the disease over the past two thousand years. What’s herd immunity? If I have antibodies against a virus, I won’t be a carrier of the virus to someone else. This reduces transmission of the disease. COVID-19 is a new type of coronavirus. No one has built an immunity, so it travels fast.

Six months ago a friend asked me what I thought about the stock market. I told him I thought it was overpriced. Should I sell some of the stocks in my 401K, he asked? I shrugged. What if stocks went down 50% like in 2001 and 2008, I asked? Would you panic? He didn’t really need the money for five years, so probably not, he said. I’d be anxious, he said. Would you be anxious if you had no money in the stock market, I asked? Yeah, he said. I hear about the stock market on the radio, get news about it on my phone. I’d worry there was another crisis like the financial crisis coming. Do you think stocks are going to go down 50%, he asked? I said I have no idea. If I knew the future, I would have to hide away in a cave somewhere because people would want to kidnap me and make me tell them what the future was going to be. The past has already happened and very often we don’t understand what happened. Even if we knew what the future was, we would have trouble understanding it.

The long bull market in stocks ended this week and the SP500 index officially entered a bear market 20% below its recent high. The bull market almost ended in 2018 when the index fell 19% from a recent high but that didn’t count. 19% is not 20%. What about 2011 when the 20% decline occurred during a trading day but recovered enough by the end of the day to be a decline of less than 20%? That didn’t count either because the “official” declaration of a bear market is based on the day’s closing price. If the 20% decline benchmark were based on the yearly closing of the SP500, we still are not in a bear market (only 16.1% down) and didn’t come close in 2018 or 2011.  But that’s not newsworthy, is it?

The financial crisis came about because of a contagion in our financial markets. That led to a contagion of distrust in our institutions in this country and around the world. The current crisis started with a contagion between people that is spreading to our financial markets. This week the Federal Reserve stepped in to stabilize the bond market (Cox, 2020).

U.S. Treasuries are the benchmark for safety around the world. Companies around the world with long term obligations – banks, insurance companies and pension funds – hold U.S. government debt. The key word in that last sentence is “hold.” As fear gripped the market in Monday’s open this week, long term Treasuries surged 10% in price. A lot of buyers wanted safety. In response, companies that would normally hold their Treasury bonds wanted to take advantage of the price increase, so they put some of their bonds on the market. The bond dealers were not equipped to handle this much previously issued long term debt coming to the market. They are accustomed to trading newly issued Treasury debt. They had trouble matching buyers and sellers. Even as the stock market fell 10% on Thursday, the price of long-term Treasury bonds fell 4% in the last few hours of that afternoon. They are supposed to move in opposite directions. Something was wrong. If there were problems in the U.S. Treasury market, it could spread another kind of contagion throughout the bond market. The stock market is like a toy boat floating on the big pond of the bond market. On Friday morning, the Fed announced that they would start buying Treasuries, starting with long-term bonds.

The financial crisis of a decade ago demonstrated that the response to a crisis becomes part of the crisis – for good or bad. A crisis creates a bottleneck which causes unexpected consequences which may need unexpected policy responses. I tell myself that our institutions are strong, that we fix problems. I’m starting to worry more about the people who stock up on a year’s supply of toilet paper. It will not save them from the zombie apocalypse. The zombies eat people, not toilet paper. I thought everyone knew that by now.

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Notes:

CDC. (2020, January 10). Disease Burden of Influenza. Retrieved from https://www.cdc.gov/flu/about/burden/index.html

Colorado Department of Transportation (CDOT). (2020, February 25). Colorado Fatalities since 2002. [PDF]. Retrieved from https://www.codot.gov/library/traffic/safety-crash-data/fatal-crash-data-city-county/Colorado_Historical_Fatalities_Graphs.pdf/view

Cox, J. (2020, March 14). The Fed to start buying Treasuries Friday across all durations, starting with 30-year bond. CNBC. Retrieved from https://www.cnbc.com/2020/03/13/the-fed-details-moves-to-buy-treasurys-across-all-durations-starting-with-30-year-bond.html

Photo by Jay Heike on Unsplash

What Hides Below

November 3, 2019

by Steve Stofka

Think the days of packaging subprime loans together is gone? Nope. They are called asset-backed securities, or ABS. The 60-day delinquency rate on subprime loans is now higher than it was during the financial crisis (Richter, 2019). The dollar amount of 90-day delinquencies has grown more than 60% above the high delinquencies during the financial crisis. Recently Santander U.S.A. was called out for the poor underwriting practices of its subprime loans. In this case, Santander must buy back loans that go into early default because of fraud and poor standards.

Credit card delinquencies issued by small banks have more than doubled since Mr. Trump took office (Boston, Rembert, 2019). Did a more relaxed regulatory environment encourage these banks to take on more risk to boost profits?

In the last century, geologists have developed new measuring and analytical tools to better understand the structure of the Earth. GPS technology can now detect movements of the earth’s crust as little as ¼” (USGS, n.d.). The same can’t be said for human foolishness. During the past half-century, financial analysts and academics have developed an amazing array of statistical and analytical tools to understand and measure risk. Despite that sophistication, the Federal Reserve has mismanaged interest rate policy (Hartcher, 2006). Government regulators have misunderstood risks in the banking and securities markets.

Earthquake threats happen deep underground. I suspect that the same is true about financial risks. To gain a competitive advantage, companies try to hide their strategies and the details of their financial products. On the last pages of quarterly and annual reports, we find a lot of mysterious details in the notes. After the Arthur Anderson accounting scandal in 2002, the Sarbanes-Oxley Act was passed to bring greater transparency and accountability to financial reporting. Six years later, the financial crisis demonstrated that there was a lot of risk still hiding in dark corners.

The financial crisis exposed a lot of malfeasance and foolishness. Some folks think that investors are now more alert. After the crisis, corporate board members and regulators are more active and aware of risk exposures. Are those risks behind us? I doubt it. Believing in the power of their risk models, underwriters, bankers and traders become victims of their own overconfidence (Lewis, 2015).

Each decade California experiences a quake that is more than 6.0 on the Richter scale. Following the quake come the warnings that California will split away from the North American continent. Still waiting. The recession was due to arrive eight years ago. We did experience a mini-recession in 2015-16, but it wasn’t labeled a recession. The slowdown wasn’t slow enough and long enough. Eventually we will have a recession, and all those people who predicted a recession in 2011 and subsequent years will claim they were right. In many areas of life, being right is all about timing. Few of us are that kind of right.

The data demonstrates the difficulty of financial fortune telling. The Callan Periodic Table of Investment Returns shows the returns and rank of ten asset classes over the past two decades (Callan, 2019). An asset class that does well one year doesn’t fare as well the following year. An investor who can read the past doesn’t need to read the future. Does an investor need to diversify among all ten asset classes?  Many investors can achieve some reasonable balance between risk and reward with four to six index funds and leave their ouija boards in the closet.

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Notes:

Boston, C. and Rembert, E. (2019, October 28). Consumer Cracks Emerge as Banks Say Everything Looks Fine. Bloomberg. [Web page]. Retrieved from https://www.bloomberg.com/news/articles/2019-10-28/consumer-cracks-emerge-as-banks-say-everything-looks-fine

Callan. (2019). Periodic Table of Investment Returns. [Web page]. Retrieved from https://www.callan.com/periodic-table/

Hartcher, P. (2006). Bubble man: Alan Greenspan & the missing 7 trillion dollars. New York: W.W. Norton & Co.

Lewis, M. (2015). The Big Short. New York: Penguin Books.

Richter, W. (2019, October 25, 2019). Subprime auto loans blow up. [Web page]. Retrieved from https://wolfstreet.com/2019/10/25/subprime-auto-loans-blow-up-60-day-delinquencies-shoot-past-financial-crisis-peak

Szeglat, M. (n.d.) Photo of lava flow at Kalapana, HI, U.S. [Photo]. Retrieved from https://unsplash.com/photos/NysO5Rdn7Mc

USGS. (n.d.). About GPS. [Web page]. Retrieved from https://earthquake.usgs.gov/monitoring/gps/about.php

The Politics of Compassion

July 14, 2019

by Steve Stofka

It was a busy week in Washington. Jerome Powell, the chair of the Federal Reserve, testified before a House subcommittee. His dovish remarks signaled Wall Street traders that the Fed would almost certainly lower interest rates at their next meeting on July 30-31 (Note #1). The market rallied to new highs even as investors continued to transfer funds from stocks to bonds during the past month (Note #2).

Not so dovish was the atmosphere at a House subcommittee hearing this week on immigration proceedings at the southern border. Very emotional testimony from several freshman House members who had visited immigrant detention facilities in Texas. The former head of ICE under Presidents Obama and Trump testified about the challenges that border patrol officers face under the surge of immigrants. Human and drug trafficking along the southern border has been at crisis levels for many months. Patrol officers are not trained to be social workers or medical attendants but find that most of their time is spent caring for people who lack the physical stamina necessary to navigate the harsh conditions of the deserts of northern Mexico.

Many immigrants are sick or injured after a long treacherous journey from Central America. The crowded facilities pose a challenge even for healthy immigrants. They are certainly no place for mothers with young children, but neither was Ellis Island (Note #3). However, most of the immigrants at Ellis left the building after several hours (Note #4).

I was reminded of my grandmother and aunt who were turned away twice for whooping cough and pink eye. It was easy to pick up contagious diseases on the 7-10 day journey in third-class quarters on a crowded transatlantic steamer a century ago. Processing hundreds of immigrants a day, doctors at Ellis Island were quick to reject those with even the hint of TB or trachoma (Note #5). In the years before World War I the northern states needed workers and government officials were largely forgiving of many disabilities and illnesses. Less than 2% of immigrants were deported. My family was one of the unlucky ones – twice. My grandfather waiting on the Manhattan shore a few miles away must have been confused and angry.

Some Americans are insistent that immigrants should follow our Constitution, but our founding document has little to say about immigration. Article 1, Section 8 states that the Congress shall “establish a uniform rule of naturalization.” End of story. For the first hundred years of our nation’s existence, each state processed immigrants. Many immigrants did not present any paperwork or pass a medical examination. State and Federal governments simply took an immigrant’s word as to their name and personal information. Those who insist most loudly that immigrants follow our laws may be descended from people who followed no laws when they immigrated into our country.

In 1891, Republican President William Henry Harrison signed into law the Immigration Act of 1891 passed by a Congress dominated by Republicans (Note #6). Republicans represented the interests of northern businesses who needed able bodied workers who were unlikely to become dependent on government for their care. The flood of immigrants into the northern states gave Republicans additional congressional seats and an edge over Democratic majorities in the southern states.

The founding documents of this country were forged in the fires of heated debate and hard bargaining (Note #7). In 230 years, the debate has not cooled. Today, Democratic majority states like California and New York stand to gain Congressional seats as they welcome and champion the rights of immigrants. While the Senate has a filibuster rule, only the Democratic Party can fix our broken immigration laws because they are the only ones capable of securing a filibuster-proof majority in the Senate. The Republican Party has not enjoyed such a majority since Senators were first popularly elected in 1914. If Republicans are ever going to take the lead on contentious issues, they will have to abandon the Parliamentary filibuster that chokes most legislation to death in the Senate.

Why didn’t the Democratic Party address the issue of immigration while they had a filibuster-proof majority in the Senate and controlled the Presidency and House? Was it not important then? Nancy Pelosi was House Speaker then and now. She is known for her political ability to “count votes.” Perhaps she would be more effective if she looked further than votes. In a deeply divided nation with a constitutional architecture that resists change, a resolution of our most intractable problems is a formidable challenge for any leader.

After the Financial Crisis in 2008, Pelosi helped patch together two large pieces of legislation under Obama’s first term. ARRA was an $800B stimulus package passed in February 2009 that did help keep unemployment from getting even worse but was ineffective in many areas because the stimulus was diluted over several years (Note #8). That and the passage of the controversial ACA, dubbed “Obamacare,” cost the Democrats dearly in the 2010 midterm elections. Obamacare has withstood both legislative and judicial assault but may fall sometime this year to yet another judicial challenge that was just heard by the 5th Circuit Court of Appeals. That’s a topic for next week’s blog.

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Notes:

  1. Schedule of Fed meetings
  2. ICI flow of funds
  3. Crowded main hall at Ellis Island
  4. Relatively short processing time at Ellis Island
  5. Medical examinations of immigrants at Ellis Island
  6. Immigration Act of 1891
  7. Michael J. Klarman’s “The Framer’s Coup” is a thorough account of the construction of our nation’s Constitution. The audio book
  8. ARRA – the American Recovery and Reinvestment Act of 2009

The Nature of Money

March 31, 2019

by Steve Stofka

Modern Monetary Theory (MMT) helps us understand the funding flows between a sovereign government and a nation’s economy. I’ve included some resources in the notes below (Note #1). This analysis focuses on the private sector to help readers put the federal debt in perspective. In short, some annual deficits are to be expected as the cost of running a nation.

What is money? It is a collection of  government IOUs that represent the exchange of real assets, either now or in the past. Wealth is either real assets or the accumulation of IOUs, i.e. the past exchanges of real assets. When a sovereign government – I’ll call it SovGov, the ‘o’ pronounced like the ‘o’ in love – borrows from the private sector, it entices the holders of IOUs to give up their wealth in exchange for an annuity, i.e. a portion of their wealth returned to them with a small amount of interest. A loan is the temporal transfer of real assets from the past to the present and future. This is one way that SovGovs reabsorb IOUs out of the private economy. In effect, they distribute the historical exchange of real assets into the present.

What is a government purchase? When a SovGov buys a widget from the ABC company, it also borrows wealth, a real asset that was produced in the past, even if that good was produced only yesterday. The SovGov never pays back the loan. It issues money, an IOU, to the ABC company who then uses that IOU to pay employees and buy other goods. A SovGov pays back its IOUs with more IOUs. That is an important point. In capitalist economies, a SovGov exchanges real goods for an IOU only when the government acts like a private party, i.e. an entrance fee to a national park. Real goods are produced by the private economy and loaned to the SovGov.

What is inflation? When an economy does not produce enough real goods to match the money it loans to the SovGov, inflation results. Imagine an economy that builds ten chairs, a representation of real goods. If a SovGov pays for ten people to sit in those ten chairs, the economy stays in equilibrium. When a SovGov pays for eleven people to sit in those ten chairs, and the economy does not have enough unemployed carpenters or wood to build an eleventh chair, then a game of musical chairs begins. In the competition for chairs, the IOUs that the private economy holds lose value. Inflation is a game of musical chairs, i.e. too much money competing for too few real resources.

A key component of MMT framework is a Job Guarantee program, ensuring that there are not eleven people competing for ten jobs (Note #2). Labor is a real resource. When the private economy cannot provide full employment, the SovGov offers a job to anyone wanting one. By fully utilizing labor capacity, the SovGov keeps inflation in check. The  idea that the government should fill any employment slack was developed and promoted by economist John Maynard Keynes in his 1936 book The General Theory of Employment, Money and Interest.

The first way a SovGov vacuums up past IOUs is by borrowing, i.e. issuing new IOUs. I discussed this earlier. A SovGov also reduces the number of IOUs outstanding through taxation, by which the private sector returns most of those IOUs to the SovGov.

Let’s compare these two methods of reducing IOUs. In Chapter 3 of The Wealth of Nations, Adam Smith wrote that government borrowing “destroys more old capital … and hinders less the accumulation or acquisition of new capital” (Note #3). Borrowing draws from the pool of past IOUs; taxation draws more from the current year’s stock of IOUs. Further, Smith noted that there is a social welfare component to government borrowing. By drawing from stocks of old capital it allows current producers to repair the inequalities and waste that allowed those holders of old capital to accumulate wealth. He wrote, “Under the system of funding [government borrowing], the frugality and industry of private people can more easily repair the breaches which the waste and extravagance of government may occasionally make in the general capital of the society.”

Borrowing draws IOUs from past production, while taxation vacuums up IOUs from current production. Since World War 2, the private sector has returned almost $96 in taxes for every $100 of federal IOUs. Since January 1947, the private sector has loaned the federal government $371 trillion dollars of real goods, the total of federal expenditures (Note #4). What does the federal government still owe out of that $371 trillion? $15.5 trillion, or 4.17% (Note #5). If the private sector were indeed a commercial bank, it would expect operating expenses of 3%, or $11.1 trillion (Note #6). What real assets does the private sector have for the difference of $4.4 trillion in the past 70 years? A national highway system and the best equipped military in the world are just two prominent assets.

The federal government spends about 17-20% of GDP, far lower than the average of OECD countries (Note #7). That is important because the accumulated Federal debt of $15.5 trillion is only .9% of the $1.7 quadrillion of GDP produced by the private sector since January 1947. Our grandchildren have not inherited a crushing debt, as some have called it. In the next forty years, the U.S. economy will produce about $2 quadrillion of GDP (Note #8). If tomorrow’s generations are as frugal as past generations, they will generate another $18 trillion of debt.

Adam Smith called a nation’s debt “unemployed capital,” a more apt term. The obligation of a productive nation is to put unemployed capital to work for the community. Under the current international system of national accounting, there is no way to account for the accumulated net value of real assets, or the communal operating expenses of the private economy. Without a proper accounting of those items, we engage in noisy arguments about the size of the debt.

In next week’s blog, I’ll examine the inflation pressures of government debt. I’ll review the Federal Reserve’s QE programs and why it has struggled to hit its target inflation rate of 2%. We’ll revisit a proposal by John Maynard Keynes that was discarded by later economists.

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Notes:
1. A video presentation of SovGov funding by Stephanie Kelton . For more in depth reading,  I suggest Modern Monetary Theory by L. Randall Wray, and Macroeconomics by William Mitchell, L. Randall Wray and Martin Watts.

2. L. Randall Wray wrote a short 7 page paper on the Job Guarantee program . A more comprehensive 56-page proposal can be found here 

3. Adam Smith’s The Wealth of Nations was published in 1776, the year that the U.S. declared independence from Britain. Smith invented the field of economics. The book runs 900 pages and is available on Kindle for $.99

4. Federal Expenditures FGEXPND series at FRED.

5. At the end of 1946, the Gross Federal Debt held by the public was $242 billion (FYGFDPUB series at FRED). Today, that debt total is $15,750 billion, or almost $16 trillion dollars. The difference is $15.5 trillion. The debt held by the public does not include debt that the Federal government owes itself for the Social Security and Medicare “funds.” Under these PayGo pension systems, those funds are nothing more than internal accounting entries.

6. In 2017, the Federal Reserve estimated interest and non-interest expenses for all commercial banks at 3% (Table 2, Column 3).

7. Germany’s government, the leading country in the European Union, spends 44% of its GDP Source

8. Assuming GDP growth averages 2.5% during the next forty years.

9. International Accounting Standards Board (IASB) sets standards for public sector accounting.

 

The Force of the Fed

To some extent, the Federal Reserve considers itself government. Other times, when it serves, it considers itself not government. – Philip Coldwell, President FRB Dallas 1968-74

September 2, 2018

by Steve Stofka

The nations of the world are the gods of Mt. Money, most of them with central banks who administer the credit and currency of each nation. Like the ancient Mt. Olympus of Greek lore, there is competition and a hierarchy among the gods. Currently the U.S. is the top god of Mt. Money.  Central banks manage credit by changing the interest rate, or price, that they will charge the demi-god banks within the nation’s borders. The banks, however, do not perfectly distribute the intentions of the central bank. Acting as intermediaries, the banks filter monetary policy and have a more direct effect on the economy. In this intermediary role, banks control the draining of Federal taxes generated by the economic engine.

In the U.S., the Federal Reserve (Fed) is the central bank of the Federal government, an independent agency created by Congress which has given it two targets: promote full employment and stable inflation. To meet those goals, Fed economists must gauge the strength of the economy, a difficult task, and estimate an ideal state of the economy, an even more difficult task.

Each August the Federal Reserve holds an economic summit at Jackson Hole in Wyoming. The newly appointed head of the Federal Reserve, Jerome Powell, is the first non-economist leading the central bank in 39 years. His paper (Note #1) is plain spoken and illustrates the difficulty of reading an economy in real time. As such, I think he will be a gradualist, someone who advocates measured moves in interest rates unless there is a more abrupt shift that requires a stronger policy tonic.

Powell uses the analogy of a sailor steering the waters by reading the stars. The waves and weather can make real time observations unreliable, yet the sailor must make decisions that steer his course. Optimizing employment is one of the two missions that Congress has given the Federal Reserve. The Fed must make a real-time estimate of what they think is the optimum or natural rate of unemployment (NAIRU) and adjust interest rates to help align the actual unemployment rate to the natural rate. Powell presented a chart that compares the actual rate of unemployment to NAIRU as it was estimated at the time, and the “hindsight” NAIRU as economists now calculate it. (Note #2) The speech balloons are mine.

UnemployEstimatesPowell2018

On page seven, Powell writes that, in the past, the central bank “placed too much emphasis on its imprecise estimates of [NAIRU] and too little emphasis on evidence of rising inflation expectations.”

Note the final word – expectations. Measuring what will happen is especially difficult because it has not happened. Probability methods can help but an economy has many more inputs than a dice game. One category of estimates are surveys of guesses about what will happen in the future, but these overstate actual inflation [Note #3]. A second category uses market prices. One method uses the price that buyers are willing to pay for a Treasury Inflation Protected Security (TIPS) (Note #4) In my July 22nd post, I introduced another market method – the net flow of money into the economic engine (Note #5)

Credit expansion has been poor since the Financial Crisis. The Fed cannot force banks to increase or decrease their loan portfolios by changing interest rates. In the years following the Financial Crisis, the Fed was frustrated by this inability, called “pushing on a wet noodle.” Interest rates are the carrot. The stick is a complex regulatory process that raises or lowers asset leverage ratios to encourage or discourage lending (Note #6).

The Fed manages credit flow through asset sales and purchases. While the central banks of other countries can buy stocks and commodities, the Fed is limited to buying debt, including foreign currencies, from its member banks (Note #7).

The Fed has the extraordinary power to purchase or sell the reserves of its member banks without their consent. Like the Fed, you or I can increase the reserves of a bank by depositing money in the bank (Note #8). What we can’t do is lower those reserves by writing our own loans. However, credit card companies, who are underwritten by banks, do provide us with a line of credit that we can draw on by using our cards. During the Financial Crisis, credit card debt jumped $50B, or 15%, because card holders reduced their payments by that much. In response, credit card companies reduced credit card limits by 28% (Note #9). While the Fed encouraged banks to loan, the behavior of consumers and businesses did the opposite. Consumers and businesses were more powerful than the Fed.

The banks administer or filter Fed policy in their interactions with consumers and businesses. If a bank must pay higher interest for its funds, then it will charge higher interest rates for consumer and business loans. Interest is the price for a loan. When the price rises, the supply for loans rises (banks make more profit on the spread) but demand for loans falls. The reverse is not true, as the data of the past decade has shown. When the price falls, the supply of loans falls while the demand increases.

Less credit expansion results in a slower economic engine, which generates less Federal tax revenue. For the engine to run properly, the internal pressure must remain stable. Inflation is one gauge of that internal pressure. The annual growth in Federal tax revenue must be equal to or greater than the inflation rate. When it is not, the engine begins to stall. In the graph below, I’ve charted the annual growth in Federal tax revenue less the inflation rate. Note the periods when this metric dropped below zero. In most cases, recession follows. Look at the right side of this chart. There has never been a time when the reading is so far below zero without a recession. That is a cautionary note.

FedTaxLessInflation

The Fed must look through the fog of the future before it deploys its money super powers. In the face of this, the Fed must act with humility and a practical caution. Once it has decided on a strategy, the banks modify its implementation because they obey three masters: the Fed, their customers and their stockholders. Actual monetary policy becomes not the work of a select few in the Federal Reserve but an emergent composite of policy force and practical friction.

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1. Powell’s speech is 14 pages double-spaced with several pages of charts and references.

2. For thirty years, from 1955 to 1985, the gap between the real-time estimate of NAIRU and the hindsight estimate is 1-1/2%, an error of 25%. In the 1990s economists’ models were more accurate. The estimate of NAIRU and its validity is debated now as it was in 1998 when Nouriel Roubini referenced several views on the topic.

3. A one-page Fed article on survey and market methods of measuring inflation expectations.

4. A one-page Fed article on long-term inflation expectations using the implied rate of TIPS treasury bonds – currently it is 2.1%. Vanguard article explaining TIPS bonds.

5. The net flows of credit growth, federal spending and taxes precedes inflation by several months (July 22 blog post).

6. Credit growth has been flat for the past decade as I showed in this July 15th post.

7. In conjunction with the Treasury, the Federal Reserve may buy foreign currencies to correct disruptive imbalances in interest rates. A NY Fed article explaining the process.

8. When we deposit money in a bank, its reserves, or cash balance, increases on the asset side. It incurs an offsetting liability of the same amount because the bank owes us money. We have, in effect, loaned the bank money. When so many banks collapsed before and during the Great Depression, people came to realize the true nature of depositing money in a bank. The banks could not pay back the money that depositors had loaned them. The creation of the FDIC insured depositors that the money creating powers of the Federal government would stand behind any member bank. My mom grew up during the Depression era and passed on the lessons learned from her parents. She would point to the FDIC Insured decal on the bank window and tell us kids to look for that decal on any bank we did business with in the future.

9. Credit card companies lowered limits. See page 8. Oddly enough, this Fed study found “we have little evidence on the effect of such large declines in housing wealth on the demand for debt.” Page 9. NY Fed paper written in 2013.

Hunt For Inflation

July 15, 2018

by Steve Stofka

Saddle up your horses, readers, because we are going on the Hunt for Inflation. I promise you’ll be home for afternoon tea. During this recovery, Inflation has been a wily fox, a real dodger. It has not behaved according to a model of fox behavior. Has Inflation evolved a consciousness?

Inflation often behaves quite predictably. The central bank lowers interest rates and pumps money into the economy. Too much money and credit chasing too few goods and Inflation begins running amuck. Tally-ho! Unleash the bloodhounds! The central bank raises interest rates which curbs the lending enthusiasm of its member banks through monetary policy. Inflation is caught, or tamed; the bloodhounds get bored and take a nap.

Not this time. Every time we think we see the tail of Inflation wagging, it turns out to be an illusion. Knowing that Inflation must be out there, the central bank has cautiously bumped up interest rates in the past two years. Every few months another bump, as though unleashing one more bloodhound ready to pounce as soon as Inflation shows itself.

Yes, Inflation has evolved a consciousness – the composite actions of the players in the Hunt. These players come in three varieties. One variety is the private sector – you and me and the business down the street. The second variety is the federal government and its authorized money agent, the Federal Reserve, the country’s central bank. Finally, there is a player who is a hybrid of the two – banks. They are private but have super powers conferred on them by the federal government. The private sector is the economic engine. The federal government and banks have inputs, drains and reservoirs that control the running of the economy.

The three money inputs into the constrained (see end) economy are 1) Federal spending, 2) Credit growth, and 3) net exports. In the graph below, the blue line includes 1, 2, and 3. The red line includes only 1. The graph shows the dramatic collapse of credit growth in this country. Federal spending accounted for all the new money flows into the economy.

CreditNXFedSpendvsFedSpend

Before the financial crisis, money flows into the economy were just over 30% of GDP. In less than a year, those inputs collapsed by almost 25%.

CreditGrowthFedSpendPctGDP

When inflation is lower than target, as it has been for the past decade, too much money flow is being drained out for the amount that is flowing in. In the case of too high or out of control inflation, as in the case of Venezuela, the opposite is true. Too much is being pumped in and not enough is being drained out. That’s the short story that gets you back to the lodge in time for a cup-pa or a pint. Next week – the inputs, drains and reservoirs of the economy.

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  1. Constrained – the private economy, state and local governments who cannot create new credit.
  2. Net exports are the sum of imports (minus) and exports (plus).