The Homeowners’ Association

August 18, 2019

by Steve Stofka

Two quick asides before I get into this week’s topic. A cricket perched on the top of a 7′ fence. It drew up to the edge of the top rail, learned forward, raised its rear legs as though to jump, then settled back. It did this twice more before jumping 8′ out then down into a soft landing on some ground cover. How far can crickets see, how often do they injure a leg if they land incorrectly and do they get afraid?

The bulk of the personal savings in this country is held by the top 20% of incomes, and it is this income group that received the lion’s share of the 2017 tax cuts. It’s OK to bash the rich but that top 20% probably includes our doctor and dentist. Before you start drilling or cutting me, I want to make it perfectly clear that I was not criticizing you, Doc.

In 2016, the top quintile – the top 20% – earned 2/3rds of the interest and dividend income (Note #1). Due to falling interest rates over the past three decades, real interest and dividend income has not changed. Real capital has doubled and yes, much of it went to those at the top, but the income from that capital has not changed. That is a huge cost – a hidden tax that gets little press. The real value of the public debt of the Federal Government has quadrupled since 1990, but it pays only 20% more in real interest than it did in 1990 (Note #2). Here’s a graph of personal interest and dividend income adjusted to constant 2012 dollars. Thirty years of flat.

Ok, now on to a story. Economists build mathematical models of an economy. I wanted to construct a story that builds an economy that gradually grows in complexity and maybe it would help clarify the relationships of money, institutions and people.

Let’s imagine a group of people who move into an isolated mining town abandoned several years earlier. The houses and infrastructure need some repairs but are serviceable and the community will be self-sufficient for now. The homeowners form an association to coordinate common needs.

The association needs to hire lawn, maintenance and bookkeeping services, and security guards to police the area and keep the owners safe.  How does the association pay for the services?  They assess each homeowner a monthly fee based on the size of the home. How do the homeowners pay the monthly fee?  Each homeowner does some of the services needed. Some clean out the gutters, others fix the plumbing, some keep the books and some patrol the area at night. They work off the monthly fee.

How do they keep track of how much each homeowner has worked? The association keeps a ledger that records each owner’s fee and the amount worked off. The residents sometimes trade among themselves, but it is rare because barter requires a coincidence of wants, as economists call it. Mary, an owner, needs some wood for a project and Jack has some extra wood. They could trade but Mary doesn’t have anything that Jack wants. He tells Mary to go down to the association office and take some of her time worked off her ledger and credit it to Jack’s monthly fee. Mary does this and they are both happy (Note #3).

As other owners learn of this idea and start trading work credits, the association realizes it needs a new system. It prints little pieces of paper as a substitute for work credits and hands them out to owners who perform services for the association. These pieces of paper are called Money (Note #4).

The money represents the association’s accounts receivable, the fees owed and accruing to the association, and the pay that the association owes the owners for the work they have done. Then the association notices that there are some owners who are not doing as well as others. It assesses an extra fee each month from those with larger homes and gives that money to needy homeowners.  These are called transfers because the owners who receive the money do not trade any real goods or services to the association. In this case the association acts as a broker between two people. Let’s call these passive transfers. We can lump these transfers together with exchanges of goods and services.

Then some people from outside the area start stealing stuff from the homeowners. The association needs to hire more security guards, but homeowners don’t want to pay a special one-time assessment to pay for the extra guards.

Instead of printing more Money, the association prints pieces of paper called Debt. Homeowners who have saved some of their money can trade it in for Debt and the association will pay them interest. Homeowners like that idea because Money earns no interest and Debt does. The association uses the Money to pay for the extra security guards.

But there are not enough people who want to trade in their Money for Debt, so the association prints more Money to pay the extra security guards.

Let’s pause our story here to reflect on what the words inflation and deflation mean. Inflation is an increase in overall prices in an economy; deflation is a decrease (Note #5). Inflation occurs when the supply of money fuels a demand for goods and services that is greater than the supply of goods and services. Ok, back to our story.

So far so good. All the Money that the association has printed equals a trade or a passive transfer. Let’s say that the association needs more security guards and no one else wants to work as a security guard because they can make more Money doing jobs for other homeowners. The association makes a rule called a Draft. Homeowners of a certain age and sex who do not want to work as security guards will be locked up in the storage room of the community center.

Now there’s a problem. Because the association has taken some homeowners out of the customary work force, those people are not available for doing jobs for other homeowners, who must pay more to contract services. This is one of several paths that leads to inflation. To combat that, the association sets price controls and limits the goods that homeowners can purchase. After a while, the outsiders are driven off and the size of the security force returns to its former levels.

Now all the extra Money that the association printed to pay for the security force has to be destroyed. As homeowners pay their dues, the association retires some of the money and shrinks the Money supply. However, there is a time lag, and prices rise sharply (Note #6).

Over the ensuing decades, there are other emergencies – flooding after several days of rain, a sinkhole that formed under one of the roadways, and a sewer system that needed to be dug up and replaced. The association printed more Debt to cover some of the costs, but it had to print more Money to pay for the balance of repairs. Because the rise in the supply of Money was a trade for goods and services, inflation remained tame.

There didn’t seem to be any negatives to printing more Money, so the homeowners passed a resolution requiring that the association print and pay Money to homeowners who were down on their luck. These were active transfers – payments to homeowners without a trade in goods and services and without some offsetting payment by the other homeowners.

So far in our story we have several elements that correspond with the real world: currency, taxes, social insurance, the creation of money and debt and the need to pay for defense and catastrophic events. Let’s continue the story.

With the newly printed Money, those poorer homeowners could now buy more goods and services. The increased demand caused prices to rise and all the homeowners began to complain. Realizing their mistake, they voted on an austerity program of higher homeowner fees and lower active transfers to poorer homeowners.

Because homeowners had to pay higher fees, they didn’t have enough extra Money to hire other services. Some residents approached the association and offered to repair fences and other maintenance jobs, but the association said no; it was on an austerity program and cutting expenses. Some residents simply couldn’t pay their fees and the problem grew. The association now found that it received less Money than before the higher fees and Austerity program. It cut expenses even more, but this only aggravated the problem.

Finally, the association ended their Austerity program. They printed more Money and hired homeowners to make repairs. Several homeowners came up with a different idea. There is another housing development called the Forners a few miles away. They are poorer and produce some goods for a lower price. The homeowners can buy stuff from the Forners and save money. There are three advantages to this program:

  1. Things bought from the Forners are cheaper.
  2. Because the homeowners will not be using local resources, there will be less upward pressure on prices.
  3. The homeowners will pay the association for the goods bought from the Forners and the association will pay the Forners community with Debt, not Money. Since it is the creation of Money that led to higher prices, this arrangement will help keep inflation stable.

As the homeowners buy more and more stuff from the Forners, the money supply remains stable or decreases. After several years, homeowners are buying too much stuff from the Forners and there is less work available in the community. As homeowners cannot find work, they again fall behind in paying their monthly fees.

Several of those in the association realize that they don’t have enough Money to go around in the community. There is a lot to do, and the homeowners draw up a wish list: repairs to the roads and helping older homeowners with shopping or repairs around their home are suggested first. A person who is out of work offers to lead tours and explain the biology of trees for schoolchildren. The common lot near the clubhouse could use some flowers, another homeowner suggests. I could use a babysitter more often, one suggests, and everyone nods in agreement. I could teach a personal finance class, a homeowner offers. Another offers to read to homeowners with bad eyesight and be a walking companion to those who want to get more exercise.

Everyone who contributes to the welfare of the community gets paid with Money that is created by the association. What should we call the program? One person suggests “The Paid Volunteer Program,” and some people like that. Another suggests, “The Job Guarantee Program” and everyone likes that name so that’s what they called it (Note #7).

So far in this story we have two key elements of an organized society:

  1. Money – a paper currency created by the homeowner association.
  2. Debt – the amount the association owes to homeowners (domestic) and the Forners (international).

Next week I hope to continue this story with a transition to a digital currency, banks and loans.

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Notes:

  1. In 2016, the top 20% of incomes with more than $200K in income, earned more than 2/3rds of the total interest and dividends. IRS data, Table 1.4
  2. In 2018 dollars, the publicly held debt of the Federal government was $4 trillion in 1990, and $16 trillion now. In 2018 dollars, interest expense was $500B in 1990, and is $600B now.
  3. In David Graeber’s Debt: The First 5000 Years, there is no record of any early societies that had a barter system. They had a ledger or money system from the start.
  4. In the Wealth of Nations, Adam Smith – the “father” of economics – defined money as that which has no other value than to be exchanged for a good. This essential characteristic makes money unique and differentiates paper money from other mediums of exchange like gold and silver.
  5. An easy memory trick to distinguish inflation from deflation. INflation  = Increase in prices. DEflation = DEcrease.
  6. The account of the increased force of security guards – and its effect on prices and regulations – is the simple story of money and inflation during WW2 and the years immediately following. The process of rebalancing the money supply by the central bank is difficult. Monetary policy during the 1950s was a chief contributor to four recessions in less than 15 years following the war.
  7. A Job Guarantee program is a key aspect of Modern Monetary Theory.

Personal Debt

April 15, 2018

by Steve Stofka

Until the financial crisis, I thought that other people’s debt was their problem. In 2008, debt became a nation’s problem and a national conversation with two aspects – the moral and the practical. Moral conversations are not confined to church; they drive our politics and policy. Many laws contain some language to contain moral hazard, which is the danger that language loopholes in a law or policy promote the opposite of the intended effect of the law. This is particularly true of many entitlement policies. Let’s leave the moral conversation for another day and turn to the practical aspects of current policy.

Bankers learned their lesson during the financial crisis, didn’t they? Maybe not. A decade of absurdly low interest rates has starved those who depend on the income earned by owning debt. Even a savings account is money loaned to a bank, a debt that the bank must pay to the account holder. In their hunger for income, investors have turned to less prudent debt products. So long as the economy remains strong, no worries.

A fifth of conventional mortgages are going to people whose total debt load, including the mortgage, is more than 45% of their pre-tax income. By comparison, at the market’s exuberant peak in late 2007, 35% of conventional mortgages were going to such households, who were especially vulnerable when monthly job gains turned negative in early 2008.

The real estate analytics firm Core Logic also reports that Fannie Mae has started backing mortgages to those with total debt loads up to 50%. FICA, federal, state and local income taxes can amount to 25% of a paycheck (Princeton Study). Add in 45% of that gross pay for mortgage and debt payments, and there is only 30% left for food, gas, home repairs and utilities, child care, etc.

I’ll convert these percentages to dollars to illustrate the point. A couple grossing $80,000 might have a take home pay of $60,000. The couple has $36,000 in mortgage and other debt payments (45% of $80,000). They have $24,000, or $2000 a month for everything else. This couple is vulnerable to a change in their circumstances: a layoff or a cut back in hours, some unexpected expense or injury.

For those who get a conventional loan despite their heavy debt load, where is the money coming from? Banks suffered huge losses during the financial crisis. The Federal Reserve tightened capital requirements for banks’ loan portfolios, forcing them to improve the overall quality of their debt. As a result, banks turned away from their most lucrative customers – subprime borrowers and those with heavy debt loads who must pay higher interest on their loans. Profits in the financial industry fell dramatically. A broad composite of financial stocks (XLF) has still not regained the price levels of 2007.

The banking industry employs some very smart people. What solution did they create? The big banks now loan money to non-financial companies who loan the money to subprime borrowers. After bundling the consumer loans into securities, the non-financial companies use the proceeds to pay the big banks back. In seven years this kind of borrowing has expanded seven times to $350 billion. Doesn’t this look like the kind of behavior that almost took down the financial system in 2008? The banks say that this system isolates them from exposure to subprime borrowers. If large scale job losses cause a lot of loan defaults, it is the investors who will bear the pain, not the banks. Same song, different lyrics.

The 2008 financial crisis is best summed up with a chart from the Federal Reserve. In the post WW2 economy, the weekly earnings of British workers rose steadily. The growth is especially strong when compared to the earlier decades of the 19th and 20th centuries. In 2008, earnings peaked.
WeeklyEarnUK

Developed countries depend on the steady growth of tax receipts generated by weekly earnings. An assumption of 3% real GDP growth underlies the health and continuation of post-war social welfare policies. For more than a decade, the U.S. and U.K. have had less than 2% GDP growth.  Both governments have had to borrow heavily to fund their social support programs.  How long can they increase their debt at such a rapid pace?

I am reminded of a time more than 40 years ago when New York City held a regularly scheduled auction to sell  bonds to fund their already swollen debt load.  None of the banks showed up to bid for the bonds.  The city is the financial center of the world.  The lack of interest stunned city officials.  To avoid a messy bankruptcy, the city turned to the Federal government for a loan (NY Times).

The Federal government is not a city or state, of course. It has extraordinary legal and monetary power, and its bonds are a safe haven around the world.  But there could come a time when investors demand higher interest for those bonds and the rising annual interest on the debt squeezes spending on other domestic programs.

Debt causes stress.  Stress causes anxiety.  Anxiety weakens confidence in the future and causes investment to shrink. Falling investment leads to slower job growth. That causes profits and weekly earnings to fall which reduces tax receipts to the government.  That increases debt further, and the cycle continues.  Other people’s debt is everyone’s problem after all.

Debt and Housing

March 18, 2018

by Steve Stofka

Republicans used to care about yearly budget deficits when Obama was President. Since Obama left office, the budget deficit is up 20%. As a percentage of GDP, 2017’s deficit was above the forty-year average of deficits (Treasury Dept press release).  At the end of the Obama term, the gross federal debt was 77% of GDP. In ten years, the Congressional Budget Office estimates that percentage will be over 90%. (Spreadsheet ) That estimate does not include the lower revenues from the tax cuts passed in December.

During the two Bush terms, Republican deficit hawks, genuinely concerned about budget deficits, were overruled by a majority of Republicans who paid only political lip service to common sense budgeting.

The Federal Government’s fiscal year runs from October to September. At the end of February, the fiscal year was five months old. According to the Treasury’s monthly budget statement, this fiscal year’s deficit has gone up 10%. Because of the tax cut passed in December, payroll tax collections are down. Because of higher interest rates, the government paid an extra $40 billion on the federal debt in the first five months of this fiscal year, which began October 2017. $40 billion is half of the food stamp program. Debt matters. The government is going into more debt to pay the interest on the existing debt.

The government paid $550 billion in interest last year and is estimated to pay over $600 billion this year. That is just a $100 billion less than the defense budget. Because interest rates are historically low, the interest as a percent of GDP is low. We cannot expect that they will remain low.

InterestPctGDP

Interest rates were low in the 1950s. By 1970, they were over 7% and had climbed to 14% by 1980. Since the financial crisis ten years ago, central banks in China, Europe and the U.S. have been buying government debt. Central banks don’t demand higher interest. As their role diminishes, price-sensitive buyers like pension funds and households will demand higher interest rates (Bloomberg article). Recent Treasury debt auctions have been lightly subscribed, and the Fed is having to step in as a buyer to artificially make a market. Remember, the Fed is just another pants pocket of the Federal Government. In essence, the Federal Government is buying its own debt.   What can’t continue forever, won’t.

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Housing

Have you gotten the impression that the housing market is going gangbusters? As a percent of GDP, housing investment is double what it was at the lows of the recession. The bad news is that current levels are near the historic lows of the post WW2 economy.

ResInvest

On the other hand, housing affordability has hit all time lows. A prudent rule of thumb is that a person or family should not spend more than 25% of their income on housing. A corollary of that rule is that a household should not buy a home that is more than 4 times their annual income. At 5.2, the current ratio is far above a prudent rule of thumb.

HousingIncomeRuleOf4

Government debt levels make the government, and us, vulnerable to any loss of confidence.  Low housing investment makes the economy less resilient.  High housing costs make it more difficult for families to save.  In a downturn, more families must turn to government for benefits.  Saddled with high debt levels and interest payments, government is less able and willing to extend benefits. The cycle turns vicious.

 

Economic Porridge

August 31, 2014

As summer comes to a close and the sun drifts south for the winter, the porridge is not too hot or too cold.

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Coincident Index

The index of Leading Indicators came out last week, showing increased strength in the economy.  Despite its name, this  index has been notoriously poor as a predictor of economic activity.  The Philadelphia branch of the Federal Reserve compiles an index of Coincident Activity in the 50 states, then combines that data into an index for the country.

This index is in the healthy zone and rising. When the year-over-year percent change in this index drops below 2.5%, the economy has historically been on the brink of recession.  The index turns up near the end of the recession, and until the index climbs back above the 2.5% level, an investor should be watchful for any subsequent declines in the index.

As with any historical series, we are looking at revised data.  When this index was published in mid-2011, the percent change in the index was -7% at the recession’s end in mid-2009.  Notice that the percent drop in the current chart is a bit less than 5%.  This may be due to revisions in the data or the methodology used to compile the index.

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Disposable Income

The Bureau of Economic Analysis (BEA) produces a number of annual series, which it updates through the year as more complete data from the previous year is received.  2013 per capita real disposable income, or what is left after taxes, was revised upward by .2% at the end of July but still shows a negative drop in income for 2013.  While all recessions are not accompanied by a negative change in disposable income, a negative change has coincided with ALL recessions since the series began at the start of the 1930s Depression.

Many positive economic indicators make it highly unlikely that we are either in or on the brink of recession.  Clearly something has changed.  Something that has routinely not been counted in disposable personal income is having some positive effect on the economy.  In 2004, the BEA published a paper comparing the methodology they use to count personal income and a measure of income, called money income, that the Census Bureau uses.  What both measures don’t count in their income measures are capital gains.

Unlike BEA’s measure of personal income, CPS money income excludes employer contributions to government employee retirement plans and to private health and pension funds, lumps-sum payments except those received as part of earnings, certain in-kind transfer payments—such as Medicare, Medicaid, and food stamps—and imputed income. Money income includes, but personal income excludes, personal contributions for social insurance, income from government employee retirement plans and from private pensions and annuities, and income from interpersonal transfers, such as child support. (Source)

Analysis (Excel file) of 2012 tax forms by the IRS shows $620 billion in capital gains that year, about 5% of the $12,384 billion in disposable personal income counted by the BEA.  An acknowledged flaw in the counting of disposable income is that the total reflects the taxes that individuals pay on the capital gains (deducted from income) but not the capital gains that generated that taxable income.  Although 2013 data is not yet available from the IRS, total personal income taxes collected rose 16%.  We can suppose that the 30% rise in the stock market generated substantial capital gains income.

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Interest

Every year the Federal Government collects taxes and spends money.  Most years, the spending is more than the taxes collected – a deficit.  The public debt is the accumulation of those annual deficits.  It does not include money “borrowed” from the Social Security trust fund as well as other intra-governmental debt, which add another third to the public debt.  (Treasury FAQ)  This larger number is called the gross debt.  At the end of 2012, the public debt was more than GDP for the first time.

The Federal Reserve owns about 15% of the public debt.  But wait, you might say, isn’t the Federal Reserve just part of the government?  Well, yes it is.  Even the so-called public debt is not so public.  How did the Federal Reserve buy that  government debt?  By magic – digital magic.  There is a lot of deliberation, of course, but the actual buying of government debt is done with a few dozen keystrokes.  Back in ye olden days, a government with a spending problem would have to melt down some of its gold reserves, add in some cheaper metal to the mix and make new coins.  It is so much easier now for a government to go to war or to give out goodies to businesses and people.

Despite the high debt level, the percent of federal revenues to pay the interest on that debt is relatively low, slightly above the average percentage in the 1950s and 1960s but far below the nosebleed percentages of the 1980s and 1990s.

As the boomer generation continues to retire, the Federal Government is going to exchange intra-governmental debt, i.e. the money the government owes to the Social Security trust funds, for public debt.  As long as 1) the world continues to buy this debt,  and 2) interest rates stay low, the impact of the interest cost on the annual budget is reasonable.  However, the higher the debt level, the more we depend on these conditions being true.

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Watch the Percentages

As the SP500 touched and crossed the 2000 mark this week, some investors wondered whether the herd is about to go over the cliff.  The blue line in the chart below is the 10 month relative strength (RSI) of the SP500.  The red line is the 10 month RSI of a Vanguard fund that invests in long term corporate and government bonds.  Readings above 70 indicate a strong market for the security. A reading of 50 is neutral and 30 indicates a weak market for the security. The longer the RSI stays above 70, the greater the likelihood that the security is getting over-bought.

Long term bonds tend to move in the opposite direction of the stock market.  While they may both muddle along in the zone between 30 and 70, it is unusual for both of them to be particularly strong or weak at the same time.  We see a period in 1998 during the Asian financial crisis when they were both strong.  They were both weak in the fall of 2008 when the global financial crisis hit.  Long term bonds are again about to share the strong zone with the stock market.

Let’s zoom out even further to get a really long perspective.  Since November 2013, the SP500 index has been more than 30% above its 4 year average – a relatively rare occurrence.  It happened in 1954 – 1956 after the end of the Korean War, again in December of 1980, during the summer months of 1983, the beginning of 1986 to the October 1987 crash, and from the beginning of 1996 through September 2000.

In the summer of 2000, the fall from grace was rather severe and extended.  In most cases, including the crash of 1987, losses were minimal a year after the index dropped back below the 30% threshold.  When the market “gets ahead of itself” by this much, it indicates an optimism brought on by some distortion.  It does not mean that an investor should panic but it is likely that returns will be rather flat over the following year.

The index rarely gets 30% below its 4 year average and each time these have proven to be excellent buying opportunities.  The fall of 1974, the winter months of 2002 – 2003, and the big daddy of them all, March 2009, when the index fell almost 40% below its 4 year average.

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GDP

The Bureau of Economic Analysis (BEA) released the 2nd estimate of 2nd quarter GDP growth and surprised to the upside, revising the inital 4.0% annual growth rate to 4.2%.  As I noted a month ago, the first estimate of 2nd quarter growth included a 1.7% upward kick because of a build up of inventory, which seemed a bit high.  The BEA did revise inventory growth down to 1.4% but the decrease was more than offset primarily by increases in nonresidential investment. A version of GDP called Final Sales of Domestic Product does not include inventory changes.  As we can see in the graph below, the year-over-year percent gain is in the Goldilocks zone – not strong, but not weak.

New orders for durable goods that exclude the more volatile transportation industries, airlines and automobiles, showed a healthy 6.5% y-o-y increase in July.  Like the Final Sales figures above, this is sustainable growth.

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Takeaways

Economic indicators are positive but market prices may have already anticipated most of the positive, leaving investors with little to gain over the following twelve months.