Spending Flows

July 19, 2015

In the past few weeks I have been unfolding an origami of sorts. In the past 7 years, the Federal Reserve has created almost $4 trillion of new money.  Contrary to centuries of history that this would cause prices to rise dangerously, inflation has been muted during the five years of this recovery.  Core inflation, which excludes more volatile food and energy items, has been below the 2% target inflation rate that helps guide monetary policy decisions at the Federal Reserve.

In a standard expenditures or spending model, personal saving is presumed to flow through the banking system into business investment.  This approach can be helpful in understanding changes in investment spending and the difference between planned and unplanned investment.  However, that model presumes that consumers have little choice in the direction of their personal savings; that these savings flows are controlled entirely by the investment spending decisions made by business owners. I proposed a different way of looking at savings – as a form of spending shifted backwards in time.  We anticipate different rates of return based on the amount of time we shift investment forward or backward in time.

Economist John Maynard Keynes proposed that one person’s income is some else’s spending.  In the private domestic economy then, consumption spending, investment and savings are forms of spending.  We can combine them into one simple accounting identity.

If these components of total spending add up to 1, then

If we subtract yesterday’s and tomorrow’s spending from total spending we get the percentage that is today’s spending.

This concept was proposed by Keynes as the Marginal Propensity to Consume, or MPC.  In the example below the MPC is .9.  If there is an extra $1 of spending in the economy, people will tend to spend 90 cents of that extra $1 on today’s consumption.

Where does that extra $1 of spending come from?  Keynes proposed that the government could step in and spend money when there was a lack of consumption spending in the economy.  Last week I said that I would cover the role that government plays in the economy but I will leave that for next week.

Keynes, Income, Spending

July 12, 2015

In the past few weeks, I have looked at savings and investment as forms of spending shifted in time.  Now let’s examine the idea of income.  We earn money, spend most of it, and hopefully save a little of it.

In the 1930s John Maynard Keynes proposed an income expenditure model to explain business cycles. (More here) Although Keynes’ model was mathematically simple by today’s standards, it showed an interlocking relationship between employment, interest rates and money.  Keynes popularized his ideas in lectures, debates and magazine articles.  Although he died shortly after World War 2, financial institutions and economic policies still bear his mark.  It was he who first proposed and then co-developed the framework for the International Monetary Fund (IMF) and World Bank.

One of Keynes many seminal insights was that one person’s income is another person’s spending.  If I decide to save $5 by not buying a latte at the neighborhood coffee shop, I am in effect putting my $5 in a savings account at my local bank.  But the coffee shop owner has $5 less in income.  $5 less in income is $5 less profit, keeping all else the same.  The owner of the coffee shop must go to the local bank and take $5 out of their savings account to make up for the lost income.  There is no net savings when a person decides to not spend money and we see the relationship between savings and profit; namely, savings = profit.

We are now ready to develop that insight of Keynes, that income = spending.  As we discussed in previous weeks, the amount that we don’t spend on current consumption is savings.  Savings = spending, either yesterday’s spending, i.e. an investment in someone’s debt, or tomorrow’s spending, i.e. an investment in someone’s future profits, or savings.  When we spend for tomorrow, we are effectively moving our savings into the future.  Likewise, when we spend for yesterday, we move our savings into the past to replace the savings that someone else did not have at the time they borrowed the money.

All of these categories – income, spending, saving, investment – are all forms of spending shifted in time.  Next week we’ll look at the GDP accounting identity and the government component of that equation.

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CWPI

The manufacturing sector stumbled during the harsh winter and strengthening dollar.  The service sectors fell somewhat but remained strong.  In June, the manufacturing sector regained strength, helping offset a slight slackening in the service economy.  The composite index remains strong in a several month growth trough.

Some are of the opinion that the stock market can be overvalued or undervalued.  In my opinion, liquid markets are usually fairly valued.  Expectations of buyers and sellers change, causing a recalculation of future growth and a change in valuations.  Comparing an index like the SP500 to a valuation model can help identify periods of investor optimism and pessimism.

I built a model based on a 930 average price of the SP500 in the 3rd quarter of 1997.  At the end of 2014, the 10 year total return of the SP500 was 7.67% (Source) which I used as a base growth rate modified by the change in growth shown by the CWPI index.  The CWPI measures a number of factors of economic growth but measures profits indirectly as a function of that economic growth.  Profit growth may outpace or lag behind economic growth and investors try to anticipate those varying growth rates when they value a company’s stock.

Until mid-2013, the SP500 lagged behind the model, indicating a degree of pessimism.  In 2013, the SP500 gained 30% and it is in that year that we see the crossover of investor sentiment from pessimism to optimism.  In the first six months of this year, the SP500 has changed little and we see the index drifting back toward the model, which was only 4% less than the closing price of the SP500 index at the end of June.

In hindsight, we can identify periods when investors were too exuberant and miscalculated future growth.  But we can only do so because in that future, profits and growth were not as hoped for.  That is the problem with futures.  We never know which one we are going to get.

Economic Theories

We grow comfortable with our theories, our hypotheses of the way the world works.  They have an internal logic which appeals to us.  We are reluctant to give up a theory when events challenge the validity of that theory.  Eventually, events force us to abandon a theory even though there is no acceptable alternative which makes sense to us.  So we adopt a mechanical model, a paradigm with no underlying rationale, which describes a progression of events but can not explain why it works the way it does. 

A classical example of this descriptive mechanical model is the relationship of electricity and magnetism first noted in the early 19th century.  Thought to be two different forces, a model was developed which defined a working and predictive relationship between the two but no one could fully understand why the relationship existed.  It was not until later in the century that James Maxwell formulated a complete theory of electromagnetism, building on the work of Faraday, Hertz and Ampere.

Yesterday I examined the Starve the Beast theory, one which should work but fails to describe the relationship between tax rates and government spending at the Federal level.  The theory works as long as the government entity does not have massive borrowing power, as the U.S. government does.  At the state level, we do see a closer correlation between reducing revenues and lowered government spending.

Another theory which should work is supply side economics, a model that predicts that lower marginal tax rates and less regulation will spur greater investment by businesses, the producers or suppliers of economic goods.  Again, the internal logic of this model makes sense.  Make it easier for people to produce and lower the tax on income from that production and people will invest more in production which will create more jobs and overall economic activity which will produce greater tax revenues to the government..  So, why haven’t income tax revenues (excluding dedicated social security taxes) over the past 30 years supported this model? 

Keynesian macroeconomic theory focuses on management of the demand side of an economy through transfer payments, greater government consumption expenditures like building roads and other infrastructure projects.  In the seventies, repeated economic crises, recessions and ultimately stagflation made it apparent that a focus on the demand side could not fully explain the dynamics of a country’s economy.  Those who clung to Keynesian theory insisted, and continue to insist, that the theory is sound but that the implementation, i.e. management of demand, was poor.

In response to the perceived weaknesses in Keynesian theory, Arthur Laffer, Victor Canto and others developed a macroeconomic theory which focused on the supply side of the economy.  Rather than manage demand, a government should manage incentives to produce, i.e. less regulation, and disincentives for those who made good income from that production, i.e. lower tax rates.  As in physics, the “holy grail” of economics is to develop a unified theory that can incorporate both the supply and demand components of an economy with a predictive relationship between the two.  I am not aware that anyone has developed such a theory.  Unfortunately, this economic debate has become politicized, with Democrats taking the demand side of the argument and Republicans taking the supply side.

Recent history has deflated both theories yet proponents of each theory blames policy implementation or some other factor which invalidates the “experiment”, i.e. events, which cast doubt on their theory.  On the demand side, economist Paul Krugman maintains that there was not enough stimulus, i.e. demand, pumped in by the government to fully test the Keynesian model.  On the supply side, economist Art Laffer has blamed  policies of taxation and income redistribution over the past 7 years which have reduced productivity.  In a 2006 lecture, when the economy was riding high atop a housing boom, Laffer had not blame but glowing praise for both monetary and fiscal policy.

We cling to our familiar theories as though they were family and regard any criticism of a cherished theory as a personal attack.  They form the foundation of our policies of government.  As a nation we alter tax policy, we adjust interest rates, we bail out, we buy more Treasury bonds and get frustrated as neither the demand or supply sides of the economy responds forcefully to our efforts.  We blame those who don’t agree with our chosen theory, we criticize those who did not implement it properly or adulterated it with compromise.

The lesson we find hard to learn:  don’t fall in love with a theory.

Romer Regrets

Jerry referred me to an article by Dana Milbank at the Washington Post, relating comments by the departing Christina Romer, Chairman of Obama’s Council of Economic Advisors.  According to Mr. Milbank, Ms. Romer said “she still doesn’t understand exactly why [the economic collapse] was so bad.”   Ms. Romer, well respected in her field, will probably share some of the blame for underestimating the deep structural weakness of an economy in which all the players had become over leveraged. In Ms. Romer’s defense, the cautious Federal Reserve, including the former chairman, Alan Greenspan, and the stock market underestimated the problem as well.  The Fed called for a recovery in the latter part of 2009.  The market’s rise from the March 2009 lows signalled the same outlook.  The stock and bond markets reflected the opinions of a majority of economists at investment houses, mutual funds, hedge funds.  How could so many educated people be wrong?

Ms. Romer is a proponent of Keynesian economics, a theory that government spending can offset the lack of demand in the private sector during recessions.  When John Maynard Keynes proposed his theory in 1930, his remedy of government spending was an antidote to smooth the regular ups and downs of business and economic cycles. In his theory, Keynes proposed that governments then run surpluses during good times to counteract the overly heated demand of the private sector.  As such, Keynes could not have imagined that governments would run up the large amounts of debt that they have in the past decades.  His theory was never designed for a recession or depression resulting from such a massive over-leveraging of both public and private debt.

Misjudging the scope and severity of the collapse of this asset and debt bubble led economists like Ms. Romer to think that Keynesian solutions like the stimulus bill passed in early 2009 would provide a substantial “kick” to the economy.  The stimulus bill has helped stopped the bleeding but the wound is deep.  Government tax credits for house and car purchases did little more than shift those purchases forward in time. Stimulus payments to states helped avoid state and local government employee layoffs – for a while.  They did nothing to fix the central problem:  businesses and consumers are paying down debt that they have spent almost a decade accumulating.  That de-leveraging is going to take time.

Economists who have a more classical view of the mechanics of commerce predicted that we might tip into a double dip recession, at worst, or a very slow “U” shaped recovery starting in 2010.  As a number of economic indicators turned positive in the early part of 2010, these same economists thought they might be wrong.  Some Keynesians felt vindicated as this economic data seemed to show that their model of government spending could shorten even a severe recession.

In February,  government deficits in Greece and several other European nations revealed the structural weakness of their economies and caused the stock and bond markets to question whether these smaller economies could withstand the relatively high ratio of government spending and debt as a percentage of each country’s GDP.  Germany, a paradigm of conservative fiscal policy, was forced to step in to help support these less fiscally responsible nations.  The European Central Bank, supported by the Federal Reserve, professed a firm support for the bonds of these weaker European nations.  With the magic that only central banks possess, the Federal Reserve pumped $1.2 trillion into U.S. government backed mortgage securities, signalling that it would not allow the newly recovering economy to fall back. In the spring of 2010, the market once again turned to the recovering economy.

Employment usually lags in any recovery and so many expected the unemployment rate to stay high going into the early part of 2010.  In April, after 8 or 9 months of expansion in the manufacturing sector and a recovering service sector, economists were expecting at least some reduction in the unemployment rate.  By late June and early July there appeared to be little increase in hiring.  Those who believed in a more traditional “V” shaped recovery began to have doubts and the market dropped to reflect these lowering expectations.

Week after week come conflicting economic reports, the Federal Reserve is running out of tools other than the rampant printing of money and the unemployment rate stubbornly hangs from the cliff of 10%.  Classical economic models seem to more accurately reflect the slow, tortuous climb out of the debt pit.

Decades from now, regardless of what happens, Keynesian economists will still profess that Keynes’ economic model was right – with perhaps a few modifications to their theory.  Classical economists who agree with the models of Hayek and Friedman will maintain that they are right – with a few modifications.  Fifty or a hundred years from now, our kids’ grandkids will get to do it all over again because too many policymakers would rather cling to their theories than learn from experience.