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.


Photo by Lucas Benjamin on Unsplash

C-Span. (2020, April 7). Firefighting. Retrieved August 12, 2020, from (00:21:15).

C-Span. (2020, July 18). Ben Bernanke and Janet Yellen Testify on COVID-19 Economic Inequities. Retrieved August 12, 2020, from (01:35:20)

Federal Reserve. (2020, July 29). Recent Balance Sheet Trends. Retrieved August 12, 2020, from

Fiebiger, B., & LaVoie, M. (2020, March 4). Helicopter Ben, Monetarism, The New Keynesian Credit View and Loanable Funds. Retrieved August 12, 2020, from

The Big Picture

May 19, 2018

by Steve Stofka

Here is a simple and elegant animation model of the economy in a thirty-minute video from Bridgewater Associates, the world’s largest hedge fund. The video illustrates the spending – income – credit cycle in easy to understand terms. The video includes an insight first noted eighty years ago by the economist John Maynard Keynes, who pointed out that one person’s spending is another person’s income. Sounds obvious, doesn’t it?  I spend money on a pizza which increases the income of the pizza store.

When Keynes explored this simple idea, he revealed a glitch in the traditional model of savings and investment. In a simplified version, money not spent is saved in a bank. The bank loans out those savings to a business.  A business invests that loan into production for future spending. When economists model the whole economy, Savings = Investment. It is an accounting identity like a mathematical definition. The financial industry transforms one into the other.

During the Depression, something was obviously broken, and economists debated various aspects of their models. Keynes asked a question: what happens to the merchant where the money was not spent? Let’s say the Jones family decides not to buy a new TV and puts the money in a savings account at the Acme Bank.  The local Bigg TV store sells one less TV and has a corresponding decline in its income. Because Bigg had less income, they must withdraw money from their Acme Bank savings account to meet payroll. The money that the family saves is withdrawn by the business. The money Saved never makes it to the Investment side of the equation.  There is no increase in investment.

Most of the time, those who are saving and those who are spending funds from saving balances out. But there were times, Keynes proposed, when everyone is saving. Keynes attributed the phenomenon to “animal spirits.” As incomes fall, people start using up their savings to make up for the lost income.

During a crisis like this, Keynes proposed that government increase its spending, even if it needed to borrow, to boost incomes and break the vicious cycle. When the crisis was over, the government could raise taxes to pay back the money it borrowed. In Keynes’ model, government spending acted as a balancing force to the animal spirits of the capitalist economy. In the real world, politicians win votes by spending money but find that raising taxes does not win them favor with voters. Without legislative debt controls, government borrowing to counterbalance declines in income only produces greater government debt.

Turning from government debt to personal debt, the average credit card rate has risen to 15.3%, an eighteen year record. As an economy continues to expand and credit is extended to those with marginal creditworthiness, the default rate grows. The percent of credit card balances that have been charged off in default has risen from 1.5% several years ago to 3.6% in the 4th quarter of 2017.

Mortgage rates have risen to about 4.9% on thirty-year loans, and about a half percent less on fifteen-year loans. That half percent difference is close to the average for the past twenty-five years and adds up to an extra $1.60 in interest paid during the life of the loan on every $100 of mortgage principal. The graph below shows the difference between the two rates.


Because shorter-term mortgages require higher monthly payments, they are more feasible for those with stable financial situations and above average incomes. When the difference in rates is less than average, there is a smaller advantage to getting a short-term mortgage.  At such times, the mortgage industry is reaching out to expand home ownership to lower income homeowners. When the difference is more than average, as it has been since the recession, the finance industry is cautious and not actively reaching out to lower income families.

Mortgages are secured by a physical asset, the house. U.S. Treasury bonds are secured by an intangible asset, the full faith and credit of the country. Just like us, the Treasury usually pays a higher interest rate for a longer-term loan.

A benchmark is the difference between a 10-year Treasury bond and a 2-year bond. As this difference declines toward zero, economists call it a “flattening of the yield curve.” At zero, there is no reward for loaning the government money for a longer term. Knowing only that, a casual investor would sense that something is wrong, and they are right. Periods when this difference falls below zero usually occur about a year before a recession starts. In the graph below, I’ve shaded in pink those negative periods. In gray are the ensuing recessions.


Before that negative pink period comes another phenomenon. Above was the 10 year – 2 year difference in interest rates. Let’s call that the medium difference. There’s also the difference between two long term periods, the 20-year minus 10-year difference. I’ll call that the long difference. When we subtract the medium difference from the long, we get a difference in long term outlook. In a healthy economy, that difference should be positive, meaning that investors are being paid for taking risks over a longer period. When that difference turns negative, it shows that there are underlying distortions in the risks and rewards of loaning money. That distortion will show first before the flattening of the yield curve.


As you can see, the difference today is positive, a welcome sign that a recession is not likely within the year.



The actuaries for Social Security and Medicare use an assumption that our average life expectancy will increase .77% per year (Reuters article)  If you are expected to live till 85 this year, then that expectation will grow to 85 years and eight months next year. That’s a nice birthday present!

U.S. lumber mills can supply only two-thirds of the lumber needed by homebuilders. The other third comes from Canada. Recent import tariffs now add about $6300 to the price of a new home (Albuquerque Journal).


October 25, 2015

Last week we looked at two components of GDP as simple money flows.  In an attempt to understand the severe economic under-performance during the 1930s Depression, John Maynard Keynes proposed a General Theory that studied the influences of monetary policy on the business cycle (History of macoeconomics).  In his study of money flows, Keynes had a fundamental but counterintuitive insight into an aspect of savings that is still debated by economists and policymakers.

Families curtail their spending, or current consumption, for a variety of reasons.  One group of reasons is planned future spending; today’s consumption is shifted into the future.  Saving for college, a new home, a new car, are just some examples of this kind of delayed spending.  The marketplace can not read minds.  All it knows is that a family has cut back their spending.  In “normal” times the number of families delaying spending balances out with those who have delayed spending in the past but are now spending their savings.  However, sometimes people spend far more than they save or save far more than they spend, producing an imbalance in the economy.

When too many people are saving, sales decline and inventories build till sellers and producers notice the lack of demand. To make up for the lack of sales income, businesses go to their bank and withdraw the extra money that families deposited in their savings accounts.  Note that there is no net savings under these circumstances.  Businesses withdraw their savings while families deposit their savings.  After a period of reduced sales, businesses begin laying off employees and ordering fewer goods to balance their inventories to the now reduced sales.  Now those laid off employees withdraw their savings to make up for the lost income and businesses replace their savings by selling inventory without ordering replacement goods.  As resources begin strained, families increasingly tap the several social insurance programs of state and federal governments which act as a communal savings bank,   Having reduced their employees, businesses contribute less to government coffers for social insurance programs.  Governments run deficits.  To fund its growing debt, the Federal government sells its very low risk debt to banks who can buy this AAA debt with few cash reserves, according to the rules set up by the Federal Reserve.  Money is being pumped into the economy.

As the economy continues to weaken, loans and bonds come under pressure.  The value of less credit worthy debt instruments weakens.  On the other side of the ledger are those assets which are claims to future profits – primarily stocks.  Anticipating lower profit growth, the prices of stocks fall.  Liquidity and concern for asset preservation rise as these other assets fall.  Gold and fiat currencies may rise or fall in value depending on the perception of their liquidity.

Until Keynes first proposed the idea of persistent imbalances in an economy, it was thought that imbalances were temporary.  Government intervention was not needed.  A capitalist economy would naturally generate counterbalancing motivations that would auto-correct the economic disparities and eventually reach an equilibrium.  Economists now debate how much government intervention. Few argue anymore for no intervention.  What we take for granted now was at one time a radical idea.

While some economists and policymakers continue to focus on the sovereign debt amount of the U.S. and other developed economies, the money flow from the store of debt, and investor confidence in that flow, is probably more important than the debt itself.  As long as investors trust a country’s ability to service its debt, they will continue to loan the country money at a reasonable interest rate.  While the idea of money flow was not new in the 1930s, Keynes was the first to propose that the aggregate of these flows could have an effect on real economic activity.


Stock market

A very good week for the market, up 2% for the week and over 8% for October.  A surprising earnings report from Microsoft lifted the stock -finally – above its year 2000 price.  China announced a lower interest rate to spur economic activity.  ECB chair Mario Draghi announced more QE to fight deflation in the Eurozone. Moderating home prices and low mortgage rate have boosted existing home sales.

The large cap market, the SP500, is in a re-evaluation phase.  The 10 month average, about 220 days of trading activity, peaked in July at 2067 and if it can hold onto this month’s gains, that average may climb above 2050 at month’s end.

The 10 month relative strength of the SP500 has declined to near zero.  Long term bonds (VBLTX) are slightly below zero, meaning that investors are not committing money to either asset class.  The last time there was a similar situation was in October 2000, as the market faltered after the dot-com run-up.  In the months following, investors swung toward bonds, sending stocks down a third over the next two years.  This time is different, of course, but we will be watching to see if investors indicate a commitment to one asset class or the other in the coming months.

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.

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.