Public Goods and Private Values

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April 16, 2023

by Stephen Stofka

This week’s letter is about the funding for public goods. More than sixty years ago economist Charles Tiebout predicted that we would splinter into different communities based on our use of and desire for public goods like schools, highways, public transportation and other facilities. Let’s dig in!

In his 1948 textbook Economics: An Introductory Analysis, Paul Samuelson introduced the definition of a public good as non-rival and non-excludable. Non-rival means that one person’s consumption of a good does not lessen another’s consumption. National defense is an example. It is difficult to exclude people from a public park or a radio broadcast so these are considered public goods. Samuelson introduced these two characteristics to distinguish public goods from common or pooled goods like a public lake. When there is a plentiful stock of fish, no one notices that when one person catches a fish, someone else cannot catch that particular fish. Overfishing results when people catch fish faster than they can replenish their stocks.

In his eager efforts to systematize and mathematize economic concepts, Samuelson sometimes introduced provocative simplifications. In two separate articles published in 1955, economists Stephen Enke and Julius Margolis gave examples of public goods that were rivalrous. A crowded public highway or school does lessen other people’s consumption. Charles Tiebout (1956) pointed out that one of Samuelson’s simplifying assumptions was that public goods were provided by one source, the federal government.  In 1954, state and local spending was actually twice that of federal spending, excluding national defense. In the chart below, the orange bars are state and local spending, which does include police protection. While it is a public expenditure, a police response to one incident means that they are not available for another call so the police are rivalrous.

A few years after the Johnson administration ushered in the social reforms collectively termed the Great Society in 1964-65, federal spending overtook state and local spending. These programs included Medicare, Medicaid and what were called Food Stamps and Welfare at the time. Today the spending roles are reversed. Without including spending on national defense, federal government spending and investment is almost twice that of state and local.

Samuelson pointed out that there is no market mechanism to price public goods. What is the appropriate price for defense, highways, schools and other public goods? Charles Tiebout (1956) argued that the price for these goods is determined in the voting booth by a public that desires to keep its taxes low. Voters will support those public goods which they consider valuable and will use. Tiebout predicted that voters would migrate to communities where they were among taxpayers who shared similar preferences for a particular set of public goods. If a couple had young children, they would vote for more school funding. Their children would get the benefit while the community as a whole bore the expense. People who liked to golf would favor communities with a like-minded interest who would vote for a public golf course. Tiebout wrote, “The greater the number of communities and the greater the variance among them, the closer the consumer will come to fully realizing his preference position.”

Writing in 1956, Tiebout’s prediction ran counter to the predominant social theory of the American melting pot – that people were becoming gradually harmonized into a single American monoculture. In 2008, Bill Bishop’s book The Big Sort confirmed Tiebout’s prediction. For decades, Americans had been sorting themselves into communities of like-minded preferences and values. Today, few would argue that we live in an increasingly differentiated society of insular interests and values. On social media, we establish community by voicing outrage at those others – what one of them said or did. We form interest clubs with a unique vocabulary, inside references, remarks and jokes that those outside the club don’t get because they don’t understand the context.

In spite of this cacophony of interests and values, there is a clamor for more public goods. More health care, more schools, more public spaces. How are we ever going to agree on the funding for these public goods? The successful ballot initiatives supporting public goods have a common characteristic. They spread the cost evenly by exacting a very small increase in a sales tax rate. People will vote for a public good if it will cost all households a small amount like $20 extra sales tax. This tax, known as a Tiebout equilibrium, acts more like a user fee than a tax.

Each year federal spending less national defense grows a bit more than state and local spending. If local voters cannot agree on spending priorities, this divide will get larger, throwing more of the spending burden on the federal purse and increasing the federal debt. Officials in local districts, frustrated by a lack of voter consensus, will increasingly look to Washington for school funding, children’s lunch programs, health care, public transportation, support of libraries and museums. Where does this end?

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As an aside, defense spending has a unique characteristic. Most government services increase as the population increases. It may not be in proportion but that is the general case. Increases in defense expenditures respond more to the perception of outside threats, not the size of the population. Here is a chart of per capita spending in nominal dollars, spending that has not been adjusted for inflation.

When spending is adjusted for inflation, it is clear that defense spending responds primarily to  perceived threats, not population growth.

After 9-11, real per capita spending on national defense increased by 33%, from $2100 to $2800 per person. In June 2009, President Obama began withdrawing troops to meet a campaign pledge. By the end of his second term in 2016, real per capita defense spending had returned to a level that existed before 9-11. Despite his isolationist rhetoric the Trump administration increased defense spending. This was largely due to pressure from a Republican Senate and House. In the less populous areas of the south, central and mountain west, more defense spending means more government jobs that promise stability and benefits. Republicans may preach small government but the communities they represent value government jobs and the economic benefits that ripples through local communities from military spending.

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Photo by Amy-Leigh Barnard on Unsplash

Tiebout, C. M. (1956). A pure theory of local expenditures. Journal of Political Economy, 64(5), 416–424. https://doi.org/10.1086/257839

Healthcare Inflation

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April 9, 2023

by Stephen Stofka

This week’s letter is about health care spending and its effect on inflation. Economists construct a composite price index number out of many components of the economy. While that construction may have a rigorous methodology we struggle to make causal inferences from the data because price movements in an economy are complex.

In 1965 President Johnson signed the law creating the Medicare and Medicaid programs. At that time, health care spending was 6% of total consumer spending. The radical reformers of that age wildly underestimated Medicare’s costs, particularly for inpatient hospital costs. Since the government now paid for the first 90 days of a hospital stay, doctors were encouraged to take a cautious approach and keep a patient in the hospital if there was a chance of infection or accident at home. The deep pockets of the federal government incentivized medical and pharmaceutical companies to develop new drugs and equipment. Hospitals expanded their surgery and rehabilitation units. Doctors increasingly turned to specialization and their numbers tripled from near 90,000 in 1965 to 284,000 in 1990, according to the National Center for Health Workforce Analysis. In 25 years, healthcare spending (https://fred.stlouisfed.org/graph/?g=12f9k) more than doubled as a percent of consumer spending, coming close to 15% of the total. It has risen to 17% in the past decade and now is 16%. Here’s a chart showing the growing contribution of healthcare spending to total consumer spending (blue line) and healthcare inflation’s impact on overall inflation (red line).

Healthcare spending has a large effect on inflation through two channels: first, during recessions healthcare spending does not decline as much as overall consumer spending; second, prices for health care services have grown faster than the prices of many other goods because the demand for healthcare services remains strong and constant. Since 1990 the prices for all goods and services have increased 81%, far less than the 131% of healthcare prices.

During recessions, total consumer spending falls and that puts downward pressure on inflation. But the healthcare component resists that downward pressure. The Federal Reserve, whose job it is to keep prices stable, might delay lowering interest rates because healthcare spending is keeping the price index elevated above the level of all other goods and services. This in turn could prolong the after effects of a recession: less lending and slower gains in employment. This is what happened after the 1990 and 2001 recessions. During the 1990 recession, inflation (the annual change in price) actually rose a bit before falling, spurred on by an 8.5% increase in healthcare prices. By the first quarter of 1991, healthcare was contributing 40% to overall inflation, rising up from 13% in 1989. The same pattern repeated in the 2000-2002 period.

Even though both recessions lasted less than a year, job recovery was slow. The lingering effect of a recession surely cost President George H.W. Bush a chance at a second term. In 1992, both Bill Clinton and Independent candidate Ross Perot reminded voters that the economy was sluggish and it was time for a change of direction. In the 2000s, Bush’s son, George, learned from his father’s misfortune. He urged the passage of tax cut packages and the Medicare Drug program, which helped secure his victory in the 2004 election despite disapproval of the conduct of the war in Iraq.

The ACA, or Obamacare, capped the growth of inpatient Medicare payments at 2% and this helped keep healthcare inflation (https://fred.stlouisfed.org/graph/?g=12f9b)  at or below 2%. Medicaid expansion doubled the contribution level of healthcare prices to overall inflation, but because healthcare inflation was restrained, that helped to contain overall inflation.

The pandemic showed the enduring influence healthcare has on the general price level. When consumer spending had a sharp decline, healthcare prices remained strong. During the 3rd quarter of 2020, healthcare inflation was 2.9% and was responsible for nearly all of the general inflation rate of 1.1%. But here, the paths diverged. As the economy reopened and the general rate of inflation rose during 2021 and 2022, healthcare inflation decreased. That divergence describes the nature of the current overall inflation. It is procyclical, driven by short-to-medium term events, not a fundamental change in the economy.

In a 2017 Federal Reserve Economic Letter, Tim Mahedy and Adam Shapiro (2017) assigned spending categories into two buckets, procyclical and acyclical. Procyclical components that make up 42% of spending are those whose demand and prices vary with the business cycle and changes in employment. These include housing, recreation, food services and some nondurable goods. Acyclical components account for 58% of spending and include healthcare, financial services, many durable goods and transportation. The authors don’t mention energy specifically but I presume that it is an acyclical component of both housing and transportation services.

The pandemic caused shifts within and between these two buckets. During the pandemic demand soared for housing services, but declined for recreation and food services – an example of a shift within the procyclical bucket. We used a lot less energy in our cars but a lot more electricity and gas at home – a shift within the acyclical bucket. We bought a lot of durable goods – a shift between buckets.

I think it is the between  shifts that had the most disruption. Supply chains for acyclical goods and services function on a less flexible timeline that does not anticipate sudden changes. Global shipping rates soared, ports were clogged with traffic, parts inventories were depleted, leading to manufacturing delays and an opportunity for companies to raise prices to make up for decreased profits due to shrinking volumes. With long delays from overseas suppliers, big retailers like Wal-Mart and Target increased their orders. As pandemic restrictions lifted, people shifted their spending again from acyclical durable goods to procyclical recreation and food services.  

Each of us constructs an instinctive index based on our individual buying habits and circumstances. An American who lives for a while over in Europe has to learn to convert Centigrade temperatures to Fahrenheit. Like the CPI price index, there is methodology for making that conversion. However, it is much easier to remember that 0°C is cold, 10°C is cool, 20°C is comfortable,  30° is hot, and 40° is hell. Much of the time we navigate our daily lives without precision, relying on professionals when we do need exactness. Sometimes the professionals can tell us why something is the way it is but sometimes even they can only guess. Complexity is the result of an interlocking causality that is harder to solve than a Rubik’s cube.

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Photo by John Barkiple on Unsplash

Mahedy, T., & Shapiro, A. (2017, November 27). What’s down with inflation? San Francisco Fed. Retrieved April 6, 2023, from https://www.frbsf.org/economic-research/publications/economic-letter/2017/november/contribution-to-low-pce-inflation-from-healthcare/

The Price Box

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April 2, 2023

by Stephen Stofka

This week’s letter is about prices. If you’ve have ever been a business owner – even a micro business like delivering papers – you are aware that price is a label on a box. My wife and I have a cat, Ellie, and we keep all of her toys in a cardboard box in the living room. The price of one product – $24.99 – is like a label on all the objects in that box.

Inside that price are supply factors, the costs of making and distributing the product and the vendor’s costs in selling the product. To a kid delivering papers on a bicycle those costs include broken chains and flat tires and brake repair. There are opportunity costs – what else a kid could be doing when they are out delivering newspapers.[i] The supply of a product entails legal costs and taxes and the institutional costs of maintaining property rights. The court system and the police force are in that price box. Is the market for that product a monopoly or competitive? Trade restrictions and tariffs, supplier subsidies, weather and seasonal factors – It’s in the box.

There are demand components in that box as well. How responsive are customers to changes in price and the trend in income growth. Consumer expectations of price increases or supply shortages for that product and competition from other vendors and goods. Substitutes or complements for the product. Consumer subsidies like low interest loans, mortgage loan government guarantees, bankruptcy laws and favorable tax laws. Time itself is in the box. Our tastes and desires change with the years and that’s in the box.

There is a calculation procedure in linear algebra where a bunch of numbers get multiplied and added together to give just one number. That’s what a price is. It is a piece of information that unfolds into an origami of the structure of our society, government and economy. If uncovers our moral values and the relationships of power within our society.

Economists of the Austrian School of Economics stress that prices help organize production and consumption decisions. They reject the emphasis on regulation as a director of resources. They sometimes refer to Adam Smith’s “invisible hand,” the idea that people seeking their own well-being can act for the benefit of everyone. Prices work in that world. The drive to seek our own well-being has a darker side that Smith explored throughout his book, The Wealth of Nations. In that world, isn’t there a need for regulations to curb individual appetites? Those who craft and enforce the regulations are themselves seeking their own well-being.  

We often say that “no one is above the law.” However, everyone wants to “get around the price,” and the politically powerful are able to do so. Smith advocated a free market only as a last resort after documenting the many instances where policymakers – “magistrates” and “council members” – wrote laws that favored the rich and influential. He was in favor of a well-regulated economy that ensured fair and equitable rules for everyone but there is no one capable of that. Smith found relationships of power corrupted most rule-making.

In Part 1, Chapter 7, he explains the price advantage enjoyed by those who secured a monopoly for their product or service. They were then able to charge the highest price. In Chapter 8, capitalists had contrived to have laws written that permitted the combining of capital but did not permit workers to form unions to increase their bargaining power. Business owners regularly colluded with each other to keep wages low. Smith writes “whoever imagines … that masters [employers] rarely combine, is as ignorant of the world as of the subject.” This from a man who studied the wages and prices in Europe and the colonies. Chapter 10, he notes the Statute of Apprenticeship laws that restricted the free movement of labor from one town to another and from one company to another. The weaving of plain linen and plain silk were similar skills but linen weavers were not allowed to transfer to another company to weave silk. In Chapter 11, he documents how French vineyard owners got a law passed that prevented any new vineyards. This preserved the vineyard owners pricing power. There were money policies and trade rules that preserved the power of the politically powerful in Britain at the expense of the American colonists. The American colonists were allowed to harvest raw materials but were required to ship them to British manufacturers to make the final products from those inputs. The book was published in 1776, the same year that the colonists finally got fed up and declared their independence.

Because prices direct production and consumption, so many of us want to alter that direction for own benefit. In the past weeks I have written that social, political and economic behavior is better understood as a recursive function where the output from the function becomes the input to the next call of the function. As some parties in the free market successfully alter the rules that govern the costs that are in the price box, that raises the call for regulation from those who are disadvantaged by that alteration. So policymakers and regulators write rules that rearrange the costs as a corrective to the distortions committed by the people and companies that they regulate.

Economic purists may envision a market of prices that work like an Antikythera mechanism, directing resources for the general well-being. Economic students are taught the ideal of the perfectly competitive market even though it rarely exists. Aircraft wing designs are tested in a wind tunnel without an engine powering the wing. This eliminates distortions in the interaction between wind and wing. Isaac Newton envisioned a universe without gravity and friction – both of them “unbalanced forces” – to derive the first law of motion. Too much deductive economic theory is founded on the assumption that a social science like economics can be tested with the same methods used in the physical sciences.

Socialist purists clamor for ever more regulation to fix an endless supply of injustice in the market. They open up the price box and see all the dark forces that Smith wrote about – monopoly and collusion and greed and bigotry that harms the general well-being. They claim that regulators and lawmakers are able to overcome their self-centered impulses and act in accordance with democratically created law. To paraphrase Smith, whoever imagines that to be the case is as “ignorant of the world as of the subject.” He did not have a cynical view of human nature but a realistic view of the natural contradictions of human nature.  

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Photo by Katrin Friedl on Unsplash

Keywords: supply costs, demand factors, Austrian Economics, price theory, regulations

[i] Conventional economic theory too often assigns little or no value to leisure. Tate & Fegley (2020) argue that leisure is a complementary good to labor the way that mustard is a complementary good to a hot dog. They countered the neo-classical assumption that people would work all of their waking hours if they were paid enough.  

Fegley, T., & Israel, K.-F. (2020). The disutility of Labor. Quarterly Journal of Austrian Economics, 23(2), 171–179. https://doi.org/10.35297/qjae.010064

The Pause in the Cycle

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March 26, 2023

by Stephen Stofka

This week I’ll look at things that are hard to measure and their effect on our lives. Much of human activity is recursive, meaning that the outcome of one action becomes the input to the next iteration of that same action. When we get nervous we may breathe fast and shallow which changes our body chemistry increasing our anxiety and we continue breathing fast and shallow, amplifying the effect. Because of that cyclic process prominent thinkers like Aristotle, Adam Smith, David Ricardo, Karl Marx, and Joseph Schumpeter, among others, have proposed circular models of human behavior.

The 19th century economist David Ricardo modeled the industrial process as a profit cycle. Increasing or decreasing profits mark the division between two phases of the cycle. The first phase is a series of more and higher –

rising profits,
more investment,
leading to more output,
an increased demand for labor,
a rise in wages,
a rise in population and consumption,
an increasing use of less efficient inputs,
higher prices,
then higher interest rates,
and lower profits.

The decline in profits signals the end of the expansion and begins the downward phase, a cycle of less and lower of each of those elements – less investment, output, less demand for labor, lower wages in aggregate, etc. Ricardo assumed that workers received subsistence wages so an individual worker might not work for wages any lower. Like his friend Thomas Malthus, Ricardo assumed that higher incomes would lead to an increase in population. In the early 19th century, less efficient inputs meant less fertile land. As our economy has transitioned to become almost entirely service oriented, the less efficient inputs are labor. It is difficult for a hairdresser or therapist to become more productive.

Since the pandemic companies have been rewarded for raising prices, a strategy Samuel Rines, managing director of the research advisory firm Corbu, called “price over volume” on a March 9th Odd Lots podcast. With this strategy, companies like Wal-Mart keep pushing prices higher, willing to accept lower volume as long as total revenue and profits are higher. After-tax corporate profits (CP) have risen more than 40% from pre-pandemic levels, according to the Federal Reserve.

In Ricardo’s model of the profit cycle, higher prices lead to higher interest rates as investors increase their demand for money to take advantage of the higher prices. In our economy, the Fed controls the Federal Funds interest rate that other rates are based on. As prices continued to rise, the Fed began to lift rates and has raised them more than 4% in the past year. As the Fed raises rates, bank loan officers tighten lending standards, beginning with small firms (DRTSCIS) and credit card loans (DRTSCLCC). The FRED data series identifiers are in parentheses. In the past year, banks have increased their lending standards by more than 50% for small firms and 43% for credit card loans. However, all commercial loans have increased by 15% in the past year and delinquency rates have not changed since the Fed started raising rates. This is part of Ricardo’s model. Investment does not decrease until profits decline. Profits (CP) still grew at 2.25% in the 3rd quarter of 2022. We are not there yet.

In the 4th quarter of 2022, real GDP grew at less than 1% on an annual basis. We won’t have an estimate of 1st quarter numbers until the 3rd week of April but employment remains strong. Since 1980, the population adjusted percent change in employment goes negative or approaches zero just before recessions. In the chart below, notice how closely the employment (blue line) and output series move in tandem. The red line is the annual percent change in real GDP.

We may be approaching the pause point but the point of decline could be six months to a year away. Although the Fed let up on the “gas pedal,” raising rates by ¼% rather than ½%, they showed their commitment to curbing inflation as long as the employment market stays strong. If the Fed had not raised rates this past week, they would have set expectations that they were done raising rates. For now we can look for these signs that the expansion of the business cycle in Ricardo’s model is coming to a close.

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Photo by Lukas Tennie on Unsplash

The Money Treadmill

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March 19, 2023

by Stephen Stofka

Inflation is a cat’s cradle of mechanisms and motivations as mysterious as time, a simple and puzzling concept that controls our lives. Our minds are caged by this thing that is objectively invariant – a second is a second – but experienced so differently by each of us. It begins when we are very young and ask a parent when we can go to the beach or an amusement park. “Next week,” we are told, and our eyes glaze over. How far away is next week? Albert Einstein was the first to understand time as a distance. Stephen Hawking, one of the most fertile minds of the last century, wrestled with the beginning of cosmological time.  Many of us struggle to knit two concepts together – time and money. To many of us the net present value of a future flow of moneylooks like something inside of a tangled ball of fishing line.

Several banks blew up recently because they mismanaged their exposure to time risk. Inflation is the experience that time is moving faster than our money. It’s like our money is running on a treadmill when someone starts increasing the speed of the treadmill. The Fed cannot directly affect the speed of the treadmill so it raises interest rates, the equivalent of adding weight to our money. More often than not, the Fed damages the treadmill, sending the economy into recession.  

I’ll include some background on the relationship between inflation and interest rates. Irving Fisher was an influential economist in the early half of the 20th century whose ideas continue to influence economic thinking. Several of these are the Quantity Theory of Money, a way of computing a price index, and a hypothetical relationship between inflation and unemployment that later became known as the Phillips Curve. Fisher hypothesized that interest rates rise in a lockstep response to inflation – an idea known as the Fisher Effect. Fisher reasoned that lenders would demand higher interest rates if they anticipated that a dollar would buy less in the future. For the same reason, depositors would demand higher interest rates on their savings. Fisher died in 1947, just after World War 2. In the decades after his death, the data did not support a simple one-for-one relationship between interest rates and inflation.

Despite the lack of a simple relationship, the Fed has limited tools to achieve – by law – two counterbalancing targets, full employment and stable prices. For several decades, its policy objective has targeted a 2% inflation rate as a quantitative mark of stable prices. To counter inflation, the Fed initiates a Fisher Effect by being the first bank to raise the interest rate it pays to all the other banks. The reasoning is that banks will charge higher interest on their loans to cover the higher cost of their funds. That should slow loan demand. Secondly, the Fed reasons that banks will raise the interest rate they pay on deposits. A higher rate should induce people to save more and spend less, thus slowing down the treadmill.

Fisher’s Quantity Theory of Money (QTM) is built on the assumption – an “if” – that interest rates stayed constant. Since interest rates were lowered to near zero during the financial crisis in 2008, there has been little movement in interest rates. This became a natural experiment that Fisher had imagined – a world where interest rates remained constant. As the Fed pumped more money into the economy during the 2010s, the QTM predicted that prices would rise. They didn’t. Just as economists had discovered that the relationship between interest rates and prices was complicated, so too was the relationship the quantity of money and prices.

Banking is the art and discipline of managing the speed and weight of money when an individual bank has no control over either the speed or the weight. Anything that stays still for long becomes invisible or at least minimizes their risk. Cats instinctively know this as they wait still and patient in the hope that a wary bird will relax its guard. The long lack of movement in interest rates tempted those at Silicon Valley Bank to take concentrated risks based on the assumption that interest rates would continue to stay low.

Retail investors are cautioned not to load up on long-term bonds just to get a higher interest rate return. From October 2021 to October 2022 Vanguard’s long-term bond index BLV lost almost 30% in value. Professional bankers broke that cautionary rule. Former Fed Chairman Alan Greenspan admitted his mistake in judgment as the 2008 financial crisis unfolded: “I made a mistake in presuming that the self-interests of … banks … were such that they were best capable of protecting their own shareholders and their equity in the firms.” By holding interest rates low for so long, some banks lost their sense of prudent risk management. The cat pounced.

This experience should guide our own choices of investment, savings and risk management. We can be lulled into thinking that some factor in our lives will stay constant. Some factors are personal – a job, a marriage, our health and the health of our family. Some factors belong to the wider community we are a part of – the local economy, the housing market and the weather. Other factors are macro – interest rates, inflation, state and federal policies. We can do what Silicon Valley Bank did not do – diversify.

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Some have likened the run on SVB to the D&D model presented in a 1983 paper. Douglas Diamond and Philip Dybvig (D&D) won the 2022 Nobel Prize for their model demonstrating the efficiency and appropriateness of government deposit insurance. Douglas Diamond was interviewed this past Tuesday on the podcast Capital Isn’t. Diamond says that the bank run on SVB was not like the ones they presented in their model. In that model the depositor base was much wider and diverse, more like a random sample than the depositors of SVB who were primarily businesses in the tech industry.

Photo by Sven Mieke on Unsplash

Paradoxes in Savings

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March 12, 2023

by Stephen Stofka

Paradoxes in Savings

The week’s letter is about the relationship between savings and inflation. On Tuesday, Jay Powell, the Chairman of the Fed, announced that they would continue raising rates to get inflation under control. The market dived a few percentage points. There are no shortage of explanations for persistent inflation. Despite an inflation rate above 5% for the past year, the employment market remains strong, a puzzle to economists. I will take a look at how changes in savings affect inflation.

There are times when we coordinate our behavior for apparent reasons. The weather and seasons synchronize the activities of farmers. The harvest comes at a particular time and farmers need to rent more harvesting equipment, storage capacity, rail cars and trucks for transporting their crops. Suppliers are on a different time schedule than their customers.  Supplying anything takes planning, investment and time.

Suppliers rely on the fact that buyers coordinate their buying decisions according to the seasons. Clothes, gardening and Christmas gifts are easy examples. Forty percent of homes are sold during the spring months. Except for big purchases, a buying decision takes less planning and this can create anomalies that suppliers are not prepared for. Sometimes it is a popular toy at Christmas or a clothes style made popular by a celebrity.

What causes asset buyers to coordinate their behavior? The economist John Maynard Keynes was particularly interested in that question. He attributed the phenomenon to “animal spirits,” an infectious rush of pessimism or optimism that affects the prices of assets first, then spreads to the purchases of goods. Normally, some of us are saving more than usual for something, while some of us are spending that savings, or borrowing to buy things. There is a balance of savers and borrowers. However, sometimes a general prudence causes everyone to save more than average and what emerges is a paradox, the Paradox of Saving. If everyone saves, then economic activity declines, unemployment rises, people spend down their savings and the economy finds a new equilibrium at a much lower growth rate.

In the spring of 2020, a surge of Covid deaths in Italy and New York City prompted the closing of many businesses. City morgues were overwhelmed, forcing hospitals to rent refrigerated trucks to store the bodies. The NY health department supervised several mass burials. Residents in rural areas who were unable to catch their breath were flown to distant hospitals with the equipment and personnel capable of bringing the patients some relief. Because many workers had abruptly lost their income, the government issued relief payments to households throughout the country. With many entertainment venues closed, many of us increased our rate of savings. Below is a graph of the quarterly change in the personal savings rate.

The savings rate shot up 15%, a historic rise. Even during the high inflation of the 1970s, the savings rate rose by only 2.5% in 1975. Such an abrupt change in savings did have an effect on prices. When the change in the savings rate is negative, people are buying stuff with their savings. Companies could take advantage of supply chain bottlenecks and raise prices. This helped make back what they had lost in profits in 2020. The quarterly change in prices began to rise, as the red line in the chart below indicates. Note that inflation is the annual, not quarterly, change in prices.

Look on the right side of that chart and you will see the blue savings line turning positive. A steadily higher savings rate should exert some calming effect on prices. I then ran a statistical regression on the annual change in both prices, i.e. inflation, and the savings rate for the past 35 years. The effect of a 1% rise in the savings rate is about a 1% decrease in the inflation rate and explains 21% of the movement in inflation.

What can you do with this information? Quick erratic changes in savings have an effect on prices. Immediately after 9-11 there was an abrupt rise and fall in savings but the change was much less than the pandemic shock, which was truly historic. In 2008 came another shock, an abrupt shift in savings and an accompanying rise in prices in the summer of 2008 before the Lehman meltdown in September and the economy tanked in the 4th quarter of 2008. These changes in savings rates don’t occur very often, but when they do we should pay attention.

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Photo by Johannes Plenio on Unsplash

The Money Cycle

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March 5, 2023

by Stephen Stofka

This week’s letter is about money and a natural resource like water. The nature of money, its origin and history have long been a subject of lively debate. What similarities and differences does money have with water? Does an analogy help uncover some less apparent characteristics of money? I’ll start with the three purposes of money that every economics student learns: a medium of exchange, a store of value and a unit of account. Coincidentally, water has three phases, gas, solid and liquid, and in each of those phases has some of the characteristics of money. The quantity of money can expand. The volume of water in all its phases is fixed.

Ice stores the energy of water the way that money stores value. As freezing water locks together in a crystal lattice, it becomes its own container. Oddly enough, most ice exhibits a hexagonal form, an efficient material transformation in response to changes in temperature. Only 2.5% of the world’s water is freshwater and most of that is locked up in glaciers. Money’s store of value is contained within assets.

In Part 5, Chapter 3 of the Wealth of Nations, Adam Smith noted that people tend to hoard their capital, to lock it away from a government which has little respect for individual property – what he called a “rude state of society.” If merchants and manufacturers have confidence in a government, they are willing to lend it money because the debt of that government can be traded in the market as though it were money. It is an interest bearing money. He lamented the fact that too many governments borrowed money to finance war and taxed people to build infrastructure. He suggested that governments do the opposite – borrow as much idle capital as possible to enhance the productivity of a country and tax people to finance wars. There would be less war and more progress.

Like money, water vapor is a medium of exchange between sky and ocean, between sky and earth. It is in constant motion within the atmosphere because its density quickly changes in response to changes in heat. It carries the water from the ocean and drops it onto the land in a conveyer belt system called the hydrological cycle. When all the earth came together in one supercontinent called Pangea 250 million years ago, water vapor transported little moisture from the oceans to the interior of the vast continent and the land was mostly desert (Howgego, 2016). When businesses around the world closed their doors at the onset of the pandemic in March 2020, we became very aware that our society, not just our economy, depends on a cycle of exchange.

Money is a unit of account, a common denominator to add up all the various goods and services in an economy. We add up tons of wheat and corn and millions of hours of labor in terms of money. . While we often think of fractions as “this divided by that,” economists understand fractions as “this in relation to that.” A social scientist might question whether it is a good idea for people to think of their labor in relation to money, the common denominator. Sadly, our society judges our worth to society in relation to that common denominator, money.

Water has a density like money has a purchasing power. Water is at its most dense – its weight per unit of volume – at 39°F and that benchmark is standardized at 1 in the metric system. The density of water at 39°F is like the benchmark price that economists use when they compute real GDP. Its volume expands as it gets colder or hotter than that temperature, so it’s density declines. The most measurable changes come at higher temperatures; at 200°F, the density is .963. We often use the language of heat when talking about inflation. The economy is overheating, for example. When there is hyperinflation¸ society itself begins to change state, just as water does at the boiling point.

Changes in the market value of our assets can have a material effect on our sense of safety. We work hard and save only a small portion of what we earn. When the value of an asset declines, it seems to melt away as though it were a block of ice on a sunny day. We may get a sense of helplessness or anxiety similar to the feeling we have when we lose electricity and worry that we will have to replace all the food in our fridge.

Readers may have other insights into money based on this water analogy. Just as equations can expose relationships that we did not understand before, analogies can do the same.

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Photo by Ryan Yao on Unsplash

Howgego, J. (2016, July 14). Travel back in time to the most extreme desert and monsoons ever. New Scientist. Retrieved March 3, 2023, from https://www.newscientist.com/article/mg22730300-600-travel-back-in-time-to-the-most-extreme-desert-and-monsoons-ever/

An Evolving Society

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February 26, 2023

by Stephen Stofka

Our political conversation often features a dispute over the role of government in our lives. Role is a shorthand word for recognition, powers, legal authority, and mutual responsibilities of government. In the U.S. this debate occurs on multiple levels: 1) the role of the federal government to the states, 2) the role of state governments to cities, 3) the role of all three levels of government to the individual. Supporting these roles are the customs and beliefs of our society.

To understand the development of society, I break it into three phases of political economy. The first is tribalism, a society built on honor. Members of the tribe are expected to accept their status and recognize the status of others. Any disruption to this network of status within the tribe is perceived as a threat to the tribe itself. A second type of society called feudalism is based on obligation. Each member belongs to a class within the society and each class has an obligation to those of other classes. A third type of society called capitalism is based on individual property claims that are tradeable. In the U.S. this set of economic and financial relationships is paired with a democratic political regime based on non-tradeable rights like life, liberty, and the pursuit of happiness as stated in the Declaration of Independence. Claims are tradeable, rights are non-tradeable.

Using this framework, socialism would be a hybrid of feudalism and capitalism. Socialist principles describe obligations to each other as a way of reaching equality and equity. Laws under a socialist regime establish government as an agent who can trade property claims for individuals as a means of meeting those obligations. Governments can redistribute resources through space, from one region to another, or across time, from one generation to another. The Social Security program is an example of such an intergenerational transfer.

Property claims depend on information to establish the claim and facilitate the trading of those claims. However, trading relies on an asymmetry, or uneven level, of information or expectations between buyer and seller. Asymmetry of information is different than misinformation, the transmission of information which someone knows not to be true in order to persuade someone else to do something without physically forcing them. This is where democratic politics, the system of non-tradeable rights, must be separated from economics, the system of tradeable claims.

Democratic politics relies on some degree of misinformation to persuade people to vote for a candidate. A candidate who holds an unpopular position on an issue will not reveal that true conviction if they think voters will reject them because of that position. Republican representative George Santos can misrepresent himself and his background to get elected but not commit criminal fraud.

On the other hand, economic transactions founded on misinformation and misrepresentation are classified as fraud. Carlos Watson, the founder of Ozy Media, can make several misrepresentations and be arrested for criminal fraud (Palma & Nicolaou, 2023). Our capitalist system emphasizes tradeable property claims and the right of contract. Our democratic system punishes transgressions against the capitalist system of contract. Votes cannot be traded legally and our political system rarely exacts criminal penalties for violations of election law.

Article 1, Section 8 of the Constitution gives Congress powers over tradeable property claims. These involve the powers
1) to tax
2) to borrow money and pay debts on behalf of all the states
3) regulate interstate commerce,
4) establish rules for bankruptcy, when property claims become forfeit,
3) control of the creation of money used to make exchanges,
4) regulation of the weights and measures of tradeable goods
5) the granting of copyrights, patents and trademarks which establish tradeable property claims (see Johnson, 2009 in the footnotes).

After specifying some regulatory control over tradeable property claims, the Constitution then grants power to Congress to regulate non-tradeable rights. These involve what economists call public goods. These include
1) Naturalization, the claim to non-tradeable rights as a citizen, including the right to vote.
2) the lower courts that address violations against both rights and claims,
3) the mechanisms for providing a common defense to protect both claims and rights from outside interference and intrusion,
4) the rules of international relations, conduct of war and treatment of prisoners,
5) establishing and administering a central capitol district.

There are two approaches to constitutional interpretation. Conservatives regard it as an instruction manual and employ two analytical techniques grouped under textualism, a close reading of the law, and originalism, understanding the text in the historical background when a law was written. Free market enthusiasts believe that the federal government should have a minimum role in the economy. The framers gave the federal government broad powers over the legal tools that facilitate economic exchange but not the regulation of outcomes. Therefore, the Congress has only those powers listed in Article 1, Section 8, as above.

On the opposite end of the political spectrum are those who interpret the Constitution as software code that needs to be maintained to meet the needs of those who use it. They rely on one phrase at the beginning of Section 8 – provide for the…general welfare of the United States – as a justification for expansive federal authority and redistributive programs. Which is it – instruction manual or software code?

These two political camps may have different perspectives on the scope of government authority but the farm bill is a big spending tent where both camps meet. Spending under this annual bill benefits both farms and individual households. The bill provides price supports to farmers, many of whom are politically conservative. The large scope of the farm bill also includes food support for low income households, addressing the concerns of those who have a more expansive view of the role of government. Democracy is a big tent of competing values and conflicting interests as messy as a finger-style Texas barbecue.

These political and economic debates evolve rather than resolve, and they evolve through conflict. The superior arms of those who believed in individual property rights conquered tribes founded on the principle of group property rights. As those tribes were confined or exterminated in some cases, the debate has been silenced. Technological improvements in farming made feudalism impractical and unprofitable. We are no longer debating the mutual obligations of peasant workers and the propertied lords granted their lands by the king. Our current system will evolve through conflict as well.

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Photo by Eugene Zhyvchik on Unsplash

Johnson, S. (2009). The invention of air: A story of science, faith, revolution, and the birth of America. Riverhead Books. This is an engaging book about Joseph Priestley and his influence on seminal thinkers of the 18th and 19th century, including Benjamin Franklin, John Adams and Thomas Jefferson. Priestley publicized his experiments and methods to advance the state of scientific knowledge. He believed that patent rights interfered with progress and the natural human instinct to share knowledge.

Palma, S., & Nicolaou, A. (2023, February 23). Ozy Media founder Carlos Watson arrested on fraud charges. Financial Times. Retrieved February 24, 2023, from https://www.ft.com/content/0669ff08-05d8-4a99-bdec-30f89d59acd6

A Labor-Output Ratio

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February 19, 2023

by Stephen Stofka

When analyzing the economies of some developing countries, economists refer to a “resource curse,” a commodity like oil or minerals that a country can sell on the global market. In a developing country, that commodity may become the main source of foreign currency, used to pay for imports of other goods. The extraction of that resource requires capital investment which usually comes from outside the country. If the production of that resource is not nationalized, most of the profits leave the country.

There are a few big winners and a lot of losers. This uneven ratio promotes economic and social inequality. Political instability arises as people within the country want to get a hold on those resources. Some politicians promise to use the profits from the resource to benefit everyone but those who seize power benefit the most. Political priorities determine economic decisions and the production of that resource becomes inefficient.

A key factor in the “resource curse” is that its contribution to GDP is usually far above its contribution to employment. If a mining sector accounts for 2% of employment but contributes 10% to GDP, the ratio of employment / GDP % equals 2%/10%, or 0.2. Ratios that are far below 1 do not promote a healthy economy. Industries that are closer to a 1-1 ratio will produce a more well rounded and vibrant economy because employed people spend their earnings in other sectors of the economy – a diffusion effect. Some economists might say that a low ratio means that capital is being used more efficiently and attracts capital investment. However, that efficiency comes at an undesirable social and economic cost.

 Let’s look at some examples in the U.S. The construction industry contributes 3.9% to GDP (blue line in the graph below) but accounts for 5.1% of employment (red line). Notice that this is the opposite of the example I gave above. The 1.31 ratio of employment/GDP is above 1, meaning that the industry employs more people for the direct value that it adds to the economy.  Construction spending includes remodels and building additions but does not include maintenance and repair (Census Bureau, n.d.). In the chart below, look at how closely GDP and employment move together. The divergence in the two series since the pandemic indicates the distortions in the housing market because of rising interest rates. Builders have put projects on hold but employment in the sector is still rising because of the tight labor market.

The finance sector’s share of the economy has grown since the financial crisis yet employment has remained steady – or stuck, depending on one’s perspective. The great financial crisis put stress on banks, big and small, but the government bailed out only the “systemically important” banks, leaving smaller regional banks to fend for themselves. The larger banks absorbed many smaller banks, leading to a consolidation in the industry. That consolidation and investments in technology helped the sector become more efficient. The ratio is about 0.75, above the 0.2 ratio in the example I gave earlier. I labeled the lines because the colors are reversed.

Retail employs a lot of people relative to its contribution to GDP. The ratio is about 1.65. Does that mean retail is an inefficient use of capital? Retail sales taxes pay for many of the city services we enjoy and take for granted. Retail is the glue that holds our communities together.

The manufacturing sector employs fewer people in relation to its GDP contribution. It’s ratio is 0.77, about the same as finance.

As I noted earlier, the mining sector is capital intensive with a high ratio of GDP to employment. This sector includes gas and oil extraction. In the U.S. that ratio averages about 0.33 but it is erratic global demand. Look at the effect during the pandemic. In our diversified economy, the mining sector contributes only a small amount, like 2%. In a developing country like Namibia in southern Africa, mining accounts for 10% of GDP. In the pandemic year, the demand for minerals declined and Namibia’s economy fell 8%.

Lastly, I will include the contribution of health care, education and social services, which contribute 7.5% to GDP but employ almost a quarter of all workers. Since the financial crisis and the passage of Obamacare, this composite sector contributes an additional 1% to GDP. These sectors include many public goods and services that form the backbone of our society. The 3.0 ratio is the inverse of the mining sector.

To summarize, the construction, retail, health care and education sectors have a ratio above 1. They employ more people for each percentage unit of output. The finance, manufacturing, mining, oil and gas sectors have ratios less than 1, employing fewer people per percentage unit of output. For readers interested in the GDP contribution of other industries, the Federal Reserve maintains a list of charts, linked here [https://fred.stlouisfed.org/release?rid=331].

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Census Bureau. (2019, April 15). Construction spending – definitions. United States Census Bureau. Retrieved February 16, 2023, from https://www.census.gov/construction/c30/definitions.html

U.S. Bureau of Economic Analysis, Value Added by Industry: Construction as a Percentage of GDP [VAPGDPC], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VAPGDPC, February 12, 2023.

U.S. Bureau of Labor Statistics, All Employees, Construction [USCONS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USCONS, February 12, 2023.

U.S. Bureau of Labor Statistics, All Employees, Total Nonfarm [PAYEMS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PAYEMS, February 12, 2023.

I will not do a complete reference for each series. Here’s the identifiers for each series: Finance Value Added – VAPGDPFI. Employment in finance – USFIRE. Construction employees – USCONS. Retail Value Added – VAPGDPR. Retail Employees – USTRADE. Manufacturing Value Added – VAPGDPMA. Manufacturing Employees – MANEMP. Education, Health Care, Social Services Value Added – VAPGDPHCSA. Employment is a composite of 4 series. Mining Value Added – VAPGDPM. Mining Employment – CES1021000001

Price Paths Rejoin

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February 12, 2023

by Stephen Stofka

Divergent paths rejoin. This week’s letter revisits a correlation between movements in oil prices and the general price level. On July 10th of last year, I noted a divergence between the change in oil inflation and price inflation. The chart graphed the change – or momentum – in oil and price inflation, not the inflation itself. Transportation is a fundamental component and cost of our economy and companies must factor in shifts in price momentum in their pricing decisions. Here’s that chart.

At the time I had thought it likely that the change in broad price inflation – the red line in the chart – would moderate toward the momentum change in oil prices, the blue line. It did. Here is a chart with the most recent data through the end of 2022.

As I was writing last July, the momentum in general price inflation had already peaked and would start declining throughout the rest of the year. Think of momentum as a strong dog on a leash. Where it pulls, general price inflation will follow. Here’s a monthly comparison of inflation and its momentum.

At just a hint that inflation was moderating, the broad market began a rally in late October but it fizzled out in early December for a few reasons. The labor market was strong despite the Fed’s interest rate hikes and market participants correctly anticipated another 0.75% rate hike. In addition, Christmas retail sales were slow, increasing the likelihood that earnings gains would decrease. The broad market has rallied 7% since the beginning of the year.

A last note for those of you who are working on taxes and reviewing your portfolio, the investment advisor Edward Jones (2023) has a nice chart titled Investment Performance Benchmarks at the bottom of the page showing the 1, 3, and 5-year returns on various asset classes within the cash, bonds, and stocks categories. Despite the 18% drop in large cap stocks last year, the five-year performance is 9%, close to the decades long averages. The tech sector lost almost 30% in value last year but its 5-year return is almost 16%. During volatile years, relatively passive investors should keep their sights on the long-term averages.

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Photo by Jens Lelie on Unsplash

Edward Jones. (2023, January 24). Quarterly Market Outlook. Quarterly Market Outlook | Edward Jones. Retrieved February 9, 2023, from https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/quarterly-market-outlook