A Broader Inclusion

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November 27, 2022

by Stephen Stofka

Hope everyone had a good Thanksgiving. This week’s letter is about a type of income that we don’t often think about, how that affects asset values and a proposal to increase homeownership. With left over buying power, people purchase assets in the hope that the buying power of the asset grows faster than inflation. There are two types of assets: those that produce future consumption flows and collectibles whose resale value increases because they are unique, desired and in limited supply. An example of the first type is a house. An example of the second type is a painting. Let’s look at the first type.

House Equals Future Shelter

A house is a present embodiment of current and future shelter. The value of that utility depends on environmental factors like schools, crime, parks, access to recreation, shopping and entertainment. These affect a home’s value and are outside a homeowner’s control. A school district’s rating in 2042 may be quite different than its current rating. Our capitalist system and U.S. tax law favors home ownership in several ways. The monthly shelter utility that a home provides is capitalized into the value of a property. Every consumption requires an income, what economists call an imputed rental income. Two thirds of homes are owned by the person living there (Schnabel, 2022) and a little more than half are mortgage free. Unlike reinvested capital gains in a mutual fund, this imputed income is not taxed to the homeowner. Let me give an example.

If the market rate for renting a similar home were $2000 a month, that is an implicit income to the homeowner. Because there is no state or federal tax on that income, the gross amount of that $2000 would be about $2400. That’s almost $30,000 a year. After monthly costs for taxes, insurance and maintenance, the annual implicit operating income of the property might be $25,000. At a cap rate of 5% (to make the math easy), the capital value of the property is $500,000. Each year, Congress requires the U.S. Treasury to estimate the various tax expenditures like these where Congress excludes certain income items from taxes. The implied income on owning a home is called “imputed rental income” and in 2021 the Treasury (2022) estimated that the income tax not collected was $131 billion. How much is that? A third of the $392 billion paid in interest on the public debt. If we did have to pay taxes on that imputed income, it would lower the value of our homes. For many decades, Congress has not dared to include that implied income.

Mutual Fund Capital Gains

Let’s return to the subject of reinvested capital gains in a taxable mutual fund held outside of an IRA or pension type account. Some of what I am about to say involves tax liability so I will state at the outset that one should consult a tax professional before making any personal buy and sell decisions. When some part of a fund’s holdings are sold, a capital gain is realized from the sale and paid to the investor who owns the mutual fund. If the investor has elected to have dividends and capital gains reinvested, the money is automatically used to repurchase more shares of the mutual fund. The balance of the account may change little but there is a taxable event that has to be included in income when the investor completes their taxes for the year. Many mutual fund holdings recognize capital gains in December.

Mutual fund companies provide the tax basis or unrealized gain/loss for each fund but often do not include that information on the statement. The unrealized gain is the price appreciation has not been taxed yet. For example, the dollar value of a fund may be $50,000 and the unrealized gain $5,000. This is more typical of a managed fund than an index fund which does not adjust its portfolio as frequently as a managed fund. If an investor were to sell the fund to raise cash, they would pay taxes on the $5,000, not the $50,000. The unrealized gain in an index fund might by 70% of the value of the fund. If the fund value is $50,000, the unrealized gain could be $35,000 and the investor would owe taxes on that amount. An investor can minimize their tax liability with a judicious choice of which fund to sell. Again, consult a tax professional for your personal situation.

Affordable Homeownership

Let’s visit an imaginary world where people do not have to pay property taxes outright. Each year they can elect to sell a portion of their property to the city or other taxing authority. Cities sometimes place tax liens on properties when a tax is not paid. This would be like a voluntary lien making the city a temporary part owner of the property until the homeowner sells it.

Imagine that a homeowner owns a home worth $400,000. For ten years, they have elected to have the city deduct an annual $2000 average property tax from the value of the home. Over the ten year period, the accrued sum is $20,000 plus an interest fee that is added to the principal sum of the tax. These voluntary tax liens would be visible to a lending institution so that the sum would lower the home’s value for a HELOC, or second mortgage. The city would report that annual amount each year as an imputed income to the homeowner and the homeowner would have to pay income taxes on it. At a 20% effective federal and state tax rate, the out-of-pocket expense would be about $480 on $2000. After the 2017 tax law TCJA, property taxes are no longer deductible so the homeowner has to earn $2400 to pay the $2000 tax outright. There is a slight change in income tax revenue to the various levels of government. When a home is sold those tax liens would be paid back to the city.

Why don’t we have such a system in place now? In the U.S. private entities own most of the capital. Some people would be uncomfortable knowing that a government authority had some legal claim to their property but they could opt out. In a pre-computer age, the accounting would have been a nightmare. Such a system is feasible today. Mutual fund companies have demonstrated that they can track the complex capital positions of their customers. Cities can do the same.

Such a system would make home ownership more affordable for a lot of people without affecting those homeowners who preferred to pay the property tax outright as we do under the current system. Investment companies would be eager to amortize those voluntary tax liens held by city governments. In the event of another financial crisis, a decline in housing prices and a rise in foreclosures, the city would be first lienholder, first in line to get paid when the property is foreclosed. Interest groups that advocate for affordable housing would be joined with investment and pension companies who wanted to underwrite the bonds for such a program.

A Capitalist System of Greater Inclusion

Some blame our capitalist system for the inequities in our society. The fault lies in us, not the capitalist system. Feudalism, mercantilism, capitalism, socialism, communism and fascism are systems of rules that embody a relationship of individuals to 1) property and the manner of production, both current and future, 2) the society, our families and communities, 3) the government that recognizes those relationships. The capitalist system is the most versatile ever invented and yes, it has been used to exclude people just as the other systems have been used to weaken some classes of people. The capitalist system can be extended to include and strengthen more of us. This homeownership policy could broaden that inclusion.  

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Photo by Hannah Busing on Unsplash

Schnabel, R. (2022, August 19). Homeownership facts and statistics 2022. Bankrate. Retrieved November 24, 2022, from https://www.bankrate.com/insurance/homeowners-insurance/home-ownership-statistics/

U.S. Treasury . (2022, October 13). Tax expenditures. U.S. Department of the Treasury. Retrieved November 24, 2022, from https://home.treasury.gov/policy-issues/tax-policy/tax-expenditures. Click FY2022 for the current year PDF estimates.

Profits and Savings Diverge

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November 20, 2022

by Stephen Stofka

This week’s letter is about household savings and corporate profits. As a share of GDP, savings are near an all-time low while profits are at an all-time high. Elon Musk, the CEO of Tesla, appeared in court this week. No, this wasn’t about his acquisition of Twitter. It concerned a shareholder lawsuit against Tesla regarding the $50B stock option package the company awarded him in 2018. In 2019 the company’s total revenue – not profit – was less than $25B. In 2022, annual revenue was $75B. At a 15% profit margin, the company must continue growing its revenue at a blistering pace to afford Mr. Musk’s incentive pay package. Large compensation packages like this are only a few decades old. Let’s get in our time machine.

In 1994, Kurt Cobain, the 27 year old leader of the rock group Nirvana, died from an overdose of heroin. Something else was dying that year – corporations were breaking free of national boundaries and moving production to countries other than their home nation. This was the last stage in the evolution of multinational corporations, or MNCs. In earlier decades, companies had licensed or franchised their brand. Perhaps they had set up a sales office in a foreign country. Now they were becoming truly global. Fueling that expansion was an increase in equity ownership by large institutional investors. To accommodate these changes, their governance structures changed. Executives capable of leading this global growth were rewarded on a parallel with superstar sports talent. That was the conclusion of Hall and Liebman (2000, 3), two researchers at the National Bureau of Economic Research. 

Let’s look at two series over the past sixty years – personal savings and corporate profits. If we think of a household as a small enterprise, personal savings is the residual left over from the household’s labor. Likewise, corporate profits are the residual left over from current production. In 1994, the two series diverged. Corporate profits (the blue line in the graph below) kept rising while personal savings plateaued for a decade. Each series is a percent of GDP to demonstrate the trend more easily.

Executive Compensation

In the mid-1990s, corporations began to issue a lot more stock options to their executives. Some think that a change in the tax code might have precipitated this shift in compensation.  In 1994, Section 162m of the IRS code limited the corporate deductibility of executive pay to $1 million (McLoughlin & Aizen, 2018). By awarding non-qualified stock options to their executives, companies could preserve the corporate tax deduction. However, the slight tax advantage did not account for the rapid increase in options awards. Hall and Liebman found that the median executive received no stock option package in 1985. By 1994, most did. The tax change was secondary – a distraction. Institutional investors wanted more growth and more profits and companies were willing to reward executives with compensation packages similar to sports stars (Hall & Liebman, 2000, 5). Some of these superstars included Jack Welch of General Electric,  Bill Gates of Microsoft, Michael Armstrong of AT&T.

Income Taxes – Less Savings

In 1993, Congress passed the Deficit Reduction Act that raised the top tax rate from 31% to almost 40%. Personal income tax receipts almost doubled from $545 billion in 1994 to almost $1 trillion in 2001. The booming stock market in the late 1990s produced big capital gains and taxes on those gains. For the first time in decades the federal government had a budget surplus. However, more taxes equals less personal savings so this contributed to the flatlining of personal savings during that period.

Household Debt Supports More Spending

During the 2000s, personal savings remained flat. On an inflation adjusted basis, they were falling. Too many people were tapping the rising equity in their home to pay expenses and economists warned that household debt to income ratios were too high. Savings as a percent of GDP fell to a post-WW2 low. As home prices faltered and job losses mounted in late 2007, people began to save more but their debt left them with little protection against the economic downturn. During 2008, personal savings began to increase for the first time in fifteen years. More savings meant less spending, furthering the economic malaise that began in late 2007.

Multi-National Corporate Profits

During those 15 years corporate profits rose steadily as companies increased their global presence. Beginning in 1994 U.S. companies began shifting production to Mexico where labor was cheaper. In 2001, China was admitted to the World Trade Organization (WTO) and production outsourcing continued to Asia. Despite the profit gains, companies kept their income taxes in check. In 2021, corporate income taxes were at about the same level as in 2004. That contributed to the rising budget deficit during the first two decades of this century.

Federal Deficit

The prolonged downturn in 2001-2003 and the financial crisis and recession of 2007-2009 put a lot of people out of work. This triggered what are called “automatic stabilizers,” unemployment insurance and social benefits like Medicaid, housing and food assistance. The federal government went into debt to pay for the Iraq War, pay benefits to people and help fill the budget gaps in state and local budgets. The tax cuts of 2003 enacted under a Republican trifecta* of government control reduced tax revenues, further increasing the deficit. During George Bush’s two terms, the debt almost doubled from $5.7 trillion to $11.1 trillion.

In coping with the recovery from the financial crisis, the government added another $8.7 trillion to the debt. That negative saving by the government helped add to the personal savings of households but too much was spent on just getting by. Following the Great Financial Crisis (GFC), the trend of the government’s rising debt (blue line below) matched the trend in personal savings (red). Sluggish growth and lower tax revenues caused the two to diverge. While the debt grew, personal savings lagged.  

Before and During the Pandemic

Following the 2017 tax cuts enacted under another Republican trifecta, personal saving rose, then spiked when the economy shut down during the pandemic and the federal government sent stimulus checks under the 2020 Cares Act. In the chart below, notice the spike in debt and savings. By the last quarter of 2020, personal savings had risen by $600 billion from their pre-pandemic level of $1.8 trillion. In late December, President Trump signed the $900 billion Consolidated Appropriations Act (Alpert, 2022) but that stimulus did not show up in personal savings until the first quarter of 2021. In March 2021 President Biden signed the $1.7 trillion American Rescue Plan. Personal savings rose $1.6 trillion in that first quarter, the result of both programs.

After the Pandemic

Some economists have said that the American Rescue Plan was too much. In hindsight, it may have been but we don’t make decisions in hindsight. As more schools and businesses opened up, households spent far more than any extra stimulus. They spent $1.2 trillion of savings they had accumulated before the pandemic and savings are now at the same level as the last quarter of 2008 when the financial crisis struck. Thirteen years of cautious savings behavior has vanished in a few years. On an inflation-adjusted basis, personal savings is at a crisis, almost as low as it was in 2005. In the chart below is personal savings as a ratio of GDP.

The Future

In the past year savings (red line) and corporate profits (blue line) have resumed the divergence that began almost three decades ago. Profits were 12% of GDP in the 2nd quarter of 2022. Savings is near that all time low of 2005. Rising profits benefit those of us who own stocks in our mutual funds and retirement plans. However, the divergence between the profit share and the savings share is a sign that the gap between the haves and the have-nots will grow larger.

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Photo by Jens Lelie on Unsplash

  • A trifecta is when one party controls the Presidency and both chambers of Congress.

Alpert, G. (2022, September 15). U.S. covid-19 stimulus and relief. Investopedia. Retrieved November 19, 2022, from https://www.investopedia.com/government-stimulus-efforts-to-fight-the-covid-19-crisis-4799723. See Stimulus and Relief Package 4 for the December 2020 CAA stimulus. See Stimulus and Relief Package 5 for the American Rescue Plan in March 2021.

Hall, B. J., & Liebman, J. B. (2000, January). The Taxation of Executive Compensation – NBER. National Bureau of Economic Research. Retrieved November 19, 2022, from https://www.nber.org/system/files/chapters/c10845/c10845.pdf. Interested readers can see Moylan (2008) below for a short primer on the recording of options in the national accounts. Until 2005, these options were recorded as compensation for tax purposes but not recorded on financial statements so they did not initially affect stated company profits.

McLoughlin, J., & Aizen, R. (2018, September 26). IRS guidance on Section 162(M) tax reform. The Harvard Law School Forum on Corporate Governance. Retrieved November 18, 2022, from https://corpgov.law.harvard.edu/2018/09/26/irs-guidance-on-section-162m-tax-reform/

Moylan, C. E. (2008, February). Employee stock options and the National Economic Accounts. BEA Briefing. Retrieved November 19, 2022, from https://apps.bea.gov/scb/pdf/2008/02%20February/0208_stockoption.pdf

The Change Changed

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November 13, 2022

by Stephen Stofka

October’s CPI report released this week indicated an annual inflation of 7.7%, down from the previous month. Investors took that as a sign that the economy is responding to higher interest rates. In the hope that the Fed can ease up on future rate increases, the market jumped 5.5% on Thursday. Last week I wrote about the change in the inflation rate. This week I’ll look at periods when the inflation rate of several key items abruptly reverses.

Food and energy purchases are fairly resistant to price changes. Economists at the Bureau of Labor Statistics (BLS) construct a separate “core” CPI index that includes only those spending categories that do respond to changing prices. It is odd that a core price index should exclude two categories, food and energy, that are core items of household budgets.

Ed Bennion and other researchers (2022) at the BLS just published an analysis of inflationary trends over several decades. Below is a chart of the annual change in energy prices. Except for the 1973-74 oil shock, a large change in energy prices led to a recession which caused a big negative change in energy prices.

We spend less of our income on food than we did decades ago so higher food prices have a more gradual effect, squeezing budgets tight. Lower income families really feel the bite because they spend a higher proportion of their income on food. In the graph below a series of high food price inflation often precedes a recession. Unlike energy prices, there is rarely a fall in food prices. Following the 2008 financial crisis, food prices fell ½% in 2009. It is an indication of the economic shock of that time.

Let me put up a chart of the headline CPI (blue line) that includes food and energy and the core inflation index (red line) which does not. Just once in 75 years, during the high inflation of the 1970s, the two indexes closely matched each other. Following the 1982-83 recession, the core CPI has outrun the headline CPI.

A big component of both measures of inflation is housing. The Federal Reserve (2022) publishes a series of home listing prices calculated per square foot using Realtor.com data. You can click on the name of a city and see its graph of square foot prices for the past year. You can select several cities, then click the “Add to Graph” button below the page title and FRED will load the graph for you. Here’s a comparison of Denver and Portland. They have similar costs.

The pandemic touched off a sharp rise in house prices in both cities. Denver residents have attributed the big change to an influx of people from other areas. However, Census Bureau data shows that the Denver metro area lost a few thousand people from July 2020 to July 2021 (Denver Gazette, 2022). In the decade after the financial crisis, there simply wasn’t enough housing built for the adults that were already here.

The surge in home buying has not been in population but in demographics. As people approach the age of 30, they become more interested in and capable of buying a home. The pandemic helped boost home buying because interest rates plunged from 5% in 2018 to 2.6% in 2021.

Record low interest rates enabled Millennials in their 20s and 30s to buy a lot more home with their mortgage payment. That leverage caused housing prices to rise. A 30-year mortgage of $320K has a monthly mortgage payment of $1349 at 3%. At 5%, it is $1718 and at 7% it rises to $2129. Ouch!

Rising rental costs and home prices drive lower income families to less expensive areas in a metro area or entirely out of an area. Declining public school enrollment has forced two Denver area counties to announce the closing of 26 schools and transfer them to other schools (Seaman, 2022). As the number of students decreases, the schools infrastructure costs do not change, increasing the per student costs. Buses have to be maintained, drivers paid, schools staffed with guards, cafeteria staff, janitors and administrative personnel. Once schools are shuttered, the building may be sold and converted to other uses, either residential or commercial. The public schooling system is like a large ship that takes some time to change course.

During our lifetimes we experience many changes. They can happen quickly or emerge over time. The effects may be short lived or last decades. Families are still living with the consequences of the financial crisis fourteen years ago. Carelessly planned urban development isolates the residents of a community. The social and economic effects can last several generations. As we grow older, we learn to appreciate William Faulkner’s line, “The past is never dead. It’s not even past.”

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Photo by Davies Designs Studio on Unsplash

Bennion, E., Bergqvist, T., Camp, K. M., Kowal, J., & Mead, D. (2022, October). Why inflation matters. U.S. Bureau of Labor Statistics. Retrieved November 11, 2022, from https://www.bls.gov/opub/btn/volume-11/exploring-price-increases-in-2021-and-previous-periods-of-inflation.htm

Denver Gazette. (2022, March 25). Denver joins big city trend with pandemic population slip. Denver Gazette. Retrieved November 11, 2022, from https://denvergazette.com/news/local/denver-joins-big-city-trend-with-pandemic-population-slip/article_65c6393d-2a4d-5b91-837c-f8c3efce3778.html

Federal Reserve. (2022). Median listing price per square feet:Metropolitan Areas. FRED. Retrieved November 11, 2022, from https://fred.stlouisfed.org/release/tables?eid=1138280&rid=462

Seaman, J. (2022, November 10). Schools targeted for closure in Denver, Jeffco have disproportionately high numbers of students of color, data shows. The Denver Post. Retrieved November 11, 2022, from https://www.denverpost.com/2022/11/10/dps-jeffco-school-closures-students-of-color/

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Economic Puzzles

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November 6, 2022

by Stephen Stofka

Many people compare today’s inflation with that of the 1970s. A better comparison might be with a much earlier period. This week’s letter will be about the change in the inflation rate. Inflation is like the speed on a speedometer. If I accelerated from 50 to 60 MPH over a certain time period, perhaps 10 seconds, the change in the speed is 10 MPH. The time period I’m looking at is one year. If inflation rose from 1% to 5% in a year’s time then the change is 4%.

I’ll start with the current year. The one year change peaked at 6.1% in the first quarter of 2022. As the Fed raised rates, that change moderated. It’s like accelerating to 60 MPH and realizing that the speed is over the speed limit and reducing speed by easing up on the gas pedal or braking.  

Most of the time the inflation rate changes by less than 2% up or down. During and after recessions it can become more volatile. In 1980, inflation soared above 14% and the one year change peaked at 5.8%, slightly less than our recent experience.

There has only been one time in the past 70 years when the inflation rate rose faster than today. That was in 1951, shortly after the Korean War began. For the first six months of 1950, prices sank – deflation – then war was declared in June 1950 and the U.S. again ramped up defense production. The one year change in inflation peaked above 10% as Federal defense spending shot up 45%.

If you would like to explore this period in more detail Tim McMahon (2014) presents 1950s inflation data in an easy to read format. A hundred years ago, a period of persistent deflation – not inflation – followed the last pandemic.  See Tim’s second link below. The Federal Reserve was still fairly new and the U.S. and European nations had adopted a gold standard that would eventually lead to the Great Depression. That’s another story. Today the world’s commerce is interlocked and pandemic shutdowns continue to deliver a series of supply shocks. Getting policy right is more difficult when circumstances are this unusual.

Volatile Inventories

Inflation rises when there are inadequate resources to meet demand. In 2021, real private gross domestic investment rebounded quickly, rising almost 32% on an annualized basis in the 4th quarter. One component, inventories, was responsible for much of that surge. Even under normal conditions, this series is a volatile component of GDP (BEA, 2019) and the BEA publishes a figure called Final Sales of Domestic Product which excludes the change in inventories. Real final sales is approximately close to inflation-adjusted GDP.

During the pandemic manufacturing and retail goods sat in container ships off the port of Los Angeles and other ports. While the goods were in transit, they were not added to inventories. In the 2nd quarter of 2021, businesses began to open again but the ports were slow to unravel their logjams. Empty truck containers sat in parking lots and on neighborhood streets near the L.A. port while ships waited in line out on the water.

Sales surged as economy reopened

In the 2nd quarter of 2021, real final sales increased 2%, finally reaching pre-pandemic levels. In the first half of the year, real food and service sales shot up 10%. Normally that increase would occur over three years. However, within months that initial surge subsided. Over the next two quarters, real final sales barely increased. Real food sales declined slightly. This confirmed a temporary response to a post-pandemic recovery. With so many items out of stock, customers were willing to pay higher prices to get products. Some businesses had orders shipped from Asia by air. In the 4th quarter 2021, the floodgates opened and real private inventories rose by a record $197 billion.

Profits Surge

Real retail and food services sales fell slightly. In the last six months of 2021 inflation topped 5% but people were not buying and selling more stuff. Where were the price pressures? During the inflationary second half of the 1970s, profits increased a whopping 12% per year in those five years. In 2021, corporate profits rocketed up. Supply disruptions and repressed demand during the pandemic gave businesses pricing power. In 2021, corporate profits increased 18%. If demand was relatively flat, that pricing power had to fade but profit growth was still strong in the first quarter. Like the 1970s, rising corporate profits and pricing power were major contributors to inflation. This week the House Committee on Oversight and Reform (2022) came to a similar conclusion. What is the source of that pricing power?

War in Ukraine

In February 2022, Russia attacked Ukraine, sending energy prices higher. XLE, a broad energy ETF, gained 35% by early March. Two months later, the BEA reported another record rise in real private inventories of $214 billion. However, real final sales fell 2.5%. Some economists pointed to low unemployment and rising wages but ECI wages of private workers were on the same trend as before the pandemic when inflation was low. Most of the rise in the inflation rate was in housing, food and energy prices. The pandemic and low interest rates had contributed to the rise in housing costs. The war in Ukraine was responsible for volatile energy prices. There was no increase in real food sales but food prices were rising. Four large meat producers had profit growth of 134%, the committee reported.

The Puzzle

Historians still argue about the causes of World War I a century ago. Economists still cannot agree on the inflation mechanism of the 1970s. Contributing causes were rising corporate profits, shifting demographics in the work force, oil supply shocks, a shift in the international monetary regime and an evolving trans-global economy in the post war era. Economists do agree that it was a gestalt of market, fiscal and monetary forces, complicated by geopolitical and policy shocks that shaped expectations of future inflation. When people expect further price increases, they buy more now, aggravating inflationary pressures. Those expectations helped entrench inflation in the economy of the 1970s. Paul Volcker, chairman of the Fed in the late 1970s and early 1980s, raised interest rates so high that it wrung inflation out of the economy but at great economic cost to many families. The high interest rates caused two recessions, one of them the worst since the Great Depression.

The Korean War

In answer to the surge of inflation in 1951, the Fed raised rates slightly but rates stayed below 2%. The government did the heavy lifting. In September 1951, President Truman started a regime of wage and price controls administered by the Economic Stabilization Agency (ESA) and Wage Stabilization Board (WSB). There were loud protests against the controls and President Eisenhower ended them after he took office in 1953. Several months later the Korean War ended. In 1971, President Nixon instituted wage and price controls and demonstrated the failure of controls. Monetary policy is the weapon of choice to combat inflation but rising rates disproportionately affect the most vulnerable workers.

Conclusion

Infrequent events are an intersection of many factors that make each one unique. As economists pull apart the tangle of causal narratives, they develop new theories or modify existing ones. Economists usually cling to a favorite – either supply or demand. I’m watching profit growth. If Republicans take the House and possibly the Senate in the coming election, they will try to further enhance corporate profits at the expense of social programs like Medicare and Social Security. Republicans continue to sell a “trickle down” narrative but decades of evidence shows that the trickle is but a few drops. What goes to the top stays at the top.

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Photo by Ana Municio on Unsplash

BEA: Bureau of Economic Analysis. (2019). Chapter 7: Change in private inventories. Retrieved November 4, 2022, from https://www.bea.gov/resources/methodologies/nipa-handbook/pdf/chapter-07.pdf

The House Committee on Oversight and Reform. (2022, November 4). Subcommittee analysis reveals excessive corporate price hikes have hurt consumers and fueled inflation, while enriching certain companies. House Committee on Oversight and Reform. Retrieved November 5, 2022, from https://oversight.house.gov/news/press-releases/subcommittee-analysis-reveals-excessive-corporate-price-hikes-have-hurt

McMahon, T. (2014, April 23). Inflation and CPI consumer price index 1950-1959. InflationData.com. Retrieved November 3, 2022, from https://inflationdata.com/articles/inflation-cpi-consumer-price-index-1950-1959/. Inflation data for 1920-1929 is here https://inflationdata.com/articles/inflation-consumer-price-index-decade-commentary/inflation-cpi-consumer-price-index-1920-1929/

Electoral Strategies

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October 30, 2022

by Stephen Stofka

This week’s letter is a detour into political branding and public opinion. In interviews with voters, I often hear “I am a [‘Democrat’ or ‘Republican’ or ‘Independent’ here].” It is not unusual to hear the same association with a religion as in “I am a Lutheran” or “I am a Catholic.” These identifications begin when we are young, extending the reach of our sense of self outside the family (Miller & Shanks, 1996, 120). These party affiliations are not mental straitjackets by any means. As we come of age, we form a unique set of values and group identifications and may adopt a party affiliation different from our parents. This can make for some uncomfortable conversation at the Thanksgiving dinner table.

We may self-identify with a party because we are not like those people in that other party. Political and cultural scientists have a term for this process of stereotyping people – othering. We might identify as an Independent voter because we are not a crowd follower like those Democrats and Republicans. We are discerning voters who study the issues and candidates before we vote. That is also a form of othering.

Magleby et al. (2011, 247) found that many self-identified Independents are leaners, leaning toward one party or the other, and are more engaged in political issues. In Presidential elections from 1952 to 2008, Republican leaning Independents voted almost 78% of the time, about the same as Weakly Partisan Republicans. Democrat leaning Independents showed the same behavior. Truly Independent voters who are not leaners have less interest in politics and voted only 63% of the time. In recent years, that percentage has dropped to 53%.

Our party system treats people as though they were computer switches – on or off, left or right. Many of us have graduated value systems that cannot be simplified like a logic gate on a circuit board. Citizen initiated ballot measures reveal that complexity. Many states have citizen initiatives, allowing interest groups to put legislative proposals on the ballot after collecting a number of verified signatures. A voter might be for a proposal to provide free lunches for all students but does not like the way the program is funded and votes NO. The ballots contain only the two choices – YES or NO. Consider a ballot that allowed a voter to represent their actual opinion. A neutral position would be 0. A voter could vote for the proposal on a scale from 1 to 5, or against the proposal on a scale of -1 to -5. We have the technology. Why don’t we have the ballots?

Despite evidence to the contrary, some Republicans voice distrust with voting machines and want to return to the days when paper ballots were counted by hand. They ignore the extensive testing procedures that their own Republican state legislatures conduct (NCSL, 2021). Republican voters who say they doubt the integrity of the vote are, in effect, doubting the honesty of their own party’s legislators whom Republican voters elected. The story is so illogical that Democrats have been unable to tell a narrative that would replace the Republican fairy tale. That is the genius of the Republican political narrative.

In Colorado, a Republican candidate for governor is one of more than a dozen Republican candidates around the country who have been telling outlandish stories that the schools are teaching children to identify as cats and use litter boxes (Klamann, 2022). If the illogical story with the voting machines caught fire with some voters, particularly Q-Anon believers, why not adopt the same strategy and try other bizarre stories? The stories are political hornets, designed to keep Democrats occupied by reminding people of actual facts. In the early 1950s, Republican Senator Joe McCarthy kept Democrats preoccupied with tall tales of Communists lurking behind every bush in Washington and Hollywood. Alex Jones emulates that McCarthyite cruelty and craziness.  

Some Republican candidates celebrate othering and continue to build the Republican party on bias and exclusiveness. Southern Democrats successfully employed that strategy for 100 years after the Civil War. Former First Lady Michele Obama encouraged people to take the “high road” and not give into hate rhetoric. Lies, wild accusations of socialism and staged Tea Party rallies contributed to a historic loss of Democratic House seats in the 2010 midterms. In our winner-take-all electoral system, there is only one road to victory and political power. It is neither high nor low.

Democracy thrives on open distrust, on bold lies and the histrionics of political candidates and their supporters. Few Chinese dare to voice distrust with their leader, Xi Jinping. At the gathering of the CCP Congress this month, there was no wild gesticulating or shouting like there is at American political conventions and sometimes at State of the Union addresses. Americans treat politics like a rodeo, swooping and hollering. Chinese leaders look profoundly serious. In both countries, people are getting hurt, jailed and isolated but the American system is entertaining.

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Photo by Nelson Ndongala on Unsplash

Klamann, Seth. 2022. “‘Incredibly Frustrating’: Colorado Schools Reject Ganahl’s Claims That Students Identify as Cats.” The Denver Post. https://www.denverpost.com/2022/10/04/colorado-schools-heidi-ganahl-students-cat-claims/ (October 28, 2022).

Magleby, David B, Candice J. Nelson, and Mark C. Westlye. 2011. “The Myth of the Independent Voter Revisited.” In Facing the Challenge of Democracy: Explorations in the Analysis of Public Opinion and Political Participation, eds. Benjamin Highton and Paul M. Sniderman. Princeton, NJ: Princeton University Press. essay, 238–64.

Miller, Warren Edward, and J. Merrill Shanks. 1996. The New American Voter. Cambridge (Mass.): Harvard University Press.

NCSL: National Conference of State Legislatures. 2021. “Voting System Standards, Testing and Certification.” National Conference of State Legislatures. https://www.ncsl.org/research/elections-and-campaigns/voting-system-standards-testing-and-certification.aspx (October 28, 2022).

Tower of Babel

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October 23, 2022

by Stephen Stofka

This week’s letter is about taxes and income. Each month, the Federal Reserve (2022) releases an estimate detailing how people spend their money and the sources of their income. I was surprised that 17% of personal income is from government transfers like Social Security and other programs. This is 2% more than the income people receive on their assets. A bit of history for context.

In the 1960s, 2/3 of income was from wages and salaries. Each decade, the wages and salaries component declined 5% until this past decade when wages and salaries were just 50 cents out of every dollar of income.

A greater portion of employee compensation shifted from discretionary income to dedicated non-taxable benefits like health care insurance and pensions. In the early 1960s employer benefits were 10% of wages and salaries. Now they are 21%. Despite the rise in the non-taxable share of compensation, workers give up more out of their paychecks to taxes.

A growing share of income goes to FICA taxes

In 1960, workers paid 6% of their paychecks to FICA taxes. The Medicare program, about 20% of our FICA taxes today, would not be enacted until 1965 when President Johnson ushered in his Great Society programs. Within five years analysts realized that lawmakers had wildly underestimated the costs of the program. By 1980, increases in Social Security and Medicare taxes increased the FICA portion to 12% of paychecks. Today, workers pay 15% of their paychecks in FICA taxes (see note).

In 1960, all other taxes were 11% of total income in 1960, had climbed to almost 13% in 1980 then to over 14% by the year 2000 and are now 15% of total income. In the past twenty years, the rich have paid a growing share of income taxes but their effective tax rate has changed little. Why? When lawmakers put a heavier burden on rich people, they lobby for legal income exclusions and Congress obliges.

Top 10% pay a growing share of income tax

In 2001, the top 1% paid 33% of income taxes. In 2019, they paid 39% (IRS, 2022). In 2001, the top 10% (the Tennies, I’ll call them) paid 64% of personal income taxes. In 2019, they paid 71%. Whether it is the super-rich or the rich, their share of income tax has grown by 6 -7%. That’s not the end of the story.

Growth in incomes of the top 10% is far higher

The Tennies have seen their share of gross income increase from 42.5% in 2001 to 47.3% in 2019, a gain of almost 5 percentage points. They have paid a rising share of the nation’s income taxes but the rise in taxes is less than the rise in personal income (BEA, 2022). In the 2001-2003 period the income tax paid by the Tennies averaged 5.6% of national personal income. In the 2017-2019 period, that tax share was 6.3%, a difference of just .7%. It is a cheap price to pay for a 5% gain in the nation’s total income.

Effective Tax Rate of the top 10% is steady despite rise in Income

In the 2001-3 period the Tennies averaged an effective tax rate of 13.5%. In the 2017-19 period, that effective rate had declined to 13.2% despite a 2% rise in the top marginal tax rate from 35% in 2001 to 37% in 2019. Raising the marginal tax rate on the highest income brackets has little net effect yet it was a campaign issue for Mr. Biden and many Democrats. Political scientists call it position-taking.

The party of no taxes produces higher deficits

Despite their rhetoric about reducing the deficit, Republicans have adopted a no new taxes on anyone pledge that ensures the deficit will get worse. True to form, the budget deficit has grown more under Republican administrations over the past four decades. The party also has a record of slower economic growth but that is mostly due to the two terms of the George Bush administration. Mr. Bush’s failures caused many Republicans to abandon more mainstream Republican values and adopt a mean spirited attitude of radical defiance exemplified by the Tea Party and the Republican Study Committee.

Action requires Compromise

The “Just Say No” Republican factions permit little compromise so the party cannot get significant legislation passed. In the first year of Mr. Trump’s Presidency, Republicans held all three legislative bodies but were stymied by their internal squabbles. In November of 2017, they hastily assembled the corporate tax reform package, TCJA, to show their constituents that they were capable of legislating and to give Mr. Trump some accomplishment that he could tweet  about.

A look ahead

If Republicans take control of the House after the upcoming elections, we can expect more of the same dysfunction under Speaker Kevin McCarthy. Libertarians in the Republican Party want a limited role for the federal government as specified in Article 1, Section 8 of the Constitution. They have little tolerance for national abortion laws and other bullying social legislation that Republicans have promised. The uncompromising factions within the Republican Party ensure that the party cannot govern. They are like drivers in a car with a manual transmission who don’t know how to clutch and shift. Democratic lawmakers, on the other hand, drive down the road, focused on staying perfectly centered between the white lane markers of equality and equity. The rich benefit when party leaders cannot assemble a cohesive coalition of interest groups and voters. The economic interests of the top 10% are protected when voters remain fragmented. Party elites and partisan interest groups speak in languages that are understandable only to a narrow constituency. By promoting dissension, social media has helped create a Tower of Babel.

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Photo by Osman Rana on Unsplash

BEA: U.S. Bureau of Economic Analysis, Personal Income [PI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PI, October 19, 2022.

Federal Reserve. (2022). Personal income and its disposition. FRED. Retrieved October 19, 2022, from https://fred.stlouisfed.org/release/tables?rid=54&eid=155443&od=#. The FICA tax percentage includes the employer and employee portion of the tax. The employee effectively bears the burden of the entire tax.

IRS. (2022). SOI tax stats – individual income tax rates and tax shares. Internal Revenue Service. Retrieved October 19, 2022, from https://www.irs.gov/statistics/soi-tax-stats-individual-income-tax-rates-and-tax-shares#Early%20Release. Table 4.2, Selected Descending Cumulative Percentiles of Returns Based on Income Size Using the Definition of AGI for Each Year.

A Global Wave

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October 16, 2022

by Stephen Stofka

On Thursday, September’s CPI came out, showing an annual price increase of 8.2%. A quarter of that increase was housing costs – rent and owner equivalent rent. Price increases have decelerated this quarter. Remember that inflation is the change in prices. Acceleration (+) or deceleration (-) is the change of that change. Inflation is like the speed in a car. Acceleration is the change in speed. The graph below shows the acceleration for the past five years.

Notice the regular up and down in small increments before the pandemic. When we drive down the highway without cruise control, we experience the same minor variations in speed. After the pandemic, price acceleration became more erratic. Why?

Usually, we do not synchronize our spending and saving. During the pandemic in 2020, we began to coordinate our buying habits. The first round of stimulus checks went out in April 2020, shortly after the economy was locked down. We bought workout equipment, computers and peripherals, appliances for the home. The second round of stimulus went out in December 2020 and January 2021. President Biden was sworn into office in January 2021 and immediately began discussions of a third stimulus payment, part of the American Rescue Plan.

Critics say the third stimulus payment was too much, that it was the impetus to the recent inflationary surge. That is an ex-post or hindsight criticism. On December 18, 2020, Moderna was granted emergency approval by the FDA (2020) for its MRNA vaccine, a relatively new vaccine manufacturing technology. The Pfizer vaccine was the first to get such approval but its vaccine required a temperature of -94F. Moderna’s vaccine required a temperature of only -4F, about the same level as the freezer temperature in a home refrigerator. The vaccine was deemed safe but the drug makers did not know how long the vaccines would last. Secondly, they needed a booster shot as well. Moderna promised 100 million doses by March of 2021. What if the vaccines lasted only a few months and development of a better formulation was delayed another year? The third stimulus would have been entirely appropriate. Policymakers must make ex-ante decisions – before all the evidence is known or evaluated.

In 2021, some economists predicted higher inflation in 2022. They turned out to be right. Ten years ago, those same economists predicted higher inflation after the 2009 ARRA stimulus. They were wrong. Economists, like traders, are right sometimes and wrong sometimes. Like traders, the winning prediction rate is closer to 50-50 or pure chance. Others are likening this to the inflation of the 1970s. However, there is a big difference. In the 1970s, price acceleration kept rising like a car which is speeding up. Currently it is falling, like a car slowing down. Here’s a look price acceleration in the 1970s.

As I mentioned last week the Social Security Administration announces the yearly COLA for Social Security recipients after the September CPI figure is reported. The 2023 COLA adjustment will be 8.7%, adding $146 to the average $1673 monthly payment for retirees. As I discussed last week, worker’s wages have not kept up with inflation. They are more on a fixed income than retirees at this point.

The inflation is global – a first in economic history. Global market research company Ipsos (2022) survey people in 29 countries. Inflation has become the top concern for 40% of respondents. Here’s the chart I downloaded from their page. Look at the surge in inflation as a concern over the past year. Unemployment and Covid-19 were the top concerns in 2020. Stimulus assistance and monetary policy in the Eurozone countries helped relieve job concerns. Covid-19 became less worrying as more people got vaccinated and hospital admissions decreased. After Russia’s invasion of Ukraine, rising oil prices lifted inflation worries in many countries.

As the world becomes more integrated financially and economically, will we reach a self-destructive resonance? Our economic systems could become less stable as they synchronize. I hope not.

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Photo by Providence Doucet on Unsplash

FDA. (2020, December 18). FDA takes additional action in fight against COVID-19 by issuing emergency use authorization for second COVID-19 vaccine. U.S. Food and Drug Administration. Retrieved October 15, 2022, from https://www.fda.gov/news-events/press-announcements/fda-takes-additional-action-fight-against-covid-19-issuing-emergency-use-authorization-second-covid

Ipsos. (2022, September 22). What worries the world – September 2022 . Ipsos. Retrieved October 14, 2022, from https://www.ipsos.com/en-uk/what-worries-world-september-2022

The Old, Young and Middle

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October 9, 2022

by Stephen Stofka

This week I’ll compare inflation-adjusted or real spending on Social Security and K-12 education with wage growth. I was surprised to learn that the number of people in both programs are the same. I’ll begin with Friday’s employment report because the market’s reaction to it indicates the erratic – but rational – thinking that higher inflation can trigger. Job gains of 263,000 were in line with expectations, but the unemployment rate went down by .1% because people stopped looking for jobs. Three years ago a .1% move would be discarded as a survey error. The unemployment rate is derived from a survey of households, not businesses, and often exaggerates any move up or down. In today’s volatile market, traders are skittish, employing algorithms that don’t care about the extent of a move, only whether it is up or down. Short term options trading leverages both money and time and they are now almost half of the options market. A minus sign might trigger a sell, a plus sign a buy. The number after that plus or minus is less important. A trader might have taken a position forecasting a slight uptick in the unemployment rate. No increase or a decrease = sell and minimize losses. This is reactive trading, not economic evaluation.

This week’s ADP report of private job gains showed a decline of 7,000. Averaged together job gains were only 116,000 in September and has shown a distinct downward response to the Fed’s raising of interest rates. The historical average of the two surveys has been the more accurate after revisions. More disappointing for workers is that wage growth has been more than 3% below the inflation rate.

While workers’ wages are not keeping up with inflation, social security recipients will likely get a COLA (cost-of-living-adjustment) raise of about 8.6% this year. By law, the COLA calculation compares this year’s average third quarter CPI to last year’s third quarter average. September’s CPI report will be released Thursday, October 13th, finalizing this year’s 3rd quarter and the final adjustment percentage. It will be the largest increase since 1981’s adjustment of 11.3%, according to the Social Security Administration (2022).

An eternal theme in the Republican platform is the privatization of Social Security before it goes broke. A few weeks before the election, some Republicans will undoubtedly use the COLA adjustment to call for Social Security privatization. They will claim that higher payments will inevitably lead to the insolvency of the fund. Retirees will get partial payments or no payments.

Former House Speaker and Republican Vice-Presidential candidate, Paul Ryan once asked Alan Greenspan, then Chairman of the Fed and a fellow conservative, a leading question meant to demonstrate the insolvency of Social Security. Wouldn’t personal retirement accounts (privatized Social Security accounts) make the retirement system more financially secure? In his dry tone, Greenspan answered that “there is nothing to prevent the Federal Government from creating as much money as it wants and paying it to somebody” (C-Span, 2005). Ryan, a champion of privatization, was disappointed in the answer.

Why then do we have the trust funds? The Social Security system is “Pay-Go.” The taxes of current workers pay for the benefits to retired workers. When the program was created almost 90 years ago, President Roosevelt (FDR) thought that Republicans – and some conservative southern Democrats – would be more hesitant to cancel the program if funds were – on paper at least – dedicated to the program and called “insurance.” Republicans challenged the program up to the Supreme Court on the basis that the Federal government had no Constitutional right to force people to pay into a retirement program. The Court ruled that, even if the program was called “insurance,” it was a tax and the government had the right to tax incomes. Read the 16th Amendment. The unfairness in the system was that the first generation of recipients paid little into the system for the benefits they received when they retired. Today, the average retiree receives $1673 a month, or $20K per year (SSA, 2022). Let’s compare that to spending on K-12 education.

The U.S. has about the same number of K-12 students as it does retirees who are collecting Social Security – a bit more than 50 million. Social Security is a federal program. K-12 education is funded at the state and local level with only 8% federal funding. The federal government has deep pockets. State and local governments have shallow pockets with many demands from their constituents. In 2019, federal, state and local governments spent $765B, or $15,120 per pupil in 2019 (Hanson, 2022). That’s 75% of what we spend on retirees. Have we shifted too many resources to seniors from children?

Retirees have paid Social Security taxes for their entire working lives and feel that those funds have been set aside for them. The federal government doesn’t have to provide goods and services to retirees. Even the task of computing and remitting Social Security taxes is done by businesses – by law and for free. The accounting is a business expense. State and local governments must provide real resources. These include schools and facilities, teachers and lunches, school nurses and security guards.

Education competes with other essential services. The 2008 financial crisis and the slow recovery “put a hurt” in most state and local budgets. Since 2008, the national average of real per pupil funding has increased only 6% (Hanson, 2022). For most of that time, inflation has been low. Imagine what a sustained period of high inflation might do. Let’s look back at the last period – the 1970s and early 1980s.

Higher inflation wakes us up. Even when inflation is low, workers are squeezed, having to support children and retirees. Inflation increases the budget squeeze so workers pay closer attention to personal budgets and public policies. In the high inflation decade of the 1970s the public discovered that income and real estate taxes were not indexed to inflation. Rising wages caused people to go into higher tax brackets even when their real wages had barely moved. Tax laws were changed in the 1980s.

Ever rising real estate taxes in California made it difficult for retired homeowners on fixed incomes to stay in their homes. A growing taxpayer revolt rose up in many states. In 1978, California voters approved Proposition 13 which limited annual increases in taxes. Real estate taxes are the largest source of funding for schools so today California spends 10% less than the national average on K-12 students. Will today’s higher inflation provoke some sweeping policy changes?

Knowing past history, the Fed can’t let high inflation get entrenched in the economy for long. People will demand policy and institutional changes. Next week I’ll look at consumer psychology during high inflation periods.

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Photo by CDC on Unsplash

C-Span. (2005, March 3). User Clip: Alan Greenspan answers Paul Ryan. C-Span. Retrieved October 7, 2022, from https://www.c-span.org/video/?c4923562%2Fuser-clip-alan-greenspan-answers-paul-ryan

Hanson, Melanie. “U.S. Public Education Spending Statistics” EducationData.org, June 15, 2022, https://educationdata.org/public-education-spending-statistics

Social Security Administration. (2022). Cost of Living Adjustments. Cost-Of-Living Adjustments. Retrieved October 7, 2022, from https://www.ssa.gov/oact/cola/colaseries.html

SSA: Social Security Administration. (2022, August). Monthly Statistical Snapshot, August 2022. Research, Statistics & Policy Analysis. Retrieved October 7, 2022, from https://www.ssa.gov/policy/docs/quickfacts/stat_snapshot/

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The Fed’s Toll Booth

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October 2, 2022

by Stephen Stofka

The dollar is the world’s reserve currency and its strength – its price relative to other currencies – is straining both the economies and the financial expectations of other countries. Businesses in developing countries with an unreliable currency regime often have to borrow in dollars – what is called “dollar denominated debt.” Businesses must make their loan payments in dollars so they must trade in ever more of their local currency to get the dollars to make the payment. European nations stocking up on liquified natural gas (LNG) from the U.S. are feeling the pinch as well. Why is the dollar strengthening?

In international finance there are two equations that model the relationship between expected inflation, exchange rates and interest rates. Currency traders are expecting inflation to moderate more quickly in the U.S. than in other countries. Because the U.S. has a better supply of natural gas, its energy prices will be less affected by the war in Ukraine. Secondly, the Fed has been increasing interest rates, enticing investors in other countries to invest their money in U.S. debt. The dollar-euro exchange rate has not been this low since 1999 when the Eurozone countries began using a common currency, the euro.

When the dollar gets stronger, exports decrease because American goods are more expensive to buyers in foreign countries. Imports become cheaper so Americans buy more stuff from other countries. However, if the U.S. is sliding into a recession, Americans are less likely to buy enough European imports to offset the LNG that European countries will buy from the U.S.  This will increase the demand for dollars relative to the euro, further driving up the price of dollars in other currencies.

The dollar has been strengthening against other forms of currency like gold and digital exchange mechanisms like Bitcoin. Priced in dollars, gold has lost about 16% of its value in the past six months. Bitcoin has lost 60% since March. Gold is both a commodity and a currency. Gold holds a store of work that it can do in the future. It has cosmetic and industrial uses.

Bitcoin is the product of past work only – a “proof of work” done in the past. It stores no capability of future work. It takes a lot of electricity and computing power to mine Bitcoin but it cannot store electricity for future use. If it could do so, the price of Bitcoin would go up when electricity prices went up.

In the graph below I’ve illustrated a key difference between the dollar and Bitcoin. On the right is Bitcoin. Its algorithm incorporates a “diseconomies of scale.” As more Bitcoin is mined, it takes more effort to mine Bitcoin. Bitcoin focuses on the difficulty of supply.

On the left is the fiat dollar. There is no difficulty in supplying it. The Fed focuses on the demand for the dollar by adjusting the interest rate, the bend in the curve. It is currently tightening that bend – the dotted green curve – and increasing the difficulty of getting more dollars. The dollar can respond to changing demand more easily than gold or Bitcoin because it targets demand.

Like Bitcoin, the dollar stores no future work. In an article earlier this year (2022), I wrote that America’s store of wealth was both a proof-of-work, proof-of-stability and proof-of-trust. The dollar itself is only a sign of trust in American institutions. The checks and balances of our system of government ensures that most policymaking is incremental. While that frustrates Americans, the relative predictability of U.S. policy is reassuring to foreign investors. Americans often run around like crazy monkeys on the deck of a cruise boat but the ship is unlikely to make a large course correction.  

Think of the bend in the curve as a toll for using the highway to the future. Bitcoin’s curve is rigid. The toll remains the same. Bitcoin enthusiasts would maintain that this rigidity should shift the curve to the right over time, increasing the buying power supplied by Bitcoin.

Let’s look at three approaches.
1) Bitcoin limits the length of highway that will be built. Enthusiasts claim that this will make each “mile” of the bitcoin highway more valuable.

2) MMT advocates offer a different solution. As long as there are resources – both labor and material – available, build more highway. By targeting the supply available, congestion will ease.

3) The Fed offers an approach that targets demand, not supply. The Fed raises and lowers the interest rate – the toll – to get onto the highway to the future. Raising interest rates is a form of congestion pricing. High inflation means that there are too many people using the available length of highway. The Fed has promised that it will keep raising the toll until fewer people are using the highway. As demand declines, some of those working on the highway may lose their jobs. Unemployment will increase but historically it is very low.

The strength of the dollar against other currencies, including Bitcoin and gold, indicates increasing demand for the Fed’s approach. What is the morality of an international floating rate regime where businesses in a developing country have to work even harder to pay their dollar-denominated loans? Bitcoin advocates claim that global adoption of Bitcoin will make a more even playing field, reducing the advantage that developed countries have over developing countries. That can be the subject of another article.

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Photo by kyler trautner on Unsplash

Stofka, S. (2022, April 16). Fortress of Trust. Innocent Investor. Retrieved October 1, 2022, from https://innocentinvestor.com/2022/04/17/fortress-of-trust/

Find the Hidden Value

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September 25, 2022

by Stephen Stofka

This week the SP500 index closed down more than 20% from its closing price at the beginning of the year. Where did the value go? When stocks were rising where did the value come from? Trained in neoclassical economics, the economist John Maynard Keynes asked the same question. He criticized the conventional economic analysis because it focused only on the present, disregarding the flow of money and goods into and out of the marketplace. Let’s explore that flow this week.

Let’s imagine that there is a car company called Drive whose stock symbol is DRV. When its stock price goes down on Monday, there were more sellers than buyers. The quantity of shares has not changed but the market value has declined. Where did that value go?

Let’s say that Sally bought 100 shares of DRV for $40,000 cash, or simply $40. I’ll leave off the 1000s in this story. She could have spent the money on a new SUV – satisfying her current needs – but buys a stock which she hopes will someday be used to satisfy her future needs. A car dealer did not make a sale. Let’s assume that the dealer has $36,000 cost invested in the vehicle.

What did the stock seller do with the proceeds? We might trace the money through many transactions in the stock market but eventually we come to Sam who took the proceeds from the sale of his 100 shares of DRV and bought a Drive SUV for $40. Sam’s net cash position is $0. A measure of economic activity, Final Sales of Domestic Product (BEA, 2022), has increased by $40,000 .

To recap the beginning positions: Sally = $40 cash, Sam = $40 stock, Drive dealer = $36 invested in car. Total = $116K. Let’s leave out income taxes, sales taxes and brokerage fees to keep the story simple.

A month later, the price of DRV goes down so that the market value of a 100 shares of stock is $36. The value of Sam’s SUV is not affected – or is it? If Sally were to sell her newly acquired shares at the lower price, she could buy a less expensive car but not that brand of SUV. Thus, there is less demand and the market for SUVs is softer because of the decline in DRV’s stock price.

Let’s imagine that Sally and Sam meet at the grocery store. Sally likes the SUV and offers to sell her DRV stock to Sam for $36, the market value. Sam thinks that is a good deal. He now has the same quantity of shares that he had before. If he had held onto the stock, the market price of the stock would have gone down anyway. He has driven the SUV for 1000 miles for free except for the gasoline. The dealer has $36 cash, covering the cost of the SUV, and $4 in cash profit.

Let’s recap: Sally = $36 car, Sam = $36 stock, Drive dealer = $40 cash. Total = $112K.

Sam and Sally each have $4,000 less than they started with for a total of $8,000 less. The dealer has $4,000 more than they started with. Where is the other $4000? Is it in the SUV’s depreciation or the stock’s lower market value?

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Photo by HAMZA YOUNAS on Unsplash

BEA: U.S. Bureau of Economic Analysis, Final Sales of Domestic Product [FINSAL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FINSAL, September 22, 2022.