Could Trump Be Right On Trade?

May 6, 2018

by Steve Stofka

On Tuesday morning I had an epiphany. Some background first. I disagree with Donald Trump about many things. One of them is his fundamental tenet of international trade: it creates winners and losers. This violates an established principle of economics: comparative advantage. Trade between countries benefits the people of both countries, or a win-win. That is Principle #5 in Greg Mankiw’s Principles of Economics taught in many colleges and universities. From the textbook (6th Ed): “Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services.”

Here’s Professor Trump on trade with the Japanese during their boom years in the late 1980s: “First [the Japanese] take all our money with their consumer goods, then they put it back in buying all of Manhattan. So either way, we lose.” (1990 Playboy interview quoted in National Review).

As I put my dishes in the dishwasher, a memory from a 1989 Christmas party in Los Angeles flashed through my mind. I was visiting from Colorado, doing more listening than talking. At the party were several people in real estate, construction and software development.

One guy complained that the Japanese were buying up chunks of California and there should be a law limiting their ownership. The comment began a spirited discussion and I sensed the resentment in the group. I asked if the Japanese owned that much California real estate. They were able to name landmark office buildings and vineyards.

As was my habit, I made a note to find out how much California real estate the Japanese did own. The Japanese had bought a few headline grabbing commercial properties, but they owned less than 1/10th of 1% of California real estate. The number of Japanese investors who bought homes did affect ordinary Californians, however. The percentage of homes bought was small but helped drive up prices, and fueled resentment of the Japanese.

The principle of comparative advantage is modeled on trade in goods. Real estate is different. That’s the point that I missed at the Christmas Party almost thirty years ago. Real estate is an investment whose present value is based on an estimate of future cash flows. A common refrain is “location, location, location.” Unlike an investment in a plant or machinery, real estate often consists of two types of asset: 1) a building, which has a limited, depreciable life; and 2) la location that has an unlimited, and appreciable, life. The first part is like a bond. The second part is like a stock. Real estate is a hybrid product of both asset types.

Let’s go to the first part of Trump’s statement: “First [the Japanese] take all our money with their consumer goods.” Let’s follow the money with an example. A company called Taro has a factory in Japan (not financed with U.S. dollars) that makes computers which it sells to U.S. consumers. Because Taro is making so many of these computers, people and peripheral businesses move near the factory.  This drives up the value of the factory’s real estate in Japan.

Taro’s capital is better deployed at making computers, so it sells the factory and land to a private equity firm, from which it leases back the factory. Taro then invests the U.S. dollars it has accumulated from computer sales, plus part of the proceeds from the sale of its real estate in Japan, to buy an office building on 5th Ave in Manhattan, that I’ll call Fifth.

To buy Fifth, Taro must outbid another buyer for the property, a U.S. investor I’ll call Bulldog. The higher price that Taro pays implies that the future cash flows from Fifth will be more than Bulldog’s estimate. If those future cash flows are mis-estimated by Taro, then Taro has introduced a form of bad money into the economic system of New York real estate. Gresham’s law states that bad money tends to drive good money out of circulation. We’ll see that the principle applies here.

There are two parts to Taro’s equity in Fifth. The first is the profits in U.S. dollars from selling computers to U.S. customers, a re-bundling of U.S. dollars. The second part is the profits from the real estate frenzy in Japan. What fueled the lofty sales price in Japan? Rosy estimates of future economic activity, robust cash flows, and a limited supply of property in desirable areas of Japan. Taro has transferred that frenzy, and risk, from a property in Japan to a property in the U.S.

Banks and other credit institutions, both U.S. and foreign, fund the rest of the sale. Because Taro has more equity to put into the property than Bulldog, the ratio of financed principle to Taro’s equity may be nearly the same as Bulldog’s proposal (the numbers are at the end below).  The rosy estimates that drove the Japanese valuation now influence, or infect, the wider international finance community as well.

Because the U.S. is not in a boom, Bulldog may not have access to the same funds and credit that Taro does.  This puts Bulldog at a disadvantage. Bulldog does not buy the building. No big deal, right? He’ll just buy another property with a more reasonable evaluation. But, wait. At any one time, only a fixed amount of credit money is available at a particular interest rate. The money that a bank lent to Taro for its acquisition is no longer available to Bulldog at the same interest rate for his buy of another property. Taro’s purchase, fueled by speculation in Japan and agressive estimates of cash flow in New York, will cost Bulldog money.

Economic models of comparative advantage tend to ignore the financing aspect for two reasons. Money is regarded as neutral in economic models, and the machinations of international finance are difficult to model.  The competition for credit is global and fierce, fought by vast private and public pools of capital and policy.  Those who buy and sell premium real estate in markets like New York City are regularly reminded of the fact.  They put their textbooks down and come out fighting.

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The numbers:  For every $100 in price that Bulldog offers, Taro offers $110. To finance Bulldog’s offer, he can put up $20 for every $100, or 20%. Taro can put in $27.50 for every $110 of its offer. In Bulldog’s case, $80 is financed. In Taro’s offer, $82.50 is financed. Taro has a leverage of 4-1 ($110 / $27.50), compared to Bulldog’s leverage of 5–1 ($100 / $20). Taro’s leverage looks safer. Its future cash flow estimates are 10% higher, but the finance ratio on the deal is only 3.1% higher ($82.50 / $80). If Taro’s cash flow projections are 5% too high, a lender calculates that Taro can still make payments.

Our Legacies

April 29, 2018

by Steve Stofka

Each generation bequeaths the benefits and costs of legislative programs to the following generations.  In the past one hundred years, Democrats have secured a dominant majority in the Congress three times. A dominant majority is one where one party controls the Presidency and both houses of Congress with a filibuster proof majority of sixty in the Senate (History of Shifting Political Power).

Each time, the Democrats have created an entitlement program, a legacy structured so that it would be difficult to undo when Democrats were out of power.  Under FDR in the 1930s, the Democrats created Social Security. Like all entitlement programs, coverage and benefits were expanded in the first ten years after creation of the program.

In the 1960s, LBJ and the Democrats created Medicare and Medicaid. Before these programs, the Federal government paid 11 cents of every health care dollar. In 2013, that 11 cents had grown to 26 cents (CMS history PDF).  As with Social Security, coverage and benefits were greatly expanded the first decade after creation. In 1960, the U.S. spent 5.1 cents for every $1 of GDP. OECD countries spent only 3.7 cents. By 2013, Americans spent 16.4 cents of each $1 of GDP, twice as much as the 8.7 cents spent by OECD countries.

For fifty years, the annual growth of health care spending was 50% more than the growth rate of the economy.  With a dominant majority after 45 years, Obama and the Democrats tried to pass single payer health care in 2009. Democratic politicians in conservative leaning districts balked at the idea. Obamacare was a compromise solution that has been compared by opponents and advocates alike to a Frankenstein contraption of legislation that needs to be fixed. Expansion was embedded in the legislation from the start through the Medicaid program.

When the BLS and Census Bureau compute the Consumer Price Index (CPI), a measure of inflation, they consider the shifting patterns of consumer spending. Since 2000, the Medical spending component of the CPI has doubled its share of the index to about 17%. Increased medical spending is affecting most American families. Regardless of one’s opinion of the solution, Obamacare was a compromised attempt to deal with this trend.

The American health care system is like the 50-year old cars in Cuba that have been patched together with duct tape and ingenuity. The system runs on policy payoffs to stakeholder groups and it will fail most of us because it cannot adapt to the extraordinary advancements in medical care. As technological changes accelerate in the coming decades, this cobbled together system born of World War 2 wage and price controls will grow ever more unwieldy.

Entitlement programs invariably cost a lot more than the designers calculate. Program benefits are easier to sell to voters than raising the funds to pay for them. Following December’s tax reform bill, the non-partisan Congressional Budget Office revised their ten year budget and deficit estimates.

For the past fifty years, the Federal government has collected an average of $17.40 for every $100 of GDP.  The CBO projects Fed revenue will be over $18.00. Here’s the problem: the Federal government has been spending $20.30, almost $3 more than it collects. That’s how the country has run up a debt of $20 trillion. It’s about to get worse. Because of increased Medicare and Medicaid spending, the CBO projects spending will increase to $22.40 for every $100 of GDP. A $3 shortage will soon turn to a $4 shortage. The interest on that steadily increasing debt? By 2023, almost $3, a sixth of what the government collects and more than the defense budget.

Nations can not declare bankruptcy.  Instead, they become failed states and descend into anarchy.  Venezuela has become a failed state and its people are fleeing the country.  Most of the institutions have failed.  Most of the daily necessities of life are in short supply. The government claims that it doesn’t even have the paper to print exit Visas.  Under the Maduro government, truth was the first to abandon the country.

The economy is strong yet Chapter 11 bankruptcy filings have reached the same level as April 2011 when there was talk of another recession. That year, the unemployment rate was still above 9% and housing starts remained at all-time lows. Then-President Obama and Republican House Majority Leader John Boehner battled over a budget compromise and the stock market dropped nearly 20%. In a strong economy like today, we should have lower levels of bankruptcy.

 

Prejudice and Jobs

April 22, 2018

by Steve Stofka

America is built on prejudice and the passionate denial that we are a country built on prejudice.

Investors who understand the role of prejudice in the economics of this society can recognize a few early signs of a coming recession. A strong economy, like a bull stock market, raises all boats, including those at the margins who are easily stranded.  During the financial crisis, they were the first to be discarded.  As the current strength of the economy is finally able to lift the fortunes of the more vulnerable, countervailing forces will undermine that strength.

From the country’s founding, broken and forced land treaties, enforced by superior military power, have sidelined those with red skin.  Like the thoroughbred horses in the upcoming Kentucky Derby, Americans with black or brown skin must carry an extra weight during the race of life. I’ll show one data sign of this weight. White people must bear their own burden: privilege. Centuries of discrimination blocked those with black skin from many housing and job choices to give those with white skin a better chance at success. The prejudice against those with brown skin is less strong but has intensified when Candidate Trump used the issue of illegal immigration to taint those with brown skin or Hispanic surnames, regardless of their citizenship.

America has a shorter history of isolating and persecuting immigrants of white skin. First it was the Irish who immigrated to America after the potato blight devastated Ireland’s staple crop in the mid-19th century. Newspapers and periodicals portrayed the Irish as ignorant, shiftless criminals. In a country dominated by Republicans, many Irish were Catholic and suspected of being more loyal to the pope in Rome than democratically elected leaders in America.

As the century turned, Italians and southern Europeans became the target of American prejudice (History). Like the Irish, many Italians were Catholic and not to be trusted. To this day, no Italian has been elected President. JFK was the first successful Irish Catholic candidate for the Presidency, and he had to overcome objections that he would turn to the Pope for advice on national policy.

As discriminatory as Protestants have been to Catholics, they have been especially unkind to those of other Protestant sects. As more Catholics migrated to America, many Protestants in America deflected their prejudices from other Protestants to the Catholics as easy targets of discrimination.

In America, Jews encountered less discrimination than in Europe but housing, job and social discrimination were prevalent in the first half of the 20th Century. In the 19th Century, those of the Mormon faith were driven out of Ohio, then Missouri, and Illinois by Protestant sects who regarded Mormons as non-Christians. The abandoned farms and businesses were auctioned off to the Christian righteous who remained. Mormons escaped across the Great Plains and the Rocky Mountains to settle in a valley in Utah. Following the Holocaust during World War 2, there was a proposal to settle many European Jews in Utah, but Mormons nixed the idea. Even those who suffer persecution for their religious beliefs are not immune to bias.

From Europe, Protestant settlers brought their prejudices with them. Those Protestants who immigrated to America because of religious persecution were often fleeing long standing animosities with other Protestant sects. Eight of the thirteen colonies established churches of a particular denomination and only those citizens belonging to that denomination were allowed to hold office. Each Protestant sect was convinced that the other sects had strayed from the message and meaning of the Bible. To counter such discrimination, Virginia adopted an amendment to protect religious freedom even before the founding of the United States. Mindful of these bedrock prejudices, the Founding Fathers based the language of the First Amendment on the laws of several states protecting religious freedom.

Jobs and their compensation reflect the value that a society places on an individual’s labor. The graph below is a sign of prejudice in America. The unemployment rate for blacks is always higher than the rate for whites. If this were a chart from the year 1890, the persistently higher unemployment rate could be labeled Irish or Italian.  A disadvantaged class of worker is more willing to do unpleasant jobs for less money.

UnemployBlackWhite

Under Obama, the unemployment rate for black men dropped from 18% in the spring of 2010 to 7.7% in November 2016. Since Trump’s election to the Presidency in November 2016, that rate has fallen another 20%. At 6.1% this rate is the lowest since the early 1970s. There are black grandfathers who thought they might die before seeing a younger generation enjoying an unemployment rate this low.

Still, the current rate for black men is 2.8% higher than the 3.3% rate for white men. Over the past forty years, the average difference between the two unemployment rates is close to 6%. This is the burden of being black in America. In the past half century, there have been few times when the difference in rates is this low: 1) during the Vietnam War when many black and white men were removed from the labor force; 2) 1999, near the height of the dot-com boom; and 3) several months this past year.

UnemplRatesDiff

It’s not just skin color, religion and nationality that drives prejudice in America. Five years after the end of the Civil War in 1865, the 15th Amendment gave black males the right to vote. Women suffragettes lobbied hard to be included in the Amendment and win their right to vote. Susan B. Anthony and Elizabeth Cady Stanton were prominent leaders of this movement. The idea was just too crazy, they were told. Women were too guided by their emotions, and too irrational, particularly during their menses, to be trusted with the vote.

In 1920, exactly fifty years later, the ratification of the 19th Amendment gave women the right to vote. The Suffragette movement had allied with the Prohibition movement to press each of their causes in a joint effort. The Volstead Act, the implementation of the 18th Amendment prohibiting the sale of intoxicating liquor, was passed a few months before the ratification of the 19th Amendment. They were a package. Had women been granted the right to vote in 1870, the Prohibition movement would have lacked a critical partner to win passage of the Amendment. Without Prohibition, the rise of organized crime might not have occurred.

Whenever there is a war, or any act of aggression with another country, Americans single out those nationalities or races for discrimination. In the 19th Century, those of Mexican descent were vilified after the Mexican-American War.

Many Germans were denied jobs and housing following the start of WW1. Historical prejudices were resurrected. German soldiers, known as Hessians, had fought with the British against American colonists in the War for Independence. Americans began to see that there was something wrong with the German character. Political cartoons pictured Germans as Huns, a mongrel and violent race of uncivilized people always lusting for battle.

Following Japan’s 1941 attack on Pearl Harbor, U.S. citizens of Japanese descent were forced to sell their homes and businesses at below market value, then were moved to internment camps away from the west coast.

The most recent assault on U.S. territory was the 9-11 attack by multiple suicide squads. Most hijackers were from Saudi Arabia, but we did not single out Saudi nationals in the U.S. Unlike the targets of previous war discrimination, Saudis have no unique language. Instead we singled out all Muslims, and all Arab speakers as potential threats.

Prejudice based on sex, on religion, on skin color, and on nationality have formed our country. America is built on prejudice and the passionate denial that we are a country built on prejudice. We can’t do the work of healing until we admit the reality.

Low unemployment rates among minority groups means that the economy is especially strong. Low levels of unemployment for black, brown and white men usually precede a recession. For white men, the benchmark is 4%. For black men, it’s 7%. For Hispanic men, 5%. Below those benchmarks, the Fed has coincidentally seen what they consider to be inflationary pressures.

In a strong economy with low unemployment, confidence and spending increase. This puts some upward pressure on prices. Central bankers jump at the slightest hint of rising prices. Inflation and employment models like the Phillips curve are imperfect. Despite mountains of surveys, equations and data, inflation is difficult to measure, and many factors influence its rise and fall.  Building a model is made more difficult because each high inflation period has had its own unique features. Among economists, fears of an awakening of the inflation beast has persisted since the recovery in 2009.  Economists had begun to worry why the beast has not awoken.  The models said the beast should be awake! Finally, the Fed is seeing some consistent signs that inflation is growing toward their 2% mark. It has begun to lift interest rates to curb inflationary pressures.

I’ve added the Federal Funds rate to a chart of the unemployment rate for white men to show the pattern. I’ve left off the series for black males that I showed earlier so that the chart was not too cluttered.

UnemplVsFedFundsRate

Economists joke that it’s the Fed’s job to remove the punch bowl just when the party is getting going. Want to know what’s ailing the stock market lately? One of them is the greater likelihood of four rate hikes by the Fed this year. At the start of the year, investors put the chances of four rate hikes at 15%. This week it stands at 45%.

To those on the edges of our society and labor force, and to those just entering the job market, the easier job market that others have enjoyed for several years is just opening to them. If there has been a party, they have been left out. As their prospects brighten, the Fed’s raising of interest rates is a cruel joke.

As interest rates go higher, fewer people can afford to buy homes, cars and furniture. Many companies run on borrowed money to meet short term funding needs and long-term investment. As money becomes more expensive, companies tighten their belts and hiring slows. The most vulnerable are the recently hired and they are often the first to be let go. Like marine life that lives in the tidepools at the ocean’s edge, some are left high and dry when the tide of easy money ebbs.

 

Personal Debt

April 15, 2018

by Steve Stofka

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

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

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

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

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

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

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

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

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

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

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

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

Trade Wind Turbulence

April 8, 2018

Remember the clip of Jack Nicholson In the 1980 movie The Shining? Jack hacks his way through a door with an axe, then presses his face to the jagged hole and announces, “It’s Johnny!” Substitute “Trade Wars” and we get a dramatic portrayal of the stock market this past week. On several days, the Dow swung 700+ points, or more than 2%, in response to fears of a tariff feud between the U.S. and China.

The share of global commodities that China consumes far exceeds its share of the world’s population (1/5) or the global economy (1/6). Here’s a chart from Visual Capitalist.

On Thursday, the market opened almost 2% down in response to comments from the chief Tweety Bird in the White House. Later that morning, Larry Kudlow, Trump’s new NEC Director, did a quite effective job of easing market jitters. Kudlow has been a host of CNBC and his own radio program for many years and is savvy to shifting sentiments. No, he said, Trump is a free trader in disguise. This is just a bargaining tactic. The market started the day 500 points down and finished up 240 points.

This is a trader’s market. Much of the price action is taking place in the last hour of the trading day. Each price recovery since mid-March has failed, so the overall sentiment is negative and Friday’s trading was near the 200-day average. For an investor who has not yet made their 2017 IRA contribution, buying now is somewhat equivalent to dollar cost averaging over the past nine months. For those with shorter time horizons, cash looks good till the market finds its head.

The Labor Report for March showed job gains of just 103,000. This was below the 175,000 anticipated gains and far below ADP’s 240,000 estimate of job gains. Mid-March weather on the east coast may have had a negative effect on this month’s survey. The average of the BLS and ADP surveys is 172K, and I find that average to be a more accurate long-term estimate.

The BLS recently released a report on unemployment rates and weekly earnings classified by degree. This chart is a dramatic picture of the advantages of higher education.

UnemplEarnByDegreeBLS
VividMaps released a map showing the income needed to buy an average home in each state. Because the data uses average house prices, the map overstates the affordability problem for many families but does reveal the underlying trend. Why do I say overstates? The average home price is far above the median price because extremely expensive homes raise the average.

First quarter earnings to be released in the next two weeks are expected to show strong annual growth. Will the confirmation of rosy expectations overcome the darker fears of a global trade war? Stay tuned.

Work

April 1, 2018

by Steve Stofka

This week I’ll look at several aspects of work, from cryptocurrencies like Bitcoin, to the minimum wage.

What is work? In general science or physics, the subject of “work” pictured a horse hitched to a pulley lifting a weight (an example). In one minute, the horse could lift so many pounds a foot in the air and that equaled so much horsepower. Thus we could reduce our definition of work to three components: weight, distance and time.

Even this mechanical definition of work illustrates a problem. If the horse lifted the weight, then let it down again, how would we know that the horse did any work? Should we give the horse a few cups of oats, or have we got a lazy horse?

A variation on that problem – I cut my lawn. My neighbor looks at my lawn and sees that work was done. In a week or two the grass has grown and time has erased any sign that I did work.

Thus, we need a way of recording work done. The product of the work performed may serve as a record. A big pyramid sitting on a desert is a permanent record that work was done. If workers dig holes in the ground, then fill the holes, how do we know any work was done? If they have dug up gold from those holes.

Bitcoin and other cryptocurrencies (crypto) are assets like gold. They recognize that some work was done. Equipment, technology and workers were needed to dig up gold. Likewise, electricity was an important resource needed to generate a bitcoin, and even more electricity will be needed to generate a replacement bitcoin if one were lost.

This Politico article is an account of a crypto mining boom in a rural area in Washington state. The electricity consumed is enormous. The mighty Columbia River nearby provides electricity at a fifth of the average cost in the country. By the end of this year, there will be enough electrical capacity in this small area to power the equivalent of a tenth of the homes in Los Angeles. Shipping containers house computer servers which generate so much heat that the exhausted air melts the snow around the containers. As gold records the digging of dirt, a bitcoin records the expenditure of some quantity of electricity.

Assets can represent past work, future work, or a combination of the two. Precious metals, jewels, books and artistic works represent work done in the past. On the other hand, a machine represents future work. Other assets include stocks and bonds, both of which are claims on future work. A bond is a fixed limit claim on a company’s assets. In contrast, a share of stock is an undying claim on a portion of a company’s assets.

The blockchain algorithm behind crypto requires agreement among many parties to confirm a property right to the crypto. The recording of property rights might seem rather ordinary to a reader in the U.S. In some countries, however, property deeds are more easily altered by those in power. In contrast, a blockchain system of recording property rights prevents forgery and alteration.

As a record of work done, money relies on a relatively stable value. High inflation damages the money record of work done. Consequently, high inflation can fracture the social bonds among people. As an example, I cut someone’s lawn on Saturday and am paid. When I spend the money on Sunday, it is worth half the amount. In effect, the money has only recorded that I cut half a lawn. Examples of this hyper-inflation are Zimbabwe in the 2000s, and Yugoslavia in the 1990s (Wikipedia article). Look no further than Venezuela for a current example of the destruction that inflationary policies can have on a society.

Let’s turn from the recording of work done to the doing of it. New unemployment claims are at a 45 year low. A decade ago, job seekers despaired. In contrast, employees today are confident they will quickly find new employment. To illustrate, the quit rate is at the same pace as the mid-2000s, at the height of the housing boom. As a percent of the labor force, new unemployment claims are the lowest ever recorded. Last week’s numbers broke the record set in April 2000 at the height of the dot-com boom.

Equally important to the strength of a job market is the fate of marginal workers who are most vulnerable to the shifting tides of the economy. This includes disabled people who want to work. During the recession, the unemployment rate for disabled men of working age reached almost 20%. Today it is half that.

Let’s turn to another disadvantaged sector of the job market – those who work for minimum wage. The 1930s depression put many employers at an advantage in the job market. The Fair Labor Standards Act of 1938 (FLSA) enacted a wage floor, but many workers were not subject to the new law. In 1955, almost twenty years after passage of the law, “retail workers, service workers, agricultural workers, and construction workers were still not required to be paid at least the minimum wage” (article).

The minimum wage affects many lower paid workers who are making more than minimum wage. In some union jobs, starting wages for helpers are set by contract at a percentage above minimum wage. The understanding may be non-written in some cases. In 1966, the rate was increased from $1.25 per hour to $1.60 per hour. Non-union clerks at a NYC hospital who had been making $1.70 per hour now complained that they were making minimum wage. As a result of their pressure on management, they got a raise within a few months.

Here’s a chart showing the annual increases in the minimum wage for each period since 1950.

MinWagePctInc

In the three decades after World War 2, annual increases in the minimum wage exceeded inflation. Since 1977, the minimum wage standard has not kept pace with inflation.

MinWageLessCPI

If Congress truly represented all of their constituents, they would make the minimum wage adjust automatically with inflation. On the contrary, Congress represents only a small portion of their constituents, and the minimum wage is used as a political football.

Finally, there is the destruction of the record of past work by war. Every minute of every day, living requires calories, another measure of work. Therefore, each of us is a record of work done.  War destroys too many human records, and the unliving records of work like buildings, roads and bridges. Perhaps one day we will fight our battles in video games and stop destroying all those work records.

Lots of Changes

March 25, 2018

by Steve Stofka

What a week it was. A glance at the headlines would lead someone to believe that it was all about tariffs and an impending trade war between the U.S. and China. On Thursday and Friday, the Dow Jones Industrial Average lost more than 1000 points, or almost 5%. Was that all about tariffs? Hardly.

As expected, the Federal Reserve raised interest rates ¼% on Wednesday.  This put the Fed rate at 1.5% – 1.75%. Half of the members of the interest setting committee (FOMC) indicated that it might be necessary to raise interest rates four times this year. The market has been pricing in three interest rate increases for 2018. Until Thursday, a fourth increase had not been fully priced in.

Further, the Fed is projecting an unemployment rate below 4% by late 2018 and early 2019. The current rate is 4.1%. Many industries are already struggling to find qualified workers. Rarely does the unemployment rate dip below 4%, and each time, inflation has risen and the stock market has fallen – sometimes substantially.

CPIUnemploy

The downturn following the Korean War was short and shallow, but the other two periods of low unemployment were followed by steep corrections in the market.

On Thursday night, the White House tweety bird announced another change in the roster. Out with the old National Security Adviser, General H. R. McMaster. In with the new adviser, John Bolton, an old school war hawk who avoided military service in Vietnam by joining the National Guard. Bolton’s first instinct is war and regime change as a solution to global disputes. In choosing Mike Pompeo as his new Secretary of State and John Bolton as his new National Security Advisor, Trump has assembled a war cabinet. The market has still not priced in the heightened chances of conflict with North Korea or Iran. Nor has it recognized a greater likelihood of armed conflict with China in the South China Sea. That might come in the next few weeks.

On Thursday, Trump enacted tariffs on imported steel and aluminum from China as promised. Stronger action against China’s trade policies are overdue, as it has long violated the spirit, if not the letter, of the WTO global agreements. Car manufacturers wanting to set up a plant in China must have a Chinese business partner with a 25% stake and – surprise – access to industrial trade secrets. The national government heavily subsidizes key industries so that they can support their own industries and workers. They avoid labor and environmental regulations, and when caught, pledge to do better. They issue a national change in regulation, but the change is only published and enforced in a few local areas.

The theft of intellectual property is a hallmark of most developing nations like China. In the 18th and 19th century, the U.S. was notorious for copying products made by companies in England and France. Article 1, Section 8 of the Constitution added some promise of patent and copyright protection, but the laws instituted protected only U.S. citizens. A half century later, Charles Dickens was “one of the chief victims of American literary piracy” (Source). A foreign inventor had to establish citizenship or residency in the U.S. for two years to gain any patent protection. In 1887, the U.S. joined a 19th century version of the WTO called the Paris Convention. As China does today, the U.S. skirted international agreements for at least a decade (Patent history).

Older Chinese citizens may have watched patrolling U.S. naval ships from the shores of the Yangtze River. The nation remembers the century of U.S. gunboat diplomacy (Wikipedia article). Despite American free market rhetoric, Chinese leaders understand that mercantilism still retains a strong political influence in the trading policies of many developed countries, including the U.S.

When NAFTA was signed in the early 1990s, subsidies of American corn farmers enabled them to sell cheap corn to Mexico. Unable to compete, many farmers in northern Mexico went out of business. As farming jobs decreased in Mexico, many laborers journeyed north to the U.S. to pick crops so that they could support their families. The U.S. is partially responsible for creating the very environment that led to so much illegal immigration from Mexico.

Around the world, developed countries cry foul when another country subsidizes goods that are exported at a lower cost into their countries. Since 1963, the U.S. has imposed a protectionist tariff of 25% on imported light duty trucks, the so called “chicken tax”. Protected for over fifty years by this tariff, domestic truck manufacturers like Ford and Chevy had made few substantial changes to their work vans in the past few decades. In 2015, Ford finally made a substantial change to its F-150 pickup. Notice those Mercedes tall work vans on the road? They are built in Germany, disassembled to avoid the tariff, shipped to the U.S. and reassembled by U.S. workers. Ford uses the same process with its Transit Connect van.

Boeing imports parts from all over the world to build its Dreamliners. Chinese companies use southeast Asia as a manufacturing supply, then assemble and ship thousands of products to the U.S. and around the world. In the truly global manufacturing economy, a trade war is a threat to the profits of many large businesses. They have tuned their operations to the contradictory rules of international trade.

Business leaders understand the political strut of free trade. Each business wants free trade when it wants to compete in someone else’s market. Each business lobbies for more regulations, tariffs and barriers to protect its competitive position within its own market. Yes, it’s all lies, so it’s important that the rules underlying this game not change too much. Trade wars change the rules and that’s bad for business.

Debt and Housing

March 18, 2018

by Steve Stofka

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

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

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

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

InterestPctGDP

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

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Housing

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

ResInvest

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

HousingIncomeRuleOf4

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

 

Spring Cleanup

March 11, 2018

by Steve Stofka

Today time springs forward. Tufts of grass turned green, and some trees are beginning to bud. It was still light after 6 P.M. even before the time change. Great flocks of cranes fly north. In the springtime evening we can hear the siren call of the booby headed tax deadline.  2017 IRA contributions are due by April 15th.

This is a good time to check our game plans. Are we saving enough? In the accumulation, or pre-retirement, phase, 10% or more of our income is a good savings goal. 5% is an absolute minimum. Savings should be used to pay down any debt that has an interest rate more than 5%. High interest rate loans are a weight we must drag around with us. Consider working part time for a while and using that money to pay down high interest rate debt.

New car loans now average over $30K with an average maturity (length of payment period) of 67 months. The average interest rate is 4.21% but anyone with less than a FICO score of 690 is paying 5% or more. This article has breakdowns by credit score, lending institution, length of loan, and other factors.

Of the money we have saved – any annual portfolio realignments to be done? This is a good time to not only think about it but to do it.

In the distribution phase of a portfolio, we begin to withdraw funds from the portfolio that we have accumulated through a lifetime of saving.  Using Portfolio Visualizer, I’ve compared two portfolios with a 60/40 mix – 60% stocks, 40% bonds and cash.  These backtests include an annual rebalancing that may be more difficult for funds in a taxable account because buying and selling may generate taxable capital gains.

Let’s pretend a person retired in May of 1998 at the age of 68 and just died last year. During this twenty years, there were two times when the stock market fell 50%. The beginning year 1998 is near a high point in the stock market. The ending year 2017 was the 8th year of the current bull market. The test begins and ends at strong points in the market cycle, a key feature of a test like this.  Beginning a backtest with a trough in the market cycle and ending with a peak only distorts the results.

Portfolio

At the time of retirement, our retiree had a $1 million portfolio, although the amount could have been $100,000 or $10 million.

Portfolio6040

Although the stock allocation is the same for both portfolios, Portfolio 2 is totally simple. Put all the money in Vanguard’s Total Stock Market fund and forget about it. Portfolio 1 manually diversifies the 60% stock portion of the portfolio among four classes: Large capitalization, mid cap, small cap value stocks in the U.S., and European large cap stocks. Think of Goldilocks sitting down to a table with four bowls of soup – big, medium, small and European.  If that person retired today, a diverse stock portfolio would include an emerging markets index fund like Vanguard’s VEIEX.  In 1998,  emerging markets were not part of a core portfolio as they are today.  For this test, I left out emerging markets.

The bond portion of the portfolio is an index fund of the total bond market. Both portfolios hold 10% in cash for emergencies and living expenses.

Income

A portfolio is like snow in the Rocky Mountains that melts and flows toward the Pacific Ocean. Will the water make it to the ocean? Each year this retiree withdrew 4% of their portfolio balance for expenses. That percentage is considered safe during most twenty-year retirement periods. Note that some advisors are using a thirty-year retirement period to test a portfolio mix. As the years go by and the purchasing power of a $1 erodes, will 4% be enough to meet a retiree’s income needs? The more diverse portfolio allowed the retiree to withdraw a larger amount every year, and the annual withdrawal did keep up with inflation.  Secondly, the ending balance was about the same as the beginning balance after adjusting for inflation.

PortfolioWithdrawal6040

Return

The more diverse Portfolio 1 (marked complex in graphic below) has a better return over this twenty-year period. See the Internal Rate of Return (IRR) column, which adjusts for the withdrawal amounts each year.

PortfolioReturns6040
The drawdown, or greatest decline in value, in the time series is a critical test of a portfolio mix. The retiree needs that portfolio to generate a certain amount of income every year. If the portfolio falls to zero, the income stream has dried up. In the chart below, look at the dip in the portfolio value during the 2008 Financial Crisis. The more diverse Portfolio 1 (blue line) dipped below the starting $1 million figure, but not by much. The investor who was 100% invested in the stock market, the 500 Index portfolio (yellow line), fared the worst during most of the twenty-year period.  In a sign that the bull market has matured, the 500 Index has overtaken the simple 60/40 mix (red line) and is about to overtake the diversified 60/40 mix (blue line).

PortfolioGrowth6040
The diverse portfolio is not complex. There are no gold or commodity assets, no energy or natural resource funds, and no real estate REITs to manage.  If emerging markets were added to the Goldilocks mix, there would now be five equal bowls of soup, each of them taking 12% of the portfolio. This portfolio would have earned 4/10% better each year.

PortfolioEM6040

We could add a Pacific stock index like Vanguard’s VPACX to the mix, but when do we stop adding indexes? In this time period, that index had a slight negative effect on returns. As the number of indexes grow, we are less likely to adjust our allocation.

Our portfolios can get cluttered and too complicated to be effective and easily managed.  Can we simplify?  It’s worth a look see. In taxable accounts, de-cluttering and re-balancing can generate taxable capital gains, so it might not be advisable to make any changes.

Labor Languishes

March 4, 2018

by Steve Stofka

Next week, the White House intends to impose tariffs on imported steel and aluminum. China subsidizes their core building industries. When global demand for China’s products wanes and inventories build, Chinese industries can sell at reduced costs, a practice known as “dumping.” Although the Commerce Dept. has warned China about dumping, the lower prices do benefit a range of U.S. industries but hurt U.S. steel manufacturers, who have endured both lower demand and unfair pricing competition from China.

Following the announcement, the Dow fell back 3%, wiping out Thursday morning’s gains. The prospect of tariff wars sent global stocks down later that night and the following morning. China’s stock index fell 6.5% for the week and Japan was down more than 4%. On Friday, the U.S. market experienced wide swings but settled nearly flat for the day and down 3% for the week.  Opinions vary on the long term consequences.

Let’s turn to a trend that has developed since China was admitted to the World Trade Organization (WTO) in 2001. A year ago two BLS economists presented a historical estimate of labor’s share of yearly GDP since World War 2. If GDP is $100, how much went to the people who produced that output?

The authors describe it: “The labor share is the percentage of economic output that accrues to workers in the form of compensation. It is calculated by dividing the compensation earned during a certain period by the economic output produced over the same period.” The paper is intended for an academic audience, but I will extract some disturbing highlights. First of all, the graph.

LaborShareOfGDP

Note the sharp decline after China was admitted into the World Trade Organization (WTO) in 2001. Some economists have concluded that half of the decline can be attributed to the mobility of computerized capital. Firms can produce a $100 of output with less labor and more of this mobile capital.

Labor in the U.S. is gradually being converted into capital. A business owner may be able to cut his labor costs by buying a machine. A rule of thumb in some industries is a two-year payback period for an investment of this type. Let’s say an owner can save $50,000 per year in labor costs with a machine. Using the two-year rule of thumb, they would not want to pay more than $100K for that machine.

During the past two decades, Asian factories have greatly improved their manufacture of such production machinery and the lower labor costs in Asian makes the machines cheaper. Quality up, costs down. It makes economic sense for more American business owners to replace some of their workers with machines. Before replacement: $100 output by the firm took $65 of labor and $20 of capital and included a profit of $15. After buying the machine, the figures might look like this initially: $100 of output by the firm costs $60 of labor, $25 capital, $15 profit. The $5 that used to go to an American worker now goes to a company in Japan and a bank in America that financed the purchase of the machine.

That laid off American worker bought stuff in their local community. Their sales and property taxes supported the services provided by the community. Although the machine may need maintenance and repairs, it doesn’t spend money regularly in the community, nor require community services like schools, police and medical care.

Donald Trump was elected President based on his claim that his administration would reverse this two decade trend.  The tariffs announced this week will have a small beneficial effect on workers in those industries because steel and aluminum manufacturing have become much more automated in the past twenty years.  The aluminum tariff will add about 1 penny to the cost of a can of beer. The tariffs are a symbolic nod to a campaign pledge that Trump made to those in the rust belt.

I applaud Trump for remembering his campaign pledges.  Professional politicians have long understood that campaign pledges are rhetoric that must fall to conflicting political alliances. Six months after taking office, most pledges have been broken or quietly slipped to the rear of an administration’s porfolio.  Trump has not forgotten the voters who put him in office, but he does have trouble maintaining a consistent stance on gun policy or immigration.  Keep those seat belts buckled.