Friday, December 22, 2006

Oil Industry Subsidies

The subsidies that the US government extends to the oil industry are in the news today, with the following story from the New York Times:
Study Suggests Incentives on Oil Barely Help U.S.

WASHINGTON, Dec. 21 — The United States offers some of the most lucrative incentives in the world to companies that drill for oil in publicly owned coastal waters, but a newly released study suggests that the government is getting very little for its money.

The study, which the Interior Department refused to release for more than a year, estimates that current inducements could allow drilling companies in the Gulf of Mexico to escape tens of billions of dollars in royalties that they would otherwise pay the government for oil and gas produced in areas that belong to American taxpayers.

But the study predicts that the inducements would cause only a tiny increase in production even if they were offered without some of the limitations now in place.
Clearly there are excellent political reasons for the oil subsidies - otherwise they wouldn't exist. But are there any good economic reasons for the federal government to subsidize the oil industry at all?

I think that the answer is probably no.

The answer, of course, depends on what you think are the nominal goals of the subsidies. I can think of a few candidates:
  • To reduce the price of oil for consumers by increasing overall oil production;
  • To earn fair market value from an asset that is owned by the citizens - the US's offshore oil deposits;
  • To support jobs in the domestic oil industry;
  • To reduce the US's energy dependence, by replacing imported oil with domestic production.
Clearly the oil subsidies fail to acheive the first goal. The US is such a marginal and expensive producer of oil at this point that it's inconceivable that any additional oil production encouraged by subsidies could possibly have any impact on the world price of oil.

The second goal is also clearly not acheived with the present level of subsidies to the oil industry. As the article points out, raising the price charged by the federal government to oil companies would have a negligible impact on the quantity of oil produced, but would have a significant impact on the dollars earned by the people of the US for that oil. Put another way, think of it as being on the left-hand side of the oil revenue Laffer curve; if we reduced the subsidies given to the oil industry (or increased the fees charged them), the American public would receive a lot more money for its oil assets than they currently do.

As far as supporting oil industry jobs goes, it's not at all clear to me why we would want to do that in the first place, as oppsed to jobs in any other industry in the US. But since the impact of the subsidies on production is so tiny, the impact on jobs is also certainly tiny. If the subsidies result in 1% more employment in the oil industry (to go along with the estimated production impact of about 1%), then the billions of dollars per year in subsidies support a total of about 1,400 workers. (There are currently 140,000 workers in oil and gas extraction, according to the BLS.) That's works out to be a cost to taxpayers of a few million dollars for each additional job in the oil industry.

So the most compelling rationale for oil subsidies must hang on the last potential goal: to make the US more energy independent. This is not, strictly speaking, and economic goal; it may have national security implications, but from an economic point of view it really makes no difference where the gallon of gas pumped into your car comes from.

But does it even have any impact on national security? That depends on how much of a reduction in imports of oil it would take to enhance US national security. Would it need to be a 10% reduction? 25%? 50%? I don't know the answer, but I do know that even increasing US production by 50% - a mammoth increase in production that would not be possible in any oil-man's wildest dreams - would only bring the US's dependence on imports down from about 65% to about 50%. I fear that trying to acheive energy independence through increased domestic US production is like trying to catch the end of an oily rainbow.

In short, I think it's easy to punch holes in every reasonable justification that one might encounter for subsidies for the oil and gas industry. There are many changes that a Democratic Congress may make to the federal government's tax and spending policies. But eliminating these subsidies would be one of the ones for which I would cheer the loudest.

Thursday, December 21, 2006

Final Revision of 3Q GDP

The BEA released their final estimate of third quarter GDP this morning. The Wall Street Journal reports:
The U.S. economy was a bit weaker during the summer than earlier believed as the sharpest housing-sector slump in 15 years took an even bigger toll on the slowest quarterly growth of 2006.

Gross domestic product rose at a 2% annual rate July through September, revised down from a previous estimate a month ago of 2.2% for the third quarter, the Commerce Department said Thursday.

Economists surveyed by Dow Jones Newswires had expected third-quarter growth to hold at 2.2%. The Commerce Department said the revision to GDP, a measure of all goods and services produced in the economy, mainly reflected a downward adjustment to consumer spending.

Consumer spending, the biggest component of GDP, rose 2.8%, down from a previously reported 2.9% increase but above the second quarter's 2.6% advance. Consumer spending accounts for roughly two-thirds of economic activity. It contributed 1.96 percentage points to GDP in the third quarter.

Another GDP component that was lowered was residential fixed investment, which plunged 18.7% in the third quarter instead of the previously reported 18.0%. Housing is bogging down the economy, which grew at a faster, 2.6% rate in the second quarter and 5.6% pace in the first three months of 2006. The drop in residential fixed investment was the sharpest since a 21.7% drop in first-quarter 1991, and cut 1.20 percentage points off of GDP. Second-quarter residential fixed investment dropped by 11.1%.
Yes, the slowdown in housing construction is having a direct impact on the growth of the US economy. But I'm actually much more worried about the eventual effects that flat or falling home prices could have on household balance sheets in most of the US's previously hot housing markets.

Put this together with the precarious financial situation of millions of US households, many of which may be facing default and eventual foreclosure over the next year or two, and I fear that the effects on personal consumption in 2007 could be substantially bigger than the direct impact on the economy of reduced home building.

Wednesday, December 20, 2006

Adventures in Capital Controls

Thailand has been in the news over the past couple of days because of the fun and games they've been playing with the imposition of capital controls. (Of course, to investors in the Thai financial markets who may have lost lots of money in recent days, it may not seem like fun and games...)

In brief, the story is this: Thailand's currency has been slowly appreciating in recent years... but the pace of that appreciation has increased noticeably in recent months, as illustrated in the picture below (note that downward movement indicates a weaker dollar, and stronger baht).

Like practically everyone else in Asia, Thailand is not too keen on their currency getting stronger, because they don't want their exports to suffer. So, they've been doing some intervention in the foreign currency markets to keep the baht from appreciating too much, as the next picture illustrates.

Obviously, those interventions have not been sufficient to prevent a growing rate of baht appreciation of late. But it's also worth noting that Thailand has not been buying nearly as many dollars as many other Asian countries, such as Malaysia ($80bn in foreign currency reserves), Singapore ($135bn), India ($170bn), Korea ($235bn), Taiwan ($265bn) and China ($1,000bn).

So instead of ramping up their purchases of dollars in the foreign exchange markets, the Thai central bank hit upon the idea of imposing capital controls, effectively taxing capital inflows into Thailand. The idea is that if money from around the world stops flowing into Thailand (which has presumably been happening because international investors think that they can earn capital gains by holding baht assets as the baht appreciates), then that will relieve the pressure on the baht to appreciate.

The problem is that the stock market in Bangkok didn't like that idea very much. It dropped 15% yesterday. Under intense pressure from Thai financiers, the Bank of Thailand then partially reversed course yesterday, allowing the stock market to recover partially on Wednesday. Bloomberg reports:
Dec. 20 (Bloomberg) -- Thai stocks rallied from the biggest slump in 16 years after the military-led government scrapped restrictions for international investors that roiled shares in emerging markets.

The SET Index jumped 11 percent to 691.55 at the close, its biggest gain since Feb. 2, 1998. It was the largest fluctuation among equity markets included in global benchmarks. Yesterday's 15 percent drop erased $23 billion in market value, prompting the government to rescind penalties on equity investors who don't keep their funds in the country for a year.

The policy reversal, a day after the new rules were announced, damages the credibility of Thailand's three-month-old government, led by former army chief Surayud Chulanont. International investors had increased stock purchases since a Sept. 19 coup ended seven months of political turmoil that disrupted government spending and dented consumer confidence.

"It makes investors doubt these people can manage the country," said Jorry Noeddekaer, who helps manage $1.4 billion of Asian stocks at New Star Asset Management Ltd. "It would take a lot of good moves to rebuild credibility."
The capital controls in place now are probably next to useless as a way of reducing capital inflows into Thailand. Any investor who wants to bet on an appreciating baht can still do so via the stock market. And a clever financial firm should have little difficulty making investments in the Thai bond market (which are nominally still subject to the capital controls) look like they are investments in stocks (which are not).

Ironically, the Thai central bank's screwy policy enactment and reversal will probably still have the desired effect. As the Bloomberg story quoted above notes, the erratic and investor-unfriendly tendencies that the Bank of Thailand demonstrated will certainly have the effect of dampening investor enthusiasm for Thai assets.

So despite their clumsiness, the Thai central bank has probably achieved their desired goal after all - just not how they originally intended to. It's a very expensive way to do it, but central bank foul-ups are always a good way to make people stop buying your currency.

Just ask Mexico.

Tuesday, December 19, 2006

Exaggerated Inflation Worries

Today's PPI report has led to some rather excessive fears about inflation this morning. Marketwatch reports:
WASHINGTON (MarketWatch) - Producer prices soared in November at the fastest pace in decades, pushed higher by rebounding energy prices and a quirky gain in car and truck prices.
The November producer price index climbed by 2%, the biggest rise since 1974, the Labor Department reported Tuesday. The PPI had fallen 1.6% in October.
If that makes you nervous, take a look at the following picture, which shows how the core and overall PPI have behaved this year.

Doesn't look so bad now, does it? It seems that October's figures were a bit of an aberration, and November's data simply corrected them. Over the past 12 months, the core PPI is up 1.8%, which is typical for 2006; with the exception of the odd behavior in the PPI over the past couple of months, the 12-month change in core producer price inflation has fluctuated between about 1.5% and 2% for the past year.

The moral of the story: don't take one month's data too seriously.

UPDATE: See Dean Baker for some similar sentiments, though with the opposite reading for what this erratic PPI data means about inflation.

Monday, December 18, 2006

Talking Exchange Rates

Menzie Chinn and I share some of our thoughts in this week's Wall Street Journal Econoblog. As you can see by scrolling down through my posts this month, it's a topic that's been on my mind a lot lately.

Enjoy, and feel free to share your thoughts.

Is the Yuan Exchange Rate a Subsidy?

The other day Nouriel Roubini pointed out how dangerous he thought Ben Bernanke's flirtation with the word "subsidy" in a speech in China last week was. As Mark Thoma (see also Menzie Chinn, among others) noted last week, the text of Bernanke's speech in Beijing called the yuan peg (which is more accurately a crawling peg) against the dollar an "effective subsidy". However, Bernanke spontaneously reworded that description to "distortion". Originally, his speech read like this:
Greater scope for market forces to determine the value of the RMB would also reduce an important distortion in the Chinese economy, namely, the effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market.
The problem with that language, as Nouriel points out, is that the word "subsidy" has a specific legal meaning which allows for specific legal retaliations, such as import tariffs. In fact, all members of the WTO have agreed to the following precise definition of what an export subsidy is:
For the purpose of this Agreement, a subsidy shall be deemed to exist if there is a financial contribution by a government or any public body within the territory of a Member (referred to in this Agreement as “government”), i.e. where:

  • a government practice involves a direct transfer of funds (e.g. grants, loans, and equity infusion), potential direct transfers of funds or liabilities (e.g. loan guarantees);
  • government revenue that is otherwise due is foregone or not collected (e.g. fiscal incentives such as tax credits);
  • a government provides goods or services other than general infrastructure, or purchases goods;
  • a government makes payments to a funding mechanism, or entrusts or directs a private body to carry out one or more of the type of functions illustrated in (i) to (iii) above which would normally be vested in the government and the practice, in no real sense, differs from practices normally followed by governments;

(2) there is any form of income or price support [which operates directly or indirectly to increase exports of any product from, or to reduce imports of any product into, its territory].
Clearly, China's exchange rate regime does not qualify under the first set of criteria. The only way one could consider it a subsidy is if one argued that it constituted a form of price support, under the second criterion. But it's hard for me to see how a fixed exchange rate could be interpreted as a "price support", since the exchange rate says absolutely nothing about what price producers will receive for the goods they sell. All it does is guarantee the price everyone will receive if they sell one currency in exchange for another.

Moreover, the very first line of the definition of a subsidy states that there must be a financial contribution by the government to the firms that benefit. China's fixed exchange rate does not involve any such financial contribution. Maintaining the peg merely involves a change in the composition of the PBoC's balance sheet - it holds more yuan liabilities and more dollar assets. So I can't see how a fixed exchange rate regime could conceivably be equated with the definition of a subsidy that the US (and every other WTO signatory) has already agreed to.

But suppose that you wanted to rewrite the definition of "subsidy". That causes its own set of problems. In particular, I think it would be impossible to find any broadly-accepted criteria to define when a fixed exchange rate is a subsidy.

Lots and lots of countries have had fixed exchange rates, including scores of countries today, and nearly every country (including the US) at some point in the past. Were they all providing a subsidy to their exporters? Clearly not. So how do you tell when a fixed exchange rate is a "subsidy"?

Does it depend on whether a country has a current account surplus? Should we stipulate that any time a country has a current account surplus, together with a fixed exchange rate, it is subsidizing its exports? Well, in that case we would have to include lots of other countries around the world that have current account surpluses and fixed exchange rates. Thailand and Malaysia, for example, and Venezuela, and most of the Persian Gulf countries, all have fixed exchange rates and current account surpluses much bigger than China's. Germany, Belgium, and the Netherlands all have a fixed exchange rate (known as the euro) with most of their major trading partners, and substantial current account surpluses. Even the US had a fixed exchange rate along with regular current account surpluses through most of the 1950s and 60s. In fact, one could come up with literally hundreds of examples over the past 50 years where a country has met those conditions. Were all of those instances examples of "effective subsidies"?

Maybe some different criteria would work better. Maybe a country is only providing an "effective subsidy" to its exporters if it has a fixed exchange rate and is accumulating foreign reserves to maintain the peg. But by that criteria, nearly every country in the world with a fixed exchange rate qualifies, since nearly every country in the world has been gaining foreign currency (mainly dollar) reserves in recent years. Many African countries have been gaining foreign reserves at an even faster clip than China has, in fact (though they're much, much smaller, so in absolute terms their gains are tiny by comparison to China's reserve increases).

In other words, I don't think that there are any reasonable, objective criteria that could be agreed on to decide whether a country's fixed exchange rate qualifies as an "effective subsidy" to its exporters. And as Nouriel wrote, without a generally accepted definition of when exchange rate management should be considered a subsidy, there would be literally scores, if not hundreds, of possible accusations of countries "subsidizing" their exporters, and no way to adjudicate between the frivolous cases and the ones with merit.

In short, I'm glad that Bernanke pulled back from using the word "subsidy" in his remarks. But I'm dismayed that he came as close as he did to opening that Pandora's Box.

Friday, December 15, 2006

More Cause and Effect Regarding the Current Account

Thanks to PGL for alerting me to this post by Steve Kyle, now at Angry Bear. Steve refers us to comments by Dean Baker, in which Baker argues that a yuan revaluation against the dollar is essential to any improvement in the US current account balance - higher savings in the US will not be enough to do it.

PGL points out that one can really think of this is a question of cause and effect (otherwise known as a chicken-or-the-egg debate). Would a cheaper dollar induce higher savings, thus bringing about the needed change to the US's savings/investment balance that would reduce the CA deficit? Or would an improvement in US savings cause the dollar to lose value, thus inducing US exports to rise and imports to fall and thereby improving the CA deficit?

Obviously, exchange rates and domestic consumption/savings behavior are both jointly and simultaneously determined. But if I had to pick one to be more exogenous, I would vote for savings behavior. I think that the US's underlying savings/investment balance has a lot more influence over the dollar exchange rate than the other way around. Dean suggests the opposite, and specifically argues that because the weak yuan has entailed the Chinese central bank buying lots of dollars, the Chinese exchange rate policy has effectively kept interest rates low in the US, which in turn has depressed savings.

But I'm not convinced. While I agree that interest rates in the US are lower today than they would be without Chinese exchange rate intervention (not to mention intervention by lots of other central banks around the world, particularly among certain OPEC countries), I think that there's pretty weak evidence that savings behavior is affected much by interest rates.

As a quick look at what I'm talking about, it's worth simply plotting interest rates against the savings rate in the US, as I've done in the following picture. Both series show 6-month moving averages.

I think it's hard to see a clear relationship between interest rates and the savings rate in the US in this picture. Personally, I believe that personal saving as a fraction of disposable income (which is what the red line shows) depends a lot more on changes in household balance sheets than it does on interest rates. While we probably shouldn't take that notion too literally, it is an interesting coincidence that the two big drops in savings rates that we've seen over the past decade both coincided with the final, frenzied stages of dramatic asset price appreciations - in the stock market in 1999, and in the housing market in 2005.

But I don't want to pretend that I really understand household savings behavior. What I do want to argue is that I'm skeptical of the notion that a different yuan/dollar exchange rate will somehow make the US savings rate rise. At the same time, it's fairly easy for me to tell a story about how an improvement in the US savings rate would cause the US CA balance to rise. That's why, if I had to choose a necessary first step for an improvement in the CA deficit, I'd vote for a change in US savings behavior.

Falling Inflation

It's pretty unequivocal now, I think: the inflation rate in the US is clearly falling, even aside from the drop in oil prices that we've enjoyed recently. Today's BLS report on consumer price inflation adds to the data:
On a seasonally adjusted basis, the CPI-U was unchanged in November, following declines of 0.5 percent in each of the preceding two months. Energy prices, which declined sharply in September and October, fell 0.2 percent in November. Within energy, the index for petroleum-based energy decreased 1.5 percent while the index for energy services increased 1.2 percent. The food index decreased 0.1 percent in November. The index for all items less food and energy was virtually unchanged in November, following an increase of 0.1 percent in October. A 0.4 percent increase in shelter costs was partially offset by declines in the indexes for apparel and for the non-energy portion of the transportation index, particularly the indexes for new and used vehicles and for airline fares.
Here's the picture of inflation for things other than food and energy products:

This simplifies things for the Fed considerably. They no longer have to keep interest rates high to maintain their inflation-fighting credibility. Instead, they can focus their attention on cushioning the slowdown of the US economy in 2007.

Wednesday, December 13, 2006

Exchange Rate Data

I'll be Econoblogging with Menzie Chinn about exchange rates over the next day or two. As a reference (primarily for myself), I wanted to just put up a couple of pictures of various US dollar exchange rates.

The first shows the value of the US dollar against a few major trading partners over the past 5 years. Series are measured as an index such that a lower index number indicates a weaker dollar, and the average exchange rate for 2003 is set equal to 100 for each series. Note that the trade-weighted exchange rate is the broad index calculated by the Federal Reserve, and that data goes up to December 12, 2006.

The next picture shows a closeup of exchange rate movements over the past year. To better show recent movements in each exchange rate, I've recentered each series around its June 2006 value, which is set to 100.


Tuesday, December 12, 2006

US Exports and Imports

We have new data today on the US's exports and imports from the BEA. CNN/Money reports:
NEW YORK ( -- The nation's trade deficit tumbled in October on lower prices for oil imports, but the gap with China kept growing ahead of a key trip to that country by Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and other top officials.

Overall, imports topped exports by $58.9 billion in October, down from $64.3 billion in September, the Commerce Department reported. Economists surveyed by had forecast a much smaller decline, to $63 billion.

But the deficit widened with China, which runs by far the biggest trade surplus with the United States of any other country.

The report comes as Paulson, U.S. Trade Representative Susan Schwab and other officials left for China for meetings that are sure to bring up some contentious trade issues. Bernanke is due to join them after Tuesday's meeting of the Fed policymakers.
China is on everyone's mind these days, and as a result, almost all international economic news is now viewed through the China lens. As this news excerpt mentions, the trade deficit with China does indeed continue to widen even as the overall US trade deficit seems to have peaked (at least temporarily).

But it's worth noting that simply looking at the US trade deficit with China is a bit misleading. In fact, US exports to China have been growing much faster than US imports from China. The problem is, of course, that the levels of exports and imports are very different, so US exports would have to grow much much faster than imports in order for the US trade imbalance with China to stop rising.

The following tables show how US exports and imports have changed in 2006 compared to 2005. First, let's take a look at changes by trading partner:

US exports to nearly all of the US's trading partners have grown solidly over the past year, but exports to most of the developing world - including China - have done particularly well. Interestingly, the parts of the world that seem to be lagging in terms of US export growth are the rest of east Asia, such as Japan, Taiwan, and Korea.

The next table shows changes in US imports and exports by type of product:

Obviously, a huge chunk of the increase in US imports is oil. The interesting thing to notice in this table is that US imports of consumer goods have actually grown relatively slowly over the past year. Meanwhile, exports have grown soidly in the US's traditional strengths: capital goods (things like machinery, telecommunications equipment, and aircraft) and industrial supplies (things like chemicals, wood and paper products, metals, etc.).

Meanwhile, Treasury Secretary Paulson heads to China to try to work some magic on the US trade deficit. The pressure on him to do so is substantial. But short of somehow managing to get Chinese consumers to do more spending and US consumers to do less of it, I think he has little chance of actually accomplishing that goal.

Monday, December 11, 2006

Too Many Yuan

Interesting news from China today, via the Wall Street Journal:
SHANGHAI -- China's central bank said it plans to absorb about $20 billion in cash in its latest effort to keep its economy from overheating. The move is meant to rein in lending without raising interest rates and to reduce liquidity in the country's financial system.

The People's Bank of China said Friday it plans to sell banks about 160 billion yuan, or $20.45 billion, of one-year bills in the yuan money markets today. The bills will yield 2.7961%. By placing the debt instruments with commercial banks, Beijing is reducing the amount of money banks have available to lend.

...China's government is concerned too much cash in bank coffers will encourage bankers to boost lending. The risk of too much lending is either inflation, as the lending sparks economic growth, or losses for banks if the loans go bad. The buildup of cash comes from China's exports, which are pulling dollars into the Chinese financial system. Exporters then spend their earnings after converting their money into yuan.
In a sense, this is not a dramatic change for the PBOC; it has been issuing "sterilization bonds" for years in order to mop up some of the extra yuan generated by its actions to keep the currency pegged against the dollar.

But in another sense, this news is quite interesting. That's because a bond issue of this size indicates that the financial pressure may be building on the PBOC to use the next obvious tool that would reduce the amount of yuan floating around in the Chinese economy: to allow the yuan to appreciate faster against the US dollar. I'm sure that there is quite a bit of ongoing discussion about this very subject within the halls of the PBOC...

Thursday, December 07, 2006

Bernanke and the Democratic Congress

Bloomberg has an interesting piece today about the sort of questions and discussion that Ben Bernanke may get at his next appearance on Capitol Hill:
Dec. 7 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke may be heading for a showdown with congressional Democrats over his warning that wage gains risk causing a jump in inflation.

Fed policy makers are threatening to raise interest rates should inflation remain elevated, even as the housing slump slows the economy. Democrats, led by incoming House Financial Services Committee Chairman Barney Frank, vow to grill Bernanke over borrowing costs and wage increases that have lagged behind profit growth under President George W. Bush's administration.
Personally, I'm all for more intense - and even critical - questioning of Bernanke on Capitol Hill. I think that Bernanke is a fantastic economist, and in ten years I expect to be able to describe him as a first-rate central banker. But that's exactly why I think it would be a very good thing for him to have to explain his understanding of the economy - including the dangers of wage inflation, the effects of the minimum wage, the phenomenon of widening income inequality, the US-China financial relationship - to the rest of us.

There are a lot of difficult and important economic issues out there right now. Who better than Bernanke to help stimulate discussion and contribute to the public debate about them?

Euro Growth

Interest rates are rising in Europe. From The Economist today:
The European Central Bank raises interest rates to 3.5%, as the euro continues to nudge up against the dollar

[T]he ECB chose to raise interest rates another quarter of a percentage point, to 3.5%, at its monthly meeting on Thursday December 7th. It was the sixth such increase in the past year, as the export led recovery has slowly spread to other sectors in the euro zone.
Naturally, rising interest rates in Europe tend to reinforce the recent trend of the euro getting stronger against the dollar. The last time the euro/dollar exchange rate was at this level, in 2004 and early 2005, the European Central Bank seemed rather unhappy about it. But perhaps not this time.
The bank isn’t quite as uncomfortable with a rising euro as it used to be: unlike 2004, there has been no attempt to talk the euro down. This time around the recovery seems solid enough to withstand (and even contribute to) a dearer euro. Europe's economy is looking more self-sufficient these days. Companies are finally starting to invest their export profits in domestic expansion, particularly in Germany. Even consumption, previously weak, has finally started to look a little less wan.
Indeed, the European economy seems to be on a reasonably strong trajectory right now, and GDP growth will probably be close to 3% in the euro-zone in 2006, compared to GDP growth in the US of perhaps 2.5%. Note that on a per-capita basis, 3% GDP growth in Europe would be equivalent to almost 4% GDP growth in the US - a very respectable rate of economic growth, indeed.

Tuesday, December 05, 2006

The Disappearing Inflation Problem

Today's most interesting data news: wage and salary payments to workers in 2006 now appear to have been far, far lower than were previously estimated. The Wall Street Journal reports on today's new data from the BLS:
Labor Costs Revised Lower As Productivity Grows 0.2%

WASHINGTON -- U.S. productivity growth was mildly stronger during the summer than first thought, while unit labor costs were revised sharply lower for two quarters in a favorable sign for inflation.

...Third-quarter unit labor costs -- a gauge of inflationary pressures -- rose by 2.3%. Economists expected a 3.2% advance. [The BLS] originally estimated a 3.8% increase for the third quarter. Unit labor costs in the second quarter decreased, falling 2.4%; originally, Labor reported a 5.4% surge.

Compared to a year earlier, unit labor costs were 2.9% higher; in Labor's last productivity report, it estimated the year-over-year climb at 5.3%.
That's a big, big difference; whereas a week ago it looked like the cost of labor had risen by more than 5% over the past year (a fact stridently noted by many inflation hawks, including members of the Fed), now it appears that labor costs have actually only been rising by just over half that rate. Note that unit labor costs are of great importance to inflation-watchers because they describe how firms' costs are changing (labor being the biggest single cost of most firms).

Note that this sharp change in the inflation picture was actually foretold by last week's GDP revision. In that revised GDP report, wages and salaries were about $100 billion lower in early and mid-2006 than had previously been estimated, as Rex Nutting of Marketwatch reported.

The following picture shows what the most up-to-date earnings data looks like. The green line shows real compensation, which is the data that matters from the point of view of workers. The red line shows unit labor costs, which is how that compensation affects the costs of firms (taking into account changes in worker productivity). This latter line is the one that concerns inflation-watchers. A 2.9% rise over the past 12 months sure looks a lot less worrying than a 5%+ increase did.

So today's data can join the growing queue of reports (see today's column by Irwin Kellner for more examples) suggesting that inflation is not the major problem that the US economy is facing today; rather, a significant slowdown in economic growth seems to be becoming the much more pressing danger.

Monday, December 04, 2006

House Price Changes in the US

The Office of Federal Housing Enterprise Oversight (OFHEO) released its quarterly estimates of house price trends in the US last Thursday. I realize that this is a little late (circumstances have been consipiring against my blogging of late), but I'm hoping that this is indeed an instance of Better Late Than Never.

From the report's news release (pdf file):
U.S. home prices rose in the third quarter of this year, but the rate of increase continued to slow and some areas experienced actual price declines. Nationally, home prices were 7.73 percent higher in the third quarter of 2006 than they were one year earlier. Appreciation for the most recent quarter was 0.86 percent, or an annualized rate of 3.45 percent. This reflects a further slowdown from that reported for the second quarter when the quarterly appreciation rate was 1.3 percent and the annualized rate was 5.1 percent. The quarterly increase is the lowest since the second quarter of 1998.
Instead of focusing on the national average, however, I much prefer looking at the house price data city-by-city; real estate markets are quintessentially local, and the national average obscures most of the interesting bits of information about the US housing market.

The following picture shows the 12-month price change in houses in several coastal cities that enjoyed a significant house price boom during the period 2000-05.

The slowdown in the market for houses is striking in this picture. What is worrying about it to me, however, is that the downturn in house price appreciation has not yet shown any signs of leveling off. In other words, it looks very possible that one or more of these series will move into negative territory within the next couple of quarters, which would indicate y-o-y price declines. How negative, and for how long, is of course the big question. But until we start to see some leveling off in house price trends, I will remain nervous that the housing market slowdown still has quite some way to go.

On the other hand, many interior cities in the US either missed out on the big appreciation of 2000-05, or else jumped on the bandwagon late. The following picture shows some examples:

Putting these two pictures together, an interesting story emerges - one that is hidden by the national averages described above: house price appreciation continues at a moderate pace in many US cities, and is actually still very high in those places (such as the mountain West) that joined the house price boom a little late. But in those cities that enjoyed the biggest appreciations earlier in the decade, the slowdown in the housing market looks abrupt, increasingly severe, and far from over.

My concern is that it is precisely those rapidly cooling coastal regions of the US that contain most of the people who have been counting on rising house prices to sustain their level of consumption, as well to sustain the solvency of their balance sheets. Only when prices stop rising in those areas - or even start falling - will we really see the full impact of the slowing housing market on the rest of the economy.

Thursday, November 23, 2006

Policy Agreements and Disagreements

The possibility of dissention among Democrats regarding economic policy seems to have been in the news this week. Mark Thoma points us to a commentary by Harold Meyerson on the subject, in which he focuses on the differences between the Hamilton Project and the EPI. And yesterday, Bloomberg had a piece about the disagreements between Robert Rubin and organized labor.
Nov. 22 (Bloomberg) -- Democrats are returning to power on Capitol Hill just as two powerful wings of the party, labor and Wall Street, are colliding over economic issues.

The dispute over trade and budget policies prompted a high- level private meeting earlier this month between AFL-CIO President John Sweeney and former Treasury Secretary Robert Rubin, who is now chairman of the executive committee at New York-based Citigroup Inc.

AFL-CIO leaders, contending Democrats won the midterm elections because of voter concern about job security and stagnant wages, say it's time to set aside the free-trade policies touted by Rubin.

"We need to review the Rubin agenda that's led to millions of lost jobs and declining standard of living for the middle class,'' said United Steelworkers President Leo Girard. "It's an agenda that has been very good for Citigroup and the financial community because they've been able to finance the relocation of jobs and refinance the trade deficits.''
I suppose that it's natural for people to want to revisit this subject in the wake of the Democrats' recent election victory. But is this really news? As Mark pointed out, Democrats from both the Rubin/Hamilton Project crowd and the EPI/organized labor crowd would probably agree, at least in broad terms, on a large number of changes to economic policy. My candidates for areas of general agreement would include:
  • Allowing the tax cuts on the wealthiest to expire, to help with the budget deficit;
  • Restore pay-as-you-go rules to the federal budget process, to at least stop the US's budget problems from getting worse;
  • Reform the Medicare prescription drug benefit to allow the government to reduce the price it pays for prescription drugs;
  • Strive for broader health insurance reform, to increase the availability of health insurance to uninsured Americans;
  • Strengthen the social safety net to help individuals who are lose out in the US economy through no fault of their own (e.g. by providing some form of wage insurance);
  • Increase the minimum wage.
I'm sure I'm leaving something out, but even so, there's clearly a lot here that both camps would agree on, and a lot of work to do.

On the other hand, there is one big thing that the two factions do not agree on: trade policy. So if you boil it all down, it seems that the one significant point of dissention among Democrats is about how to change (if at all) US trade policy.

But the existence of pro-trade and anti-trade groups in the Democratic party is nothing new - they've both been around since at least the 1980s. Furthermore, very vocal anti-trade and pro-trade factions also exist within the Republican party; for example, a dozen Republican Senators voted against CAFTA this past summer, while a dozen Democrats supported it.

Yes, the issue of trade policy is indeed a source of disagreement among Democrats. But it's also a source of disagreement among Republicans, and among independent voters. So while the anti-trade faction may be larger in the Democratic party than in the Republican party (at least if measured by votes in Congress), the divisions over trade policy really seem to often transcend party and ideology. I haven't yet figured out what separates people into the anti-trade and the pro-trade groups, but whatever it is, I don't think that the division is anything new, or unique to Democrats.

UPDATE: Menzie Chinn has additional commentary (thoughtful and informative, as always) about the question "Are the Democrats Truly More Protectionist?" over at Econbrowser. In short, Menzie's answer is no.

Tuesday, November 21, 2006

Housing Market Nonsense

My head feels a like it's going to explode. How does one reconcile these two statements, from today's Wall Street Journal:
The worst of the housing bust is over, economists said by nearly 2-to-1 in the latest economic forecasting survey.
The 49 economists responding to the forecasting survey expect home prices, measured by the government's Office of Federal Housing Enterprise Oversight index, to rise 2.8% this year and to fall by 0.5% next year. That contrasts with a 13.4% increase in 2005.
Can someone explain to me how house prices rising a little this year, and then actually falling next year, is consistent with the notion that "the worst is over"? To me, "the worst is over" somehow implies that next year will be better than this year. Am I wrong? I don't understand.

As a reminder, here's what happened to housing prices in a couple of major cities during the last downturn in the housing market.

If you define "the worst is over" as "the decline in the rate of change of the rate of change in house prices is moderating," then you might have been able to say that the worst was over by the end of 1990. And by that definition, I suppose one could possibly argue that the worst is over today.

But that's a pretty tortuous and ill-conceived definition of "the worst", in my opinion. I think most people who tried to sell a house during the early 1990s would agree that it took years for the worst of that housing market slowdown to pass. Do we really think that today will be the last time we'll read a story like this one?

The real estate market is notoriously cyclical. But historically, those cycles have been 10 or 15 years, not months, in length. I can't see why this time should be any different.

Thursday, November 16, 2006

Milton Friedman

From the AP:
Economist Milton Friedman dies at 94

SAN FRANCISCO - Milton Friedman, the Nobel Prize-winning economist who advocated an unfettered free market and had the ear of three U.S. presidents, died Thursday at age 94. Friedman died in San Francisco, said Robert Fanger, a spokesman for the Milton and Rose D. Friedman Foundation in Indianapolis. He did not know the cause of death.

"Milton's passion for freedom and liberty has influenced more lives than he ever could possibly know," said Gordon St. Angelo, the foundation's president and CEO, said in a statement. "His writings and ideas have transformed the minds of U.S. presidents, world leaders, entrepreneurs and freshmen economic majors alike."

In more than a dozen books, a column in Newsweek magazine and a TV show on PBS, Friedman championed individual freedom in economics and politics. The longtime University of Chicago professor pioneered a school of thought that became known as the Chicago school of economics.

His theory of monetarism, adopted in part by the Nixon, Ford and Reagan administrations, opposed the traditional Keynesian economics that had dominated U.S. policy since the New Deal. He was a member of Reagan's Economic Policy Advisory Board.

His work in consumption analysis, monetary history and stabilization policy earned him the Nobel Prize in economics in 1976.
Whether they agree or disagree with Friedman's economic prescriptions, I think that nearly every economist in the world would acknowledge that he was a giant in the field. Friedman's own work - as well as the voluminous work done as a direct reaction to his work - played a huge role in shaping the field of economics, and in changing our understanding of the powers and limitations of economic policy-making.

Inflation Update, October 2006

This week we were treated to new inflation data by the BLS. The PPI report and the CPI report both showed dramatic falls in the rate of inflation, driven mainly by lower oil prices. But both reports indicated that inflation in other (e.g. non-oil) types of goods and services is also falling. The picture below illustrates.

By almost any measure of inflation you look at, the rate of inflation seems to have already passed its peak and begun falling. This was, of course, exactly what the Fed hoped to acheive by raising interest rates steadily for the past two years. Economic growth in the US has slowed, and the ability of firms to raise prices has been reduced along with it.

The Fed has also been lucky that oil prices have fallen considerably in recent months, of course. Together, the slowing economy along with lower oil prices have spelled a dramatic change in the inflation picture over the past few months - and may have rendered the Fed's concern about inflation obsolete. Discussion about the Fed raising interest rates further thus seems premature at best, and possibly downright foolish. To me, this picture is one of the best indicators yet that the economy began to soften significantly during 2006.

The real question is this: how slow will the economic slowdown go?

Tuesday, November 14, 2006

Economic Growth in the Euro Zone

It looks like the economy of the EU may actually experience faster growth than the US economy in 2006, for the first time in several years. New data out today from Europe indicate solid growth there. From the Wall Street Journal:
BERLIN – The euro-zone economy grew by 0.5% in the third quarter, less than forecast but enough to keep the region on course for its strongest economic expansion in six years.

France's surprise stagnation last quarter weighed on the 12-nation euro zone's overall growth rate, which economists had expected to be about 0.7%.

Strong growth in Germany, which expanded 0.6% from the previous quarter, and Spain, where quarterly growth hit 0.9%, propped up the overall figure for the euro zone. Spain's economy continued to be driven mainly by consumer spending and construction, while Germany's government said exports, business investment and consumer spending all contributed to growth.

Economists said the euro zone's slight slowdown last quarter may have been a partial correction from particularly strong growth in the second quarter, when the region's economy expanded by 0.9%, unusually fast by European standards.

The latest growth data, combined with strong business surveys, still back up the European Central Bank's view that the 12-nation currency area is heading for growth of around 2.5% this year, the region's fastest pace of growth since 2000. The ECB is widely expected to raise its key interest rate by a quarter point to 3.5% next month.
Another couple of interest rate hikes by the European Central Bank seem entirely possible. Coupled with some possible (or even likely) cuts in interest rates in the US next year, we could well see short-term US interest rates drop below European rates in 2007.

Monday, November 13, 2006

Ups and Downs

Sometimes the juxtaposition of two stories can tell more than the two tell us individually. From CNN/Money:
CEO: Ford ahead of schedule on layoffs

DETROIT (Reuters) -- Ford Motor Co. is "a little bit ahead" of schedule in settling buyout offers with its 75,000 unionized factory workers, the automaker's chief executive told the Detroit Free Press in an interview published Saturday.
And from the Wall Street Journal:
Toyota Races to Rev Up Production For a Boom in Emerging Markets

Toyota Motor Corp., already in a frenzied push to expand its auto output, is stepping up its race to open new factories as part of a confidential blueprint to grab a 15% global market share by 2010 amid an expected surge in car sales in India, China and other emerging markets.

The Japanese auto giant, which recently passed Ford Motor Co. to become the world's No. 2 auto maker by sales and is poised to overtake General Motors Corp. as early as this year, aims to open three more new plants by 2009 as part of a "global master plan," boosting its production capacity by 450,000 vehicles a year.
It's nothing we haven't heard about before. But still.

Monday, November 06, 2006

Reading the Polls

Okay, I admit it. Over the past couple of weeks, I've become addicted to polls. I find myself checking every day or two to see the latest poll results for the Senate and House races. I find myself thinking about the chances that the Democratic Party will win a majority in the Senate (pretty slim, I think) and the House (very good).

The following picture from a post on Pollster by Charles Franklin is a neat way to think about those probabilities.
Reading this picture takes a little practice. The black line is the easiest part to understand. It represents the average probability that the Democratic candidate will win any particular race given average poll results.

So for example, if the Democratic candidate is trailing by 5 points, then in 2000-02 the Democrat won the election about 30% of the time. But if the Democratic candidate was ahead in the polls by about 5 points, then they won more than 70% of the time. A lead in the polls of 10 points meant that the Democratic candidate won over 90% of the time.

Note that this suggests that the "margin of error" reported with polls applies to the support received by each candidate, not to the difference between the two candidates. Thus, if a poll reports a margin of error of 4% (which is typical), that means that the support for either candidate could be higher or lower by 4% - which means that the difference between them could be higher or lower by 8%. That's my interpretation for why the polls only tell us the winner with 95% confidence if the difference in support between the two candidates was at least 8 or 9%.

Being curious, I compared these probabilities with current polling in the Senate races. They indicate a 95% chance that the Democrats take Ohio and Pennsylvania, an 80% chance that the Democrats take New Jersey and Rhode Island, and a roughly 70% chance that they take Maryland and Montana.

If we take a look at the House, we can use these probabilities to form an estimate of how many seats the Democratic party is predicted to gain. For example, according to Franklin's results, in races where the Democratic candidate is ahead in the polls by, say, 5-10 points, the Democratic candidate wins about 80% or 85% of the time. In races where the Democratic candidate is ahead by 2-5 points, the D wins about 70% of the time, and so forth. The following table summarizes.

Since 15 of these 87 seats listed by (from where I took these poll averages) are currently held by Democrats, these results predict a net gain for the Democratic party in the House of 31 seats.

There's one big caveat that needs to be applied to this reasoning, however. Franklin's analysis assumes that each race is statistically independent from the others. That, of course, is rarely true; if a close contest breaks in favor of one particular party, chances are that other close contests will also break in favor of that party, if for no other reason than that there are national factors affecting election outcomes across states.

So what does this mean? I think a net gain of 31 seats for the Democrats is a good starting point for an estimate, but it's quite likely that the true result will either be substantially higher or lower. How's that for hedging my bets?

If I had to pick numbers, though (and I don't, but what the hell), I'd say:
Senate: D +5 (OH, PA, RI, MT, VA)
House: D +22

On Wednesday we can start talking about why I was so wrong...

Friday, November 03, 2006

A Textbook Example...

Greg Ip has an interesting piece in today's Wall Street Journal:
Fed Official Says Bad Data Helped Fuel Rate Cuts, Housing Speculation

In an apparent and rare in-house critique, the president of the Federal Reserve Bank of Dallas said that because of faulty inflation data, the Fed kept interest rates too low for too long earlier this decade, fueling speculative housing activity.

...Mr. Fisher said from 2002 to early 2003, inflation, as measured by the price index of personal consumption expenditures (PCE) excluding food and energy, was running below 1%. That suggested that a serious shock to the economy could turn inflation to deflation, or generally falling prices... To reduce the risk of deflation, the Fed lowered its target for the Fed funds rate -- charged on overnight loans between banks -- to 1% in June 2003 and held it there until mid-2004. It has since raised it to 5.25%.

Mr. Fisher noted that subsequent revisions show PCE inflation was actually a half a percentage point higher than originally estimated. "In retrospect, the real Fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been," Mr. Fisher said.
This seems like a pretty good description of the situation. But it's nothing that economists haven't known about for a long time. Just look up the term "recognition lag" in any intro macro textbook, and you'll see a description of exactly this phenomenon.

It's nice to see that the things we teach our students actually happen in real life. Except, of course, when those things mean that monetary policy may have made some serious mistakes that might have lasting negative repercussions on the economy...

Slowing Job Creation

The US economy continued its sluggish pace of job creation in October. From this morning's BLS news release:
Employment increased in October, and the unemployment rate declined to 4.4 percent, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Nonfarm payroll employment grew by 92,000 in October following gains of 148,000 in September and 230,000 in August (as revised). In October, job growth continued in several service-providing industries, while employment declined in manufacturing and construction. Average hourly earnings rose by 6 cents over the month.
This is disappointing news, though it was tempered a bit by sizeable upward revisions to the previous two months' employment gains. Nevertheless, the 92,000 net new jobs created in October was substantially below expectations, particularly since only 58,000 were in the private sector (the rest were in government); the expectation for total job creation had been for closer to 130,000. Atrios wins yet again!

At any rate, it still seems that the pace of job creation in the US has cooled a bit in recent months. The picture below shows the 6-month average job creation over the past 10 years.

As many economists have commented about previously, the best job creation of this economic expansion was never nearly as good as during the previous expansion. But even the modest job creation of the past few years seems to be slowing down now.

By the way: if you think that this slowdown in job creation is exclusively the fault of the construction industry, think again. As the following picture shows, nearly every industry in the economy - except for the government - has created fewer jobs over the past 6 months than it did over the previous 6-month period.

The housing sector may be leading the economy toward slower growth. But the rest of the economy seems to be joining in, too.

Thursday, November 02, 2006

Is the Great Productivity Boom Over?

This morning the BLS released its estimates of third quarter productivity growth and labor costs. From the news release:
Productivity in the nonfarm business sector remained unchanged during the third quarter of 2006. Output grew at a 1.6 percent annual rate. Hours of all persons in the nonfarm business sector also increased 1.6 percent, reflecting 0.8-percent gains in both employment and average weekly hours at work. In the second quarter, nonfarm business productivity increased 1.2 percent, as output grew 2.7 percent and hours worked rose by 1.5 percent.

Hourly compensation increased at a 3.7 percent annual rate in the third quarter of 2006. When the rise in consumer prices is taken into account, real hourly compensation rose 0.7 percent during the July-September period. During the second quarter of 2006, real hourly compensation had increased 1.6 percent.
So, does this mean that the great productivity boom of that past several years is over? It's sure beginning to look that way. Take a look at this picture, which shows the 24-month change in productivity in the nonfarm business sector since 1995.

After years of average productivity growth in the range of 2.5% - 3.5% per year, productivity growth has clearly been trending down since late 2004, and over the past two years productivity has grown at an annual rate of just under 2%.

Part of this slowdown in productivity growth surely has something to do with the US now being in the late stages of this business cycle; productivity typically rises most in the early stages of an economic expansion, and rises least in the expansion's late stages. But since we didn't follow that pattern during the last recession (productivity kept booming as the economy slowed down in 2000 and 2001), it gets more difficult to write off the current slowdown in productivity growth as simply a matter of being at the wrong place in the business cycle.

One last note: the compensation that workers are receiving for their production has still not caught up from the substantial divergence that we saw from 2001-05, as the picture below illustrates.

The huge productivity gains enjoyed by the US economy from 2001-05 went almost entirely to the owners of corporations, not to workers. That was very unusual, by the way; normally real compensation tracks productivity quite closely (for a picture of what I'm talking about see this old post from Angry Bear). But for some reason, that relationship broke down during the first five years of this decade. Recent gains in compensation mean that the gap between worker productivity and compensation is at least not getting any larger; however, it's not really getting much smaller either.

That may be yet another reason for average Americans to feel that the current economic expansion has left something to be desired.

When is a Dollar Not Worth a Dollar?

Apparently, the answer is: when it's more than five years old, and trying to be used in a developing country. From an interesting story in today's Wall Street Journal:
ANTANANARIVO, Madagascar -- Once a month, Jean Yves, a cabin attendant on an Italian cruise ship, gets in line at the purser's office to collect his pay -- seven $100 bills.

If he's lucky, the bills will indeed be worth $700 when he arrives in port and tries to spend them. If he isn't, they'll be worth closer to $600. The difference? The good bills are new ones that bear Treasury Secretary John W. Snow's signature. The bad ones are signed by Treasury Secretary Robert E. Rubin.

...In many countries, from Russia to Singapore, the dollar's value depends not just on global economic forces that move international currency markets, but also on the age, condition and denomination of the bills themselves. Some money changers and banks worry that big U.S. notes are counterfeit. Some can't be bothered to deal with small bills. Some don't want to take the risk that they won't be able to pass old or damaged bills onto the next person. And some just don't like the looks of them.
Okay, I'm not too sure that the last factor has much to do with the discount on older US currency, since I'm sure if it were just a matter of taste for some people who don't like the looks of the older currency, then there would be others who would be willing to trade in the "unattractive" currency anyway to make some money. But still, the phenomenon is interesting.

By the way, it's also worth noting that suspicion of older notes in developing countries is a perfectly rational thing to do, if the circulation of counterfeit bills is much more common in those countries. No one wants to be the last one holding a fake bill, after all. Which is why those currency traders in the developing world may be among the greatest beneficiaries of the new and more counterfeit-proof bills introduced in the US in recent years.

Wednesday, November 01, 2006

Telling the Future with Interest Rates

Barry Ritholtz points us to a post in yesterday's WSJ Marketbeat about how the markets' optimism about the direction of the US economy seems to be changing.

I think they're right. As an illustration, let me show you two interest rate series that tell us something about market participants' expectations.

The red line in the picture below shows the difference in the yield curve between interest rates on 5-year government bonds and 3-month treasury bills. In the past few months that yield differential has moved decidedly negative, meaning that people are willing to accept a lower rate of interest when lending money for 5 years than they will accept to lend money for 3 months.

If you think (pretty reasonably) that the only reason you'd ever accept a lower rate of interest on a loan you were making for 5 years would be to lock in that rate for a long period of time in the face of falling interest rates, then this series tells us that the market expects interest rates to drop. (For more about what the yield curve tells us, see the blogosphere's resident expert on the subject, Jim Hamilton, or this handy primer from the NY Fed.)

Economists have developed models to gauge the probability of recession based on the yield differential. A neat tool over at Political Calculations (hat tip: Jim Hamilton) uses the predictive model of economist Johnathan Wright to calculate the probability of recession. If you plug today's interest rates into that calculator, it tells us that there's a 52% chance that we'll have a recession sometime in the next 12 months. That's a pretty high chance.

The green line in the chart tells us something else: what market participants expect inflation to be over the next 5 years. That series is calculated by subtracting the inflation-adjusted TIPS interest rate from the interest rate on the nominal 5-year government bond. (Yes, there's a little bit of error because the TIPS market is not very liquid, but it still gets us pretty close to average inflation expectations.)

The thing to notice in that series is how sharply inflation expectations have changed over the past few months. It seems likely that that reflects a new feeling in the market that the economy is about to slow down significantly. Of course, the series also shows how volatile those inflation expectations are (or how big of an impact liquidity issues have on the TIPS market, depending on your interpretation), so take that data with a grain of salt. But it still seems pretty clear that along with expectations of lower interest rates, the bond market seems to be expecting lower inflation sometime soon.

Put those two together, and this picture tells me that market participants think there's a pretty good chance of a dramatic slowdown in the US economy happening pretty soon. Reading the tea leaves of today's interest rates, the future looks a little bleak.

Tuesday, October 31, 2006

Employee Compensation

The BLS released its quarterly estimate of labor compensation this morning. From the news release:
Total compensation costs for civilian workers increased 1.0 percent from June to September 2006, seasonally adjusted, virtually unchanged from the 0.9 percent gain from March to June, the Bureau of Labor Statistics of the U.S. Department of Labor reported today... The Employment Cost Index (ECI), a component of the National Compensation Survey, measures quarterly changes in compensation costs, which include wages, salaries, and employer costs for employee benefits for civilian workers (nonfarm private industry and state and local government).
The purpose of this survey is to look at how much more firms are paying their workers in wages and benefits. But naturally, the cost of labor to firms is the same thing as the compensation for labor earned by workers, so this data can be read in very different ways.

First, one might worry that it suggests inflationary pressures, as the cost of labor goes up.

But at the same time, this report signals that workers are earning more - which is good news for workers, after all.

Except for one problem: the figures cited above are all in nominal terms. Adjusting for inflation, the report provides yet more evidence of why most average Americans do not think that the economy is in great shape - the increases in compensation to workers are merely keeping up with inflation.

The chart below shows the series for wages/salaries and benefits for workers in the private sector. The wage/salary series was then deflated by the price index for personal consumption expenditures, and the benefits series was deflated by the price index for health insurance. (2006 figures were extrapolated from the first three quarters of the year.)

To be fair, benefits include things other than simply health insurance (namely employer retirement contributions), so this inflation-adjusted benefit series may overstate the degree to which inflation has eroded the value of those benefits. On the other hand, I'd be willing to bet that most of the nominal increase in the cost of providing benefits to workers is the result of rising health insurance premiums, not due to increasingly expensive retirement contributions... in which case the approximation presented above may not be too bad.

Regardless, this report certainly seems consistent the notion that average workers are not enjoying much of an increase in prosperity during this economic expansion.

The Incredible Shrinking Car Company!

Ford Motor Company is shrinking. From today's Wall Street Journal:
Ford Motor Co.'s plan to cut North American production as much as 12% in the first half of next year signals that Detroit's Big Three auto makers -- as well as their many suppliers -- could face headwinds in 2007 despite industry cost-cutting efforts.

Meanwhile, as a fresh sign of the ripples the auto makers could send across the manufacturing belt with further production cuts, Dura Automotive Systems Inc. became the latest auto-parts supplier to file for Chapter 11 bankruptcy-court protection. The separate developments highlight the continuing pain faced by General Motors Corp., Ford and DaimlerChrysler AG's Chrysler Group, amid signs of a slowing economy.

Ford's projected first-half 2007 cuts -- reported yesterday by trade publication Automotive News -- come on top of a 21% production cut planned for the current quarter.
The following picture, which I've reproduced from the Wall Street Journal piece, sums up the story.

Ford is now only 60% as large as they were a few years ago. And of course, they're not the only ones; GM and Daimler-Chrysler have been losing money for a while now, and just like Ford, they are also responding by obeying Alice's "DRINK ME" sign.

But note that the US auto industry as a whole has not been shrinking. Overall production of motor vehicles in the US continues to grow over time, despite fluctuations from quarter to quarter or year to year. The following picture shows total auto production in the US, measured in real terms, as reported by the Bureau of Economic Analysis (table 7.2.3b).

Even with the most recent quarter's possibly aberrant measurement of real auto production, the US as a whole has clearly been producing more cars over the past year or two than ever before.

So how do we reconcile these two pictures? Obviously, the answer is that auto production in the US is being gradually taken over by the big Japanese auto manufacturers, who seem to be able to make up for Ford and GM's production cuts, and then some.

That's why I tend not to see Ford and GM's problems as being signs of a sick industry in the US, but something much more prosaic: the replacement of poorly-run firms with well-run firms.

Sunday, October 29, 2006

The Previous 'Soft Landing'

Has the Fed managed to raise interest rates by exactly enough to bring the US economy down to a "soft landing"? There was substantial disagreement among economists about Friday's GDP report, with some arguing that it was a harbinger of a looming recession, while others argued that it was still consistent with the soft landing scenario, and didn't really contain anything to worry about.

We won't know which camp was closer to the truth for many months. But in the mean time, I can't help but be reminded of the discussions happening among economy-watchers in mid- to late-2000. The situation in 2000 was somewhat similar to today's economy in some ways; in particular, the Fed had been raising interest rates for some time in an attempt to cool the economy and bring down incipient inflation without pushing the economy into a recession, and many observers were of the opinion that they had succeeded. To help refresh your memory, here are some excerpts from the news at the time (sorry, I haven't tracked down links):
August 10, 2000
The Boston Globe
Economy Slowing for 'Soft Landing; Fed Reports Braking in Key Growth Areas: The hard-charging US economy slowed in the late spring and early summer, the Federal Reserve reported yesterday, suggesting a "soft landing" for the 10-year expansion indeed could replace the traditional boom-and-bust dynamic...

September 2, 2000
The Washington Post
Economic Growth Gradually Slowing; Reports May Reduce Chance of Rate Hike: More clearly than ever, three new economic reports out yesterday show the U.S. economy coming in smoothly for a soft landing. A series of increases in short-term interest rates by the Federal Reserve and other forces have combined to slow economic growth just enough to keep inflation largely at bay without significantly raising the risk of a recession.

The reports all pointed in that direction, according to a number of analysts, who also said the way events are unfolding suggests that Fed policymakers won't be raising rates again anytime soon.

September 18, 2000
The Wall Street Journal
Economic Data Continue to Augur Soft Landing:

October 28, 2000
Cleveland Plain Dealer
Economy Cools to Rate Suggesting Soft Landing: The economy shifted into a much lower gear during the summer, registering its slowest speed in more than a year and reflecting a drop in government spending and weaker business investment... "We have downshifted ... but we're not on the brink of a recession," said Paul Kasriel, chief economist for Northern Trust Co. The report, he said, is consistent with the Federal Reserve's desire to bring the high-flying economy down to a more sustainable rate of growth.

October 29, 2000
The Atlanta Journal and Constitution
Stock market fall hurts, but 'soft landing' helps

November 27, 2000
Business Week
This Political Shock Won't Upset the Soft Landing: THE FED SEEMS CONTENT that the slowdown is leading toward the desired soft landing, although policymakers are still not convinced that the threat of rising inflation is abating. After hiking its overnight rate from 4.75% in June, 1999, to 6.5% in May, 2000, the Fed at its Nov. 15 policy meeting continued to leave interest rates unchanged. The Fed admitted that the economy could slow to a pace even below its long-run trend, generally taken to be 3.5% or so. However, it said that the slowdown in demand to date has not been sufficient to alter its view that the risks in the outlook are weighted toward conditions that could generate higher inflation.

...The bottom line is that, yes, the economy is slowing as the Fed's efforts to pull off a soft landing bear fruit. And little indicates that this nation's ongoing political shock will rattle the economy, especially since the fundamentals remain quite sturdy. The Greenspan Fed pulled off a soft landing in 1994, and it will very likely succeed again in 2001 -- regardless of how long it takes to elect a President.

Dec 7th, 2000
The Economist
Slowing down, to what?: The latest economic figures are consistent with a soft landing. As Mr Greenspan made plain in his speech, an economic slowdown is what the Fed has been aiming to achieve by raising interest rates six times in the past 18 months. By creating economic slack, this should stop inflation rising further. And despite the share-price jump this week, recent market edginess will usefully remind investors about risk and so deter reckless investment.

The markets are also right that few economists are actually predicting a hard landing. The average forecast for growth in 2001 by 15 economists polled by The Economist this week was 3.0%.
For reference, we now know that the US economy experienced negative economic growth between July and September of 2000, and officially entered a recession in early 2001.

My point is a relatively simple one: I don't think that we have nearly enough evidence yet to conclude that the Fed has acheived a soft landing for the US economy. Any guesses about how rough the landing will be will thus have to be based on guesses, predictions, and assumptions about how consumers and businesses will behave over the next several months. So I would be hesitant to congratulate the Fed on its successful soft landing until we know (maybe by mid-2007) if the relatively optimistic suppositions about future consumer and business behavior were right.

It's also worth noting that even as late as November 2000, the signals from the Fed and the interpretation of Fed-watchers were that the chances were that the next interest rate move by the Fed would be an increase. Now we know, of course, that they were compelled to decrease interest rates just a few weeks later. So despite the Fed's rhetoric to the contrary, I would still be cautious in believing that the Fed's next move in the current episode will end up being another increase.

Friday, October 27, 2006

Third Quarter GDP, 2006

And the new numbers are in! What do they show? From today's BEA press release:
Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 1.6 percent in the third quarter of 2006, according to advance estimates released by the Bureau of Economic Analysis. In the second quarter, real GDP increased 2.6 percent.

...The deceleration in real GDP growth in the third quarter primarily reflected an acceleration in imports, a downturn in private inventory investment, a larger decrease in residential fixed investment, and decelerations in PCE for services and in state and local government spending that were partly offset by upturns in PCE for durable goods, in equipment and software, and in federal government spending.
That hurts, a little. This estimate comes in below expectations of a number more like 2.0%. I'll take a closer look at the data later today, but the one thing that really stands out right away is the big slowdown in residential investment. It looks like this is the housing market slowdown in action...

Thursday, October 26, 2006

More Class Warfare

Andrew Samwick shares some thoughts about the issue of Rich v. Super-rich. He argues that what the Rich resent is that their occupations are not rewarded as they think they should be, under some sort of socialist economic system:
I think the educated trade classes resent that the contributions they make through their intellect and efforts are not valued by the market as highly as the returns to innovation and risk taking in product markets. The amenities that would accrue to them under (their idealized notion) of a more socialist system are becoming more expensive.
I have to disagree with Andrew. And I think I can pinpoint the source of our disagreement: I don't think that the division betwen the Rich and the Super-rich is occupation-based. In other words, I'm skeptical that it's as simple as Andrew describes, wherein well-educated professionals (doctors, lawyers, etc.) are merely Rich, while the Super-rich are entrepreneurs and financiers.

My hunch is, instead, that there are both Rich and Super-rich people from each of these various occupations. Some doctors, lawyers, as well as entrepreneurs, entertainers, and athletes become Super-rich, but most of each group do not. And that's where the trouble starts. Those who are merely Rich look at their peers who have become Super-rich, and feel cheated. And resentful. They gripe and complain. They gnash their teeth. And then they vote to soak the Super-rich.

If the divisions between the two groups are indeed not occupation-based, then the success of the Super-rich could seem much more arbitrary to people, and thus be a much greater potential source of bitterness. After all, if it's simply a question of choosing a different occupation to become Super-rich, then you have only yourself to blame. But if you see others with your exact occupation becoming Super-rich, then that's different.

Shorter Kash: I think being lucky has a lot more to do with becoming Super-rich than being in the right occupation.

Is the Worst Really Behind Us?

I don't know, something about these types of quotes (in reference to yesterday's data showing that the slowdown in the housing market is continuing) worries me:
WASHINGTON, October 25, 2006 - Existing-home sales eased last month, as did the number of homes available for sale – indicating the housing market is stabilizing, according to the National Association of Realtors®.

...David Lereah, NAR’s chief economist, said stabilizing sales should build confidence in the housing market. “Considering that existing-home sales are based on closed transactions, this is a lagging indicator and the worst is behind us as far as a market correction – this is likely the trough for sales."
A little patience, please. The housing market slowdown has been happening for 6 months or so. Isn't it a little soon to conclude that the worst is over?

As a comparison, suppose that you had concluded that the worst was over one year into the last major national housing market slump, in 1990. By the end of 1990 you would have seen the trajectory of house prices looking something like this:

Patience, I urge. Because if you had indeed supposed that the worst was over at the end of 1990, merely one year into that housing slump, you would have been quite mistaken. For the housing market works slowly, and its cycles are very long. The worst was not over by the end of 1990. Not even close.

It will be years, not months, before we will be able to say that "the worst is behind us" regarding the housing market.

UPDATE: If I had waited a few more minutes on this post, I could have built this morning's news into it:
Builders slash prices to sell more homes
Sales up 5.3% in September, but prices plunging at fastest rate in 36 years

WASHINGTON (MarketWatch) -- U.S. homebuilders slashed prices at the fastest pace in 36 years in September and managed to boost sales to the highest level in three months, the government said Thursday.

The government reported that sales of new homes unexpectedly rose 5.3% in September to a seasonally adjusted annual rate of 1.075 million, the most in three months and well above the 1.05 million expected by economists surveyed by MarketWatch. However, sales in June, July and August were revised down by total of 67,000 annualized, continuing a pattern of downward revisions to the originally reported data.

...Median sales prices dropped 9.7% in the past year to $217,100, the lowest price in two years. It's the largest percentage decline in median prices since December 1970. Median prices for existing single-family homes are down 2.5% in the past year, the largest decline ever recorded.

A Brief History of Pauses by the Fed

With the Fed's action yesterday, the Fed funds rate will remain at its current 5.25% at least until December (barring something really dramatic and unforseen) - which means that the pause in changes in the Federal Funds rate will be at least 163 days long.

For comparison, there have only been three previous instances in the past 25 years when interest rates were held steady for at least 100 days following an interest rate hike:
  • 1989: rate hike, then a 101-day pause(with the exception of a tiny 19-day blip in rates at the end of that period), then rate cut;
  • 1995: rate hike, then a 154-day pause, then rate cut;
  • 2000: rate hike, then a 231-day pause, then rate cut;
  • 2006: rate hike, then at least a 163-day pause, then... ?.
And that is all.

The Fed's statement yesterday seemed relatively bullish, in the sense that it warned that the Fed might need to raise rates in the future, but said nothing about the possibility of needing to cut rates in the future. However, history certainly seems to be on the side of those who suspect the next move (when it comes) will be a rate cut, not another rate increase.

Wednesday, October 25, 2006

The Value of Oversight

Democrats around the country are campaigning largely on the idea that they will provide much-needed oversight over the executive branch. It's not a sexy topic to run a campaign on, and some have interpreted it as a thinly disguised call for Democrats to dig up dirt on the Bush administration and be obstructionists for the next two years.

But perhaps "oversight" could mean a little more than that. Menzie Chinn does a nice job highlighting a speech that GAO Comptroller David Walker gave last month. The table he highlights shows that the US government's future liabilities more than doubled between 2000 and 2005 - an increase of $26 trillion. Menzie writes:
When the President speaks of the Administration's commitment to fiscal restraint, and the need to rein in Social Security, it behooves us all to look at the fourth line under "implicit exposures"; the largest single increment to the the present value of liabilities -- larger than explicit liabilities (U.S. Treasury debt) run up with all the budget deficits over the past 5 years, and larger than Social Security liabilities that have troubled the Administration -- is Medicare Part D, passed by this Congress, and signed into law by President Bush.

Wasn't there any oversight at the time? And didn't somebody know about the immense fiscal burden imposed by the passage of this legislation. The answers are respectively "no" and "yes".
So what's the value of proper governmental oversight? Apparently, several trillion dollars.

Tax Reform versus Tax Cuts

David Altig today provides a nice summary of some recent discussions of the Laffer curve, prompted by the recent claims by some that the federal budget deficit is falling thanks to the Bush tax cuts. He also gives a qualified defense of, if not the actual Laffer curve, then at least some "Laffer-type effects". The example he points to is this:
Several years back, I was part of a team that simulated the effects of the HR flat tax, and similar forms of fundamental tax reform. We found that in the most straightforward version of this type of tax reform, the shift from something like our present income-based tax system to an HR-like consumption-based system would require a tax rate on labor-income of 21.4 percent in order to keep revenues from falling. Over time, as the growth effects of removing capital taxation took hold in our experiments, the tax rate required to maintain revenue neutrality fell by 2 percentage points.
The study he cites is a fascinating one, which I had forgotten about (so thanks for the reminder, David!). But I would disagree considerably with David about how to characterize the simulation result that he mentions, however.

I think that the results he alludes to are not at all of the Laffer variety. The idea of the Laffer curve is that cuts in tax rates lead to increased tax revenues. Yet what David is describing is something quite different, it seems to me: revenue-neutral tax reform. In other words, rather than the simulations showing that tax cuts cause tax revenues to go up, they show that certain types of tax reform (e.g. shifting taxes away from capital and onto consumption or labor) may cause revenues to go up.

I don't think that most economists would disagree with the notion that tax reform, if done properly, could be greatly efficiency-enhancing (though I'm not personally convinced that capital formation is that sensitive to the rate of taxation of capital). And as a result, most economists would agree that if one changed the ways taxes are collected, one might be able to collect the same amount of tax revenue at lower marginal rates. And that seems to be what the Altig, et al. study illustrated. But that seems to be something quite different from Art Laffer's notion that simply cutting the marginal rates of the taxes we have today will lead revenue to rise.

Class Warfare: Rich v. Super-rich

Matt Miller tells a story in this week's Fortune Magazine that is almost a parody. Almost, but not quite. Because he may actually be on to something...
(Fortune Magazine) -- Not long ago an investment banker worth millions told me that he wasn't in his line of work for the money. "If I was doing this for the money," he said, with no trace of irony, "I'd be at a hedge fund." What to say? Only on a small plot of real estate in lower Manhattan at the dawn of the 21st century could such a statement be remotely fathomable. That it is suggests how debauched our ruling class has become.

The widening chasm between rich and poor may well threaten our democracy. Yet if that banker's lament staggers your brain as it did mine, you're on your way to seeing why America's income gap is arguably less likely to spark a retro fight between proletarians and capitalists than a war between what I call the "lower upper class" and the ultrarich.

Here's my outlandish theory: that economic resentment at the bottom of the top 1 percent of America's income distribution is the new wild card in public life. Ordinary workers won't rise up against ultras because they take it as given that "the rich get richer."

But the hopes and dreams of today's educated class are based on the idea that market capitalism is a meritocracy. The unreachable success of the superrich shreds those dreams.

"I've seen it in my research," says pollster Doug Schoen, who counsels Michael Bloomberg and Hillary Clinton, among others. "If you look at the lower part of the upper class or the upper part of the upper middle class, there's a great deal of frustration. These are people who assumed that their hard work and conventional 'success' would leave them with no worries. It's the type of rumbling that could lead to political volatility."
I actually know quite a few "lower uppers", and I have to agree - some of them are really bitter and angry at the way income is flowing to the upper-uppers. They're as smart (or smarter), they've worked just as hard, but they just haven't gotten that one lucky break that separates the rich from the super-rich. Who knows what such resentment could cause?