Inflation from China?

I have been reading a few comments lately about how inflation in China, running quite high in the 7% range, is not causing inflation in the US. Paul Krugman made this point and points to a WSJ commentary that does the same on his blog. The reasoning is that our total imports from China account for only 2% of our GDP, so it would take astronomical inflation in China to have an impact on inflation in the US. Unfortunately I think this analysis misses the point.

What is causing inflation is primarily the cost of raw materials such as oil, copper, metal, etc. These costs are rising because of the incremental demand from China and other developing countries for raw materials for both production and infrastructure development. The same is true for food – as incomes are raised around the globe the demand for food increases. These trends are, of course, exacerbated by the decline in the value of the dollar that drives up the price of imported materials such as oil, but without that decline we would likely be in a much worse economic condition right now than we are. I have not done any specific research on this topic, but I have heard many executives from the various mining and metal companies come on CNBC and explain that the demand from China is one quarter to one third of their total demand and until they can gear up to meet this demand prices will be higher. Others imply that speculators may be driving up prices as well, perhaps even creating the next bubble – commodities.

So in the end, inflation in China is not causing inflation in the US, but this analysis misses the point. The point is that because of the increase in demand for raw materials from China and other developing countries (and perhaps some speculation) the prices of materials for everyone, including China and the US, are going up and that is causing inflation in both countries. Perhaps some of the commentators can do a bit of numerical research on this in their spare time. If I find some perhaps I will.

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Proposals for Taxpayer Bailout of Banks

I was reading this article in The Wall Street Journal Online Edition titled Worried Bankers Seek to Shift Risk to Uncle Sam about proposals being shopped around DC to move defaulted subprime loans to FHA. According to the article:

The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers.

This will almost certainly lead to a taxpayer bailout in my opinion. I have been writing about this for months and the fact that it is being considered in DC is truly troubling. Congress has been warned about the consequences of this in 2006 testimony before the Committee on Banking, Housing and Urban Affairs. You can read that testimony here. If you would like my article on this issue you can find it here. The ideas discussed in the WSJ article referenced above go beyond what I wrote about back in December.

If you object to taxpayers bailing out the banking industry, again, I urge you to write to your congressional representatives.

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Income, Debt, Taxes, and The Economy

I have been trying to figure out why so many people (including myself) have been so negative about the direction of the economy so I have been playing around with some data published by various governmental sources, primarily the Bureau of Economic Analysis tables and Federal Reserve Z.1 from December 2007. I created a few graphs because I believe a picture says a thousand words and I wouldn’t expect anyone to read so many of my words. So, here goes.

The first chart I think really lays it out. This is Consumer Debt plus Mortgage Debt as a percent of Personal Income. I also charted Personal Disposable Income and it looks the same except the percentages are a little higher. This ratio has increased from 51% in 1974 to 112% in 2006 and an estimated 111% in 2007. So the good times for consumers over the past three decades appears to have been funded through incremental relative debt burden as opposed to income gains. This is simply another way of saying that we have been spending more than we are producing (unless we are borrowing to save, but keep reading), and perhaps we are close to hitting the proverbial wall.

The second graph titled Debt to GDP breaks out some components of debt as a percent of Gross Domestic Product. Note the sharp rise here too. One reason this is so steep is because I have added the National debt to the mix. This does not include State and Local debt, but believe it or not as a percent of GDP those items are relatively unremarkable. Business debt to GDP has also increased, but not at an alarming rate. It averaged 60% over the 1974-2007 time period and is currently high at 69.5%, the highest point in the time series. This is not a net number so it does not take into account cash that businesses have, so if businesses are flush with cash the higher number could be meaningless.


The graph titled Percent Change in GDP Components illustrates the makeup of GDP over this time period. The reason I like this graph is because it gives you an idea what is driving the economy; business investment, personal spending, or residential real estate. What I would like to point out here is the surprising suggestion that business investment is not what has driven the economy since the Bush tax cuts. In fact, with the exception of one spike in 1984, business investment doesn’t look very strong during the Reagan and Bush I presidencies either. I find it hard to see in this data support for the idea that tax cuts on high incomes lead to business investment raising all boats (you know, the trickle down theory). What, then, has been driving growth in this decade? We know from our Debt to GDP graph that mortgage debt increased dramatically over this period in both absolute and relative terms. Is it consumers borrowing against real property and spending that has fueled the economy? Add that to the fiscal stimulus of continuing budget deficits and maybe that’s the answer. To put this into perspective, take a look at the final graph, Personal Consumption and Business Investment. These amounts are in nominal dollar amounts. As the graph illustrates, we have been increasing our consumption at a much faster rate than business investment, and it appears this is what has fueled our economic growth. Borrow and spend, at the personal and federal government level. And this is why, I believe, there is so much bad feeling out there. Unfortunately it may be justified.

So where do we go from here? Well, if we have a major economic downturn we could go through an extended period of hardship as debts are written off and asset values decline. This is one school of thought – that we are headed for a period of deflation (not just disinflation but actual falling prices and values). On the other side is inflation. If you owe a lot of money, inflation is good for you because as overall prices and wages rise, the debt you owe becomes a smaller and smaller amount in real terms. So we could inflate our way out of this by flooding the system with money – but this creates more debt. Ah, and therein lies the problem. How much debt will it take to inflate our way out of debt? Looking at the Debt to GDP graph I am not feeling very good about this approach.

I want to go back here to the economic policies of the past 27 years, since we began the reduction in marginal tax rates. I don’t have the numbers yet to support this so consider it an unsupported hypothesis for now. If I find some time I will look for the numbers, if they are even available, to try and support this. What if, instead of tax cuts that benefit the wealthy resulting in business investment the tax cuts actually resulted in cheap available consumer credit? Lets take an example. Person A makes a very good living, say $2 million a year. Person A gets a tax cut and finds they have an extra $100,000 at year-end. What happens to that 100,000? Perhaps some gets spent, and that could account for some of the increase in personal consumption. But what if a large portion of it goes to a hedge fund for investment? Perhaps much of it flows into safe investments such as CDs and money market funds. What is the impact of the additional savings? The result would be an increase in the supply of funds available and, if our Eco 101 is working, a decrease in the cost of capital. If business does not use this capital to invest, it will find its way into some use because sitting idle it makes no return at all. We can speculate where this money may have ended up, and I speculate that over the past few years it ended up in places that include exposure to subprime mortgages and other consumer debt funded through securitization and commercial paper. If this is correct, then tax cuts to the wealthy do not in fact trickle down to the rest of the population through employment and income. Rather, they trickle down through debt, leaving the wealthy to accumulate more wealth and many of the not-so-wealthy wondering how they will make their next credit card payment.

The cost in revenue to the Federal Government of the Bush tax cuts is estimated to be approximately $1.7 trillion through 2011. This begs the question: what if those tax cuts went to the middle and lower income taxpayers who would be more likely to have spent it rather than invest it. On average, that would be like getting the current stimulus plan being rammed through Congress every year for ten years. Would Greenspan have felt it necessary to keep interest rates as low as he did after the 2001 recession? Would the economy have rebounded faster? Would we have had the real estate bubble without the historically low interest rates? We will never know the answers to these questions, but I think they are well worth asking.

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More Phony Baloney from Art Laffer

Although I had planned to pen an article today regarding the stimulus plan and some other pieces of information from the week, I was alerted to this OP-ED piece in Today’s Wall Street Journal Online Edition and felt a need to respond. This piece is, in my humble opinion, another example of professional obfuscation by the very experienced Art Laffer. It requires little to dispose of this three-plus page propaganda piece, which states:

Since 1980, statutory marginal tax rates have fallen dramatically. The highest marginal income tax rate in 1980 was 70%. Today it is 35%. In the year Ronald Reagan took office (1981) the top 1% of income earners paid 17.58% of all federal income taxes. Twenty-five years later, in 2005, the top 1% paid 39.38% of all income taxes.
There are other ways of looking at tax receipts by income bracket. From 1981 to 2005, the income taxes paid by the top 1% rose to 2.96% of GDP, from 1.59% of GDP. There was also a huge absolute increase in real tax dollars paid by this group. In 1981, the total taxes paid in 2005 dollars by the top 1% of income earners was $94.84 billion. In 2005 it was $368.13 billion.

He goes on to devote almost an entire page to listing statistics about shares of taxes paid by the top 1% vs. the bottom 75% illustrating the point that the poor unfortunate top 1% have been carrying a much larger share of the total income taxes. What he does not explicitly mention is what I have set forth in the first graph above. The top 1% paid a larger share of the income taxes because the top 1% continue to get more and more of the total income. In fact, in 1986 the top 1% of taxpayers earned 11.3% of the total adjusted gross income reported to the IRS. In 2005 the top 1% earned 21.2% of the total adjusted gross income, an increase of 87.6%. In 1986 the top 1% paid 25.75% of all personal income taxes paid to the IRS. In 2005 the top 1% paid 39.38% of all the taxes, an increase of 53%. How is this bad for the top 1%? (See how easy it is to manipulate numbers? Think for a minute why percentage increase in income share is so much higher than the percentage increase in tax share. I will point this out to you, unlike some.) In reality, that entire page of percentages is irrelevant to anything other than deflecting from the fact that the rich have achieved higher riches relative to everyone else and this has occurred during the period in time that tax rates on the top 1% have been dramatically lower (the post 1981 period).


Mr. Laffer goes on to claim that the effective tax rate on the top 1% really does not change from year to year (thus proving my point above), concluding that this is because the rich find ways to alter their income so as to avoid the higher marginal rates (not that the wealthy don’t do some of this but it does not result in flat effective tax rates for the wealthy). There are two problems here. First, he is wrong as evidenced by the second graph above titled "Average Effective Tax Rate Top 1%". The effective rate does vary and the effective rate is measured over ALL income, not just the marginal portion at the higher rate. As a result we would expect the effective rate to vary much less than the marginal, and it does. The other problem is that if he is correct then the rich are masters at tax avoidance and the easy way to fix that is enforcement. His argument finishes with the proposition that if we cut taxes on the middle-class we will lose that revenue and if we raise taxes on the upper income earners, since they never pay the higher amount, we will lose income there too. Of course we just learned that this is not true, at least in connection with the top income earners.

Mr. Laffer’s piece ends with this hopelessly biased and unsupported conclusion:

Mark my words: If the Democrats succeed in implementing their plan to tax the rich and cut taxes on the middle and lower income earners, this country will experience a fiscal crisis of serious proportions that will last for years and years until a new Harding, Kennedy or Reagan comes along.
Trained economists know all of this is true, but they try to rebut the facts nonetheless because they believe it will curry favor with their political benefactors.

Really?

I have one final point about Mr. Laffer’s “analysis”. I find it interesting that he begins at the point in history when the highest marginal rates were dramatically lowered but goes no further back in time. I wonder if this change in income tax philosophy so strenuously argued for by the likes of Art Laffer has enabled the vast accumulation of wealth that appears to be concentrating at the top? I suspect there is a reason the analysis begins when it does.


Note: This article was revised from the original to add the second graph.

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Why I Think We Will Have A Recession

Here is why I think we will have a recession. The graph above plots the Financial Obligations Ratio from the Board of Governors of the Federal Reserve. This ratio is an estimate of consumers' fixed payment obligations as a percent of their disposable income. Here is how the Board describes it:

The household debt service ratio (DSR) is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt.
The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments to the debt service ratio.

So this ratio tells us the estimated percentage of the average person's disposable income that is already committed to making these fixed payments. The rest of the disposable income goes to pay for everything else including food, clothing, energy, education, savings, and so on.

The wavy line is the FOR for the third quarter of each year and the dark straight line is the trend line. I think this graph says a lot about why I hear people talking about being "tight" and not having extra income to spend lately. Add rising food and energy prices and I think there is just less truly discretionary money in the average household. This is also why I think any stimulus should be focused on consumers.

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Two Ways to Lose Your Job

I just wanted to juxtapose two situations that are similar but very different. The first relates to a person who lost their job when the factory he worked at closed. The second relates to a person who lost his job because he did a terrible job costing his company billions of dollars.

After 30 years at a factory making truck parts, Jeffrey Evans was earning $14.55 an hour in what he called “one of the better-paying jobs in the area.”… Wearing a Harley-Davidson cap, a bittersweet reminder of crushed dreams, he recently described how astonished and betrayed he felt when the plant was shut down in August after a labor dispute. Despite sporadic construction work, Mr. Evans has seen his income reduced by half.
So he was astonished yet again to find himself, at age 49, selling off his cherished Harley and most of his apartment furniture and moving in with his mother.

From the NYT here.

Former Merrill Lynch & Co. Chief Executive Stan O'Neal has found a new home: Alcoa Inc., which Friday named Mr. O'Neal as a director.
The move came a day after Merrill Lynch reported a $9.8 billion loss for the fourth quarter, the worst in the firm's 94-year history. The results were driven by $16.7 billion in losses on complex securities, subprime mortgages and other debt that piled up as the bank took what ratings firms have said were excessive risks under Mr. O'Neal's watch….
Mr. O'Neal left Merrill with benefits valued at $161.5 million from various pension plans and stock grants.

From The Wall Street Journal here.

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Where Should The Stimulus Go?

There is a lot of talk today about a stimulus package from the Federal Government to help counter the slowing economy. A lot of generalities were discussed during Fed Chairman Ben Bernanke's testimony before The House Budget Committee. You can read his prepared statement here.

Some pundits and politicians are arguing the stimulus should be focused on business with ideas such as accelerated depreciation. The thinking behind this is that it will stimulate businesses to acquire capital goods and the only cost to the government is the time value of money because businesses get the tax benefit now instead of over time. I haven't heard anyone yet limit such a plan to goods manufactured in the US, and without that this idea could be very watered down. That's also an issue with any of the other plans, however, but using a depreciation incentive to spur purchases of capital goods could be targeted toward domestic manufacturers as other plans may not be. Of course there are likely trade partner issues with any such limitations.

On the other end of the spectrum is giving to the poor. Expand the food stamp program and other help to the poor. The argument here is that these people will immediately spend the money and it will have the most immediate stimulative impact on the economy. If the stimulus is limited to tax breaks these people will see no help at all because they are not taxpayers to begin with.

Then there is tax relief for the investor class, otherwise known as the good old trickle down theory. According to this thinking, if we cut taxes on investing businesses will have access to capital and will invest thereby putting people to work and lifting all boats. Of course, if business in general is already sitting on large piles of capital then this plan would have no impact other than to add to the coffers of the wealthy.

Also under consideration is a tax break for the middle-class. The thinking here is that many people will spend it because times are tough, and so the stimulative impact will be relatively quick. An argument against this is that so many middle-class families are in so much debt that a large portion of such stimulus will go to paying down credit cards rather than new expenditures. This would help in the long run as consumers in too much debt can't consume, but there would be a delay in the impact. This plan could be attractive to the banks and credit card companies, so I think it has a pretty good chance of being at least part of any plan.

There are those who argue that this is the time to make the Bush tax cuts permanent. This just goes to show how extreme the position of this wing of the Republican party is. This would have zero impact until 2011, and is simply not relevant to the discussion of a stimulus plan. You can, however, count on those regular foot soldiers of the neocons who have gone a long way to destroying the fiscal health of our country to come out and tell us why this would be a good idea now.

As far as the Fed Chairman is concerned, he was non-committal on any particular stimulus package although he clearly warned that any plan that increased the structural fiscal deficit must be avoided, and government must address that issue sooner rather than later. He avoids recommending the solution to Congress, as he should, because he is not political (not supposed to be anyway) and this is clearly a political issue. What he does say is that the long term problem is simple arithmetic. What comes in must equal what goes out or at some point we have a crisis (and that point is within the next decade or two). In crafting a stimulus package:

As I have discussed on other occasions, the nation faces daunting long-run budget challenges associated with an aging population, rising health-care costs, and other factors. A fiscal program that increased the structural budget deficit would only make confronting those challenges more difficult.

I have a suggestion for Congress and the President. Since the years of following a policy of tax-cuts, borrow and spend have left us in the painfully foreseeable position of a pending fiscal crises, perhaps it is time to change course. As a place to begin, I suggest the research of Romer and Romer oft-cited by supporters of tax cut policies as evidence that their way is the best. What we do not hear about is the conclusion reached in that very same research report that a tax increase to repay an inherited deficit does not have a negative impact on economic growth. Just in case those tax cut pundits misplaced their copy, here is a link to it.

For tax increases to deal with an inherited budget deficit, the results are more interesting. The
point estimates imply that output does not fall at all following deficit-driven tax increases.

(From page 24)
If you would like a really good example of how the tax cut soldiers use this kind of report, here is a link to a recent Art Laffer report, as in the Laffer Curve. If you search this report for "Romer" you will find that he relies on it heavily. I cannot, however, find any reference in his report to an inherited deficit. I also love the title of his report: THE ONSLAUGHT FROM THE LEFT, PART I: FACT VS. FICTION. The true onslaught is a 28 year old attack on the poor and middle class from the right.

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