Thursday, February 21, 2008

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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Wednesday, February 13, 2008

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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Friday, February 1, 2008

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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