(What’s Left of) Our Economy: Why Investors Shouldn’t Blame U.S. Workers for Inflation

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bonds, budget deficits, Federal Reserve, Financial Crisis, inflation, interest rates, manufacturing, monetary policy, quantitative easing, recession, recovery, stock market, stocks, wage inflation, {What's Left of) Our Economy

Thanks to the U.S. government’s new inflation data, we can cross one often fingered culprit off the list of developments being blamed for the recent turbulence in American, and therefore global, financial markets – wage inflation. For by a crucial indicator, real hourly pay in the United States is not only failing to lead prices upward – it’s been trailing overall inflation recently and indeed has been in recession lately by one commonsense standard.

Of course, market turmoil (like most big developments) springs from several, overlapping reasons. The first is one I discussed last Friday, and which I consider the most important: Investors fear that the Federal Reserve and other world central banks will start tightening monetary policy faster than expected, in order to prevent (more of) the kinds of reckless investments that tend to mushroom when credit is super cheap, and that can often trigger financial crises like the near global meltdown roughly a decade ago. (Happy Anniversary!)

If credit becomes more expensive, then economic growth and corporate profits will struggle to maintain their current rates of increase, and stocks will become less attractive investments, all else equal. In addition, the very increase in interest rates almost certain to result from such central bank “tightening” heightens the appeal of bonds and dims that of equities.

To complicate matters further, another engine of higher rates might be a combination of the great increase in federal budget deficits likely from the new tax cuts proposed by the Trump administration and passed by Congress, and the big-spending budget deal reached by the lawmakers and the President. The consequent budget gap will boost federal borrowing needs (and all else equal, push up the rates Washington will need to pay lenders for all this new debt) at a time when the U.S. central bank has started selling the ginormous amount of government bonds it’s been purchasing and holding since late 2008 (a practice called “quantitative easing) in order to halt the Great Recession and speed up recovery . This version of tightening – which also stems from financial stability concerns – will raise the supply of bonds even further.

The second reason for the turmoil is investor concern that rising inflation will spur central banks to raise rates regardless of the above financial stability concerns – because excessive inflation can produce its own economic disaster. And in fact, the proximate cause of the current bout of market instability seems to be those very inflation fears, and in particular, the possibility of wage inflation.

Higher compensation costs could deal their own blow to stock prices by reducing corporate profits; or by sending upward price pressures rippling throughout the entire economy (as companies tried to pass higher costs on to their customers either elsewhere in the business world or in consumer ranks); or through some combination of the two. (Interestingly, the chances seem pretty low that companies could absorb higher wages through greater efficiency, as productivity improvement has been very slow at best recently.)

So that’s why today’s widely anticipated (to put it mildly) U.S. government inflation data is so important. The inflation figures were somewhat “hotter” than most investors were predicting. But it couldn’t be clearer that wage inflation has nothing to do with these higher prices.

The numbers that most observers – whether investors or not – are looking at are the year-on-year numbers, and they do seem to signal some wage inflation. From January, 2017 to last month, the Labor Department’s headline reading showed a 2.14 percent rise in prices nationwide, and a 1.85 percent increase in “core” prices (which stripped out from the headline food and energy prices because they’re considered so volatile in the short-term that they can generate readings regarded as somewhat misleading).

During that same year, wages adjusted for inflation for the overall private sector were up 0.75 percent – which means they rose faster than overall prices. Moreover, between previous Januarys, real wages actually declined fractionally (by 0.09 percent). So in principle, investors (and other economy watchers) have reasons to be nervous about wage inflation.

But a more recent time frame tells a very different story. For since last May, private sector wages have been down on net. Although the cumulative decline is only 0.19 percent, this means that on a technical basis, real wages are in recession. (I feel justified in using this term because when economists talk about growth, a decline for two consecutive quarters is defined as a recession. So a six-month cumulative downturn seems close enough.) Indeed, more accurately, real wages are still in recession, since this development was apparent last month, too.

And the latest month-to-month figures indicate that real wage pressure is weakening, not strengthening. From December to January alone, they dropped by 0.19 percent, after rising by that amount from November to December.

The picture looks even grimmer when you go back to the start of the current economic recovery – in mid-2009. Since then, real private sector wages have risen by only 4.07 percent. And that’s over more than eight years!

But private sector real wages are practically torrid when they’re compared with inflation-adjusted pay in manufacturing. Such compensation has been in technical recession for two full years, as it’s fallen by 0.09 percent since January, 2016. On a monthly basis, after-inflation manufacturing pay plummeted by 0.46 percent in January, its worst such performance since August’s 0.64 percent tumble. At least the December figure was revised up – though only from a 0.09 percent dip to a 0.09 percent increase.

Over the current economic recovery’s eight-plus years, real manufacturing wages have risen by a mere 0.37 percent – less than a tenth as fast as those of the private sector overall.

Yet although inflation – and especially wage inflation – doesn’t seem to warrant a quicker pace of Federal Reserve interest rate hikes (or even the current, “gradual” pace), a case can still be made for tightening on a financial stability basis. And those massive federal deficits, which will need to be funded by equally massive increases in bond supplies, seem here to stay for many years. So as has been the case for so long, assuming these moves do slow U.S. economic growth, American workers appear certain to pay many of the costs for disastrous policy mistakes they never made.

(What’s Left of) Our Economy: What’s with Those Financial Markets?

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bonds, bottom-line, budget deficits, central banks, correction, debt, Federal Reserve, Financial Crisis, financial markets, Great Recession, interest rates, leverage, monetary policy, profits, stocks, tax cuts, top-line, {What's Left of) Our Economy

Heckuva week on the world’s financial markets, eh? This post isn’t intended to provide any investment advice, but rather to shed some light on what strikes me as the most interesting question posed by the stock market correction and the related spike in bond yields: Why is it happening as evidence keeps emerging that the world economy (including America’s) is entering its best stretch of growth since the last (Great) recession ended in mid-2009?

Right off the bat, in the interests of full disclosure, the vast majority of my investments are in bonds (mainly munis) and bond proxies (high-dividend stocks whose share prices are relatively stable, so that their main value is spinning off income). This means that my main hope is that bonds keep doing well (notwithstanding their recent slump).

That said, it seems clear to me that the answer is that investors are worried that the stronger growth seen globally isn’t sustainable. Indeed they seem fearful that it’s about to come to an ugly end because the world’s central banks look more determined than in many years to at least limit the easy money conditions they created to fight the financial crisis (and ensuing recession), and to try to spark something of a recovery.

This kind of monetary policy tightening – or even a further slowdown in or halt to the loosening, which is what’s most likely in the near future – could create a pair of closely connected economic and financial dangers. First, slower growth could imperil the sales and profits of companies that issue stocks, which could depress their prices. And P.S.: Despite the record central bank stimulus, growth has been unimpressive enough. How much tightening is needed to tip the economy back into recession?

Of course, businesses all around the world have performed magnificently in boosting profits in a slow-growth environment, and this also goes for non-financial companies that haven’t been able to enjoy the full benefits of borrowing from central banks at super-cheap rates and lending at higher rates. But precisely because growth even during the recovery’s best periods so far has been sluggish despite the gargantuan stimulus, much of the profit improvement has come from improvements in the bottom line, keyed by cost-cutting (including keeping the lid on employee paychecks). Top-line growth – that is, stronger sales of products and services – has been more difficult to come by.

Since costs can’t be cut completely, and possibly not much further, a growth slowdown could greatly reduce these firms’ potential to increase profits going forward, and turn them into much less attractive buys for investors. And tighter monetary policy, including raising interest rates, historically has been pretty effective at slowing growth.

Just as important, low interest rates per se have super-charged stock prices. The reason? They greatly depress the total return on bonds, and thus greatly boost the appeal of stocks.

Of course, this raises the question of why central banks would take such actions, or even think (out loud) about them. The reasons are that they’re worried that all this easy money will ignite a new round of dangerous inflation, and that they’re concerned that, because money has been so cheap for so long, borrowing consequently so easy, and mistakes therefore so easy to withstand, too much capital has been poured into risky investments. Central bankers are rightly concerned that this “mal-investment” eventually could imperil the entire financial system and hence the real economy just as it did during the previous decade. So they’re hoping they can wean the world off this sugary diet.

The challenge they face is making sure “the patient survives,” or doesn’t become gravely ill again. After all, the previous decade’s financial crisis showed that when dubious investments reach a certain level, creditors can start doubting borrowers’ ability to repay or even service their debt even when the cost of money is very low. When they start to pull in their bets, panic can easily set in – and did.

These dangers become much greater when the cost of money starts to rise, which is exactly the situation the nation and world are in now. Just one indication of heavily indebted businesses are: According to Standard & Poor’s, one of the financial ratings agencies, in 2007 (just before the global bubble burst), 32 percent of the world’s non-financial companies were “highly leveraged” (i.e., up to their ears in debt). The latest figure? Thirty seven percent.

This corporate debt, of course, is relatively easy to service and manage when interest rates are very low. In a higher rate environment? Not so much. And don’t think creditors don’t know this. So that’s another reason that companies could start looking less appealing to investors, and if major debt servicing (much less repayment) problems emerge, credit channels could start seizing up just as they did ten years ago. On top of this prospect, all else equal, rising rates tend to be trouble for stock prices, as more and more investors decide to opt for (higher) guaranteed returns on bonds rather than riskier equities.

P.S. If you’re wondering whether higher rates could significantly increase the debt burden on the U.S. government, even without the immense new borrowing that will be needed thanks to the Trump administration’s tax cuts and the new big-spending Congressional budget compromise, the answer is, “You bet!”

Not that reasons for optimism about stocks in particular can’t be identified. Because the big ramp up in federal budget deficits that’s on the way will inject massive new resources into the economy, more growth will result. In principle, that new growth could convince the Federal Reserve to speed up its tightening – but perhaps not enough to offset the fiscal boost. Moreover, anyone who’s positive that the Fed will keep tightening in the face of either future stock market turbulence and/or weaker economic growth hasn’t been paying attention to its record in recent decades. The central bank has been, in the view of many, all too willing to keep the economic party going at all costs, and may well do so again.

One more bullish possibility for stocks – as they did during the previous decade, the leaders of stock-issuing companies decide to use most of their tax cut windfall to buy more shares of their own stock. The result would not only would prop up the share price, but in many cases boost their own compensation (which not so coincidentally is often based on that share price).

The most vexing aspect of both the investment and the economic situation is that, even though both may suffer in the short run, both urgently need to end their addiction to central bank stimulus and create the kind of foundation that will promote healthier, and thus longer-lasting (even if not faster) growth. Moreover, the longer the addiction lasts, the worse the cold turkey experience.

Because I doubt that either the Federal Reserve or the rest of the U.S. government has the spine to administer the needed policy medicine, I remain pretty bearish long-term on both the markets and the real economy, and will stay very conservatively invested. But the short term can be surprisingly long lasting; in fact, I’m surprised that the Fed’s high wire act has lasted this long. So I’m anything but an infallible guide to either. I’m just trying to be prepared for major trouble – whenever it decides to arrive.

 

(What’s Left of) Our Economy: The Republican Tax Plans’ Biggest Flaw

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Alan Greenspan, Barack Obama, Bill Clinton, budget deficits, business spending, capital gains, corporate taxes, dividends, Federal Reserve, fiscal policy, George W. Bush, House, income taxes, monetary policy, multinationals, non-residential fixed investment, Paul Volcker, repatriation, Republican tax bills, Ronald Reagan, Senate, tax cuts, taxes, {What's Left of) Our Economy

The tax bills passed by the Republican-controlled House and Senate and strongly supported by President Trump (despite some important differences between them) can be fairly criticized for any number of big reasons: the mess of a drafting process in the Senate, the impact on already bloated federal budget deficits and the national debt, the cavalier treatment of healthcare reform, the seemingly cruel hits to graduate students and to teachers who buy some of their students’ school supplies.

My main concern is different, though. I could see an argument for the main thrust of the bills – even taking into account most of the above flaws – if they boasted the potential to achieve its most important stated aim. In Mr. Trump’s words, “We’re going to lower our tax rate to the very competitive number of 20 percent, as I said. And we’re going to create jobs and factories will be pouring into this country….” Put less Trump-ishly and more precisely, the idea is that by slashing tax rates for corporations and so-called pass-though entities, along with full-expensing of various types of capital investment, American businesses will build more factories, labs, and other productive facilities; buy more equipment, materials and software; hire more workers and increase their pay (since the demand for labor will soar).

Actually, since automation will surely keep steadily reducing the direct hiring generated by all this promised productive investment, let’s focus less on the jobs promise (keeping in mind that manufacturing in particular generates lots of indirect jobs per each direct hire), and more on the business spending that will boost output – since faster growth is the ultimate key to robust employment and wage levels going forward.

Unfortunately, after spending the last few days crunching some relevant numbers, I can’t see the GOP tax plans living up to their billing – which makes their flaws all the more damning.

What I’ve done, essentially, is look at inflation-adjusted business spending during American economic recoveries (to ensure apples-to-apples data by comparing similar stages of the business cycle) going back to the Reagan years of the 1980s, and examine whether or not individual and especially business tax cuts have set off a factory etc building spree. And I didn’t see anything of the kind, except possibly over the very short term. Moreover, even these increases may have had less to do with the tax cuts than with other influences on such investments – like the overall state of the economy and the monetary policies carried out by the Federal Reserve (which help determine the cost of credit).

Let’s start with the expansion that dominated former President Ronald Reagan’s two terms in office – lasting officially from the fourth quarter of 1982 through the second quarter of 1990 (by which time he had been succeeded by George H.W. Bush). The signature Reagan tax cuts, which focused on individuals, went into effect in August, 1981 – when a deep recession was still underway.

Interestingly, business investment kept falling dramatically through the middle of 1983 – when an even stronger rebound kicked in through the end of 1984. Indeed, that year, corporate spending (known officially as private non-residential fixed investment surged by 16.66 percent. But this growth rate then began slowing dramatically – and through 1987 actually dropped in absolute terms.

A major tax reform act was signed into law by the president in October, 1986, and individuals were its focus as well. Two provisions did affect business, but appeared to be at least somewhat offsetting in their effects, in line with the law’s overall aim of eliminating incentives and disincentives for specific kinds of economic activity. They were a reduction in the corporate rate and a repeal of the investment tax credit – whose objective was precisely to foster capital spending. Other provisions had major effects on business but principally by encouraging more companies to change over to so-called pass-through entities, not (at least directly) on investment levels. Business spending recovered, but its peak for the rest of the decade (5.67 percent of real GDP in 1989) never approached the earlier highs.

Arguably, fiscal and monetary policy were much more influential determinants of business spending, along with the recovery’s dynamics. The depth of the early 1980s recession practically ensured that the rebound would be strong, as did the massive swelling of federal budget deficits, which strengthened the economy’s overall demand levels, and their subsequent reduction.

Perhaps most important of all, the Federal Reserve under Chairman Paul Volcker cut interest rates dramatically from the stratospheric levels to which he drove them in order to tame double-digit inflation. And yet for most of 1984, when business spending soared, the federal funds rate (FFR) was rising steeply. Capex also strengthened between 1987 and mid-1989, which also witnessed a scary stock market crash (in October, 1987).

The story of the long 1990s expansion, which mainly unfolded during Bill Clinton’s presidency, was simultaneously simpler and more mysterious from the standpoint of business taxes – and macroeconomic policy. Following a shallow recession, Clinton raised both personal and corporate tax rates while government spending was so restrained that the big budget deficits he inherited actually turned into surpluses by the late-1990s. For good measure, the FFR began rising in late 1993, from 2.86 percent, and between early 1995 and mid-2000, stayed between just under six percent and just under 6.5 percent.

And what happened to capital spending? In late 1993, right after the tax-hiking, spending- cutting, deficit-shrinking Omnibus Budget Reconciliation Act was passed, and the Fed was tightening, businesses went on a capex spending spree began that saw such investment reach annual double-digit growth rates in 1997 and stay in that elevated neighborhood for the next three years.

It’s true that Clinton and the Republican-controlled Congress passed tax cut legislation in August, 1997, that among other measures lowered the capital gains rate. But the acceleration of business spending began years before that. And although we now know that much of this capital spending went to internet-centered technology hardware for which hardly any demand existed then at all, from a tax policy perspective, the key point is that this category of spending rose strongly – not whether the funds were spent wisely or not.

The expansion of the previous decade casts major doubt on whether any policy moves can significantly juice business spending. Just look at all the stimulative measures put into effect, tax-related and otherwise. The recovery lasted from the end of 2001 to the end of 2007, and during this period, on the tax front, former President George W. Bush in June, 2001 signed a bill featuring big cuts for individuals, and in May, 2003 legislation that sped up the phase-in of those personal cuts and added reductions in capital gains and dividends levies. For good measure, in October, 2004, the “Homeland Investment Act” became law. It aimed to use a tax “holiday” (i.e., a one-time dramatically slashed corporate rate) to bring back (i.e., “repatriate“) to the U.S. economy for productive investment hundreds of billions of dollars in profits earned by American companies from their overseas operations.

In addition, under Bush, the federal budget balance experienced its biggest peacetime deterioration on record, and starting in the fall of 2000, the Federal Reserve under Alan Greenspan cut the FFR to multi-decade peacetime lows, and didn’t begin raising until mid-2004.

The business investment results underwhelmed, to put it mildly. Such expenditures fell significantly throughout 2001 and 2002, and grew in real terms by only 1.88 percent the following year. Thereafter, their growth rate did quicken – to 5.20 percent rate in 2004, 6.98 percent in 2005, and 7.12 percent in 2006. But they never achieved the increases of the 1990s and by 2007, that expansion’s final year, business investment growth had slowed to 5.91 percent.

There’s no doubt that something needs to be done to boost business spending nowadays, which has lagged for most of the current recovery and turned negative last year – even though the federal funds rate remained near zero for most of that time and the Federal Reserve’s resort to unconventional stimulus measures like quantitative easing as well, despite unprecedented budget deficits (though they began shrinking dramatically in 2013), and despite the continuation of all the Bush tax cuts (except the repatriation holiday, and the imposition of a small surcharge on all investment income to help pay for Obamacare). Business investment’s record during the current recovery has been even less impressive considering a Great Recession collapse that was the worst in U.S. history going back to the early 1940s, and that should have generated a robust bounceback.

But if history seems to teach that tax cuts and even other macroeconomic stimulus policies haven’t been the answer, what is? Two possibilities seem well worth exploring. First, place productive investment conditions on any tax cuts and repatriation (the 2004 tax holiday act did contain them) and then actually monitor and enforce them (an imperative the Bush administration neglected). And second, put into effect some measures that can boost incomes in some sustainable way – and thus convince business that new, financially healthy customers will emerge for the new output from their new facilities. To me, that means focusing less on ideas like raising the national minimum wage to $15 per hour (though the rate should, at long last, be linked to inflation), and more on ideas like trade policies that require business to make their products in the United States if they want to sell to Americans, and immigration policies that tighten labor markets and force companies to start competing more vigorously for available workers by offering higher pay.

In that latter vein, the 20 percent excise tax on multinational supply chains contained until recently in the House Republican tax plan could have made a big, positive difference. Sadly, it looks like it’s been watered down to the point of uselessness, and the original has little support in the Senate. The House Republican tax plan also had included a border adjustment tax that would have amounted to an across-the-board tariff on U.S. imports (and a comparable subsidy for American exports), but the provision was removed from the legislation partly due to (puzzling) Trump administration opposition.

Mr. Trump clearly has acted more forcefully to relieve immigration-related wage pressures on the U.S. workforce, but it’s unclear how quickly they’ll translate into faster growing pay.  If such results don’t appear soon, and barring Trump trade breakthroughs, expect opponents of the Republican tax plan to keep insisting that it’s simply a budget-busting giveaway to the rich, and expect these attacks to keep resonating as the off-year 2018 elections approach.   

 

(What’s Left of) Our Economy: Gallup Survey Shows No Public Consensus on Boosting Recovery

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2016 elections, balanced budget, budget deficits, economy, education, executive pay, Immigration, infrastructure, minimum wage, recovery, regulation, Social Security, spending, taxes, Trade, training, {What's Left of) Our Economy

I’m a strong believer the American people’s ability to understand policy clearly enough to govern themselves wisely, and an equally strong believer in viewing opinion polls skeptically. But some new Gallup findings on economic issues are so contradictory and confusing that it’s enough to make the most dedicated populist think twice.

You can see the full results here. (And Gallup says it will expand upon this exercise throughout the rest of this presidential cycle.) But here are some that are especially head-scratching:

> Of the 47 policy ideas presented to voters, only nine were judged likely to be “very effective” at improving the economy by half or more of respondents, and of these, four were so rated by 50 percent even. That’s no doubt in part a function of the large number of proposals (which would tend to fragment preferences – as we seem to be seeing for the Republican presidential field). But the diversity of popular responses strongly points to less comforting explanations.

> The only two proposals cracking the 60 percent “very effective” mark were “Ensuring that women receive equal pay for equal work” and “Improving job training for veterans.” Trailing close behind, at 58 percent, was “Giving small businesses easier access to loans to start or expand their businesses.” Nothing else exceeded 55 percent.

> The 50 percent neighborhood is where the fun really starts. Principally, budget deficit hawks will be heartened by roughly this level of enthusiasm for “Reducing federal government spending”; “Requiring a balanced budget”; and, arguably, “Reforming Social Security to ensure it remains solvent.”

> But spending doves will be just as pleased to see that roughly half of respondents saw great potential in “Spending more government money to improve U.S. schools and education”; “Providing free community college education for all Americans who want it”; and “Providing new federal government programs designed to increase manufacturing jobs.” Perhaps tipping the balance in the doves’ favor is the near-majority backing for increased public sector funding for pre-school education, more government loans for small businesses, and tax incentives to encourage business to train workers. These results also seem to signal fairly high public confidence that more educational opportunity is needed for spurring and spreading prosperity.  

> Some of the measures most prominently touted by politicians in both major parties haven’t lit raging fires under American voters, according to Gallup. “Increasing the minimum wage” was described as a “very effective” way to strengthen the economy by a solid but not spectacular 44 percent of respondents. Generating even less excitement were “Reducing income tax rates for all Americans” and “Reducing government regulations on small businesses,” which both came in at the 40 percent mark.

> However much Americans complain about the quality and quantity of their infrastructure, only 39 percent regard “Developing federal, state, and private partnerships to invest” in such systems as a great way to spur better economic performance. And for all the animus against Wall Street and the rest of Big Business, only 38 percent registered great confidence in “Setting a limit or ceiling on corporate executives’ salaries.”

> Immigration and trade issues were gauged by Gallup, too, but here the results look less reliable, thanks to some dubious wording choices. One possible reason: The polling firm received input on the entire survey from, among others, “economists, academics and economic and political observers” – groups where orthodox, establishmentarian views (of both liberal and conservative varieties) reign supreme.

> The immigration questions seemed unexceptional, and showed the public saw relatively little economic payoff from encouraging more immigration either by “high-skill” foreign nationals who graduate from American universities, by skilled workers generally, or by their low-skill counterparts. But respondents were never asked about the potential of limiting or reducing legal immigration flows, much less about cutting off illegal immigrants’ access to jobs and public benefits.

> Much more problematic were the trade questions, which gave respondents two choices: “Negotiating trade and economic agreements designed to enhance trade with other nations” and “Increasing tariffs and taxes in order to make it more expensive to import goods into the U.S. from overseas.” The former was seen as a very promising growth engine by 29 percent of respondents, the latter by 24 percent. But if you think about it, why should anyone intrinsically doubt the benefits of “enhancing trade,” especially if no drawbacks are listed? Conversely, including the word “tax” in the question suggesting trade barriers was bound to reduce this option’s popularity. What kinds of results would Gallup have gotten, for example, if its question mentioned something on the order of “Increasing tariffs to replace goods in our stores made by foreign workers with goods made by American workers”?

I’ll keep monitoring Gallup’s efforts on this score – and hope that the company does a better job framing the debate on the globalization-related hot button issues that seem to be generating an unusual number of political headlines.

By the way, it’s important to recognize that this survey doesn’t measure public backing for or opposition to these economic ideas. Instead, it measures how well the public believes these measures will or won’t improve the economy.  These questions are similar, but not identical.