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How Not to Do Income-Disparity Statistics
I am a statistics snob. It unfortunately means that I end up sounding like a cynic most of the time, because I am naturally skeptical about every statistic I hear. One gets used to the fact that most stats you see are poorly measured, poorly presented, poorly collected, or poorly contexted. I actually play a game with my kids (because I want them to be shunned as sad, cynical people as well) that I call “what could be wrong with that statistic.” In this game, they have to come up with reasons that the claimed implication of some statistic is misleading because of some detail that the person showing the chart hasn’t mentioned (not necessarily nefariously; most users of statistics simply don’t understand).
But mostly, bad statistics are harmless. I have it on good authority that 85% of all statistics are made up, including that one, and another 12.223% are presented with false precision, including that one. As a result, the only statistic that anyone believes completely is the one they are citing themselves. So, normally, I just roll my eyes and move on.
Some statistics, though, because they are widely distributed or widely re-distributed and have dramatic implications and are associated with a draconian prescription for action, deserve special scrutiny. I saw one of these recently, and it is reproduced below (original source is Ray Dalio, who really ought to know better, although I got it from John Mauldin’s Thoughts from the Frontline).
Now, Mr. Dalio is not the first person to lament how the rich are getting richer and the poor are getting poorer, or some version of the socialist lament. Thomas Piketty wrote an entire book based on bad statistics and baseless assertions, after all. I don’t have time to tackle an entire book, and anyway such a work automatically attracts its own swarm of critics. But Mr. Dalio is widely respected/feared, and as such a simple chart from him carries the anti-capitalist message a lot further.[1]
I quickly identified at least four problems with this chart. One of them is just persnickety: the axis obviously should be in log scale, since we care about the percentage deviation and not the dollar deviation. But that is relatively minor. Here are three others:
- I suspect that over the time frame covered by this chart, the average age of the people in the top group has increased relative to the average age of the people in the bottom group. In any income distribution, the top end tends to be more populated with older people than the bottom end, since younger people tend to start out being lower-paid. Ergo, the bottom rung consists of both young people, and of older people who haven’t advanced, while the top rung is mostly older people who have Since society as a whole is older now than it was in the 1970s, it is likely that the average age of the top earners has risen by more than the average age of the bottom earners. But that means the comparison has changed since the people at the top now have more time to earn, relative to the bottom rung, than they did before. Dalio lessens this effect a little bit by choosing 35-to-64-year-olds, so new graduates are not in the mix, but the point is valid.
- If your point is that the super-wealthy are even more super-wealthier than they were before, that the CEO makes a bigger multiple of the line worker’s salary than before, then the 40th percentile versus 60th percentile would be a bad way to measure it. So I assume that is not Dalio’s point but rather than there is generally greater dispersion to real earnings than there was before. If that is the argument, then you don’t really want the 40th versus the 60th percentile either. You want the bottom 40% versus the top 40 percent except for the top 1%. That’s because the bottom of the distribution is bounded by zero (actually by something above zero since this chart only shows “earners”) and the top of the chart has no bound. As a result, the upper end can be significantly impacted by the length of the upper tail. So if the top 1%, which used to be centi-millionaires, are now centi-billionaires, that will make the entire top 40% line move higher…which isn’t fair if the argument is that the top group (but not the tippy-top group, which we all agree are in a category by themselves) is improving its lot more than the bottom group. As with point 1., this will tend to exaggerate the spread. I don’t know how much, but I know the direction.
- This one is the most insidious because it will occur to almost nobody except for an inflation geek. The chart shows “real household income,” which is nominal income (in current dollars) deflated by a price index (presumably CPI). Here is the issue: is it fair to use the same price index to deflate the incomes of the top 40% as we use to deflate the income of the bottom 40%? I would argue that it isn’t, because they have different consumption baskets (and more and more different, as you go higher and higher up the income ladder). If the folks at the top are making more money, but their cost of living is also going up faster, then using the average cost of living increase to deflate both baskets will exaggerate how much better the high-earners are doing than the low-earners. This is potentially a very large effect over this long a time frame. Consider just two categories: food, and shelter. The weights in the CPI tell us that on average, Americans spend about 13% of their income on food and 33% on shelter (these percentages of course shift over time; these are current weights). I suspect that very low earners spend a higher proportion of their budget on food than 13%…probably also more than 33% on shelter, but I suspect that their expenditures are more heavily-weighted towards food than 1:3. But food prices in real terms (deflated by the CPI) are basically unchanged over the last 50 years, while real shelter prices are up about 37%. So, if I am right about the relative expenditure weights of low-earners compared to high-earners, the ‘high-earner’ food/shelter consumption basket has risen by more than the ‘low-earner’ food/shelter consumption basket. Moreover, I think that there are a lot of categories that low-earners essentially consume zero of, or very small amounts of, which have risen in price substantially. Tuition springs to mind. Below I show a chart of CPI-Food, CPI-Shelter, and CPI-College Tuition and Fees, deflated by the general CPI in each case.
The point being that if you look only at incomes, then you are getting an impression from Dalio’s chart – even if my objection #1 and #2 are unimportant – that the lifestyles of the top 40% are improving by lots more than the lifestyles of the bottom 40%. But there is an implicit assumption that these two groups consume the same things, or that the prices of their relative lifestyles are changing similarly. I think that would be a hard argument. What should happen to this chart, then, is that each of these lines should be deflated by a price index appropriate to that group. We would find that the lines, again, would be closer together.
None of these objections means that there isn’t a growing disparity between the haves and the have-nots in our country. My point is simply that the disparity, and moreover the change in the disparity, is almost certainly less than it is generally purported to be with the weakly-assembled statistics we are presented with.
[1] Mr. Mauldin gamely tried to object, but the best he could do was say that capitalists aren’t good at figuring out how to share the wealth. Of course, this isn’t a function of capitalists. The people who decide how to distribute the wealth in capitalism are the consumers, who vote with their dollars. Bill Gates is not uber-rich because he decided to keep hundreds of billions of dollars away from the huddling masses; he is uber-rich because consumers decided to pay hundreds of billions of dollars for what he provided.
Retail Investors Aren’t As Stupid As They Tell You
Let’s face it, when it comes to the bullish/bearish argument about equities these days, the bears have virtually all of the arguments in their favor. Not all, but almost all. However, I always think the bears hurt their case with certain poor arguments that tend to be repeated a lot – in fact, it’s one way to tell the perma-bears from the thoughtful bears.
One of the arguments I have seen recently is that retail investors are wayyy out over their skis, and are very heavily invested in stocks with very low cash assets. This chart, which I saw in a recent piece by John Mauldin, is typical of the genre.
Now, bears are supposed to be the skeptics in the equation, and there is just nowhere near enough skepticism being directed at the claim that retail investors are being overly aggressive. Gosh, the first place a person could start is with asking “shouldn’t allocations properly be lower now, with zero returns to cash, than they were when yields were higher?”
But as it turns out, we don’t even have to ask that question because there’s a simpler one that makes this argument evaporate. Consider an investor who, instead of actively allocating to stocks when they’re “hot” (stupid retail investor! Always long at the top!) and away from them when they’re “cold” (dummy! That’s when you should be loading up!), is simply passive. He/she begins in mid-2005 (when the chart above begins) with a 13% cash allocation and the balance of 87% allocated to stocks. Thereafter, the investor goes to sleep for twelve years. The cash investments gain slowly according to the 3-month T-Bill rate; the equity investments fluctuate according to the change in the Wilshire 5000 Total Market index. This investor’s cash allocation ends up looking like this.
How interesting! It turns out that since the allocation to cash is, mathematically, CASH / (CASH+STOCKS), when the denominator declines due to stock market declines the overall cash ratio moves automatically! Thus, it seems that maybe what we’re looking at in the “scary” chart is just the natural implication of fluctuating markets and uninvolved, as opposed to returns-chasing, investors.
Actually, it gets better than that. I put the second chart on top of the first chart, so that the axes correspond.
It turns out that retail investors are actually much more in cash than a passive investor would be. In other words, instead of being the wild-and-woolly returns chasers it turns out that retail investors seem to have been responding to higher prices by raising cash, doing what attentive investors should do: rebalancing. So much for this bearish argument (to be clear, I think the bears are correct – it’s just that this argument is lame).
Isn’t math fun?
The Phillips Curve is Working Just Fine, Thanks
I must say that it is discouraging how often I have to write about the Phillips Curve.
The Phillips Curve is a very simple idea and a very powerful model. It simply says that when labor is in short supply, its price goes up. In other words: labor, like everything else, is traded in the context of supply and demand, and the price is sensitive to the balance of supply and demand.
Somewhere along the line, people decided that what Phillips really meant was that low unemployment caused consumer price inflation. It turns out that doesn’t really work (see chart, source BLS, showing unemployment versus CPI since 1997).
Accordingly, since the Phillips Curve is “broken,” lots of work has been done to resurrect it by “augmenting” it with expectations. This also does not work, although if you add enough variables to any model you will eventually get a decent fit.
And so here we are, with Federal Reserve officials and blue-chip economists alike bemoaning that the Fed has “only one model, and it’s broken,” when it never really worked in the first place. (Incidentally, the monetary model that relates money and velocity (via interest rates) to the price level works quite well, but apparently they haven’t gotten around to rediscovering monetarism at the Fed).
But the problem is not in our stars, but in ourselves. There is nothing wrong with the Phillips Curve. The title of William Phillips’ original paper is “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.” Note that there is nothing in that title about consumer inflation! Here is the actual Phillips Curve in the US over the last 20 years, relating the Unemployment Rate to wages 9 months later.
The trendline here is a simple power function and actually resembles the shape of Phillips’ original curve. The R-squared of 0.91, I think, sufficiently rehabilitates Phillips. Don’t you?
I haven’t done anything tricky here. The Atlanta Fed Wage Growth Tracker is a relevant measure of wages which tracks the change in the wages of continuously-employed persons, and so avoids composition effects such as the fact that when unemployment drops, lower-quality workers (who earn lower wages) are the last to be hired. The 9-month lag is a reasonable response time for employers to respond to labor conditions when they are changing rapidly such as in 2009…but even with no lag, the R-squared is still 0.73 or so, despite the rapid changes in the Unemployment Rate in 2008-09.
So let Phillips rest in peace with his considerable contribution in place. Blame the lack of inflation on someone else.
.
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The Internet Has Not Killed, and Will Not Kill, Inflation
Every few years or so, this story goes around to great acclaim: inflation is dead, killed by the internet. Recently, we have been hearing this story again, quite loudly. The purchase of Whole Foods by Amazon helped bring commentaries like these to the fore:
“Credit Suisse’s Varnholt Says Internet Killed Inflation” (Bloomberg)
“Low U.S. Inflation? It’s Your Phone: BlackRock Bond Manager” (New York Times)
“Amazon Deal for Whole Foods Casts Doubt on Fed’s 2% Inflation Goal” (Barron’s)
And the list goes on and on. These are some of the more-reputable outlets, and they simply misunderstand the whole phenomenon. This isn’t unusual; almost no one really understands inflation, partly because almost no one these days actually studies something that most people presume isn’t worth understanding. (But pardon my ranting digression.)
The internet has not killed, and will not kill, inflation.
In the late 1990s, the internet was having a much greater relative impact. We went from having essentially zero internet in 1995, to a vast array of businesses in 1999 – most of whom were busy transferring money from capital markets to consumers, by raising equity investments which were then use to subsidize money-losing businesses (see especially: Amazon). And inflation? Core CPI in 1999 was 1.9% (Median CPI was 2.03%).
“But there’s more internet now than there was then!” runs the natural objection. Yes, and the internet was dramatically more impactful in 2001 than it was in 1999. Indeed, as the penetration of the internet economy exploded further despite the recession of 2000-2001, core inflation rose to 2.8% (Median CPI topped out at 3.33%) by late 2001.
There is always more innovation happening, whether it’s the 1940s or the 2010s. Innovation is a relatively steady process on the economy as a whole, but very dramatic on parts of the economy – and we tend to fixate on these parts. But there is no evidence that Uber is any more transformative now than Amazon was in the late 1990s. No evidence that Amazon now is any more transformative than just-in-time manufacturing was in the 1980s (in the US). And so on.
“But the internet and mobile technology pervades more of society!” Really? More of society than the J-I-T manufacturing innovation? More of society than airlines and telephones, both of which were de-regulated/de-monopolized in the 1980s? More of society than personal computers did in the 1990s? We all like to think we are living in unique times full of wonder and groundbreaking innovation. But here’s the thing: we always are.
“But Amazon bought Whole Foods and disrupted the whole food industry! How can you be more pervasive than food?” It remains to be seen whether Amazon is able to do what Webvan and FreshDirect and other food delivery services have been unable to do, and that is to remake the entire delivery chain for food at home. But let’s suppose this is true. Food at home is only 7.9% of the consumption basket, which is arguably less than the part of society that Amazon has already reorganized. Moreover, it’s a highly competitive part of society, with margins that are already pretty thin. How much fat is there to be cut out by Amazon’s efficiency? Some, presumably. But after Amazon makes some kind of profit on this improvement, how much of a decline in food prices could we see? Five percent, over five years? 10%? If Amazon’s “internetification” of the food-at-home industry resulted in a 10% decline in prices of everything we buy at the grocery store, over five years, that 2% per year would knock a whopping 0.16% off of headline inflation. Be still, my heart.
“In any event, this signals that competition is getting ever-more-aggressive.” No doubt, though it is ever so. But here is the big confusion that goes beyond all of the objections I’ve previously enumerated: microeconomic effects cause changes in relative prices; macroeconomics is responsible for changes in the overall price level. Competitive pressures in grocery may keep food prices down 10% relative to price increases in the rest of the economy. But suppose the money supply doubles, and all prices rise 100%, but food prices only rise 90%. Then you have your 10% relative deflation but prices overall still rose by a lot. If the governments of the world flood economies with money, no amount of competition will keep prices from rising. This is why there wasn’t deflation in 2010, despite a massive economic contraction in the global financial crisis and concomitant cutthroat competition for scarce customers in many industries.
So inflation isn’t dead, and neither is this myth. It will come back again in a few years – I am sure of it.
Pre-Existing Conditions and Fire Insurance
When it comes to health care, I continue to be amazed at the utter nonsense that gets tossed about when the discussion comes to insuring pre-existing conditions. The problem seems to be that no one who understands insurance has anything to say about health care legislation, because the question of why you may not want to guarantee issuance of insurance at a given rate no matter what pre-existing conditions the patient has is really not hard to understand. Consider this little vignette:
Caller: Hi, I’d like to buy some home insurance, please.
Agent: Sure, I’d be happy to help with that.
Caller: Does the insurance cover loss from fire?
Agent: Of course. That’s just one of many coverages you get with our insurance. Can you tell me a little bit about your house?
Caller: It’s three bedrooms, two baths. Worth about $300,000. What will the insurance cost me?
Agent: It depends on a few more pieces of information I have to gather from you, but about <pause> $800 per year.
Caller: That sounds great. Sign me up. Do you need my credit card?
Agent (laughing): Just a moment, sir! I need to get more information to give you an accurate quote. Can you tell me about the condition of your home?
Caller: You mean, right now?
Agent: Um…yes.
Caller: It’s on fire.
Agent: Your house is on fire?
Caller: Yep. Can we speed this up a bit?
Agent: Sir, we can’t insure your house against fire if it’s already on fire!
Caller: Why not? Just because it’s a condition that existed prior to my call?
Agent: Well, yes.
Caller: That’s outrageous! I demand you issue me insurance!
Agent (after conferring with management): Sir, it turns out we can offer you insurance on your home…
Caller: See? I knew you could be reasonable.
Agent: …for $350,000.
See, here’s the thing. Insurance is based on the principle of distributing money in a pool of similar risks from insureds who don’t experience the insurable event to those who do experience the insurable event. If someone enters the pool who has already had the insurable event, it’s simply a transfer – there’s no insurance. Person A needs $100,000 in surgeries, and gets an insurance policy that costs $1,000. Where does the rest of the money come from? It doesn’t come from the insurance company, and I think perhaps people don’t understand that point (and Republicans are truly abysmal at explaining it). The rest of the money comes from other insureds. Consider this situation: rather than get private insurance, you and twenty of your fraternity brothers from college – all about the same age and health – decide to form your own mutual insurance network. Everyone agrees that if anyone gets sick, the whole group will pitch in equally to pay the medical bills of the sick person. Now, suppose one person says “can we take my mom in as well? She has early-onset dementia and was just diagnosed with lung cancer. She’d be glad to join the group and pay an equal share, because fair is fair!” Do you think it is fair that mom pays the same amount?
The insurance company makes money if the money they pay out is less than the money they take in, but they also stand to lose if they underwrite the risks poorly and pay out more than they take in. And insurance companies don’t systematically rip people off by underwriting policies super-conservatively. In fact, the evidence seems to be that insurance companies rather frequently fall prey to pressures to move more product, and underwrite policies too aggressively.
The social-justice question can be separated from the health care insurance question. If you feel that everyone should have their medical bills covered, no matter what, then create a federal umbrella program for high-risk insureds and pay for that program with taxpayer funds. That’s explicit: let the cost of health insurance cover the actual cost of health insurance, which involves conditions the risk pool doesn’t have yet, and represent the welfare or charity – because that’s what it is, of course, when others pick up the expense of those unable to pay – as exactly that. After all, the federal government offers flood insurance to landowners who can’t get insurance at a “reasonable price” because the land floods all the time; that is a similar welfare situation in which taxpayers have decided they are willing to foot the bill because it’s a social good that people live or build on the flood plain. (I’m not sure why, but that’s the import of the federal flood insurance program). So there’s precedent for the government taking over pools that are too risky for private markets.
Again, this isn’t rocket science and it isn’t hard to explain. Why doesn’t someone get on television and explain it? How about a commercial using my script?
Profits and Health Care: A Beneficial Connection
I usually try to avoid political commentary in this space, because it has become so personal to so many people. If I point out that a particular program of the “left” is smart, or cleverly put together, then half of my readership is annoyed; if I point out the same about the right, then half of my readership is angry. It doesn’t really make sense to waste article space except on those occasions when a policy has a clear effect on inflation over time, such as when the structure of the ACA made it clear that it would put upward pressure on inflation (as I pointed out in 2013) or in response to someone else’s flawed analysis of a policy, as I did last year when I tackled the San Francisco Fed for their weak argument about how the ACA would hold down inflation because the government would demand lower prices. Actually, there is no policy I have written about more than the ACA over the years – but again, this was economic commentary and not political commentary.
This article will be short, but different in that I am writing it to express frustration with the absolute lack of intellectual clarity on the part of the Republicans in making a particular argument that immediately impacts the debate over health care but also extends far into other policies. And, because the argument is simple, direct, and has tremendous empirical support, I couldn’t restrain myself. I expect this article will not be picked up and syndicated in its usual channels since it isn’t directly about economics or markets, but it needed to be said.
I’ve been stewing about this topic since Tuesday (March 14th), when I happened to catch part of the daily White House press briefing. Press Secretary Sean Spicer was asked a question about the President’s health care proposal, and tap danced away from the question:
Q Thanks, Sean. You mentioned the call with the CEO of Anthem Health. Can you tell me what this proposal of the President means for health insurance companies? Will their profits go up or down under the President’s proposal?
SPICER: Well, I don’t think that’s been the focus of the President’s proposal. It’s not about them, it’s about patients. But I think what it means for them is that they finally get to create more choice and more plans and allow people to choose a plan that fits them. Right now, they don’t have that choice. And, frankly, in more and more markets, companies like Anthem, UnitedHealth, Signa are pulling out — Aetna — because they don’t have the choice and because of the government mandate. I think what we want to do is allow competition and choice to exist so that they can offer more options for the American people.
Q But will those companies make more money under the President’s plan or less?
SPICER: I don’t know the answer to that. That’s not been the focus of what we’re doing now. And at the end of the day, right now they’re pulling out of market after market, leaving the American people with fewer and fewer choices. So right now it’s not a question of — from the last I checked, I think many of them were doing pretty well, but it’s the American people and its patients that are losing under the current system. So I think that there’s a way you can do a little of both.
Spicer’s response was the usual drivel that the Republicans have adopted when they run in fear from any question that includes the word “profits.” To summarize, the question was basically, “you’re doing this to throw a sop to fat-cat insurance companies, aren’t you?” and the answer was “we don’t think about that. No idea. Profits? Who said anything about profits? It’s about patients and choice. And, if anyone gets more profits, it wasn’t on purpose and we didn’t have anything to do with it.”
But this was actually a softball question, and the answer ought to have been something like this:
Q But will those companies make more money under the President’s plan or less?
BIZARRO SPICER: Well, I hope so. After all, the insurance companies want every person in America to have health care – which is the same thing that we want – because the more people they sell their product to, the more money they can make. The insurance companies want to sell insurance to every person in the U.S. The insurance companies also want costs to be lower, and constantly strive to lower the cost of care, because the lower that costs are, the more profit they can make in the short run. But they don’t want lower costs at the expense of health – clearly, the best outcome for their profits is that most people covered by insurance are healthy and so don’t require the insurance they’ve paid for. So, if we just get out of the way and let companies strive for better profits, we are likely to get more coverage, lower costs, and a healthier population, and that is the goal of the President’s plan.
The reason we don’t already have these things is that laws we have previously passed don’t allow insurance companies to offer certain plans, to certain people, which both sides want but which politicians think are “unfair” for one reason or another. Trying to create a certain preconceived Utopian outcome while limiting profits of insurance companies is what caused this mess in the first place.
If you want to beautify gardens in this city, does it make sense to limit the amount of money that gardeners can make? If you did, you would find fewer gardens got tended, and gardeners would not strive to make improvements that they didn’t get paid for. We can see this clearly with gardeners. Why is it so hard to understand with the companies that tend to the nation’s health? Next question.
For some reason, Republicans think that saying “profits are good” is the same thing as saying “greed is good” and leads to caricatures of conservatives as cigar-smoking industrialists. But while at some level it is the desire for a better material outcome – which I suppose is greed, but aren’t there degrees of greed? – that drives the desire for profit, we cannot dismiss the power of self-interest as a motive force that has the effect of improving societal outcomes. “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest,” after all.
Of course, Republicans must also remember that profit without competition is a different animal. If an insurance company creates an innovation that lowers medical care costs, but does not face competitive pressure, then the benefit of the innovation accrues to the company alone. There is no pressure in such circumstances for the company to lower the price to the customer. But consider what happened to air fares after the deregulation of 1978, or to the cost of telephone service when the AT&T monopoly was broken up in 1984, as competition was allowed and even encouraged. Competition, and the more brutal the better, is what causes companies to strive for an edge through innovation, and it’s also what causes the benefit of that edge to eventually be accrued by the end customer. The government didn’t invent cell phones. Motorola did, in order to try and gain an edge against AT&T,[1] but until the telephone monopoly was broken up there were no commercial versions of the cell phone. The first cell phones cost $10,000 in 1983, about $25,000 in today’s dollars, but now they are ubiquitous and cost about 2% as much in real terms. But this didn’t happen because of a government program to drive down the cost of cell phones. It was the profit motive, combined with competition. All that government did was create the conditions that allowed innovation and competition to happen. And wouldn’t we like health care to be as ubiquitous and cheap as cell phones are?
This is not a hard thing to get right. It isn’t hard for people to understand. But for some reason, it seems incredibly hard for politicians to believe.
Note that nothing I have written here should be construed as an opinion about the President’s health care plan, which I have not read. My remarks are only meant to reflect on the utter inability of Republicans to properly convey the reasons that a different approach – one where the government’s involvement is lessened, rather than increased – would make more sense.
[1] The first cell phone call was made by the inventor, Martin Cooper at Motorola, who called his competition with it: the head of the cellular program at AT&T. According to him, he said “Joel, I’m calling you from a cellular phone, a real cellular phone, a handheld, portable, real cellular phone” and he said it got really quiet on the other end of the line.
That Smell in the Fed’s Elevator
A new paper that was presented last week at the 2017 U.S. Monetary Policy Forum has garnered, rightly, a lot of attention. The paper, entitled “Deflating Inflation Expectations: The Implications of Inflation’s Simple Dynamics,” has spawned news articles such as “Research undercuts Fed’s two favorite U.S. inflation tools”(Reuters) and “Everything the Market Thinks About Inflation Might Be Wrong,”(Wall Street Journal) the titles of which are a pretty decent summary of the impact of the article. I should note, because the WSJ didn’t, that the “five top economists” are Stephen Cecchetti, Michael Feroli, Peter Hooper, Anil Kashyap, and Kermit Schoenholtz, and the authors themselves summarize their work on the FiveThirtyEight blog here.
The main conclusion – but read the FiveThirtyEight summary to get it in their own words – is that the momentum of the inflation process is the most important variable (last year’s core inflation is the best predictor of this year’s core inflation), which is generally known, but after that they say that the exchange rate, M2 money supply growth, total nonfinancial credit growth, and U.S. financial conditions more broadly all matter more than labor market slack and inflation expectations.
Whoops! Who farted in the Fed’s elevator?
The Fed and other central banks have, for many years, relied predominantly on an understanding that inflation was caused by an economy running “too hot,” in that capacity utilization was too high and/or the unemployment rate too low. And, at least since the financial crisis, this understanding has been (like Lehman, actually) utterly bankrupt and obviously so. The chart below is a plain refutation of the notion that slack matters – although much less robust than the argument from the top economists. If slack matters, then why didn’t the greatest slack in a hundred years cause deflation in core prices? Or even get us at least close to deflation?
I’ve been talking about this for a long time. If you’ve been reading this blog for a while, you know that! Chapters 7-10 of my book “What’s Wrong With Money?: The Biggest Bubble of All” concerns the disconnect between models that work and the models the Fed (and most Wall Street economists) insist on using. In fact, the chart above is from page 91. I have talked about this at conferences and in front of clients until I am blue in the face, and have become accustomed to people in the audience staring at me like I have two heads. But the evidence is, and has long been, incontrovertible: the standard “expectations-augmented-Phillips-Curve” makes crappy predictions.[1] And that means that it is a stupid way to manage monetary policy.
I am not alone in having this view, but until this paper came out there weren’t too many reputable people who agreed.
Now, I don’t agree with everything in this paper, and the authors acknowledge that since their analysis covers 1984-present, a period of mostly quiescent inflation, it may essentially overstate the persistence of inflation. I think that’s very likely; inflation seems to have long tails in that once it starts to rise, it tends to rise for some time. This isn’t mysterious if you use a monetary model that incorporates the feedback loop from interest rates to velocity, but the authors of this paper didn’t go that far. However, they went far enough. Hopefully, this stink bomb will at last cause some reflection in the halls of the Eccles building – reflection that has been resisted institutionally for a very long time.
[1] And that, my friends, is the first time I have ever used “crap” and “fart” in the same article – and hopefully the last. But my blood pressure is up, so cut me some slack.
Do Shortages Cause Lower Prices?
This is a quick post this morning because it is rainy and I am grumpy and feel like complaining.
Over the weekend I saw a post from a major market news website. I don’t want to name the website, because what they wrote was embarrassingly obtuse. I wouldn’t like it if someone cited my blog when I write something obtuse, so I won’t link to theirs. Consider it professional courtesy.
Here is what they wrote: “The global bond selloff was blamed largely on fears the European Central Bank and the Bank of Japan will eventually run out of bonds to buy.”
At this point, time yourself to see how long it takes you to figure out what’s wrong with that sentence. Score yourself with this table:
1 second or less: Congratulations! You have excellent common sense.
2-30 seconds: You have good common sense but maybe spend too much time around markets.
31-2 minutes: You are smart enough to figure this out, but you watch too much financial TV.
Over 2 minutes: You can be a Wall Street economist!
“I don’t see anything wrong” : You can write for the blog in question.
I could give an answer key, but in the interest of ranting let me present instead an analogy:
In a certain town there is a grocery store, whose proprietor sells apples for 50 cents. One day, a man walks in, flags down the proprietor, and says, “Hello kind sir. I see you have apples for sale. I would like to buy your apples. You see, I have bought all of the apples in this state, and in the surrounding state. I have bought every apple in this town. In fact, I have bought almost all of this year’s harvest. So, I’d like to buy your apples because I have money to buy apples and you have the only apples left.”
The proprietor responds, “Great! I will sell them to you for a nickel each!”
Because, you see, since the apple buyer has just about run out of apples to buy, the price of apples should fall. Right? Well, that’s exactly the point the blog made about bonds: because investors fear the ECB and BOJ will eventually run out of bonds to buy, bond prices fell. If there are really investors out there who think that when the supply of something declines, its price will fall…please introduce me to them, because I’d like to trade with them.
The fact that global central banks continue to buy bonds is the single, best reason to think that yields may not rise. In normal times, bond yields would be rising right now to reflect the fact that inflation is rising, just about everywhere we measure inflation (maybe not in Japan – core inflation in Japan was rising thanks to more-rapid money growth, but when the BOJ lowered rates into negative territory it lowered money velocity and may have squashed the recent rise). But if central banks are buying every bond they can, then prices are more likely to stay high and yields low – even in places like the US where the central bank is not currently buying bonds, because a paucity of Japanese and European bonds tends to increase the demand for US bonds. The risk to the bulls is actually that central banks stop buying bonds.
Maybe that is the weird reasoning that the blog in question was employing: once there are no bonds, central banks will have to stop buying them. And when the central banks stop buying bonds, their prices should fall. Ergo, when there are no bonds to buy the prices should fall. Sure, that makes sense!
Shooting Blanks
Almost eight years after the bankruptcy filing of Lehman Brothers and the first of many central bank quantitative easing programs, it appears the expansion – the weakest on record by several measures – is petering out. The Q2 growth rate of GDP was 1.2% annualized, meaning that the last three quarters were +0.9%, +0.8%, +1.2%. That’s not a recession, but it’s also not an expansion to write home about.
But why? Why after all of the quantitative easing? Is the effectiveness waning? Is it time for more?
I read recently about how many economists are expecting the Bank of England to increase asset purchases (QE) this Thursday in an attempt to counteract the depressing effects of Brexit on growth. Some think the increase will be as much as £150 billion. That’s impressive, but will it help?
I also read recently about how the Bank of Japan “disappointed investors” by not increasing asset purchases except incrementally. The analysts said this was disappointing because the BOJ’s action was “not enough to cause growth.”
That’s because no amount of money printing is enough to cause growth. No amount.
It seems like people get confused with this concept, including many economists, because we use units of currency. So let’s try illustrating the point a different way. Suppose I pay you in candy bars for the widgets you produce. Suppose I pay you 10 candy bars, each of which is 10 ounces, for each widget. Now, if I start paying you 11 candy bars instead of 10, then the price has risen and you want to produce more widgets, right? This, indirectly, is what economists are thinking when they think about the effect of monetary policy.
But suppose that I pay you 11 candy bars, but now each candy bar is 9.1 ounces instead of 10 ounces? I suspect you will not be fooled into producing more widgets. You will realize that I am still paying you 100 ounces of candy per widget. You are not fooled by the fact that the unit of account changed in intrinsic value.
Now, when the central bank adds to the money supply, but doesn’t change the amount of stuff the economy produces (they don’t have the power to direct production!), then all that changes is the size of the unit of account – the candy bar, or in this case the dollar – and the number of dollars you need to buy a widget goes up. That’s called inflation. And the only way that printing more money can cause production to increase is if you don’t notice that the value of any given unit of currency has declined. That is, only if I say I’m paying you 11 candy bars – but you haven’t noticed they are smaller – will you respond to the change in terms. This is called “money illusion,” and it is why money printing does not cause growth in theory…and, as it turns out, in practice.[1]
There is nothing terribly strange or unpredictable about what is going on in global growth in terms of the response to monetary policy. The only thing strange is that eight years on, with numerous observations on which to evaluate the efficacy of quantitative easing, the conclusion appears to be that it might not be quite as effective as policymakers had thought. And therefore, we need to do lots more of it, the thought process seems to go. But anything times zero is zero. Central banks are not shooting an inaccurate, awkward weapon in the fight to stimulate growth, which just needs to be fired a lot more so that something eventually hits. They are shooting blanks. And no amount of shooting blanks will bring down the bad guy.
[1] I address this aspect of money, and other aspects that affect inflation, in my book What’s Wrong With Money: The Biggest Bubble of All.
Twits and Brits
I want to talk today about some of the really important pieces of information that circulated this weekend. First, I am certain that everyone is familiar with the following chart, which made the rounds after the Brexit vote. It shows an enormous surge in the search term “What is the EU” after the Brexit vote was completed:
This chart, or something very much like it, was all over the place. Oh, wait! I just realized that I forgot to put the axes on the chart! Here it is with a few more relevant pieces of information – incidentally the same information that was left off the original chart. It turns out that it wasn’t the chart I thought it was. Sorry about that…they looked the same.
(For the record, after an extended period of indolence, on Thursday I went for a run; on Friday I went for a run before putting on any other shoes first; on Saturday I went for a run and then later put on different shoes to go to a cocktail party.)
Is it too much to ask that people seeking to insult the British voters at least put some effort into their attempt? Ignore for a moment the simple fact that we don’t know who was searching this – it might well have been the people who voted to Remain, after all – and so the story line that the people who voted Leave were just morons gets no support from this chart. It also turns out that this was the second-most-searched term only for one small time segment: early in the morning after the vote. By 5am it was eclipsed by questions about the weather. Oh my – it seems the Britons also don’t know what weather is! Also, as the Telegraph’s skeptical story (linked above) points out, the raw number of people asking the question was only on the order of 1,000 – it was just a massive increase since it hadn’t been previously asked very much. This is where not having axes matters…it turns out this is a non-story, and nonsense.
Another piece of nonsense I want to point out is more general. I have seen several Twitter polls and other polls in something like this form:
Q: What effect do you think that Brexit will have on the global economy?
a) Deeply contractionary
b) Moderately contractionary
c) Somewhat contractionary
d) Expansionary
Now this is nonsense because the actual result not only has nothing to do with opinion, it’s not even clear why we would care about people’s opinion in this case (unless we are trying to show how pervasive the negative news stories are, or something). Polls work comparatively well when there is not a lot of information inequality – for example, when each person is asked about his or her own vote. But the poll above is analogous to this poll:
I submit that only me, and my valet, have the information sought by this poll; all other respondents have zero information. Therefore…what’s the value of the poll? Unless I or my valet are respondents, precisely zero; if we are, then the value is inverse to the number of other respondents diluting the response of the people who know.
Similarly, there is likely some information asymmetry among respondents to the poll about the effect of Brexit on the global economy. I would respectfully suggest that most people who are responding are saying what they have heard, or what they fear, or what they hope, while some people – macroeconomists, for example – might have actual models. To be sure, those models are probably only slightly better than the fearful and hopeful assumptions put into them, but the point is that this poll is nonsense in the same way that polling people about what they expect inflation next year to be is nonsense. The vast majority of respondents have no way to evaluate the question in a structured way, so what you are capturing is no more and no less than what people are worried about, which is itself just a reflection of what they’re seeing and hearing…for example, on Twitter.
(For what it’s worth, I think that thanks to the weakening of sterling Brexit is likely to be mildly stimulative to the UK economy, as well as somewhat inflationary, and slightly contractionary and disinflationary to the rest of the world. But the question about global effects is a trick question. Obviously, global production and consumption are unlikely to change much in real terms just due to the arrangement of trade flows. More friction in the system to the extent that Europe puts up significant trade barriers against the UK – something I don’t view as terribly likely – will lower global output slightly and raise global prices.)
These flash polls and Google trends data are part and parcel of the Twitterization of discourse. They have in common the fact that they can be snapshot and draw eyeballs and clicks, whether or not there is any content to the observations. In these cases, and in many others, there isn’t.
Here’s a thought: why don’t we wait a few months, or better yet a few years, before we judge the impact of Brexit? Sometimes, having actual data is even better than a Twitter poll.
