Dr. Sherry Jarrell

Audio of Interview on State of the Union Address

1-25-12 Sherry Jarrell WFU State of Union

The Insanity of Government Spending

Until Congress and President Obama can find the discipline to cut (non-defense) spending, all spending increases must stop. Otherwise, obviously, we will be stuck with them forever -- this year's additional spending will become the spending Congress refuses to cut NEXT year.  

 

A Tutorial on Basic Economics for President Obama

Consider it my belated birthday present for the President - a mini-primer on some basic irrefutable economic facts.  

Let's take his statements today on the extension of the federal gas tax. Here is what will happen should Congress fail to extend those taxes, according to Obama's view of the world: 

According to the White House, there are a million jobs riding on the highway bill and over 4,000 workers will be furloughed immediately if it is allowed to expire. “That’s just not acceptable,” Obama said. “It’s inexcusable to put more jobs at risk in an industry that’s already been one of the hardest hit over the last decade. 

Okay..........let me see if I can make this simple.  Businesses create jobs by staying in business and being profitable.  Profits are created when revenues are higher than costs. Taxes are part of a business' costs, as are regulations, and fees, and paperwork, etc.   If the federal taxes rise, costs in that industry will rise, output falls, unemployment goes UP -- not DOWN -- and prices to you and me would rise.  So, taxes UP, employment DOWN.  Fact.

I suppose Obama is talking about the government jobs paid for with this period's tax revenues, but those are not real jobs. Those are not the same as the jobs created in private industy. No, this period's government "jobs" are paid for with this period's tax revenues confiscated from private industry, which then slither through the political bureaucracy losing 40-50% of their value along the way, finding their way to unions, special interest groups, and causes that will support the Obama White House.  And that is just this period; next period, the process starts anew, except they always need more, because they can't ever cut any government spending. 

Private industry jobs are, well, actual jobs!  They are evidence of something working right.  They are the result of real business producing a real product or service and selling it to a free people who voluntarily choose to spend their hard-earned money on that item.  If a business does all of that well they earn --on my gosh, brace yourselves for a dirty word -- PROFITS!!   And they can then use this period's profits to reinvest in the business in order to try to earn even higher profits, can hire more people, produce more products..you know, employment and GDP and quality of life?   Businesses can actually support themselves!  They generate funds internally or, if they have to borrow or sell equity, they have to convince the lender that their future profits are sufficient to pay the lender back.  None of it by force or edict or regulations or threat -- all due to the wonderfully objective, voluntary free-market system.  

No, folks, it is a fact of life just like gravity and matter:  when you raise costs to business, profits fall, less is produced, unemployment goes up, prices go up, and we are all less well off.   Any one who has run a business, or known someone who runs a business, knows this is true. It's the economics that sometimes confuses them.  Maybe because people like President Obama and the popular press are the ones trying to invoke economic theory and facts to make claims that make absolutely no sense.  Hence, the offer of the remedial training for our Commander in Chief.

And don't even bring up the deficit....our second remedial lesson for the day, Mr. Obama, is the deficit. Mr. President:  when government spending, G, is greater than tax revenues collected, T, we have a deficit. The accumulated deficit is the debt.  You know, the two things that are increasing at record levels under your leadership?  So, you can either lower G, which would help lead the country back to economic liberty and its bounty, or we can raise taxes, which would lead to the series of negative events noted above.  And every time you ask for more tax revenues to fix the deficit, you make it abundantly clear that you do not understand that spending is the problem, not taxation.  

This, sir, is not an opinion, it is not wishful thinking, a theory or a political point of view.  It is such basic economic fact that I cannot find any more basic words to try explain it to you.  Maybe a set of props that you could touch and smell and move around and count, like in a shell game?  Maybe you are a tactile learner!  I'd be happy to give it a try -- just get and touch and we'll get it done!

Respectfully,

Sherry L. Jarrell, Ph.D. 

Fed's Pledge of Low Rates -- Good News or Bad?

The Federal Reserve pledged on August 9th to maintain near-zero interest rates through the summer of 2013.   This was an unprecedented move by policymakers and one has to wonder what they were trying to accomplish by committing themselves now to a specific policy for the next two years.

The federal government really has only two tools for influencing the macroeconomy -- fiscal policy and monetary policy.  By committing themselves now to a specific interest rate target, they have essentially neutralized one of those two tools.   

I see the announcement as an admission on the part of the Fed that they are unable to further stimulate the economy by lowering interest rate targets.  The rates are already as low as they can go; there is no room left for trying to stimulate the economy with actions.  All they have left is talk; tell the market that they are going to keep the rates low.  It's a fairly impotent policy, not just because it's just talk, but because the pledge is vacuuous:  if conditions change, I certainly hope and expect that the actual policy will change as well.

And we have to recall what a low interest rate policy actually means:  the Fed will have to increase the money supply at whatever rate is required to satisfy money demand -- which is beyond their control -- at the target interest rate.   The Fed is clearly banking on (no pun intended!) money demand remaining anemic, otherwise the very increase in money supply which is intended to keep interest rates low would push nominal interest rates up due to inflationary pressures.   

From where I stand, the Fed's handcuffing itself to near-zero interest rates over the next two years smacks of both desperation and gloom.   They are desperate to wield monetary policy, to "do something," even when rates are already as low as they can go.  And for the Fed to commit to near-zero rates over the longer term says very clearly that they do not expect the economy to recover for some time.

S&P Ratings - They either mean something or they don't

You cannot have it both ways. Either the bond credit ratings mean something, or they don't.  Public officials cannot point to the AAA ratings as evidence of good policy, then lambast them as "inaccurate" and "flawed" when they drop to AA+....or below.  

It is a fact that the ratings agency does not originate information; it simply gathers and interprets data that are publicly available to all of us.   The rating itself, however, is unique in that it summarizes a particular agency's forecast of how likely the US government is to repay its debt and sustain its borrowing needs.  

Don't get me wrong -- there is a LOT of information out there about the risk-adjusted rate of return on US debt to be digested.  But we don't have to re-examine it from the ground up -- we need only look at the marginal changes, the most recent developments, the direction of change, to update our expectations, and -- in my view -- to understand easily why S&P downgraded the debt.  

I think most of us realize that all government spending is financed by the private economy but I'm not as sure that everyone realizes that the return on government debt is also enabled by the productivity of the private economy.   The more productive the private economy, the higher rate of real return we can afford to pay on U.S. debt, and the more willing others are to buy our debt.  Being able to generate a return on debt is a good thing -- it's a sign of a healthy economy.   

Then there is the other side of the equation: the required return on debt from the point of view of the lender. The lender assesses the risk (or likelihood or uncertainty) that they will get their money back (and that the "money" is worth the same per dollar....so we are ignoring inflation just to simplify things).   The less certain they are, the higher the return they are going to demand before they buy the debt.  This required rate of return is a cost to the economy -- a higher cost eats away at profits, and makes the economy less productive, less able to reinvest, employ capital and labor, and grow.  

In the simplest terms, government spending is supported first by taxes and then, when those run out, by borrowing.  The debt ceiling debate made it clear that Washington was unwilling or unable to reduce or curtail government spending, which was on its way to starving the private economy of the sufficient earnings, liquidity and financing to continue to be productive.  The wealth creation capacity of the private economy is vast and impressive and has somehow miraculously employed labor and capital and supported AAA rating returns on government debt for a very long time, but it's not limitless.  

No, the ratings do not originate information. They simply publicly confirmed what many of us who understand and respect what private enterprise does day in and day out saw coming:  the current level of government spending is unsustainable. The private economy cannot take much more of the oppression and costs imposed by government policy, taxes, fees, regulations and -- perhaps the most troubling and insidous of all -- the public denigration and disparagement of the private economy, Wall Street and capitalism by our President.

 

It will be very interesting to see if this was a surprise to the markets.  

It's Official: Geithner knows NOTHING About Economics

I'll let Geithner's own words display his ignorance about the source of economic wealth creation in our economy and the size and sign of the Government spending multiplier.  Patently unbelievable: 

Geithner, continuing, argued that if the administration did not extract a trillion dollars in new revenue from its plan to increase taxes on people earning more than $250,000, including small businesses, the government would in effect “finance” what he called a “tax benefit” for those people.

“We're not doing it because we want to do it, we're doing it because if we don't do it, then, again, I have to go out and borrow a trillion dollars over the next 10 years to finance those tax benefits for the top 2 percent, and I don't think I can justify doing that,” said Geithner.

Not only that, he argued, but cutting spending by as much as the “modest change in revenue” (i.e. $1 trillion) the administration expects from raising taxes on small business would likely have more of a “negative economic impact” than the tax increases themselves would. http://www.cnsnews.com/news/article/geithner-taxes-small-business-must-rise

Significant Reversal by Eric Holder

U.S. Attorney General Eric Holder, on behalf of President Obama, has reversed himself. The five alleged co-conspirators in the 9/11 bombings will be tried by military commission at the Guantanamo Naval Station in Cuba.

I refer you to my post on the subject from November: http://www.sherryjarrell.com/2010/11/terrorist-wins-we-lose.html

 It's about time for this particular about face.  

The Sad State of Macroeconomics Theory

I have to get this off my chest.  Macroeconomics is not economics at all.  What little sense it makes can be traced directly back to the bits and pieces of microeconomic that is uses along the way.  

Macroeconomics is basically nothing more than glorified national income accounting with a lot of politics thrown in.  And accounting is the antithesis of anything finance and economcis.

I believe that Keynes was looking for a theory that would support his idea for how to fix a depressed economy.  And his work is what justifies most of the government's fiscal policy to this day.  

The problem is that his view of the macroeconomy is incomplete, illogical and, most troubling, it is static.  

Reader's Question: Are Retiree's Driving Stock Market?

In a recent comment Financial Ruin asked:

Despite the economy's seemingly poor condition, the stock market is moving upward. One of my acquaintances insisits that what is driving the stock market is not economic growth, but the maturing baby-boomer's need to put their money "somewhere". In other words, the retirement money in 401K's by the soon-to-retire population bulge known as the baby-boomers is driving the stocks, not value. Any truth?

My response:  No, not if by that your friend means that the shift in investment funds itself is what is driving the stock price up. 

What drives any stock's price, and thus all stocks' prices, is the market's assessment of the current value of its future profit stream, discounted for risk and time. If a stock's price goes up, this means that the marginal investor expects the firm's profits per unit risk to rise.   It can be due to either firm-specific developments or to economy-wide developments which affect the firm's revenues, costs, or risks.  

Just because there is "more money invested" does not mean that stock prices will rise -- the act of choosing to buy a stock does not make the management of the company smarter, or its production processes better, or its cash flows less risky.  But the belief by the market that the company is smarter, more efficient, or less risky will, when investors trade on that belief, cause its stock price to rise.  

Think about this issue at the level of the individual transaction:  what would make you willing to pay $10 for a share of XYZ, Inc. instead of $9? If you believed that you would get a higher return on  your investment, even after paying a higher price. You see higher profits per unit risk in the future of this company, or you follow the investment strategy of someone who expects good things of this company.  It is the forecast of higher cash flows and/or lower risks that generates the demand and encourages investment, not the size of the pile of money being invested.

Better?  Or still too subtle?

Reader's Question: Is Bernanke the problem?

Reader Randy Tanner asks "Is Bernanke the problem?"  in response to a recent article by Vasko Kohlmayer titled Why Isn't Peter Schiff Head of the Fed? In that article, Kohlmayer makes the case that over the period 2002-2007, while Ben Bernanke was saying that the economy was strong, Peter Schiff was warning us about the coming housing bust, rising unemployment, and falling dollar.  

The short answer is no, Bernanke is not the problem, not in the way Kohlmayer implies, at least.  The Fed did not cause the financial crisis.  I personally do not like everything about the way the Fed responded to the crisis, in particular their purchase of toxic assets, but they did not cause the crisis.  

And, no, Schiff should not be running the Fed, even if I believed that successfully predicted falling housing prices, rising unemployment, and a weak dollar. Which I don't.  But again, not in the way you might think.

Being a good economist does not require one to predict the state of the economy during a certain window of time.  In fact, the very best forecasters know to not even try to predict economic activity beyond the next quarter.   

No, what good economists understand is cause and effect, and most of that occurs at the level of the firm, the consumer, or the transaction.  Extrapolating that to the level of the economy involves so many countervailing factors that "predicting" what will happen at the macroeconomic level is not really meaningful.  In other words, you can find someone out there at any point in time making predictions about macroeconomic outcomes who will end up being "right."  Eventually.  On some level.  And this does not help us to make better policy, to allow the economy to be as healthy and productive as possible.

Let me give you a specific example to help make my point.  And I agree at the outset that Randy's point is a difficult one to argue against, and that my point is fairly subtle.   What I believe was perfectly predictable was the impact of the political decisions that mandated easier and cheaper access to home ownership, and charged Fannie Mae and Freddie Mac with implementing those policies.  When the government inserts itself between suppliers and demanders, as it did with these policies, it distorts the price signal and gets either too much or too little of that economic activity.  

So what happened here?  Because of the mandates, banks made loans to individuals that they would not have otherwise, largely because Fannie Mae and Freddie Mac were standing in the ready to buy those mortgages from the banks and get them off the banks' books.  So the banks did not have to bear the risk of those homeowners defaulting on the loan.  Therefore, those mortgages were underpriced.  And if the interest rates had been higher, where they should have been, less creditworthy individuals (which include high income individuals overextending themselves with a second mortgage as well as low-income individuals overextending themselves with too much house) would have not have applied for the loan in the first place.  

If you lower the price of an activity, the demand for that activity rises.  So the mandates led to a situation where a larger-than-sustainable fraction of existing mortgages were high risk, were susceptible to foreclosure should the economy take a turn for the worse. THAT is what is predictable, not that the economy in fact took a turn for the worse.   

Left to their own devices and profit-incentives, banks are perfectly able to price mortgages and absorb the risk that a fraction of those mortgages will go belly up.  And the private economy is perfectly well equipped to pool those mortgages, combine the funds, and issue and fairly price various mortgage-backed securities.  

The problem centers on the fact that a politically motived player in the form of Fannie Mae and Freddie Mac used our tax dollars to pursue a social agenda instead of a dollar of profits.  Mr. Schiff seems to overlook this fact as a primary contributor to the financial crisis, and Mr. Bernanke, though I suspect is fully aware of the issues surrounding Fannie and Freddie, is not responsible for what Fannie Mae and Freddie Mac do, and must enact predictable monetary policy regardless of their actions.  

Again, I do have issues with the Fed's actions over the last few years, and I do worry about inflation and the loss of autonomy of the Fed to the brutish attitude of the Treasury, but those are separate issues in my mind from the supposed ability of Mr. Schiff to predict the housing crash and the financial crisis of the recent past.  

It is possible to flip ten heads in a row; unlikely, but possible.  And the 10th toss does not predict the 11th.  They are independent events.   Predicting the 11th toss based on the preceding 10 makes as much sense as predicting that housing prices will fall because they are now high.  Neither prediction is based on economics.   But when you use tax revenues to subsidize high-risk mortgages, economics correctly "predicts" that more foreclosures and financial distress will occur than would have otherwise. That's a prediction you can count on.