How to rebuild the middle class

The COVID-19 pandemic and the related economic shutdowns and fallout has greatly exposed the deep class divisions in our country. The divisions have been there for decades of course. The “hollowing out” of the middle class has been occurring in waves throughout the long period of economic transformation that began in the early 1970s, as the industrial age gave way to the information age. For most of this period, the hollowing out has been explained away by many as the natural forces of economics at work. The pandemic, on the other hand, is a true “Black Swan”, an event exogenous from the economic system, shining a light on our society from a completely different angle than usual.

The vast iniquities are now on full display. The majority of those in the upper reaches of our economic system work from home and home school on broadband connections with adequate savings to stock up on supplies; large businesses serve us via ecommerce and delivery. The fate of the working class is laid bare for all to see: lack of savings, reliance on school for day care and meals, poor access to health care, no sick leave, high fixed costs tied to rent and debt service, jobs that don’t provide benefits even when employed, the risk of bankruptcy in the event of a personal or health crisis. The small proprietor faces many of the same challenges, with the risk of starting a business so high that entrepreneurship in the United States is a record low levels as a percent of the population.

Yes, these issues have been there for a generation or more, but when endogenous to the economic system the meritocratic elite of the country attributes the disparity to a natural outcome of personal choices and talent in the free market for labor. When the trigger is an exogenous shock like COVID-19, the random nature of fate reveals itself to the fortunate as well.

The U.S. government’s historical role in promoting the middle class

The Founders believed that the fate of the Republic lay in the hands of a virtuous middle class (even though that term was not used at the time). From the Founding forward the government of the United States has usually had a program to promote the middle classes. In the beginning the debate was between Alexander Hamilton’s “American System” of protective tariffs, a central bank and funding of internal improvements and Thomas Jefferson’s vision of an agrarian republic built by yeoman farmers. Both systems had influence over the early republic, with Jefferson’s vision having the upper hand through the Civil War and its aftermath. Eventually, when the Republicans took power following the Civil War, Hamilton’s vision won out, with high protective tariffs, the promotion of railroads and industrial development and eventually restrictive immigration to protect workmen’s wages.

During the Great Depression, Franklin Roosevelt’s New Deal promoted unionization for the working class and the beginning of a social safety net in the form of Social Security, supports for farmers, banking regulation, promotion of single family housing and culminating with Medicare under Lyndon Johnson’s Great Society. The economy was dominated by big manufacturing and consumer products companies that, through a quirk of law and history, became the providers of employee benefits: pensions, health insurance, sick leave, paid vacation, etc. Industries tended to be consolidated into a small number of large companies with strong unions and what was effectively regulated or managed competition.

Today’s hybrid system

In the late 1960’s and early 1970’s the New Deal system became harder to maintain. Why this happened is beyond the scope of this essay, but in the effort to advance our economy in the face of competition from our NATO allies and Japan, the government began deregulating industries, finance and the labor markets. As a share of the economy, manufacturing began to decline, and the service industries began to rise. Many of the larger service businesses, particularly those in higher margin industries like finance, technology and entertainment could afford to maintain the old system of company-provided benefits. But many smaller businesses and those in lower margin sectors like retail, hospitality and restaurants could not, especially as benefits like health insurance became more expensive. The post Cold War period of globalization and high levels of low skill immigration brought many benefits but also accelerated the pressure on the U.S. working class.

During the period from the 1970’s to the 2010’s we have maintained the basics of the New Deal system of employer-provided benefits plus certain universal benefits like Social Security, Medicare and unemployment insurance. Many social safety net programs added in the late 1960’s and later, on the other hand, have been non-universal benefits to support those that fall out of the employer-provided benefit system like Medicaid, welfare and food stamps. Because these programs would benefit only subsegments of the population, they have been easy to scapegoat as political payoff for the undeserving and have therefore never been particularly popular among the general public. Hence the relatively low popularity of the Affordable Care Act, while theoretically available to all, is also seen as benefitting only a few at the expense of many.

The tension between employer-provided benefits and non-universal benefits will continue to grow if the current trends are allowed to go on. Free-market conservatives have traditionally disliked non-universal benefits as they are perceived, with some justification, as paying people not to work. But in the highly-globalized, highly-competitive, free-market economy the pressure on margins, wages and benefits faced by businesses outside of technology, finance and certain large enterprises will continue. Couple this with the highest health care costs in the world and the trend toward service economy work and more people will be forced into the haphazard system of non-universal benefits or no benefits at all…a barbell system of a protected upper middle class, a dwindling cadre of manufacturing workers clinging to the Post World War II system in the middle and a growing class of unprotected service workers.

The way forward

To rebuild the middle class we need to both slow the decline of manufacturing work and make service work pay. The economy is going to keep transforming into a service economy whether we like it or not, and that does not mean that the only good jobs need to be in technology and information. There is no reason that we can’t set up a system to put pride and remuneration into service work, no reason we can’t build a solid middle class that includes not only manufacturing, government and health care workers but also waiters, fitness instructors, hairdressers, hospitality workers, retail and wholesale workers, sanitation workers and so on.

The policies needed to build this middle class are all on the table now and being debated individually, but not as a cohesive program. The program would basically be a fusionism between the policies of Trump and Obama:

  • Core protections for U.S. workers
    • Higher minimum wages, so those who work in service businesses make enough to not have to rely on non-universal benefits while employed;
    • Moderate tariff protection, to encourage more production in North America;
    • Restrict low-skill, particularly illegal, immigration, so there is less competition for low wage or off-the-books labor;
  • Encourage key areas of investment
    • Invest in basic infrastructure, to encourage more construction work and make our economy more productive;
    • Encourage more housing construction, particularly in cities and inner suburbs by reforming land use regulations that discourage construction, thereby keeping housing costs reasonable and encouraging construction work;
    • Create an industrial policy for key sectors to move production to the U.S., as the crisis has exposed the weakness that comes from reliance on global supply chains. There is no long-term economic reason that we can’t produce the medical devices, pharmaceuticals, semiconductors, communications equipment, defense goods, auto and aerospace parts, appliances, furniture, capital goods, aluminum and steel that we need in the U.S. or North America;
  • Beef up the social safety net to add universal, portable benefits
    • Build on the Affordable Care Act, mainly the exchanges, to create a system of universal health care that is portable and not employer-based. Health care premia should remain tax-deductible for all, so there is no disparity between employer-based and ACA policies. The Medicaid portion of the ACA should be reduced to encourage liquidity in the exchanges;
    • Build on the 401k system, to provide a universal system of portable savings accounts with policies that encourage savings among the general public;
    • Provide universal day care and pre-school, to reduce the stress on two-income households or single parents;
    • Create a policy of universal sick leave, to prevent workers from having to come to work sick (but being careful to not encourage abuse, which may be difficult) while also reforming the disability insurance system to discourage abuse;
  • Tackle two areas of extreme inflation that are a result of our hybrid system
    • Regulate health care costs, to rein in health care inflation since Americans already pay more for health care than any country in the world;
    • Reform and regulate higher education funding, to reduce indebtedness and rein in higher ed inflation, including adding training credits to the unemployment insurance system;

I have been a free market capitalist my whole life and am well aware of the economic arguments against the programs highlighted above. The economic transformation of the last 50 years has brought many great benefits, including technological innovation, cheaper consumer goods and a huge reduction in poverty around the world. I have also seen the negative side effects as we have created a winner-take-all economy where vast swaths of our country and people are left behind with declining towns, stagnant wages and soaring costs for necessities like health care and education.

How this get paid for will have to be the topic of another essay, but it should be noted that we are paying for most of these things already anyway, and in the case of health care are paying more than other countries that have universal health insurance. Universal social insurance taxes should be preferred, with subsidies from taxes on higher incomes as the secondary form of funding, rather than the other way around. Such a system, as is used in Europe and in the U.S. for Social Security and Medicare, has proven much more durable and popular than making one group of people pay for the other.

I am not calling for an end to the free market, or even globalism, but am calling for a shift in the balance between economic efficiency and looking out for our fellow countrymen. We should be focused on building a middle class for the information age, one based on remunerative work, healthy families and strong communities.



Mid-year 2013 Market Overview: The Plates are Shifting

My core base case at this time is that we are in the midst of a regime change in the market driven by a shift in the economic cycle. The timing of economic and credit cycles both in the US and abroad should be turning the market relationships of the last 10 years on their heads. I'll cut to the chase: over the next several years I expect the dollar to strengthen, I expect growth stocks to outperform value stocks, I expect real interest rates to rise and bond prices to fall (but only modestly), I expect inflation to remain subdued, I expect commodity prices to fall, I expect emerging markets to have problems, I expect Europe and Japan to recover modestly, and I expect US real estate to perform ok.

Cyclically, I would compare where we are today to a subdued version of the mid-1990s. The 1990s had the benefit of being within the Kondratiev Autumn of the long cycle, helped along by the tailwind of falling interest rates and risk spreads (and rising investment valuations) and both consumers and business leveraging up with debt. The 2010s are in the Kondratiev Winter, where interest rates are already low (and risk spreads are already tight, thanks to the Fed's reflationary actions) and consumers are still reducing their debt leverage.

We are heading into the most powerful part of the upwave in both the 15-20 year infrastructure cycle and the 7-10 year standard business investment cycle. Barring some major catastrophe that throws the economy off course, the next 2-5 years are likely to be the best economic years we enjoy in the whole period from 2008 to the mid 2020s, driven by the continued recovery in business investment.

We are probably exiting the "Rounded Bottom" recovery and entering into a US-centric expansion.

So with that background, let's discuss the state of the markets:

Interest Rates

The chart below breaks down the current interest rate yield and risk curves:

Chart One

(click to enlarge)



As I discussed in "Why Gold is in a Bear Market", real interest rates have risen since my last market update in Q2 2012 "Have Corporate Profits Peaked?" as demand for private investment capital has risen. Private investment remains at levels normally associated with recessions (mainly due to low levels of real estate investment), but today's current level of real interest rates (represented by the interest rate on TIPS in the chart above) is also abnormally low. We are moving from depression levels of real rates to recession levels instead. An improvement nonetheless.

I actually don't think the Fed has helped the yields of treasuries that much…if anything the Fed has kept rates elevated by maintaining inflation expectations in the equilibrium range of 2.25% rather than at the lower levels had deflation been allowed to run its course. Where the Fed has helped the markets is by crowding out private investment from the risk-free treasury bond and government-back mortgage securities market and into the risk markets of corporate bonds and equities. This is evidenced by the lower-than-equilibrium risk spreads even during a relatively weak economy.

The only area where risk spreads are wider than usual is the municipal bond market. Seeing what happened to Detroit recently may make the reason for this obvious. Nevertheless the only cheap asset class in the fixed income market is long term municipal bonds. Floating rate bank debt funds can also make an attractive option to get some spread while hedging against the risk of rising interest rates (which make bond prices fall).

US Dollar

The dollar has been rallying a bit but has remained cheap as the Fed has remained more aggressive on the easy money front than the European Central Bank. Nevertheless as real interest rates rise in the US with increased investment demand, I expect the dollar bull market to continue. Go back to my 2011 piece "Get Ready for a Dollar Bull Market" to see more on why I think we're due and what a stronger dollar means for the financial markets.

Chart Two

(click to enlarge)


As we can see in Chart Two above, in nominal terms against major currencies the dollar has rallied to near the top of its long term (downward-sloping) channel. Against a trading basket of all currencies, however, and in real terms (which is what matters economically), the dollar is still weak. This means that the dollar still has alot of potential to rally against emerging market currencies and that the US terms of trade remain pretty favorable (good for exports and US industrial activity).


The housing market got a good bounce off the bottom in the second half of 2012 and so far in 2013.

Chart Three

(click to enlarge)


US housing has gone from being a cheap asset class to a fairly valued one pretty quickly. The stabilized economy and financial system should be good for housing, while rising real interest rates provide a headwind. Its a fine time to buy a house, but not for speculative purposes, assuming the overhang of the bubble will prevent another bubble run to rival the last decade's.


Figuring out the right price for stocks is trickier. I've long been unenthused about stocks, even as they've risen strongly over the past four years. I've owned them because I maintain a diversified portfolio, but I've felt they are riding the advantages of low interest rates, a cheap dollar, moderate inflation and a particularly capital-friendly environment to artificial heights. That said, the absence of alternative, attractively-priced investment options make stocks seem like the best of a bunch of bad choices.

Here are my calculations:

Chart Four

(click to enlarge)


The market is priced at about 16x the $103 earnings assumed by S&P analysts for 2013. That, on the surface, would appear to be fairly priced. I believe, however, that we should price stocks off of long term trend earnings (which smooth out rises and falls in business and inflation cycles) which are currently $66. The 16x multiple (which is the fair multiple) on trend earnings leaves a fair value of the S&P of 1,049, 38% below the current level of 1,686. It should be noted that S&P earnings fell (slightly) in 2012 compared with 2011. Although they do appear to be rebounding in 2013. Perhaps fiscal austerity, a stronger dollar and higher real interest rates won't hurt earnings because the economy is going to move into a higher gear, which I do believe it will.

I have a problem with this alternative hypothesis. The analysis shown in Chart Four shows that my trend line of real earnings shows growth of 2.5% per year over the past 50+ years, which makes perfect sense, as it is in line with or slightly below real GDP growth. If we add a 4.5% equity risk premium to the equilibrium long term treasury bond yield, we get an assumed long term return on stocks of 8.8%, in line with long term performance. If we assume the 8.8% return, and real earnings grow at 2.5%, inflation is assumed to be 2.25% (which is clearly the equilibrium level that has been assumed by the market over the last four years), and we assume the payout yield is 60% (dividends plus buybacks), we mathmatically arrive at the PE of 16x, which is also the historical average (a little higher even). The theory is sound.

So where could I be wrong? My trend line could be using the wrong y-intercept, because it doesn't have data going back far enough. Perhaps if earnings were higher in the 1940s and 1950s, the full long cycle trend would have a 2.5% growth line cutting through today's assumed earning level of $103 as the mid-cycle trend earning level. The other thing that could be wrong is that the equity risk premium has shifted permanently to a lower level, like 3%. Or maybe earnings will continue to grow faster than the economy.

This last chart is what makes me nervous when I try to embrace any of the above theories:

Chart Five

(click to enlarge)


Corporate profit margins are at a peak level as a percent of GDP. Given the historical pattern (i.e. margins don't seem to linger a peak levels very long), we should assume that corporate earnings start growing more slowly than the economy for a spell. Perhaps margins will continue to hit new records (possible) or perhaps it won't matter because the economy is going to start growing very quickly. I don't see a catalyst to make stocks plunge anytime soon, but I'm weary nonetheless. I will continue to take profits if stocks rise and keep myself hedged. Stockpicking is the name of the game, I think. Large cap growth will likely have the upper hand.

I am not a financial adviser and write these articles purely for my own amusement. Please consult your financial adviser before acting on any of the recommendations posted here. 

Why Gold is in a Bear Market

First of all, apologies for not writing this column many months ago. I haven't had much time to sit down and convey my thoughts on this matter. Most of the money being short gold has probably been made, but I'd like at least to do my best to hypothesize why gold has slipped into a major bear market even while the Fed and other central banks around the world have been "printing money" with their QEs, Abenomics and the rest. Gold has slipped into a bear market because the improving economy and increasing private investment are pointing to an eventual normalization of real interest rates to a positive level away from a gold-friendly negative level.

Gold as a neutral currency

Over the long term, the way to look at gold is as the "neutral currency", i.e. a store of value against paper currency inflation and the price of things in general. In the short run, however, gold is as prone to speculation as any asset and tends to go through long bull and bear markets depending on traders' views of monetary policy and the structural state of the economy.

Why does gold serve as a store of value more than other commodities? Because it doesn't get "used" in the same way that oil or corn get used, nearly every ounce ever mined is still in human possession either as jewlery or bullion. That means the gold supply is extremely stable, virtually unaffected by the amount that gets mined each year.

This quality is why gold has been used as a monetary asset throughout history. As an investment, however, gold doesn't pay interest, so it only serves as a long term store of value or as a short term vehicle for speculation.

In a normal environment, holding a dollar in the bank would pay enough interest to compensate you for the risk of holding that dollar. Because the FDIC guarantees cash bank deposits against default, the only risk of holding cash at a bank is that the interest rate may improperly compensate the holder for inflation.

Gold versus cash

All things being equal, if the interest rate on bank deposits is less than the rate of inflation, then the value of bank deposits are losing purchasing power and thus gold would serve as a better store of value than cash and the price of gold in dollars would rise. If the interest rate on cash is above the rate of inflation, then you would get a positive "real" return on cash and because gold pays no interest you would prefer cash and the price of gold in dollars would fall.

As a side note, if we assume a 2% inflation target and a 28% average tax rate on bank interest (or short term treasury securities), the "neutral" overnight interest rate would be 2.8%, generating an after-tax, after-inflation risk free return is 0%. So if there was no business cycle and/or the Federal Reserve Bank was perfect at executing policy, then all future maturities of US Treasury bonds would yield 2.8%, inflation would always be the Fed's 2% target and the rate on Treasury Inflation Protected Securities ("TIPS") of all maturities would be 0.8% (to compensate investors for taxes).

The forward market for real interest rates

Of course all things are never equal. The capital markets are always
trying to anticipate the future. When looking at the market for Treasury
securities, investors are making assumptions about how real interest
rates will average out in the future based on the Fed's reaction to the
business cycle and how it will effect inflation and the business cycle
itself. The business cycle is primarily driven by the changes in
psychology of the suppliers of cash (savers and banks) and the demanders
of cash (businesses, governments and real estate developers). The
treasury market represents the market's assumptions about the future of
the market for risk-free cash, while the rest of the securities markets
represent the market's assumptions about the performance of
non-risk-free investments relative to the market for cash.

Because the future is uncertain, a normal treasury curve has a rising, positive slope to reflect increasing amounts of uncertainty over time. The assumption I have always used for my market model is that the overnight level of real rates is 0.8% and that the 2-year TIPS yield would be 1%, the 5-year TIPS would be 1.3%, the 10-year would be 1.8% and the 30-year would be 2.3%.

During recessions, when the demand for cash by savers is high relative to longer term investments, the Fed engineers cash interests rates below the rate of inflation to entice savers to increase their demand for longer term securities.

When savers become more optimistic, the prices of long term securities improves and the Fed would then be able to normalize the level of short term rates to balance the demand for cash versus long term securities.

When savers become too optimistic about the business cycle, the excess demand for long term securities pushes the cost of capital too low, causing more marginal projects to get funded. If the Fed sees this happening, it raises the short term interest rate to above the rate of inflation to entice savers to invest less in long term securities and hold more cash. Of course it's very hard to get this exactly right, as we'll see below.

The chart below reflects the assumptions of the treasury market over the course of the recent bull market in gold (2003- ):

Chart 1

(click to enlarge)


The real estate boom, 2002-2005. In the early 2000s, we can see that even though the short term interest rate (in green) was well below its equilibrium (and the rate of inflation) following the downturn of the early 2000s, the TIPS market was assuming that the Fed would get the balance basically right over time and the rate on the 5-year and 10-year TIPS were relatively stable around their equilibrium levels. In early 2004, the Fed started raising rates. Instead of its practice in 1994, when it raised rates to above equilibrium relatively quickly, the Fed embarked on a telegraphed, incremental program of raising rates.

The credit boom and real estate top, 2005-2007. It took a full year (until mid-2005) for short term rates to reach equilibrium. By this point the housing market was already going haywire and the credit markets were gaining a sense of false confidence due to the Fed's telegraphed game plan, even though it kept raising rates to above equilibrium levels. From this period until mid-2007 long term real interest rates also rose to an above-equilibrium level as investors felt that the investment wave was strong enough to withstand an extended period of above-equibilirium short term rates.

The bust and the aftermath, 2007-2009. Of course that is not what happened. Higher short term interest rates eventually made real estate investment less attractive. Construction peaked in 2006 and prices peaked shortly thereafter. More and more marginal loans were being made and the credit allocation system was far more fragile than investors realized. As the credit market started to unravel, the Fed started cutting rates and long term real rates started to fall, touching very low levels in early 2008. During the height of the credit crisis in late 2008 and early 2009, long term real rates reversed and spiked as the market feared uncontrolled deflation, but then quickly dropped again as they realized that the Fed was on top of things and willing to do what it took to keep inflation positive.

The "U" shaped recovery, 2009 – 2013. In the period since, private investment in general, and real estate investment in particular, has been very weak, so demand for cash for long term projects has also been weak. The Fed has been aggressive about keeping rates below inflation and about reducing the cost of capital of long term securities. Even though businesses have returned their levels of investment to more normal levels, real estate investment has remained at abnormally low levels while excess capacity from the boom was worked off. During this period, investors came to the conclusion that investment would be abnormally weak for a long time and that the Fed would thus have to hold rates below inflation for a long time. The 10-year TIPS yield has been negative, implying that we would be in this state of affairs for 10 years or more on average.

Private investment

As we can see in the chart below, private investment relative to GDP was actually pretty healthy in the early 2000s when the Fed was erring on the side of being too easy. That was the major mistake that fed the housing bubble (in addition to their failing to recognize the excesses in the shadow banking system). After the credit bubble, on the other hand, investment fell to its lowest level since World War II. Thus the Fed has been correct to err on the side of being easy during the lackluster recovery.

Chart 2

(Click to enlarge)


Private investment, while improving, is only just above the level at which recessions usually bottom, so the Fed can be easy (i.e. keep rates below inflation) for a while longer without doing too much damage. The housing market has started to turn and housing has a long investment cycle. Investors can therefore see the economy returning to a relatively normal level over the intermediate term and not wallowing in the state of perpetual weakness that would necessesitate 10 years of negative real interest rates. It is the improving housing market, not the Fed's jawboning, that is causing long term real interest rates to rise.

Bringing it back to gold

OK, but real interest rates are still predicted to be negative over the next five years and the Fed's rate hikes are a year away at least. So why is gold falling now?

The market for gold, like the one for treasury securities, is focused on the future. For a long time the people focused on gold were very different than those involved with the more mainstream fixed income markets. In the early 2000s, gold had gone through a 20 year bear market and had been left for dead by all "respectable" market participants. During the high real interest rates of the technology investment boom of the late 1990s, gold had fallen to under $300 per ounce. The people that followed gold at that point were mainly ideological…people who hated paper currencies.

Gold bugs are contrarians that think an economy built on paper currency is a castle made of sand. I know, because as I was investing I gold during the early and mid 2000s, I used to traffic gold bug websites. Because there was no greater castle of sand than America riding the dot com bust, followed by the Iraq War, followed by the housing bubble, all on the back of a falling dollar and Chinese imports, the gold bug crowd was having a contrarian field day in the early 2000s.

The gold bull market had three phases that correlated with the the phases of the treasury market described above. The first phase lasted until about early 2006. As the Fed eased policy and the dollar declined from its lofty levels of 2000, the price of gold normalized to its old level of $350-$400 per ounce that held before the tech bubble. In late 2005 and early 2006, the gold market recognized the Fed's mistake of feeding the credit bubble with its telegraphed policy and that the housing market would eventually fall, necessitating a major Fed easing. It was during this period that the price first spiked to $600+, signalling a real bull market.

Chart 3

(click to enlarge)


Gold had a hard time rallying in 2006 and 2007 as real interest rates were high, but it held its ground as it rightly anticipated that there would be a recession and real interest rates would fall again. Then by early 2008, gold investors realized that the credit bubble was even worse than they thought, and prices spiked to $1000 per ounce anticipating a massive Fed rescue.

In late 2008 and early 2009, however, the market feared that the Fed may be erring on the side of being too tight, and real interest rates spiked and gold fell to below $800 per ounce. Then the Fed and the Treasury Department rode to the rescue and the gold and TIPS bull market resumed. As can be seen in Chart 3 above, the gold market has done a pretty good job of anticipating the decline in long term TIPS yields (shown on an inverted scale).

In 2011 and 2012, these markets started topping out for fundamental reasons. The economy is improving, the Fed has not proven to be overly reckless, price inflation is quiescent and it has gotten pretty tough to justify buying long term TIPS at a yield of negative 1%. Gold bugs point to consipiracies and treasury investors can blame the Fed, but it was time for real rates to rise and the smart money started getting out of both gold and TIPS.

So what's the right price for gold?

In a bear market that follows a big bull market with three upwaves and two consolidation waves, you figure the bear market wipes out the last upleg or "extended fifth wave". That would take us down to the $800-1000 range.

The other old rule of thumb is that an ounce of gold over time is about equivalent to the price of a "decent man's suit". This follows the store of value or neutral currency notion. When I was gruaduating from college and starting work, a suit at Brooks Brothers cost about $350, about equal to an ounce of gold. The price of a Brooks Brothers suit today…$1000 (interestingly, currently marked down to $700). Sounds about right.

I am not your financial advisor. These posts and the observations therein are written purely for the author's pleasure. Please consult your own financial adviser before making any investment decsions.

2012 Election Preview (and quasi-endorsement)

My core theory of US politics can be summed up with two, very optimistic principles. The first is that the US electorate as a whole is very wise, notwithstanding the less-than-wise nature of many individuals. The second is that the US political system, as devised by the Constitution and its collective amendments, is self-healing; it is the greatest application of complexity theory in the history of the world. I realise these two principles go against the grain of much educated thought, but they have proven themselves over time, having really failed only once (in 1860). I can go more into these principles and why I believe in them in some future post.

Previous writings from the Dynamist: from realignment to backlash

Back in 2010, I wrote two pieces analyzing the state of politics. In the first from March 2010, "The GOP will not repeal ObamaCare", I first walked through why I thought the outright repeal of Patient Protection and Affordable Care Act ("PPACA" or "ObamaCare") would not really be a winning political issue for the GOP in the end, even though the nature of the Democrats' overreach on the issue was certainly helping the GOP in the 2010 midterms. I then ran through the laundry list of remaining issues (from the perspective of the electorate) and found 4 favoring the Republicans, 2 favoring the Democrats and 3 mixed. In the second from October 2010, "The Middle Class is Still Up For Grabs", I previewed the Democrats' upcoming defeat (where I believe I was the first to use the term "shellacking", but received no attribution from President Obama). I put that defeat into the context of building political coalitions, and how neither party had built a platform that truly builds up the middle class.

Both of these articles represented an adjustment from my 2008 writings which posited that 2008 might have been a "realigning election" that created a new majority coalition in favor of the Democrats and the northern, "blue" states. If I had to reflect on the realignment theory today, I would instead say it happened in two steps. First, in the late 1960s and early 1970s, when the "New Left" was forming in opposition to Vietnam and Jim Crow and in favor of women's rights, environmentalism and affirmative action, it could just as easily formed within the Republican Party as the Democratic Party. At the time, it was the Southern, socially-conservative Democrats that had gotten us into Vietnam and had defended segregation in the South. The Republican Party made the choice, however, to shortcut a longer term realignment in favor of uniting with Southern conservatives to implement an economically conservative agenda which has since become dominant in our politics, achieving realignment in 1980 with Ronald Reagan and gaining in strength during the 1990s and early 2000s under Clinton and Bush II. While the New Left would become marginalized during the Nixon and Reagan years, it eventually mellowed a bit and strenghened during the Clinton years before achieving realignment status under Obama.

The political framework today – stalemate?

Demographic changes have given the New Left its boost over the top in the Obama years, as the coalition of strong support for Obama among African-Americans, Latinos and single women on social issues will likely outweigh the decay of Obama's support among white men and married white women over economic issues over the past four years. The other factor keeping the Democrats in the game, however, appears to be the holdover of the economic Old Left in the industrial Midwest that is not being won over by the GOPs purist free market orthodoxy, particularly led by a former leveraged buyout impresario.

In many ways, the GOP has become a victim of its own success. It's dominant Presidential or Congressional coalitions of the 1970s through the 2000s faded as the party racked up victories on the wedge issues that divided the Democrats: deregulation, free trade, monetarism and inflation, income taxes, the Cold War and defense, urban crime, gun control, illegal immigration, welfare reform, capital gains taxes, the estate tax, the War on Terror and gay marriage. In each case, either the Democrats conceded the issue (gun control, crime, welfare reform, defense) or the GOP took the issue too far (illegal immigration, the War on Terror). Now the parties have fought to a draw on defense (both basically settling in on the center-right) and social issues (by region, with a slight center-left electoral college advantage to the Democrats).

I continue to believe that the economic agenda of the future is still up for grabs, however. The Republicans have become too rigid in their free market orthodoxy, being overly focused on promoting capital formation while mostly ignoring human capital development, which in the new economy can just as, if not more, important as pure capital formation. This is why the regions that have benefitted the most economically from the new economy like New York, Boston, Chicago, the Bay Area, Los Angeles, greater DC don't favor the GOP even though they have done very well under the era of conservative economics. As discussed above, the nearly complete victory of capital over labor in the old economy in the last thirty years has also weakened the GOP economic argument in electorally-rich Midwestern industrial states like Michigan, Ohio, Pennsylvania, and Wisconsin.

The Democrats, on the other hand, still have vestiges of the Old Left in their approach to economics, favoring the kind of centralized approaches to problem-solving that served them well in the industrial, mass-market world of the 1930s through the 1960s, but that are less appropriate for the decentralized, networked world of today. In the long term, the Democrats have an advantage in that they have more flexibility with their base on economic issues than the Republicans, while the Republicans have an advantage in that their basic philosophy is closer to the ulimate endgame if they can back off their fealty to capital and focus more on the middle class (promoting progressive goals with conservative, market-driven means). Until one of the parties seizes the advantage, we have basic stalemate with plodding progress.

Scenarios and issues

With a pretty evenly divided electorate we can be highly confident that the GOP will retain control of the House. Because of two decades of GOP-friendly redistricting, the Democrats need to win the generic House vote by more than 3% or so to flip control. This is pretty important in that the President really doesn't have that much power on domestic issues, and with a GOP House (particularly this GOP House), there isn't much chance of Obama passing any more big agenda items over the next four years. In addition, the Senate is likely to remain evenly divided, so no matter which party nominally has control, there isn't much chance of a president Romney getting the 60 votes necessary to pass any radical policy changes either.

For the next two years at least, the electorate is not voting for either Obama or Romney's agenda. It is instead voting for the type of compromises it wants to see occur. If Romney is elected, the compromises will be as center-right as the Senate will allow. If Obama is reelected, the compromises will be as centrist as the House will allow. If you think about it, this makes much of the apocalyptic rhetoric we've been hearing from both parties seem pretty silly, doesn't it?

Through that lens, the issues:

  • Foreign affairs – Here is an area the president does control. Obama is operating in the non-ideological conservative internationalist tradition of Dwight Eisenhower, Richard Nixon (perish the thought) and GHW Bush. After the adventurism of the GW Bush years, Obama's approach pretty well suits the country's mood, which is probably why you saw Romney embrace Obama's positions in the third debate. Despite some of Romney's hawkish talk on the campaign trail, I doubt he would differ much from Obama, but you don't really know, so advantage Obama.
  • Social issues – If you vote on social issues, you know who you're voting for. It appears that these issues are helping Obama a bit more, but I'm not going to wade into this, because I don't really vote on social issues and you don't know who won these until you see the turnout on election day.
  • Individual Taxes – Polls say people favor seeing the wealthy pay more, which is why Obama isn't being hurt by his stance. Although we can quibble with the math, I think Romney's general approach of flatter rates with less deductions for wealthy is superior. Since I highly doubt the Senate will pass a 20% cut in nominal rates most of Obama's attacks on Romney's "$5 trillion tax cut" aren't really operative. I also think the odds of a "fiscal cliff" disaster would be much lower under Romney as there would be less of a fundamental standoff between him and the House. By the way, this is under the radar screen but both guys are planning to let the payroll cut lapse this year. Advantage Romney.
  • Corporate Taxes – Both parties realize that the nominal corporate rate needs to come down to be internationally competitive, offset by a reform of loopholes. Romney favors moving to a territorial tax (focusing on domestic activities only), while Obama wants to tax overseas earnings like domestic earnings (as opposed to only when they are repatriated). While Obama's plan sounds better (taxing companies that "move jobs overseas"), it's not very realistic, since no other country does that and it would therefore encourage foreign takeovers of US companies to save on taxes by moving the corporate domicile abroad. In the end, under Obama, the House will either insist on a territorial tax or nothing will happen. Under Romney, I'm pretty confident we'll see reform pass, so advantage to Romney.
  • Fiscal policy in general – I don't think the markets or the economy want a sharp fiscal consolidation in the near term. I think the combination of a slightly revenue-positive tax reform, long term entitlement reform and discretionary spending controls without sharp cuts (aka something like "Simpson-Bowles") is probably the best outcome. While I think Romney would be better at finding a compromise on taxes, I think Obama would have a better chance to craft a broadly-acceptable reform of entitlements if he's willing to do so. Obama has the opportunity to reclaim the Democrats' brand equity on fiscal prudence by crafting a "grand compromise" and a GOP House is likely to go along with it this time around. Advantage Obama.
  • Trade policy – Both candidates would be more activist on promoting US exports than the Clinton and Bush administrations, with Romney promising to get tough on China's currency (which I agree with). In the end I think they would both be fine. Toss-up.
  • Monetary policy – The next president will get to appoint the next Chairman of the Fed. I would be in favor of reappointing Ben Bernanke or someone like him. It is no longer 1980, where inflation was the big threat and taxes were too high. Now deflation is the threat and tax collections are the lowest since before World War II. We need to move from the default of tight monetary policy and loose fiscal policy favored by the Republicans to a default of loose monetary policy and tighter fiscal policy more favored by Democrats. Advantage Obama.
  • PPACA / ObamaCare - The idea of repealing the PPACA with nothing to replace it doesn't seem realistic in the context of our history. Besides, since the Senate is unlikely to repeal the non-budget items, the idea of just starving it seems like a recipe for chaos. While it's a deeply flawed bill, it is probably among the least bad of a bunch of crappy options available to us until we reform the way health care is ultimately paid for. Since the PPACA maintains a "competitive" private system, it leaves the door open for pro-market reforms that could bring costs down while sustaining innovation. If Obama is reelected, keeping the PPACA is place is the only thing that he could really describe as a mandate. Advantage Obama.
  • Medicare reform – Medicare will bankrupt this nation if it is not reformed. I actually like the Paul Ryan voucher approach for Medicare in the long run, but ironically I also think that it would need the PPACA in place to succeed. Basically there needs to be a competitive marketplace for individual coverage that can't deny you for pre-existing conditions (like being old). The only way that really works is to have the individual mandate for the PPACA so everyone is in the pool. Ultimately we need to reform the way Medicare pays for health care to move away from the current fee-for-service if we ever want to use competition to drive down costs, so the Ryan plan and ObamaCare go hand-in-hand. Kumbaya! Toss-up.
  • Social Security reform – We only need to tweak Social Security to make it solvent. Everyone knows the ultimate solution will be a combination of reduced benefits for the wealthy and a gradual increase in the retirement age, so let's just get on with it already. Advantage Romney.
  • Education – Obama and his Education Secretary Arne Duncan have been doing a good job building on Bush's No Child Left Behind reforms, gradually introducing competition to the system. Obama has coopted a bit of the GOPs reform mantle here, but it works. Otherwise, most of the real battles in education reform are at the state and local level. Advantage Obama.
  • Energy – We need to ride the fracking, shale oil and deepwater drilling boom as hard as we can without harming the environment too much. While Romney would let it run harder, Obama gets more cover from environmentalists. While I think the idea of millions of "green-collar jobs" is a joke, I'm not totally against investing in research on green energy (solar and wind, not biofuels) and conservation (electric cars, green architecture). Toss-up.
  • Infrastructure investment – Obama blew his big opportunity here with his boondoggle of a stimulus bill. If he has focused on bread and butter spending like bridges, airports, roads and local transit, he could have built a strong coalition for a multi-year increase in infrastructure spending. Instead the bill was known for esoteric stuff like high-speed intercity rail and poorly-invested green energy loan guarantees that left people scratching their heads. To me this was the biggest disappointment of Obama's first term. Romney doesn't really talk about this, so I'd still say advantage Obama.
  • Financial reform – The Dodd-Frank financial reform bill is a bad bill that can rightly be attacked from both the left and the right. I would have focused on simpler, but more fundamental reforms (like limiting the size of an bank's liabilities relative to GDP and increasing the required capital cushion beyond what is currently contemplated). Instead we have a byzantine mess that was nevertheless better than no reforms at all. Since the GOP hasn't articulated a realistic alternative, I'd have to begrudgingly say advantage Obama.
  • Other stuff – Beyond the above on budget issues I'd prefer the GOP's approach. The Federal government should be made to be better at a smaller number of things, with more devolution of responsibility to the states (or to international bodies, where appropriate). I know not everyone agrees with that, but I think it's more appropriate for the decentralized world we live in today. Advantage Romney.

My quasi-endorsement of Mitt Romney

So looking at the above, it looks like I favor Obama, but I don't. While I voted for Obama last time, I intend to vote for Romney this time around. Personally, I am most focused on macro economic issues where I tend to prefer Romney's approach. I also think he will be better at crafting compromises with Congress and therefore there would be less of a chance of the kind of stalemate disaster scenarios that have a small chance of occuring under Obama. I am also more familiar with Romney's business background than most and so respect his skill and acumen and think he might make a better problem solver than Obama. That said, I also think neither party nor candidate really has a set of policies to build up the actual employment and earnings of the middle class. I like Obama enough and think he has done a good job on some things and I understand why he is favored to win reelection. As I said before, either man would be pretty hemmed in by Congress if elected. So while I slightly favor Mitt Romney, I'm probably one of the few people in the country who thinks it won't really matter that much in the end.

All opinions expressed herein are my own, and are not meant to represent the views of any organization with which I am affiliated.

Q2 2012 Market Update: Have Corporate Profits Peaked?

This post is an installment in a continuing series supported by The Dynamist's Market Valuation Model. Please click the link to see past installments.

Interest Rates

As usual, we start by examining the current state of the interest rate complex, which gives us the market consensus of underlying economic policy. The breakdown of the yield curves of US treasury bonds, muni bonds and corporate bonds is shown below.

If we look at the market's inflation expectations, it is generally assumed that the Federal Reserve will succeed at maintaining inflation right around its target range of 2%-2.25% over a variety of time horizons. Real interest rates (the inflation-adjusted rate on the Treasury Inflation Protected Securities or TIPS) are expexted to remain low for the forseeable future, averaging NEGATIVE -0.5% over the next ten years. This implies that the sluggish economy will force the Fed to maintain nominal interest rates below the rate of inflation for more than five years at least. This would be consistent with my view that we are in a long down cycle as the world economy struggles under its large debt load, resulting in weak demand relative to supply. (The phase known as the Kondriatev Winter to you cycle theory buffs.)

The combination of below equilibrium real interest rates and equilibrium inflation expectations results in nominal treasury yields well below equilibrium. And even though the spreads of municipal and corporate bonds relative to treasuries are currently attractive, their resultant nominal yields are relatively unattractive. While this would normally singal that fixed income in general is overvalued at this time, I believe the bond market is accurately reflecting the likely long term economic scenario, meaning that bond yields are unlikely to rise significantly in the intermediate term at least. Overall, I am overweighting cash and intermediate munis and corporates and underweighting treasuries (and I have sold all of my TIPS).

I'll discuss what this rate structure means for the dollar, gold and commodities in a future post.


As long time readers of these columns are aware, I base my assessment of equity values on the S&P price relative to the long term trend in inflation-adjusted earnings. Using long term returns that fail to take into consideration the unnaturally large surge in inflation during the 1970s will overstate the long term earnings growth assumption. It was the great surge in prices (and thus nominal earnings), followed by the long decline in interest rates that underpinned the massive bull market since the 1980s. I tend to believe that it would be folly to expect a repeat of those extreme conditions.

The long term chart of inflation-adjusted S&P 500 earnings is shown below, along with the calculated trend line.

So while the earnings of the S&P500 were $86.95 in 2011 and are expected to be $97.98 in 2012 (according to S&P analysts, not Wall Street analysts) and $108.76 in 2013, the trend earnings were only $64.88 in 2011 are only $67.73 over the next twelve months.  In this view, the trend market PE is about 20, as opposed to 13 or so on projected forward earnings.

The chart below breaks down the components of the projected S&P return, which I calculate to be 7.6%. This return is below what I believe to be the equilibrium return of 8.3%, but is not wildly off.

If you want to earn an 8.3% return, you would have to wait fot the S&P500 to drop to a PE of 16 on trend earnings. That level is currently 1104, about 19% below where it currently trades. That said, given today's interest rates, a 7.6% return sounds pretty good. In fact I calculate the current the equity risk premium (the spread of the expected equity returns over the risk free rate) to be 5.4%, above the proper premium of 4.0% (according to my read of the literature, at least).

Another way to look at PE is to reverse the ratio to earnings to price, or earnings yield. The chart below shows the earnings yield of trend earnings over time. The current yield of 5.2% is more in line with the late stage bull market of the 1960s than the bear market or early bull market valuations of the 1970s or 1980s.

One potential flaw in my model is that my trend earnings could be too low, dragged down by artifically low earnings in the 1970s and 1980s and ignoring the structural changes like globalization that have permanently increased corporate earning power. There may be some validity to this view, but I could easily counter with the theory that recent earnings have been artificially inflated by financial earnings and the effect of the weak dollar on foreign income.

Have corporate profits peaked?

Let's see what the statistics say. If I take the level of corporate profits in the economic statistics and compare them with GDP, we can see that corporate profits are indeed at record levels.

The trend for corporate profits has been on the way up for the past few decades, now exceeding the levels from the mid 1960s. If we break down corporate profits into domestic profits vs. financial and "rest of the world" profits, however, we come up with a different story.

Domestic corporate earning power relative has remained in the same "trading range" since the early 1970s, oscillating between 4% of GDP at lows to around 7.5% at highs. The level is currently 7.3%, signalling that they may be near a cyclical peak. The big change over time has been the increase in financial and rest of the world profits. Financial profits have increased steadily with the long bull market in treasuries, which we can probably safely say has likely run its course. As interest rates flatten out and as Dodd-Frank and Basel III regulations are implemented, it is highly probable that financial profits as a percent of GDP will decline over the next decade.

Rest of world profits have recently caught up with financial profits (they are roughly equal now). Foreign profits could fall with a strengthening of the dollar or any sort of rollback of globalization, either of which are possible or even likely in this environment. 

Teed up for disaster?

While not necessarily likely, the outlines of a potential meltdown scenario for earnings is becoming more clear: the quagmire in Europe, leading to banking problems, leading to a crash in Chinese real estate, leading to a rising dollar, leading to a crash in commodities, leading to a bout of deflation, leading terrible earnings, leading to a stock market swoon.

The alternative scenario is that we are headed for a weaker version of the late 1990s, where after a mid-cycle slowdown the US economy steams ahead on the back of a powerful investment cycle as real estate investment recovers and business investment picks up its pace. The US could be able to prosper even while Europe languishes, with US imports keeping Asia afloat. In my last post "Atlas Done: The US Can't Carry the World Economy" I argue why this scenario would be difficult to achieve, but I have been wrong before. In this event, we could see domestic profits continue to head higher and to reach the levels to the late 1960s relative to GDP, rendering my trend earnings too low and making stocks a screaming buy at these levels.

The other perhaps most likely scenario is that the US real estate market, Europe and China can all muddle through for the next year or two. In this case, the market would trade choppily for the next few years as time continues to heal the wounds of the credit bubble. Private sector debt levels would gradually decline until the point that the private sector is able take the growth baton back from the public sector. In this scenario, an investor would want to be modestly underweight equities and overweight fixed income. This is the "Rounded Bottom" scenario that I view as my base case.

I continue to believe that we are riding a cyclical bull within a secular bear market and that investors need to be careful here. The chance of a deflationary crash probably exceeds that of a powerful second leg to the bull market. The most likely scenario is more of the same. The good news is that we are likely nearer to the end of the long bear market than we are to its beginning. In the meantime, caution should rule the day.

I am not your financial advisor and I write these articles purely for my own enjoyment. Please consult your own financial advisor before acting on any recommendations or views made in this article.


Atlas Done: The US Can’t Carry the World Economy

Today's release of the May jobs report showing that the economy only created 69,000 jobs and that the unemployment rate rose to 8.2% confirms what the equity markets have been hinting at for the past month…that the world economy is starting to slow down, perhaps dramatically.  Europe's slow-motion financial crisis is dragging down its economy, which is in turn dragging down Asian export economies, who are  cutting their commodity imports and hitting commodity-producing economies like Australia and Brazil in turn.

Once again, the entire world is depending on the profligacy of the United States to keep the global economy afloat. It doesn't have to be this way, and frankly at some point the US should stop putting up with it. I will get to how the world can fix the current state of affairs later, but first, I must pose the question as to whether the US can continue to muscle through a global slowdown given the state of its own economy.

The common complaint among Keynesian-oriented commentators is that we are suffering from insufficient demand. On the surface this would appear to be true. (All GDP figures reported on a nominal basis and sourced from

  • Industrial capacity utilization stands at only 79% as of April 2012, up 67% at the trough of the crisis in 2009 (a record low for the post-war economy), but below what used to be considered a normal level of 81-84%.
  • Unemployment stands at 8.3%, above a full employment level of 5% or below. If anything unemployment is being understated due to a large decline in the labor force participation rate and the large number of workers working part-time who would like to work full time.
  • Wages and proprietors' income as a percent of GDP is at a near-record low level of abut 52%, down from 57% in the early 2000's and the around 60% that frequently prevailed in the 1960's.

Yes, but…

  • Personal consumption as a percent of GDP is at a record high of nearly 72%.
  • Personal income as a percent of GDP is at a near-record high level of 86%, right around the levels that prevailed in the late 1990's and higher than the levels of the 1960's.
  • Personal disposable income as a percent of GDP is at 89%, which is right around the level that has consistently prevailed since the 1960's. Basically the decline in wage income as been continuously offset by rising transfer payments from the government and for health care, and in the past by a large decline in personal tax collections.
  • Personal saving as a percent of GDP is at only 3%, below an equilibrium level of 4-6% (although higher than the levels that prevailed at the end of the housing boom).

So basically the government has done a good job of propping up consumer demand with unemployment insurance, transfer payments and tax cuts, just like a good Keynesian should want. Consumers have even kicked in a bit extra by cutting their savings to drive consumer spending to record levels. Consumers, neither rich nor middle class, can be accused of irrationally hoarding cash and holding back our economy.

Another source of demand is private investment.

  • Business investment including software, equipment, mines and wells, is running at 7.6% of GDP, firmly in the equilibrium range of 7-9% that has largely prevailed since the early 1970's. It can go higher, but is not irrationally low.
  • Real estate investment on the other hand, is at only 4.3% of GDP, far below a more normal range of say 6.5% to 7.5%. Commercial real estate investment is about 1% of GDP below a normal level and residential real estate investment is about 2% below a normal level.

Given the large amount of overbuilding in the 2000's and the slower growth in the working age population now that the baby boomers are starting to retire, there is no way for policy makers to force real estate investment to meaningfully higher levels until consumers' balance sheets are cleaned up and excess inventories have been worked off.

My overall view on real estate has been that investment bottomed in 2011, but that the market would not start clicking until 2013.

  • Government expenditures (federal, state and local) are about 19.5% of GDP. (These are direct expenditures and don't include transfer payments.) This figure is about average for the period from 1980 to the present, but lower than the prime Cold War years when the defense budget was far higher as a percent of GDP. The US has room to increase direct government spending, but combined with the massive deficits it is running to support transfer payments, the US government is not being parsimonious.

In addition, how can the US economy be accused of having insufficient demand when…

  • The trade deficit is 4% of GDP, meaning we spend 4% more than we produce.
  • Our imports are 2% of GDP too high relative to the long term trend of US international trade and our exports are about 2% of GDP too low.
  • Running a trade deficit means that our investment is greater than our savings. But, as we established above, our investment is running about 3% of GDP below normal levels. Private saving (business plus consumer) is running at levels slightly higher than normal, so more than the entire trade deficit can be accounted for by a higher-than-normal government deficit.

If demand for investment is outstripping savings, even at abnormally low levels of investment demand, we would expect interest rates, particularly real interest rates to rise. Instead, however, real interest rates are not only negative, but projected to remain negative, on average, over the next 10 years. The cause is of this paradox is that global savings flowing into the US (i.e. the demand for dollar-denominated savings) chronically exceeds the demand for dollar-denominated investment, even during the great business investment boom of the 1990s and the great real estate investment boom of the 2000s.

For the US to bring trade in to line it would either have to cut domestic demand and/or increase exports. Domestic demand can be cut by raising taxes, cutting government spending, and/or raising tariffs to shift demand to domestically-produced goods.  Exports can be increased by running an aggressive trade policy that steps up against those countries that are manipulating trade via their capital accounts (more on that later).

The US has geared its economy to a level of demand, for both consumption and investment, that outstrips its ability to produce. In this case demand equals standard of living. The US needs more investment to make its workers more productive, but it is already operating with excess industrial capacity and high unemployment, which circles back to the fact that domestic demand is insufficient to match domestic supply. In other words, international demand is too low relative to international supply more than US demand is too low relative to US supply.

This is not a new observation. China, Germany and the OPEC countries need more consumer demand to sop up excess savings and to increase demand from chronic deficit countries like the US, UK and southern Europe. The US, UK and southern Europe need more investment to maintain or increase their competitiveness versus other countries, but need to fund those investments with more domestic savings.

Here's what needs to happen:

  • Germany needs to step up to the plate. Yes, it must be annoying for Germany to have to bail out countries like Greece. Overall, however, Europe has a relatively balanced economy (i.e. a neutral trade deficit), so it has the power to fix its own problems. Germany needs to allow domestic consumption to rise and needs to invest more in southern Europe, which southern European economies need to cut back their state relative to their private economies. Otherwise the other countries are right to protest, as to date Germany has been just looking to cement its advantaged status and protect its own banks.
  • The US needs to stand up to currency manipulators. The main culprits here are China and the OPEC countries. If the governments are the ones investing in US securities to keep their currencies fixed and suppress domestic consumer demand, then they are currency manipulators, plain and simple. Letting the dollar weaken won't help, particularly with the OPEC countries, because that just increases the price of oil, making the problem worse. The US should impose capital controls or tariffs on these countries while firming the value of the dollar instead.
  • The US needs to cut its petroleum imports. Petroleum accounts for a large portion of our trade deficit. A firmer dollar and a concerted move to domestic natural gas (and electric cars) should do the trick.
  • The US needs to increase its savings. It should not be up to the US to support the world economy by running up its debt. The US should implement policies to increase consumer savings, particularly among the middle class.
  • The US should increase its infrastructure investment. Such investment should be able to put some construction workers to work while we wait for real estate investment to recover. Plus, its actually needed. This would not be spending money for spending's sake.
  • The US should implement policies to encourage domestic investment and exports. Reforming our corporate tax code would be a great place to start.

I realize that many of these solutions sound nationalistic or mercantilistic by themselves. I hope, however, that the facts are pretty clear that most of the demand shortfall that the US faces is due to (i) a shortfall in foreign demand that is a direct result of mercantilistic trade policies, (ii) an excess of domestic demand driven by lower-than-market US interest rates due to excess foreign savings and (iii) a shortfall in real estate development that only time will heal. Outside of using tariffs and capital controls to reduce our trade deficit, the US government doesn't have much further that it can do to stimulate domestic demand without badly distorting the US economy. All of the other actions I recommend are meant to deal with long term structural issues that are also tied to our need to increase the international competitiveness.

Europe has the same internal issue that the US has with China and OPEC, where explicit policies need to be put into place to increase the competitiveness of southern Europe and the UK relative to Germany. These policies need to deal with the short term issue of debts and liquidity, but also with the long term issues of excessive labor regulations, weaker productivity and underinvestment in the tradeable sectors. These improvements will either require a tighter fiscal union or some really enlightened multilateral policy making.

These issues are all fixable, but they arise to remind us that we remain in a Kondriatev Winter, where the economy is consistently weighed down by high debt levels, weak demand and a tendency toward deflation without heroic measures by governments and central banks. Believe it or not, the US has struck the balance pretty well so far. It is now time for Europe to put their house in order before they drag the whole world into stagnation and deflation.

The Death of US Manufacturing has been Greatly Exaggerated

I often get comments from my friends that they look to my blog to get an optomistic viewpoint on the economy given all the "doom and gloom" that pervades most economic and political discourse these days. Seeing as that I call my base case view of the current economic situation a "Rounded Bottom", I figured optimism is clearly a relative concept. That said, I generally do believe in a self-correcting system, and so therefore counsel against panic and dispair. Tough times make people gloomy, and gloomy people call for more radical action than is generally needed. Often times, it is the very government action designed to goose the economy in times of distress that sows the seeds of the next economic downturn (see housing market, the).

It is in times like these that declinist theories roam the land. While I don't deny that the United States has faced a nasty cyclical decline in the housing market that may have led to a secular downshift in consumer spending and debt accumulation, I don't necessarily view that as a long-run negative. Consumerism, while beneficial to one's near term standard of living, can be carried too far if it becomes a debt-fuelled bacchanal that diverts resources from other productivity-enhancing investments like business equipment and infrastructure.

Exhibit A to most declinists is the supposed decline in American manufacturing. This seems like a no-brainer given our huge trade deficit, the large declines in manufacturing jobs and the visible industrial ruins in former manufacturing hubs like Detroit, Cleveland, Pittsburgh, Philadelphia and Baltimore. A closer look at the numbers, however, tells a much different story.

In October 2011, after one of the nastiest recessions and slowest recoveries in modern history, the United States produced $3.3 trillion worth of manufactured goods on an annualized basis (in 2005 dollars). To put this into perspective, the entire GDP of Germany in 2010 was only $3.3 trillion (in 2010 dollars, no less). China's GDP is only $5.9 trillion. The U.S. is thus by far the largest manufacturer in the world. While production is down about 5% from the $3.5 trillion produced at the end of 2007, and it is up 5% from what was produced in 2000. It is fully 80% higher, on an inflation-adjusted basis, than the manufacturing production in 1979, when manufacturing was still the centerpiece of the U.S. economy.

Look at the chart below (click to enlarge):

For comparison purposes, it is important to compare similar points in the business cycle. In the case of manufacturing production and capacity, it is most meaningful to compare cycle peak to cycle peak. I have also included the mid cycle break points (1984 and 1995) where the currency and policy regimes changed somewhat.

The things to notice in the chart above are (1) the long term decline in the peak capacity utilizations (meaning that capacity has increased faster than production); (2) the huge increase in manufacturing production per employee; (3) the decline in manufacturing employment as a percent of total employment from 24% in 1973 to 9% in 2011; and (4) the more modest decline of manufactured final goods production as a percent of GDP from 24% in 1973 to 19% in 2011.

Given the huge gains in technology, finance, professional services, leisure and hospitality, retail, healthcare and education since 1973, the fact that manufacturing has only declined by 4 percenage points from the 1973 peak to the 2007 peak is quite surprising.

In terms of employment, we have to look at manuacturing as the new agriculture. It is a hugely efficient, highly capitalized economic sector that just doesn't employ that many people anymore. I fully believe in supporting manufacturing as a way to increase national wealth, but any politician who tells you that we can bolster the middle class with tons of new manufacturing jobs is out of touch with reality.

Nominal numbers don't provide as much context as relative numbers, however. The following chart translates the numbers above into annual growth rates by business cycle (click to enlarge):

The interesting thing about the chart of above is how the numbers vary from business cycle to business cycle, but that they are pretty stable over the long run. The first thing that jumps out is the huge increase in manufacturing employee productivity since the early 1990s, particularly relative to employees as a whole (as defined by real GDP per employee). The second thing that jumps out is the huge surge in manufacturing capacity (5.4% annualized from 1995 to 2000) in the late 1990s bubble boom. Since capacity growth was so far above trend in the late 1990s, the relatively low levels of business investment of the 2000s is not surprising. The huge surge in the capital-to-labor ratio, combined with advances in information technology, has helped create a large increase in per employee productivity…also not terribly surprising yet highly beneficial for the long run health of the economy.

If we look at the longer 16-17 year Kuznets cycle of long-lived investment (consisting of three business cycles as I define them), we see consistent results. Real GDP grew about 3% p.a. peak-to-peak in both the 1973-1989 cycle and the 1989-2007 cycle. Manufacturing production grew 2.4% in the second cycle versus 2.1% in the first, even though manufacturing was viewed to be in decline in the 1990s and 2000s. Capacity grew 2.6% per annum in both cycles. The big difference between the performance under the two cycles is in employee productivity, which grew 3.9% per annum during the second cycle and only 2.5% in the first. Manufacturing productivity growth far exceeded productivity growth in the economy as whole over both cycles.

The good news is that were are now pretty close to having worked off the excesses of the late 1990s. For that reason, I expect the front end of the current Kuznets cycle to produce a powerful resurgence in business investment, which we should see accelerate over the next 6-8 years (with perhaps one recession occuring dueing that time). We can already see it in the numbers. While everyone is focused on the travails of the housing market, the U.S. economy has gradually become a lean and mean manufacturing powerhouse.

The Dynamist’s Jobs Plan

President Obama is set to give his jobs speech tonight. In it, he will outline a series of proposals to stimulate job creation. I don't know what these are yet, but if I was appointed philosopher-king, the following would be my ideas to stimulate near-term economic activity and hiring while not exacerbating our long-term economic problems:

Employ construction workers by investing in infrastructure. The most obvious hole in economic activity is the smoking crater left by the collapse residential real estate investment. Construction employment has fallen from over 7.5 million in 2007 to about 5.5 million today. Of course with housing inventories well in excess of normal levels and with consumers overburdened by mortgage debt, re-inflating the housing bubble is not an option. The government could put construction workers to work by investing in infrastructure like roads, bridges, commuter rail, power infrastructure, broadband infrastructure, ports, etc. The focus should be on shortening commuting times, reducing trade friction and supporting export infrastructure…stuff that should be done anyway. Do not focus on controversial and dubious items like intercity high speed rail and solar power. The goal should be to employ about 1 million additional construction workers over the next couple of years. After two years or so the housing market will clear and the pace of infrastructure spending can be reduced. Yes, environmental and other types of reviews may need to be streamlined to make projects "shovel ready" this time.

Stimulate domestic investment by reforming corporate taxes. There is clearly an imbalance between the perceived return on business investment made abroad versus domestically. We need to change that. My solution would be to reform the corporate tax code by (i) leaving the rate where it is, at 35%, (ii) make worldwide earnings subject to the tax (now it is only taxed when brought back to the United States), (iii) make investment in research, development and capital expenditures made in the United States immediately tax deductible (as opposed to depreciated over several years) and (iv) make dividends tax deductible. The design here is to reward investment in the US while discouraging the hoarding of cash on corporate balance sheets (particularly in foreign banks) or squandering cash on empire-building acquisitions. Corporations should either invest their cash in the US or pay it out as dividends. If a corporation wants to make an acquisition, it should subject itself to the discipline of the financial markets and issue debt or equity. Because this reform encourages actual investment by businesses and would eliminate the double taxation of dividends, there would no longer be a need to give preferential treatment to dividends and capital gains for personal income taxes. In addition, the tax difference between corporations and "flow-through" business entities like LLCs would be dramatically reduced, ending a major distortion in the tax code.

Remove barriers to domestic energy production. The oil and gas industry is running at over 95% of capacity, the most of any domestic industry, so it needs more investment now. We need to remove barriers to offshore and onshore drilling and "fracking" and to encourage nuclear power and wind power, where appropriate. Within the energy complex we can encourage demand for domestic energy by putting a tariff on imported oil, which would also help fight the biggest source of our chronic trade deficit. The long term goal would be to move to a straight carbon tax. We can also raise revenue to offset other measures encouraged herein by eliminating the preferential tax treatment of oil and gas investment, which isn't needed given the tight capacity and proposed tariff. The tariff on oil prices would help encourage a transition to more fuel-efficient automobiles, whether hybrid or electric.

Encourage hiring by permanently cutting the payroll tax. We can increase the return on labor to businesses by permanently eliminating the employer side of the payroll tax (which is 6.2% of wages). It needs to be a permanent cut because businesses are otherwise rational and won't hire based solely on a temporary cut. The long term goal would be to replace the payroll tax (a regressive tax on hiring) with a carbon and/or consumption tax (a regressive tax on consumption). The cut would be partially offset by letting the temporary 2% cut in the employee-side of the payroll tax expire as scheduled.

Stand up to currency manipulators. There is no reason that an innovative, productive economy like the United States has to run a persistent trade deficit. We are being manipulated by the central banks and sovereign wealth funds of East Asian and OPEC nations, plain and simple. The inflow of these excess savings must be matched by an equal trade deficit, artificially suppressing American manufacturing. For example, there is no reason that manufacturing of high tech goods for American companies, which requires relatively little labor, should be done in Asia and not at least mostly in the United States. We are needlessly allowing excess capital formation outside of our borders. While I think the corporate tax reform mentioned above will help in this regard, we should also explore a wider array of "sticks" like currency interventions, tariffs and capital controls in addition to diplomatic "carrots" like trade deals in seeking to promote trade balance. (Our trade deficit is currently 4% of GDP.) I know that such a proposal will spark warnings of "trade wars", but in reality other countries use these types of tools all the time (Switzerland did this week) and if they are used to negotiate an end to market interference by the other country, there should be no long term repercussions.

Stop encouraging inflation. One of the biggest fallacies in all of economics is that you need positive inflation for the economy to work properly. It is absolute hogwash. Prices were basically flat for the hundred years prior to World War I and the US economy grew faster than ever. All inflation does is transfer purchasing power from ordinary people to the elites who know how to profit from inflation in the financial markets. Stopping inflation would also have the benefit of making finance boring again, which would stop the drain of talent and capital from the real economy toward non-productive endeavors like designing the latest hedge fund trading algorithm or speculating in commodities. While targeting zero inflation wouldn't create jobs per se, it would lift the real income of American workers, since prices have been rising faster than wages. I frankly don't understand what the Fed has been trying to accomplish lately. The dollar is already at the bottom of its long term trading range and gold prices are soaring. Asset prices are generally pretty expensive. It's time for a new approach.

All of these ideas are incremental steps toward what I think should also be America's new (or at least modified) long term economic strategy. I also include some revenue offsets designed pay for these programs in a way that would not harm the economy and would also serve our long term goals. I realize that some of these proposals cut strongly against the conventional "wisdom", and I don't care. The long term goals are to get more Americans working, to make sure they get paid more by their employers, to produce more domestic investment and to pay for it with more domestic savings. It can be done. We shouldn't expect miracles, however. The economy is going to be abnormally weak for some time to come. This is the time, however, that we can band together to build a long term foundation for strong growth and general prosperity.

The market does not want austerity (now)

If one looks at both nominal and inflation-adjusted treasury yields for the next five years, the market does not think near term austerity is necessary. In fact, it is pretty clear that the market wants more treasury issuance not less, with negative real yields through at least the next five years. With fiscal stimulus being reined in, the market expects the Fed to be the stimulator of last resort (and all the Fed can do is try to promote inflation through bond purchases), hence the gold price is rising as the market expects an even longer period of negative real interest rates.

Our economic problem is simple, we went from a period of over-stimulated and debt-fuelled real estate investment running at 8.5% of GDP to a collapse in real estate investment down to 4% of GDP. The collapse in real estate prices reduced the collateral value on trillions of dollars of loans and forced austerity among consumers.

To deal with the problem we needed only three steps:

  1. Recapitalize the banks to prevent an uncontrolled unwinding of leveraged positions (done);
  2. Increase temporary transfer payments to individuals to prop up consumer spending while savings levels are increased (done, but in danger of being unwound); and
  3. Increased government investment in infrastructure to put the millions of unemployed construction workers to work (not done, we focused on health care instead).

Business investment, exports and consumer spending have been doing fine since we came out of the recession, but the markets are fearing that a pullback in government spending worldwide, combined with continued weakness in real estate investment will tip the scales to recession.

I personally think the odds favor us muddling through for the next year or so and avoiding recession, and that the recent market correction is probably overdone. That does not mean I am calling a bottom, because the momentum could overwhelm the facts on the ground. I do, however, feel ok nibbling at stocks at this level.

With US banks in far better shape than in 2008, I don’t see a mini-replay of that crisis as the major threat to the economy. Europe has major issues, but they are also solvable in due course as long as Germany steps up to the plate. The next crisis may come from exactly where we don’t expect it today: a crash in emerging markets leading to global deflation.


Seeking American Renewal

We are flailing economically. No question about that. Sadly, no one has any good answers for what to do about it.

Sometimes, there's just not that much to do. We just have to ride it out.

The immediate economic problem is quite simple. There is a gigantic hole in the economy where real estate investment used to be. The chart below pretty much sums it up.

Source:, calculations by

As a percent of GDP, business investment has snapped back nicely and has returned to a relatively normal level. As I mentioned in my previous post "Momentum is Building", I think we are likely on the front end of a powerful investment cycle for business investment.

Real estate investment, on the other hand, has cratered to by far the lowest level recorded since World War II.

Enter John Maynard Keynes

The Keynesian economic solution would be for the government to step in and fill the hole in demand (1) by supporting consumption with lower taxes and transfer payments and by (2) directly investing in infrastructure and other public works. The government has done plenty of number (1), which is why our deficit is so large, and not enough of number (2).

What people forget about Keynes was that he advocated withdrawing stimulus and running surpluses when the economy is strong. Instead, the "Keynesians" that have been running our economy since World War II (and that includes both political parties) have made stimulus a permanent feature of our economic policy. Overall it worked great…until 2008.

As a result, we have run up huge debts in all sectors of the economy (government, financial, consumer, business).

Source:, calculations by

And have gotten to the point that government transfer payments and health benefits are equal to about 20% of GDP.

Source:, calculations by

Even more disturbing, if we total transfer payments and investment income (dividends, interest and rental income), non-work income equals 35% of GDP, while work-related income (wages, salaries and proprietor's income) equals only 50% of GDP. This is a classic sign of potential national decline, when more and more income flows to the upper "rentier" class and the government mollifies the masses with transfer payments.

This trend can also be seen as fewer people of working age are even participating in the labor force (working or looking for work).

Source:, calculations by

Generational imbalance

It gets worse as time goes on. As the baby boomers retire, transfer payments will take up more and more of GDP, particularly health care payments, but also Social Security and unfunded pension benefits.

Source: "Where's Your Budget Mr. President?" by Paul Ryan, Wall Street Journal, 8/3/11

As can be seen above, if left unchecked government health care spending will continue to gobble up more and more of GDP. The chart above assumes that the rest of the government actually shrinks as a percent of GDP.

So while in the short term today's Keynesians are right, in the long term they are wrong. Our budget deficit is hovering around 10% of GDP, and we still can't stimulate growth. In addition, even though we supposedly have insufficient demand, we are running a trade deficit of 4% of GDP. In other words, even with 9% unemployment and only 76% industrial capacity utilization we consume 4% more than we produce.

We can no longer have a smaller and smaller portion of the population earning a smaller and smaller proportion of income and expect the country to thrive. The welfare state needs to be scaled back to make room for more productive activity.

Seeking American Renewal

While the Republicans are right to focus on scaling back the welfare state, they do not have a good plan for fostering future growth. Scaling back government spending will cut back demand, and the coincidence of super-low interest rates with deficits of 10% of GDP and strong money printing prove there is extremely weak demand for investment capital. It is therefore unlikely that private investment has been crowded out by government deficits.

In the big picture, Obama actually articulates a more credible vision than the Republicans for long term growth…less focus on consumption, imports and residential real estate, more focus on savings, exports and investment, focus on infrastructure investment, technology, education, health care and reducing our reliance on imported oil. His execution, on the other hand, has left a lot to be desired. He was elected to help rebuild the economy and instead dissipated his political capital on his health care bill. Only time will tell if that was the right call or not.

While our political culture is raucous and messy, they are slowly getting it right. Cut back the welfare state, allow private investment to grow and eventually throw the government behind a new growth plan. The focus should neither be on further increasing the returns to investment (the Republican plan) nor on increasing transfer payments (the Democratic plan). We need a plan that gets more people working and making more money. (More on that in a later post.)

In the meantime, all we can do is wait for the real estate downturn to play out before we fire on all economic cylinders again. Until that time, the "Rounded Bottom" scenario holds.