Debt Service: First the Silver Lining, then the Cloud

Back in early January, Edward Harrison observed Consumer credit: largest gain in 16 years and well ahead of expectations:

Economic data coming out of the United States continue to show a robust consumer-led expansion.

Harrison gave some numbers, and was optimistic:

Analysts see this not as reflective of distress but buoyancy as the Conference Board’s measure of consumer confidence hit a 17-year high in November. Nomura, for one, released a note saying: “This appears consistent with a strong labor market with low unemployment and elevated consumer confidence, which we expect will continue in the near term.”

Moreover, since consumer spending makes for almost 70 percent of the economy, these numbers bode well for economic growth figures to be released at the end of the month...

Then he dropped the other shoe:

The dark cloud in all of this is the fact that this is debt-fueled consumption.

Yep. But if these signs of economic vigor were fueled by debt, then they should have been predictable -- as predictable as the trouble that will arise from growing consumer debt.

More predictable, even. You might have looked at Household Debt Service two years back and noticed it rounding the bottom:

Graph #1: Household Debt Service as of 3 March 2016

You could have selected the round bottom data, just after the sharp "V" that bottoms out in 2012Q4, and put a trend line on it:

Graph #2: As Above, with Trend based on 2013Q1-2015Q3

You might have said to yourself, "Hey! That thing's going up!"

If you look at where the trend line is in the first quarter of 2018, it seems unrealistically high. But now (two years later) we can ask: How did your prediction turn out?

Right on track:

Graph #3: Same as Graph #2, plus Current Household Debt Service Data (red)

The current data (red) is a surprisingly good match to the path predicted by the trend line.

Of course, the good match does not guarantee that our economy will soon be vigorous again. Still, as Ed Harrison was saying, "Economic data coming out of the United States continue to show a robust consumer-led expansion."

I expect vigor. Vigor until Debt Service costs get too high, and then we lose the vigor.

Why?

You can see Debt Service going up in the early 1980s, after the 1982 recession, when Reagan got that massive spike in Real GDP growth. You can see Debt Service going up in the mid-1990s, when Bill Clinton got what Alan Greenspan called "the new economy":

Graph #4: Household Debt Service (blue) and Real GDP Growth

Debt Service costs went too high in the Reagan years, and that interfered with vigor. In the Clinton years, Debt Service costs stayed between 11.0 and 11.5 until the end of the decade, and the economy's performance was impressive enough that Greenspan gave it a name.

The two datasets are on different scales. However, in both the Reagan years and the Clinton years, the economy regained vigor while Debt Service costs were low, and then economic growth remained vigorous until the blue line went above the other.

Debt Service costs went low again after 2010. Now, though, they are picking up again, and the economy is improving. You could have predicted it two years ago.


I expect our economy to show increasing vigor over the next couple years as Household Debt Service continues to follow the trend line up toward the 11.0 level. Above 11.0, I worry that Debt Service costs will become burdensome and cause growth to slow. I guess we'll have to wait on that and see how things go.

Meanwhile, if you want to play along, take a look at productivity. It too is rising.

You say it's a "given". I say it was created by policy in the first place, and to create new policy now to aid and abet your so-called "given" is pure folly.

Wordy Bill has posted Part One of his response to a German critic of MMT. I figured I'd read it, as it should be an overview of key points of controversy from the perspective of one of the mainstays of MMT thought. Bill says:

The aim of fiscal policy is not to deliver a particular fiscal outcome (surplus or deficit). Rather, it is to ensure that the discretionary government policy position is sufficient to ensure full employment and price stability, given the spending and saving decisions of the non-government sector.

He emphasizes the word "given".

The spending and saving decisions of the non-government sector are a "given", he says. In other words: Those decisions create an economic environment, and the aim of fiscal policy is to ensure full employment and price stability in that environment.

I disagree.

The spending and saving decisions of the non-government sector arise largely in response to policy. Those decisions may seem a "given" at the moment. But it's not like the government had no hand in creating them. You know goddamn well, for example, that economic policy encourages saving. It has been policy since the beginning of time, almost, to encourage saving. So when you look at the amount of money that has been tucked away as saving in one form or another, what you are looking at is a result of policy: the decisions of individuals (or groups or businesses or whatever) in response to policy.

That's not at all the same as what Bill says, that those decisions are a "given".

This comes up because I recently quoted the last bit of Chapter 10 from Keynes's General Theory. Here again is his last sentence:

We have to accept [the sufferings of unemployment] as an inevitable result of applying to the conduct of the State the maxims which are best calculated to “enrich” an individual by enabling him to pile up claims to enjoyment which he does not intend to exercise at any definite time.

We do not have to accept the spending and saving decisions of the non-government sector as a given. Those decisions are an inevitable result of policy. If the result turns out to be a problem, then the policy was bad, and we should change it.

It is a great error to accept as given, that which is not a given.

Are US trade deficits caused by high US labor costs?

Lotta noise in the news lately about the Trump tariffs. My wife, at dinner, says something about the tariffs compensating for US wages being higher.

But I'm not sure US wages are still "higher". Higher than wages in China, maybe, but China is a latecomer to our trade deficits problem. So I have to stop and wonder if higher US wages really are the problem. Because, you know, for me it's always the cost of finance that creates our problems.

At a glance, all the Google search results mention labor. Like my wife, everybody thinks US wages are the cause of our trade deficits. But that's why I do graphs.

To see for myself.


The trade deficit developed in the 1970s...

Graph #1: US Trade Deficit as Percent of GDP

... just about the same time that wages inexplicably started falling behind:

Graph #2: via EPI

Odd, isn't it? Looks like the trade deficit developed when we didn't have the income to "buy American" because our wages were too low. Not because our wages were too high.


Nobody ever points this out, but if wages were too high, wouldn't that be good for wage earners? When I look at the economy I don't see "good for wage earners".

You've heard of "labor share" -- labor share of income. You might have heard people say labor share has been falling since the year 2000:

Graph #3: Labor Share

Since 2000? Looks to me like it's been falling since 1960.


At FRED a search for Costs per unit of real gross value added of nonfinancial corporate business: turns up 10 series. Five of them show quarterly data. Among these are "Compensation of employees (unit labor cost)" and "Unit nonlabor cost".

If a cost is not a labor cost, it's a non-labor cost, right? So if I take labor cost per unit, and add in non-labor cost per unit, then I have the total cost per unit.

Labor cost per unit relative to total cost per unit shows decline from beginning to end:

Graph #4: Unit Labor Cost as a share of Unit Total Cost

Is high labor cost the cause of our trade deficit? I am inclined to say no.


Here, maybe this is a better picture. Compensation of employees as a share of Gross Domestic Income:

Graph #5: Employee Compensation as a Share of Income in the US

There is a flat in the 1950s and '60s -- you have to have lived in the 1950s and 60s -- and employee compensation goes high after the flat, peaking in 1970. Since then it's all downhill. Faster down since 2000, just like Labor Share.

Maybe the big spike in compensation, 1965-1970, made US goods and services too expensive to compete in global markets, creating our trade deficits?

Maybe. But compensation has been trending down since that peak in 1970. Meanwhile, trade deficits have been getting worse, not better. So there does not seem to be a clearly defined "high employee compensation causes trade deficits" relation.

Anyway, since the early 2000s, employee compensation (as a share of US income) has been lower than it was in the 1950s and 60s. And the trade deficits just get bigger.

Are US trade deficits caused by high US labor costs? I don't think so.

"the possible positions of equilibrium"

"I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium."

-- from Chapter One of The General Theory by J.M. Keynes

The "possible positions of equilibrium" can be understood as different average levels of employment in different periods, due to the economy being in different equilibrium states. A "limiting point" is a minimum or (in this case) a maximum. The level of employment which corresponds to the "special case" described by Keynes is the highest level: the one he called "full employment".

But it is hard to see equilibrium levels of employment on a graph like this:

Graph #1: Unemployment

The cycles may be obvious, but is the equilibrium is not.

Business cycles are like the economy breathing. Even at rest, you're breathing. Even with the economy at equilibrium, the business cycle is going through its phases. As a result, it is not easy to see when the economy is in equilibrium. If there is such a thing.

Is there such a thing as economic equilibrium? Some people say no. You could look at the unemployment graph and say no. And yet, the economy can be "good" for thirty years or more, or "not so good" for thirty years or more. Those could be 30-year periods of equilibrium, even if there are multiple business cycles in each period.

Anyway, Keynes thought the economy experienced equilibrium. The economy could settle into a low-employment equilibrium or a high-employment equilibrium, he said. And who am I to disagree with him.


I was looking at the debt of Domestic Nonfinancial sectors relative to GDP, a US version of the multi-nation data Stephen Cecchetti looks at in The real effects of debt, and I noticed something:

Graph #2: Non-Financial Debt relative to GDP

Three periods of equilibrium. Three different levels of equilibrium in my lifetime. And between times of equilibrium, disequilibrium. Times of undeniable economic calamity: One that ended with a "great" recession. And one that started with inflation so severe that it still informs policy today.


If you want to see equilibrium in the economy, don't look at employment. Look at finance. Why? Because finance is the source of disequilibrium.

"Fixed-weight" problems

RE: Karl Whelan's A Guide to the Use of Chain Aggregated NIPA Data PDF from June, 2000.

The U.S. Department of Commerce in 1996 switched from "fixed weight" calculations to "chain-weight" calculations for converting nominal values to real values. Solved one problem, created another.

I want to understand the problem with the newer method. But I have to start by trying to understand the problem with the older method. Because the problem with the older method, as Whelan describes it, is unbelievable:

While the fixed-weight methodology has the advantage of simplicity and ease of interpretation, it also has a number of undesirable features. Most importantly, the growth rate of a fixed-weight measure real GDP depends on the choice of base year. Take 1998 as an example: The growth rate of fixed-weight real GDP in this year was 4.5 percent if we use 1995 as the base year; using 1990 prices it was 6.5 percent; using 1980 prices it was 18.8 percent; and using 1970 prices, it was a stunning 37.4 percent!

In a footnote, Whelan adds: "These figures actually understate the true pattern."

Yikes. How is this even possible?


I went to ALFRED to see the RGDP data immediately before and immediately after the change:

Graph #1: Last Data Before the Change (blue) and First Data After (red)

Same two series, indexed to the start-date of the red line:

Graph #2: Same Data, Set Equal at Start-of-Red

And as a ratio:

Graph #3: After the Change, relative to Before the Change

Yeah, I don't see anything there. The revision made Real GDP higher, as you would expect. That's our main way of improving the economy these days: revise the data. That's the fallback strategy whenever theorists come to resemble Euclidean geometers in a non-Euclidean world and their deep divergences of opinion destroy the practical influence of economic theory.


Whelan explains:

The reason we get higher growth rates for real GDP when using earlier base years is the well-known problem of "substitution bias" associated with fixed-weight indexes. Categories with declining relative prices tend to have faster growth in quantities; the further back the base year the larger is the weight on these fast-growing categories and so the faster is the growth rate of real output.

He adds:

Similarly, for a given base year, the growth rate of a fixed-weight quantity index tends to increase over time as the output bundle becomes increasingly expensive when measured in terms of the base year's prices. This problem became more severe after the mid-1980s because of BEA's decision to measure computer prices according to the hedonic method...

Yeah, this part I don't get. Why does the growth rate increase as the output bundle becomes increasingly expensive? That doesn't sound right. Giving an example of when it supposedly happened doesn't explain anything.

But the "Categories with declining relative prices tend to have faster growth in quantities" part, that makes sense. If the price of beef goes up more than chicken, people switch to chicken. If beef and chicken prices both go up, people switch to beans.

I'm still troubled by this. I still postpone belief in the truth of Whelan's claim that the "fixed weight" growth rate of real GDP in any given year depends on how distant the base year is from the given year.

I'm still ruminatin'.

"the hedonic method"

I'm reading Karl Whelan's A Guide to the Use of Chain Aggregated NIPA Data PDF. Menzie Chinn linked to it, and Justin Fox, regarding errors in the use of "chain-weighted" inflation-adjusted data.

I need some background on "hedonics":

Source: OECD

Source: Abstract, The Hedonic Method by Laura O. Taylor at Springer Link

In economics, hedonic regression or hedonic demand theory is a revealed preference method of estimating demand or value. It breaks down the item being researched into its constituent characteristics, and obtains estimates of the contributory value of each characteristic....
Hedonic models are commonly used in real estate appraisal, real estate economics, and consumer price index (CPI) calculations. In CPI calculations, hedonic regression is used to control the effect of changes in product quality. Price changes that are due to substitution effects are subject to hedonic quality adjustments.

Source: Wikipedia, Hedonic regression

Whelan describes the problem with the old "fixed-weight" method, the problem which led to the adoption of the "chain-weight" method:

... for a given base year, the growth rate of a fixed-weight quantity index tends to increase over time as the output bundle becomes increasingly expensive when measured in terms of the base year's prices. This problem became more severe after the mid-1980s because of BEA's decision to measure computer prices according to the hedonic method pioneered by Zvi Griliches (1961). This approach revealed enormous declines in the quality-adjusted price of computing power and the introduction of these prices accentuated the tendency of fixed-weight GDP to accelerate over time.

"The quality-adjusted price of computing power". That's the "hedonics" thing.

OECD describes quality adjustment:

The process - or the result of the process - of estimating what the market price of a replacement product would be if it had the characteristics of the product it replaces and with whose price its price is to be compared.

BLS explains it less objectively:

The CPI is calculated using prices for a fixed basket of goods and services through time. While the basket is periodically revised to reflect changing consumer expenditures, some items being priced in the sample come and go from the marketplace, making collection of these prices from month to month difficult. When an item is no longer available in the marketplace, a similar replacement item is selected. Often there are no similar items from which to choose, and as a result, a less comparable item is selected, potentially introducing quality change and an associated price differential into the index. The hedonic quality adjustment method removes any price differential attributed to a change in quality by adding or subtracting the estimated value of that change from the price of the old item.

consumerpriceillusion has a different take:

Ostensibly, the CPI is a linear combination of the “prices” of things/stuff consumers could actually purchase weighted by a percentage that the “ideal consumer” spends on any particular stuff/thing in his “ideal” basket. The main problem here is that the “prices” used are not the prices a consumer would actually pay; instead the real price for an item is scaled by what the BLS calls a “Hedonic Quality Adjustment (HQA)”. The HQA was designed to solve a real world problem economists face: the market keeps pumping out new and better devices. In practice the HQA is used to artificially depress the prices used in the calculation of the CPI.

For me... Well, let me tell you about my experience with computers. When I bought my first modem it cost me $150. It was a 300 baud modem. Several years later I bought a 56K modem. It cost me $150. For me, $150 was an acceptable price for a modem.

My first hard drive cost me $400. It was a 40-meg drive. Several years later I bought another hard drive: 400 gig. It cost me $400. For me, $400 was an acceptable price for a hard drive.

In my experience, the price of modems and hard drives didn't go up at all. But if you used hedonics to "adjust" those prices for quality, the prices would have fallen. A lot.

But the prices didn't fall. The technology got better, but the prices didn't fall.

"In practice the HQA is used to artificially depress the prices used in the calculation of the CPI."

Yup.


Oh. The reason this comes up. There is a lot of noise these days about low productivity, and how productivity "really" isn't low. It's just not counted right, they say. Or it's not countable. Or some other story. It's all noise.

It is noise that will eventually lead to a revision in the way productivity is calculated. A revision that makes productivity look better than it is today. A bullshit revision, another one, like not counting people who are unemployed and like using hedonic adjustment to "reduce" inflation.

I object.

The whole is not equal to the sum of its parts? Really?

Menzie Chinn, in Assessing Trends in Real Shares at Econbrowser brings up a problem: "Chain-weighted" real numbers don't add up. Chinn links to Justin Fox's Friends Don't Let Friends Calculate Shares of Real GDP. Both of them link to Karl Whelan's A Guide to the Use of Chain Aggregated NIPA Data (PDF).

Chinn quotes Fox: "the different components of real GDP can no longer be added together. That is, they can be added together but, except in the base year, they don't add up to real GDP." Pretty clear.

Fox also says:

The BEA's remedy to the problem is to put up warnings against doing share-of-real-GDP calculations all over its website.

That's pretty funny. Also true, as even I have noticed those warnings.

But I'm having an awful lot of trouble understanding the problem. To use the example both Chinn and Fox use, consider manufacturing as a share of GDP. If you figure Nominal Value Added (for manufacturing only ) relative to Nominal Value Added (for all of GDP) you are okay. But maybe you think your result is unsatisfactory because prices have gone up more slowly for manufacturing than for all of GDP ("think health care", Justin Fox says). The nominals don't give you a good picture of manufacturing's share of real output over time. But that's not the error.

The error comes in when you switch to inflation-adjusted data. Since the mid-1990s, inflation-adjusted values have been figured by the "chain-weighted" method. Because they use this new method, when you take the inflation-adjusted components of GDP and add them up, the total doesn't come out equal to inflation-adjusted GDP. Here's Whelan:

A crucial feature of this chain aggregation methodology is that the real aggregate of X and Y will generally not equal the arithmetic sum of the real series for X and Y.

For chain-weighted values, the whole is not equal to the sum of its parts. That's the problem. That much I get, but that's where I lose it.

It just doesn't make any sense to me. Y=C+I+G+NX, but only if they're nominal values? I have to ruminate on this for a while.