Both sides now

They're still counting votes in Georgia, but CNN seems to think things will soon be settled.

I think the only thing that gets settled is: Most people get more convinced that things will get worse, one way or the other.

Politics is the problem. No, not politics: People being politicized is the problem, because now everyone thinks our troubles have political roots. 

Our problems appear to be political because we have taken sides that we didn't need to take on political issues that didn't even need to come up.

Our problems, at root, are economic. You have to peel the onion pretty far down to see it, because things have been getting worse for such a long time. But the original problem, which still waits to be solved, is economic in nature. Economic growth is slow and has been slowing since Paul Volcker ran the Fed or maybe since the mid-1970s. Or maybe since the mid-1960s or before; a long-term problem in any case, impacting people for two generations and counting.

When economic growth is slow, jobs are harder to come by. Income is harder to come by. There is greater incentive for crime and corruption. Unresolved, the problem gets worse.

I remember Newt Gingrich, in To Renew America, hypothesized a world of better economic growth, and wrote:

In this world of merely 1 percent higher growth, the Social Security Trust Fund never runs out of money for as far as the current model can look into the future.

That, from the 1990s when Social Security was a big issue. Add one percent to the average growth rate, and the problem would be solved. The same is more or less true today: More jobs, more income, less need for "government interference" (or "government help" if you prefer) in the economy. Less need for that kind of help makes the "secondary" problems (arising as consequences of the initial problem) easier to solve. Smaller problems, less interference, less objection to the interference, less partisanship, more cooperation. It all works together.

Less need for Obamacare, for example. Doesn't "less need for it" help solve that problem? They came up with Obamacare because people couldn't afford health care. (We call it a "health care" problem. It is mostly an affordability problem.) But getting the government to pay for health care (or forcing us to  pay) doesn't solve the problem of rising cost.

If there is a cost problem, the solution is to find and fix the cause of that problem, not to get someone else to pay the rising cost. Besides, there is a good argument to be made that throwing money at a problem makes the problem more expensive.

If you threw money at me, I'd take it. That's how it works.

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The initial problem? The rising cost of finance, perhaps as long ago as the 1950s. The rising cost of finance, embodied in our growing reliance on credit, created cost-push pressure. Cost pressure creates inflation, or slows growth, or both. The more we fight inflation, the greater the slowing of growth. Eventually, the slowing takes on a life of its own and inflation doesn't even try anymore. And here we are today.

Did I leave anything out?

A glance at corporate profits

Download the PDF

It is pretty well recognized that corporate profits in recent years have been high:

Graph #1: Four Measures of Corporate Profit, relative to GDP

They're jiggy, but these measures of profit move pretty much together, and after the year 2000 profits do go high. Sure, profits have fallen some since 2012, but in total, corporate profits are still above 10% of GDP, as the red and blue lines show.

The red is annual data that begins in 1929. The others show quarterly values that begin in 1947.

To summarize what Graph #1 shows: Red and blue represent all of corporate profit. Green represents corporate business profit. The purple line represents nonfinancial corporate business profit. 

Nonfinancial business makes and services things.

The space between the blue and green lines represents the profit of corporations that are not businesses. The space between green and purple represents financial corporate business profit. 

Financial business makes and services money.

Here's the hierarchy: 

corporate profit, which consists of

profit of non-business corporations, and
corporate business profit, which consists of

financial corporate business profit, and
nonfinancial corporate business profit, which consists of

profit arising from nonfinancial activity, and
profit arising from financial activity

As you may notice, this hierarchy is organized by type of business, not by type of profit. To my mind, it is important to view profit by type of profit. Specifically, I want to know the profit arising from the production of goods and services by nonfinancial corporate business, as opposed to the profit arising from their financial assets. If that information is available, I am unaware of it.

However, a good portion of the assets of nonfinancial corporations are financial assets: near a quarter of their assets in the 1950s, near half today.

If we assume that the financial-to-total ratios for profit and for assets follow the same "rising from near a quarter to almost half" pattern, we can estimate the shares of nonfinancial corporate business profit attributable to financial and nonfinancial activity.

Then we can take the financial profit out of nonfinancial corporate business profit, and add it to financial corporate business profit. In other words, we can take the given data, which is categorized by type of business, and re-categorize it by type of profit. A significant and useful improvement.

Including the profit of non-business corporations noted earlier, we end up with three categories of profit. So we can figure the three components of total corporate profit:

• non-business profit,
• financial profit, and
• nonfinancial profit
  

each of which I show here as a percent of the total:

Graph #2: The Components of Corporate Profit, 1951-2020 (Stacked Graph)

Nonfinancial profit falls from two-thirds to one third of total corporate profit. The profit arising from financial and non-business corporate activity doubles, from one-third to two-thirds of the total. (Click the "Graph #" text to see the graph at FRED.)

Corporate profit may have been high in recent years, but for the nonfinancial corporations that produce the goods and services we regularly consume, profit is low. If unemployment is as a rule too high and economic growth too slow, it is because nonfinancial profit is low.

Cost-push and the dual mandate

This is about the economy before covid and, I expect, the economy after covid.

At the Adam Smith Institute: Inflation is not a cost-push phenomenon

The first two paragraphs:

Many economic commentators used to believe (and some still do) that inflation could result from rises in the input costs of production. An increase in the price of raw materials or in the wages paid to workers would have to be passed on, it was supposed, leading to a rise in the price of the finished product. If enough goods were thus affected, this would bring about the general rise in price levels which is popularly called inflation.

If the money supply is unchanged, then price rises for some products will be matched by lower prices elsewhere. If people have to pay more for their essentials, for example, following increased prices brought about by higher input costs, then they will have less money to spend on non-essentials, the demand for which will go down.

When the price of essentials goes up, some spending moves out of non-essentials and into essentials. The demand for non-essentials goes down. Producers cut back the production of non-essentials, and some workers lose their jobs, or work fewer hours. There is less employment in the non-essentials sector of the economy.

But there is not more employment in the essentials sector. Costs went up, and prices went up, but demand didn't go up. We're lucky demand didn't go down, and that's only because the essentials are "essential". Employment stays the same in the essentials sector, and falls in the non-essentials sector. There is a net loss of output and employment. The economy has slowed because of the higher input costs.

There are three more paragraphs in the article at the Adam Smith Institute. But they don't address the problem of declining demand. They don't address the problem that rising cost pressure leads to a slowing economy. They address only the problem of inflation.

//

Inflation is an unacceptable solution to the problem of rising cost. The other solution, equally unacceptable, is slow growth. The dual mandate of the Federal Reserve is to achieve "maximum employment and price stability". The one goal is price stability, as opposed to inflation. The other goal is maximum employment, as opposed to slow growth.

Both inflation and slow growth contradict the mandate. Both are unacceptable. And yet, policymakers do a good job of keeping inflation to a minimum, while employment is potluck.

But on second thought, maybe that's a flawed evaluation. When unemployment falls to a 50-year low, nobody knows why. And inflation? Inflation has been contained, running below 2% for some years. Running below the 2% target for some years, as if policymakers are unable to raise inflation to the target.

"The core problem stems from the fact that neither central bankers nor anyone else knows what causes inflation." -- Daniel L. Thornton

Maybe it's not that policymakers do a good job of keeping inflation to a minimum. Maybe economic growth is so slow that inflation simply refuses to rise to target.

Maybe, instead of trying to contain inflation and trying to boost growth and employment, maybe policymakers should concentrate on the problem of rising cost, the problem that has long been the source of inflation and slow growth.

I know. It's not in the mandate. But that is no excuse.

"Toynbee maintained that the fate of civilizations is determined by their response to the challenges facing them." -- Stefan Zenker

An end-of-year pause

Lately much of my writing has focused on the cost pressure arising from our increasing reliance on credit and the growth of finance. For me, "financial cost" explains what happened to our economy between the end of the second World War and the disruption of 2007-2010. But the story of what happens in the years ahead may be different.

At the time of the disruption and the first Quantitative Easing, there was much concern about inflation; this concern lasted several years but then, like Q.E. itself, abated. There has been little such talk since that time. Instead, inflation talk has been chiefly about the difficulty of reaching the target of two percent inflation, or about raising that target.

Recently, in response to covid, there has been renewed increase in money printing. But apparently those who warned of inflation from Q.E. were stung by the failure of that inflation to appear, for there seems to be no renewed increase of inflation warnings. People learned their lesson, and we no longer rattle the bars of the ape cage with warnings of inflation. 

Not talking about the threat of demand-pull is dangerous.

//

In Inflation is not a cost-push phenomenon, Dr. Pirie writes:

... if people pay less for essentials because falling input costs allow lower prices, they will have money left to spend elsewhere, with the increased demand leading to higher prices in other sectors. The significance of this is that for over a decade cheap imports from China meant lower prices in developed countries for many household goods. The result was downward pressure on the consumer price index, leading central banks to keep interest rates low, with easy credit and cheap money.

And then, this:

The fall in prices was mostly in goods which show in the various price indices. It left people with money to spare elsewhere, some of which found its way into asset bubbles, including housing. Some of the goods which saw increased demand and higher prices did not feature in price indices, and therefore did not undermine the visible fall in prices. The choice of some items and not others to feature in price indices means that some price rises are effectively hidden from consideration.

When I read those two paragraphs I dismissed them impatiently because I was focused on cost pressure and on Pirie's analysis of cost-push in terms of "essential" and "non-essential" purchases.

But I was awakened in the middle of the night by the thought that some price rises are effectively hidden from consideration. It's true, you know.

This is not a story I would ordinarily tell. But it woke me up, so I had to tell it.

 

Happy New Year.

Two points in time

1973 and 2016:

Graph #1: Monetary Interest Paid as a percent of GDP (annual values)

In 1973 the money we paid out as interest added up to just about 15% of GDP.
In 2016 it was a little less, about 14.3% of GDP.

So interest rates were probably similar 1973 and 2016, right?

Let's see. Here's the policy rate of interest, set by the Federal Reserve:

Graph #2: The Federal Funds Rate (annual values)

In 1973, more than 8 percent. That's unusually high.
In 2016, less than half a percent. That's unusually low.

You and I couldn't borrow at those rates; I think the Federal Funds Rate is for loans of what Milton Friedman called "high powered money". We would have had to pay higher rates. But different interest rates tend to move together. The Fed tweaks the Fed Funds Rate in order to get other interest rates to move. Or as some people might say, the Fed Tweaks the Fed Funds Rate so that it moves with other interest rates. Either way, the different interest rates tend to move together.

In 1973 the Fed Funds Rate was more than 20 times its 2016 value. That's a big difference. But in 1973 the interest we paid (as a percent of GDP) was only a little bit more than what we paid in 2016: 14.98% of GDP in 1973, versus 14.3% in 2016, from the first graph.

I show interest relative to GDP because GDP is a measure of income. I'm looking at the cost of interest in comparison to the money we earned. As a bite out of income, the money we paid as interest was almost the same in 2016 as in 1973: between 14 and 15 percent.

The portion of income that went to pay interest was almost the same, even though the interest rate was a lot higher in 1973. How come? Because the interest rate is only one of the factors that determines how much interest we pay. The other factor is the size of our debt. But you knew that:

Graph #3: Debt of All Sectors: Government and Other (annual values)

In 1973, debt of all sectors was something over $2000 billion.
In 2016, something over $66000 billion.

By calculator, our debt in 2016 was 29.7 times the size of our debt in 1973.

//

Interest rates were high in 1973 and low in 2016. Debt was low in 1973 and high in 2016. The cost of interest was just about the same percentage of income in 2016 as in 1973.

It's not a coincidence that the cost numbers are similar. That's what I started with. I picked years where the interest cost was between 14% and 15% of GDP. Then I looked at interest rates and accumulated debt for those years. Tricky, huh.

Anyway, when you think about the cost of interest, you have to figure both the rate of interest and the amount of debt on which interest is paid.

Most people that talk about interest rates ignore the level of debt. The other way around, too: Most people that fret about debt don't talk much about the interest rate. Both views are incomplete.

Spinach, anchovies, and covid

Marguerite Rigoglioso:

In 2006, spinach producers were hit by an outbreak of E. coli contamination that ground the industry to a halt as all spinach-based food products were yanked from the U.S. market. This nightmare scenario is a particularly dramatic example of the kind of temporary shock that can affect a company's fortunes overnight.

I like this example: spinach instead of oil and wages.

 

 

rommeldak:

I remember reading in an economics textbook of the example of anchovy fishing off the coast of Portugal. Apparently, anchovies are not just for pizza. They are also a major part of cattle feed. One year, for some reason the anchovies didn’t show up in their usual places and so the harvest was very light. Since there had not been a change in the demand for the tiny, salty fish, this caused a rise in price. It cost cattle-feed manufacturers more to produce cattle feed, meaning that ranchers had to pay more, too, and on down the line. The fact that the anchovies didn’t show up caused inflation, which affected the incomes of those involved... Again, however, this is what the market is supposed to do.

 

 

Eric Olson:

While the Federal Reserve and congressional responses to the crisis is well-intentioned and probably necessary, it has also increased demand-pull inflation risk over the next 24 months. Here’s an example of how that might work: Once restaurants reopen for indoor service, they likely will not have the same capacity as they did before. If a restaurant had 150 seats before the crisis, it may only have 75 seats due to social distancing requirements. Restaurants may need to increase prices to “make up” for the lost revenue. The same holds true for movie theaters, basketball arenas, football stadiums, water parks, theme parks, etc. My suspicion is that demand for most goods and services will likely come back at a faster rate than supply, resulting in some demand-pull inflation.

Great insight.

I would have said cost-push: shortfall of supply ==> cost-push, I dunno. But restaurants and movie theaters permanently operating at half-capacity, that's definitely a supply shock.

Tight money

Picking up where I left off yesterday: Tight money depresses output and increases costs. 

That is exactly what happens with cost-push inflation, too. First, cost pressure creates the need for more money; and second, the refusal to satisfy the need for more money keeps money tight and keeps depressing output.

But how do you even know if money is tight?

John Quiggin compares the interest rate to its "long run average" value to determine whether money is easy or tight. Scott Sumner rejects this, and compares NGDP growth to its long run average value to make that determination. Sumner is clear:

Woodford and Bernanke are right; the stance of monetary policy depends on outcomes like NGDP growth and inflation, not interest rates and the money supply.

Sumner makes the monumental mistake of applying "other things equal" to the real world: He assumes that nothing else has changed that could possibly be depressing growth, so that if NGDP growth is slow it must be because money is tight. And yet if there is some other factor causing slow growth -- or if there could be such a factor -- then Sumner's evaluation cannot tell us whether money is easy or tight.

But what has changed? What could possibly be responsible for slow growth? In 2020, covid. But for decades before 2020? Debt and debt service: The cost of accumulated private debt. And with excessive debt slowing the economy, you cannot use NGDP growth as a yardstick to determine if money is easy or tight.

//

Scott Sumner says the economy's bad because money's tight. He's right about that, but he doesn't know how to show tight money. To see tight money, look at circulating money relative to accumulated private debt, or relative to total debt, public and private. Or look at narrow money relative to broad. 

Or just look at the bills that come due, relative to the money available to make the payments. That's how we know for sure money is tight.