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About Mike

Prof of Economics, Wms School of Commerce, Washington and Lee University, Lexington VA

3

Here's a comparison of the inflation rate for the CPI less food and energy, and the inflation rate for food and for energy. As you can see, rising energy prices by themselves don't seem to lead to higher inflation down the road. Ditto food prices. They will however make the overall CPI more volatile than otherwise. Their noise, statistically, so eliminating them doesn't change the bottom line while making the bottom line easier to see. Go to the BLS charts page and click on CPI vs CPI less food and inflation to see the difference.

 
 

Here is "core" inflation (the CPI less food and energy) versus (i) healthcare services, (ii) new car prices and (iii) apparel prices. On average the latter two have been flat (+0.1% for cars) or falling (-0.3% for clothing). Old houses didn't have closets. New ones have walk-in closets. In contrast over the past 20 years overall "core" inflation has been 2.0% ("headline" everything included inflation has been 2.2%). Healthcare has averaged 3.8%. That means that over the past 20 years "core" prices rose 50%, while healthcare prices more than doubled [compounded 20 times = (1.02)^20 vs (1.038)^20 in Excel]. That makes sense: out of the past 241 months, the prices for healthcare services rose faster than core inflation in all but 4 months.

15

Here's a comparison of the inflation rate for the CPI less food and energy, and the inflation rate for food and for energy. As you can see, rising energy prices by themselves don't seem to lead to higher inflation down the road. Ditto food prices. They will however make the overall CPI more volatile than otherwise. They are noise, statistically, so eliminating them doesn't change the bottom line while making the bottom line easier to see. Go to the BLS charts page and click on CPI vs CPI less food and inflation to see the difference.

 
 

Here is "core" inflation (the CPI less food and energy) versus (i) healthcare services, (ii) new car prices and (iii) apparel prices. On average the latter two have been flat (+0.1% for cars) or falling (-0.3% for clothing). Old houses didn't have closets. New ones have walk-in closets. In contrast over the past 20 years overall "core" inflation has been 2.0% ("headline" everything included inflation has been 2.2%). Healthcare has averaged 3.8%. That means that over the past 20 years "core" prices rose 50%, while healthcare prices more than doubled [compounded 20 times = (1.02)^20 vs (1.038)^20 in Excel]. That makes sense: out of the past 241 months, the prices for healthcare services rose faster than core inflation in all but 4 months.

16

Here is a table of the income side of our GDP accounting, with data for 2017Q3, the most recent available. You can find much, much greater detail on the NIPA portion of the Bureau of Economic Analysis web site. What you can see is that compensation is the largest single component. Of course we might think that should be combined with small business income of $1,382 billion. Other changes? Observations?

Gross domestic income 19,515 100%
compensation 10350 53%
wages & salaries 8388 81%
supplements (social security contributions) 1962 19%
excise & import taxes less subsidies 1270 7%
net operating surplus ("profits") 4842 25%
net interest 805 17%
transfer payments (social security taxes) 153 3%
small business income* 1382 29%
rental income 747 15%
corporate profits less government business 1755 36%
taxes 476 27%
dividends 764 44%
retained earnings 527 30%
depreciation (“consumption of fixed capital”) 3052 16%

Of course we would like to know how things changed over time. I could for example look up the change in compensation of workers as a percent of GDP. For some questions, that is the proper metric. But we really want to know how we're doing, how compensation has changed over time. The graph I add uses "real" data, that is, corrected for price changes. We'll get to the nominal / real distinction on Friday.

Note that in the following graph I use a log scale. That's preferable when there's a growth trends and the magnitude changes a lot. If X is the level, then a 10% increase is X*(1+.10). If we take a log then that becomes log X + log 1.1. So the same vertical increment represents the same percentage increase, whether the level of pay is low or high. If we use a regular scale, then a modest vertical increment to pay in 1960s represents a large percentage increase, while the same vertical increment in 2017 represents a small one. In other words, we can't "eyeball" what is going on. Another takeaway: with a log scale, the slope of the line is the (percentage) rate of increase. Again, your eyes fail you with a regular scale, as the slope doesn't translate directly into the rate of change.

Short-cuts: each item, as with any accounting system, incorporates lots of detail about what is and isn’t measured. Here is one example. Small businesses that aren’t set up as formal corporations don’t pay their owners a salary. Instead, earnings are simply part of personal income, and included as one part of overall income on Federal Income Tax Form 1040 (Schedule F for farmers, Schedule C for other businesses). A hint as to the technical accounting aspects: the formal line item is “Proprietors’ income with inventory valuation and capital consumption adjustments.”

3

Here is a table of the income side of our GDP accounting, with data for 2017Q3, the most recent available. You can find much, much greater detail on the NIPA portion of the Bureau of Economic Analysis web site. What you can see is that compensation is the largest single component. Of course we might think that should be combined with small business income of $1,382 billion. Other changes? Observations?

Gross domestic income 19,515 100%
compensation 10350 53%
wages & salaries 8388 81%
supplements (social security contributions) 1962 19%
excise & import taxes less subsidies 1270 7%
net operating surplus ("profits") 4842 25%
net interest 805 17%
transfer payments (social security taxes) 153 3%
small business income* 1382 29%
rental income 747 15%
corporate profits less government business 1755 36%
taxes 476 27%
dividends 764 44%
retained earnings 527 30%
depreciation (“consumption of fixed capital”) 3052 16%

Of course we would like to know how things changed over time. I could for example look up the change in compensation of workers as a percent of GDP. For some questions, that is the proper metric. But we really want to know how we're doing, how compensation has changed over time. The graph I add uses "real" data, that is, corrected for price changes. We'll get to the nominal / real distinction on Friday.

Note that in the following graph I use a log scale. That's preferable when there's a growth trends and the magnitude changes a lot. If X is the level, then a 10% increase is X*(1+.10). If we take a log then that becomes log X + log 1.1. So the same vertical increment represents the same percentage increase, whether the level of pay is low or high. If we use a regular scale, then a modest vertical increment to pay in 1960s represents a large percentage increase, while the same vertical increment in 2017 represents a small one. In other words, we can't "eyeball" what is going on. Another takeaway: with a log scale, the slope of the line is the (percentage) rate of increase. Again, your eyes fail you with a regular scale, as the slope doesn't translate directly into the rate of change.

Short-cuts: each item, as with any accounting system, incorporates lots of detail about what is and isn’t measured. Here is one example. Small businesses that aren’t set up as formal corporations don’t pay their owners a salary. Instead, earnings are simply part of personal income, and included as one part of overall income on Federal Income Tax Form 1040 (Schedule F for farmers, Schedule C for other businesses). A hint as to the technical accounting aspects: the formal line item is “Proprietors’ income with inventory valuation and capital consumption adjustments.”

1

Here's a sample post, done quickly just to illustrate. Life expectancy has risen around the world, helped by potable water, progress against malaria and similar public health policies. (If you think a bit, you'll realize that lowering child mortality has a large impact on life expectancy.) However, in some countries – the US, Russia – it is no longer improving. Is that a macro issue?

It depends on whether it reflects economy-wide changes in income equality (as a cause) and is presaged by years of disability (a burden on the economy).

Nov 29, 2017

Here are the target upper limit for Federal funds,
and the realized interest rate, both on a daily basis. Rock steady. As you can see, other short-term rates track this closely. Of course most businesses need finance longer than a month or even three; no individual building a home cares [or should care – stay away from variable rate mortgages!] about anything other than a 20- or 30-year interest rate.

Compare this with the "monetarist" period during Paul Volcker's chairmanship of the Fed. Interest rates of course were high, but they were also volatile. See for yourself:

42

Why do expectations matter so much? Because predicting the future has to be really precise to serve as a reliable basis for building a new plant or otherwise undertaking "I" investment. The following is from an online discussion forum in which someone claims to have "the" value for a company, or rather the publicly traded shares in it.

... Always be skeptical! ...

A wise man once said: In theory, there's no difference between theory and practice; in practice, there is.
It's true, the fair value of a company is based on how much cash it can generate over its lifetime. But it's impossible to even roughly estimate this cash generation. The discount rate is also difficult to estimate, and somewhat subjective.
If you're off by even 1% on any of your assumptions, your fair value estimate can be off by as much as 50+%, depending on how far out your estimate is.
My advice: Beware of delusional Tesla bulls bearing discounted cash flow models.

09 Nov 2017, 11:59 AM
Boris Marjanovic, [Seeking Alpha] Marketplace Contributor

The bottom line: you can use formal spreadsheet analysis to highlight assumptions, but in the end the yes/go is based on the expectations of senior management for which scenario is likely, and which (money-losing) scenarios are unlikely. Because such managers read the same publications and interact with each other and give interviews, investment "I" in our macroeconomic sense (and investment in the little "i" stock market sense) reflects social behavior and correlates across firms and individuals. Always be skeptical!


43

As Congress works on a package of tax cuts, it's important to think about whether our current deficit is sustainable. Now Japan is fast approaching a point where debt issues will overwhelm their financial system.Note The US is not Japan: we have a growing population, less debt, and smaller deficits. Nevertheless at some point we too will need to put our fiscal house in order.

...we don't need to run a surplus, but the current deficit isn't sustainable...

What follows uses a simple (but standard) arithmetic framework to clarify what matters. As long as debt to GDP is stable, we should be OK, because the demand for financial assets grows with the economy. In general institutional investors such as pension funds hold government bonds for good reasons, and that a particular bond has matured doesn't change that. So they want to buy new bonds to replace the old. In other words, at today's level of debt, the Treasury can "roll over" debt, issuing new bonds to replace old. There's not only no need to repay our debt, financial markets would be hard-pressed to find alternative assets if we did so. Indeed, 20 years ago, when the Clinton administration was running budget surpluses, Federal debt was declining rapidly. Tax cut proponents found Wall Street figures to wring their hands about how markets couldn't function debt was repaid.

Our economy is also growing. So even if the absolute amount of debt continues to rise, potentially debt to GDP will not. Indeed, that's what happened following WWII. By the end of the war debt surpassed GDP, but fell to just over 20% by 1974. This didn't happen because we ran budget surpluses. Quite the contrary, on average we ran small deficits after 1948. But we did grow, enough to outgrow our debt. But today we're running significant deficits and not growing.

Interest rates matter. In the 1950s and 1960s they were relatively low, so the interest the Treasury paid on our debt didn't offset growth. Today we again have low interest rates, but we also have low growth. So we need to ask whether that changes the situation.

Again, what we want to look at is whether debt is stable relative to GDP. That is, if B is the stock of bonds and Y is GDP, is B/Y growing? On its own – assuming bonds are rolled over – the stock grows with accumulated interest: Bt+1 = Bt(1 + r), where Bt is the stock of bonds at time t and r is the nominal interest rate. Similarly, GDP grows at Yt+1 = Yt(1 + g) where Y is nominal GDP and g is the nominal growth rate. Hence debt to GDP will grow at:

B(1+r)
Y(1+g)

To put this to use, we need three pieces of information: what is the level of debt, B/Y; what is the growth rate g;, and what is interest rate i. That will give us an indication of whether debt is sustainable, and if not, what level of surplus is needed to keep it within bounds.

The first is easy: Federal debt is approximately 100% of GDP, that is, debt to GDP ratio is 1.0 – convenient for arithmetic, as multiplying by 1 is easy. We then need to know the ratio (1 + r)/(1 + g). When r and g are single digits in percentage terms, as in the US, that ratio is approximately 1 + r - g. In other words, with our debt ratio of 1, B/Y will shrink as long as (1 + r - g) is less than 1. The critical issue then is the value of (r - g). If r > g then our debt level will rise, unless we run surpluses. If r < g then we can run (small) deficits indefinitely, as happened during 1949-1974, yet not see our debt level rise.


Now while it might seem that we ought to be able to earn better than the growth rate, this is fundamentally an empirical question. Thanks to the Great Inflation of the 1970s and 1980s nominal interest rates and nominal growth varied wildly. But real growth and real interest rates stay within fairly narrow bounds, except at the depths of our recent Great Recession. The graph below sets forth those data. Excluding the peak around 2009 we find that the average level of (i - g) is about -0.6%. If we include the peak, the average is roughly 0. Now as the graph below indicates, real long term bond yields fell over the past 15 years and are now on the order of 0.8%. Investors, rightly or wrongly, have not built strong growth into bond prices. So to date there's no evidence that the Fed's ongoing normalization of interest rates will raise real interest rates relative to growth. If so, we can run deficits of 0.6% of GDP forever.

To reiterate, we don't need to run a surplus. However, we do need to bring the budget close to balance. Unfortunately, our current deficit is about 3% of GDP. Now that's a vast improvement over the -10% of GDP level at the trough of the Great Recession. Employment growth and profit growth led to stronger income tax receipts, while the improved employment situation led to a drop in "safety net" expenditures. That combination lowered the deficit by a full 7% of GDP. Unfortunately we can't expect further gains, as profits are now high and (un)employment low. There is however downside potential. So we ought to count on the deficit averaging out at -3.5% of GDP, not -3.0%.

...that means we need to "enhance revenue" by 4% of GDP, not cut taxes...

That does not factor in the aging of the baby boomers, who haven't fully retired and whose healthcare expenses will continue to rise until offset by rising boomer mortality. Such retirement-related expenses will likely come to at least 1% of GDP. Hence we need a fiscal adjustment on the order of 4.0%-4.5% of GDP. Congress needs to "enhance revenue," not cut taxes.

Note: Hoshi, Takeo, and Takatoshi Ito. 2014. “Defying Gravity: Can Japanese Sovereign Debt Continue to Increase without a Crisis?” Economic Policy 29(77): 5–44.