Relevant and even prescient commentary on news, politics and the economy.

On Monetary Economics: Fischer Black v. Milton Friedman

Tyler Cowen discusses a view put forth by Fischer Black that challenged part of Milton Friedman’s monetarist view:

why did both Milton Friedman and Bob Solow scorn him as a macroeconomist? Well, Fischer pushed two (actually more) controversial claims. First, the Fed cannot influence real or nominal variables, unless traders allow it to … Black’s economic thought is centered around the view that all profit opportunities will be exploited. So what happens if the central bank decides to add zeros to the accounts held at the Fed? … In Black’s view banks were already holding all the dollars they wished to. One reaction is for banks to borrow less money at the discount window, or perhaps borrow less from each other. Money will leave the system as quickly as it entered.

Tyler links to a textbook discussion of the old-fashion money multiplier model and sides with Friedman. I wish I could link to the old James Tobin lecture notes where he noted that this model presumed some sort of government imposed quantity restriction on the amount of money banks could supply. Imagine if reserve requirements were repealed – or even lowered such that the money multiplier model would predict a constraint well about the market-clearing demand = supply of money level. Black’s claim would then not be so controversial.

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Putin Tax: Back in the USSR

What did the Beatles mean by “I’m back in the USSR. You don’t know how lucky you are boys”? And why is the Club for Growth crowd arguing we should emulate Russian economic policy as in this tribute from Stephen Moore:

All over the world, from Estonia, to Albania, to Russia to Hong Kong, flat taxes are in vogue. The flat tax is being instituted to enhance economic growth, increase tax revenues and make tax codes fairer. Why not in the U.S. After all, isn’t the world topsy-turvy when Moscow, the onetime center of socialism, has a 13 percent top income tax rate compared to 35 percent in America, the land of the free? … I would suggest one politically viable way to overcome the special interest opposition to tax reform is adoption of a Freedom to Choose Flat Tax. The potential economic gains are gigantic for American workers and firms if the tax panel adopts this approach. For example, if the $200 billion a year compliance costs attributable to the tax code could be cut in half, the financial windfall to the nation would be larger than the value of all goods and services produced by every worker and business in the states of Maine, Vermont and New Hampshire combined. On top of that, Harvard University economist Dale Jorgenson estimated several years ago that if replacing the U.S. tax code with some kind of flat and simple consumption tax would increase economic growth by about 10 percent.

Before we turn to the real story in Russia, let me suggest two things. #1: having a dual system of taxation would likely increase compliance costs and #2: Moore misrepresents what Jorgenson and other economists have said when he claims reducing tax rates encourage rapid economic growth. The real message is that a fiscally neutral change in tax policy might provide a modest boost to savings assuming people consume less. The Reagan-Bush43 fiscal agenda seems to be to “give people their money back” so they can consume more. But even if the national savings rate is increased by a couple of percentage points, my Excel simulation model does not say that the growth rate rises by 10%. Rather, real income eventually increases by about 9% in a new steady state that occurs in a couple of centuries with the immediate boost to the growth rate being only 0.2%. Yet, Moore et al. continually misrepresent economic research by claiming a free lunch with a massive boost to the growth rate.

Mark Thoma noted:

Yes, let’s strive to emulate the economies of Estonia, Albania, and Russia – as the administration’s current economic policy seems to be doing …

Actually, the CIA sees the Russian economic scene thusly:

Economic growth slowed down in the second half of 2004 and the Russian government forecasts growth of only 4.5% to 6.2% for 2005. Oil, natural gas, metals, and timber account for more than 80% of exports, leaving the country vulnerable to swings in world prices. Russia’s manufacturing base is dilapidated and must be replaced or modernized if the country is to achieve broad-based economic growth. Other problems include a weak banking system, a poor business climate that discourages both domestic and foreign investors, corruption, and widespread lack of trust in institutions. In addition, a string of investigations launched against a major Russian oil company, culminating with the arrest of its CEO in the fall of 2003, have raised concerns by some observers that President Putin is granting more influence to forces within his government that desire to reassert state control over the economy.

With per capita income less than $10,000 and 25% of the population in poverty, why is the Club for Growth crowd arguing that Russia is a shining example of supply-side economics. It is true that real GDP growth was 5.1% in 2001, 4.7% in 2002, and 7.3% in 2003 but also note that real GDP grew by 6.3% in 1999 and 10% in 2000 before the reduction in income tax rates. And despite the strong growth since 1998, real per capita income may still be below its levels when the Soviet Union fell. If you are wondering why the Club for Growth blog discontinued comments, blame me for pointing out to Andrew Roth what Joseph Stiglitz wrote in his chapter “Who Lost Russia”. It seems Andrew considers it to be sneaky liberalism to point out something written by a Nobel Prize winning economist.

For sources on why Russia’s economy has seen such rapid growth since 1998, see the various reports from the World Bank. Their discussions note that Russia’s progress is attributable in part to restructurings that have undone some of the damage from the crony capitalism era and in part to rising petroleum prices, which is also discussed by Fiona Hill:

Looking carefully at Russia’s economic growth since 1997, there is a clear correlation between growth and the rise in world oil prices … In 1998, when world oil prices dipped to around $10 a barrel, this drop coincided with the worst of Russia’s economic crises and the collapse of the ruble. High oil prices and Russia’s oil production rebound after 1999 were good news for the Russian federal budget. Natural resources constitute around 80% of Russian exports and oil and gas account for 55% of all exports — making Russia’s budget particularly dependent on the energy sector. In fact, 37% of Russia’s budget revenues are provided by taxes on oil and gas. Recent research by the World Bank and the IMF has shown that each dollar increase in the price of a barrel of oil (Ural crude) raises Russia’s federal budget revenues by as much as 0.35% of GDP.

To his credit, Bruce Bartlett does not try to argue that the income tax change of 2001 increased economic growth and only notes an improvement in compliance as he points to an IMF analysis, which states:

there is no evidence of a strong supply side effect of the reform. Compliance, however, did improve quite substantially-by about one third according to our estimates-though it remains unclear whether this was due to the parametric reforms or to accompanying changes in enforcement.

Check out the report in its entirety to see what evidence there might be for a supply-side compliance effect – and while you do so, look at table 3 on page 16, which shows income tax revenues were 3.4% of GDP in 2003 (as compared to 2.4% in 2000) with total tax revenues being 36.6% of GDP (as compared to 36.9% in 2000). Imagine what a fiscally prudent liberal such as Alice Rivlin might do if total tax revenues (Federal, state, and local) were as high a percentage of U.S. GDP, that is, if we raised $4.4 trillion in taxes. We could easily fund public schools, better health care, and have better roads and still pay down government debt so as to protect our Social Security retirement. But Dr. Rivlin might also wonder if income tax revenues were a mere $0.4 trillion – how we would raise the other $4 trillion. Is Mr. Moore proposing we increase other forms of taxation that much?

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Housing, the Fed and M3

The Federal Reserve has been sounding the alarm: the housing market is on fire!

It started with Kohn 4/22/2005.

“Prices have gone up far enough since [a couple of years ago] relative to interest rates, rents, and incomes to raise questions; recent reports from professionals in the housing market suggest an increasing volume of transactions by investors, who (along with homeowners more generally) may be expecting the recent trend of price increases to continue.”

Then Chairman Greenspan 5/20/2005 (in Q&A):

“… only those who have purchased very recently, purchased just before prices actually literally go down, are going to have problems.”

Guynn 5/25/2005 (in Q&A):

“Some buyers, some builders, some lenders are going to get burned …”

And now Ferguson 5/27/2005:

“…right now, housing prices in many markets in the United States are relatively high when judged by conventional valuation measures”

The comments from Federal Reserve Vice-Chairman Roger Ferguson are from his speech in Berlin titled “Asset Prices and Monetary Liquidity”. In the speech Ferguson discussed possible links between “excess liquidity” and asset prices; both equities and housing. With many cautions and caveats, Ferguson suggested that there was no obvious correlation between liquidity and equity prices, but that housing prices were somewhat correlated to M3 across many countries and periods.

Dr. Ferguson presented the following figure and discussion to show the historical relationship between housing prices and M3:

Click on graph for larger image.

“The solid line in figure 3 shows the average behavior of the growth rate of M3 from twenty quarters before a peak in real house prices until twenty quarters after the peak, where the average is taken across all the cyclical episodes in our broad sample. The broken line in the chart is the log level of real house prices indexed to zero in the peak year. As can be seen from the chart, on average the growth rate of money increases fairly steadily until around two quarters before the peak in real house prices and then drops fairly steadily for ten quarters afterward before recovering somewhat. Although there are some variations, this pattern tends to occur in most countries’ episodes.”

As a follow up to Dr. Ferguson’s speech, the following chart shows the real prices of housing nationwide since 1976. This data is from the OFHEO home price index, a “constant quality” index that is based on repeat transactions of individual homes. The nominal prices are adjusted with CPI less shelter.

NOTE: Chart starts at 80 (instead of 0) to better show when price declines started, not magnitude of the decline. For a discussion of price declines in previous busts see “Housing: After the Boom“.

This clearly shows the nationwide real price declines for housing in the early ’80s and early ’90s. In Ferguson’s speech, he presented a similar figure that included the early / mid-70’s housing bust (see figure 2).

The following graph is of the price adjusted value of M3 for the same period. The vertical lines indicate when housing peaked in the previous cycles.

It is important to repeat Dr. Ferguson’s caution regarding not confusing correlation with causation, but it does appear that housing has peaked in the past when price adjusted M3 has peaked. Price adjusted M3 appears to be peaking right now: April 2005 only saw a 1% increase YoY.

Here a couple of more comments from Ferguson. On housing valuations:

“For housing, rent-to-price ratios and income-to-price ratios are commonly used measures to assess valuation. Over the past several years, both measures have decreased sharply in many countries, and they currently are well outside historical ranges in some countries.”

For an interesting discussion on this topic, see General Glut’s post today.

And finally, Ferguson expressed concern about the impact on the economy of a housing bust:

“In a scenario of collapse, the damage to balance sheets and private wealth could go as far as undermining the soundness of the financial system and threatening stability of the real economy.”

The NY Times had an excellent article on this topic on Saturday: “Hear a Pop? Watch Out“. I also discussed this topic earlier on Angry Bear: “After the Housing Boom: Impact on the Economy“.

Finally there were too many housing related articles this weekend to comment on them all. As an example, did you know that Georgia leads the nation in Interest Only loans? That was a surprise to me! See Patrick’s links for a list of recent housing related stories.

Best Regards, CR Calculated Risk

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Increase in the Dividend Yield and the Samwick Effect

Is Meg Richards confused as to the fundamentals of finance:

With earnings growth on the decline, there’s renewed interest in what was once considered an old-fashioned investment. Dividends – regular payments to shareholders out of a company’s retained earnings – have long provided a boost to total return, and now analysts say they could help drive the stock market higher … Historically, dividends have played a much more important role than they currently do, accounting for about 4 percentage points of the roughly 10 percent average annual return stocks have delivered since 1926. But their popularity waned during the bull market … Why now, two years after the tax act was passed, are dividends taking the lead? It’s partly because earnings growth was so strong, it eclipsed the importance of the humble dividend

Mark Thoma tries to make sense of her article:

Why has the dividend payout ratio increased in recent years? According to the article below, there are several possible reasons: (1) Concerns about future returns. When investors expect the market rate of return to exceed the internal rate of return for the firm, they would prefer to have dividends paid out instead of reinvested internally. Thus, as investors anticipate lower rates of return in the future, they will shift towards firms offering dividends and away from firms that use profits for internal reinvestment. (2) The tax act of May 2003 made dividends relatively more attractive from a tax perspective. (3) A change in corporate compensation law has led to a restructuring towards compensation packages that rely more heavily on dividends. (4) There has been a recent shift by investors towards assets with less risk, and historically firms with both solid growth and yield characteristics have less risky overall returns.

Mark leads with the key issue of expected future earnings, which is why I raised the Samwick effect, which we mentioned here. Simply put – if expected future earnings growth is low, firms that wish to serve shareholder interest will increase the proportion of current earnings that are paid out to shareholders. While Mark seems to have a shorter term perspective, the Baker-DeLong-Krugman paper that Mankiw commented upon by in part drawing on the Samwick effect (which is a corollary of the Miller & Modigliani proposition) addressed the of slower long-term growth on asset values and returns. If growth slows, the payout ratio increases but stock valuations decline.

Ms. Richards argues that stock valuations may increase – and her argument drifts from noting lower earnings growth to a suggestion that the market might be expecting higher short-term earnings growth. It is not inconceivable that the market may expect higher future earnings, but in that case – wouldn’t the Samwick effect suggest a lower payout ratio?

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A Security For Calculated Risk to Buy

In a series of posts CR of Calculated Risk, who posts here most Mondays, argued rather conviningly that there is a housing bubble (e.g., here, here, and here). Soon, he’ll have a chance to bet invest accordingly (WSJ-subscription):

Robert Shiller knows bubbles, and he might have just the solution.

The Yale University finance professor – and author of “Irrational Exuberance,” a book that deftly called the dot-com bubble – is a lead figure at Macro Securities Research. The New York research group has developed financial instruments – called “MACROs” – that will be tied to a housing index that tracks property values in certain cities. By purchasing Up MACROs or Down MACROs, investors would be able to place bets on whether a property market is going to keep rising, or whether it’s going to fizzle.

In effect, speculators could play the bubble: They could short the City of Angels and go long on the Big Apple, or vice versa. Homeowners in bubbly markets could hedge against a pop. They could stand to gain if the value of their homes go down. If property values keep rising, of course, the homeowners lose on their MACRO investments — but at least their homes would be worth more.

These days Mr. Shiller is convinced the U.S. housing market is rife with bubble-like behavior. Home-buyer psychology today “fits in with the model of a bubble,” he says. “It’s a wishful-thinking atmosphere that develops the idea that everything is going to be all right, and there’s the sense that you have to get in at any cost because prices are going to keep going up.”

Robert Hartwig, chief economist at the Insurance Information Institute, says the MACRO securities may be the best — and only — way homeowners can protect the value of their homes. Speculators, including hedge funds, could help add liquidity to the market, he says.

MACRO Securities has filed plans for the new securities with the Securities and Exchange Commission. The company intends to roll out its MACRO securities later this year and, in its filing with the SEC, said it hopes to list the securities on the American Stock Exchange. It also has a deal to develop housing-price-indexed futures with the Chicago Mercantile Exchange.

I’ll have to ponder whether the emergence of a financial instrument that allows investors to short residential home values will hasten the bursting, or perhaps listing, of the bubble.


UPDATE: Mark Kleiman reports on some shorting of his own:

Assuming that the deal doesn’t come unstuck between now and the June 15 closing date, I’ve just sold my house. My current place is pleasant to live in and very convenient to my job (about a 12-minute commute, with no freeway driving), and I’m not planning to change jobs or marital status.

I’m selling for purely speculative reasons; I’m going short the Los Angeles housing market. That is, I’m planning to rent, and perhaps to buy back in when housing prices bear a more reasonable relationship to incomes.

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Fact Checking Kudlow’s Latest

While Andrew Samwick has joined the cottage industry of those who parse every word from Paul Krugman, I like this standard:

Challenge every assertion of fact, provide evidence to support it, or change the language to reflect alternative explanations. If the Times won’t do that, then who needs the Times?

But why stop with applying this to the New York Times as we can explore whether the National Review applies this standard to Lawrence Kudlow:

While the trade gap has narrowed, raising overall GDP growth, there are actually signs of a somewhat slower economic pace inside the basic economy. Wall Street economist Joe LaVorgna points out, however, that first-quarter wages and salaries were revised up by a huge $163 billion, with the measure growing 7.5 percent over the year-ago pace. That explains double-digit federal tax-collection returns: Lower tax-rates have expanded incomes, which are in turn throwing off more revenues. This, of course, is the Laffer-curve effect.

So Kudlow starts talking about how economic growth may slow but then gives some obscure reference to suggest workers are earning a lot more. I tried to find what Mr. Lavorgna may have written and this is all I could find remotely similar to what Kudlow claimed:

Incomes probably increased about 0.7% in April as wages and salaries surged on higher hourly wages and a longer workweek.

As far as the average wage rate per hour, BLS reported that it fell to $8.16 in 1982$, which compares to $8.29 at the end of December 2003. The average workweek did rise from 33.7 hours as of March 2005 to 33.9 hours in April 2005 – but this is below the 34.2 hours in January 2001. So with lower real wages, a pedestrian performance as to the average workweek, and an employment to population ratio still at only 62.6%, only Kudlow could consider this a roaring economy for workers. But he says profits have never been better:

As for the all-important business sector, strong corporate profits, in particular, signal the health of this economy. Profits on an IRS income-tax basis, as reported in the national income accounts, have moved up to 10.9 percent of GDP – the highest level since 1968.

“Profits on an IRS income-tax basis” is an odd concept and once again Kudlow gave his readers no clue what he was babbling about. Searching BEA’s NIPA tables, the closest that I could find is table 7.16 (Relation of Corporate Profits, Taxes, and Dividends in the National Income and Product Accounts to Corresponding Measures as Published by the Internal Revenue Service), which reconciles to NIPA table 6.16 (corporate profits). Of course, corporate profits are only a subset of total profits. A more comprehensive measure would be line 12 of table 1.10 (net operating surplus: private enterprises). The following table shows both measures as share of GDP. By either measure, the profit to GDP ratio is the highest since 1997 – not since 1968.

But then Kudlow is rarely honest with his readers. Maybe I’m holding the National Review to too high of a standard.

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Club for Growth: Savings = Taxation

Adam Doverspike reveals his “our way or the highway” view as he criticizes the attempt among Senate moderates to fashion a reasonable bipartisan approach to Social Security reform. He especially does not like add-on accounts:

It seems that some big government Republicans are looking to “add-on” personal accounts, which is another way of saying “raising taxes on those who can least afford it.” The President must stay firm on demanding Social Security reform include significant voluntary personal accounts from the existing taxes.

Voluntary contributions in the form “add-on” personal accounts are considered taxation?

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The Increase in Gasoline Prices – Robert Novak Gets Something Almost Right

Ben Stein must pay a lot for gasoline:

At my local gas station in Beverly Hills, self-service – yes, self-service – high test is now $3.22 a gallon, so I believe that the concern is real.

The day the New York Times published his op-ed, I was purchasing gasoline at a nearby service station that charged only $2.69 a gallon for unleaded premium. But why have gasoline prices increase so much in the last few years? One story notes:

“As the demand goes, so does the price of oil and gasoline,” says [Eric] Bolling. Roughly half of what you pay in America – 44 percent – is determined by the price of crude oil; another 15 percent is for what it costs to refine that oil and get it to you … Regardless of where you fill up,nearly a third of what you pay at the pump is taxes: Federal and state … So, you get what you pay for. And while some costs – crude oil, distribution, taxes – change, some things do not.

The pundits at Capital Gang were in a heated discussion a few weeks ago when Robert Novak claimed:

There’s a lot of Saudi bashing from all parts of the political spectrum, when in fact, Saudi Arabia has very little to do with the whole question of what the price of gas and oil is. And I just love the fact that the president says we have to build oil refineries. We haven’t built any oil refineries in this country in what, 30 years? And so we can build the oil refineries, but Nancy Pelosi says it’s not good. So it’s all demagoguery, I think, from the left wing conservationists.

Novak in effect is making the claim that the increase in gasoline prices is due more to an increase in refinery margins than an increase in the price of crude oil. While might scoff at the notion that something that represents only 15% of the price at the pump is responsible for much of the increase in gasoline, but there maybe a little to what Novak claimed.

Using this data from the Department of Energy, I constructed the following graph of the components of gasoline prices, which include the estimated price per gallon due to crude oil prices, taxes, the margin for refineries, and the margin for distribution. Average prices for a gallon of gasoline rose from just under $1.52 as of March 2000 to just over $2.24 as of April 2005. This almost 50% increase in the nominal price compares to an approximately 13% increase in the overall consumer price index over the same period of time. Note that neither taxes nor the distribution margin even rose as much as the overall consumer price index, while the refinery margin doubled. Of course, given its low weight, its dramatic percentage increase only translated into a $0.24 per gallon price increase. Crude oil prices rose by 65%, which translated into a $0.44 per gallon price increase.

Of course, this data is only the accounting of the increase in gasoline prices and does not give the cause of variability of gasoline prices. Saudi bashing is indeed silly as they have not caused the upward shift in oil demand. If gasoline prices remain high, I suspect market incentives will induce companies to build new oil refineries even if the Bush-Cheney energy bill does not pass. And I’m not sure why Mr. Novak is surprised that new refineries were not built when gasoline prices were low during the 1990’s.

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Help-Wanted Advertising Index Unchanged

The Conference Board reports some disappointing news:

The Conference Board’s Help-Wanted Advertising Index – a key barometer of America’s job market – was unchanged in April. The Index now stands at 39. It was 38 one year ago. In the last three months, help-wanted advertising declined in seven of the nine U.S. regions. Steepest declines occurred in the South Atlantic (-12.4%), East North Central (-10.8%), and West North Central (-9.9%) regions.

Says Conference Board Economist Ken Goldstein: “The labor market indicators were soft in April. Want-ad volume was flat while the data on initial unemployment claims was essentially unchanged. These are indications that hiring intentions again turned cautious in April. The reason for caution appears straightforward. While the Coincident Economic Index continued to edge higher in April, the Leading Economic Index fell for the fourth straight month. Other economy-wide data were pointing to the possibility of the economy falling into a soft-patch this summer, for the second year in a row. If that were to develop, it would be enough under ordinary conditions to make businesses cautious with respect to adding expensive labor over the next few months.”

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