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Dallas Fed lays an important Foundation for Fisher Effect

There is a movement taking place to understand the Fisher Effect. What is the Fisher Effect? Basically the idea is that low and stable nominal interest rates from the central banks leads to low and stable inflation.

I have been writing here on Angry Bear that the Fisher Effect is made stronger when the nominal rates are projected to be stable years into the future. And we are seeing now that central banks are projecting abnormally low nominal rates for years to come.

J. Scott Davis, Adrienne Mack and Mark A. Wynne from the Dallas Fed have presented an important foundation for the Fisher Effect we are seeing. They wrote an article, Central Bank Transparency Anchors Inflation Expectations. In this article they describe how the transparency of central banks have risen over the years. And they also write how inflation expectations have become increasingly anchored over time, not only in the US but other advanced countries. They write…

“Among advanced countries, a review shows a strong relationship between an index of central bank transparency and one measuring the anchoring of inflation expectations.”

How do transparency and a stronger anchoring of inflation expectations make the Fisher Effect stronger?

The Fisher Effect is slippery like a fish. You need to have the right economic conditions for it to appear. Here are 4 conditions.

  1. Productive capacity in relation to Effective demand. When productive capacity is low and effective demand is high, like after a war, there are forces to generate higher inflation. These forces overpower the Fisher Effect of low nominal rates to keep inflation low. On the other hand, we currently have a situation where productive capacity is high in relation to effective demand. The current situation supports low inflation.
  2. Past stability of nominal rates. For 5 years, the nominal rates from many central banks have changed very little. Most are stuck at the zero lower bound. Thus, nominal rates have had little impact to actively influence inflation expectations. So inflation expectations have had to react to broader economic conditions, which in themselves are based on a stable nominal rates, high productive capacity and low effective demand.
  3. Projected stability of nominal rates. When there is more certainty that nominal rates will stay low within a narrow range even in the face of future economic growth, it is safer for firms to embed lower price levels in contracts and business plans. The goal is to maximize returns and profits for investors and firms alike. So they arrive at a balanced relationship. Low nominal rates make it safer for borrowing firms to embed lower prices, because there is less of a need to hedge against possibly rising nominal rates. Likewise, it is safer for lending firms to accept lower price inflation.
  4. Strongly anchored inflation expectations. When the monetary policy coming from a central bank is more transparent and stable, it is even easier for firms to embed stable inflation expectations. If there was more uncertainty, we would see firms hedging more by embedding the possibility of higher prices just in case nominal rates rose. A greater uncertainty over future nominal rates can lead to greater embedded possibilities of higher inflation.

Now the authors of the Dallas Fed article give evidence for the 4th point to support the Fisher effect. There has been an increasingly greater transparency of monetary policy from central banks. The intent was to create greater credibility. They have achieved that. Yet, at the same time, probably without realizing it, they have created a trap for low inflation alongside their reasoning for low nominal interest rates.

One might assume that the Fisher Effect leads to only one solution for low inflation; That is to just raise nominal rates. However, that solution creates a disinflationary effect in the short term. Well, there is another solution. Central banks could create more uncertainty in their monetary message wthout actually raising nominal rates. The uncertainty can form cracks in the Fisher Effect, which allow for higher embedded inflation hedging in business plans.

Central banks are being too credible, too transparent, too stable with their low nominal rates, too certain, too narrow… They are also being too stubborn in their thinking that ever lower nominal rates will eventually make inflation rise. Their stubbornness may lead to an underlying unstable uncertainty about the future, which could generate uncontrollable effects on inflation.

The best practical solution for low inflation is for central banks to allow the possibility of higher nominal rates in the future and not lock themselves into a narrow range of abnormally low projected nominal rates.

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Consumption by Capital Income could be Falling… look out

As the stock market moves sideways and house prices slow their march upward, 2014 is shaping up to be a less profitable year than 2013 for those with capital income. We saw consumption from capital income increase greatly over the last couple of years, but this year I expect it to stop rising and even decline.

Today we see that personal income rose, but spending went down in April.

“Personal income increased $43.7 billion, or 0.3 percent, and disposable personal income (DPI) increased $44.6 billion, or 0.3 percent, in April, according to the Bureau of Economic Analysis. Personal consumption expenditures (PCE) decreased $8.1 billion, or 0.1 percent.” (source)

I expect that any spending increase from increased personal income will be offset by declines in consumption spending by capital income. April is showing this effect. Data for the 2nd quarter in general will reveal more whether this trend is growing.

Here is the graph (updated to 1st quarter 2014) of consumption as a percentage of capital income estimated from calculations using the NIPA accounts.

 update perc capital consump b

The percentage of capital income used for consumption rose through 2011 to 2013. Yet, for almost a year, it has peaked at around 22%. With the April numbers of lower Consumption alongside rising Income, I expect the percentage of capital income used for consumption to decline through 2014.

update gross capital consump

Total real dollar spending of consumption by capital income has peaked too. It is not too much of a stretch to imagine consumption by capital income falling to $800 billion on an annual basis. That is over a $100 billion drop. Real personal labor income would have to rise by more than $100 billion just to maintain real consumption spending.

The effect of declining capital income consumption will be too mute the effect of wage inflation to generate price inflation. So will rising personal income with stable price inflation signify more consumer power? Yes… but up to a point.

I can hear you asking… Up to what point?… If capital income gets so weak as to fall too much in its spending, there is an underlying concern of a recession among capitalists. However, if capital income can accept lower returns and be content, then the economy can enjoy a steady-state. The problem is that capital income has little psychological tendency to accept a steady-state that is “mediocre” in their eyes. If they don’t get “adrenaline-motivating” returns, they get nervous, too nervous. Eventually the capitalists create a recession by pushing against a steady-state too much.

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Wealth Is Not Capital: The Brilliant Seth Ackerman Explains It All 4 U

I’m stunned by how good the new Jacobin piece by Seth Ackerman is: “Piketty’s Fair-Weather Friends.” It gives what I find to be the best understanding so far of the whole Piketty “think space.”

It’s so good that I can’t encapsulate it, so I’ll just share some of the passages I’m most taken with, with my highlights for your skimming pleasure. RTWT.

it’s increasingly doubtful whether (or how) [Capital‘s] arguments can be reconciled with the MIT-style economic paradigm to which Piketty’s most ardent American promoters — liberal economists like Joseph Stiglitz, Paul Krugman, Brad DeLong — swear allegiance.

For [Paul Krugman], the lesson of Capital in the Twenty-First Century is that mainstream theory has shown its worth: “You really don’t need to reject standard economics either to explain high inequality or to consider it a bad thing.”

At the heart of the neoclassical apparatus lie the twin concepts of marginal productivity and the aggregate production function (more on these below), and as Thomas Palley has written, when it comes to these totems, “you are either in or out.” Thus, as soon as an economist who aspires to theoretical originality wishes to investigate the dynamics of income distribution, she’s liable to find herself swiftly tangled in a conservative straightjacket.

Now that the book’s arguments are being digested, the same liberal, MIT-style economists who did so much to thrust Piketty’s book into the spotlight are expressing serious doubts — and the reason goes back to marginal productivity theory. That theory might end up resembling less a wall that Piketty could circumvent than a maze in which he will find himself trapped.

Marginal productivity theory … makes up something like neoclassical economics’ “operating system” — the language in which almost every proposition must be embedded in order to work.

Popular attempts to recount [the Cambridge Capital] debate tend to get needlessly bogged down in the abstract. They typically focus on the brain-teaser question of whether it’s possible to quantify the “amount” of capital in the economy, given that this capital stock is made up of a vast number of heterogeneous goods, from jackhammers to hard drives. And that was, in fact, the issue that first got the debate started.

But what the argument was fundamentally about was whether the marginal productivity theory of income distribution — marginalism — is a logically coherent theory.

In the Cambridge capital debate, this textbook theory was advanced by neither side. It’s a fairy tale told to undergraduates.

the leading mid-century neoclassicals, they had long disavowed any claim that this story could logically explain the income distribution, for a simple reason: whether or not such marginal products actually exist in the real world is an entirely empirical question, and the answer is that they generally don’t.

Today, empirical studies of manufacturing industries are unanimous in finding that per-worker productivity is constant, not diminishing, as more are put to work in a factory; while even in fast food joints (as this riveting online tutorial for McDonalds managers makes clear) the volume of sales per worker does not depend on how busy the store is, except maybe during the graveyard shift, due to a residuum of fixed labor costs.

it would be irrational for a firm to lay off some workers just because, say, a strike or a minimum wage law hiked up their wage. The employer would get the worst of both worlds: a lower profit margin on every unit of output produced (because of the higher wage) and fewer units produced (because of the laid-off workers). Rather, her best option would be to keep producing as much as she can manage to sell while simply accepting the lower profit rate, assuming profits are still being made. Analyzed in this way, there’s no necessary reason why the platitude “when the price goes up, less is bought” ought to apply to human labor.

But the neoclassical economists on the MIT side of the Cambridge debate already knew all that. They were defending a more sophisticated version of marginal productivity theory that was subtler and, in a way, simpler.

It argued as follows: when the wage is hiked up …consumers switch their purchases from labor-intensive to capital-intensive goods, while firms and entrepreneurs building new lines of business choose more capital-intensive, rather than labor-intensive, techniques. … they are exerting demand for labor or capital through their purchases

And this was the argument that the Cambridge University side defeated

it becomes clear that a rise in the wage does not necessarily make labor-intensive goods relatively more costly to produce, as the neoclassicals had assumed. …it all depends on the complex pattern of input-output relations in the economy as a whole — how many units of good A it takes to produce good B, how many of good B to produce good C, etc., for all the millions of goods in the economy.

Once this neoclassical story — where the relative demands for labor and capital are dependent on their relative prices — is “debunked,” to use Paul Samuelson’s contrite term [he admitted that he lost the argument –SFR], the competitive market economy no longer contains any necessary mechanism pushing the various wage rates or the profit rate to any determinate level.

Rather, history and custom, as well as politics, laws and struggle, will determine who gets what. It’s a system of grab what you can.

Or in my words: the distribution of income, and supermanager compensation, is determined not by scarcity, but by rivalry. The prize goes not to those who put resources to best use, but to those who control who gets them.

it’s unsurprising we should find marginal productivity to be the point where Piketty’s sweeping vision of modern inequality would run into trouble with the economics mainstream.

marginal productivity theory sees a rise in the capital-output ratio as an increase in the “supply of capital,” which, in classic supply-and-demand logic, ought to bring about a reduction in its “price” — that is, a fall in r. According to the theory, this should neutralize the effect on the rg gap.

[Piketty] contended that as growth slows and the capital-output ratio rises, r might decline (as theory predicts) but the magnitude of the decline might still be small enough to permit a net widening in the – g gap.

The technical term for the quantitative relationship involved (that is, between the size of a change in the capital-output ratio and the size of the change in r that supposedly results, or vice versa) is the elasticity of substitution: the higher the elasticity, the smaller the “response” of r to a given change in the volume of capital.

Piketty’s estimate of the elasticity of substitution can’t really be compared with those in the literature. … his pertain to all private wealth, while the literature focuses narrowly on production capital. These are very different concepts.

To interject: this is exactly what I’ve been trying to say, folks. Returns on financial wealth (in the form of money/financial assets/dollars) have only the vaguest and most tenuous relationship to returns (in the form of real output) on real capital — even over very long periods. That’ the crucial lesson of the Cambridge Capital Controversy.

Money matters, and money doesn’t only appear due to the creation of real assets. It appears when real assets are indebted (particularly or generally).

Wealth is (financial assets, including deeds, are) claims on real capital — both particular claims on particular assets, and generalized claims on the stock of real assets. The relationship between wealth and capital remains almost entirely untheorized by economists.

Wealth is not an input to production. Capital is. The creation of wealth in the form of financial assets requires no inputs to production, or any real production at all. Capital does.

Even Piketty fails here; he uses “wealth” and “capital” synonymously, thereby walking right into the rhetorical mind-trap that is marginal productivity theory.

Ackerman says it perfectly:

the elasticity of substitution simply cannot be regarded as a meaningful measure of an economy’s technology (or anything else), or as providing any clue to its future.

What’s essential, rather, is Piketty’s empirical demonstration that the rate of return on wealth has been remarkably stable over centuries — and, contra Summers, with no visible tendency to vary in any consistent way against the “supply of capital.”

And that brings us to a lacuna in Piketty’s analysis that Paul Krugman and other reviewers of Capital have rightly pointed to. The skyrocketing of top-end income inequality we’ve actually witnessed so far in the English-speaking world has mainly come in the form of inflated “labor” earnings, rather than pure capital income.

Which brings us back to marginal productivity theory. Manacled to that concept as their “baseline” theory of income distribution, most liberal economists have done no better than Piketty in their efforts to account for the elephantine growth of these managerial incomes. They’ve had to depict that growth as the result of “rents,”

The problem with these arguments is that neither financiers nor public company executives have led the swelling of high-end incomes over the past several decades. Rather, the single largest contributor has been the income growth of managers in closely-held corporations outside the finance sector  — that is, firms with only a few shareholders, where the controlling owners are almost always the managers themselves, usually family members.

the incomes of supermanagers are in fact an inseparable blend of “labor” and “capital” income.

resurgent capitalists in the 1970s and 1980s, emboldened by a weakened working class, drafted managers tightly into their ranks using the tools and personnel of Wall Street, and reshaped the economic landscape.

Capital has used extraordinary compensation schemes to conscript top management into their ultimate project: ensuring that all possible surplus from production goes to them.

Which prompts me to share this perfect encapsulation of our current situation, from an Albert Wenger post that you should also read in full:

Unskilled labor has been pushed to its reservation price, skilled labor is receiving its marginal product, and all the value creation [the surplus from production] is being split between top management and capital.

I’d say that pretty much nails it.

Cross-posted at Asymptosis.

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Northwest Plan 2013 – Extracts by Webb

2013Northwest-Bruce Sum 1
Click to embiggen. And then do some magnifying. Because even a selected file covering the whole 75 year projection period yields small type.

Anyway this is my first take from Dale Coberly’s numbers for 2013 Northwest Plan with three calculated columns added by me. Those are the three with “Cost-Non Interest Income” as part or all of their label. Which should actually be “Cost-New Non Interest Income”. In any event what this extract shows is that even after the series of FICA increases seen in “New Payroll Tax Rate” there would be a shortfall between FICA and Tax on Benefits on the one hand and Cost on the other, which difference would need to be made up from interest on the existing Trust Fund. The very last column shows this shortfall as a percentage of that year’s Trust Fund and so closely approximates the interest rates needed to have the Trust Fund break even, with any excess being devoted to building up the TF balance to maintain actuarial balance.

‘Approximates’ because there is a missing data point here in that calculated Trust Fund balances depend on a (here) hidden return based on assumed interest rates. So to really evaluate the last two columns you would need to view the entire spreadsheet (coming soon to a forum near you).

Which might have us turn to the column third from the right. This shows the non-interest cash deficiency before and after the series of FICA increases start in 2018. In this scenario the deficiency stabilizes at about 5% of Cost over the 30 years of maximum Boomer impact and then goes to a closer approximation of true Pay-Go after mid-century. The effect of this roughly 5% medium term cash shortfall would be to reduce the Trust Fund Ratio from its current level of nearly 4 times cost to a target level of around 1.25 times cost, a small cushion over the 1.00 requirement under current law for ‘actuarial balance’. The result is that the Trust Fund shrinks in relation to all of Cost, GDP and probably Total Public Debt even as its nominal principal value nevers goes negative. That is the NW Plan is designed to put Social Security on a glide path towards Pay-Go having taken care of the Boomer Bulge along the way. Which is to say providing the piece missing (and by some Commissioners by design) from the 1983 Greenspan Commission inspired Social Security legislative deal.

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St. Louis Fed is seeing the Fisher Effect

The Federal Reserve Bank of St. Louis published an article that low nominal interest rates lead to low inflation… In essence they describe the Fisher effect about which I have been writing here on Angry Bear. There are many economists who do not accept the Fisher effect that low nominal interests lead to stable low inflation. These include Mark Thoma, Nick Rowe, Paul Krugman and David Beckworth.

What did the St. Louis Fed say in their article…

“Assistant Vice President and Economist Yi Wen and Research Associate Maria Arias, both of the Federal Reserve Bank of St. Louis, explain that, in a liquidity trap, investors choose to hoard the additional money resulting from an increase in the money supply rather than spend it because the opportunity cost of holding cash—the forgone earnings from interest—is zero when the nominal interest rate is zero. If this increase in money demand is proportional to the increase in the money supply, inflation will instead remain stable. If money demand increases more than proportionally to the increase in money supply, the price level falls.

In a paper last year, Wen argued that large-scale asset purchases by the Fed at the current pace could reduce the real interest rate by 2 percentage points, but would also put severe downward pressure on the inflation rate, among other effects. In The Regional Economist article, the authors argue that low inflation makes cash more attractive to investors, in turn making a liquidity trap easier to occur.

Wen and Arias wrote, “Therefore, the correct monetary policy during a liquidity trap is not to further increase the money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate. … Only when financial assets become more attractive than cash can the aggregate price level increase.”

Evidence and logic is growing for the Fisher effect.

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Northwest Plan 2012 – Numbers by Request of Commenter BK

I am just beginning an attempt to tranform the Northwest Plan for a Real Social Security Fix into a series of Tables and Figures (and original spreadsheets) that people can review at length. But since the authors were effectively accused of not really having numbers at all here is an advanced peek at some of the future workproduct. This one extracted from Excel and tranformed into a graphic. Click to embiggen.

This is from the 2012 version of NW and shows the first increase in FICA in 2018. Which obviously explains why Revenue stays the same until 2017. Note that Trust Fund balances never decline in nominal dollar terms although the Trust Fund Ratio does. But in this data series never below 1.24 (or 124 in Trustee terms) or 24 points above the 100 level that represents ‘solvency’ as the Trustees define it.

The 2013 version differs in detail as will the 2014 once the Report is released (next week?) and we develop it. But the general outline remains the same, phased in increases in FICA over a 20 year period with adjustments at intervals after.

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Michigan Republican Senate Candidate Terri Lynn Land Declares Federal “War Generals” Incompetent. The Targeted Enemy Being Michigan.

[Michigan Republican Senate candidate Terri Lynn] Land, a Byron Center Republican, had defended presidential candidate Mitt Romney’s anti-bailout position two years ago and noted that GM had become known as “Government Motors.” She declined to revisit the topic Wednesday during a brief exchange with reporters, which she cut short following the forum.

“I’ve always supported auto workers,” Land said. “Detroit put Michigan on wheels. They’re the backbone of our economy here in Michigan. It’s great that the autos are doing well. I support the autos, and what I want to do is go down to Washington D.C. and make sure we have a competitive environment here in Michigan and that you don’t over-regulate, you don’t overtax and you don’t over-burden Michigan families.” …

Land used the forum to tout her credentials as a former Kent County Clerk and Michigan Secretary of State while suggesting that “the federal government has declared economic war on Michigan.”

— Terri Lynn Land dodges auto bailout question, clarifies call for ‘free’ Internet after Senate forumJonathan Oosting,, yesterday

Uh-huh.  I mean, if you’re conducting a war, you really shouldn’t deliberately give the enemy the ammunition it needs to regroup and fight back.  Michigan’s economy was down for the count in 2008-09, when suddenly the federal government’s economic war generals handed the enemy, Michigan, the only lifeline anywhere in sight. Talk about snatching defeat from the jaws of victory!

These generals should be court-martialed for treason. Or at least for gross incompetence.

Count me among the (apparently) very few politics watchers who think these Republican Senate candidates will not make it to November spouting utter gibberish and disconnected cliches, and win.

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‘Unemployment Insurance and Disability Insurance in the Great Recession’

Via Economist’s View comes this note on ‘Unemployment Insurance and Disability Insurance in the Great Recession’

From the NBER Digest:

The authors find very little interaction between UI benefit eligibility and SSDI applications, and conclude that SSDI applications do not appear to respond to UI exhaustion. While the authors cannot rule out small effects, they conclude that SSDI applications do not respond strongly enough to contribute meaningfully to a cost-benefit analysis of UI extensions or to account for the cyclical behavior of SSDI applications.

The authors suggest that the tendency for the number of SSDI applications to grow when the economy is weak may reflect variation in the potential reemployment wages of displaced workers, or changes in the employment opportunities of the marginally disabled that influence the evaluation of an SSDI applicant’s employability. These channels are not linked to the generosity or duration of UI benefits, and they imply that more stringent functional capacity reviews of SSDI applicants may not reduce recession-induced SSDI claims if these claims reflect examiners’ judgments that the applicants are truly not employable in the existing labor market.

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Boston, MA: This Saturday, The Patriotic Millionaires for Fiscal Strength will sponsor a landmark dialogue between Sen. Elizabeth Warren (D-MA) and economist Thomas Piketty. Senator Warren is one of progressivism’s most admired and powerful leaders and–despite her “I’m not running” assertions–a top presidential pick for many progressives. Thomas Piketty

The discussion will be streamed on HuffPost Live this coming Monday at 8:30pm (EST).

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