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

Iowa Open Thread: I know you got opinions, predictions

I knew what was going to happen on Monday three days ago. My argumentation was solid and based on data. Even data-based. But now I don’t. At all. Because ‘reasons’.

But I am sure all you do and will fill me in while we wait for actual results about 26 hours from right now. Let the Games Begin! And unlike Hunger Games I am not sure the prediction odds are with anyone. You all can prove me wrong, trump me if you will. Or cruise to victory or whatever horrible pun play you like.

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The Fed messed up

This post will build upon my previous post with the Cobra equation. In that post, I gave a model showing that the Fed is completely behind the curve of the business cycle. The Fed should not be raising rates at this point in the business cycle.

When to Normalize in Theory

In the model, aggregate profit rates have a somewhat circular movement through a business cycle. I say somewhat because in other business cycles, the circular movement looks more like a bouncing ball off of the effective demand limit.

healthy cycle

In the green portion of the cycle, aggregate profit rates are increasing. There is broad momentum to expand utilization of labor and capital. It is the best time for interest rates to get on a path to normalization. The economy can withstand the good medicine of normalizing interest rates because of the momentum of increasing profit rates.

If US interest rates are too low or too high in the green area, global imbalances will grow to some extent.  In the present business cycle, inflation and the labor market looked weak, interest rates were kept low. Even though the economy seems weak and fragile in the green area, the underlying profit momentum drives economic developments and possibly imbalances. Normalizing interest rates are meant to moderate those imbalances.

So the Fed decided not to normalize interest rates because the economy seemed weak and partly because economists like Paul Krugman said the Fed needed to wait for inflation. But global debt accumulated, even emerging market debt, because interest rates were not normalizing in the US.

The accumulated debt is a problem that hinders growth. Apart from there just being more debt, much of the debt in emerging markets is in US dollars. So if interest rates are normalizing in the US, there is a control over too much US dollar debt developing in emerging markets. That is a good thing, because now we see greater problems as the cycle begins to tighten with monetary policy and peaked profit rates.

Also in hindsight, the increased use of US dollars in emerging markets is a problem now that commodity prices are falling. As well, the devaluation of the Chinese Renmibi may have occurred earlier in a more balanced way, if the US had been normalizing interest rates earlier.

So what has the Fed done?

healthy area

This graph seeks to show that the Fed should have been normalizing interest rates in the green area when there was the momentum of increasing aggregate profits rates. The “global” economy would have had better discipline, better balance in order to not create cyclical debt imbalances in US dollars. (Cyclical means that at a certain point in the business cycle, the imbalance becomes a problem.)

Moreover, the efficiency of the US economy would have been greater. Higher interest rates imply more productive companies and consequently better net social benefits, as long as the interest rates are normalizing with the profit rate cycle and with a correct estimate of the real natural rate.

The generally accepted normalized rate for the Fed rate is between 3% and 4%. We are far from there.

The Fed should have been normalizing rates in the green area, and certainly not in the red circle… as they have done. They are completely behind the curve.

With aggregate profit rates peaked for over a year now, it is clear that the business cycle has peaked. So from what I see, the Fed has really messed up, even Paul Krugman. They seem to think that the economy is still within or arriving at the green area of the business cycle.

Now is absolutely the wrong point in the profit rate cycle to be normalizing rates. In a normal cycle, this would be the time that interest rates peak or even fall, but not rise. The Fed can tip the economy into recession.

As I have said before, the Fed will go through some deep soul-searching… as things will not turn out well for them.

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Re: Tim Duy… Brains need not explode

Tim Duy, who is a cool economist, points out a difference between the labor market and output GDP… Labor market improving while GDP is slowing. He describes this difference for the Fed.

“Now they have slow GDP growth and fast employment growth. That will make brains explode on Constitution Ave.”

Yet, Brains need not explode. I have had a model of this difference for a couple of years, which predicted perfectly this situation. Yet, my model ultimately shows that the business cycle has ended, which is something economists like Duy and others at the Fed may not accept.

The Cobra Equation

The driving force behind an effective demand limit is the aggregate profit rate. When companies have increasing profit rates, it is more difficult to have a recession. We have seen in the past year that the aggregate profit rate is falling. This is not a good time to be raising interest rates. It would have been better a few years ago. Anyway…

I gauge aggregate profit rates in 3-dimensional space with what I call the Cobra equation, because it resembles a cobra in 3-D space…

Profit rate = (U + C) – a*(U2 * C2)

U = (1 – unemployment rate)
C = Capacity utilization
a = effective labor share2 – 2.475 * effective labor share + 2

When I take the derivative of the equation, I can gauge the potential change of the aggregate profit rates. I can take the derivative with respect to C and U.

d profit rate/dC = (1 – 2aCU2)

d profit rate/dU = (1 – 2aUC2)

They look the same but in reality they take different paths. Here are the derivatives up to December 2015.

update change in cobra profit rate

Basically the graph shows that the utilization of capital reached its max profitability towards the end of 2014, when the red line reached zero %. Businesses have squeezed all they can from capital in the aggregate. For capital, the business cycle is over. But hiring labor is still profitable, so as the business cycle hangs on, we will see improvements in the labor market.

This model predicted perfectly the path of utilizing labor and capital. Here is a graph plotting the Cobra equation. The utilizations of labor and capital reached profit maximization, slid along the max limit, and have since backed off which is setting the stage for a recession type scenario.

update 3d monthly

The Greater Meaning

The greater meaning behind this model is that the economy has already reached the top of the business cycle and the Fed is completely behind the curve for raising the Fed rate now. They should have been normalizing the rate before the plot in the above graph reached the effective demand limit. The economy had momentum at that point to withstand interest rate rises… but not now.

The Fed should stop trying to raise the Fed rate and just let the business cycle collapse on its own. The Fed is just hastening the recession process by projecting rate increases beyond the effective demand limit.

The Fed is really messed up because they do not have a “real-time self-calibrating” measure of an aggregate effective demand limit. But we have one here… so brains need not explode. However, brains may explode once the Fed realizes they are completely behind the curve.

Update: A bit to add about slowing GDP…

This goes back to the equation for profit rate…

Profit rate = (Productivity – Real compensation) * Total labor hours/Capital stock

Increasing labor hours increases the profit rate. Whereas increasing the capital stock would tend to decrease profit rates. So when capital is maxing its use in the aggregate, we will see an aggregate drop in capital investment, which is the current driver of slowing GDP.

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Trump vs Cruz: Transactional Inside-Outsiderism

What fresh hell/word salad is this?!! Bear with me a second and then treat this as a political open thread.

Trump and Cruz are each in their ways walking talking self contradictory oxymorons. Each purports to be the outsider speaking for the common man yet each came straight to the top through insider channels. Trump manages to be a nouveau riche guy born to money, itself a contradiction, who brags how that money allowed him to outright buy politicians in both parties. Cruz is a guy actually born to the working class who managed to punch every ticket through Ivy League to Harvard Law to Supreme Court Clerk to Texas Solicitor General to U.S. Senator by his early 40’s. And married a Wall Street banker to boot.

Yet though both on any conventional metric are consummate insiders by CV they have convincingly sold themselves as outsiders. How? Because each man is fundamentally, deeply, at basis, bedrock (how low can Bruce go?) transactional in ways that cross cut their undoubted establishment ties and path. Cruz by all evidence convinced himself or was convinced by his evangelical father that he was destined to be Leader of the Free World. Except maybe without the “Free” part. As such you can see every single career decision. however seemingly at the heart of the establishmen.t as actually being inside-out. He has punched every inside ticket on his way to being the outside leader, the path being subordinate to the goal.

And of course Trump as a person and a politician cannot be separated from his book The Art of the Deal, for him it is transactional turtles all the way down, except that unlike Cruz’s desire to be King of the World, and a world that has some relation to the one we live in, Trump seems to dream of being the High Trump of Trumpistan, “First, Last and Penultimate of His Name”

Transactional. Taking the Inside path to Outsiderism to the Mountain Top. Same shit different day.

(Some people would apply this same analysis to Hilary. Well the shoe fits too closely for this Yellow Dog Dem’s comfort, but run free my Droogs)

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Will more economists say that Fed waited too long?

I have been saying for more than two years that the Fed should have raised the Fed rate earlier. Now it is too late because the economy is over the top of the business cycle… or as I would say, against the effective demand limit. They should have raised the Fed rate when effective demand was open and available to give momentum. (my recent post on this.)

So I give you this video from Boom Bust. I direct you to the end of the show in the segment called, Big Deal (21:30 minutes [point). You will see across the bottom of the screen, Federal Reserve Tightening Too Late. They talk about why the Fed should have raised the Fed rate earlier. Will more economists end up realizing this? … I think so…

You might also watch the segment of the show with DiMartino Booth. She has said the Fed waited too long too.

Update: Why did the Fed wait too long? This to me is an interesting question. Paul Krugman is kind of upset that the Fed is raising rates now and is unclear why. But ironically, the Fed may actually have been listening to Krugman and DeLong and others causing them to hold off. But eventually the Fed had to get on the normalization path. Yet, waiting until the top of the business cycle is kind of not smart. But they did not know that the business cycle was reaching its top fast… but I did with my effective demand calculation…

They over-estimated the output gap. While I saw less actual potential because I re-calibrated potential lower with a drop in labor share.

So what are you going do?

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Habemus Bad Bank

I’m not sure if AngryBear readers noticed, but Italy is suffering a slow motion banking crisis– we are so backward that we are getting to 2008 in 2016.

This post is my attempt to translate and summarize this story in Italy’s leading paper La Repubblica and an angry blog post by Luca Fantuzzi
update: in comments run75441 warns that Norton is afraid of the blog post which is in Italian anyway, so I suppressed the link.

Four small banks failed in December. It is, more or less known that large important banks (including the one where I have an fully insured checking account) are in danger.

The Italian solution is to set up a bad bank. A new special purpose entity — the bad bank — will buy bad loans from banks at a harsh discount (I read at 25% of face value written by people who don’t really know). The bad bank will be financed by tranches of debt. Payments on the senior tranch will be guaranteed by the state which will charge the banks for the banks share of CDS at the average rate for “bonds of the same rating”. This means that the fee will depend on the always reliable rating agencies.

This CDS is really provided at a modest discount. For three years it will be based on CDS on debt maturing in 3 years even though the bad bank’s debt will be rolled over.

The Italian finance minister Pier Carlo Padoan promises that the Italian state will make a (small) profit on the deal. I’ll believe it when I see it (and I am the world’s only TARP enthusiast).

Since the bad loans are on Banks’ balance sheets at face value, participating banks will have to admit they have less equity capital than they claimed. It is reasonably likely that at least some will have to issue new common stock (diluting the old stock) to satisfy capital adequacy requirements. Italian firms actually do this (I can’t remember the last time an already listed US firm issued new shares).

I was always a fan of the proposal to set up a bad bank to hold toxic US residential mortgage backed securities, so I feel a bit of responsibility for the Italian Bad Bank.

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Wolverines/Militia vs the U.S. Army/Federal Marshals

It is still early hours in the confrontation between the Malheur Wildlife Refuge occupiers and the ‘jack booted thugs’ but one thing has always been clear. When it comes to a armed confrontation between ‘patriots’ and the forces of government the ‘Patriotic Wolverines’ will lose. Until or unless they subvert the military and the federal police forces over to their side. Which to their ‘credit’ is the premise of the Oathkeepers.

But otherwise this is a dream punctured by Ike in 1957, the year of my birth. The President doesn’t even need to federalize the National Guard. Though Ike did to integrate schools in 1957. The fact is that no amount of appeal to ‘Posse Comitatus’ is going to prevent the President of the U.S from suppressing armed sedition. I don’t care how many rounds you have in your basement gun safe, unless you have the U.S. Army and Marines on your side you are going to get (in a technical term often utilized by professional soldiers) fucked sideways and backwards. This isn’t 1776 and those are not Red Coats trying to reload muskets.

It may be true that The Tree of Liberty Must be Refreshed from Time to Time with the Blood of Patriots and Tyrants. But these days it is the self professed ‘patriots’ who are likely to do the watering. Because you got Play Soldiers and real Soldiers. And it take a LOT to get real Soldiers to go against lawful orders issude by their superiors.

And occupying a bird sanctuary isn’t going to trigger Lexington and Concord against the frigging U.S. Army and Marines. Or for that matter the SWAT teams of the FBI and the U.S. Marshals. Life isn’t a video game. Some folks in Oregon just learned that lesson.

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