Wealth, Equity, and The Recovery

This blog has had two previous discussions about the causes of the 2007 recession.  The first was a post on the merits of Keynes, Hayek, and Fisher in providing an answer to the question of what caused the 2007 Great Recession.  Despite the popularity of Keynes and Hayek in popular editorials, the forgotten Fisher provides the best answer.  Our country forgot the lessons of Fisher and encouraged a bubble in real estate that caused the debt-deflation cycle that we have experienced for the last five years.

The second discussion was a post on Roger Farmer on the role of wealth to create a productive society.  Citing Milton Friedman, Farmer provides the evidence that supports the view that employment tracks positively with wealth.  The more wealth we have as a country, the more employment we have.  With more employment comes more growth and more governmental revenues that provide more services and reduce deficits and debt.

My own research supports the Farmer position.  However, instead of talking about wealth, I use the term equity since I use an accounting view of the economy.  When I look at a statement on the Gross Domestic Product, I see something that is similar in large terms to a national income statement.  And if the country has an income statement, there must be a balance sheet.  I found some data and built a balance sheet going back sixty years.  I analyzed it and saw how equity dropped seriously in the 2007 recession and in the years following. 

Equity is important because it creates the leverage that enables all of us to buy houses and cars and other things.  How many of us postponed a great many purchases because we wanted to repair our own individual balance sheets following 2007?  Both Richard Koo and John Taylor termed this effect as a “Balance Sheet Recession” in their discussions of the Great Recession.  If, from a macro view, the national economy is a composite of our microeconomic behaviors, then our 2007 recession and recovery should reflect the goals of rebuilding our balance sheets.

This brings us to the Stimulus package.  If the cure to the recession is to rebuild our individual balance sheets, then stimulus should enable that to happen.  What did the Stimulus package do?  First, it was a limited series of tax cuts.  Most people used the extra money to pay down debt, which is good, but it failed to stimulate.  In other words, the money was used to rebuild individual balance sheets.  Second, the Federal government transferred money to the states to reduce program cuts.  The Stimulus reduced the number police and teachers that would have been laid off without the Stimulus.  While this is a good thing, it is not stimulative.  In short, this action did not create growth.  The third was a package of road and infrastructure improvements that took far longer to implement than was planned, and the growth effect was diluted.  The sum of these parts is that the Stimulus package did not stimulate very much.  

The reason why this happened is because the policy makers of the time from both parties, including many economists, just got it wrong.  The administration assumed that the recession was basically the same as before.  They did not ask if it was different, and the administration recommended that the medicine from before would cure it. 

The first economists who said otherwise were Carmen Reinhart and Kenneth Rogoff in their book This Time is Different.   They referred to 2007 as a financial recession but they did not offer a prescription for curing it.  We had to wait for people like Roger Farmer to offer a suggestion.

We should also note that as the recession continued, people on their own would improve their balance sheets, which has enabled them to begin buying again.  Once we get back to a national debt/equity leverage typical of the years leading up to 2007, then the economy will begin to approach pre-2007 growth levels.

If we knew then what some know now, the recovery would have been different. 

Roger Farmer on Wealth and Unemployment

I heard a lecture this semester by Roger Farmer who is the Chair of the Economics department at the University of California, Los Angeles.  Dr. Farmer is different from most economists in that he is attempting to address the 2007 recession from a new perspective.  In a previous post I mentioned that there are the Keynesians, and the Hayekians.  There is also Irving Fisher who explained the 1929 depression in terms of a debt-deflation cycle.  Dr. Farmer explains Fisher by pointing us to look at the end result of Fisher, which is wealth.  It is wealth that is lost once a debt-deflation cycle occurs.  This is equity on the balance sheet, and in financial terms, it is that residual value in our own individual financial structures that allows us to borrow in order to buy things.  It is the basis for our own personal leverage.

When the 2007 Great Recession hit lots of personal wealth was wiped out.  Some estimates put it as high as 40%.  This restrains consumption from a Fisher perspective.  However, Farmer makes wealth a more central part of his economic argument.  He bases much of his argument on Milton Friedman, whom he described as a Keynesian.   Friedman stated that consumption is based on wealth and not income, which is counter to a traditional Keynesian argument that wealth is based on income.  I know what you are thinking, but I am just reporting what I heard.

Dr. Farmer presented several graphs that brought his argument into focus.  He traced unemployment through the 1930’s and showed how growth in employment marched hand in hand with the value of the stock market.  He then used this information to build a model of the relationship between the S&P and unemployment over fifty plus years.  He used the first have of the years to establish a foundation of data for the model.  He then used those years to predict unemployment from the 1980’s to more recent years, and the model was incredibly accurate.  He demonstrated that wealth and unemployment move together, and wealth can be used to predict the level of unemployment.   

What are the policy implications of this?  Dr. Farmer proposed a solution that could be received as a “big brother” type of method to stabilize the economy.  He proposed that the Federal Reserve establish an indexed fund of stocks.  The term “index fund” means to buy a set of stocks from the market that mirrors the overall market.  The idea is not to buy a set of winners over loosers.  The fact that the Federal Reserve would buy an indexed set of stocks to stabilize asset values in down cycles would also protect employment from moving to the downside in the proportions that it has in the last five years.

My own personal recommendation is not to tax capital, because taxing capital would retard its growth.  If you want employment to grow, wealth should grow.  

Dr. Farmer has a little book that I recommend to anyone who wants to understand the economy, but who has not the time or the patience to suffer through a college course on the subject.  The book is How the Economy Works and it is available on most bookseller web sites.  Dr. Farmer’s own web site with his mathematically based technical working papers is linked here as well.

The idea that wealth relates closely to unemployment is not a new idea, but Dr. Farmer has been able to put together persuasive evidence that the relationship is real.  

President Obama and Executive Responsibility to Mitigate Risk

Every modern day executive is concerned about selecting the right policy for the organization.  Associated with policy selection, planning the implementation of policy and mitigating risk associated with that policy is an equally important responsibility.  In other words, if a plan is at risk of not going well, the executive has to ask what can be done to put the policy back on track?  When a policy is adopted and not after, good executives ask what can go wrong.  They then ask how to place corrections in place at the time the policy is adopted, not later when things go wrong.  Good executives anticipate what can go wrong and insure against it at the onset through their actions.  This happens before things can go wrong.

This is a skill that President Obama has not exhibited in his first term in office.  He should have asked a series of “what-if’s” with each new policy he put before Congress and implemented in the bureaucracy.    What could be done if the Stimulus Program failed to stimulate?  What could be done if Obamacare failed to contain costs?  What could be done if gas prices double?  And there are other policies where mitigations were not identified.

One of those policies is President Obama’s mid-east policy that was announced in Egypt in 2009.  When he adopted it, an obvious and foreseeable question to ask at the time is what should happen if the mid-east perceives the policy as weak?  One obvious and foreseeable mitigation is to strengthen US embassies in the area.  Any executive of any worth would have protected the policy from any potential risk to the downside at the time of the decision.  When requests for increased security from the field were received would be too late. 

A potential risk that awaits us in the future is what happens when China no longer wants to buy our debt.  When China transitions from an export economy to a consumer economy, there is a good possibility that they will need an inflow of cash from their investments.  There is also the possibility that China may use our debt as a strategic weapon in case we need to compete with them in the Pacific for influence over some critical issue.  This type of risk analysis is sufficient cause us to restrain our growth in fiscal debt.  The question is what mitigations should be put in place to deal with this risk.  This is a President Obama question.

Dealing with uncertainty through risk mitigation is an executive responsibility.  It’s basic.    

Keynes, Hayek, and Fisher

Most people who follow economic events have some familiarity with John Maynard Keynes and Frederick Hayek.  Both economists were contemporaries at the London School of Economics in the 1930’s and have huge followings in economics and public policy to this day.  People associate the public policies of expanding government during recessions financed through public debt and a weak dollar with Keynes.  They also associate austere government programs and a strong dollar policy with Hayek.  While Barack Obama would be characterized as a follower of Keynes, Ron Paul would be characterized as a follower of Hayek or what is currently referred to as the Austrian school, which was Hayek’s home country where he grew up and first taught economics.   While these two people represent the extremes of contemporary economic thought, there is a third economist that should be mentioned when attempting to understand the major economic event of the last five years.

That person is Irving Fisher who was an economist in the United States in the 1930’s during the Great Depression.  He had a number of followers who elaborated on his work.  Among them was Charles Kindleberger.  These two economists described the mechanisms associated with great financial economic depressions that apply to today’s economics. 

A financial collapse, such as the ones that were experienced in 1929 and 2007, usually begin with an asset that can grow over time faster than the average asset.  Speculators begin to recognize the growth potential and borrow money to buy more of the asset, which in turn, causes the value of the asset to grow at a more accelerated rate.  Financiers begin to see the potential of financing the asset as a growth market and put more funds into the area.  Soon, credit requirements are lowered.  More speculators are enticed by the financing possibilities and more credit is put into the market.  This cycle continues until there are no more speculators that can be enticed into the market to bid up the value of the asset in question.  In other words, there is no more credit that can be drawn into the market to finance the asset.  Either way, the value of the asset will fall leaving vast sums of unsecured credit exposure.  There is a financial collapse and neither Keynes nor Hayek adequately addresses it.

Fundamentally, what do we have here?  Assume that the national economy can be represented by a set of financial statements that a company, whether big or small, would maintain.  There is a balance sheet, which is a snapshot statement of assets, liabilities and equities, and an income statement, which is a summary of revenues and experiences.  Note that the Fisher process focuses on assets and liabilities, or balance sheet items.  It does not focus on employment, jobs, and growth, which are income statement items.

The policy responses of a Keynesian would be to expand government to take up the slack in the GPD.  In short, borrow funds to keep people working, which is an income statement strategy.   It assumes that the income statement would correct the balance sheet, which is rarely the case.   The policy responses of an Austrian would be to assume that the capital markets heal themselves.  In short, the impairment to the capital markets will result in creative destruction.  The economy will heal itself faster though a great many more people being hurt in the process when compared to a Keynesian approach that will not grow the economy much while not hurting as many people.  Both sides of this continuum sound silly, don’t they?

The policy response of the Fisher approach is to repair the balance sheet.  Unfortunately, we cannot do that without betraying a lot of bedrock American principles.  We do not take over banks and forgive the debt of the American public.  We recognize “moral hazards”, and avoid forgiving rational people for rational decisions that ended up badly.   So, how do we get out of this mess?

One thing that should not have been done is to adopt the stimulus program that was executed.  It turned out to be a “make work” program to keep as many people working for as long as it could.  If the President recast it into acquiring assets that could be leveraged for growth, then we would have been better off.  He talked about improving the electrical grid, which would have lowered energy prices and help businesses and consumers operate with lower margins.   He also talked about solar farms and similar things that would have improved our competitiveness globally.  This did not happen and we are left with the debt and not much productive improvement to our base that can be used to pay it down.  The result is more burdens on all of us.  It turned out to be a bad investment.  It still does not answer the question of what we do now.

One thing that should not be done is to increase the taxes on capital, which would be the impact of the current tax plan advocated by the Democrats and President Obama.  Assets need to be leveraged for productive use, and taxing capital will reduce this country’s ability to acquiring productive assets that create jobs.  Tax fairness is a legitimate issue, but cutting off one’s nose despite the face is not the way to go.

The public wants an administration that will increase employment and lower the unemployment rate.   Government has proven itself incapable of achieving this goal.  The business sector is all that is left and that raises the question of how do we make business work without raising our risks of capital destruction in a Fisher asset bubble?  Not totally sure, but the two approaches we have in our major political parties are not producing answers to our problems.   What I am looking for is a pro-growth economic philosophy that includes not just protecting our capital assets but also leveraging them for growth.  So far, I have not seen anyone on the current stage that talks this stuff, though Romney comes closest.

My apologies.  I led you, the reader, through a number of economic alternatives that probably raised the hope of you reading a bunch of easy to remember policy prescriptions only to find out that I don’t have any  -- yet.  I only have a bunch of questions with some clues as to what those prescriptions should be, and the realization that the current crop of answers is inadequate.

Public policy is not easy.  Those who say it is are not being honest.

 

  

President Obama, Capital and Property Rights

If you’ve got a business -- you didn’t build that.  Somebody else made that happen. 

President Obama, July 15, 2012

Having a business requires capital, and having capital empowers an employer to hire employees.  Capital comes in the form of assets, and owners of assets have property rights with respect to those assets.  The owner can sell them or loan them out for a fee or use them to create a product or service.  In other words, assets have productive uses and owners can expect a return on them.  These rights are guaranteed in law.

An expected return on assets is a function of the prevailing competitive rate of return on similar assets adjusted for the risk incurred on the investment in the asset.  Again, the decision to use that asset for a particular reason is the right of the owner.  If the asset is usurped by the government to use on a purpose other than that the owner intended drives up the risk attached to the asset.  Correspondingly, the expected rate or return on the asset goes up significantly to compensate for the increased risk.

The Obama administration has demonstrated that it does not respect property rights.  The most notable example is the auto bailout in which the Obama administration forced General Motors and Chrysler Corporation bondholders to accept stock in place of cash payment for their bonds.   In a bankruptcy, bondholders usually get a first or secondary call to liquidation proceeds.  This did not happen.  The result is that it sent a signal to the investment community that their assets were at a higher risk than they originally planned, and it was one of several factors that persuaded many investors to withhold money from the markets.  There is a high amount of business cash waiting on the sidelines.  One of the reasons why the economy did not grow during the first three years of the Obama administration is because the process of investing private capital in projects was frozen, and one of the contributing factors was the Obama administration attitude on capital.  

President Obama is campaigning for re-election with an 8.2% employment rate.  The President wants hiring to increase.  Now we see his quote from yesterday and it appears the Obama administration attitude on capital has not changed.

The lesson is very clear.  Capital employs people.  If you want hiring to increase, respect capital and the property rights that go with it.  It would be a win-win for President Obama and investors, unlike todays loose-loose.