Currency Adjustments and “Contagion”

Today I want to talk about debt. Not the kind you think about when you see headlines about student loans, credit cards, or the federal budget. No, this is a very special kind of debt, a kind you likely will hear nothing about, but a kind of debt that has a tremendous amount of influence around the world.

Let’s start in broad strokes. If you’ve read my previous blogs, or any article about floating currencies (fiat money, for the gold bugs out there), then you will know my thoughts on the state of the U.S. Dollar. The USD is the most stable currency in the world today, and it gets that ranking from both its Liquidity (the frequency that it is used) and its Notoriety (the amount of people and institutions that recognize its stability, and thus use it). Most
global energy transactions are made in USD, most financial clearinghouse activity is done in USD, and almost every country in Earth recognizes it as, for better or worse, a stable currency.

This blog post is not about America, however. It is about the rest of the world. How do other countries’ currencies compete with the Dollar in a floating currency system? Do other countries attempt the same industrial booms that America had? What about the same debt issuances, fiscal policy, or foreign direct investment?

The answer, as with most things financial, eventually comes back to the U.S. Federal Reserve. The Fed sets monetary policy for the U.S., which either makes the USD stronger or weaker relative to other currencies. When the USD gains strength, more people will want to hold USD, and when the USD weakens, people will want to sell. Recall that a stronger USD means imports to the U.S. will cost less, as a stronger dollar will be able to purchase more of a foreign currency for each dollar spent. However, a stronger USD also makes exports more expensive, as the stronger USD will push up dollar-denominated prices of goods, and other countries will want to buy less. It’s important, though, to think of currency strength not on a numeric scale. One Dollar will only ever be worth one
Dollar. Its strength or weakness is a result of how much in goods, services, or other currency it can purchase. By that metric, currencies can strengthen or weaken as needed to respond to a growing global marketplace and changing resources.


                                                               Monetary Policy Overview
For a more in-depth explanation of how all this works, the Federal Reserve sets U.S. interest rates, through the Federal Funds Rate (FFR). The FFR is the overnight interest rate on loans from Bank to Bank, set to an annualized percentage. If JPMorgan Chase, for example, needs to borrow money in anticipation of a large cash withdrawal in a few days, they will want to borrow from the Wells Fargo down the street, but Wells Fargo will not want to lend that money if they do not receive interest in return. That is the FFR in a nutshell, and the Fed raises and lowers it in response to economic strength and weakness, but based on consumer trends.

In a strong economy, theoretically, consumers will have more disposable income and will be spending a healthy amount. The Fed wants to protect against the economy getting too hot (and runaway inflation caused by overspending), so they will raise the FFR, thus pushing up the borrowing costs of banks and businesses, and also pushing up the effective interest rates paid on bonds. Consumers will then, theoretically, want to save more of their money by buying those bonds, and economic activity slows.

Conversely, in a weak economy, consumer spending will be weak, and saving will theoretically be strong. The Fed will lower the FFR in this situation, in order to entice people to save less money, and spend more. Lowering the FFR will lower the borrowing and lending costs to banks and businesses, letting them respond more effectively to consumer trends and letting the economy pick up steam.

The Fed has announced in recent years that their “normal” desired FFR is around 1% higher than the inflation rate, which as of August 2018, has come in at 2.2%.


                                                                 The Central Issue
The world is an ever more connected place these days, and that includes the financial world. Recall that investors, businesses, and governments from all over the world acknowledge the stability of the USD. Other countries (with the USD as not their local currency) can, for purposes of this blog, be lumped into three groups; Developed Markets, those that have strong currencies of their own and compete with the USD, Emerging Markets, those that have less pronounced, often pegged currencies to the USD, and Tertiary Markets, those with the weakest economies and most volatile currencies. For this blog post, we will focus on Emerging Markets.

Emerging Markets have seen an explosion of economic growth over the past 20+ years, due to a multitude of factors. These include, but are not limited to, easier access for developed-market investors to invest more directly in them, increased media coverage and grouping of certain countries (The African Union, BRICS, ASEAN, etc.) and overall liberalization of eastern markets. But no factor has had as much impact, nor been as lasting to long-term economic success of developing nations, than cheap debt. Loose monetary policy and cheap debt has been a tailwind to global growth for decades, and has allowed otherwise struggling countries, rife with political and economic turmoil, to reap the benefits of virtually unlimited investment, near-free money, and confidence that the good times would keep on rolling.

I often talk about secular trends in western civilization being responsible for lower interest rates, those trends being an aging population and falling birth rate, stagnant or decreasing real wages, and asset prices (stocks, homes, etc.) rising faster than the rate of GDP or wage growth. Think about this in tangible terms. You work as long as you need to, but your income doesn’t seem to rise much year to year. You look around, and everything is financed nowadays. Average home values have climbed in the last 30 years from under $200,000 to over $300,000, college tuition has more than tripled, even your phone costs more than $1,000. Rising costs for such common expenses pushes them to be paid in installments, and those have interest rates attached. As debt levels rise among
citizens of the West, the interest rates necessarily have to decrease in order to keep affordability. Since western economies make up such a large portion of the global economy, this dictates a lower overall world interest rate, and makes debt cheaper.

Emerging markets will want to take full advantage of this situation, because to them, it could not be better. Countries that can experience massive growth rates do so with mass influx of construction and industrial activity (the American way!) and that takes a lot of capital. Some of the most popular emerging markets are Turkey, Argentina, South Korea, and Indonesia, and I’m sure you’ve heard at least a little about the growth they have
experienced in the past few decades. How do you think they achieved it? Massive capital inflows, often, to their long-term detriment, denominated in USD.

Remember when I said the USD was the most reliable, stable, liquid currency in circulation? It holds true even in those emerging markets. Debt can be issued, bought, sold, and paid easiest when it is denominated in USD. It’s how investors in New York can lend money to Turkish construction companies, or South Korean software companies, or even Chinese bank notes. It’s how financial institutions can transact with each other without foreign currency adjustments getting in the way of quarterly earnings. But at its core, it’s most definitely how countries with no vibrant economy or stable currency of their own, can “borrow” one, to prop themselves up and propel massive growth.
                                                                         


                                                                          Contagion
Here’s how this works for governments. Say Turkey wants to undergo a massive infrastructure plan involving a lot of companies building new buildings. The project will cost, say, 5 billion Turkish Lira. Turkey does not have the money to cover this cost, and they have a choice to make. They could issue Lira-denominated debt to cover the cost, but that comes with a 24% interest rate paid every year. They could alternatively use their Lira to buy Dollars, and issue Dollar-denominated debt at a 5% interest rate. U.S. monetary policy is loose, and interest rates are still at historic lows, remember? Naturally, Turkey would choose the latter option. The effect is twofold. Dollars exit the U.S. and enter Turkey as a Foreign Exchange Reserve, which buoys the value of the Lira (because, theoretically, Turkey could sell its Dollars to keep its liquidity of Lira) and also allows Turkey to take advantage of the far lower U.S. interest rate. If the debt is rolled over every expiry, then demand for that debt will be high, and Turkey will experience a lot of growth as a result.

It works in a similar way for businesses. Say Turkey wants to infuse its private sector with a ton of cash in order to juice its economy. Countries do this all the time, in the form of tax cuts, tax rebates, sovereign wealth funds, or even helicopter money. Turkey wants to lend its businesses 50 billion Lira. Turkey only has 5 billion Lira, and has a choice to make. It could lend the 5 billion Lira now and accept a lesser result, it could invest the Lira in the hopes of having a larger amount in the future (but not lending it now), or it could buy Dollars with that Lira, issue Dollar-denominated debt to lever themselves and receive many more Dollars, and sell those Dollars to buy the 50 billion Lira it wants to lend. Businesses within Turkey’s domestic economy can only transact in Lira, so they cannot use Dollars. The effect of this is once again beneficial to Turkey. 5 billion Lira used to purchase Dollars results in leverage that allows Turkey to “borrow” the ability to access much more of its currency, as a much lesser cost. Once again, Turkey is taking advantage of lower interest rates and cheaper U.S. debt to grow its own economy.

Sounds like a win for Turkey, right?  Seems like a true “miracle” situation, one with no downside, right?

Surely you can see a glaring flaw in all this. The system only works when dollar-denominated debt has a lower interest rate, or put simpler, when the USD is cheaper. For the last 30 or so years, this has been the case, with the massive interest rates of the 1980’s giving way to the Greenspan-led mass lowerings of the 1990’s, the teaser rates of the 2000’s, culminating in the all-time-low interest rates in the 2010’s of 0% – 0.25%. As you can imagine, zero is the “effective lower bound” here, as money cannot get any more free than “free”. But what happens when U.S. interest rates, finally start to rise?


Recall that the Fed raises interest rates to combat inflation and strengthen the Dollar. When the Dollar strengthens, it can buy more foreign currency, and foreign currency can buy less of it. This is where we begin to see the concept of Contagion. In our Turkey examples, for both government and business, growth in Lira terms is being fueled by Dollars, and in both instances, Turkey needs those Dollars to be as cheap as possible so they can keep buying them and issuing debt. If their liquidity dries up, and they can no longer buy as many Dollars with their Lira, then investors quickly lose confidence in the ability of the Turkish government to satisfy its debt obligations, and those investors will not buy Turkish debt. That forces Turkish debt to become more desirable to compensate, and it does this by pushing their interest rate higher. If it gets high enough, then Turkey will not be able to pay its debts, it will lose the ability to attract foreign capital, and its economic growth will flatline.

You’re probably thinking to yourself, surely this isn’t as big a problem as you’re making it out to be? A percent or two of interest won’t make or break an entire country’s economic performance, right? I say to that, look to history as the judge, specifically the events of 2007-2009. The Fed’s Quantitative Easing to combat the Recession had the double impact of shoring up debt markets (by buying distressed mortgages and bonds, eliminating much of the bad apples from the tree) and flooding the U.S. financial system with trillions of new, cheap, accessible Dollars, in the hopes that banks would lend them out and get the economy moving again. The net effect was an all-time-low interest rate (mentioned above), and emerging markets took full advantage of this. Liquidity was so high, and they could afford to borrow so much, that the situation had the look of a Liquidity Trap, when debt costs are so low, and so much is borrowed essentially for free, that when rates finally go up, borrowers have no way of paying it back.

This is what I believe has happened, and what is beginning to finally show, in emerging market economies. U.S. interest rates are about to pass the 2% minimum threshold, and the Fed is continuing to signal that the rate hike cycle is nowhere near over. As the Dollar continues to strengthen compared to more volatile, weaker emerging counterparts, borrowers of Dollars will not have a way to repay their debts. This will lead to massive capital flights from those economies, economic contraction, and continued divergence of the West, and the U.S. in particular, as the sole economic choice of the world’s money. So the next time you turn on the financial news and see the word Contagion, remember what it means, and keep your money close.

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Fiscal Policy Part 2 – A Primer on Tariffs

If you haven’t been living under a rock for the past half year or so, you likely saw some variation of this headline on the news:

“Trade war heating up with China and/or the EU and/or Canada and/or Mexico!”

“Trump administration pressures Beijing to make trade fair”

“Business owners uncertain about their future after most recent tariffs”

“Business owners optimism showing after most recent tariffs”

If you noticed that these headlines seem to contradict each other, you would be correct! Tariffs are trade actions are all over the news, and don’t seem to be showing any signs of slowing down. What exactly this means for U.S. and Global commerce, like all specific things in economics, is evidence-based and remains to be seen. However, in this post, I will discuss the basics of tariffs; why they exist as a tool of fiscal policy, some applications of tariffs and quotas in the past (both good and bad), and some general economic application of this kind of policy in today’s context. And, as a bonus, I’ll also talk a little about a political theory that has application with this topic, Dependency Theory, and why it matters in the environment that is most suited for tariffs to take place.


Let’s start with the basics. What are tariffs?

Tariffs are essentially a way for a domestic government to make the prices of foreign goods more expensive, to achieve the goal of protecting domestic industry from foreign competition. When you hear the word “Protectionism”, tariffs should immediately come to mind. Tariffs are most often used to prop up domestic industry that cannot yet support itself financially when faced with much larger global competitors. Think of a nascent company in a mature industry, such as Tesla competing with Toyota or GM, or Venezuela’s oil company competing with Saudi Arabia’s. These are perfect examples of companies that are tapping into a big, rich marketplace, but are new and lack the capital or reach to compete effectively.

The way tariffs work is relatively straightforward. The domestic government will see that domestic industry needs to charge higher prices than foreign competitors, and will tack on an additional tax (the actual tariff) to those foreign companies when they want to sell their goods to the domestic economy. In theory, this raises the price of foreign goods up to or just below the price of the domestic goods. Since prices are now equal in the domestic market, consumers have less incentive to not buy domestic, and producers and governments can appeal to consumers’ patriotism to make them buy more out of the domestic market. In theory, this props up domestic employment and reduces exports.


Sounds good, right? Don’t get set on the idea just yet. For all the upside, there’s a whole lot more downside. The following series of paragraphs will address some of the problems with tariffs, from multiple points of view, followed by criticism of each paragraph. I apologize for the dryness in advance, but it’s interesting stuff, and if you understand both the good and bad sides, you will know more than many in government today.

First, there exists in macroeconomics a concept called “Crowding Out”. This is most commonly used to chastise government spending as a way of stimulating demand. Raising government spending levels necessitates more government borrowing, which raises interest rates as more bonds are issued. Since big governments like the U.S. can essentially spend as much money as they want, and their bonds are seen as ‘safer’ investments, huge demand for government bonds is created when interest rates rise. Money that would otherwise go toward more productive assets, such as corporate bonds or common stocks, instead goes toward government bonds, where it is theoretically safer, but does not contribute as much to private sector activity. In other words, private sector investment is “Crowded Out” by government investment. Many people think this is a leading contributor to the slowdown of western economies’ GDP in recent decades.

Now, let’s apply the concept of Crowding Out to tariffs, in the context of the modern United States. Ours is an economy with an enormous amount of Demand, coming from a multi-million-person population with a high amount of disposable income relative to other countries. But as wages stagnate, the demand of the U.S. will shrink as fewer and fewer people have access to more disposable income. Considering this macro issue, let’s assume that Demand in the U.S. is flat, and while it is high, will not rise unless acted on by a massive force. Consumers naturally try to access the highest quality product for the lowest cost, so they will buy more foreign goods while they are cheaper, and more domestic goods from companies that can compete on price. If prices of goods rise enough, then consumers will have to adapt while their income is stagnant. I would think this adaptation means simply buying less stuff, both foreign and domestic. In this way, even though tariffs are meant to stimulate demand for domestic products, that demand is Crowded Out by consumers’ need to save their money.


Second, tariffs fly in the face of fundamental concepts of free trade, such as Competitive Advantage. Competitive Advantage is the flip side to the consumer demand trend shown above, where economies will specialize in industry where they have an advantage relative to their peers. We see examples of this everywhere, all the time, from Software Technology hubs in the U.S. (due to our world-class university system and earning power) to Oil Drilling in the Middle East (due to their overabundance of natural resources) to Call Centers and Textile Manufacturing in India and Bangladesh (due to their dual characteristics of a massive population that is relatively poor and can perform cheap labor), all the way to exports of Chocolate from Ghana (actually, cocoa from Ghana is a primary source of world famous Swiss chocolate). When Opportunity Cost is lower for an area of industry, economies will naturally take advantage and specialize. Because of this, goods and services will increasingly come from places where cost is lowest, and as long as a country has an advantage in one measure of industry, they will gain market share against their peers. This is Competitive Advantage in a nutshell.

What does this have to do with tariffs? Remember the definition I gave to tariffs, and how they are mostly used to protect nascent industry from bigger foreign competitors. This reason can be perverted easily, and stretched to mean the protection of any industry the domestic government sees fit to protect, even at the long term expense of its economy. The context of the 2018 world economy is a perfect example of where tariffs are neither necessary nor appropriate. The Trump administration levied a 25% tariff on foreign steel because it sees the preservation of U.S. steel manufacturing as a national security priority. It even went as far as to call steel imports from our strongest allies (Canada, the EU) a national security risk. Tariffs are unnecessary here because they drive up costs wastefully and without reason. Canada and the U.S. enjoy the largest peaceful border in world history, and have not been at war since the War of 1812. You would be hard pressed to find a more allied set of two individual nations, as evidenced by our cultural and athletic rivalries that could not be friendlier. If the U.S. can secure reliable steel imports from Canada at cheaper prices than in the U.S., then why would we want to raise those prices and increase expenses of every U.S. company that uses steel as a raw material? Would it not make more sense, from both a consumer standpoint and a long-term producer standpoint, to keep the inputs of manufactured goods as cheap as we can reasonably make them, and foster better relations with Canada so they keep reliably exporting to us? I digress. The point of this example is to illustrate that Canada is able to produce steel at less cost, so they have a Competitive Advantage in steel production. Instead of propping up our own steel industry, and possibly sacrificing a portion of our workforce that can be more productive elsewhere, we should instead rely on the cheaper good from a close and loyal ally, and use that savings to advance industries where we have advantage of our own (notable examples are Tech, Movies & Entertainment, and Military/Defense).


Third, in a world of ever-increasing globalization and competing world economies, tariffs do more harm than good. In the era of tariffs’ heyday, when the world was comprised of many individual countries that dealt with each other one on one, as opposed to in a group, hostile fiscal policy made more sense because it was used as a cudgel for a stronger economy to make a weaker economy do what it wanted. In case you didn’t know which era I’m talking about, it is the 1600’s – 1800’s. The great economies at that time, England, France, Holland, and Spain, all used economic hostility just as frequently as they used military hostility, to further their mercantilist goals of colonization and resource extraction. You may be aware that this era was comprised of many, many wars, and very few alliances or friendly relations. This was due in no small part to all the hostility between nations, in its various forms. Nowadays, the world is decidedly not that. The past 70+ years have seen rise to international and multilateral institutions previously unseen and unimagined, facilitating international development, financing, cooperation, and security. The effectiveness of these organizations is up to your personal interpretation, of course, but the world in general has taken great pains to make a world order than is without a doubt, one hundred percent not bilateral.

Why am I explaining all this? To drive the point home that bilateral economic relations is mostly a thing of the past, and attempts to further one nation’s agenda at the expense of a second nation will assuredly spill over and have negative effects with a third nation. To put it in a middle school context, other nations will talk behind our backs! If we slap a bunch of tariffs on China, for example, that drives the Chinese economy further from us. But if we also push away the Canadian economy, there is no rule saying Canada will be forced to deal with us and no other nation, regardless of how we treat them. Quite the contrary! China suddenly has more incentive to do business with Canada, since their economies are both further away from ours, and thus closer to each other. Who’s to say they won’t both levy tariffs of their own on U.S. exports, pushing up the world price of goods even further?


There have been a few notable examples of tariffs throughout American history, and the vast majority have been met with negative results on net. The most popular example is the Smoot-Hawley Tariff Act of 1930, meant to protect the profits of farmers suffering from the Dust Bowl. The Act set tariffs on foreign imports of agricultural products as high as 19%, pushing up domestic production and employment of agriculture in the short term. But US tariffs were already high at this time, and the additional tariff contributed to other countries’ rapid and substantial declines in global commerce. Obviously due to the Great Depression, the exact effects of the tariff were unclear, but the consensus is that Smoot-Hawley exacerbated its effects. Some notable statistics having to do with tariffs are, however, well documented. U.S. exports decreased 61% from 1929 to 1933 and Gross National Product fell 27% from 1929 to 1931. You don’t need me to tell you that the Great Depression was the worst economic event in modern history, but the tariffs certainly did not help, as foreign imports were discouraged in the U.S., which led to U.S. exports being discouraged in foreign countries.

Another example of tariffs in history is the Tariff of Abominations, enacted by Andrew Jackson in 1828. This tariff was a fixed 38% rate set on almost all foreign imports of products produced by the Northern states, so that they could compete with their British competitors. Again, this tariff produced more net negative than positive. By raising the prices of foreign goods to match domestic goods, the Northern states could compete on a level playing field in the domestic economy. However, the Southern states, which were not manufacturing states and relied on agrarian exports with cheaper foreign tools, suffered immensely due to a two-pronged effect. Their costs rose dramatically, while foreign countries they normally exported to would not accept as much of their exports due to perceived isolationism and unfair treatment. South Carolina in particular was hit so badly by this tariff, that in 1832, the state assembly approved a nullification measure, essentially saying that the states could choose to nullify any federal law they did not agree with. The ensuing clash over states’ rights and North vs South economies contributed in no small part to tension between the two sides of America, eventually leading to the civil war.


Finally, what about Dependency Theory? I’m no political scientist, but as I understand it, Dependency Theory is the emerging theory of international development that essentially splits the world into two types of nations. There are strong, sustainable nations, typically in the West and Europe, and smaller, weaker nations, typically found in Africa and East Asia. The growing inequality present in today’s rendition of capitalism causes the rich nations to grow richer on their own, and the poor nations to need the rich nations in order to get richer as well. So, the richer nations will turn this need into a predatory relationship, buying up natural resources and raw materials found in poorer nations for far cheaper than they would have had to pay to other richer nations. Since they pay the poorer nations far less than the resources are ‘worth’, poor nations only gain a small amount of wealth while rich nations keep the vast majority of their wealth. Tell me if this sounds familiar to you, because it should. This theory basically describes a modern version of Mercantilism, with poorer nations subject to ‘colonization’ by companies of richer nations, not unlike the East India Trading Company or the Hudson Bay Company belonging to England in the 1600’s.

The reason this theory comes to mind when talking about tariffs is because it gives a very good reason for tariffs to exist. If developing countries cannot sustain their own necessary industry, why would they allow themselves to be taken over by foreign developers and companies? Sure sounds good in theory, but again, it suffers the same fundamental negatives that we discussed already. Competitive Advantage is the cure for this. When I talked about Competitive Advantage above, I briefly brought up cocoa exports from Ghana, a small, developing African country. Despite having little in the way of manufacturing, a pegged currency, and a small population, cocoa exports from Ghana are the second largest exports of chocolate products in the world! Ghana happens to have several regions where rainfall is very heavy, and conducive to increased farming and production of cocoa and other chocolate products. As I mentioned, they export to famous chocolate producers like Switzerland, but they also export to and have beneficial trading relationships with the U.K. and Singapore. More facts about the cocoa exports of Ghana can be found here: https://www.cocobod.gh/

I’m not saying that Ghana’s cocoa exports are a perfect example of a country using competitive advantage to gain an edge in industry, but it is an example of how developing countries can effectively use this concept to compete with their foreign peers without limiting other industry. Countries like Ghana would do well to become friendlier with their neighbors, to pool resources for the common defense, and to promote commerce that is mutually beneficial and plays to all countries’ forms of advantage. In Ghana’s case, the African Union is a rapidly growing player in global trading blocs, and in a few decades, could become as important as the Association of South East Asian Nations (ASEAN) or even the European Union.


In summary, though I have not expressed my own opinion on whether tariffs are good or bad, I hope I have shown you that on the whole, tariffs are more negative than positive in a globalized, integrated economy like that of today. As with all things in economics, circumstances are never the same and everything should be taken with evidence. What’s important is that you make up your own mind using information readily available, and use your influence to make policy that better suits not only the U.S. population, but the population of the entire world. As always, thank you for reading, feel free to leave a comment or message me with any questions or concerns you have, and be sure to look out for more!

Why is GDP Growing Slower?

In my last post, I brought up the idea that Tax Policy should not be measured in terms of GDP, and that GDP is, broadly speaking, in a prolonged period of slowing growth. Today, I want to take a closer look at the US GDP, how we calculate it, trends over time, and why it may not be where some influential people want it to be.

GDP stands for Gross Domestic Product, and it measures the value of all final goods and services produced within the borders of a country. That means all goods that are a part of other goods are only counted once, such as car steering wheels only being counted upon assembly into a car, or glass phone screens only counted when they are fixed onto a phone. It also counts all economic activity in a country, including from businesses that have headquarters in other countries, which explains why American politicians are so happy when foreign companies announce plans to open plants in the US.

You can view the Federal Reserve data for US GDP here:  https://fred.stlouisfed.org/series/GDPC1

And here is the Fed data for the percentage change in GDP:  https://fred.stlouisfed.org/series/A191RL1Q225SBEA

You can almost instantly see a flattening in the both charts. The percentage moves are far less volatile in recent decades than in prior ones, and the total GDP chart is not quite the parabolic shape that would suggest constant percentage gains. Recent data comparisons show the same thing, that GDP growth in the post-financial crisis period has averaged 2% while growth was around 5% in the 1950’s and 60’s.

Why has this been the case? Is there purposeful slack in the economy due to policy errors? Are people just less productive now than they were before? Or is there something bigger going on that we are just not tracking? I will endeavor to explain some possible theories.

First, the popular reasons. Janet Yellen and the Fed would be remiss if they did not mention, in every policy announcement, the slowdown of GDP growth due to several structural factors. First, they say the population is aging, pushing down the workforce participation rate. Then they say that workforce productivity has been weak in recent years, pushing down supply. There is ample data to support both of these factors, available on the Fed’s database. But does this explain the whole picture? If you are a demand-sider, like I am, then you believe that consumer spending influences economic activity more than producer supply, and by extension, that the economy would continue to grow at a constant rate if consumer spending remains the same over time. Wages have remained flat for a few decades even as credit availability has boomed, suggesting that consumers are spending the same amount or more per year, even as GDP growth has slowed. So to summarize, I do not believe productivity is the culprit here. To answer the workforce participation rate question, it is true that baby boomers have begun to retire in larger numbers, but millennials are the largest population group currently in the workforce, having largely replaced the boomers. I believe GDP should increase as the population increases, and a few factors are pushing the population growth rate down. Immigration crackdowns (including deportations of illegal immigrants, who do you think tends to American farms) are growing higher while the US birth rate is at its lowest point since 1913. With not as many new people entering the labor force, we can expect to see GDP slow down, and this has been the case.

Second, we may be seeing lower than normal GDP growth because we may simply be monitoring it the wrong way. I will use the example of employment here, and explain its relation to the greater economy. In prior decades, typical employment was simple; work was done in factories, with taxes withheld on your W-2, and a pension paid after years of work. Back then, the economy was primarily goods-producing. Today, the economy is primarily services-producing, with the good-producing jobs either outsourced or automated. In recent years, and especially with the advent of the internet, employment can be defined many different ways, from being a doctor or accountant, a construction worker, or even a direct marketer or video streamer on the internet. Thanks to advertising revenue and the rise of big data, many more avenues of ’employment’ are possible, each with their own avenues of risk and reward.

We may not be accurately gauging the impact of this on the traditional employment numbers. Would you say a YouTube streamer playing the newest Call of Duty video game for donations is one more worker in the labor force, or one less? Would your answer change if you found out that he makes $100,000 a year doing what he does? Would you call the entertainment he generates for his viewers a service, or just a waste of time? If you want to gain a bigger picture of what employment has turned into in the US, this is something to consider.

Third, and last, comes from a theory that has been around for over 200 years, but a theory that few economists have explored. Adam Smith (yes, the father of laissez-faire capitalism) wrote in The Wealth of Nations an interesting theory about how GDP tends to slow down as nations become more developed. The 1700’s version of this theory took the form of European nations colonizing America. As land was being explored, fresh soil and more abundant resources resulted in more supply for colonizing nations, and growth rates reflected the new territory. But as colonies became more developed, and less new land was gained, growth rates would slow.

I like to extrapolate this example to the various phases of the economy. Going back even to the Industrial Era, the economy has had big boom phases as new industry and secular changes affect the country. Various factors play into these ‘secular changes’, from invention and efficiency in the Industrial Era, to the tremendous labor supply increases in the 1940’s and 50’s as soldiers returned to work and baby boomers were born. The 1970’s had wild growth rates, no doubt affected by stagflation and the subsequent Fed actions, but you can see in the charts above that growth had begun to level out as early as the 1980’s. I believe the ‘secular change’ that brought the growth of the 1990’s was the rise of the internet, and the inception of tech giants Amazon, Apple, and others. But that initial tech boom was some time ago, and the internet is increasingly going from growth to maturity. As there is less ‘room to grow’ in a particular economic ‘era’, then Adam Smith’s theory shows, and GDP growth does tend to stall. For further support on this theory, check out Larry Summers and his work on ‘Secular Stagnation’.

In summary, these are just a few of the many theories as to why GDP growth in the US is consistently below historical norms. There are many factors that play into GDP, and unlike what politicians would want you to believe, it is not easily influenced by any one of those factors. Perhaps GDP is not actually lower than it should be, and it simply reflects where the economy currently is. But at the end of the day, it is important to consider all the factors for the best assessment, as this is how the best policy gets done.

On Interest Rates, Inflation, and the Business Cycle

If you have read the first few posts on this blog, you have surely noticed that I talk about interest rates a lot, and inflation only a little. If you know nothing about rate structures, or wonder why I don’t equate these two terms when they sound very much alike, this post is for you. I will go into both the Keynesian view and my personal view of how interest rates, inflation, and employment are all connected.


I will start with the Fed and Money. You’ve seen me talk about money before, about how it has no intrinsic value and how it only serves as a function of exchange. The Fed controls the Money Supply through various operations, both direct and indirect. Some indirect methods are dictating how much money banks can lend out (the Money Multiplier) versus hold in reserve (Reserve Requirements), and these park money in the banks so it cannot circulate through the economy. Direct methods are more, as you can tell, direct, where the Fed itself steps in to limit or grow the Money Supply. Some of these methods are printing money (or, as an extension, easing credit requirements), or what’s known as Open Market Operations, where the Fed buys and sells Bonds (usually treasuries) on the open market (the secondary bond market that we all use to invest). The most prominent feature in the Fed’s policy arsenal is the setting of the Federal Funds Rate (FFR), which is the lending rate on overnight deposits from banks to other banks, as well as from banks to the Fed itself. The FFR is presented in a range, and currently sits at 1.00% – 1.25%, showing a 1.00% deposit rate from bank to bank and a 1.25% rate from bank to Fed.

You may recognize that Open Market Operation method as the Fed’s role in the 2008-2009 housing market collapse, where many billions worth of mortgage bonds went underwater and the Fed purchased then in rounds of Quantitative Easing. The Fed does this in times of extreme cash crunch, or liquidity crunch, where the worry is that money will rapidly exit the economy and stimulate Deflation, rather than Inflation.

The Treasury has operated on deficits for as long as any of us can remember, and they finance through treasury bonds. These are sold in fixed intervals and their rates are easily tracked. The different types of treasuries sold are denominated by time until maturity. with the shortest being 4 week Bills, and the longest being 30 year Bonds. Interest rates on this debt is influenced by a number of factors I will go over shortly, but in general, investors will expect a higher interest rate for bonds with longer time until maturity. The scale of different rates for different term bonds is called the Yield Curve.

Inflation, Deflation, Mortgage bonds, Yield Curves, what does all this have to do with the topic of the post? All of it is connected as the economy moves. Let’s assume that the economy has just come out of a recession, and businesses are ready to grow and hire again. The banks need to be able to lend those businesses more money, so the Fed will do some variation of loosening credit requirements, lower the Federal Funds Rate, or conduct Open Market Operations so there is more money in the economy (buying bonds). Businesses take that easier money and either expand their operations (investment) or hire more people. As more people are hired, the unemployment rate goes down, so the Supply of Labor does the same. Bear in mind that in the upward portion of the business cycle, Demand for Labor is going up while Supply goes down. This results in the Price of Labor (wages) being pushed to a higher level, as businesses need to compete more heavily for the same workers (typically in the form of higher wages, benefits, upward mobility, etc.).

As people make more money working, they can spend a greater quantity of that money on goods and services. This is where I believe inflation comes from, because I view economics from the Demand side first. The Keynesian view of inflation shows that consumer demand serves to ‘push’ inflation up, more than producers can ‘pull’ it. For example, if Microsoft releases a new gaming console but prices it high enough to where only a small portion of the consumer base can afford it, then Microsoft will have to lower the price to a more reasonable level. But if the price was in an affordable range for most of the country, then so many more people would want to buy the console that Microsoft could be justified in raising the price a small amount. It is in this way that consumers dictate inflation by their spending more than producers dictate it by their pricing.

As the business cycle moves along and the economy begins to do well, The Fed begins to worry about the economy doing ‘too well’. Why do they do that, you ask? The answer, predictably, has to do with inflation. As consumers do better and can spend more money, there is always the risk that inflation can become too large, causing price movements that are not justified to consumers. This makes them stop spending as much money, which hurts businesses and causes them to cut expenses(lay off workers). One of the Fed’s congressionally mandated goals is to achieve full employment, so it will take steps to combat inflation when it gets too high. It does this by doing the opposite of what it did as the cycle was starting, some variation of raising the FFR, selling bonds on the open market, or tightening restrictions on credit. All of this serves to take money out of the economy and loosen inflationary pressures.

As interest rates rise (due to the FFR pushing up minimum rates and there being more bonds on the market) the cost to borrow becomes greater, and businesses will not continue to expand and hire. Consumers will have greater incentive to save their money in vehicles that take advantage of those higher rates, rather than spend it, so consumption will decrease, and with it, business profits. Those businesses will trim their expenses and lay off workers, causing the economy to shrink. The Fed then starts the cycle over again with policies designed to make money looser and stoke inflation, so businesses will begin to hire and people will begin to spend again.


There are many subtle pushes and pulls on interest rates to make them not perfectly reflect the state of the economy. Bond investors will buy and sell if they think rates are too high or low, and traders will do the same on price. These are not perfectly liquid markets. Sometimes, as expectations about the economy doing well in the long term lessen, while expectations for the short term improve, the Yield Curve will invert, meaning lower-term bonds will pay more than higher term bonds,

Overall, though, I believe interest rates are a good gauge on employment and inflation pressures and the state of the economy in general. Treasury rates are used as benchmarks for other interest rates all over the world and in the US, with Savings accounts tracking short-term bills with expiry in less than 1 year, to Mortgages tracking the 30 year treasury bond. The bond market can tell us a lot about where expectations are for consumer spending, business hiring, and the overall state of the economy. To see this information for yourself, feel free to visit the websites I have listen on the sidebar of this website! And stay tuned for more in depth posting about all the terms gone over in this post.

The Case for the American Sovereign Wealth Fund

We’ve seen it many times. The natural disasters, the foreign entanglements, the income inequality. All reasons for people to want the government to spend more money, yet nobody wants the government to actually spend any more money! Spending more money requires either raising taxes or raising deficits, both of which are undesirable to the American People.

So, what is the solution? Could it be so simple that other countries have already discovered it?

America, I raise you the Sovereign Wealth Fund.


How It Works

Sovereign Wealth Funds (SWF’s) are essentially State-run hedge funds. They are funds set aside by a nation’s government to grow, separate from their budget, to be used for a specific purpose or purposes.

These funds are typically created two ways. A country can have a significant Current Account Surplus (trade surplus), usually resulting from that country specializing in one industry and dominating that market. Think Germany with Automobiles or East Asia with Tech Hardware. The second way SWF’s are typically created is through a Commodity Surplus. The nation’s government would own a corporation that sells that commodity, and sets aside some of the profits for the fund. Examples of this would be the Oil-rich countries of the Middle East, with some of the largest SWF’s located in Qatar and the United Arab Emirates.

Sovereign Wealth Funds are able to invest this money and let it grow over time. Countries will use their SWF’s to invest in their own Bonds, to build infrastructure, as well as financial instruments worldwide, including Foreign & Domestic Stocks. Norway’s SWF, currently valued at just over $1 trillion, is said to own at least 2% of every Global Stock.

These funds are spent in many interesting ways. Countries can direct their SWF’s to pay for citizens’ pensions, infrastructure spending, and various one-off budget items. The funds can also directly subsidize government spending projects and provide pensions to the nation’s citizens.


American Style

I believe then benefits of managing a SWF far outweigh the costs of obtaining one, and America needs one badly. I understand there is politics to this decision as well, and many people will be skeptical and unsatisfied. However, there are benefits to both moral sides.

For the Liberal side, the fund will provide the government with an additional sum of cash to advance key agendas, with the benefit of directing foreign investment in countries as a tool for diplomacy. For the Conservative side, it would not take the form of a Federal role, only Federal funding, and best of all, it would be funded voluntarily.

Woah, woah… the fund would be funded voluntarily???

Sounds hard to believe. Yet this Millennial Economist thinks there is a case to be made. There is, after all, a public elections fund that is funded voluntarily. How does that work? Take a look at the IRS Form 1040. You’ve seen this form if you’ve paid taxes before. On the top right corner of that form, there is a box asking you to direct $3 to the public election fund’. This money does not go on top of your taxes. Rather, it gets taken from your tax payment.The $3 donation takes $3 from government revenue to fill the fund. This will automatically reduce the role of government, which is another win for Conservatives.

The donation amount does not need to be big. I propose a donation amount of $1. An amount that small is enough to not be thought about, so the act of donating is an act that can be coached, and not just instinct. And if 500,000 taxpayers donated a year, for 20 years, that money invested in a good fund would generate substantial returns on investment. And over time, the fund will grow, and more money will be available for its spending targets. The number one target I would expect to direct the SWF would be disaster relief. Climate change, with the storms it’s brought and will continue to bring, will be met with all the economic fight we can give.

This is more than just a possibility. Your Millennial Economist thinks it is a no-brainer. Creating a Government Hedge Fund would create brave new tools for international relations, as well as be able to provide incredible amounts of relief to American citizens.