Monthly Archives: November 2016

Production Spurs The Economy, Not Consumption

Economy

Economy

With Black Friday and Cyber Monday now behind us, economists and investors are hoping people shopped till they dropped in order to give the economy an extra boost. In addition, the latest GDP report on Tuesday came in higher than expected, largely driven by consumer spending. However, buying more flat screen TV’s  isn’t what makes an economy healthy.

Many people believe the fate of the economy relies on retail sales and consumer spending, especially because news outlets continually note that “the consumer sector accounts for two-thirds of the economy.” Unfortunately, this is not only misleading but it is also mistaken economic theory.

What GDP Is – And Is Not

The measure of GDP, or gross domestic product, is simply the value of all goods and services sold within a country. While this seems like a simple enough calculation, the devil diddles in the details.

One problem is that the calculation only accounts for the sale of final goods and services. This is done in an attempt to avoid double counting. For example, if a steel maker produces steel that is then sold to an automaker to build a car, only the final sale of the car will be counted and not the earlier sale of the steel. This is one reason why GDP data is so dependent on consumer spending.

This leads many to believe that consumer demand and spending is what drives an economy forward. This is a notably Keynesian idea where recessions are caused by drops in demand and cautiousness causes consumers to keep their wallets closed. Following this line of thinking, the solution to any stagnant economic growth becomes obvious: get people spending!

True, there is a grain of truth here because the money I spend on a new sofa goes into the hands of the shopkeeper who then has income to spend. In the same manner, if nobody buys my services, I will not have any money to buy that new sofa. The gears of the economy would grind to a halt without spending.

Putting The Cart Before The Horse

Spending money does move the economy, but only to the extent that it is an exchange of goods and services. The critical step everyone seems to forget is that in order to spend money, you must have that money in the first place!

How do you get that money? By producing something of value that someone else wants. Therefore, it is production that drives the economy, not consumption. There is never a problem or a drop in consumer demand because people never tire of wanting new and better things; the problem is maximizing production to fulfill more of those wants and needs.

How is production increased? By increasing productivity. How is productivity increased? By saving, or deferring consumption so new tools can be forged and research undertaken to increase productivity.

A Robinson Crusoe Economy

Imagine you and your friends are stranded on a deserted island, and it takes all day to catch that one fish or harvest those few coconuts that you need just stay alive. Your economy is 100% consumption, correct?

How could you improve your standard of living? Not by consuming more, but by actually consuming less. You and your friends would need to go hungry for a day or two and use your new-found spare time to construct a fishing net, fashion a spear, or create other tools to make procuring food easier.  

This would in turn make you more productive, allowing you to gather more food during the course of a day. With the extra food, you could go back to 100% consumption and live a slightly better life, but to achieve an even better standard of living, you would need to continue to save and continue to defer consumption.

Why This Is Crucial

It is saving and producing that should be the focus in order to grow an economy. Sustainable increases in

Production

Production

consumption are a symptom of an economy that has already grown and produced more, not the cause of prosperity.

GDP is merely a statistic. Although it is not a bad thing per se, what gets measured also gets managed – even manipulated – by governments. Telling the populace that consumer confidence is high and consumer spending is up can make an economy look stronger, inducing governments and central banks to continue to pursue policies that boost spending.

Indeed, not only are central banks continuing to try to keep interest rates low and stock markets high to produce a “wealth effect” of more debt and more spending, but governments are also considering additional spending measures (government spending is also counted in GDP).

Investors need to remember the true causes of wealth creation, and seek to protect their own wealth in the face of a government-managed economic environment.

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Why are Interest Rates so Low?

Higher Interest RatesWhy are interest rates so low?

Ask most people on the street why interest rates are so low, and they will reply that central banks are
responsible. Okay, perhaps most people have no idea about interest rates or central banks and would likely shrug their shoulders, but regular blog readers are certainly aware of all of the central bank actions to try to keep rates low!

However, academics and economists are increasingly opposing this commonly held notion, countering that interest rates are affected by more powerful market and economic forces than central banks, contending that the decline in productivity is causing rates to be low. Therefore, which theory is correct? The answer may be both – and linked to the same cause.

The ‘natural’ versus ‘market’ rate of interest

To understand what may be going on, we need to go back to the 19th century economist Knut Wicksell, who differentiated between the ‘natural’ rate of interest and the ‘market’ rate.

Interest rates are a type of pricing and, like prices, they signal the relative supply and demand for something; in this case, the supply and demand for loanable funds. The natural rate of interest is the equilibrium rate that balances the amount of money to be loaned and borrowed, or the level of savings and investment. This natural rate therefore coordinates economic activity much like prices coordinate activity.

Like other prices, the equilibrium or natural interest rate that correctly balances economic activity cannot be known by someone. Only the market process can bring it about, and it is constantly changing and adapting to different conditions.

The natural rate of interest is affected by real economic forces; people changing their preference for saving versus taking on debt, or consuming now versus later. But the market rate is the rate that is the prevailing interest rate, influenced by central bank actions as they target various rates to be lower.

Central banks claim they want to set the market rate at where they believe the natural rate to be, in order to bring about a balanced economy. But this is an impossible task. Just as no central planner knows the correct price of steel or milk, so the Federal Reserve does not know the correct interest rate to set in order to coordinate economic activity.

It is this very attempt at setting rates that causes so much economic upheaval. If the Federal Reserve sets rates too low (or too high), misallocation of resources will occur, typically in the form of inflation, bubbles and then subsequent crashes.

Is the Federal Reserve the perpetrator of low rates?

A main criticism to this theory is that interest rates have been low now for quite a long time, and therefore there is something else going on besides the Federal Reserve and other central banks keeping rates low.

In other words, such critics believe the natural rate of interest is actually very low and has been declining, therefore the Federal Reserve is merely setting market rates to be consistent with this low natural rate level.   

One of the reasons cited for the decline in the natural rate is the decline in productivity of American workers and the general sluggishness of the economy. However, this may actually be a symptom of the previous boom and bust caused by erroneous central bank actions, rather than an unrelated factor.

The Fed set rates too low

The Federal Reserve fueled the unsustainable boom prior to 2008, and we are still feeling the negative effects today, such as  lower productivity. Because the Fed set market rates below the natural rate, misallocation of resources occurred. Instead of allowing those resources to reallocate themselves to better uses (such as out of housing and banking), the Fed was intent on keeping the status quo and avoid liquidations and bankruptcies.

The Bank of International Settlements (BIS) suggested this possibility in their recent annual report, noting that low interest rates could actually cause a cycle of lower productivity:

“Alternatively, persistently low yields could end up having pernicious effects on the economy and become to some extent self-validating… They may also distort financial and real economic decisions more generally, for instance by encouraging unproductive firms to maintain capacity or by inflating asset prices, thereby weakening productivity.”

We see this when we examine so-called zombie banks that continue to hold bad loans on their books in order to avoid the charge-offs. We also see factories and retail stores that continue to operate because the Fed has incentivized consumers to continue to spend, rather than cut back on spending, repay debt and save.

Central banks should stop meddlingRate Hike Calculator Words Increased Interest Cost Borrow Money

In conclusion, there are certainly other factors and forces that determine interest rates, besides the central banks. But lower productivity may actually be a logical outcome of previous low rates set by central banks. This is precisely why central banks should get out of the business of trying to set the correct interest rate, just as Soviet central planners had no business trying to set the price of eggs.

What does this all mean for your investment portfolio? As long as central banks try to guess at what interest rates “should be”, they will fail. This will cause continued misallocation of resources, and therefore investors need to be aware of continued instability such as inflation, bubbles and crashes.

Inflation is the 24 Hour Tax on Everything

Wallet and stethoscopeInflation is the 24-Hour Tax on Everything

The Wall Street Journal recently reported that inflation, after “being given up for dead,” is coming back to life. While that may appear to be the case on the surface, inflation has been alive and well – hiding out beneath the official government statistics for years.

The WSJ is referring to the data released last Friday by the Bureau of Economic Analysis, known as Personal Consumption Expenditures (PCE), which measures the change in actual spending and prices and is the Federal Reserve’s preferred measure of inflation.

More specifically, the article was referring to Core PCE, which is PCE excluding food and energy, and is currently at a two year high of 1.7% on a year-over-year basis. The other measure of inflation is the Consumer Price Index (CPI), which has also been markedly higher, coming in at a 1.5% annual increase as of this past September.

Inflation is NOT a Good Thing

With inflation getting closer to the Fed’s 2% target, WSJ’s columnist Greg Ip casually comments that “This isn’t bad news. To the contrary, markets and central bankers alike will be relieved the world is no longer skirting a deflationary abyss.” But while central bankers might welcome this news, consumers will not.

Sustained inflation in consumer prices is never a positive for any economy, and is also not necessarily an indicator of a growing one. Prices may rise due to changes in supply and demand, and therefore help to reallocate resources and signal those changes; but an overall and sustained increase in prices is different.

If the price of an item rises for consumers, they will then stop buying it or switch to a cheaper item or cut back on another category in order to accommodate the household budget. Therefore, the only way for all prices to rise indefinitely and consistently is for new money to be constantly created and injected into the economy.

This of course is merely a tax on consumers because the new money and consistent increase in prices makes the consumer poorer. Contrary to popular economic theory today, there is no threat of a“deflationary abyss”. During the nearly 100 year history of the classical gold standard, prices gradually declined an average of 2% to 3% per year as technology and productivity increased, giving consumers the benefit of these advancements in the form of lower prices.

Inflation is Worse Than Reported

This week, Visual Capitalist made a stunning infographic using AEI’s Mark Perry’s (equally as interesting) inflation observations. Over the past 20 years, from 1996 to 2016, total inflation has been 55% as measured by the CPI.

However, digging into the Bureau of Labor’s data and then channeling down to the various items that make up the CPI basket of goods, you can see that inflation varies greatly from one type of good to the next.

For example, things that have increased more than the average 55% include tuition (up almost 200%), childcare (122%), medical (105%), food and beverage (64%) and housing (61%) – in other words, virtually all of the living essentials needed to survive or raise a family.

Counteracting this, items that fell in price included TV’s (96% decline!), toys (67% decline), and software and cell phone service (66% and 45% respectively). Clothing and furniture declined slightly, while new cars increased only slightly.

Obviously the dramatic decline in electronics, software and toy prices has brought wonderful benefits, but these are still largely discretionary items, and they take up a much smaller portion of most household budgets. The average family is therefore likely facing more than the average 55% increase in prices over the last 20 years.

Indeed, in his latest book, David Stockman has modified the CPI to put heavier and therefore more realistic weights on the four essential items of everyday life: food, energy, shelter and medical care. Using this measure, he finds the actual inflation rate over the past 29 years (when Greenspan became Fed Chairman) has been 3.1% per annum, rather than the official CPI rate of 1.7% per annum.

How to Protect Yourselfdates falling dollar

Unfortunately, inflation will continue to be a problem for any person living in a country whose money is a fiat currency that is being debased by their government – which includes nearly all modern economies today.

Thankfully, there is nothing stopping you from converting some of that fiat paper money directly into your own store of hard currency: physical gold and silver. During the past twenty years, while the official CPI increased 55%, gold has increased in value 235% and silver 282%.

Time to buy gold and silver, perhaps?