Wednesday, January 6, 2016

Economic Predictions for the Coming Period

Our economic future will be determined by the Double-Ds: Deflation and Debt.

Or, put another way, Main Street is doing just fine, but Wall Street has some serious problems. Unfortunately the two are interlinked.

We are experiencing deflation (not disinflation) and have been for some years now. I base this opinion on these facts:
  • Commodity prices (especially gold and energy) have fallen dramatically. 
  • Our major trading partners (China, Brazil, and probably Canada) are exporting deflation.
  • The cost of labor is going down. Yes, there has been some increase in individual wages, but there is a decline in labor force participation, meaning that total wages are likely declining. And, as Thomas Piketty famously claimed, the fraction of GDP going to labor is getting smaller.
  • Technology is making stuff cheaper.
  • My anecdotal opinion is that the prices of things I buy are declining, or failing that the quality of what I get is increasing.
  • Nominal interest rates have remained very low for a very long time. This is not because of Fed manipulation
I understand that government statistics indicate merely disinflation, but I think they're wrong. First, I doubt they can properly correct for quality issues. Dinner at a decent restaurant still costs $17, but you get a much better meal today than you did a few years ago. Health care, admittedly more expensive, is also much improved over the past. (Higher education, on the other hand, is increasingly just a dead-weight loss.)

And second, deflation is bad for governments, and especially for the Fed. The latter is trying to raise inflation by changing expectations, that is, trying to convince the public that it's just around the corner. But I think that's propaganda. There is no inflation on the horizon.

Many pundits, along with my friends over at ZeroHedge, argue that there was massive monetary stimulus during the Great Recession bailouts, along with the subsequent quantitative easing (QE). But George Selgin argues convincingly (here and here) that this isn't true. The base money supply has remained mostly constant over the last decade. For example, QE was accompanied by paying interest on reserves. The former added liquidity, while the latter took it away again. The net money supply remained unchanged. Mr. Selgin describes the entire decade as a process of removing liquidity from solvent enterprises and transferring it to insolvent enterprises.

Not good. But also not something that will lead to inflation.

So is deflation good or bad? To answer that question we need to invoke Scott Sumner's dictum: Never reason from a price change. For deflation can have two causes: demand side or supply side.

Demand-side deflation happens when consumers get poorer and can no longer buy as much. This occurred during the Great Depression, and also what might be happening in China today. Because there is less demand prices must fall. Demand-side deflation is unambiguously bad, and to the extent we have that the Fed is absolutely right to resist it.

Supply-side deflation happens when producers get better, either through new technology or because of cheaper inputs. Widgets used to cost $10 to make, but because of new technology now they only cost $2. Thus the cost of widgets goes down dramatically. This kind of deflation, while often disruptive, is a very good thing. Our standard of living goes up, not because of higher wages, but rather because of cheaper prices.

I argue that our current deflation is mostly supply-side. The big new technology is fracking, which has reduced the cost of energy by 50% or more. Computer-aided improvements in logistics (see, e.g., Amazon) have reduced the costs of retailing--not even Walmart can make money anymore. And then other countries are exporting deflation, which from a US standpoint simply means lower costs for similar or better products--i.e., supply-side deflation.

Of course there are some demand-side issues as well, slowing population growth being key among them. But the fact is that at least in the US deflation is mostly supply-side. That means American consumers are getting richer because they're paying lower prices for the things they want to buy. I argued as much in a post a couple of years ago, here.

So if the goal of an economy is to make consumers (i.e., everybody) richer, then we are undoubtedly succeeding. Or speaking metaphorically, Main Street is on a roll.

Financially, however, things are not so rosy.

The other big D is debt. "Debt is cheap," or so they say, what with interest rates at "historic" lows. And people sure have piled it on: student loan debt is over a trillion dollars, and auto loan debt is not far behind. Many cognoscenti (e.g., Paul Krugman) argue that we should massively invest in infrastructure--finance has never cost less.

Even on the Right pundits agree: the Fed, so they maintain, has arbitrarily kept interest rates low making it cheap to borrow, with the collateral damage of screwing grandma out of her savings.

But I think both the cognoscenti and the pundits are wrong. Real interest rates are precisely not cheap--indeed, they're quite high. Suppose, optimistically, that we have 2% deflation, which mean Americans are getting richer at 2% annually even without a pay raise. Then the 10-year Treasury, nominally at 2.2%, is actually paying a real rate of 4.2%. That's not cheap! Grandma is doing just fine.

So who is hurt by deflation? Anybody in debt. If you owe money on a student loan (nominally at 4.29%) you are paying real interest at 6.29%. There is no way that's a good deal, and only the very top students will make enough to earn that back. A car loan these days (if you have good credit) costs 2.6%. In real terms that's 4.6%, again hardly a bargain. Fortunately for homeowners, a lot of the housing debt was liquidated during the last recession.

So who is the biggest debtor today? Governments, both in the US and abroad. China, for example, has borrowed billions to build useless infrastructure, including whole ghost cities. Japan has splurged on bridges to nowhere in a futile attempt to "jumpstart" its economy. Puerto Rico is in default. Illinois stiffed its lottery winners (giving the IOUs, since redeemed), and is bankrupt in everything except name. National and sub-national entities around the globe are hopelessly in debt.

The State of New York, for example, owes an amount equal to 23.6% of state gross product, or approximately $370 Billion. Of this, $140 Billion is owed by the state, while $230 Billion are owed by local governments. It comes out to $18,600 in debt per person, even for every newborn baby. Remember that upstate New York (where a lot of these local governments are located) is losing population and has a declining economy.

This won't end well, and it will end suddenly.

One of these days creditors will refuse to lend money to New York to roll over its bonds. This may be because of something that happens in New York, or more likely it may be because of a credit crisis in China or Japan or Portugal or wherever. However it happens, it means that New York will default--suddenly, dramatically, catastrophically. There will be no warning. One day life is normal. The next day retired state employees won't receive their pensions.

Deflation brings the day of reckoning closer. States, especially Blue states like New York, are losing their tax base, both by population loss and by declining prices. I don't know if New York is one recession away from default, or if it will take two or three. But I certainly wouldn't want to be part of the public employee retirement system right now. (I'm not, thank God, despite my status as a state college professor.)

So we have too much debt. Private debt has been (slightly) paid down since the last recession, but government debt has grown. The most dangerous sort is owed by municipalities and school districts. Many of them are doomed.

The Great Liquidation is still in front of us. It will happen eventually. I don't know when, but deflation brings it closer. It will wipe a huge amount of wealth off the table.

So here's my advice to you young-uns out there: Worry less about your salary and more about your savings. Stay out of debt. Don't buy real estate in New York.

Further Reading:

No comments:

Post a Comment