Why Policy Has Failed

7/30/2019 Why Policy Has Failed

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Why Policy Has Failed 22.1

Upon re-thinking what I have written, I am now starting where I originally ended because itcreates some context:

I will certainly admit there are things I may be wrong about. I am not an economist. I am aninvestor by background. Despite my cynicism the economists are all really bright guys and haveput a lot of thought into the issues. What I can say with absolute certainty is that I have lost a lotof faith and trust in the system. And I am not the only one. This sentiment is running at all-timehighs amongst business leaders (their collective in-actions prove it) and guys on the street. It isboth sides of the barbell and middle that are upset. Often its one or the other, but not all three.This time its not at an external state, its directed inwards. That is a tough problem to solve.Jingoism is not the answer either as we already tried that.

If any of my commentary is wrong in fact, it is not wrong in principle. I am exhibit A when itcomes to lost faith, and as I said this sentiment is not unique to me. If there is no faith in the

system, it has a really hard time working. And I mean real underlying faith and trust in thesystem, as opposed to the confidence born from economic steroid injections or entitlements.These are valid notions, but as a point of clarity I am talking about a something different. Therealso is a subtle but important distinction between faith and trust versus confidence. Faith andtrust are longer term and more powerful concepts.

For example, common wisdom tells us it was all the government spending in World War II thatgot things turned around. This notion is far from factual, and any argument that portrays it assuch should be taken with a grain of salt. And it is insufficient as the primary evidence forpolicy decisions. There is a big difference between coincident and causal. How did all the warrelated spending work out for the Axis powers? The Soviet Union? Truth is nobody really

knows what got the flywheel spinning in the right and sustainable direction for the U.S. afterWWII. I believe all the WWII government spending would have been meaningless withoutpeople finally feeling really good for obvious reasons when the Allied powers won the war, afterabout 20 years of misery post the great depression. And the system cleansed for a long timeprior to this all happening. There were pre- and post-conditions in place for a rebound then thatare not in place now. A happy and invigorated population is very powerful for any economy.Oftentimes its impossible to know what is the chicken and what is the egg, governmentinvestment catalyzing corporate and consumer spend or a rare positive exogenous event resultingin a suddenly happy consumer pulling investment through the system, or if neither can occurwithout the other and with sound economic policy in place at the same time as well.

And even if the spending was the final lynchpin then, it does not mean the economy and thenature of risk aversion today is of the same nature. That is what the collective inaction ofbusiness leaders with their muted response to policy for many years is telling us. There is moregoing on than a temporary lull in animal spirits that current fiscal and monetary policy will cure.If that was the case, it would be working already.

It may be I have focused too much domestically, as this notion of belief could now extendglobally, and the economy is also much more global now than at any point in the past. By


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extension business leaders think of countries like they do customers. No CEO would rely oncustomers or suppliers with the balance sheets a lot of countries have. In the back of their mindsthey must be wondering how exactly this all hangs together (as do many individuals who readthe Wall Street Journal and have a ton of money in cash).

Now, something has to happen to restore our collective faith. And more short term fixes andempty promises during campaign speeches and the State of the Union addresses are not what doit. It may start with a new leader (Democrat or Republican) after the next election. Or it mayjust start under current leadership with something as simple as people feeling the system isrunning well again. Or maybe the Fed starts showing more restraint and markets becomemarkets again. It may be the notion that issues in other countries around the globe start toresolve. Or it just may be time. It is impossible to know, but I hope faith is restored and that theAmerican spirit ultimately prevails over the impediments in place.

Killing Me Softly

At any rate, on to the details. I pulled together the following chart to illustrate the historicalrelationship between corporate profits (red) and employed Americans (blue). As you can see itbegan to diverge in the ~2003 and ~2009 corporate profit cycles, when corporate profits startedto fare much better than the number of working Americans. I also included total public debt(green).

Debt

Employed

Profits


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Here is my thinking about what has happened and some other related points. Think about it fromthe perspective of a CEO. First some interesting facts which if one had a-priori, one wouldprobably not think there would be an explosion in corporate profits under these conditions:When the stock market was at this price in 2007: Consumer Confidence: then 99.5, now69.6; Americans on Food Stamps: then 26.9 million, now 47.69 million. Also real median

annual household income (using what is an understated CPI in my opinion) in January of 2013was $51,584or 92.7% of the level in January 2000 and it remains well below the $54,008 levelseen at the start of the recovery in ~2009. But at the same time counter-intuitively corporateearnings and margins have skyrocketed to a new peak which is theprimary reason the equitymarket has rallied. Despite all the chatter about QE driving the stock market up, from the moveoff the bottom most of it has to have been profit driven (profit margins being un-natural andfunded by the government which I will explain next), whether profits account for 70% or 90% or99% of the move I cannot tell you although I have some guesses.

Profits are the question at hand. The chart shows corporate profits have generally trackedemployed Americans. Makes sense. Jobs = income = consumer spend = corporate revenue

=profits. Fewer jobs = less revenue = less profits. Economics 101.

However as the chart shows, things clearly changed in the ~2003 and ~2009 profit cycles ascorporate profits surged while employment did not. My explanations:

Starting with the ~2009 cycle first. In the 2008 downturn companies eliminated a lot of jobs.The depth of the downturn forced them to make the tough decision. Normally that killsconsumer spend due to wage loss. But the government plugged the revenue gap with transferpayments and direct investment. See the green line go nearly vertical and it is fascinating howprofit growth has mirrored the trajectory of debt growth. The consumer has started to dis-saveagain as well. Thus corporations kept the revenue, lost the labor, and voila record margins. Youcould argue unemployment is being subsidized. Like anything else, when something issubsidized, you tend to get a lot of it.

Normally corporates would take the excess profits and re-invest in capacity and labor, drivingmargins back down to mean levels or even into an excess capacity situation (normal businesscycle). Certainly at this level of profits the return on investing idle cash in capacity (capital andlabor) should be much higher than having it accumulate and earn 0% interest. When businessesinvest and hire to take share because share and growth is profitable, that competition pushesprofits to consumers (wage earners) through higher employment, higher wages and lower realprices. Competition and risk-taking often hurt investors over the short term. It's risky andsometimes unprofitable or profit margin lowering, but is great for the economy over the longterm. The economy needs risk taking and competition to grow and sustain itself.

But now there is greatly subdued competition because CEOs are scared to take risk. Investmentsin capital and labor are long lived and expensive if wrong (even labor as there is a high frictionalcost of firing employees). Other forms of regulation and things like Obamacare and lack of faithin the government lead to further risk aversion by employers. Thus low growth, but high profits.

Investors for the time being seem to love this condition, especially when it is hard to find yieldelsewhere. Now high profits are discounted with low interest rates because nobody sees any


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growth. They start extending the time horizon over which they are willing to discount highprofits with low discount rates. Or more simply we end up with record margins, high profits, lowgrowth, underemployment, and high stock prices.

G-Unit

Unless the laws of economics have changed, these margins should be unsustainable. In 1999,Warren Buffett warned In my opinion, you have to be wildly optimistic to believe that corporateprofits as a percent of GDP can, for any sustained period, hold much above 6%. One thing

keeping the percentage down will be competition, which is alive and well. In addition, there's a

public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing

portion of the American economic pie, some other group will have to settle for a smaller portion.

That would justifiably raise political problems--and in my view a major re-slicing of the pie just

isn't going to happen.

Today corporate profits are near 11% of GDP, and G is a bigger hunk as well, so flow that math

through and think of the implications. With respect to Mr. Buffetts point about competition, Ipreviously stated my view on what has happened to competition (and more on this topic tofollow). And if competition goes away forever and margins hold here, a condition I dont thinkpossible, that is just terrible for the US economy. You might as well run to the hills forgood. And I am not sure exactly what Mr. Buffett means with his public policy point, better toask him. I suspect its about unacceptable income distribution and poverty and lack of revenuegenerating real consumer income. I guess that is why he uses corporate profits as a % of GDP asopposed to margins relative to their own history which is simpler. Mr. Buffett is right that thisproblem seems to be politically unacceptable, but it is now being dealt with and financed in away he must not have thought possible or sensible. Debt financed direct or indirect transferpayments cannot sustain at this rate without negative consequences.

But clearly, Mr. Buffett has changed his mind. I doubt he would make the simplistic rates arelow and dont fight the Fed argument, he never seems to have been that guy (in the past which Ireference in the next section he has said roughly the opposite). It may be he is worried aboutexcess inflation and views equities as the best inflation hedge he can find, especially the ones heis buying, but hasnt said that for obvious reasons. I hate to think that could be the case atcurrent margins and multiples, but I am scared that it may be. And there is no doubt he is abetter investor than I ever was, the scoreboard is the scoreboard. However, a rise in equitiessolely due to inflation is not a rise to be celebrated, nor does it produce real wealth. Historyshows equities lose value in real terms in periods of high inflation. And if one is bullish onequities for inflationary reasons, one really is bearish on the economy because real wealth andincome is being destroyed. Be careful what you ask for because you might get it. But maybe asinvestors thought the internet was creating a new equity valuation paradigm in 1999 when heoffered this quote (and he was not young and unwise then), investors are now thinking continualgovernment borrowing and intervention and ZIRP are creating a new investment paradigm inthis day and age, and that profit margins will never mean revert as they always have, nor will anyother bad things happen?


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I wonder what S&P EPS would be if the G component of GDP was back to normalized levels(which still seems to mean running a deficit) which would lead to less revenue, and marginswere closer to normalized levels as well? My guess is it would be roughly near 6% of GDP asMr. Buffett suggested, or said more simply a lot lower than it is now.

Scared Straight

At any rate, the first step by the Fed and Government post 2008 was straight Keynes and thesecond step now is a Keynes derivative which is to use the threat of inflation to force corporatesand individuals to put cash to work as the value of money is perishable. Except it is not exactlyworking like the fiscal and monetary authorities thought it would. All this stuff that issupposed to lower the discount rate in fact increases it the longer lived and costly a decisionis. It scares CEOs. CEOs running real business (not experimental models) that live withdecisions for a long time and pay for them when they are wrong cannot act frivolously. Andeven though they sitting on record levels of cash earning 0%, they are concerned about losing itor investing in a manner that will ultimately cause EPS to drop (bad hiring or capital investment

decisions). And I do not blame CEOs one bit for having these concernsthey are actually veryrational concerns given the state of our government and the global economic situation. If I werethem I would be equally concerned about protecting cash flow for shareholders. And I wouldntwant to go through again what I had to go through 2 or 3 times over the last 10 years alone. It istorturous and costly to reduce organizational capacity.

In my opinion, the shorter lived an investment decision is and the lower its frictional cost or costof exiting the mistake is, the more effective current Fed policy has been. Equities and credit andother highly liquid assets, investors play along because they are just renters and can exitwhenever they want (although they never seem to exit at the right time). And speaking ofrenters, the second area where Fed policy has been effective is real estate which counter-intuitively is the next shortest duration asset (even though they are about the longest-lived). Realestate values are significantly influenced by interest rates which are locked in at the time ofpurchase. Oftentimes real estate is bought with other peoples money. And even though theassets themselves are long-lived, they can be sold, and importantly are almost alwaysincorporated independently, so the investment risk is contained to the single project alone if itturns out poorly.

For example, see the recent new investor activity in single family homes and farmland of allthings, including equity hedge funds who apparently think homes are like stocks. Maybe its asign that other asset categories (equities and credit) are getting toppy or inflation expectations areincreasing when hedge funds begin to foray into the single family housing market and farmland(some having little or no prior experience in these markets). At any rate, it seems odd and notgood to me when policy results in hedge funds buying single family homes and farms. Itcertainly raises price for the new natural buyer, and therefore lowers their disposable income.According to Mark Hanson "For Sale" vs. "Sold" spreads have blown out to record highs incertain markets. In San Mateo County the spread is $1.7 million, 150% greater than the averagepurchase price. In Santa Clara County the spread is $750k, or 80% greater than the averagepurchase price. In a normal environment at these price levels the spread is $100k to $200k. Ialso noticed the median price of a home in Washington D.C. reached its highest point in history


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in March. D.C.s median sale price increased to $460,000 from $405,000 in March 2012, anincrease of 13.6 percent year over year. Interesting the government sector which is a big part ofthe problem is flourishing while everyone else isnt. Not a great incentive structure. And as anaside, unfortunately homebuyers have now been trained to think buying a home is a call optionon society. The same goes for the guys who were/are running large financial institutions.The liquid segments of economy are acting like they believe rates will stay low forever. To me,investing on this basis is a recipe for disaster. One should always assume a normalized level ofrates to value anything.

Sorry Mr. Greenspan we have seen where valuing assets solely on the basis of current rates gotus. If we should do that, baseball cards and chewing gum would also be great investments today.My suspicion is from here baseball cards and chewing gum will hold their value over time betterthan the typical company trading at 15x earnings derived from profit margins that are twice itsaverage levels. And in point of fact according to the CPI the price of candy and chewing gumincreased 31% between the years 2000-2012, while the S&P index including this years rip is

only up 6% since 2000. Yes it matters what the price is that one pays for an asset!

Interestingly Warren Buffett also stated that interest rates "act to stock prices like gravity acts onmatter." Now, interest rates are at generational lows and at least in theory have little to do but goup (while at the same time margins are at record highs). Here is the entirety of his thoughtfulcommentary from 1999 which includes his aforementioned thoughts on profit margins andinterest rates, and his view that the inescapable fact is that the value of an asset, whatever itscharacter, cannot over the long term grow faster than its earnings do. Unfortunately one of hisconcluding thoughts has not come to fruition: Best of all, the rewards from this creation ofwealth will have flowed through to Americans in general, who will be enjoying a far higher

standard of living than they do today. Even guys as smart and wise as Mr. Buffett can be

wrong. http://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/269071/

Projecting rates this low sustainably into the future also means projecting no growth into thefuture which is not an exciting condition for the EPS growth which is needed for a broad marketadvance from these levels (note Mr. Buffets comments about an assets value not being able togrow faster than its earnings do). As an aside you never hear anyone tell you to sell equitiesbecause growth is accelerating and interest rates are starting to go up. The argument for using anormalized level of rates to value assets is the only one that remains internally consistent overthe cycle. That is how businesses think when they make longer term investments.

Anyway with respect to rates, in practice using a normalized view of rates to value assets

unfortunately doesnt happen and this is precisely why the Fed jawbones the notion rates willstay low until 2015 to extend the threshold as long as they possibly can. I believe this cannotend well. It helps over the short term, but it ultimately destroys capital which gets poorlyallocated in the feeding frenzy ZIRP causes.

Back to CEOs running a business. I believe of all decisions (investing in liquid securities,investing in real estate, and investing in capacity and employees), investment in capacity andemployees is the longest duration decision and the most expensive if wrong. Even though in


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theory employees can be terminated with relative ease, in practice there is a lot of friction andtime involved. On a cash basis it is costly. Capacity is not cheap, not easily purged, and on acash basis expensive to purge it (along with the cash losses along the way the excess capacitycauses).

Thus this is why Fed policy has worked with respect to increasing the values of liquid securitiesand real estate, and failed to date with respect to employment and capital investment.

Its All About the Benjamins

If one believes in rational expectations theory, CEOs in aggregate who are making long-dateddecisions do not trust an economy that is powered by monetary amphetamines, nor do they havefaith in our government. Business leaders by their collective in-actions have voted a resoundingNo on current monetary and government policy. As Abe Lincoln said You can fool some ofthe people all of the time, and all of the people some of the time, but you cannot fool all of the

people all of the time. This latest massive and expensive effort by the government and Feddesigned to encourage CEOs to increase risk-taking has done the opposite and scared them intoa shell or at a minimum just not worked. Whatever CEOs are afraid of ZIRP, QE,buildingmore roads and bridges and paying out more entitlements is not making them unafraid of thosethings.

If the appetite for risk can be measured on a scale of 0-10, and it can go from a 10 to a 0, cantthis appetite also go irrationally negative? Isnt that what CEOs sitting on a record amount ofcash in this environment are doing (losing money on a real basis)? Doesnt this then also tell youthat todays risk aversion and the economy is of a different nature than it was in the past? Isnt acrisis of belief about the only thing that could drive risk appetite amongst business leaders intonegative territory for such a prolonged period no matter what the policy is that is thrown atthem?

And again, I think this irrational fear is actually perfectly rational for CEOs to have. As I look

at the state of our government, and the global economic situation, it seems perfectly rational tobe concerned about the sustainability of demand. As I said before, if I were them I would beconcerned about protecting cash flow for shareholders. And I wouldnt want to again go throughwhat I had to go through 2 or 3 times over the last 10 years alone.

And it may be this crisis of belief extends globally. The economy is much more global now thanat any point in the past. By extension business leaders think of countries like they do customers.No CEO would rely on customers or suppliers with the balance sheets a lot of countries have. Inthe back of their minds they are wondering how exactly this all hangs together. Domestic fiscaland monetary policy cannot solve this problem, period.

There is much more going on than technology replacing labor at an accelerating rate,globalization, or a structural mismatch of skills to available jobs. Sure they are part of theproblem, but not a majority. They are a convenient excuse to rationalize failed policy.Productivity growth was always hailed as a good thing, both in terms of job creation and its


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ability to contain inflation. These same policy makers now offer it as an excuse for tepid jobcreation. For example:

Paul Krugman 2008, Why Most Economists' Predictions are Wrong,The Red Herring (P.S. yup Iagree and then why offer predictions with such assertiveness all the time and bet the monetary

and fiscal house on them?):

So never mind the hype. The truth is that we live in an age not of extraordinary progress but oftechnological disappointment. And that's why the future is not what it used to be...The growth of

the Internet will slow drastically, as the flaw in "Metcalfe's law"--which states that the number of

potential connections in a network is proportional to the square of the number of participants--

becomes apparent: most people have nothing to say to each other! By 2005 or so, it will become

clear that the Internet's impact on the economy has been nogreater than the fax machine's As

the rate of technological change in computing slows, the number of jobs for IT specialists will

decelerate, then actually turn down; ten years from now, the phrase information economy will

sound silly.

http://web.archive.org/web/19980610100009/www.redherring.com/mag/issue55/economics.html

Paul Krugman 2012, Robots and Robber Barons, NY Times:

Still, can innovation and progress really hurt large numbers of workers, maybe even workers

in general? I often encounter assertions that this cant happen. Butthe truth is that it can, and

serious economists have been aware of this possibility for almost two centuries

http://www.nytimes.com/2012/12/10/opinion/krugman-robots-and-robber-barons.html?_r=1&

All the anti-technology sentiment all of the sudden is starting to remind me of Karl Marx. Seethe Financial Times article Obama Must Face the Rise of the Robots:http://www.realcleartechnology.com/2013/02/04/obama_must_face_the_rise_of_the_robots_10997.html. Does anyone ever think about all the jobs technology companies have created (newhigh growth companies, industries and products)? Work by both the US Fed and the OECDshows that more technology leads to more productivity and more employment, and as I said thisis what they used to always claim until their policies started failing.

As an aside, dont whine about technology and at the same time put policy in place which runs

up the value of high beta stocks the most (ergo a lot of technology companies), and often to un-naturally high levels giving them an even lower absolute and relative cost of capital and

therefore the ability to develop even more technology. And with higher stock prices in general,that is more $ spent on stock buybacks to retire an equivalent amount of shares, which is lessmoney to be invested in capital and labor.

Simply if businesses were investing and growing, they certainly would be hiring all types oflabor domestically, they wouldnt even have much of a choice! This is the main issue,everything else is just a side-show or an excuse and not in the 80/20. This is also what is meant
http://www.nytimes.com/2012/12/10/opinion/krugman-robots-and-robber-barons.html?_r=1&http://www.realcleartechnology.com/2013/02/04/obama_must_face_the_rise_of_the_robots_10997.htmlhttp://www.realcleartechnology.com/2013/02/04/obama_must_face_the_rise_of_the_robots_10997.htmlhttp://www.realcleartechnology.com/2013/02/04/obama_must_face_the_rise_of_the_robots_10997.htmlhttp://www.realcleartechnology.com/2013/02/04/obama_must_face_the_rise_of_the_robots_10997.htmlhttp://www.realcleartechnology.com/2013/02/04/obama_must_face_the_rise_of_the_robots_10997.htmlhttp://www.nytimes.com/2012/12/10/opinion/krugman-robots-and-robber-barons.html?_r=1&


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to naturally drive up the value of homes and other financial assets, as opposed to the other wayaround!

There is more going on than a temporary lull in animal spirits that current fiscal and monetarypolicy will cure. If that was the case, it would be working already. And I know those in favor ofthese policies will retort by saying we have just not done enough. But if the nature of theeconomy and risk aversion is different, spend and ZIRP and QE all you want, it wont help, andwill just result in more imbalances, a larger deficit and a bigger tax on the future.

I also suspect that if Keynes were brought back from the dead he would be skeptical of todays

monetary policy. He realized it cannot do everything and at some point it is akin to pushing on astring. And he might worry monetary policy has gone too far and is trying to do the job of fiscalpolicy and creating distortions in markets. I also wonder how he would think about todaysfiscal policy? Although directionally consistent with his thinking, he might also realize todayseconomy is a lot different than the economy of the 1930s.

Keynes himself on the topic of inflation:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an

important part of the wealth of their citizens. By this method they not only confiscate, but they

confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The

sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in

the equity of the existing distribution of wealth. Those to whom the system brings windfalls,

beyond their deserts and even beyond their expectations or desires, become profiteers, who are

the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than

of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly

from month to month, all permanent relations between debtors and creditors, which form the

ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and

the process of wealth-getting degenerates into a gamble and a lottery.

Regardless, no matter how well intentioned the current spending is, it will fail or even backfire ifbusiness leaders dont trust it or believe in it. No amount of spending can overcome a lack oftrust and belief. Trust and belief are central elements to a government working, an economyworking, and a fiat currency having value. When trust and belief fail, the system will fail. Andif the nature of risk aversion or the economy is somehow different than it was in the past,historical theoretical remedies will also fail.

I Want To Ride My Bicycle

Circling back to the ~2003 profit cycle, there is a similar dynamic that occurred, yet it also hadsome very different dynamics as well. Similar to this current profit cycle, corporate profitsvastly outpaced employment. The ~2003 cycle seems to have been a function of globalizationand credit growth. Globalization led to blunt hiring in the US as cheaper labor was sourcedabroad. Cheaper production helped US corporate margins. Similar to the ~2009 cycle,consumer revenue that normally would be lost due to tepid hiring and wage growth was replacedby credit. Then it came in the form of the US housing bubble and record consumer credit / homeequity extraction.


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The important similarity to both profit cycles is that they were driven by credit growth thatsupported corporate revenues above what consumer income alone would have. In both casescorporate profits were the offsetting asset relative to the liability of government and consumerdebt. The credit growth of 2003 proved itself not only un-sustainable, but tremendously costly.

That loss of consumer credit has now been shifted to the government balance sheet and that ofthe US Federal Reserve. By definition, this also is unsustainable in some form. Sure it cancontinue to grow, but if it does at some point I believe it has to resolve itself painfully throughhigher rates or inflation, some other form of taxation orconfiscation, or something else I cantthink of. Or a hunk of spending just has to stop. If I could tell you what, when, or how this is allgoing to happen, and what to do in the interim, I would be a billionaire tens of times over asopposed to writing stuff like this.

Wont it be interesting if going forward economic cycles are not marked by the supply of excessproduction capacity, but instead the supply of excess credit which creates asset bubbles asopposed to excess production capacity? I believe CEOs have more rational expectations than

certain classes of investors, namely the renters, who are a very big group collectively investingenormous amounts of capital. Thus policy causes a rice in price in certain asset classes (often aswe have seen recently to irrational levels) more effectively than it stimulates investment bybusinesses in capital or labor. The costs and risks of monetary policy attempting to substitute forun-sound structural policy are much greater than the potential benefits! It just causes assetbubbles and does not drive employment. The cycle during the housing bubble was marked bytepid and disappointing employment gains. And this cycle, equity prices have ripped andhousing prices have rebounded, and again employment growth has been very disappointing.

Turning Japanese

I find the notion that QE and more QE and ZIRP and more ZIRP will cause CEOs to invest incapital or labor to be wishful thinking, especially at this point. Japan has already tried that.Japan like the U.S. has excess private savings including the corporate sector. Counter-intuitively Japanese gross fixed business investment over the last 10 years has averaged 13.7% ofGDP versus the U.S. at 10.5% of GDP, yet Japan has still grown less quickly than the U.S.Monetary policy which doesnt work perfectly to begin with cannot overcome structural,demographic, or political problems. Oftentimes monetary policy makes these issues worse fornumerous reasons including causing capital misallocation and providing steroid boosts thatenable politicians to ignore making the necessary structural change that needs to occur for aneconomy to become sustainably healthy. This may be the worst of all the negative side-effectsof monetary policy. Hypocritically the Fed as part of its excuse making for the tepid response toits policy often cites the fiscal side of the house. But the Fed has been and continues to enablethis problem. Lack of necessary structural change is what has happened in both the U.S. andJapan for a long time. Now the Japanese are resorting to outright debasement. I hope they arenot a roadmap for U.S. and the rest of the world, but I am worried that is what is happening.And you could argue the U.S. is the roadmap they are following, and on it goes.

From Caterpillars recent disappointing quarterly earnings report in the 2013 economic outlooksection the following appears: With interest rates at or near record lows in many countries,


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some central banks injected more funds (quantitative easing) into financial systems to promote

lending and economic growth. With both Japan and the United States following aggressive

quantitative easing policies, we expect other countries will eventually implement similar

policies. It is quite odd when statements like this work their way into quarterly earningsreports, and from the way it is written it appears they view this as a good thing. Maybe they are

hopeful this all results in commodity price inflation, which they believe will be good forpurchases of their equipment. Be careful what you wish for.

But QE is generating neither growth nor currently not a lot of excess inflation as measured by theCPI (although between QE and ZIRP we do seem to have simultaneous inflation in certain assetprices and a lot of the costs the man on the street is experiencing and deflation in smallerportions of the average persons basket). All the Fed does is with QE is create excess reserves,but they dont put money in the pockets ofthe average consumer. QE cannot cause credit to beextended. Currently QE just equals excess reserves because demand is not increasing as policyis scaring business leaders and other investors therefore credit is not being extended (althoughthere is now an enormous amount of dry powder). Also banks are potentially afraid to lend for

the same reason potential borrowers are afraid to borrow. Additionally even though spreadsmight be decent, at these absolute very low levels of rates, it is risky to lend long against them ata fixed price for a long duration. And on top of it all the Fed is also paying banks to sit on thesereserves.

Excess reserves dont benefit from a money multiplier. That is why they are excess. Creatingan excess reserve is only excessbecause banks havent levered it. There is a difference betweencapital and money. Capital can be created when a business borrows at low rates and then turnsaround and invests. But in order to spark inflation, we need more money in circulation which isa proxy for wages and other prices. Credit extension is what puts money into circulation andmoves prices higher on a broad basis. Ultimately either price will decline to meet wages orwages will rise to meet price.

The huge risk to this is eventually the high-powered money may be put into use by banks (inaddition to the leakage I describe in the previous paragraph which may not necessarily be wellunderstood). If it does I suspect it will not happen in an orderly fashion. I am sure the Fedbelieves that if all the sudden this money starts to work its way into the economy and it begins tooverheat they can remove money or credit at the exact appropriate time and rate such that excessinflation never happens. They probably also convince themselves this is the better problem tohave. The same guys that get every forecast wrong, have missed at least 2 bubbles, and whohave been flummoxed by QE and ZIRP not doing what they thought it would, think they cananticipate all the global knock-on effects of this policy action and also remove the stimulus atexactly the right time and rate and engineer a smooth landing?

Where I may be understating QEs impact is the excess liquidity and consumption that hasentered the economy through specialty finance companies (consumer finance, mortgage REITs,etc.). Specialty finance companies and mortgage REITs can access capital from banks viasecuritizations and the repo market incredibly cheaply now (30 day rate currently 15bp) becausebanks have excess reserves, and then turn around and lend it, which they have started doingaggressively again (and last time this did not end well). So some segments of the economy may


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have received disproportionate liquidity from QE. Here are some data-points and they are scaryabout the degree to which certain segments of the economy seem to have re-bubbled or over-consumed due to ZIRP and excess liquidity:

- The average maturity for car loans to borrowers with blemished credit contained inasset-backed securities surpassed 70 months last year for the first time since at least2005, according to Moodys Investors Service, which uses General Motors Co.s GMFinancial as a bellwether for the segment. All loans longer than 72 months more thandoubled to 14 percent as of April 20 from six percent in 2010, according to J.D.Power & Associates.

- Auto loans which specialty finance companies crowded into that were made in 2012are already running at a rate of non-performance that equates to the 2006 vintagewhich had the record rate of non-performance

- Auto sales back to roughly 2007 levels when U-6 unemployment was about 8% andnow it is 14%. How does that make sense and how is it good to once again pull abunch a demand forward and put cars in the hands of people that may not be able to

afford them, which previously helped bankrupt the industry and cost taxpayers $25bband counting- Covenant-light loans on pace to break 2007 record issuance, already at $88bb YTD

(April) versus 2007 peak of $97bb

The whole topic of QE is akin to particle physics, I am not sure anyone fully understands it.There are some that even make the argument QE is now becoming deflationary because it takessafe assets out of circulation, and that QE is now supporting short term rates as opposed tolowering them due to the ability to hold excess reserves at the Fed.

I believe deficit spending is more akin to creating money that goes into the economy than QE hasbeen. But tax and spend that is failing is counter-productive, it just takes equity away frombusiness leaders and other investors who take better risk. The spend doesnt help in an economythat is less manufacturing driven than it used to be and the fear is of a different nature than itused to be, perhaps now extending globally.

QE is not resulting in credit extension or job creation for the same reason ZIRP and fiscal policyare not working. And these policies have not been working for a long time. When is thereenough evidence that the problem is of a different nature and doing more of and different flavorsof the same does not help? It only adds to the deficit and removes equity from the better risk-takers, creates more imbalances, and lets politicians off the hook from addressing structuralproblems.

I Want a New Drug

Related to the notion of capital allocation this latest batch of Fed policy has many marketparticipants rooting for bad news so the monetary juice continues. Perverse incentives andcapital misallocation are not good for the economy. In a capitalist economy the market is meantto determine asset valuations, not the Fed.


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Because these perverse incentives now exist, the U.S. market has rallied post the recent weakjobs report and some other soft economic data and numerous poor bell-weather earnings reports.The following snippet from a market pundit is typical: sometimes bad news, like the jobsreport, is in fact good news. The fed gives you the game plan, and in the spirit of all good bets,

follow the rules, and bet with the house. Or Chuck Prince in 2007 as long as the music is

playing, youve got to get up and dance. Were still dancing.And this phenomenon is a globalissue now. We have seen what has happened with Japanese equities, and we just had a 4% rally

in EursoStoxx 600 in 3 trading sessions after the German PMI came in at a 6 month low of 48.8,French jobless claims hit a record high 3.22mm, and Spanish unemployment jumped 1% to arecord high 22.7%, leading investors to anticipate more intervention in European economies.

The Fed has lost credibility, even though recent minutes show some debate, nobody reallybelieves there is real debate and the monetary amphetamine users expect continued doses. Awell-known market strategist during a recent CNBC interview Central bankers are alwaystrying to demonstrate that they are reasonable and that they are worrying about inflation and

asset bubbles but proof is in the actions and fact of the matter is that they have actually flooded

the system with liquidity.we may call it asset bubbles, they call it the wealth effect, they like it.

The Fed has adopted wealth effect driven policy for a long time, but it is only making peoplepoorer. As I pointed out real median annual household income is 8% lower than it was in theyear 2000. And it is not creating jobs. Monetary policy cannot accomplish what soundstructural policy is meant to accomplish. The longer global markets are on monetaryamphetamines, the less they do and the harder they are to get off. The only thing worse thanstopping this (which will have consequences) is to continue doing it which will ultimately resultin a larger problem.

Johnny Be Good

Moving to a different but related subject, JS Mills raised the notion that democracy ultimatelyleads to collective mediocrity. That is at best what we seem to have now in America. Millsthought about the potential solve for this problem and surmised it could be the ideas of great mensuper-ceding those of the democracy. But he concluded that the ideas of great men can often bewrong as well, and this concept is fraught with risk. For example, the men who sat in a smokefilled room and decided occupying Iraq and Afghanistan was a peachy idea and it would turn outjust fine. Uhno!!!! In the end Mills concluded collective mediocrity is probably the best of alot of imperfect solutions. And this is probably one of the things that influenced the followingquote from Winston Churchill: Indeed, it has been said that democracy is the worst form ofgovernment except all those other forms that have been tried from time to time.

Similarly Hayek, amongst numerous interesting points, argued that when an individual or aselect group of individuals must determine the distribution of resources, these planners will neverhave enough information to carry out this allocation reliably. And that a monopolisticgovernmental agency like a central bank can neither possess the relevant information whichshould govern supply of money, nor have the ability to use it correctly: "the past instability ofthe market economy is the consequence of the exclusion of the most important regulator of the

market mechanism, money, from itself being regulated by the market process." He concurrentlyargued that the business cycle resulted from the central bank's inflationary credit expansion and
http://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Credit_cyclehttp://en.wikipedia.org/wiki/Credit_cyclehttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Central_bank


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its transmission over time, as artificially low interest rates would lead to gross capital mis-allocations. Coincidentally one of his books was titled The Road to Serfdom.

And Galbraith. Financial memory is "notoriously short. What currently seems to be a "newfinancial instrument" is inevitably not. "The world of finance hails the invention of the wheel

over and over again, often in a slightly more unstable version ." He also asserts that the commonfactor in boom-and-bust is the creation of debt to finance speculation, which "becomesdangerously out of scale in relation to the underlying means of payment."

Todays economists (at least those on the Fed and advising the President) seem to be the polaropposites. The more government intervention and borrowing, the better. And in a much morecomplex world, they seem to act as if they have 100% certainty that they are correct when whatthey are directionally doing has a long history of ending with terrible consequences. They oughtto remember economic thinking also runs in cycles, and although consensus generally appears tobelieve a certain school of thought for a period of time (and thinks itself smarter than all theprevious guys and all the folks that disagree with them), this thinking inevitably has proven to

have flaws and evolved to a different school of thought over time or reverted back to olderones. For example, Keynes was hugely out of fashion for a while, and now he is haute coutureonce again. Here are two good articles on the history ofKeynes fashion status and the otherside of the argument to provide some perspective:http://www.american.com/archive/2011/november/our-two-keynes-problem/http://csinvesting.org/wp-content/uploads/2012/05/govt-spending-and-deficits1.pdf

By way of analogy and not to belittle the severity of either event, 9/11 became an excuse to try tooccupy two countries amongst other things. Now we are figuring out it didnt turn out so welland was very costly. Similarly the financial crisis turned into an excuse for certain economistsand politicians to uncork experiments and spend money like it is going out of style. Hopefullythe latter turns out better than the former. But so far, both events have led to an enormousamount of wasteful and failed government expenditure and intervention which has ballooned ourdeficit and diminished our influence on the world stage. Schumpeter said exogenous eventsdiminish risk taking in an economy. But these same events seem to be used as excuses toincrease risk-taking amongst those running the show as they unfortunately have no real equity atstake. Generals want to fight, economists want to experiment, and politicians want to spendother peoples money. I guess they often just need an excuse.

I understand that the upside of a government is that it can take risk when the private sector isntwilling to do it, but is this the sort of stuff that is appropriate? Not all government risk taking isgood or ends well. And when the government or Fed has no governor on its risk taking (equityor controls) by definition they will take a lot of bad risk. It is interesting that equity is meant tobe such a great incentive and measure of performance for corporate executives, and we nowunderstand unfettered risk-taking is a bad idea for financial institutions, but the concept ofpenalties for taking bad risk does not exist for the Fed or government officials. We have endedup with a system where the worst of the risk takers have the ability to take the most risk and arecurrently taking it at extreme levels.

Nobody Does it Better
http://en.wikipedia.org/wiki/Interest_ratehttp://csinvesting.org/wp-content/uploads/2012/05/govt-spending-and-deficits1.pdfhttp://csinvesting.org/wp-content/uploads/2012/05/govt-spending-and-deficits1.pdfhttp://csinvesting.org/wp-content/uploads/2012/05/govt-spending-and-deficits1.pdfhttp://en.wikipedia.org/wiki/Interest_rate


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Back to Mills and Hayek, what has the US Federal Reserve (and other Central Banks)become? Arent they the great men or a monopolistic government agency independentlysolving problems that our imperfect system has been designed to avoid? And clearly they arewithout the enough of or even the relevant information as amongst other things they couldnt

even figure out there was a housing bubble when it was staring them in the face. The economy isnow much more of a complex system and far less local than when Hayek argued a central bankcan never have enough information or use it correctly.

And sure there is a Fed mandate in place, and other theoretical supervisory mechanisms, butdont kid yourself; the amount of leeway the Fed has is far beyond that of any institution indemocratic America by orders of magnitude. Its ability to conduct its recent round of economicexperiments is proof of this point. And by doing it to the degree it is, the Fed is acting as if it has100% certainty it is correct when what they are directionally doing has a long history of endingbadly.

One should have realized over the prior twenty years just how much leeway and power the Fednow has and how politicized it has become. Maybe even starting in 1960 when Nixon blamedMartin and tight credit conditions for his defeat, and then later appointed Burns is when the Fedand politicians may have started to become joined at the hip and the Fed began stretching itsmandate. Coincidentally soon after, the methodology for calculating the CPI was revised severaltimes and finally morphed to the point where it almost cant show inflation, which gives the Fedeffectively no controlling mandate.

Interestingly since the Fed has become more interventionist with its policy, the depth andduration of recessions have declined versus the past. But at the same time, trendline GDPgrowth has been reduced by about 1%. GDP growth averaged 4% between 1930 and 1969(which includes the Great Depression) and only 2.8% from 1970 until today. Nixon pulled theplug on the gold standard in 1971, part of the rationale being that a gold standard constricts theability of the economy to grow as an economy's productive capacity grows, so should its moneysupply. But since that has happened, somehow the economy has started growing less quickly?Look, the data is the data, whether what Nixon did with the gold standard was partly causal ornot others can debate as you could certainly argue we were effectively off the gold standard for along time prior to that. But regardless since 1970 successful attempts at smoothing the economyhave resulted in less total output, fewer jobs, and giant structural problems. Nassim Taleb:

In economic life and history more generally, just about everything of consequence comes fromblack swans; ordinary events have paltry effects in the long term....Mr. Greenspan kept trying to

iron out economic fluctuations by injecting cheap money into the system, which eventually led to

monstrous hidden leverage and real-estate bubbles.Modernity has been obsessed with comfortand cosmetic stability, but by making ourselves too comfortable and eliminating all volatility

from our lives, we do to our bodies and souls what Mr. Greenspan did to the U.S. economy: We

make them fragile. We must instead learn to gain from disorder.

Frighteningly many things going on today resemble what began to happen in the early 1970sunder the Nixon administration that kicked off a period of stagflation. In both cases a new


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president inherited a recession and a war that he continued to fund, then feared another recessionprior to re-election with a Fed providing cheap money and both entities doing everything theycould to create jobs, and then increased social welfare spending (as Nixon did with SocialSecurity in 1972). Now we dont have price controls and an oil shock, but we do have globalcentral bank aggressiveness on an unprecedented scale. Clearly in 1970 all the intervention

completely backfired.

Torn Between Two Lovers

Personally I am conflicted, now more than ever, as I see our political system flailing. But thedangers of great men making independent decisions have also been proven time and timeagain. What I cannot fathom ever working is when one segment of government (political/fiscal)is a dysfunctional collective mediocrity and what is really the other and equally importantsegment of government, the US Fed (monetary) is great men more or less doing whatever theywant. And even worse, as I said before the Fed with its monetary steroids enables the collectivemediocrity to ignore making necessary structural change. With each segment being co-

dependent on the other, how can that sort of system can ever work in the end? Its like having acar with the pistons pushing in the opposite direction and running on flat tires.

My suspicion is if the great men werent there in the first place (or had a much reduced role orwere operating under the restrictions of real data), we wouldnt have had nearly the problems wedid over the last ~15 years or even the inflation problem of the 70s to the degree it occurred.

This is an interesting old interview with Milton Friedman, pay attention to what he says startingin about minute 1:10 with respect to free markets and political appointees: the record of historyis absolutely crystal clear that there is no alternative way so far discovered of improving the lot

of the ordinary people that can hold a candle to the productive activities that are unleashed by a

free enterprise system.is it really true that political self-interest is nobler somehow than

economic self-interest.just tell me where in the world do you find these angels that will

organize society for us? Seems like a blend of Adam Smith and JS Mills notion of greatmen. The entirety of the brief interview is insightful, none of it having much to do with hisview on money: http://www.youtube.com/watch?v=RWsx1X8PV_A

It would be interesting if the American public were able to vote on Fed policy. Both sides arguetheir views in several very public debates, and the population votes. My strong suspicion is exthose in the financial industry, the vote would be a resounding no. And it would be by a largermargin than by what the current president was elected with. So is the Fed having all this powerand leeway a good structure? Maybe. Democratic? Certainly not.

And to be clear, I am not arguing the Fed should be politicized or even become a democracy. Ido think part of the problem is it has become politicized. But I am arguing there needs to be astricter limit on what the Feds powers are and how they are measured as the current governancemechanism (the mandate alone) and measurement system (the CPI and employment) has giventhem too much leeway. If I were to argue the US Fed was now more influential than the rest ofour government (all three branches combined), you might disagree with me, but you could notprove that argument incorrect. And if I were to argue Ben Bernanke is the most powerful man in


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the world, same thing. The President might control the military, but money and the economymight be the new military. And Bernanke has already started setting off monetary bombswithout something like the War Powers Resolution of 1973 to check this power, and the rest ofthe world is responding in kind. This used to be referred to as Mutually Assured Destruction. Isthis how it is supposed to be that the US Fed has become this powerful and influential?

Here are some recent comments from Paul Volcker which I interpret as him saying the Fed hasnow overstepped its role: "Central banks are no longer central banks. I think it gets dangerouswhen they lose sight of the basic function of the central bank."

This is an issue people ought to spend more time thinking about, and it might be one of the mostimportant ones facing our country. Clearly the government needs to function better as well, butthat issue is at least getting attention, although not yet resulting in any meaningful change. TheFed cannot adopt a role of trying to correct for poor structural policy, especially when the Feds

only real policy tool is to try to drive up asset prices. This is the downside of the employmentcomponent of the Feds dual mandate and its current un-governed interpretation. All this is

resulting in distorted markets, poor capital allocation decisions, a poorer population in real terms,larger and larger imbalances in the system that ultimately need to resolve, and a declining rate ofgrowth in GDP and perennial underemployment.

Check, Please!

How is it possible to check the powers of the Fed in an effective and productive fashion? Ibelieve its via its own mandate and specifically altering how inflation is measured ifemployment is included in the mandate. Also there could be a change to the way the Fedpresident and governors are nominated. Others (a small and quiet minority) have argued tosignificantly curtail the Feds powers to being a lender of last resort. Without arguing specificpolicy points, something needs to be done to rein in the power and degrees of freedom the Fedcurrently has.

The most influential economists and thinkers in the world are not spending time figuring out howgood an aggregate measure of price the CPI as currently constituted is, and how reasonably it isbeing interpreted by the Fed as part of its mandate or even how reasonable that mandate is. Itsnot a terribly exciting topic (its crunching a lot of numbers), its not a way to endear yourself toa peer group many want to advance within, and it limits the ultimate powers of that peer group(probably a big reason the CPI has become what it has become). Those who do spend time onthis issue seemingly just find ways for inflation measures to show less inflation. Who has evertried to cut back their own role in the world?

Importantly all the entitlements are tied to the CPI, so the government has another incentive tokeep the CPI as low as possible. It is a poor solution for solving the problem with entitlements.If it werent for the ability to lie with statistics, maybe we would be forced to come up with a realand sustainable solution to this problem? But if that is how the powers that be want to partlysolve for the problem, they should use the tortured CPI number for entitlements and a morerealistic set of numbers for governing the behavior of the Fed and implicitly the US government.


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There is a powerful incentive structure in place for the CPI to understate real inflation. Andsince the governance method for the Fed I have suggested is better measures of inflation and achange in how they are appointed, I will address that issue. And for the following to make sense,one must also be familiar with the concepts of hedonics, substitution and owners equivalentrent. I wont explain what they are, but I will address what I think is wrong with them.

Fool on the Hill

But first, with respect to how Fed officials are appointed, no target or constraint will make a badbanker a good banker. It comes down to the people doing the job. But we may have developed aself-reinforcing culture of politicized short-term focused, single-minded, confirmation biasedcentral bankers due a flawed appointment system. Due to human nature and confirmation bias,they push or pull facsimiles of themselves through the ranks and therefore become a like-mindedgroup. For example as Greenspan transitioned to Bernanke, Bernanke will probably transition toYellen, and she is cut from the same cloth. Three in a row doing the same thing that isntworking, and in higher doseswhat Albert Einstein referred to as the definition of insanity. Its

the same issue with many of the Governors as well. Look who is running the NY Fed forexample and where he formerly worked, and how different are the folks running the Chicago,Boston, NY and San Fran Feds from each other and Bernanke?

The twelve members of the FOMC average 57 years of age with a standard deviation of only 4.5years. The three members of the Presidents Council of Economic Advisors average almost thesame 56 years of age with a standard deviation of only 2.6 years. All PhDs, and a big overlap inacademic institutions. Talk about a tightly grouped bunch. Now this does not guarantee they allthink the same way (come from same school of thought), and self-selected themselves, but it sureincreases the chances. Per my point, as controversial as current Fed policy is, and despite anypretense of vigorous internal debate, there is only one active dissenter of the twelve on theFOMC. And if confirmation bias is bad for investors, how can it be good for the guys runningthe economy? The economists involved in setting policy today ought to spend more time talkingto CEOs and less time talking to each other and doing differential equations.

It could be interesting to alter the way Fed Governors and Chairs are chosen. The sevenappointees to the Board of Governors are all nominated by the President and confirmed by theSenate. This makes seven of the twelve on the FOMC Presidential appointees. They havefourteen-year terms which are designed to avoid political influence. However the Fed Chairmanand Vice-Chairman only have four-year terms in those roles and need to get re-appointed by thePresident (they still have a guaranteed fourteen years as Governors). Given the Fed Chairmenneed the Presidents approval to keep their jobs as Chair, its a reason to make the Presidenthappy. So what is meant not to be political ends up being political, or at least self-serving.Greenspan somehow ended up hanging on for 20 years and visited the White House more oftenthan any other previous Fed official. Instead it could be interesting to have the then minorityparty (with a minimum threshold of % of seats so they are not a super-minority) nominate theChairmen and Governors as their terms come up. And allow a maximum six-year term for anyFed Chair (still allowing for fourteen years as a Governor). Since they are very powerful, but notelected, it seems they should serve for less time than the actual President can. And six years islonger than many actual Presidents do serve. Granted the Supreme Court is different, but for a


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different reason, and no one Supreme Court member is as differentially powerful as the FedChair is. Hopefully this process would result in a more mixed and less self-perpetuating group.And for those who say this will put a Fed Chair in charge who will act counter to the goals of theactual President, well I thought the Fed wasnt supposed to be political to begin with, right? Andarent checks and balances supposed to exist? Or maybe simply just eliminate the role of the Fed

Chairs entirely, resulting in a more consensus driven process. Or require the standard deviationin age range is seven or nine instead of three or five (this hard to do but you get the point). Andsome say even more simply just return the Fed to its original and primary role as the lender oflast resort.

No system will work optimally if everyone thinks the same way, anchoring and confirmationbias will just take over. If there are twelve people in a room, and they all think the same way,you might as well just have one. As CEO if one pursues a strategy and it doesnt work, youchange it, or lose your job. In investing, if you make a bad investment, you sell it. In life, if youare in a bad relationship, you change your behavior, or end it. But apparently in economics, if apolicy isnt working, you sit in a room and agree with each other that it is great and do more of it

and get promoted through the system?

There are certainly issues with my proposed solutions. At least term limits for politicians arebeing discussed. The same discussion should be had with respect to how members of the Fed areappointed as well. Searching on Google I could not find one reference to an alternatemethodology. That shows how little thinking has been done on this issue. I believe the currentsystem we have in place is self-perpetuating and politicized and broken. On a related point manyAmericans vote for the President on the basis of who they believe they will appoint to theSupreme Court if a seat is vacated. The Fed Governorships which are of equal importance donot have that degree of influence from the people, probably because people do not understand theissue.

And regardless of how Fed officials are appointed, human frailty being what it is, they do need tobe constrained by limits.

Murder By Numbers

So on the subject of limits, lets start with hedonics and substitution. It seems hedonic qualityadjustments only go one waydown. The average American weighs 35 more pounds than wedid in 1969. Its because cheaper calories are really bad for you. Not to mention that like forlike the quality of the meat and produce is lower than it used to be (measure-ably fewer nutrients,more chemicals). Our cheap food now results in a huge incremental healthcare cost in the future(which has become now), both in terms of units per individual and more volume of thoseneeding the units of care. The price of food is not hedonically adjusted up to adjust for its lowerquality and significantly higher lifecycle cost. But somehow mens shirts are hedonicallyadjusted. Huh? List of adjustments here:http://www.bls.gov/cpi/cpihqaitem.htm. And althoughmy computer might cost more, it also gets hedonically cheaper even though I cant type anyfaster or coherently so in practice I am not one bit more productive with it.
http://www.bls.gov/cpi/cpihqaitem.htmhttp://www.bls.gov/cpi/cpihqaitem.htmhttp://www.bls.gov/cpi/cpihqaitem.htmhttp://www.bls.gov/cpi/cpihqaitem.htm


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Interestingly Paul Krugman from the same 1998 Red Herring article I previously cited. He toomust think the CPI has understated inflation to some degree as this statement runs counter to theconcept of hedonic adjustments:

One answer is that input isn't the same as output. The raw power of computers has advanced

at a stunning speed, but has this advance translated into a comparable improvement in theirusefulness? Word processing, to take the most obvious example, hasn't fundamentally improved

since the late '80s. And in the view of many people I know, WordPerfect 5.1 for DOS was

actually better for their purposes than any of the bloatware that has followed.

With respect to substitution, if one substitutes horse for beef because beef is too expensive, bydefinition the horse is of lower quality because one prefers beef. So shouldnt there be a hedonic

adjustment back up for the price of horse that is exactly equal to its price differential from beef?It seems hedonics and substitution should mathematically always cancel each other outthenotion of substitution should not exist if hedonics exists. Regardless if the price of beef changes,I want to know it changed. But with substitution in place, the meat category will have decreased

in price as opposed to having gone up in price like it did in the real world.

With respect to owners equivalent rent it is an obvious policy goal to increase home prices, but

then we have a measure that may not show this increase in prices. Odd. It is also based onsurvey data as opposed to actual rents. From the BLS website: The expenditure weight in theCPI market basket forOwners equivalent rent of primary residence (OER)is based on thefollowing question that the ConsumerExpenditure Survey asks of consumers who own theirprimary residence: If someone were to rent your home today, how much do you think it wouldrent for monthly, unfurnished and without utilities? And this survey data is also a whopping30% of the core CPI basket (4x as large as the next component), so if it doesnt budge, itoverwhelms the movements in price of everything else. So rates can be dropped, the price ofeverything else goes up, housing prices go up a lot, owners equivalent rent barely goes up, andthe CPI really understates the changes in prices that are occurring for everything else in theeconomy. This is what happened with OER between 2000 and 2008 (and from ~1977-~1982).And to be fair the use of owners equivalent rent can also result in the opposite problem. Butwhen its gone up faster than housing prices, its only been to a very small degree. Used as theonly measure of housing prices, it can be very problematic. And we are at a point in the cycleagain where housing prices are going up, the prices of other things are going up, and ownersequivalent rent is going up much less quickly.

Then with respect to the notion of the CPI ex food and energy, the Fed itself has claimed it doesnot influence all prices at all times. For example the notion of CPI ex food and energy whichstarted during the oil crisis was a function of the Fed claiming they had no control over food andenergy prices at that point in time.

Although Fed policy likely did not heavily influence food and energy prices during the oil crisis,now it is probably highly influential. In fact if the Fed is suggesting their policy is increasingasset prices (they have as Bernanke himself cited the increase in the equity market asjustification of the success of QE) and increasing aggregate demand (which is why they claim tobe doing it as demand = employment), and an increase in demand (along with an increase in


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asset prices) will by definition increase the price of commodities, how can they conclude they arenot influencing the price of food and energy and exclude it from the measure they use to governthemselves? In the case I describe food and energy are really no different than the price of laboror anything else they would admit they influence the prices of at a minimum due to the impact ofgrowth on those prices. Seems disingenuous at best to me to currently exclude food and energy

from the prices the Fed is influencing.

We Wont Get Fooled Again

Net/net the CPI is full of subjectivity: measurement, substitution, hedonics, composition of thebasket, owners equivalent rent, ex food and energyafter all the data torturing it goes through itshould really be called the CPI ex ex ex ex. It is also static in its composition (except when itstarts to show inflation then the methodology is changed) and sometimes additionally flawed as ameasure of the Feds influence on prices, especially with respect to the notion of ex food andenergy. The best case for the CPI is that it is a best guess. It is impossible for it to be exactlyright. Tying a very important mandate to what best case is a best guess is problematic.

The Reserve Bank of Australias approach is to look at all measures, and they manage it over acycle. If something is a persistent source of inflation, they're still under an obligation to tightento offset it (target average inflation range of 2%-3%). Still imperfect as it sounds like a recipefor looseness, but better. It gives them discretion to be sensible. The RBA started tightening bylate 2009, lifting their cash rate target from 3% to 4.75%, in part because their CPI actually canand did show inflation above target levels. They've since eased again back to 3%. But its farfrom ZIRP and they have tightened and loosened to reasonable levels while we have only stayedat ZIRP. This is their methodology:http://www.rba.gov.au/inflation/. The British completelyexclude housing prices from their CPI. Again not perfect, but at least they dont have 30% oftheir CPI not budging and masking the degree change in price of everything else. If there was asimple answer everyone would do it the same way. They are all smart people. But almost everycountry does it differently. The baskets are vastly different and so are the methods of measuringprice. So there is a good chance our method is just not right. And it certainly does not resonatewith what the average consumer has been feeling.

As a reality test, how about a simpler basket comprised of actual home prices, college tuition(which by itself is interesting because a lot of cost factors are embedded in college tuitionincluding labor), food (maybe just the prices of a Big Mac which are up 5.2% per year since theend of the recession and labor is also part of the price of a Big Mac) and energy (gas) and healthinsurance prices (includes labor). Look at how these actual prices have changed and then tell mewhether or not there is inflation. Is it a perfect measure? Probably not. An interesting realitytest and point of compare? You bet! And it is probably a fair bit closer to what the averageconsumer seems to be feeling now. This basket also would have set off giant red flags about Fedand Government policy long before the financial crisis reared its ugly head in 2008.

So another solve is to develop several metrics that the Fed is held accountable to and is forced totighten if any single one of them gets out of whack. In addition to what we have now andworking within the constraints of the current system, for starters I would like to see a CPI exowners equivalent rent and ex hedonics and substitution, done both with and without food and
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energy. If those series were run starting 20 years ago, I wonder what the cumulative differencein prices would be that they would show versus the current CPIs? I suspect others could suggestdifferent relevant measures and components, maybe even referring to some of the oldermethodologies as points of reference.

With respect to my prior points where I am trying to be provocative, by definition if the CPI isnot a correct measure of the change in price the average person is experiencing, then there is anissue with respect to the Fed mandate. Is it possible the inflation that the average person hasexperienced over recent economic cycles is higher than what the CPI ex food and energy or justeven the CPI implied? If so, even by only 1% or 2%, what would the implications have been?

First of all at a minimum less power for economists and the Fed and a higher cost ofentitlements, which is one reason why nearly every great man will dismiss this point out ofhand and call me a crackpot for even thinking it might be true. More importantly, I believe atmany points over the last 20 or so years we would have had different monetary policy from theFed and likely different fiscal policy from the government which would have put us on a better

path where underlying structural changes were actually made by politicians, and we would haveavoided two costly global asset bubbles and the damage their bursting caused.

Nonetheless it is interesting that those governed by the number including the politicians via theirlinkage to the Fed directly and through the economy also seem to indirectly control the numberitself. Therefore how it is calculated has been changed at interesting times in the past. Andevery change somehow coincidentally has lowered the reported rate of inflation, and seems tohave occurred at important policy making (fiscal or monetary) junctures. Not much of aseparation between Church and State. Speaking of which, the former Commissioner of theBureau of Labor Statistics which produces the CPI (Katharine Abraham) is now one of the threemembers of the Presidents Council of Economic Advisors.

Per my point, now politicians are contemplating a potential move to the chained CPI (loweragain) to calculate certain federal benefits. This may be an elegant way of cuttingunsustainable entitlements, but it also makes my point about every new inflation measureshowing less inflation.

And I am not the only one to think along these lines, see Haute Con Job by Bill Gross, hisPIMCO investment outlook dated October 2004. It is good reading:http://www.pimco.com/EN/Insights/Pages/IO_Oct_2004.aspx. I know it sounds nuts to talkabout a faulty CPI and the role of the Fed. But Bill Gross is a pretty credible and important guy,and in his piece he says more or less the same thing as I did, with more data, and morearticulately. According to Bill Gross substitution and hedonics alone wipe out an additional 1%or more of real inflation (notwithstanding issues with food & energy and owners equivalent rentthat he does not address). And its become a much bigger issue since 2004 when he wrote thispiece.

If Bill Gross is right that inflation is understated, at many points over the last 20 or so years wewould have had a higher reported rate of inflation and therefore different monetary policy from
http://www.pimco.com/EN/Insights/Pages/IO_Oct_2004.aspxhttp://www.pimco.com/EN/Insights/Pages/IO_Oct_2004.aspxhttp://www.pimco.com/EN/Insights/Pages/IO_Oct_2004.aspx


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the Fed and likely different fiscal policy from the government which would have put the globaleconomy on a better and more sustainable path.

Another way of thinking about this, current inflation measured using the pre-1980 methodologywould be about 10%, and using the pre-1990 methodology would be about 6%. Therefore by

deduction if the current methodology for the CPI was in place in 1970, there would not havebeen a disastrous inflation problem according the CPI at least. Interesting because there is nodoubt there was a lot of inflation in the 1970s. And I am not claiming the CPI as it wascalculated then is right. However, what is clear is that when the Feds dual mandate was put inplace, the CPI then gave the Fed much fewer degrees of freedom than it has now. If thinkingabout the CPI has evolved, so should thinking about the mandate and how much flexibility thenew CPI should give the Fed. By analogy, when the 2nd amendment was put in place, machineguns did not exist. If thinking had not evolved since then, everyone would be allowed to walkaround with a machine gun and buy it with no license and no background check.

I dont buy the argument that the US Bond market trading where it is means there is no inflation

and no prospect of inflation. First of all it is no longer clear to me the bond market is even amarket anymore. And without going into detail, there are more factors affecting the prices of ourdebt than just a view of inflation, such as our exorbitant privilege amongst other things. Also weknow markets have been badly wrong. It would be a fascinating experiment to find out whatwould happen to bond prices if our CPI was printing 1% or 2% higher numbers with the exactsame underlying change in price occurring? I have no idea if the psychological influence wouldoverwhelm what should be the real influence, or if it would even matter in the face of what isgoing on in todays market.

Back to the Future

Switching gears, when Bernanke talks about the Fed having kept inflation under control for thelast 20 years, he is taking an enormous amount of creative liberty. Globalization and technology(formerly known as capitalism and free markets and competition and innovation) is what haskept inflation under control. Not all deflation is badlower prices driven by innovation andproductivity is good. And if productivity is driving the prices of certain things down, it shouldnot result in the Fed trying to drive the prices of everything else up (real estate, equities, etc.).

With all the talk about QE and inflation, from an economics 101 perspective even disregardingFed policy and inflation measurement, I still cannot see how we are not between a rock and ahard place. Lost in the inflation question which seems to now center on ZIRP and QE is thequestion of productivity. Simplistically for a few reasons I do think it will be tough forproductivity to increase at rates it did over the last 20 years. Unless a new internet is inventedand there is another planet with low cost labor that joins the global supply chain, there is going tobe a problem. Although in theory, at some point a new internet probably will be invented, it isprobably not happening in next five to ten years or maybe even twenty.

Here is some data. US non-financial sector productivity growth rose in the twelve monthsending Q3 last year by just 0.4%. For 2012 it is likely to have been lower because non-farm


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productivity just released fell 1.9% q/q annualized in Q4. Therefore a 4.6% q/q annualized rise inunit labor costs in Q4 (up 2.2% y/y).

By comparison non-financial sector productivity averaged 2.5% pa from 2000 to Q3 2008 and2.4% per annum in the 1990's. Non-farm productivity grew just 0.6% last year compared with

2.2% per annum in the 2000 - Q3 2008 period and 2.1% the previous ten years. Despite the highunemployment rate, we are not getting productivity, and growth is seemingly more nominal thanreal. Coincidentally, inflation expectations, as measured by the 5 year breakeven yield, are rightat the top of the post-2008 range at ~2.4%.

If this all sounds nuts, then tell me why the average American seems to not feel so good, dis-satisfaction with the government is running at an all-time high, and casual dining establishments(a good measure of disposable income for the average consumer) are now seeing sales down5.4% Y-Y as of last month. I find it interesting that policy which on the surface is seeminglydesigned to redistribute wealth is apparently doing the opposite for the time being.

Wrapping things up I believe if there is growth there will have to be an inflationproblem. Malthus may finally be right. The world does seem to finally be short of naturalresources. At the same time even nations who have been a source of low cost labor are seeingtheir wage rates go up, and less relative production is being shifted to them. And productivitygrowth has slowed. On top of these underlying factors that would normally pose significantinflation risk, there is an enormous amount of competitive easing going on by central banksaround the world.

Apparently inflation is the problem they seek to have. If there is growth and credit extensionthey will certainly get it, and likely in spades. And the other side of the coin is there is somechance we may never get the growth (especially in real terms) as real income does not seem to becooperating, and some significant mis-allocations of capital and imbalances are also emerging inthe process, and that often comes undone with unforeseen consequences as well.

Then there is the problem with entitlements. This is an issue that people are at least thinkingabout. Here is another interesting article:http://www.american.com/archive/2012/february/the-american-lefts-two-europes-problem/. And this from a guy who has done pretty well for himself:http://www.bloomberg.com/news/2013-03-01/druckenmiller-sees-storm-worse-than-08-as-seniors-bankrupt-kids.html

And I worry our country is wrestling with the 6 issues described in the book ImmoderateGreatness by William Ophuls to varying degrees:http://cassandralegacy.blogspot.com/2013/02/immoderate-greatness-narrative-of.html. Althoughone or two of these issues may be manageable, all 6 are not. I have indirectly touched on someof these themes. It may simply be that what is described in this book is the root cause of many ofthe issues I raise, or even simpler its just hubris, overconfidence and a sense of entitlement thathas become rooted in our leadership (they seem to play more golf in 1 year then I did in 15) andtoo much of the population across all segments (this includes the wealth and very wealthy).
http://www.american.com/archive/2012/february/the-american-lefts-two-europes-problem/http://www.american.com/archive/2012/february/the-american-lefts-two-europes-problem/http://www.american.com/archive/2012/february/the-american-lefts-two-europes-problem/http://www.american.com/archive/2012/february/the-american-lefts-two-europes-problem/http://www.bloomberg.com/news/2013-03-01/druckenmiller-sees-storm-worse-than-08-as-seniors-bankrupt-kids.htmlhttp://www.bloomberg.com/news/2013-03-01/druckenmiller-sees-storm-worse-than-08-as-seniors-bankrupt-kids.htmlhttp://cassandralegacy.blogspot.com/2013/02/immoderate-greatness-narrative-of.htmlhttp://cassandralegacy.blogspot.com/2013/02/immoderate-greatness-narrative-of.htmlhttp://cassandralegacy.blogspot.com/2013/02/immoderate-greatness-narrative-of.htmlhttp://www.bloomberg.com/news/2013-03-01/druckenmiller-sees-storm-worse-than-08-as-seniors-bankrupt-kids.htmlhttp://www.bloomberg.com/news/2013-03-01/druckenmiller-sees-storm-worse-than-08-as-seniors-bankrupt-kids.htmlhttp://www.american.com/archive/2012/february/the-american-lefts-two-europes-problem/http://www.american.com/archive/2012/february/the-american-lefts-two-europes-problem/


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The book is a great read and it is only 70 pages (with about 40 additional pages of footnotes hedraws on an amazing amount of content). It is scary how much of what he describes is going onin America today, especially starting in his 4thchapter Excessive Complexity. I dont think hisintent was to describe America therefore it is even scarier how much of what he describesmirrors what is going on here now. Particularly interesting to me is Ophuls description of

inflation which begins on the bottom of page 59. He notes that this process often starts with thenotion of attempting to create a little bit of inflation to grease the wheels of commerce andfoster economic growth. He concludes that this process is always suicidal in the long-runand those who controlthe policyare convinced that they are in control of events.the

delusion of control is revealed to be what it was all along: hubris. He also offers a deliberatepolicy of inflation is tantamount to and abdication of responsibility and an omission of failure on

the part of the governing class. It demonstrates they have allowed the societys problems to

become intractable and lack the competence or the integrity to deal with them.I does not solvethe problems of society; it aggravates them and leads inexorably on toward self-destruction.His manner of describing what leads to this state and how it resolves is fascinating and I have notdone it justice. The book is a must-read. At least it sounds warning bells. He more or less

concludes that there is not much hope as society will fail to recognize its problems and will nothave the courage or will to act.

I keep trying to tell myself it will all be fine in the end, because it always seems to be fine in theend. But what if the American spirit just isnt what it used to be? I hope that is not the case,because of all things that is the one that matters the most! I guess 20 to 50 years from now wewill know.

Still Crazy After All These Years

My writing probably makes me sound more extreme than I am in practice. Part of what I amtrying to do is to be provocative. Not all Keynesian ideas are bad, many are good. Keynes isalso largely misinterpreted as he advocated building up a surplus in good times, but the bigproblem is this never seems to happen as programs meant to go away end up sticking. Oftenausterity is not good, especially in an inter-linked global economy. Not all debt is bad, credit isnecessary for an economy to thrive. Certain social safety nets are necessary and a big positive.With all these things it is a question of what, how much, and for how long. Not all economistsare short-term oriented and want to run experiments on the economy. And not all economiststhink the Fed should have the flexibility it does, and that government policy should be what itcurrently is. The w

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