The Consumer's Least Elastic Expenditures

Data from the Federal Reserve shows that debt service ratios have declined into the end of 2009. 

Debt service ratio looks at debt payments to disposable personal income while the financial obligation ratio includes other obligatory payments such as property tax, automobile leases, rental payments and homeowner’s insurance. These ratios peaked in the first quarter of 2008 and have each dropped about 1.3%.

Looking specifically at homeowners, the drop from 2008 is seen to have been driven equally by both consumer and household related payments.  However, it can be argued that mortgage debt has more to fall before it reaches historical averages.

Interestingly enough, the financial obligation ratio of renters is lower than its historical averages. This is probably due to selection bias, as many people with a predisposition for borrowing money figured out that becoming homeowners was the easiest way to access more debt. The higher average financial obligation ratio of renters can be explained by renters earning less because they are younger than homeowners and because a sizable fraction of homeowners don’t have any mortgage to pay while all renters have to pay rent.

Revisiting the median income chart, comparing it to per capita GDP

As I mentioned in my introductory post, the basic pessimistic chart of complete white male median income stagnation is very misleading.  However, the picture is bad enough that it does bear an explanation.

This analysis will focus on white male personal income in order to avoid complications from the change in household size and the impact of the changing gender and racial components of the workforce. Real median income growth from 1973 was negative, while real mean income growth occurred at only a rate of 0.6% a year. This means that mean income growth doesn’t come close to explaining the increasing gap to between per capita GDP growth and real median income growth. Unless GDP per capita growth has been completely disconnected from the well being of the average person in the economy, there should be some way to reconcile the two.

Some people think that the explanation is that the rich have rigged the economy in their favor so all of the improvements have gone to them. If this explanation was true, we would expect to see mean income diverge much from median income than it actually does.  If the rich getting richer is the reason for flat wages and it is not fully captured by looking at mean income instead of median income, then corporate profits are the next logical place to look. The below chart shows that there has been no drastic change in corporate profits/GDP since 1973.

While looking at GDP per capita we should acknowledge that there is a problem when comparing real GDP and real personal income from the census; these time series are deflated by different indices. The GDP deflator has not risen nearly as much as the CPI index, as the CPI Index counts the oil increase while the GDP deflator only looks at domestic goods.

Deflating the mean male income by the GDP deflator instead of CPI gets us a little bit closer to the increase in GDP per capita, but there is still a 55% difference that has yet to be explained.

A large part of the gap is explained by the changing nature of pay over time. In 1973, total compensation consisted of 73% of personal income and this dropped to 65% in 2008.  Wages and salaries consisted of 87.4% of total compensation, dropping to 81.4% in 2008.

If the wages had remained constant as a percentage of personal income, the median income would be 22% higher today. This approach yields a lower value to benefits that I found when looking at the employment cost index (Which by some measures has increased by almost 250% since 1981, explaining all the difference between median income and per capita GDP growth).  When the changing nature of pay is combined with the other factors, this helps close the gap between per capita GDP growth and the change in while male income since 1973.

Much of the rest of the difference can be explained by the changing workforce participation numbers.

When adjusting for this additional factor, the difference between median income and per capita GDP is almost fully explained.

At times, the adjusted factor is higher than the per capita GDP, but since white males earn on average more than females and other ethnic groups this is to be expected. The below table explains why median income differs from per capita GDP, but it also explains why real income has been flat in the census data since 1973.

From this table, we see that when looking at why median income and per capita GDP diverge, the changing nature of pay from total income to benefits is the most important variable, followed by changes in the distribution of income, differences in inflation calculation and the changing nature of the workforce. If the changing nature of pay is broken up into wages vs. total compensation and other forms of income, then benefits would account for 11% of the change with transfer payments and asset income explaining the rest.  Understanding why the real median income has been stagnant is interesting, but the situation is much more complicated than the simple graph would lead naïve readers to believe.

Underestimating Exponential Growth

"The greatest shortcoming of the human race is our inability to understand the exponential function." 
-Albert A. Bartlett

Exponential growth is often widely underestimated. Here are a few issues where many people make mistakes because they don’t understand the simple math of exponential growth.

  1. Economic Growth: When there are trade offs between efficiency and equality, many people today think that the taxes, regulation and redistribution are worth a slightly lower growth rate.  However, when this trade off is applied over a long time period, the results can be staggering. If the choice was made in 1870 to have more equality at a cost of 1 percentage point of growth a year, America in 1990 would be no richer than Mexico.
  2. Entitlement Spending and National Debt: As I have pointed out previously, the United States is headed for very high debt levels if entitlement spending is not reformed.  One very simple way to fix this is to index entitlement benefits to inflation and not income. The growth of the economy would make it easy to pay for a safety net at today’s living standards. Unfortunately, this would only work for Social Security and not Medicare as the medical system is structured in a way that leads to health care inflation greater than that of the real economy.  Additionally, there is another problem when the net national debt reaches 100% of GDP. If the market perception of the debt turns negative and nominal interest rates remain higher than nominal GDP growth, then there is no way for the economy to grow itself out of debt.  This is the current situation with Greece, and Japan isn’t doing too much better.
  3. Personal Finance and Pension Plans: If a prudent investor can make 10% real returns in a year, then they can turn 50 thousand dollars into over 1.6 million dollars after 35 years. This simple math explains how many of the rich people today consist of those who have saved and invested prudently. On the other hand, a supposedly fully funded pension fund planning on a world of 8% real returns that finds itself in a world of 4% real returns will find itself underfunded by over 75% 35 years later (In this case, the people making pension return assumptions are underestimating how much they matter, they just know that their books look better if they assume a higher return). Robin Hanson has been proposing that people don't give to the future because they don't care about it, but it may also be that they do not fully understand the impact of exponential growth*.
  4. Overpopulation and increasing Resource Consumption: Overpopulation does not seem to be the exponential problem that we once thought it was. Once become rich enough, their population growth rate slows down. The UK’s Ministry of Defense 2008 Strategic Trends report expects the population to level out at around 9 billion people between 2050 and 2100 (page 25).  While overpopulation is itself not a problem, the exponential economic growth of these emerging economies are coincident with an exponential increase in demand for resources and these limited resources present constraints on growth.

Having established that exponential growth rates are important, here is a handy rule of thumb that will give an intuitive understanding of exponential growth. To calculate the doubling time of an exponentially growing series, take 70 (or 69.3 to be exact) and divide it by the growth rate. This means that a 10% growth rate leads to a doubling every 7 years, a 7% growth rate is a doubling every 10 years and a 3.5% growth rate is a doubling every 20 years.

*It is also possible that someone who both cares about the future and understands exponential growth might think that there were existential problems for the current society that are significant enough to reduce the probability of a far future donation from ever paying off.

Also relates to the economic blogosphere

Eric Falkenstein has a great one-liner in his latest blog post on the irrelevance of most economic research and model building.

For fundamental constants, physicists argue about the 7-th digit, while economists argue about the sign.

Given that there is still a constant debate over whether the latest health care bill will push the cost curve up or down and if it will help or hurt the budget deficit, the quote is very apt.

Demographic Growth, Resource Constraints and Conflict

The UK’s Ministry of Defense has a Strategic Trends Programme that made a report in 2008 called “Global Strategic Trends – Out to 2040”. If you skim through the report, there are some very enlightening charts.

-Page 28 lays out the population growth and aging forecasts for the different regions of the world.

-Page 42 has a very interesting chart of global infrastructure and resources.

-Page 67 contains a map highlighting the areas with the most potential for conflict driven by frontier disputes.

One of the most interesting charts is on page 69 of the report. It highlights areas where there will be an overlap of at least two of the following: demographic growth, water and food shortage and crop decline. The top chart looks at the current situation, which shows that current stress zones are correlated with conflicts containing greater than 8000 fatalities since 1997. The bottom chart uses forecasts to identify where the future stress zones will be in 2040.

The forecast of larger stress zones in China is particularly interesting. China is going to have water management issues that they will have to deal with as they try to keep their economy on course. Water treatment facilities are a large part of this solution, but since they require a lot of energy, this will add to China’s energy demand.

The Equity View of Two Bubbles

While debt levels in both Japan and the US got to comparable heights, it is interesting that it would be very difficult to pick out the US housing bubble from a chart of their relative nominal USD equity market returns.

Source: Palantir Finance

There are a few possible reasons as to why this might be the case.

  1. A larger fraction of the profits in the United State’s bubble went directly to highly paid individuals rather than corporations.  This would be more likely if corporate profits didn’t reach 12% of GDP in 2006, levels not seen since the 1960’s.
  2. The US housing bubble was focused on the leverage in housing, which was residential in nature. Japan’s financial bubble was also to a degree about the real estate, but a lot more of this real estate was owned by companies who were on a whole more directly involved in their bubble.
  3. The technology bubble of the late 1990’s prevented the valuation of US equities from getting too disconnected from their earnings so soon after the last bubble.
  4. The United States’ bubble drove equity markets all around the world while Japan’s bubble was focused on Japan.
  5. Japan was benefiting from China driven growth the same time US assets were benefiting from the housing bubble.

Number 5 could be a coincidence or it could be seen as similar to #4 if the theory is that US consumers helped China’s exporters who created demand for Japanese imports.

Trading the Long Term Government Trend

In the United States, betting that government is going to grow is what some people might call a “positive carry trade”. A positive carry trade is a trade that makes money as long as things stay the way things are currently priced.  The growth of government under current conditions can easily be seen in data on projected spending levels from the CBO.

As spending levels increase, revenues are not at this time projected to rise to keep pace with earnings. There are a few ways that this extra revenue can be found.

1. More debt: The CBO currently projects that under current policies the US will have much higher debt levels in the future.

The trade based on these projections would be to sell short US government debt, as an increase in supply without a subsequent increase in demand should lower the price of an asset.

2. Inflating away the debt: A lot of people worry that the debt won’t be an attractive asset, so the government will have to raise money from seigniorage (issuing new government currency). The trades that make sense in this current situation are to buy gold and sell bonds. This scenario is what most people who worry about government spending often decide they need to focus on, so there is a question of whether there are too many people buying gold and selling bonds in the absence of any present fiscal crisis. However, if a fiscal crisis does occur it may be too late to put on any of these trades so it isn’t completely illogical for a person who thinks there is a higher probability of a fiscal crisis than other people admit to try and hedge their portfolio against the possibility.

3. Higher taxes: This is the least extreme case, though there are still investments that can be made if this occurs. Although the average US voter loves low taxes, they may decide that they like their entitlements more. The recent healthcare policy is a shift in the direction of more entitlements and higher taxes. This negatively impacts domestic growth while not having much of an international impact.  The fact that companies with more international exposure have outperformed companies with domestic exposure even when the dollar was strengthening could be attributed to the wave of new regulations in the US.


Source: Palantir Finance. For International/Domestic Index: GS International Growth Theme Index (68% of revenue from sales outside the US) divided by GS Domestic Sales Basket (less than 1% of its revenue from international sales)

4. Repeal of future entitlements: I’m not sure that this scenario is likely enough absent an inflationary shock to make it worth considering, but the basic scenario would make gold less attractive and while bonds might sell off due to higher future growth they would not be at risk of a major sell off.

Links worth reading

1. Megan McArdle has some interesting predictions about what won’t happen after yesterday’s healthcare vote.

2. Arnold Kling discusses why Modigliani-Miller just doesn’t apply in the real world. It is interesting that many of the differences happen to favor leverage.

3. Eric Falkenstein highlights the difference between a popular account and an accurate account of the recent bubble. It is too bad that people are seemingly hardwired to prefer stories with heroes and villains.

4. Scott Sumner vs. Paul Krugman on US policy as it regards China and its currency.

5. Michael Pettis looks at the potential impacts of a revaluation of China’s RMB.

In the footnotes

Bernanke’s latest testimony has an interesting final footnote (Emphasis added):

9. The authority to pay interest on reserves is likely to be an important component of the future operating framework for monetary policy. For example, one approach is for the Federal Reserve to bracket its target for the federal funds rate with the discount rate above and the interest rate on excess reserves below. Under this so-called corridor system, the ability of banks to borrow at the discount rate would tend to limit upward spikes in the federal funds rate, and the ability of banks to earn interest at the excess reserves rate would tend to contain downward movements. Other approaches are also possible. Given the very high level of reserve balances currently in the banking system, the Federal Reserve has ample time to consider the best long-run framework for policy implementation. The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

What costs? In June 1993 The Federal Reserve published a paper on this topic called Reserve Requirements: History, Current Practice, and Potential Reform by Joshua N. Feinman.

Reserve requirements are not costless, however. On the contrary, requiring depositories to hold a certain fraction of their deposits in reserve, either as cash in their vaults or as non-interest-bearing balances at the Federal Reserve, imposes a cost on the private sector equal to the amount of forgone interest on these reserves—or at least on the fraction of these reserves that banks hold only because of legal requirements and not because of the needs of their customers.The higher the level of reserve requirements, the greater the costs imposed on the private sector; at the same time, however, higher reserve requirements may smooth the implementation of monetary policy and damp volatility in the reserves market.
The Federal Reserve could resolve this policy dilemma by paying interest on required reserves, or at least on the part of these reserves that banks would not hold were it not for legal requirements. Paying an explicit, market-based rate of return on these funds would effectively eliminate much of the costs of reserve requirements without jeopardizing the stable demand for reserves that is needed for open market operations and for the smooth functioning of the reserves market.

In general, I am very much in favor of reducing taxes. However, these companies should probably be paying something extra for their free put options, and yet the current tone of the federal reserve is still geared towards finding ways to help banks get away with paying even less.  Furthermore, the consequence of 0% reserve requirements are rather interesting, as someone reading this  primer written by the New York Fed in May 2007 might figure out:

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

They go on to explain that taking these calculations to their logical extreme is incorrect, since time deposits and savings accounts don't have these requirements and yet don't multiply as much as a zero percent reserve requirement would imply. Still, it is rather worrisome that the Federal Reserve is thinking of switching the whole banking system onto a system that would support extremely large money multipliers*.  The primer also mentions paying interest rate on reserves.

The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has been opposed because of the revenue loss that would result to the U.S. Treasury. Each year the Treasury receives the Fed's revenue that is in excess of its expenses. The payment of interest on reserves would, of course, be an additional expense to the Fed.

Scott Sumner (and presumably other economists) have often wondered why the Fed started paying reserves on interest in the middle of the crisis since it effectively tightened monetary policy by reducing the bank's incentives to lend even further.  The Federal Reserve might have realized that during a time of crisis they would be given whatever they wanted to fix the crisis, so they asked for something they've wanted for a long time even though they could have done more to stimulate the economy with quantitative easing than with their long ability to pay interest on reserves.

*The formula for calculating the money multiplier is (1+c)/(c+R). c is the rate at which people hold cash instead of depositing it. If everyone deposited their cash and reserve requirements were zero, then the money multiplier would be infinite.