A quick solution to the debtlocked Congress

It involves finding an average between the three constitutional bodies - the House, the Senate and the Executive.

The first thing to do is discern how much the difference between revenue and expenditure currently is. In 2011 Q1 it was $2.5231 trillion revenue and $3.7290 spending, a difference of -$1.2059 trillion. If we assume that that number has to be reduced to zero it should come as a result of spending cuts, taxation increases or a combination of both.

So what happens is that each member of the House is given a piece of paper. On that piece of paper they write down what percentage of this -$1.2059 Trillion should be paid for by spending cuts and what percentage by tax increases. I'm sure that right wing extremists are likely to nominate 100% cuts and 0% tax increases, while some lefties are likely to nominate 0% cuts and 100% tax increases. At the same time as members of the House do this, members of the Senate do as well. President Obama also does it.

Equal weighting is given to each of the three bodies (House, Senate, Executive) because they are equally weighted under the Constitution. The "averaging out" process would essentially be enforcing a mathematically based bipartisan compromise.

What happens then is that the average for cuts and tax increases is determined for the House. Let's say it is 61% cuts and 39% taxes. Let's say the Senate average is 46% cuts and 54% taxes. Now let's say that Obama goes for 40% cuts and 60% taxes.

This would mean that an average 49% of the three constitutional bodies say spending cuts while 51% want higher taxes. This would translate to $590.891 billion in spending cuts and $615.009 billion in new taxes (in annual terms). If you do the math, that would result in $3.138109 trillion revenue and $3.138109 trillion spending - a balanced budget.

Of course this voting structure would mean that the final number would have to be accepted by all parties before the vote is cast. This will allow members of congress to vote according to their ideology and please their voters, while at the same time creating a compromise solution.

It goes without saying that an increase in the debt ceiling would also accompany the bill.

America and the terrible, horrible, no good, very bad GDP data

The recent GDP figures paint a bleak picture. My spreadsheet does too:

There was a revision of past GDP performance and it was very bad. The graph above shows quarterly changes in Real GDP per capita, annualised. Of course the big hit was 2008 Q4 but notice that 2011 Q1 has gone negative. I don't think this is the beginning of an annual decline of Real GDP per Capita but it can certainly be seen to presage one later on.

A very sad thing to notice about the new release of these GDP figures is that Real GDP hasn't yet passed its previous peak yet.

Real GDP peaked in 2007 Q4 at $13.326 trillion, then bottomed out in 2009 Q2 at $12.6413 trillion and has grown since then to reach $13.2701 trillion in 2011 Q2. 15 quarters - nearly 4 years - in which real GDP remained below the peak. As far as my spreadsheet tells me, there is no other period in postwar US history where it has taken this long (and counting) for the economy to at least equal its previous peak. Both the 1974 and 1982 recessions took 9 quarters to reach this level.

On a side note, measuring per capita figures has been harder this year due to the work of the US Census. Monthly population figures have not been updated since December which has meant that 2011 per capita figures have had to rely upon mid monthly figures. Caveat Cognitor.


The 14th Amendment and the potential for economic disaster

The 14th Amendment of the US Constitution is currently being examined and touted as an important factor in the current debate about the government debt limit. I've blogged about this recently but I've had some more ideas about it. Here is the text again:
The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave. But all such debts, obligations and claims shall be held illegal and void.
Okay, the background of this amendment was post civil war. In its original context that first sentence guarantees the payment of debts incurred by the Federal Government in fighting and defeating the South. The second sentence, however, absolves the Federal Government from having to pay debts incurred by the Confederate States of America. The third sentence spells this out even more, permanently settling the question of Confederate debt.

It's the first sentence that applies in this current situation. Obviously the framers of the amendment thought it important not just to guarantee payment of debt by the Federal Government in the successful waging of the civil war, but to make it part of the constitution itself via an amendment. This means that they intended the principle behind this amendment to have an ongoing application.

The question is, what does it mean by debt? Obviously this debt is public meaning that it is owed by the Federal Government. In short it is money owed, and money owed that has been authorized by law. In other words, it is money that the Federal Government owes creditors - so long as it has been authorized by law.

As I pointed out in my recent article, this naturally applies to government bonds. As of the 26th July 2011, the US Government owes $14,342,830,116,551.28 in public debt. But is "Public Debt" in 2011 the same as "Public Debt" in 1868? There is a broader application of this term: there is debt accrued by borrowing, and there is debt accrued by buying. For example, if a government office gets a local company to mow their lawns, they naturally have to pay this local company. If we expand this idea outwards, we see that the Federal Government has legal obligations to pay for goods and services delivered to them by private industry.

But what about entitlements? Are entitlements considered debt? I think not. Entitlements such as Medicare and Unemployment benefits are probably not considered "debt" in this situation. Sadly this means that the 14th amendment does NOT cover money spent on Medicare or other social services.

"Public debt authorized by law" has also been interpreted by various bloggers and experts recently as to apply simply to spending bills authorized by congress. Essentially it means that if congress has authorized spending, then this cannot be invalidated by a debt ceiling... hence the debt ceiling as it stands is unconstitutional. I'm not sure of this broad definition for a number of reasons. The first is that the amendment itself doesn't specify it. The second is that we are talking here about Public debt - debt owed to the Public, ie not the government.

If you take this second definition to be important - PUBLIC debt - then what to make of government spending bills authorized by law? Well so long as the PUBLIC get what they are owed, the 14th amendment will not be broken. But if the Federal Government decides to stop paying its own employees, that is completely different because the money owed to their employees is not public. There are approximately 2.8 million people employed by the Federal Government.

Here's a summary of my thinking on this issue:
  • "Public Debt" means money owed to non Federal Government creditors.
  • These creditors include those holding government bonds, as well as those who have sold goods and services to the government.
  • The 14th Amendment prevents the Federal Government from defaulting on money it owes to bond holders.
  • The 14th Amendment does not specify whether payment of money to bond holders needs to be paid "on time" or "later"
  • The 14th Amendment prevents the Federal Government from defaulting on money it owes to private businesses and individuals for goods and services provided.
  • The 14th Amendment does not specify whether payment of money to these private businesses and individuals needs to be paid "on time" or later".
  • Money for those who qualify for government services and entitlements - such as unemployment benefits and Medicare services - are not considered "Public Debt" since they are not "owed" money they have directly invested or money they owed through the provision of goods and services.
  • Under the constitution, Congress is responsible for all spending bills.
  • A self imposed limit on the amount of debt the Federal Government can borrow is within the constitutional powers of Congress.
  • The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself on the bond market. Intragovernmental debt is not "Public Debt".
  • The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself via spending bills.
  • Money owed to government employees and government departments is not "Public Debt".

So given that these are true, what happens if the debt ceiling is not passed? We need to assume here that without a debt ceiling, the Federal Government will be forced to spend only as much as it gets in tax revenue. Specifically what might happen here?
  • The Federal Government will not default on paying back interest and principal on bonds owed to the Public.
  • Social Security payments are likely to be defined as money owed to the Public, so payments will continue.
  • The Federal Government will not default on paying back money owed to private businesses and individuals for goods and services provided.
  • Delays in payments nevertheless may occur.
  • The ordering of future goods and services from private businesses and individuals may be cut.
  • Money for entitlements (Health Care, Unemployment benefits, etc) can be cut.
  • Money for defense can be cut.

As I have pointed out, I don't think an arbitrary self-imposed debt limit set by Congress is somehow unconstitutional since Congress is responsible under the constitution for spending government money. Also, it won't be a case of a law passed earlier (the debt limit) being superseded by a law passed later (spending bills) since the earlier law was specifically designed to prevent something happening in the future.

So if the debt limit is not passed and is not declared unconstitutional, what we won't see is a default on government bonds but there is a chance that these payments might be delayed. This would be viewed by the market as a form of selective default. Similarly Social Security payments might end up being delayed, as would be money owed to government suppliers for goods and services owed.

But in order to ensure that these obligations are met (either straight away or over time), certain government departments would have to undergo a drastic reduction in spending. We would see the government either retrench or put on furlough tens of thousands of its employees, if not many, many more. Those with unemployment benefits would have them reduced or postponed indefinitely. Those awaiting or needing medical procedures covered by Medicare will have them delayed indefinitely with priority given only to the most severe cases.

As I pointed out in my previous post on this subject, the US Federal Government currently takes in revenue equivalent to 15% of GDP while its spending is equivalent to 25% of GDP. The 10% gap between revenue and spending is shored up by borrowing. If the debt limit is not raised then the Government will have to reduce its spending to meet its revenue. We would see a reduction in spending from 25% or GDP to 15% of GDP, which is a 40% cut in spending. If we assume that bondholders, social security recipients and government suppliers are protected by the 14th amendment then everything else covered by government spending will be cut.

Needless to say this will have a hugely negative effect upon the economy. With 10% of the economy suddenly halting, you could assume that GDP would drop by at least 10%. The knock-on effects, caused by the money multiplier going into reverse, could conceivably double this impact. And this would be the case even without defaulting.


Peak Oil: All signs point to yes

This diagram comes from The Oil Drum:

I was initiated into the world of Peak Oil some time in 2004. Initially I thought it was a bunch of scary tinfoil hat wearing nonsense - partly because some tinfoil hat wearing people were promoting it (not you Dave!). The deeper I dug, however, the more the evidence piled up. The tinfoil hats were replaced by serious looking academics with qualifications from reputable universities and experience working in petroleum geology. They pointed out that data consistently showed that individual oil fields had an oil production rate like a bell curve, and that less and less oil comes out once the "peak" of the curve has been reached  - which usually comes when the oil field is half empty.

The problem was, and still is, that many are under the false understanding that oil supplies will simply run out suddenly. They are buoyed by market reports showing that oil reserves have another 100 years production left in them. Thus they are ignorant of the fact that, when the majority of the world's oil fields reach 50%, worldwide production will drop.

The graph above shows very clearly that this moment has arrived. Depending upon which metric you use, oil production has either reached a plateau now, or reached one about five years ago.

Being an econophile before I understood Peak Oil, I naturally assumed that price signals would motivate the market to increase production. Yet if an increase in production is geologically impossible what happens when demand increases? When supply is constrained and cannot rise to market demands, what happens?

Simple: Production remains the same, while prices skyrocket. The graph above shows this phenomenon so clearly that you would have to be cognitively deficient not to notice. Some time in 2004 the price of oil begins to rise due to increased demand. This demand was not met by an increase in production, as the graph shows. Oil production then simply sits at the same level for some years. Oil producers are literally unable to pump the stuff out fast enough to meet demand. Oil prices double from their 2004 levels. Then they triple. Then they reach a peak in 2008 before demand destruction hits - the Global Financial Crisis.

Since then prices have dropped. But notice that they have begun skyrocketing again.

Many years ago I blogged about a "perfect economic storm" to hit the US. While I didn't know the date I knew that it would happen. I knew that Peak Oil would be the major cause. What I didn't realise was the extent by which the US economy had over-geared itself and when this occurred I became far more worried than I had before. It was as though I had predicted the arrival of the largest category 5 hurricane in history, only to realise that it would be a category 6 hurricane (which doesn't exist of course, but that's not the point).

If there's anyone out there who is still doubtful about Peak Oil, remember this: If an increase in price doesn't lead to an increase in production, then there is something preventing an increase in production. If this phenomenon is experienced worldwide by many different and disparate sources, then production must be limited by more than just human choices.

Scientists have proven the existence of Peak Oil. The evidence is clear and unambiguous. Moreover it has been experienced by the entire world economy for the past 7-8 years. What more evidence is needed?

And until we wean ourselves off oil, the lag on economic growth will continue. Policy decisions needed to be made in 2004 and weren't. They need to be made NOW.


Some simple facts about the Utøya shooting

The perpetrator:
  • Opposed Muslim immigration.
  • Was once a member of a dominant conservative political party.
  • Espoused anti-government sentiments.
  • Hated Marxism.
  • Detonated a bomb near the office of the Prime minister, who belongs to a left-wing political party.
  • Shot and killed at least 86 young people who were members of the left-wing political party.

In short, he is a classic right-wing extremist in the same mould as Timothy McVeigh.

While I don't deny that left wing extremists exist and have also perpetrated violence upon people, I would just like to point out the simple fact that, at least in the West, violence caused by left-wing extremists has been dwarfed by the violence of right-wing extremists. And when you consider the fact that it is the right-wing who are espousing all sorts of radical views using violent rhetoric, you can understand why.

Note: The words "Marxist Hunter" appear on the patch on his left arm in the picture above.


It's so gratifying to leave you wallowing in the mess you've made

Not good news:
Negotiations over a broad deficit reduction plan collapsed in acrimony on Friday after House Speaker John A. Boehner suddenly broke off talks with President Barack Obama, raising the risk of an economy-shaking default.

The epic clash between the White House and Congressional Republicans came a week before the government hits its borrowing ceiling, and set off sharp accusations from both sides about unwillingness to compromise.

A visibly angry President Obama, in a hastily scheduled White House news conference, demanded that Congressional leaders come to the White House on Saturday morning.

“I want them here at 11 a.m. tomorrow,” Mr. Obama said. “They are going to have to explain to me how it is that we are going to avoid default.”
Anyone who has played Sim City 2000 will remember the importance of maintaining a tight budget. But if your city in the game gets to a point where you're running out of money you have a number of serious choices to make in order to balance the budget. One option you have is to cut funding to roads. When you do so, this guy (your roads and transport secretary) pops up and yells at you:

What happens then? As time goes by your roads begin to crack up and become unusable. This is turn reduces economic activity and your own tax revenue even further. It's a short term solution but ends up costing you far more in the longer term. It's a sure fire way to lose to game.

Then, of course, there is that Simpsons episode where Homer becomes the town's sanitation commissioner. He manages to gain this position through an election campaign where he simultaneously lies about the incumbent (and even defames him) and gives outrageous promises to the voters, all with Bono's consent. When the scheme blows up in his face (the yearly sanitation budget is used up in a matter of weeks) he resorts to a scheme whereby funds are generated by taking the trash from various US cities and storing it underneath Springfield. This, of course, turns the town into a smelly, garbage infested hell hole. An emergency meeting is held in the town hall and the people unanimously vote for the previous commissioner (Ray Patterson, voiced by Steve Martin) to retake the job. Patterson saunters on stage to music and then says this:

Oh gosh. You know, I'm not much on speeches, but it's so gratifying to... leave you wallowing in the mess you've made. You're screwed, thank you, bye.

I have to say that part of me wants to call the Republicans' bluff and not raise the debt ceiling. To be honest with you it would be the easiest and quickest way for them to achieve their ideological ends. I have already pointed out that such an action would cut federal government spending by around 40% and represent a cut in spending from about 25% of GDP to around 15% of GDP. According to historical notes on the US budget, the last time the US government was that small was 1951 - in other words the Republicans have a once-in-a-lifetime chance to shrink the government to its lowest level in 60 years. Moreover, this would not lead to debt default, as the 14th Amendment protects bondholders.

And it's not as though such a move wouldn't be popular, at least initially. There are many in the US who claim that the Federal Government has no real input into the economy. "Let's shut her down!" some would say, confident that such a move would have no real impact upon the economy and society in general. And as for all those pesky civil servants out of a job, well they weren't doing anything really important anyway. And it's not as though we can't afford to pay them unemployment benefits since such benefits would disappear anyway for everyone once the great spending cut occurs. And with so many people unemployed and not receiving benefits, they would then be able to get off their collective lazy asses and find jobs. Then the economy would start booming again.

Of course these sentiments are nonsense. Anyone with any understanding of the complexity of economics, the effect of government programs and the problems besetting the unemployed would know that such a gigantic cut in government spending would have only a negative impact upon the US. It would cause social and economic pandemonium.

And yet part of me wants to the GOP to do it. I do admit that there is some perverse pleasure in watching an economic collapse unfolding, in the same way that people hang around and watch the aftereffects of an accident.

Nevertheless I do have a rather pragmatic reason for wanting this to occur - the disaster that it brings on the nation (and the rest of the world) will be so damaging that no one would take hard-line conservatism seriously ever again. The disaster would be so horrible that Obama would be re-elected by a landslide and the Republicans would be utterly humiliated in Congressional elections. More than that, hard-line conservatism throughout the world would be discredited in the same way as communism was discredited after the collapse of communism.

And why? Conservatives have painted themselves into a corner. They are just so angry that things like Medicare, NASA, unemployment benefits and the Department of Education exist. It's not just that they don't like big government, it's that they so strongly believe that their understanding of limited government was the same thing believed by the founding fathers that anything, anything which suggests slightly higher government tax revenue or spending is immediately cause for revolution and "watering the tree of liberty". In the words of Grover Norquist, "I don't want to abolish government. I simply want to reduce it to the size where I can drag it into the bathroom and drown it in the bathtub."

Of course I see such people as not just hard-line but extremist. Their ideology has regressed so far that even Ronald Reagan, patron saint of Conservatives, would be labeled a "Republican in Name Only" for many of his policies.

And so this is why part of me wants the Republicans to follow through with the extremist ideology that now controls their party - it would allow them the chance to finally do what they've always wanted to do while simultaneously proving to the rest of America and the world the utter stupidity and unworkability of their policies. Their fate would be to disappear from the political landscape for a long, long time. The world would then become a much better place.

And as their doom descends and the party faithful shrink in horror at what they've done and seek to make amends, the voice of Ray Patterson calls out to them:
It's so gratifying to leave you wallowing in the mess you've made. You're screwed, thank you, bye.


A response to New Deal Democrat

"New Deal Democrat" at the Boondad blog took the time to examine my latest recession indicator and question some of the methodologies and outcomes. NDD actually contacted me a while ago and expressed some of his opinions over these issues so the fact that he has blogged about it is not only welcome but also allows me a chance to respond.

NDD specifically has an issue with using real 10 year bond rates as a recessionary indicator. The reason is that the relationship between negative real 10 year bond rates and an eventual recession appears to break down in before 1953. Now the reason why I did not use any pre-1953 data in my study is because the 10 year bond rate series (GS10)  available at the St Louis Fed only starts in 1953, while seasonally adjusted inflation (CPIAUCSL) starts in 1947. NDD, however, has pointed out that a discontinued government bond data series called LTGOVTBD has data going back to 1925, and that because both GS10 and LTGOVTBD follow each other closely from 1953 to 2006 (when the series was discontinued) it is therefore a good proxy. Add to the fact that non-seasonally adjusted inflation figures (CPIAUCNS) begin in 1913 and you have the beginnings of a pre 1953 data series that could confirm or deny my assertion that negative real 10 year bond rates will always lead to recession.

And the conclusion that NDD has come up with is that they don't always lead to a recession. And here is the salient graph:

When looking at this graph, understand that whenever the red line is higher than the blue one, then that is an example of negative real 10 year bond rates (or, more specifically, negative real long term bond rates). As you can see, there are seven instances since 1925.

Now of course what I have done is to average out the results over three months. This is what we get in the first instance:

1925 and 1926 see some low rates but the only negative result occurs in January 1926. So what happens after? A recession in October 1926. Hmmm.

The second and third instances occur during the New Deal era:

Actually what is notable from this graph is the sheer height that real long term bond rates hit during the depression - peaking at 14.27% in March 1932. If anything this is pretty solid evidence that real 10 year bond rates can operate as a "window" for the economy to grow: too low and the economy crashes, too high and the economy crashes.

As you can see, real bond rates return to more reasonable levels around 1934. The key date here is March 1933 when the Emergency Banking Act was passed. Another important date was June 1933 when Glass-Steagall was passed. Both of these acts resulted in an increase in the money supply and a subsequent move out of deflation. By December 1933, prices began inflating again. This is important to realise in the data in the graph above since the presence of inflation again reduced real long term bond rates from the stratosphere of 14% to around 3% by December 1933.

Of course the graph then shows that in 1934, inflation had reached a point where real long term bond rates had turned negative. They turn negative again for a short time in 1935, and then negative again 1937... which, um, then turns into another recession.

I suppose I could argue that the instances of negative real long term bond rates in 1934, 1935 and 1937 were the cause of the 1937 recession. I think that is not an unreasonable assumption to make, especially the 1937 instance. We need to remember though that the massive hangover of debt and deflation that typified the great depression's stratospheric real long term bond rates needed a little bit more than a few months of negative long term rates to balance against. Nevertheless, if my "window" theory is true, then it could possibly be said that the US economy might've avoided the 1937 recession had real ten year bond rates always remained positive from 1934 onwards. In short, too much inflation was created.

After all, you could put out a house fire with a fire hose, but if you immerse the burning house in the sea, you still end up damaging it badly.

Okay, so let's move on to the war and post-war years:

So as you can see, the war brought about a huge drop in real 10 year bond rates. A recession occurs in February 1945, and then another huge drop in real ten year bond rates occurs during 1946-1949. In fact that period has the deepest recorded period of negative real long term bond rates (which peaks at -16.96% in April 1947). Then another recession hits in November 1948. Then another period of negative rates hits between 1950-1952, followed by a recession in 1953. Beyond this point my data series kicks in.

The first thing to look at here is the effect of the war, specifically the effect of a Total war economy upon the United States. This graph shows what I'm talking about:

Between Japan's attack on Pearl Harbor and the demobilisation of forces in 1946, the US government effectively quadrupled in size. This was due to massive spending to create a war machine capable of defeating Japan and Germany. The growth in the size of government was not "added onto" the economy, but effectively "crowded out" the private sector. The US government increased taxation and went on a massive borrowing spree to fund the war.

Now this is very important for us to understand. In my analysis of real long term bond rates, we're not just looking at causal relationships but also the effect of such causal relationships to the wider economy. Long term bond rates are an indication of how the market is acting at a certain time. If the government is 10% of the economy then the private sector is 90% of the economy, which means that any negative long term bond rates are being experienced by that 90%. But in the war years we see an increase in the size of government and a decrease in the size of the private sector. This means that the negative real long term bond rates during this period are only experienced by around 55% to 60% of the economy. Thus the effect would be less - hence the lack of recession until 1945.

As for the period of negative real long term bond rates between 1946 and 1949, these end up presaging the 1948-49 recession.

In short while the pre-1953 data is essential to examine, I do not think that it rules out the correlation and causation effect at all. Two huge events - The Great Depression and World War 2 - are enough to affect the quality of the data under examination.

There is another issue: Is LTGOVTBD a good proxy for GS10? Just because they correlate when they are measured concurrently doesn't mean that the same correlation existed pre-GS10. Long term government bond rates hardly move much at all between 1925 to 1956, despite the huge swings in inflation and deflation in this period. They do not exhibit the same ups and downs which typify GS10 rates. this makes me think that LTGOVTBD rates, at least in the early days, were pegged by government order. GS10, especially from the 60s onward, seem to move according to the actions of the market.

And finally an answer to a commenter at Boondad who points out:

You cannot calculate CURRENT "real long term interest rates." It's a fallacy.

To calculate a CURRENT "real long term interest rate," you would need to know what "inflation" (CPI, whatever) WILL BE over the next TEN YEARS while you collect your 10-Year Treasury Coupons. You don't know that.

I think this commentator has got it wrong because the interest rate, while certainly applicable over a ten year period, is determined by what the market wants at the time. So while it has a long term function it also has a short term indicative effect. Bond rates go up when investors see bonds less as less attractive to other investments (such as shares) and go down when the market is running away from something. This can be seen during late 2008 when bond rates plunged to 2.42% during the credit crunch after being 4.1% 5 months before. The idea is that the interest rates of government bonds is a  way of measuring market sentiment and activity. 10 year bonds are thus a good measurement of what is going on at the time that they are invested in.

And my argument is that when investors put money into ten year bonds they are essentially investing in something "safe". But when inflation exceeds that "safe" investment, things go wrong and a recession follows. This will be because a calculation of your return on interest will be less than the increase in consumer prices. In other words, the amount of money you gain from such an investment will be less than your increase in spending. Thus a recession. And if my "window" theory is correct, a recession will also occur when the amount of money you gain from an investment will be more than offset by a decrease in income from other sources.


US Recession Indicators - July 2011

According to data from negative Real Interest Rates, another US recession is likely to occur between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely... See below.


Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has increased even further with a June reading of 598. This is an increase from last month's reading of 540.

Since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation.
Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed


Federal Funds Rate vs 10 Year Bond Rate (spread)

The 10 Year Bond Rate has decreased markedly from 3.46% in April to 3.17% in May and 3.00% in June. The Federal Funds rate remains at near zero. As a result the June spread comes in at 291 basis points, well above the historical average but a decrease from the previous readings.
Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).
Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed



Real 10 Year Bond Rates Rates

Again a tweak to my reporting in this area after discovering that a three monthly average was better than a monthly result. I have also decided to call this indicator "Real 10 Year Bond Rates" rather than "Real Interest Rates" since the latter term can be used to refer to the Federal Funds Rate.

Real ten year bond rates came in at -0.12% in June. As I have pointed out before, all experiences of negative 10 year bond rates since the 1950s have resulted in an eventual recession.

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.
Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds. A negative result over a three month average indicates that a recession may occur between 4-18 months, with an average of 8½ months and a median of 6 months.
Note: Not all recessions are preceded by negative real 10 year bond rates. Nevertheless all instances of negative 10 year bond rates (since the 1950s) have been followed by a recession.

Data Series:
St Louis Fed





Why invest in investment when you can invest in growth?

Come with me to the fictional economy of the future.

The year is 2030. The price of gold has passed $1 million (in today's dollars) per ounce. Nevertheless the world economy is shrinking badly. There are high levels of unemployment, massive poverty and starvation everywhere.

So how did we get to the point of $1 million per ounce? It could be argued that with the economy tanking so bad, investors have taken refuge in the only thing worth investing in. Why invest in companies that produce goods and services? No one is buying! Everyone is poor! It makes no financial sense to invest in such a scheme because the returns are just so low.

But the reality is that investors have gotten it backwards: It isn't that the economy is bad so we need to invest to gold, it's because we invested in gold that the economy is bad. Gold in the fictional world of 2030 has become another Tulip mania phenomenon - a massive investment bubble that drives itself bigger and bigger because people with money make rational decisions about where to invest it - and anything which rises in value should be invested in. Of course we would expect that, just like Tulip mania, this gold bubble would've burst, except that in the year 2030 the entire financial world has become so dependent upon it that any drop in the gold price is fixed simply by loose monetary policy. It isn't as though the central banks in the year 2030 are creating inflation - they're not - they're increasing the money supply via quantitative easing and keeping inflation within acceptable levels. Governments, sadly, have cut spending in line with their receipts, which have dropped faster than their country's GDP.

The problem here is simple. Past occurrences of investment bubbles have oftentimes resulted in huge busts. These days they do not. Instead, the investment bubble gets re-inflated because the ones who inflated it in the first place have not been removed from the financial system. Why is this? It is because any losses incurred by the bubble's deflation have been minimised through monetary policy - an increase in the money supply due to stimulation enacted by a central bank.

But there's something rather insidious about an investment bubble that has been going on for decades. The problem is not whether the investment itself gives a return to the investor (as is the common belief), but whether the investment itself actually creates economic growth.

Say you have $20 million to invest. You could invest it in gold. Alternatively, you could invest it in a biotechnology company that grows human body organs in a factory to be used in transplants. Now if the return on gold is higher than the biotech company, you would naturally invest in gold. But what growth comes from gold? Well apart from gold mining companies employing workers to mine the stuff, there is very little growth at all. Of course there will be a knock-on effect as gold mines are begun and people get employed and secondary industries and retail enterprises start up - but with everyone investing in gold, very little of the wealth created gets turned into economic growth. Investing in the biotech company, on the other hand, does the same thing in employing people directly and indirectly, but has the added feature of creating economic growth. How? With transplants cheap and plentiful, people will live longer and happier and be more productive.

So on the one hand you could invest in something that will make you money. Or you could invest in something which makes money for you and a whole bunch of people. We could, of course, choose to "invest ethically" but most investors simply throw their money at whatever is performing.

Now understand that I'm not having a go specifically at gold investors here (though to be honest with you I see absolutely no reason for people to value something that has no real usefulness). Instead I'm being critical of the entire financial system itself which values rising equity prices far more than returns - and whose "returns", by the way, are simply the result of accounting tricks and high equity prices traveling through the broader system.

Try to understand it like this. You give $1000 to investment company A so you can see a return on your investment. Investment company A invests it with industrial manufacturer B, who in turn decides not to use it to make anything but gives it to its own financial department to invest in Investment Company C. Company C then places it in Bank D, who lends it out to Investment Company E. Company E, a small financial company, then hands the money back to Investment Company A as part of an industry investment fund... and then the process begins again.

From a fractional banking system you can see here that each step of the way from A to B to C to D to E back to A will increase the money supply and the money velocity. Yet nothing of value has actually been created in this process. In the past such situations would quickly result in financial crash - but these days central bank monetary policy has moderated any damage and ended up perpetuating the growth of the bubble.

You see it is my belief that most western countries have been building a huge, unsustainable investment bubble for the past 30 years. The world of finance has grown exponentially in that time but economic growth itself has begun to slow down. Even when you account for the effects of lower birth rates, GDP per capita in most western nations has significantly slowed down since the mid 1970s and early 1980s. Credit market debt in the US over this period has grown from about 150% of GDP in 1976 Q1 to a peak of 375% of GDP in 2009 Q1 (it has fallen slightly since then to around 250% in 2011 Q1).

So what should the solution be? I have pointed out recently that, in the US at least, there should be a higher level of government spending along with increased taxes to support it. Yet the current economic malaise is not just suffered by America but also by the European Union, whose governments have already spent up big. This is where regulation needs to come in. There needs to be firm and easily enforced financial regulation to prevent the growth of investment bubbles:

  • A market capitalisation tax should be instituted so that publicly traded companies are forced to pay higher taxes when their value goes up - which would also punish companies with high p/e ratios (in fact the market cap tax rate should be increased across all public companies when the p/e ratio average for the whole sharemarket increases, with a commensurate decrease in the tax rate when the average p/e ratio drops). The idea here is that the market should be punished whenever signs of over-investment become clearer.
  • The property market needs to be subject to the same investment regulations as the financial market. It may even be necessary for a government agency to be created that will enter the market directly to buy and sell properties in order to keep house prices at a reasonable level (buying up houses when the housing market drops, selling houses and/or building houses when the market rises)
  • The financial industry needs to stop profiting from investing in the financial industry. The important thing to remember is that financial companies need to invest in companies that produce goods and services - but not invest in companies that produce financial services. One way to do this would be to remove financial companies from major stock indices. Another solution would be to prevent financial companies from being publicly tradeable altogether, forcing them to become private companies or even non-profits. In any case, stricter regulation and tax disincentives should be enacted to ensure that financial companies divert their funds towards industries that actually produce things.
  • Ensure that monetary policy keeps prices low. Even though I have criticised monetary policy in this article it is only because the current system has been able to take advantage of it. Once financial regulations have been improved (as per my suggestions here), monetary policy will be more effective. I still believe in "hard money".
  • Ensure that government debt does get paid off. Better regulations and more investment in industries that actually produce things will create economic growth - growth that will be accompanied by higher tax revenues to pay off debt. Governments need to be restrained once a sustainable recovery gets underway (which is unlikely for some time now that the US is about to go into recession again). Instituting a market capitalisation tax would help increase revenue too.
  • Higher taxes on the rich. It has been the rich who have driven much of the investment bubble since the early 1980s. Tax cuts for the rich since that time have led to great wealth amongst the wealthy but little in the way of economic growth.

Read this.


Treating Rail Transport as The Commons

As a child in Northern Sydney in the mid 1980s, I lived near a railway line. On the way to school each morning I would see the regular-as-clockwork XPT pass by, New South Wales' newest high speed train. I remember feeling a sense of pride that we had built and operated such a great piece of machinery.

Since then neoliberal economics has made rail transport difficult to maintain or expand or promote. The idea of "user pays" and government departments (such as Countrylink) being corporatised and made to run profits was turned into policy. Of course there's nothing wrong with such policy if it can indeed create more efficient services - but in the case of rail it has not. As a result, rail has been seen as an increasingly obsolete and expensive infrastructure.

Yet there are two important factors we must keep in mind when looking at rail transport.

Firstly, the long distance delivery of bulk grain and bulk ore needs rail. In Australia (as in other countries) ore from mines and grain from farming areas can only be transported to ports by rail. Using trucks to carry that much material would be prohibitive. As a former Newcastle resident I can testify to the power and presence of trains transporting coal to the port from up to 100km inland.

Secondly, studies have shown that the total cost of rail-based public transport is less than the cost of running a car. I blogged about this in 2006 and subsequently argued for free rail-based public transport paid for by taxes.

Given that these two facts are true, why has rail been relegated to the "expensive and unprofitable" category? Simple. It's because the neo-liberal doctrines of "user pays" does not work.

A good way to think about this issue is to compare the rail system with the road system. While there are certainly toll roads run by private corporations, the vast majority of road infrastructure is owned by government and maintained via tax revenue. The NSW government sought some years ago to approve private tollways, but the result has been less than impressive with some consortiums going insolvent due to financial losses. In short, running private tollroads in NSW has been problematic. This is because it is almost impossible to impose a direct "user pays" system whereby users of a certain road pay for the upkeep of such a road. At a tollway level there is still a chance that it might work. But for ordinary suburban streets the idea is simply ludicrous.

So if the road system should be maintained by government and funded by tax revenue, then why shouldn't the rail system?

At present, mining and agriculture companies pay enough for rail freight to exist solely upon a user pays system. But what about suburban public transport? Since a user pays system has been in place for over a century in most places in the world and has not worked, and since studies have shown that rail is more efficient a transport system than road (in terms of money spent on travel) maybe we should see the rail system in the same way as we see "The Commons" - a resource that is collectively owned. Of course for most rail systems this is technically true - the rail system is owned and funded by government, who act on behalf of the people. Yet the problem does not seem to be its ownership, but how people can use it. Charging people a ticket fee for traveling from A to B, while seemingly common sense, is what seems to cause the problem.

In short, making rail-based public transport free and funding it entirely by tax revenue is the policy governments should take. While it might "reek of socialism" the reality is that it will make transport cheaper, which means that it is a type of microeconomic reform which, ironically, is what neoliberalism preaches as an important goal.


US Downturn for 2012 now assured

The Real 10 year bond rate average over 3 months has now dropped below zero to -0.12%. As I have been pointing out for the last month, this presages another economic downturn for the United States.

Inflation just came in at 3.4%. Even though June saw a monthly deflation, it wasn't enough to prevent a move into negative real bond rates.

The monthly Real 10 year bond rate also had its second month in negative territory at -0.43%.

The 14th amendment and the possible government shutdown

Oh dear:
Crisis talks on the United States' debt limit remained deadlocked overnight as negotiations led by US president Barack Obama degenerated into a slanging match.

The president is said to have stalked out of the latest debt talks, which both sides have acknowledged as the most heated yet.

"This may bring my presidency down, but I will not yield on this," Mr Obama is quoted as saying.

The prospects of politicians reaching a deal to raise the debt ceiling are still in question after fifth straight day of talks.
Some econ bloggers have pointed out that the 14th Amendment of the United States renders the "debt ceiling" unconstitutional:
The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave. But all such debts, obligations and claims shall be held illegal and void.

My view is that the "debt ceiling" is not unconstitutional. What is unconstitutional is to default on this debt. Let me explain.

All the "debt ceiling" does is prevent the government from borrowing any more money beyond the previous predetermined limit. Since congress has the power under the constitution to legislate borrowing and spending bills, any self imposed limit on the amount of money the federal government borrows is entirely within their purview.

So what happens when congress doesn't increase the debt limit a "government shutdown" is initiated?

All it means is that the government will have to cut spending in order to fit into the amount of money they do receive. Spending must be cut. And if we believe that the 14th amendment will be followed, then we can assume that paying back interest and principal on money borrowed will not be affected at all. Instead, spending cuts will be made to other areas of government control. Spending on health care will be cut drastically. Military spending could possibly be cut. Social Security spending cuts would only occur if the spending is not considered "government debt".

My spreadsheet tells me the following about US government debts and receipts:

So if revenue represents 16.61% of GDP and spending represents 25.29% of GDP, then any failure to increase the debt ceiling will force the federal government into spending only as much as it gets. This would mean 16% spending instead of 25% spending. In short, it would reduce the spending size of government by around two-fifths. You can imagine how devastating such an action would be upon the economy.

But what about government debt? The last time I checked, interest paid on government debt made up around 2.8% of GDP. Even after a potential failure to increase the debt ceiling, interest on treasury bonds and other debts will have ample room to be paid back.

A failure to raise the debt ceiling will most certainly shrink government spending, but it will not result in debt default. The unemployed will no longer be given payments, Medicare will grind to a halt, NASA will disappear, even social security has the potential to be scaled back... but at least those who lent the government money will get their interest - hardly a cause for celebration.

To summarise the 14th amendment on this issue: The amendment doesn't invalidate a debt ceiling, it just ensures that government debt will be paid off even if any debt ceiling isn't increased.


A reminder

I still consider myself an "Austerian" in the sense that strategies must be put in place to reduce US government debt. My solution is not to cut spending, though, but to increase spending and to increase taxes even more.

So do I like the idea of the Republicans and Obama working together to lower taxes and cut spending? No. Taxes need to be raised. The only thing that needs to be cut is military spending.

So do I like the idea that the US Federal Government should just spend more in stimulus packages? No. Any increase in spending must be over the long term rather than the short term, and no spending increases should be implemented without tax increases.


Bigger government is needed for the US economy - OSO's New Deal

This graph from Calculated Risk has been worrying me for a while:

The most noticeable thing about this particular recession is just how long it has taken for unemployment to recover - or not recover as the case is. But this is not an isolated case. The 2001 recession took ages for unemployment to recover, as did the 1990 recession. Obviously something has happened to the US economy that has prevented quick employment recovery even while GDP recovers.

I'm still trying to work out what that is. I have at theory but that will come in another posting.

What is obvious though is that the market is just not creating enough jobs. While the cause might be debatable, the result is not.

But what is needed to fix this is not just another round of stimulus packages. What is needed is a structural expansion of government spending. In essence, the US government needs to spend more.

Of course readers of this blog might wonder if I have changed my mind from recent times when I advocated austerity. The problem is that the word "austerity" has ended up becoming synonymous with spending cuts - which is the favoured position of conservatives. While I have advocated spending cuts in the area of military spending I came to the conclusion that the only way the US could ever hope to cut enough spending to make any difference would be to destroy Medicare or Social Security (and I don't use the word "destroy" lightly - you'd be looking at cuts of over 50% to make any difference). The alternative is to raise taxes - and that is the option I have always promoted. I still define this as "austerity" since it causes pain, but it is not the preferred description of the word in these times.

What I have done, though, is change my position on the market's ability to recover properly. I would've been happy for Obama to cut military spending and raise taxes in order to run a small deficit (at the least) but do little else while the economy stumbles, falls and eventually recovers from my austerity package. Now I realise that the economy wouldn't recover - at least not quick enough to make any difference.

So here's my big government solution:

More government spending.

I would create the following long term or permanent programs:

  1. Universal Health Care. This would involve "Medicare for all" and would probably increase the size of government by 4-5% percent of GDP. So you're looking at an increase in government spending from around 25% of GDP to around 29-30% of GDP. This would naturally have the effect of Keynesian stimulus but the result would be healthier citizens - something that would boost the productivity of workers. The increase in spending relative to GDP would be permanent.
  2. Building a renewable energy infrastructure. This would involve the eventual shutting down of all coal and gas powered power stations and the building of renewable alternatives to replace them. Developing nuclear reactors based on the Thorium & Molten Salt technologies would be acceptable but I can't get over the sheer availability of deep geothermal power: they would be expensive to develop and build but once they're there they will last for many decades. To fast-track the building of these, a renewable energy sector would take at least 10 years to complete. But as we can see from the military buildup during world war 2, all it takes is the will to do it. This would radically reduce America's carbon emissions. An upgrading of America's electricity grid would also accompany this. You're looking at adding another 1-2% of GDP being spent on this over a ten year period.
  3. Mandate and support an electric car industry. This would involve a legal framework preventing the sale and registration of carbon-emitting cars by a certain date (say 10 years in the future) but would also need substantial government investment in battery technology. The Nissan Leaf, the first real "electric car" sold to the market, still has only a short range. Inventing batteries that hold more power is essential if electric cars are to effectively replace their petroleum or lpg powered competitors. Spending on this program would also build a nationwide network of recharging stations to ensure that no electric car is out of recharging range. Not only would such a program reduce carbon emissions, they would also reduce America's dependence upon oil and mitigate the problem of Peak Oil. Add another 1% to GDP being spent on this over a ten year period.
  4. Set up a national water grid. This would involve potable water being distributed over all states and towns throughout a national network of water pipes and purification plants. This would ensure that any future droughts in the US (brought on by global warming) would not affect town and urban water supplies. It would theoretically mean water sourced from Seattle finding its way to Texas through this proposed water grid. While this would require a huge amount of work, a lot of the work would simply involve connecting up disparate water infrastructure and bringing standards up to a national level. You could probably add 0.1% to 0.5% of GDP on this over a ten year period.
  5. Provide a national child tutoring strategy. This would involve the hiring of personal tutors to deliver numeracy and literacy skills to the nation's Kindergarten,1st and 2nd grade students. Each student would receive one hour of personal tutoring per week at the school they attend during the school year. While this will not have any immediate economic benefit apart from increasing the money velocity, it will eventually produce adults who are better educated and more likely to succeed at employment and less likely to end up in jail. All economic benefits. I'm not sure how much this would cost but you'd be looking at at least 0.1% of GDP being spent on this program on an ongoing basis. Additional tutoring, say in 3rd grade and above, would increase this effect even further.

Less money on Defense

America does not need to spend huge amounts on national defense. Of course it is important that some level of defense spending exist to defeat any potential attacker, but I am convinced that the most bloated, most inefficient and most corrupt sector in government spending is in defense contracting. Reducing military expenditure may not even reduce America's military strength, it will make the whole contracting system better.

In fact I would suggest a change in the way the whole contracting thing works. Rather than contracting out to companies who design weaponry and other military items, the government should actually do this themselves. Let's say we want to build the fictional B-5 supersonic stealth bomber. Instead of contracting out the design to Boeing, the design is actually made by government employees working in a government building somewhere. Once the design is complete, they then contract out the parts building to the defense companies - and ensure that common parts can be made by many different manufacturers in order to reward the productivity and profitability that would arise in a competitive environment. The B-5 could even be manufactured by different aerospace companies, with Boeing manufacturing some, Northrop Grumman some more, and Lockheed Martin the rest.

Higher Taxes - especially for the rich and corporations

Alongside this substantial increase in spending should be a substantial increase in taxation. I don't believe that deficits don't matter and there is a need for the debt to be paid down. Since we can no longer rely upon the market to provide enough economic growth to increase tax revenue,  the government will simply have to step in, increase spending and increase taxation. In fact I would argue that the increase in taxes should be substantially higher than any increase in spending. I would advocate not only an increase in spending (outlined above) but an increase in taxes so high that a budget surplus is created. It is expected that any economic pain generated by this increase in taxation would be matched by the economic gain of the increase in government spending (above)

There are many ways to achieve this - one way is to increase the highest marginal tax rate. Another is to introduce a Tobin Tax.

My preferred method of taxing the financial market would be to create a market capitalisation tax: public companies being taxed incrementally on a daily basis according to their market capitalisation (share price multiplied by amount of shares). In fact I would adjust the tax according to the average p/e ratio in order to punish over-investment - if the p/e ratio of the whole sharemarket is too high, then there will be an increase in the market capitalisation tax. If the p/e ratio falls down low, then the tax would also be lowered. This system would not only generate income for the government to balance its finances, but would also act as an "automatic stabiliser" for the financial industry - punishing the market if it approaches unsustainable investment bubbles, encouraging the market if it there is not enough investment.

OSO's New Deal

Of course once the spending I have outlined above runs out over ten years (with the exception of Medicare and the tutor system), we would also assume that government debt would have been paid off by the increases in tax revenue. What then? Well I'm happy, once America has reinvented its energy, transport and water infrastructure, for taxes to drop. Hopefully the success of my "New Deal" would see so much economic and social success that Norquisters, Randians and Supply Siders would descend into obscurity. It would also force political conservatives to be more centralist, where they can be far more effective at promoting non-extremist conservative policies and ideas (conservatism does, after all, still have many considerable strengths once the extremism is removed from it).

So what are the chances of this occurring? Probably none. Rather, I expect the coming downturn to turn people against Obama and vote for a crazy Republican in 2012, ensuring a Republican controlled congress as well. What they would do from there is anyone's guess, but I doubt that any polices they do enact will do anything except make things worse.


The chance of avoiding another downturn is now almost impossible

10 Year bond rates for June 2011 came in at 3.00%. Inflation figures for the same month are due on 2011-07-15 (Friday next week).

In order for the US Real 10 year bond rate to remain positive, June inflation needs to have an index reading of 223.496 - which implies a monthly deflationary result of -0.6%. At this point there is very little evidence of a deflationary hit in June (eg soaring US dollar, credit crunch, large drop in sharemarket value).

Take a look at my spreadsheet.

June's potential recession avoiding index result of 223.496 is shown there in green. Any inflation index result of 223.497 or higher will result in column N (real 10 year bond rates averaged over three months) moving into negative. This presages a recession. When the inflation data comes out Friday next week, a coming downturn will be confirmed.

For those of you who are spreadsheet minded, here are the details:
  • Column C data from here.
  • Column D equation (at 701) is =PRODUCT(((C701-C700)/C700)*100).
  • Column E equation (at 701) is =PRODUCT(D701*12).
  • Column F equation (at 701) is =PRODUCT(((C701-C689)/C689)*100). (This is the "headline inflation" result).
  • Column I data from here.
  • Column J equation (at 701) is =SUM(I701-F701).
  • Column N equation (at 701) is =AVERAGE(J699:J701).


Recession Measurement

A while ago I chose to use as my recession indicator a decline in annual real GDP per capita. The reason for this is twofold. Firstly it can be derived from official figures (ie St Louis Fed) as opposed to the more nebulous proclamations from the NBER. The second reason is that simply measuring real GDP doesn't cut it in an annualised form since, by that measurement, there was no recession in 2001 and the 1970 recession wasn't too bad at all.

The thing is that population always affects economic growth. If an economy is expanding and population along with it, chances are that economic growth is being driven by an expanding consumer and producer base - more people means more potential consumers and more potential producers.
  • Nominal GDP = the actual numbers. This ignores inflation and population.
  • Real GDP = nominal GDP adjusted by inflation. This ignores population.
  • Real GDP per capita = Real GDP per head of population.
Of course the question arises as to whether you should measure annual changes or quarterly changes. Again there is nothing really "wrong" with doing this, but it does create problems in defining recessions. If we measured quarterly declines in real GDP per capita, we would end up having recessions in 2005 Q2, 2003 Q1, 2000 Q1, 1988 Q3 and 1986 Q2 amongst many others. So while I don't measure with the NBER I do listen to what they say - and measuring declines in annual Real GDP per capita do match up quite closely with NBER proclamations. The exception to this relationship appears to be a single quarter recession in 1956 Q3 which the NBER doesn't include on their list.

As you can see there are very close correlations between the NBER pronouncements and annual declines in real GDP per capita. The differences (apart from the 1956 Q3 blip) seem to be in measuring the start date - the NBER measurements always start between 1-3 quarters before annual declines in real GDP per capita - and in measuring the length.