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Blissex

«when a government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends.» I wonder whether that applies to the CPI or the jobseeker rate, or whatever other measure of ''inflation'' and ''unemployment'' the government tries to target... :-)

Arthur Eckart

It's important to note that U.S. actual output has generally been below U.S. potential output throughout the 2000s. Export-led economies have been absorbing U.S. dollars to maintain acceptable levels of employment and output. Just like the volume of output in itself will cause declining prices and induce demand, the volume of capital will in itself cause interest rates to fall and induce demand. The gains of U.S. assets increased faster than the gains of U.S. liabilities. Similarly, the gains of U.S. output increased more than the losses in U.S. inflation or purchasing power, which induced demand and raised living standards. Export-led economies needed to accept small gains of trade to spur export growth (which imply the U.S accepts large gains of trade). Also, while the U.S. dollar depreciated, export-led economies were required to accept even smaller gains of trade to maintain export-led growth. The U.S. had abundant capital from foreign capital inflows and capital creation of U.S. firms. Much of that capital flowed into the U.S. housing market creating an oversupply of houses and causing a subprime crisis, i.e. Americans who couldn't really afford to buy houses were able to buy them, and Americans who couldn't really afford to buy more expensive houses were able to buy them. The U.S. economy can be viewed as a Black Hole attracting imports and capital. Now, the U.S. is also attracting foreigners who own that capital, e.g. through the depreciated dollar, relatively low prices, low interest rates, etc.

Arthur Eckart

I agree more with the study that concluded: "From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25 percentage points, yet long-maturity yields and forward rates fell. We consider several possible explanations for this "conundrum." The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic uncertainty and financial market volatility, more predictable monetary policy, and the state of the business cycle."

From 2004-06, U.S. real GDP expanded about 4% a year, which was above trend growth, although it remained below the 10-year moving average. There were diminished economic uncertainty and less financial market volatility, while U.S. monetary policy was consistent, which lowered risk premiums. However, the "state of the business cycle" is a key point. The expectation was U.S. real growth would slow, because of the restrictive stance (i.e. domestically), which inverted the yield curve, while the U.S. current account deficit and U.S. capital account surplus both increased substantially, which kept U.S. long-term yields low.

It should also be noted the U.S. economy moved closer towards "optimization," on both the production and consumption sides, which lowered risk. The efficiencies of U.S. firms, gains in U.S. consumer surplus, and improvements in U.S. government financing increased substantially, throughout the 2000s, which raised U.S. living standards and strengthened the U.S. economy.

Also, I may add, below is BLS data on U.S. consumption and living standards. Some interesting 2003 findings are about 40% of U.S. homeowners didn't have a mortgage, 3.2% of income went into gasoline and motor oil, 5.9% of income was allotted for health care, and 5.1% of income was allotted for entertainment. The data show U.S. purchasing power increased three-fold from 1901 to 2003. However, the rise in U.S. living standards is understated, because quality isn't taken into account. For example, the median house today is newer, bigger, and better than the median house in 1901 (also, median household size has shrunk from 4.9 in 1901 to 2.5 today, while the homeownership rate rose from 19% to about 70%, which increased the number of houses). Moreover, there's no comparison in median automobile quality (few autos existed in 1901), etc. Furthermore, there are many products that exist today that didn't exist in 1901, which raised living standards.

http://www.bls.gov/opub/uscs/report991.pdf

Arthur Eckart

Moreover, I may add, the U.S. had a mild economic boom/bust cycle, where actual output generally exceeded potential output in the mid and late '90s (i.e. real GDP growth slightly above 3% per year), and potential output generally exceeded actual output throughout the '00s (i.e. real GDP growth slightly below 3% per year). From 1993-98, 17.6 million U.S. jobs were created, and from 2001-06, only 3.7 million U.S. jobs were created. So, much fewer inputs were needed for a given level of output in the '00s compared to the '90s.

The quick and massive U.S. Creative-Destruction process, generally between 2000-02, freed-up resources, particularly capital (e.g. some tech stocks losing 99% of their market capitalizations). The freed-up capital was redeployed into firms that generated even more capital, i.e. U.S. Agricultural and Industrial Revolution firms, e.g. Boeing, Caterpillar, Gillette, Coca Cola, Pepsi, Johnson & Johnson, GE, McDonalds, Disney, DuPont, Hilton, Harley Davidson, Paccar, Heinz, Hersheys, Ingersoll Rand, International Paper, Kellogg, 3M, Alcoa, etc. They now have greater market power, since they focused on higher quality "core" products, while offshoring less profitable goods to Third World countries for larger profits (rather than discontinue operations of those products). Consequently, U.S. corporations generated double-digit profit growth for a record 18 consecutive quarters in the 2000s, which resulted in strong balance sheets. Also, the efficiencies of U.S. retail and finance became the envy of the world. Moreover, U.S. oil firms (energy firms are roughly 15% of the S&P 500) made more money refining oil than oil producers made selling oil (at least when oil was $50 a barrel, although profits continued to soar), while U.S. gold, copper, steel, etc. firms, also made huge profits, along with homebuilders, etc. Furthermore, much of the redeployed capital flowed into business start-ups, which helped keep the U.S. unemployment rate low. U.S. Information and Biotech Revolution firms continued to lead the rest of the world combined (in revenues and profits) after the Creative-Destruction process. The only way to move from one economic revolution into the next is through efficiencies, which free-up limited resources. It's all interrelated, and inevitable, which is why the U.S. leads the world in the Agricultural, Industrial, Information, and Biotech Revolutions.

The U.S. government was able to sell Treasury bonds at lower rates, which helped shrink the U.S. budget deficit to $150 billion in 2007 (or slightly more than 1% of 2007 U.S. GDP). Most of the increases in debt were by U.S. households, which were able to consume more than produce (e.g. reflected in the U.S. trade deficit, which reached over $800 billion in 2006). Rising incomes, low prices, and low interest rates induced demand, which raised living standards, on both the production and consumption sides. Consequently, U.S. household assets increased more than U.S. household liabilities, and U.S. consumer surplus increased. U.S. households will work longer to pay-down debt and build-up saving, which will add to future U.S. economic growth. Also, U.S. exports will accelerate faster than U.S. imports, which will add even more to U.S. growth. Moreover, less slack in the U.S. economy (to close the output gap) will cause wage growth to accelerate and profit growth to slow.

Arthur Eckart

Furthermore, I may add, the rise in energy and raw material prices harm many U.S. trading partners more than the U.S., since U.S. corporations offshored less profitable goods, including heavier goods, while shifting more resources into lighter goods (e.g. products of Microsoft, Google, Amgen, etc.). However, U.S. households used more energy, because of larger houses, cars, etc. Nonetheless, the net gain in U.S. living standards (which include both the production and consumption sides) were much larger than its trading partners. Perhaps, the biggest threat to the U.S. economy is if one or more export-led economies fall into recession or collapse, to where they can't afford U.S. goods. Consequently, the U.S. economy will continue to underproduce, although the U.S. will lose less than export-led countries. There's evidence to suggest many export-led countries cannot afford U.S. products, although they've outproduced the U.S. For example, most of China's imports from the U.S. are inputs for exports to the U.S. China's consumers, in general, cannot afford the world prices of U.S. goods. Consequently, large trade imbalances persist. A danger is the U.S. will kill China's economy, which is the goose that lays the golden eggs. For example, less restrictive U.S. monetary policy may narrow the U.S. output gap (i.e. raise actual output), while China's output gap may shift further away from equilibrium (i.e. also raise actual output). Nonetheless, global imbalances were basically created by export-led countries, and changing their policies can begin to correct them.

Arthur Eckart

Also, much of the income earned by oil producers is reinvested in the U.S. (since oil is generally priced in dollars), which raises U.S. income. Moreover, the U.S. is the third largest oil producer, after Saudi Arabia and Russia, while U.S. oil firms have operations almost all over the world.

Arthur Eckart

Moreover, Bill Gross, who manages the largest bond fund in the world said the following in a Jan '07 interview (with my comments below):

Bloomberg's Tom Keene: "Bill [Gross], your note every month is always interesting. This last one is one of my favorites. As you know, I'm a big fan of nominal GDP - this, folks, is real GDP plus inflation. It's the 'animal spirits' that's out there. You say be careful, Bill Gross. It looks real good to me, Bill. I see 6% year-over-year nominal. You say that's going to end?"

Pimco's Bill Gross: "I think almost assuredly, because of oil prices. I'm not suggesting it end because of real growth going down - that's the Goldilocks scenario in which we have 2% plus or minus real growth. With oil prices doing what they're doing - if they hold in the $55 range - gosh, we're going to see CPI prints y-o-y over the next three or four months of 0.5% or 1.0% and that means nominal GDP is down in the 3% range. "Ultimately, the inflation component affects the real growth component. To the extend that you have nominal GDP - in my forecast 3 to 3.5%, that's really not enough growth in terms of the economy itself to support asset prices at existing levels. And so, declining assets prices ultimately factor into eventually lower real growth. But that's not for mid-2007 but perhaps for later in the year."

Tom Keene: "When we look at six months of low nominal GDP, is that enough to link directly into the 'animal spirits" of the business investment component of GDP - the "animal spirits" of business men and women?"

Bill Gross: "Well sure it is. When you realize that the average cost of debt in the bond market - and therefore in the economy and this includes mortgages - it is about 5.5%. If you can only grow your wealth and service that debt at 3.5% rate, then that has serious implications. When you go back to 1965, Merrill [Lynch] did this study - in terms of asset prices during periods of time when nominal growth grew less than 4%. Risk assets have been negative in terms of their appreciation and actually bonds have done pretty well. The question becomes why hasn't that happened yet, and I think we're simply in a period of time where there are leads and lags that are much like the leads and lags of Federal Reserve policy."

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So, based on the Bill Gross interview, if the Fed doesn't ease further, the (benchmark) 10-year bond yield may fall below 4%, further inverting the yield curve (below the 4.75% short-term Fed Funds Rate), because of expected slower economic growth.

Also, Gross states: "The average cost of debt in the bond market, and therefore in the economy and this includes mortgages, is about 5.5%." So, if economic growth accelerates (to close the output gap) and/or inflation accelerates (e.g. wage growth rising faster than profit growth), then households will be in a stronger position to pay-down debt and build-up saving.

Most of the debt acquired in recent years were by U.S. households, not U.S. firms (which had 18 consecutive quarters of double-digit earnings growth) or U.S. government (where the budget deficit shrunk to $150 billion in 2007).

Moreover, it's important to note that income growth is exponential growth, while debt often declines at roughly a steady rate, e.g. paying-down the principal of a mortgage helps increase equity and decrease debt, while both housing prices and income rise geometrically. Consequently, U.S. household debt can fall, at least relatively, somewhat quickly.

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Furthermore, I may add, the U.S. budget deficit continues to shrink in absolute and relative terms (e.g. compared to GDP). 2007 and 2006 info below):

Deficit falls to $162 billion, the least red ink since 2002

"The deficit for the 2007 budget year that ended on Sept. 30 was 34.4 percent lower than the $248.2 billion deficit recorded in 2006, reflecting faster growth in revenues than in government spending."

http://money.cnn.com/2007/10/11/news/economy/budget_deficit.ap/index.htm?postversion=2007101113

Unexpected tax revenue to shrink U.S. budget deficit

Last Update: 3:35 PM ET Jul 8, 2006

NEW YORK (MarketWatch) -- An unexpected spike in revenue from corporate taxes, individual stock market profits and executive bonuses is curbing the projected budget deficit this year, according to a media report.

The White House on Tuesday is expected to say that tax receipts are about $250 billion higher than they were a year ago, rising twice as fast as the administration forecast, the New York Times reported Saturday.
As a result, the budget deficit will be about $100 billion less than the White House predicted six months ago, the paper said.

The tax receipt windfall has been building for months, but its size and effect on the deficit surprised budget analysts, given the high costs for the war in Iraq and hurricane relief.

Congressional analysts told the Times that the greater-than-expected tax receipts could cut the deficit to $300 billion this year from $318 billion a year ago.

Corporate taxes that have nearly tripled since 2003, executive bonuses, and higher individual taxes on stock market profits are fueling the spike in tax revenue, the paper reported.

The Congressional Budget Office said Friday that corporate tax receipts rose 26% for the nine months ending in June compared with the year-ago period.

Arthur Eckart

It seems, U.S. export and tourism booms are offsetting the U.S. housing bust, although many other factors are involved. Last week's U.S. real GDP report (link below) showed a 3.9% rise in real growth (following a 3.8% expansion in Q2). Consumption (two-thirds of GDP) rose 3%, business investment increased 5.9%, government spending expanded 3.7%, and exports rose 16.2%. However, the U.S. trade deficit remained at roughly $800 billion a year, which subtracts from GDP. Other data include:

"Core" prices -- excluding food and energy -- rose at a rate of 1.8 percent in the third quarter. That was up from a 1.4 percent pace in the second quarter; (home)builders slashed investment in housing projects by 20.1 perecent; 'Employers' costs to hire and retain workers rose 0.8 percent in the July-to-September quarter. That was down a bit from a 0.9 percent increase posted in the second quarter, but still suggested workers are seeing solid compensation gains; business investment in commercial structures, such as office buildings and factories, grew at a 12.3 percent pace in the third quarter. It was a robust showing but down from a sizzling 26.2 percent growth rate in the second quarter."

When the FOMC lowered the (short-term) Fed Funds Rate to 4.5%, the (benchmark) 10-year bond yield rose to 4.475% (although, it fell below 4.3% soon after). If U.S. real GDP can expand at roughly 3% over subsequent quarters, that may be near optimal.

http://biz.yahoo.com/ap/071031/economy.html

Arthur Eckart

I suspect, the U.S. economy will enter a period of accelerating or high growth, after a "soft patch" in early 2008, which will steepen the yield curve and close the output gap. However, one or more export-led countries falling into recession will slow the pace of the U.S. acceleration.

The U.S. should be able to benefit tremendously from improvements in its terms-of-trade and the depreciated dollar, which will continue to capture the greatest gains of trade. U.S. wage growth should increase at a faster rate, at the expense of slower U.S. profit growth.

The increases in U.S. income and employment will shrink household debt, relative to GDP, and build-up saving, at the expense of slower consumption growth. Nonetheless, the U.S. Gini Coefficient should rise, because the number of affluent U.S. households (which were 14 million in 2005) will continue to increase at a much faster rate than U.S. population growth.

Arthur Eckart

Another conundrum is falling U.S. real wages and rising U.S. living standards.

The first chart in the link below shows U.S. real wages in 2005 were equal to U.S. real wages in 1964, before the 1965-82 bear market. However, the second chart shows U.S. real compensation rose over 70%, since 1964. Moreover, the second link provides more info.

Income taxes in 1964 were much higher. So, disposible income in 1964 was much lower. Also, unions, which control the supply of labor, had more power. Union workers were grossly overpaid, while non-union workers were grossly underpaid. However, that disparity narrowed substantially, since U.S. union membership fell from a peak of 35% in the mid-1950s to 12% in 2007, while employment increased substantially.

The per capita quantity and quality of U.S. output is much higher today than in 1964. Also, huge annual trade deficits added to higher U.S. per capita living standards. Falling U.S. interest rates and prices helped clear U.S. markets of "excess" capital and goods.

http://www.econbrowser.com/archives/2005/12/declining_real.html

http://www.heritage.org/Research/Economy/bg1978.cfm

http://www.msnbc.msn.com/id/16811982/

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