A Lesson for George Mason Economics Chair, Boudreaux As He Attempts to School Dilbert Creator, Scott Adams

Today Donald J. Boudreaux, who is Professor of Economics and Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center at George Mason University, wrote an open letter to Dilbert creator Scott Adams.  The letter was a rebuttal to Scott disagreeing with Michigan Rep Justin Amash about Trump’s trade policy.

Justin Amash had tweeted out that tariffs will hurt the consumer in higher prices.  Scott retorted that the tariffs will not be applied because the threat of applying a tariff on firms who chase cheap foreign labor but then sell that production back to the US consumer they just laid off will disincentivize the firms from leaving in the first place.  It was then that Mr. Boudreaux jumped in, stating unequivocally that Scott is wrong and Justin is right.

Boudreaux argues that while he agrees the tariff would actually not be applied it would stifle competition and thus consumers would pay a higher price.  Boudreaux seems to imply that low consumer prices are a top priority of trade policy.  Below is the main argument within Boudreaux’s open letter to Scott Adams.

Rep. Amash is right and you are wrong.  Although no formal tax collection is triggered if Mr. Trump’s threats prevent all offshoring, Trump’s tariff – by restricting competition – would artificially reduce outputs and raise prices.  American consumers would pay unnecessarily higher prices, an outcome inseparable from the very purpose of the tariff.  That consumers pay these extra, unnecessary amounts to domestic producers rather than to domestic customs agents is irrelevant: the tariff forces all consumers of these products to pay extra, unnecessary amounts to some small group of fellow Americans who, rather than earn these higher payments, extract them using threats of state coercion.

Let me explain the logical fallacies that Mr. Boudreaux fails to recognize in his chivalrous attempt to defend Rep Amash and our existing international trade agreements (note there is nothing free trade about these agreements).

  1. Boudreaux’s entire argument is based on an unsubstantiated notion that offsetting the labor cost savings from cheap foreign labor with a tariff somehow limits competition.  This is equivalent to saying American production limits competition.    There are currently 28.5 million private firms producing in the US, more than ever before.  I’ve never seen any data to substantiate that American production limits competition. In fact, I find it quite an absurd proposition.  Unless Boudreaux can substantiate that claim, it simply cannot be accepted.  And if the basis of his argument is unsound then the rest of it is invalid.
  2. Secondly is the implication that US firms chase cheap foreign labor so that they can pass those cost savings onto the consumer.  Price models are a function of what the market will bear, not cost.  The point of the cost savings is to drive profits, profits which over the past 5 years are paid directly to shareholders.  Dividends have almost no money multiplier effect.  And so reallocating labor income, which has the highest money multiplier effect, to profit is a net economic value destroyer not creator.
  3. Even if consumers paid a higher price as a result of the tariff, which we know isn’t true based on points 1 & 2 above, the offset of that is they would be paying a higher price with labor income earned as opposed to credit or welfare.  Meaning if I can keep my job, I’m ok paying a slightly higher price because while I might be able to buy less things I can still support my family without private or public debt.  And so to suggest the top objective of trade or any economic policy should be getting the lowest possible price is another absurd proposition.
  4. Boudreaux suggests the tariff is state coercion yet fails to recognize the tariff is a reaction to a state intervention of free markets i.e. international trade agreements that allow labor cost arbitrage to exist without the naturally higher risks of the undeveloped nations that offer the cheaper labor (the cheap labor and higher risk being a function of the same underdeveloped societal infrastructure).  Higher return means higher risk.  Lower labor cost means higher ROI.  Higher ROI means higher risk.  But through state coercion, the higher risk is negated leaving just the higher ROI.  This is not free market.  This is state intervention.  The tariff is being used to level the playing field so to speak.

Mr. Boudreaux, while I appreciate your zeal for trade agreements, I am slightly surprised as to the naivety of your argument.  You haven’t given the readers enough credit.  Something you PhD economists are going to be facing much more of in the coming years.  There is a movement to educate and draw in the American public to such economic discussions.  We will be better prepared to understand your theoretical, applicable and logical fallacies.  You should take note, and be better prepared next time.

Starring: Paul Krugman as The Idiot & Justin Wolfers as The Hack

Well this election certainly clarified a few things for the people of the world.  Most notably is that the experts are clueless.  Paul Krugman, notable ‘expert’ on all things economic has almost 2 million followers on Twitter and an op-ed with the NY Times.  This means he has a platform of great influence.  And yet, time and time again, he does well to prove he’s an idiot.  The following piece posted on election night.

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Well “Never” or by noon.  So he overshot by eternity.  None of us are perfect eh?  Now I shouldn’t single out Mr. Krugman as almost every market pro and economist on Earth has predicted that a Trump victory results in complete financial and human obliteration.  At least that was the message leading up to the election.

In a piece by Justin Wolfers, for the NY Times, titled “The Markets Are Afraid of Donald Trump“, written just over a month ago the message is clear from his conclusion.

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So while over the past 130 years markets tend to react well to Republicans, Justin concludes it will be different with Trump, in fact, worse than the market reaction to the greatest tragedy ever to take place on American soil.

Now if you get a chance to read the full article you’ll see that Justin gives you a glimpse at the fancy math economists use to extrapolate predictions.  It’s just enough to make you believe, “Wow this guy really knows some fancy math, he must know what he’s talking about”.   But this is the very reason economists like Justin have tragic forecasting records.   Now don’t get me wrong the math has its limited place and I’ve sat through all the same fancy math classes as Justin.   But the difference between most economists and most good economic and market analysts is understanding that markets and economics have almost nothing to do with math.

Economics and markets are studies about human behaviour and societal constructs, that is the bilateral relationships between humans and the logistic economic and financial environments.  And if you don’t understand that there is no math in the world that will help your forecasting.  Just look at Justin and Krugman.

Now I write this piece obviously in reaction to the massive clusterf*ck that occurred when Trump’s victory failed to ignite financial Armageddon as all the PhD’s predicted it would.  I can’t tell you how many calls I received yesterday from risk managers, traders, money managers, etc. trying to figure out why the market wasn’t collapsing.  And frankly, I expected it might simply as a self fulling prophecy.  That is, because everyone had been told it would so it would.  But the market, while giving a short head fake, decided that low corporate tax rates, improved breadwinner job market in the US and a bit of fiscal stimulus may be good for the economy.  Go figure.

I guess my point is that guys like Krugman and Justin are false authorities yet are major players in setting and selling economic policy.  This phenomenon of appointing idiots and hacks to roles of policy setting is a true mystery.  Until we begin to replace the policy  making industry (and it is an industry) with people who actually understand the subjects for which they are setting policy we will continue to find ourselves waking up wondering what in the hell went wrong.

 

 

 

Private Capital Allocation Matching Only the Great Depression for Inefficiency

The Summary:

  1. Economic policy objectives (monetary and fiscal) are meant to incentivize domestic private business investment, which drives incomes and the money multiplier effect, i.e. the engine of the economy.
  2. Economic policy objectives have failed because CEO’s, the private capital allocators, simply cannot accommodate business investment when the demand function is as weak as we currently find it, no matter how available and how cheap the capital.
  3. The demand function is weak because we misunderstood and ignored the side effects of trade policies and their reliance on new world economies that naturally have a lower money multiplier effect than old world economies.
  4. A materially damaged demand function leads to a misallocation of resources; for the past 15 years capital has been and continues at an accelerating rate to be allocated to cash distribution (the most economically inefficient use of capital) rather than investment, further deteriorating the demand function (economic death spiral).
  5. The only question that matters now then is;  How do we get private sector capital allocators to allocate capital more efficiently?  I’ll give you a hint, it requires indications of sustainable demand improvement and neither monetary nor fiscal policy have the capacity to generate sustainable demand improvement when the demand function is damaged to the point that CEO’s refuse to invest productively.  This then requires a new economic policy framework, one that CAN generate sustainable demand improvement, which will allow capital allocators to invest productively.

We can understand the problem without villainizing any particular stakeholders by focusing on where we are today and delivering a viable solution.  Mistakes were made and judging whether they were honest or malicious in nature is irrelevant to finding the solution.  Our focus here is a solution.

The Proof:

What is the objective of Monetary and Fiscal policy expansion?

Domestic business investment.  Both policy frameworks look to incentivize capital allocators (i.e. CEO’s) to implement microeconomic strategies that achieve macroeconomic goals (economic prosperity).  In other words,  monetary and fiscal easing/expansion look to incentivize CEO’s to allocate capital to domestic business investments (fixed and/or human capital and technology).

However, CEO’s have two choices on how to allocate capital.  The economically stimulating choice is productive business investment and the financial engineering choice is cash distributions.  We know the Fed has printed roughly $13T since ’08 to incentivize CEO’s with cheap capital thus providing a lower cost structure and generating a theoretically higher return on investment (ROI) by which CEO’s should be incentivized toward business investment.  Let’s see if it worked.

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The above chart depicts net domestic private business investment to GDP (blue line) and dividends to GDP (red line).  The chart  shows that the massive monetary easing that started in the mid 1990’s has failed to incentivize private business investment over cash distributions.  CEO’s are now allocating capital to cash distributions at a rate 3x higher than to private domestic business investments.  The only other time in history we’ve seen such an inefficient use of capital were the years heading into and through the great depression (note the above chart is 7 year moving avg so raw data begins in 1929; also it does not include buybacks).

Further evidence of Monetary policy failing to achieve its goal of domestic business investment.  The next chart shows annual business investment less annual additions to money stock.

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We can see from the above chart that historically business investment is a multiple of additions to money stock meaning that for every additional dollar printed we generated more than a dollar of domestic business investment.  However, since 2009 we have generated less than a dollar of productive investments for each dollar printed.  What does this mean?  It means we are printing dollars and passing those dollars through to the secondary financial markets (as depicted in the first chart above) meaning those dollars never hit the economy (i.e. 95% of secondary financial market activity is separate from the economy meaning does not expand corporate operational assets).

If we just look at straight nominal real domestic business investment, the problem again is very clear.

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Much of the period since 2009 has seen domestic investment in real dollars at levels lower than any other time over the past 5 decades and is now moving back into those lows.

For the sake of diligence, I will mention productivity separate from productive investment because I know some of you will jump on me if I don’t.  The reality is that without productive investment productivity is doomed as well but let’s look at the evidence.

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Clearly productivity has collapsed as well (source: St. Louis Fed).

So it is abundantly clear that the economic policy objective of stimulating domestic business investment (which we know is the engine of economic prosperity via money multiplier, I will spare you the data assuming we can all agree on that point) has failed.  The failure is despite the most extreme monetary easing in the history of this nation.

Why has it failed?

Janet Yellen recently stated “I don’t know why business investment is weak”.  Allow me to explain.  CEO’s cannot invest in operational expansion without the backdrop of sustainable demand expansion.  It’s that simple.  The fact that we cannot convince CEO’s to allocate toward business investment signals they’ve got too much standing capacity for a demand function that is damaged.  There is a plethora of evidence to back up this claim and so let’s look at just a couple.

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The above charts shows an already under-utilization of existing capacity and an utter collapse in per capita consumption, a terribly difficult decision then to allocate capital to more capacity.  This means that growth in domestic aggregate consumption (i.e. realized demand; i.e. top line) must come from population growth or foreign customers.

Let’s look at the prospects for population growth to provide a major boost to the domestic demand function.

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So it seems unlikely that population growth is going to provide any material pop in economic activity.

But what about foreign customers?

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Well currently exports are a relatively small but growing part of GDP.  And this is the argument of many pro ‘free’ trade economists.  Specifically the argument is that if we open up international trade, US companies can increase sales to foreign customers and thus begin to allocate again to domestic business investment.

The problem is it hasn’t worked.

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The above chart shows total manufacturing plus white collar service sector breadwinner jobs here in the US as a percent of working age population.  You’ll note that the 5 decades before 2000 breadwinner jobs remained on a steady long run average around 21.5% of working age population.  However, since 2002 we’ve been below 21% and since 2009 we’ve been below 20%.  These may seem like minor percentage losses but when you’re talking about 200M people each percentage point lost represents 2 million working age people without a good paying job.  The change from the long run average represents about 5 million more people without a breadwinner job and 8.5 million more relative to the peak of 1999.

In order to get a longer view let’s look at these jobs to total population (more data available).

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We are back to levels not seen since the late 1950’s and early 1960’s when most households could get by on one income.  That simply is not a reality anymore.  This translates to financial stress on consumers (i.e. households).

Now the argument of the free trade agreements is that while we would ship some low skilled breadwinner jobs out of the US we would more than make up those lost jobs with new world high skilled jobs.  And while it is clear from the above charts this hasn’t happened let me explain why that didn’t happen.  It is really very simple.

When GM was at its peak it employed 500K employees and a slew of upstream suppliers and vendors.  Facebook has 12K employees and maybe a relative handful of upstream suppliers and vendors.  This is simply the result of an increasingly digital rather than molecular world.  The point being, the money multiplier of new world economies is far lower than old world economies.  The result is a concentration of wealth and a reduction of income distribution.  The result of that is a damaged or much weaker demand function as we saw above.

The key to the old world economy is it provides a natural tie between domestic consumption and domestic production.  That is why as total domestic consumption grew, the amount of breadwinner jobs grew proportionately (producing a steady 21.5% average of breadwinner jobs to working age pop over time).  However, subsequent to the initial build out of the new world infrastructure in the mid to late ’90’s the growth rate of new world jobs has not kept up with the supply of labour (i.e. population/consumers/consumption).  And this is a function of the digital world requiring far less labour than the molecular world and therefore  unable to replace the number of old world jobs lost to trade agreements.

I am not suggesting that international trade is a bad idea.  I’m suggesting that like with most medications there can be severe negative side effects that need to be acknowledged and also treated.  Most economists seem to abhor the notion that trade agreements do create severe negative side effects and argue with the idea that we just haven’t trained a modern workforce to match the new world.  Again they fail to recognize new world economies require far less labour and so the very basic math simply doesn’t work.

And so we cannot let the pro ‘free’ traders off the hook with their suggestion of a mis-trained workforce.  We are still consuming more old world products than at any other point in history.  We have just chosen to send the increased production of old world goods (requiring lots of labour) to foreign nations generating a growing imbalance between domestic consumption and domestic production.  This imbalance requires private and public debt to fill the gap.

The following chart shows PCE (domestic consumption) over GDI Wages & Salaries (a proxy for domestic production).  As the level increases it means that the imbalance of consumption to production is widening.

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Notably, this is another metric that we find ourselves today at a level only ever before seen around the great depression.  This is not an unimportant observation.  When we find a pattern of fundamental aspects of the economy mirroring only one other point in history and that point happens to be the period around the great depression we should definitely explore the phenomenon.

Remember personal consumption generally comes from wages and salaries (a function of domestic production), credit and welfare.  And so lost production means lost labour incomes meaning credit and welfare have to make up the short fall otherwise the domestic demand function will weaken.  The data is clear that credit and welfare have made up the shortfall.  But what we are finding is credit and welfare relative to income has a cap and so without real income growth for the past 2 decades, real top line growth (realized demand) has stalled and in several key sectors declined.  The now secular contraction and/or deceleration of Revenues and Earnings are a representation of the damaged demand function that is preventing domestic business investment.

The solution lies in repairing the demand function in order to drive domestic business investment.  But because this is a chicken and the egg problem meaning without investment we cannot improve demand but without demand improvement we won’t get business investment, the existing economic policy frameworks are trapped.  And so the solution necessarily requires a new economic policy framework.

In an effort to find such a solution, I founded a nonprofit called Institute for Sensible Economics that has developed a platform to launch a new economic policy framework, one the aligns the actors of policy setting with the objectives of policy setting.  We will be introducing the Institute and the platform post election.  Stay tuned.

If anyone is interested in learning more and potentially getting involved please reach out to me: tb@thechicagoeconomist.com  We are particularly keen to expand strategic partnerships with business associations, collegiate student groups and grass roots organizations.