Where is this Economy going?

Harvard and Bernanke, Bernanke and Harvard. Harvard has crept into my blog this week. Fed Chairman Ben Bernanke spoke at Class Day at Harvard University yesterday and naturally made a few remarks about the state of our economy. He even went so far as to compare and contrast the economy and the Red Sox baseball team of 1975, the year Ben Bernanke graduated from Harvard with a degree in economics, with the economy and the Red Sox in 2008.

I remember 1975 as the year the Cincinnati Reds beat the Boston Red Sox to win the World Series. And, I remember the Big Red Machine beating the New York Yankees four straight to sweep ‘em in the 1976 World Series. The great thing about great sports teams and great armies is that they all work together for the same result, to win. Talking about winning, I even remember President Ford in 1975 and the WIN buttons, “whip inflation now.”

The problem as I see it today is that where our economy is perhaps more efficient and productivity is up from where it was in 1975, the politics part of the political-economy is down. While economists with their computers and piles of data may have a more accurate picture of the economy, the politicians are even more in the pocket of special interests groups that have the dollars to lobby them. Today, the campaigning and collection of campaign contributions starts one minute after the election results are posted. Because of the cost of running a campaign, politicians are perpetual running machines for reelection.

The Fed can not do the right thing for all the people without the cooperation of the Congress and the President. Fiscal policy and tax policy that are crafted for the benefit of the very wealthy, leaves the vast majority of the American people paying the price in blood and dollars for policies they do not even have a hand in shaping.

No, there are no long lines at the gas stations in 2008. No even/odd days to buy gas as there was in 1975 either. But the price of gas is a tax on everyone that buys it and it is especially a tax burden on the families of the so called “middle-class.” To think that inflation is under control is a serious mistake. When the war in Vietnam came to an end with the last helicopters flying people out of Saigon in 1975, inflation was just heating up. Fed Chairman Paul Volcker would have to push interest rates up into the double digit range before the inflationary psychology in the country was broken like a fever. I remember the years 1975 to 1985 very well, as I traded bonds, both government and municipal, during those years five days a week. I managed bond portfolios during those years and I remember 15.75% corporate bonds being offered at par and 13% or higher municipal bonds. These were not junk bonds either, they were rated AAA by the major rating agencies in 1981-82. Inflation does not just show up one morning out of no where. Inflation works its way through the economy over several years. The peak in interest rates, as I remember, was the fall of 1981, a good five years after 1975. In early 1982, the fever had been broken and interest rates started to move very slowly downward.

I do not doubt our Chairman’s sincerity when he says that inflation today is different than inflation in 1975, but 1975 was not the year that saw bond prices tumble out of bed. The inflation that will be caused by the increase in the price of gas and diesel will work its way through the economy over the next five years. People that can afford $5 a gallon gas, or higher, will continue with their present buying habits, while the vast majority of Americans who can not afford $5 a gallon gas with modify their spending by eliminating services and products they can no longer afford.

Unless the United States implements a strong self sufficient energy policy that includes the production of our own oil resources, it will be many years before this country achieves energy independence and eliminates their dependence on foreign oil. If only our politicians could come together and craft an energy policy that would create a path towards energy independence, and let the world know we are serious people about taking charge of our future, perhaps then we would receive the respect of other nations. We give the world plenty of reasons to believe we are a paper tiger when it comes to our energy policy. Would it not be nice to get OPEC off our backs and out of our pockets? Stay tuned.

The Monetary Puzzle in 2008

On Tuesday, our Fed Chairman Ben Bernanke spoke via satellite to a conference in Spain. While he touched on many things, I think the important thing to note is that he is keenly aware of the threat that inflation presents to the economy and to the American people. As I would like to say, Chairman Bernanke’s heart is in the right place.

A fair and just central bank must be fair and just to the least among us as well as to those most able to withstand the effects of inflation. When you are making over a million dollars a year, $3, $4 or $5 gas is not going to break your piggy bank. But, what percent of the population makes over a million dollars a year? A half million? A quarter of a million?

The task before the Fed is not a simple one, and the Federal Government’s penchant for running deficits does not make the Fed’s task any easier. The realities of the trade deficit and the budget deficit are two important pieces of the puzzle that the Fed must deal with. These two large numbers impact the Fed’s ability to administer to a monetary policy with little or no inflation.

On the one hand, the Fed would like to be able to raise rates. Debt service on new US Treasury obligations would go up as key central bank rates would certainly dictate a rise in short term rates. Long term rates are a little more complex. While short term rates are influenced by the supply and demand for capital, long term rates have the added components of the present rate of inflation and the anticipated rates of inflation going forward. If the Fed raises the discount rate, the fed funds rate or increases the reserve requirement, interest rates will go up. Through Open Market Operations, buying and selling of US Treasury debt, the Fed can fine tune interest rates and in turn the growth rate of the money supply. When the Fed buys US Treasuries in the open market, they put money into the banking system. Conversely, when the Fed sells US Treasury debt from their portfolio, the Fed takes money out of the banking system.

But, if the Fed is serious about fighting inflation, the Fed can take big steps to slow the economy. And, that is the problem. The central Bank wants low inflation and a growing economy. Given the problems in the credit markets, the mortgage market and the slow down in the housing market, the Fed is being called upon to keep the economy on track with hopefully more new jobs coming online, while at the same time keeping price inflation under control. The Fed could use a little help from Congress and the President. What can the Congress and the President do?

This country has run on cheap energy since the end of the Second World War and the end of gas rationing. We can not become green over night, it will not happen. Realistically, the energy policy with regards to oil drilling here in the United States needs to be modified. We need to take responsibility for a bigger percentage of our oil needs. This one move can slow down the rate of inflation. We also need to build some new state-of-the-art oil refineries. Our exposure to foreign oil must be reduced if we are going to get more control of our economy. At this point, OPEC is playing the tune and we are dancing to their music. Strategically and economically this has to stop.

A lower price for gas may not fix the credit problem, the sub-prime mortgage mess or the housing market, but it would take significant pressure off the consumer and permit family budgets to repair themselves. What is the Stimulus Package of 2008, passed by congress and signed by the President, all about? After the consumer’s budget has been taxed by first $3 and now $4 a gallon gas, how much money is left for needed purchases for a family? Do not look now, but these gas and diesel prices are a form of a tax. And, this kind of a tax eats into the budgets of those least able to afford $4 a gallon gas. Not to mention what the price of diesel fuel is doing to the trucking industry and the price of everything that we buy and use that is brought to us by trucks!

We would never let OPEC or Saudi Arabia be responsible for our defense, so why do we let them control our economy? They are not on the ballot in November and yet we pay a tax to them every time we fill up our tank. Perhaps it is time for the American consumer to wake up to what the economic facts are. Do not be confused by labels and colors on a map. Stop and think about where your money is going and how much your money is purchasing for you when you shop. This country needs a new energy policy, and while long term oil may not be the answer, for the present our need for cheap gas and diesel must be recognized as imperative for our economic health and recovery. Stay tuned.

Basketball, Rock 'n Roll & Taxes

“If you ain’t got no money, ain’t nobody calls you honey.” -- Bo Diddley (1928-2008)

Yesterday Bo Diddley died at the age of 79 of heart failure. Bo Diddley as you all know played rock ‘n roll and much more on a square guitar. His music was played all over the world. He was not an economist, yet what he had to say about money pretty much summed up what others have taken books to say. Today Moneythoughts remembers Bo Diddley.

Yesterday while I was waiting for my pickup truck, I had some work done. I read an article, in the Sunday New York Times, by a professor of economics from Harvard University. He was concerned with the economy and made the suggestion that if we lowered the corporate tax rate from 35% to 25%, that the country would be a more attractive place for people to invest their money. He was counting on foreign investors bringing their dollars to invest here in the United States.

The professor also recognized that the reduced tax rate for corporations might mean that taxes collected from corporations would be down as a result of the lower tax rate. He suggested that to make up for this short fall in taxes that the government add a 40 cent a gallon additional tax onto gasoline. I do not remember if there was a tax exemption for diesel.

The professor reasoned that the tax dollars lost by reducing the corporate tax rate from 35% to 25% could be made up with the additional 40 cent tax on each gallon of gas sold. The professor knows that the demand for gas is almost inelastic. What does inelastic demand mean? What is elastic demand?

Let us take a look at elastic demand first. Remember the simple supply/ demand graph with one line representing supply and the other line representing demand, and where they cross is where people will buy one of an item, but as the price falls they will buy more of the item until any further decline in price will not cause them to buy any more of those items. How many pairs of socks do you need? How many TVs can you watch? You get the idea.

Now, let us take a look at inelastic demand. Gas is an excellent example of inelastic demand. At $1 a gallon we fill up our tank, at $2 a gallon we fill up our tank, at $3 a gallon we fill up our tank and at $4 a gallon we fill up our tank. If you drive to work, and it is the only way you can get to work, your demand for gas is inelastic. Regardless of what the price is for a gallon of gas you must get to work. The professor of economics from Harvard knows you need to get to work and therefore suggests that another 40 cent tax on a gallon of gas would make up for the short fall from the reduced corporate tax rate.


Some economists would call this trickle down economics. Giving corporations a tax break to encourage jobs to be created through investment here in the United States.

You might say that this is not fair. I am sure that every mother that sent her little boy or girl to Harvard told them that life was not fair. Taxes are not fair, nor logical. Taxes have been with us since the beginning of time. I remember reading a short biography of Frederick William the First, father of Frederick William II, also known as Frederick The Great, and what advise he gave his son about taxes. He told his son that when he needed a little extra tax money, he could levy an extra tax on the Jews, but not to do it too often otherwise they would leave his state. Why the Jews? Why a gallon of gas?

When I attended the University of Cincinnati (UC), they had great basketball teams. In my freshman year ('60-'61), UC won the NCAA Championship by defeating Ohio State in overtime. The next year they had a sophomore forward from Muncie, Indiana on the team. In those days freshmen played freshman ball. UC played in the Missouri Valley Conference which was a real tough conference. One game against Drake at UC's fieldhouse, the UC Bearcats went with their usual starting lineup. That meant the boy from Muncie was on the bench. Drake came out with a zone defense and collapsed around our big center Paul Hogue when the ball was worked into the paint. This went on for a few minutes as the zone defense seemed to keep the ball away from the big center inside. Then the head coach, Ed Junker, called a time out and put the kid from Muncie in the game. The guards brought the ball up court, but instead of passing the ball into the center, they passed it to the boy from Muncie, who had set up in the corner on the left side of the court with his heels almost touching the line. The sophomore forward put the ball in the air and with a one-handed jump shot the ball sailed through the net. The announcer as was the custom said, “basket by Ron Bonham, Bonham." The next two times up the court the guards moved the ball around, but again standing in the corner with the ball in his hand was the kid from Muncie, Indiana. Again and again the announcer repeat, “basket by Ron Bonham, Bonham." Three straight all net one hand jump shots caused Drake to take a time out. When they came back out on the court they were out of their zone defense. The game was over, the zone defense was broken. UC went on to win the NCAA Championship in ‘62 as they beat Ohio State in regulation time, soundly.

So, what does this have to do with the price of gas, or an extra 40 cent tax on gas? People make changes just like teams. They adjust. To reason that some American consumers will pay the gas tax is correct. But there are others that will make changes, and for others items will not be purchased if such a tax was placed on the backs of the consumer. As for corporations creating more jobs because of the favorable tax rate, there are arguments that that may not happen either. Stay tuned.

Got A Stamp?

Monday and a new week begins. Inflation is back in the news again after taking a back seat to other economic problems. The credit crisis is still with us as is those darn credit swaps that we are all wrapped up in. Just kidding. I know you are not out there involved in the credit swap mess. Gas and diesel fuel is still a problem as truckers are having a difficult time making it with the price of diesel. The housing crisis is also still with us and from what I read, the problems are actually starting to reach the wealthy. Solutions can not be far behind if that is the case.

Inflation is an interesting concept. There are several ways to approach a discussion of inflation. There is the Cost of Living Index, but that does not take into account the increases in the cost of energy or food. There are political reasons for this narrow definition that involves COLA (cost of living adjustments). Then there is the Consumer Price Index (CPI) and the Producer Price Index (PPI), both of which are closely watched by Wall Street for signs of an increase in the rate of inflation. Remember, inflation increases a business’ cost of service or production. If a business can not pass their increased cost along to the consumer, the profit margins of the company are squeezed and the earnings of the company go down. Since stocks sell at a price/earnings ratio, lower earnings mean a lower valuation for the stock. This translates into a lower stock price. It is my opinion that it is the sudden rate of increase that is most up setting to an economy, not the increase.

I think we could have handled $4 a gallon gas if the price of gas had increased over the years, say since 1973, the year of the first oil embargo, in a straight and continuous line. Now, I know commodity prices do not move in a straight and continuous line, because if they did, they would probably not be a commodity.

Let us take a look at the cost to mail a first-class letter. One piece of paper in an envelope with a stamp, nothing fancy, keep it simple. On July 6, 1932, it cost 3 cents to mail a letter, and the 3 cent price remained until August 1, 1958 when the price moved up to 4 cents. By January 7, 1963, the price to mail a first-class letter became 5 cents. On January 7, 1968, the first-class stamp was now 6 cents. The cost to post a first-class letter continued to go up: 1972 8 cents, 1974 10 cents, 1975 13 cents, 1978 15 cents, 1981 20 cents, 1985 22 cents, 1988 25 cents, 1991 29 cents, 1995 32 cents, 1999 33 cents, 2001 34 cents, 2002 37 cents, 2006 39 cents, 2007 41 cents and May 12, 2008 42 cents.

I think most people would agree that this steady increase in the cost of posting a first-class letter, while no one likes it, does not hit us all at once. Personally, I still have an affection for stamps and buy them at my local post office and use stamps to pay my bills. I told the lady at the Northside Post Office that when the price of a first-class stamp gets to $1.00, I will find another way to pay my bills. Could the price of a first-class stamp double in the next few years? It is possible.

In 1981, a first-class stamp was 20 cents and by 1985 it was 22 cents. Now in 2008 the price to post a first-class letter is 42 cents. That is more than a double since 1981.

So, what is the point? Inflation is part of life in the United States. The way monetary and fiscal policy is run, inflation is something everyone must deal with. Those that deal with inflation successfully will survive and those that do not deal with inflation successfully will suffer and perhaps not even survive.

I believe that both the government and the Federal Reserve Bank could, if they wanted to, do a better job with holding down the rate of inflation. In 1998, it cost 32 cents to mail a letter. Within 10 years, the price increased to 42 cents, a 10 cent increase. The percent increase in the last 10 years is 31.25%. If over the next 10 years the price to purchase a first-class stamp only increases by 31.25%, the price of that stamp in 2018 will be 55 cents.

Monetary policy is important. The way monetary policy is administered in the United States affects us all and it even affects those countries and people doing business with us. For far too long monetary policy and the discussion of monetary policy has been limited to too few people. It is time for monetary policy and a discussion of our monetary policy come out of the closet. The well being of millions of poor and elderly people is at stake. Stay Tuned.

Breast Cancer Research Bike Ride

This morning is the second annual Ride Cincinnati in memory of Marlene Harris, who died after a 15 year battle with breast cancer. Last year I rode and I plan to ride today. Last year, the first year of the ride, the ride raised $132,000 for breast cancer research, today they may raise $200,000. This is my 100th posting and I can think of no better posting for this milestone than to raise our awareness of the important work that is being done to eliminate breast cancer. I am posting a photo of an old bike rider from this year's ride.

Saturday Is For Art

Today, from The Envelope Collection: Top to Bottom

1. Level Playing Field Out The Window

2. Uncle Fred's Oil & Gas Station

3. Popular Messiah

4. Level Playing Field No. 5

5. Black Flag

All five of these paintings were done on the back of a 9"x12" black envelope. When I was working, I received hundreds of monthly reports about the status of investment portfolios. One company located in New York City sent me their reports in these black envelopes. I liked the texture of their envelopes and started to save them. Because the envelopes were black, I covered the back of the envelopes with white acrylic paint so I could draw on them with a ballpoint pen. The first few pictures I did in ballpoint and one I sent to the company in NYC where it is framed and hangs. Back when I worked in the trust departments with several banks, I would take 9"x12" envelopes, that I had received research reports, into investment meetings to draw on. Some of these investment meetings would last more than an hour, and after one hour of listening to people talk , my brain would switch to screen saver unless I started to draw. Sometimes , I went into these meetings with my pencil moving and I did not stop drawing until the meeting was over. Originally, I worked mostly with bonds. At one trust department, I was the only person working with bonds, so my fixed income meetings were short. I did however enjoy listening to the discussions about the equity market, and at times, I even added my 2 cents. Trying to explain, in those days, how the Fed operated and how monetary policy influenced the stock market, the bond market and inflation was not easy. I tired to explain it, but not everyone was ready to hear it. Well, that is how I got started working with paper envelopes. Later, I started painting on the black envelopes and that is how The Envelope Collection came about.

What About Banks?

The father of a good friend of mine worked his entire career for one local bank. He would say that banks lend people money that do not need it. Back in the old days before credit cards, banks made loans for cars, homes and would if you had decent credit, lend you money on a 90 day note. I remember walking into Central Trust Bank’s main office on the corner of Fourth and Vine Streets to apply for my first mortgage in June 1970. I was buying a 2-family house, in some parts of the country know as a duplex. The mortgage department was all the way to the back and I walked through several sliding glass doors. I remember standing in front of this man’s desk and telling him I would like to apply for a mortgage. The first question he asked me was, “where is the house?” I said, “Clifton.” Clifton is a neighborhood just north of the downtown and near the University of Cincinnati. He then said, “ north or south of Ludlow Avenue?” I answered, “north of Ludlow Avenue.” Then he said, “have a seat.” I got the loan. I also took advantage of being a veteran, buying the house with no money down. That was 38 years ago next month. I still own that house.

Banks can make money from several ways. The oldest way is for people to deposit their money in demand deposit accounts also known as checking accounts. The Fed permits the bank then to loan a large piece of that demand deposit you have created with your deposit. The Fed requires that the bank hold on to a piece of that deposit and it is because of this reserve requirement that the bank does this. The Fed can raise or lower the reserve requirement depending on the economy. If the Fed wants to encourage economic activity they lower the reserve requirement. If they believe economic activity is too hot they can raise the reserve requirement and by doing this slow down the creation of new loans which leads to more demand deposits.

When the bank makes a loan they create a new demand deposit. This new demand deposit can again be loaned to another borrow, but first the bank must hold back a reserve requirement from that new demand deposit. From one demand deposit of say one million dollars the bank can create several million dollars in demand deposits (loans). This is how banks create money, and this is how the money supply grows. The size of the reserve requirement that is set by the Fed influences the expansion of the money supply and the speed that money moves through the economy. By raising and lower this reserve requirement, the Fed can influence the velocity of money.

If you do not borrow money or you can not borrow money, you have lost the use of a major tool in creating wealth. Borrowing money is leverage, and leverage makes people wealth. In emerging countries today there is such a thing as mirco-lending. This started in India and Bangladesh to give poor women an opportunity to build a small business. Sometimes the loan was for no more than buying a sewing machine and some material to make clothes. From this beginning, the women would make a living a pay back their micro-loan. This program has been very successful and has spread to other parts of the world.

Being able to borrow money is a good thing. The problem arises when the growth rate of the money supply leads to inflation. Inflation is when prices go up and our money buys less. Corporations will raise their prices if their costs go up so they can maintain their profit margin. Oil now costs $130 a barrel, so the price of gas, refined from oil, must also go up. If you own stock in an oil company, you would want them to maintain their profit margin because without earnings there are no dividends and pension funds that pay pensions every month depend of dividends as well as interest income.

Banks also make money from charging fees. Fee business is not as risky as making money on the spread. What is the spread? The spread is the difference between what a bank pays (interest rate) for money and the interest rate they charge the borrower to borrow money. Demand deposits pay very little if anything to the depositor. Saving accounts pay a higher interest rate to depositors. The problem with spread banking is that if interest rates rise, the bank has to offer a higher interest rate to attract new deposits. If a bank finds itself paying a higher interest rate for new deposits than it is receiving on old loans, it is then losing money. Banks are not suppose to lose money. This is a problem for banks that borrow short term funds and make long term loans. Banks hire at least one brainy person that watches over the balance between assets and liabilities. This may be also know as risk management. Before risk management banks got themselves into trouble. It is amazing to me that they still do manage to get themselves into trouble.

To match up loans with deposits that are locked in for a while, banks offer CD’s (certificates of deposits). When a bank needs money to cover a large loan, they will offer a large CD for a specific rate of interest. The spread between the interest rate on the CD and the rate of interest the bank charges on the loan is the spread. If the person pulls their money out of the CD they take an interest rate penalty. The bank then may have to borrow money from another bank until they have sold another CD.

The rate of interest banks lend to each other is known as the Federal Funds rate. This rate of interest is influenced by the Fed. So, you can see that the Fed, our central bank, has a lot to do with interest rates and the growth rate of the money supply. The Fed has several responsibilities, but for me the most important responsibility for the Fed is the integrity of the dollar. Changing the size of the ball in the middle of the game just does not get it for me. Lending money is an important function. Borrowing money and the ability to borrow money leads to the creation of wealth. People that can not borrow or do not want to borrow money should not be penalized for their decision. The playing field is angled too much in favor of the borrower. The bigger the borrower the more the field is tilted in their favor.

The Federal Reserve Bank administers to our monetary policy. People that live from pay check to pay check or on a fixed income like a pension can not afford inflation. Inflation eats into purchasing power and leads the elderly and poor to make difficult choices between food and medicine, heat in the winter and freezing. Monetary policy controls all these things, and people need to know this. Stay tuned.