March 20, 2008 - Stagflation

Stagflation

Stagflation is the condition in the economy when there is a rise in both inflation and unemployment. Typically, these two economic troubles are opposites. (See "Macroeconomics 101" from the March 18, 2008 posting). However, a bigger problem arises when both are apparent simultaneously. It is usually the result of a faltering financial market with an external shock that drives up prices. The relationship between inflation and unemployment is shown statistically on the Phillips Curve.



The illustration shows that there is a tendency when unemployment is low for inflation rates to be higher and vice-versa. The statistics above shows a period of stagflation in the 1970s and early 1980s. During that time period the curve is moved up and to the left. And just as it was during that time period, the major external shock to the economy was abnormally high fuel prices.

The goal of the Fed's loose-money policy is to decrease the unemployment rate however it does not seem likely that this will happen. The first sign is that commercial banks so far, do not seem to be willing to lower their interest rates to consumers. The reason is the fear that the rate of inflation will exceed interest rate. If the interest rate is lower than the inflation rate the real value of the money used to pay off the loan in the future will be worth less than the value of the money borrowed. As a result, banks will be losing money in the long-run if they lower their interest rates to match the Fed's rate cut. The formula used by banks to help determine the interest rate charged to borrowers is as follows:

Nominal Interest Rate = Real Interest Rate + Inflation Premium

Nominal Interest Rate = rate charged to borrowers
Real Interest Rate = base rate of borrowed money
Inflation Premium = anticipated rate of inflation

Hence, if the Real Interest Rate = 2.25%, and the anticipated rate of inflation = 4%, the nominal interest rate will be 6.25%. Since banks expect prices to continue to rise, it is not in their best interest to issue loans with lower interest rates even though the real interest rate may be cut.
For more, read "Banks Not Following Fed's Lead" from the Savannah Morning News.

March 19, 2008

Macroeconomics 102

Yesterday's question: If the Fed lowers the interest rate, what will happen to unemployment and inflation?

OK, everything you needed to answer yesterday's question was in the post. All things equal, a decrease in the interest rate will cause there to be an increase in inflation and a decrease in unemployment. The goal is to stimulate the economy by getting businesses to borrow more to expand production by spending the borrowed money and hiring new workers. This explanation makes the decrease in unemployment clear, but how does this cause inflation?

First we must understand that the United States currency is not backed by gold, silver, or any other commodity for that matter. It is considered fiat money. Which means, it has value because we believe it does. As long as we continue to accept it as a legitimate medium of exchange it will continue to have value. As a result, in our economy we assume that people will get paid based on the value of the contribution to production. In other words, the person who gets paid $7.00 per hour to make fries at the fast food joint is actually contributing $7.00 per hour to production. And the Gross Domestic Product (GDP) of the United States is the sum of all the effort put into production in a given year, measured in dollars. Put another way, GDP is the value of all goods and services produced in a country for a given year. Therefore:

(the sum of all the effort put into production in a given year measured in dollars) = (the dollar value of all goods and services produced in a country for a given year)

When this happens, it is assumed that all the money in the economy is equal to all the goods and services in that economy.

Second, the money that is loaned out reproduces. That is to say, the multiple-deposit system employed by our banking system causes the amount of money to multiply. Remember Macroeconomics 101 (March 18 post), one of the three tools of the Fed is to change the Reserve Ratio. The Reserve Ratio is the percentage of all deposits a bank must keep on hand in order to pay for withdrawals. So, if the reserve ratio is .1 (or 10%), what does the bank do with the remaining 90%? The Answer: Loans it out.

Below is an illustration of the multiplier effect:

As you can see by this illustration, a simple $1,000 deposit will multiply to become $10,000. The formula for the Multiplier effect is:

m = 1/R

where m is the multiplier, and R is the reserve ratio.

Therefore, by implementing a loose-money policy, the Fed is allowing for money to be in circulation by encouraging consumers to borrow and spend more money. If we go back to our fiat money about, if there is more money in circulation it will continue to equal the same number of goods and services produced. When this happens it will cost more dollars to by the same number of goods and services than before, thus creating inflation. A calculated risk in order to help boost production and head off unemployment.

But more on the implications of the Fed's policy tomorrow. Until then, listen to this commentary on NPR's "Marketplace" from today. They are warning Ben Bernanke to learn from the past. Just follow the link below.

http://marketplace.publicradio.org/display/web/2008/03/19/70s_parallel/

March 18, 2008

Macroeconomics 101

The Federal Reserve (Fed) is sometimes called the banks' bank. That is to say, it the a central banking system for the United States to which practically all banks must belong. It is where your bank deposits its excess reserves , buys government securities, borrows money. It is through this central banking system that government has a great deal of control over the economy - when not hit by an exogenous shock from some outside source. The main goal of the Fed is to maintain economic stability for the nation; for the most part, that means making sure that inflation rates are in check and that unemployment stays relatively low (within acceptable limits). The Fed has three major tools to help control this:

1) Open-Market Operations: the buying or selling of government bonds and securities to the banks and the general public. This controls the amount of money in circulation. When the Fed buys bonds back from the public or banks, it is putting money back into circulation. When the Fed sells bonds to the banks and the public it is taking money out of circulation.

2) The Reserve Ratio: the percent of all deposits banks must have available in order to pay withdrawals. The lower the reserve requirement, the more money banks have available to loan out.

3) The Discount Rate: the interest rate charged to banks in order to borrow money. This interest rate is often times passed on to the consumer (private individual or company). In other words, if the Fed lowers the discount rate, consumers will likely see lower interest rates at their banks - for both loans and savings - and vice-versa.

Definitions:
Loose-Money Policy - Actions of the Fed to make more money available to consumers. The goal is to have more people borrow money so that they will spend more money, resulting in a boost to the economy. This is used when the economy is slowing, this is usually accompanied by higher rates of unemployment. The idea is that businesses will borrow more money to invest in their production. Such investment will require more workers (lowering the unemployment rate), who themselves will now have more income to spend, ideally creating an upward spiral in the economy. (Fed buys back bonds, the reserve ratio is lowered, the discount rate is lowered).

Tight-Money Policy - Actions of the Fed to make less money available to consumers. The goal is discourage people from spending money in order to slow the economy. This is used when the economy is growing too rapidly, this is usually accompanied by higher rates of inflation. The idea is to discourage businesses from borrowing money thereby decreasing production, in turn decreasing the demand for workers. If not done cautiously, this can cause a downward spiral in the economy. (Fed sells bonds, raises the reserve ratio, raises the discount rate).

The problem with both Loose- and Tight-Money Policy is that the effects are usually not seen right away. Sure the stock market will react that day (big gains for loose-money, big losses for tight-money), but the economy as a whole will not feel the effects for quite some time. Therefore, the Fed does not know if it has done too much or too little, that is why it will usually make small changes.

The perfect example of all this took place today. Ben Bernanke announced another decrease in the Discount Rate: -0.75% down to 2.25%. I know what you are thinking, 3/4 of a percentage point is a small amount, but think about it, 3/4 of 3% is really a big amount. Let's take a look at a 30-year fixed rate mortgage for a $200,000 home.
Fed Cuts Interest; Stocks Soar (Yahoo! News)

At 7.00% Interest the monthly payments are $1,330.60, for a 30-year total of $479,016.00
At 6.25% Interest the monthly payments are $1,231.43, for a 30-year total of $443, 314.80.

This 0.75% difference changes monthly payments by $99.17, and will change the total payout over 30 years by $35,701.20. For the average individual, that is a big difference, the nearly $100 per month is a huge savings. I doubt anyone would turn their nose up to an extra $100 per month ($1200 per year).

Apply what you have learned today (here is the word problem):
If the Fed lowers the Discount Rate, what will happen to unemployment and inflation?
(Answer tomorrow!)

March 17, 2008 (part2)

Normally I would have added this to the previous blog for the same day, but this is so important that I felt compelled to make it its own.

I did a little homework to find Directive 51. The good news is that it is not a secret directive, it is there on the White House web site.

http://www.whitehouse.gov/news/releases/2007/05/20070509-12.html

It is not very long for a government document but it outlines the "continuity" of government in case of a "catastrophic emergency." After reading through the document, with Annexes as classified, it is not possible to ascertain the doom and gloom outlook of my posting from March 14. However, careful inspection of the document that states:

(9) Recognizing that each branch of the Federal Government is responsible for its own continuity programs, an official designated by the Chief of Staff to the President shall ensure that the executive branch's COOP [Continuity of Operations] and COG [Continuity of Government] policies in support of ECG [Enduring Constitutional Government] efforts are appropriately coordinated with those of the legislative and judicial branches in order to ensure interoperability and allocate national assets efficiently to maintain a functioning Federal Government.

But, in defining "Enduring Constitutional Government", the directive gives the President the authority to coordinate the continuity plans of the three branches, and places the Secretary of Homeland Security at the forefront of the effort for the Executive Branch. As a result, one should be skeptical as to the legitimacy of the "continuation of Constitutional government" when all efforts will be directed by the Department of Homeland Security which consistently hides behind the USA PATRIOT Act and the abused idea of "executive privilege.

March 17, 2008

Please help me to understand. A high school student who complains about the way the class is being taught is given the opportunity to watch a movie to take notes about some key points in order to prepare for an open-notes quiz in which they can turn in the notes for extra credit chooses to fall asleep during the movie, or passes notes, or plays with their iPod, or texts others with their cell phone. I know by asking to make sense out of the irrational (a teenager) itself does not make sense, but this is the type of uphill battle I must fight on a regular basis. I give notes in class, the student puts her head down; I give a work sheet, the student fusses with her cell phone; I put on a movie (a "real" movie - academy award-winning type movie, not a documentary), and the student passes notes across the class. How can I win?

I have given her special opportunities to turn in assignments and make up tests by creating a calendar with the dates to take the tests, she fails them miserably. Please explain to me how I a supposed to accountable for this same student who has been absent one-third of the school days this marking quarter? And yet "No Child Left Behind" says that this is a negative reflection on me! That when this happens, the school fails. Well, I have a simple message to those who may agree: sometimes it is the student who fails.

March 16, 2008

Book Review:

Pirates and the Lost Templar Fleet - The secret War Between the Knights Templar and the Vatican by David Hatcher Childress

A few months ago I was at Borders and was looking in the history section thinking about pirates when I saw an interesting title: Pirate and the Lost Templar Fleet. I read the topic listings on the back and the brief synopsis; it sounded very interesting - could the Templars have created settlements in the Americas centuries before Columbus?

The book's premise is that people have been sailing the oceans for thousands of years, much longer than we give humans credit. But it is possible that the Atlantic ocean was navigable to people as long ago as the ancient Egyptians and Phoenicians. There are claims of artifacts from Roman vessels found off the Atlantic coast of North America. In addition, the author goes to great lengths to try and prove that maps existed LONG before Columbus that clearly, and pretty accurately diagram the coastline of the Americas.

I must admit, the idea is very interesting to me; I am always looking to find controversies in history, without the controversies history is nothing more than the boring subject of school - people and dates. Therefore, I like his theory but am not convinced by his evidence. But his idea that the Knights Templar, in an attempt to escape persecution by the Vatican, sailed across the Atlantic with ancient maps provided by Muslim sailors and kings, did not convince me. In my opinion, this book is a good place to start for additional research that may support the author's supposition, but as it stands now, it needs some help.

A much more compelling and convincing argument is put forth by Gavin Menzies in his book 1421: The Year China Discovered America.

March 14, 2008

Despite recent criticisms, I am going to post another blog today.

I found a really interesting blog just the other day. I like it because it seems the author shares the same contempt for the president as I do. The site is CitizenSugar.

One of today's articles shows George Bush with an arm over the shoulder of Henry Kissinger waving to the crowd at the Economic Club of New York. I find it appropriate that two war criminals would appear together in a picture after the smug performance given by Bush last week at an annual roast. In his performance he mocked about many of the problems and inproprieties faced during his administration. If you have not heard the song, check out this link.

http://www.citizensugar.com/1109830

But this is also interesting: the Top 10 reasons to impeach Bush.

http://youtube.com/watch?v=bKeOv7qme1U&feature=related

Are you scared of this government yet? Maybe we should be. Remember why we created a Constitution with so many protections of our rights and liberties; it isn't to protect us from our neighbors, it is to protect us from our government.

Today I learned of a very frightening directive issued by the President in May of 2007. Essentially it gives the President near dictatorial powers in the case of a national emergency declared by the President. In other words, if the President wants to rule as a dictator, all he has to do is declare something a national emergency - a devastating hurricane that disrupts the economy, a terrorist attack on the US either in the US or abroad, an extremely potent strain of the flu - and then initiate Directive 51.

http://www.youtube.com/watch?v=mMs733gFg-I

It is time we started fearing our government. As we speak, the House of Representative is battling the White House and the Senate over a FISA (Foreign Intelligence Surveillance Act) and whether to grant phone companies retroactive immunity from criminal and civil cases for voluntarily turning over telephone and email records to the federal government - all done without a warrant. That is one important issue, but shouldn't we also be afraid of the fact that the government has access to this information without a warrant? And to go a step further, this information is only requested in the interest of National Security. Therefore, any individual who has his computer, telephone, or emails raided and is arrested will never get to know exactly what it is they did or said to get them arrested.

Our Constitution, Article 1 section 9 paragraph 2 guarantees Americans Habeas Corpus protections - the right to know the legal reason for one's arrest and detention. If no legal reason can be presented, then they are to be set free. Under FISA and the USA PATRIOT Act, the federal government is not required to present such information is national security is suspected to be in danger. And Habeas Corpus supposed to be just the first protection for those alleged to have violated the law. Due process must be maintained:

1) Grand Jury Indictment
2) The right to a speedy and public trial (not possible if it is a matter of national security)
3) The ability to present witnesses in defense (which would not be possible if you do not know from what actions you must defend)

Where does that leave the American citizen? It should leave us frightened that an individual who may be politically spoken against the government can be accused as a possible terrorist and arrested for federal crimes to which we may never be made aware. For example, I should be a little nervous about this email since I am speaking out against the government - although I am not advocating any form of violence.

What does this do to the American way of life? It cripples free speech, free press, right to assemble and petition the government. Without these cornerstones of American government how can democracy be possible? How can ideas be shared?

Throughout history, the United States has been an outspoken opponent to dictatorships and oppressive governments around the world. This is part of the reason why Iraq was invaded, why Iran and North Korea are part of the "Axis of Evil", why the US has pressured China for decades. Hitler, Stalin, Mussolini, Mao Zedong, Pol Pot, Maximilian Robespierre, Fidel Castro, and many others are world leaders that we learn in school were tyrannical and oppressive to their people, limited the ideas of freedom - speech, religion, press - and here is our government doing all that it can to do the same.

And yet we sit by and allow it to happen, and those who speak up, or try, are ridiculed, belittled, and isolated. We are accused of being unpatriotic, of being worse than terrorists, when the irony is that those doing the ridiculing are behaving in very fascist ways to help limit and stymie freedoms that we hold dear.

"The price of freedom is eternal vigilance."

PS I am in the process of finding the document Directive 51. I will share once I locate it.
PPS Adolf Hitler also had a Directive 51.