Sunday, June 8, 2014

Macro economics are hiding true economic growth and underestimates our increased purchase power (deflation?)

This is 2014 and since 2008 we have nothing but depressing news about a slowly forward grinding economy with no way out.  Yet we have had a bull market in stocks and in real estate.  Yes, it took nearly five years to ‘recover’ from the trauma of 2007-2008.  Strange, everyone was worried over everything from a relapse of the economy to hyperinflation because of QE (Quantitative Easing).

Well guess what, we were climbing a big wall of worry which is the essential ingredient of every bull market.  Right now, most experts (and I don’t like ‘experts’) don’t foresee major economic problems and think that the sky is blue for the foreseeable future.  Most retail investors still feel theoretically concerned about losing money in the stock markets, but money market funds hold less and less money and where do these past money market funds go?  Right into the stock market.

Ladies and gentlemen we’re at the start of the ninth inning of the current bull market!  Right before euphoria and major crash.  This is the stage of musical chairs where prices go higher and higher; where ‘investors’ will pay stupid high prices and then? The big crash; the end of the world, yet again!  This is also the stage that people will make most money in the market but you have to be agile and cash in before everything goes to hell. It is literally a game of musical chairs and it is often the retail investor who can’t find a chair when the music stops and nobody has cash left to buy.
In the meantime, even the prophets of doom and gloom, the economists – scientists of the dismal science – noticed that things are getting better and are becoming more ‘normal’. But this time there is something truly different.  What happened to inflation that is so unavoidably connected to the printing of money by central banks?
What is happening to GDP growth that so stubbornly seems to stays below or around 3%? How come manufacturing is returning from emerging economies to North America in spite of low labor costs and lower employment taxes in those emerging markets?
We should have had a lot of inflation with rising commodity prices and real estate prices between 1998 and 2008. But really interest rates and inflation have been falling as  far back as 1982. First it was Paul Volcker who beat inflation back by pushing up interest rates to the absurd levels in 1981-1982 ; next it was China and India's large and cheap labor forces that reduced manufacturing costs and pushed inflation even lower.  In the growing economy of the late 1990s and early 2000’s, in spite of rising asset prices, inflation was still falling and so were interest rates.  Between 2008 and now we have had historically low interest rates. Last week the ECB introduced NEGATIVE interest rates.  GDP numbers don’t seem to budge much; although now the U.S. is growing at close to 3%. But after how many years of misery?  What lower labor prices created in the late 1990's is now replaced by manufacturing cost reductions due to automation and technological innovation.
Yes, the U.S. has now the same number of people working in the economy as at the previous peak in 2007. Yet, the total number of people available to work has increased due to population growth (babies) and immigration – both legal and illegal. We call that an increased work force.  When the work force is expressed as a percentage of the total population we call it the ‘participation rate’. The participation rate has not been this low since the early 1970s. More people competing for less jobs results in lower wages of the middle class. Wages have not increased and the overall cost of production has gone down.
I highly recommend reading ‘The Second Machine Age’ by Erik Brynjolfson and Andrew McFee, two academic types who review the impact of automation on society. Two things caught my attention:
1: with increasing automation what is going to happen with our jobs? We will no longer need workers to grow our food and make our cars. If there is no grunt work then how are younger people ever to compete with older experienced workers or workers with college education?  Will there be a new form of unemployment? Because of automation will we need less human workers? Technology unemployment - a new structural form of unemployment?
2: Are our economic assumptions and measurements such as Gross Domestic Product and Inflation obsolete? 

If technology takes away the grunt and routine work, what is the future form of employment? For all of us it is nearly a life essential to do things we feel are worthwhile. A worthwhile job helps build self-discipline and makes us feel useful contributors to society and life in general. No matter how much we crave for vacation trips, working on a worthwhile project is a near wonder-drug.
We’re living in a low inflation era but is that due to cheap labor in China and other emerging economies who make products cheaper than us in the more developed world?  Then why have nearly 25% of factory jobs disappeared in China over the last decade in spite of its enormous economic growth?  And why are manufacturing jobs returning to especially North America?
Well, wages have not been falling in China; rather the opposite. On top of that, transporting products from their point of origin to the customer is becoming increasingly more expensive.  Manufacturing automation has reduced the number of manufacturing jobs and this combined with higher wages in emerging markets, lower or stable wages at home, and the increased price of transportation has brought manufacturing back to North America.
Whether you have a bunch of robots working in a factory in China, Vietnam or in North America, what is the difference? Machines costs as much to run in China as they do in the U.S. or in Canada. Also, energy prices and all manner of commodity prices are currently a lot cheaper in North America than in China or Europe. Energy replaces labor as well as that it reduces the cost of transportation.
Expensive machines require a better educated workforce with more high tech skills and a tendency to innovate rather than just a large number of muscles. This all explains the return of manufacturing to North America.  Just like cheap labor reduced inflation during the expansion of emerging markets in the 1990s, it is now the impact of technology and energy costs that has been driving down manufacturing costs and thus inflation.
Then there is demographics.  Yes the world population, in particular Europe, Japan, Russia and to a lesser degree in North America is growing greyer. Longevity increases combined with baby boomer’s reduced consumption needs have lowered consumer spending and increased the savings rate of the greying but still money earning generations. Schools get closed because of the lack of new students. House and household sizes are declining and also the need for debt so typical for young families is on the decline. This results in lower government deficits and an oversupply of private investment funds, in particular funds available for lending. This, in turn, contributes to cheap credit and again to less inflation.
Lots of products such as on-line news services; internet communication and on-line retail such as EBay, Amazon, Vacation by Owner, hotel bookings and air flight bookings have driven down prices and increased our quality of life. On-line Banking has reduced transaction costs to virtually nil. E-books have reduced the cost of book publishing to zilch.

Also, the costs of generating productivity enhancing software like Microsoft Office, Publisher, Quicken Books and other accounting software has fallen to only pennies per copy; even less now that traditional retail expenses can be bypassed and we download software from our home or office instead. These cost reductions are difficult to quantify in consumer price indexes that focus on daily food consumption and energy costs.
Software production and internet services are indeed very profitable to its creators.  Creating castes of wealthy entrepreneurs and executives that reap huge profits while the middle class disappears. Welcome to the one percent society.
We are living in an era of an extensive number of life improving services and products that costs less and less to produce. It requires less and less labor costs to output these new products while the profits go to innovators and executives who run the companies that through automation use less and less staff and more and more machines. The end result is excessive profits for the few and less jobs and reduced income for the middle class.
We’re also are living in an energy revolution that started out with horizontal well and multi-stage fracking technology. These innovations resulted in drilling of large volumes of rock that were considered not producible just 5 to 10 years ago. Now we have in North America enough energy to last us another century with the U.S. having the potential of becoming once again an energy exporter. Other continents have similar resources but population density and excessive concern regarding the environment as well as unfamiliarity with the energy industry stops them from benefitting from these 'new' resources.
With current land locked energy reserves, North Americans have a tremendous economic advantage. Especially when combined with technology, we can beat the foreign competition especially if we can drive down the exchange rates of our currencies versus the Yuan, Euro and Yen.
Compare how we, North Americans live today to a decade ago or 5 decades ago. It is hard to argue that our quality of life hasn’t improved and that our progress is accelerating at a near exponential rate. Measurements such as inflation and GDP provide only pre-second machine age yardsticks  showing us a depressing economic picture that often is far from reality. These deceptive numbers of inflation and GDP have dampened our spirits making us think that, contrary to reality, things are going from bad to worse.

GDP does not include products and services that can be produced virtually for free compared to just a few years ago as GDP is expressed in dollars.  Cost-of-living indexes that represent a measure of inflation do ignore the reduced costs of many innovations not traditionally included in cost-of- living items while the new technologies have dramatically reduced the cost of labor across the board. Inflation may be dead for the next decade or will stay at least largely muted for a long time.
 Underestimating the revolutionary times we’re living in results in many missed investment opportunities and in missing out on the benefits of real progress. By underestimating GDP and over-estimating inflation we will make adjusting to these revolutionary times and their effects even more difficult.

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