January 5, 2006
Donald R. Byrne, Ph.D.
Edward T. Derbin, MA, MBA
Note: To print a hard copy of this newsletter, click on the following link for a PDF download…
THE FEDERAL RESERVE: CONTINUED RESTRICTIVE MONETARY POLICY AND ITS FALLOUT
The Fed’s Policy concerning the Specter of Inflation
Most of the inflation we have been experiencing is coming from a single source: energy. The Federal Reserve policy is most effective in curtailing demand side inflation – not supply side. Demand side inflation has been increasingly been suppressed due to rise of competitive pressures throughout the economy. As we have argued, this is the essence of the New Paradigm – increasing competition in markets eliminates the price power of firms. When inflation comes from supply-side shocks, marked by OPEC price increases, a recartelized domestic oil industry and an anti-growth environmental lobby, the Fed’s weapons become ineffective and in fact cause extensive collateral damage, as we will discuss below.
Beyond the issue with OPEC’s pressuring global prices upward, a major cause of the explosion in energy prices in the past two years is the fact that the domestic energy industry has not increased capacity because it is not in their best interest to do so in terms of their profit picture. A second problem is the very powerful and extensive environmental group. Its antigrowth policies have resulted in a virtual shutdown in the nuclear power industry and the halting of any expansion in the production and refining capacity of the American oil industry. Even in the area of coal and renewable resources such as wind and solar power, environmental roadblocks are more the rule than the exception. Inflationary pressures, caused by energy shortages, cannot be managed through the use of monetary policy by the Fed.
It has to be made very clear that the policies and decisions of the Department of Justice and the Federal Trade Commission allowed the American oil industry to recartelize over the past fifteen years. This has to be rectified and competition must be reintroduced into the American oil industry. On the environmental front, we must move from the current “Chicken Little” policy of the sky is falling, to a more rational approach to protecting the environment. It must be noted that much of OPEC’s current power would be absent if it were not for the recartelization of the American oil industry and the outdated and obstructionist attitude and quasi-scientific stance of the environmental lobby. Until this is accomplished, the American consumer will continue to be suffer from high energy costs and Fed induced high-interest rates. Short of a Federal Reserve induced economic collapse (a la 2000), their policy of pressuring interest rates upward are of no avail, given the current structure of the domestic energy industry and the environmental obstructionist policies.
Please note that this is not to ignore that strong growth in the U.S. economy and China, for example, have put upward pressure on global oil prices, but again, the primary cause for the huge spike is coming from the supply side.
As we move on, we’d like you to consider the following two questions:
1) Who is benefiting from the Fed’s policy of pushing up the federal funds rate?
2) Who is hurt by the Fed’s policy?
The answer to these questions will be addressed…
The Killing Fields: Weak links in an otherwise strong economy…
As you can tell by the following illustration, the U.S. economy destabilized late in 1999 and collapsed in 2000. Beginning in the fourth quarter of 2001, the economy has been humming along strongly as it enters the fifth year of its expansion.
Job growth from 2001 (two surveys)
The steady strength in the economy is reflected in solid job growth and an unemployment rate running around 5%.
This economic growth has sustained itself in spite of two consecutive record hurricane seasons, including 2005 with well in excess of $100 billion in losses due to Katrina alone (http://www.ncdc.noaa.gov/oa/climate/research/2005/hurricanes05.html) and the cost of the ongoing wars on Terror, in Iraq and Afghanistan (http://www.house.gov/appropriations_democrats/pdf/iraq-funding-timeline-6-15-2005.pdf).
There has been little inflation, other than that caused by the recartelization of the oil industry, despite the prolonged expansion in the economy.
The Weak Links
v Restructuring (Auto and Education)
v Energy Costs
v Rising Mortgage Interest Rates
v Trade Deficit
A painfully familiar aspect of restructuring:
(U.S.) AUTO INDUSTRY
Some argue that the American auto industry is at best dying and at worst already dead. This may seem like the case if you live in places like Southeastern Michigan, but if you are living in the Southeastern U.S., where the auto industry is migrating, you are experiencing a boom. Some emphasize outsourcing and plant closings occurring in the more northerly latitudes, but south of the Mason-Dixon Line, in sourcing is the norm – where new plants are opening.
See Hyundai in Alabama
Southern Hospitality - automotive industry relocating to the South http://www.findarticles.com/p/articles/mi_m3165/is_2002_August_1/ai_90091366/print
Southeast’s Auto Industry Climbs into the Driver’s Seat
While this relocation is going on, in terms of geography, there is just as dramatic a shift occurring in market share. Back in 1950, the hey-day of the Big Three as the dominant players in the auto market of the U.S., their market share was between 90 and 95 percent. Imports comprised most of the remaining portion with the exception of a few dying brands, including Studebaker, Packard, Checker… Now, a generous estimate is that those same Big Three have between a 50 and 55% market share, with the rest going to transplants and imports. In addition, in 1950 the market was the United States – it is now defined as the NAFTA (North American Free Trade Area).
An interesting thing to note here is that around 80% of the vehicle sales in the U.S. auto market are homegrown: Traditional Big Three (GM, Ford and DaimlerChrysler) 55%; Transplants (foreign brands producing and selling those products here) 25%; Imports 20%.
Between 1961 and 2003, the U.S. share of global vehicle production went from 44% to 20%
As is chronicled in this newsletter and elsewhere, the major problem causing this dramatic restructuring has been linked to high labor costs and compensation packages in the Big Three. The differences between total labor compensation in the traditional Big Three and the foreign transplants in the auto industry…or, where the killing fields lie in the domestic auto industry...
In the U.S. domestic auto market, the hourly compensation (including benefits) for workers at the three traditional nameplates is estimated at $65/hour or $130,000 per year, while a similar estimate for the transplants is about $30/hour or $60,000 per year. According to the U.S. International Trade Administration, in terms of the wage portion of auto workers total compensation package:
“Auto manufacturing remains one of the economy’s best paying industries. Production workers’ average hourly earnings reached $29.05 (excluding benefits) in 2004. Wages were 80% greater than the national average for all manufacturing industries.”
Again, the bulk of the difference between the Big Three autoworker and that of the transplant autoworker is mostly in the area of non-wage compensation (including such things as health care and pension benefits).
“After Delphi filed for bankruptcy, its chairman and CEO, Robert "Steve" Miller, said that the company needs to get rid of a "substantial" number of its North American operations and reduce its 51,000-member workforce. He wants the UAW to agree to concessions that would reduce members' average wage-and-benefit packages from about $65 an hour to about $20 or $25 an hour. Of that total compensation package, the hourly wage alone would drop from $27 to $10 if Miller has his way.”
“With wages as low as fifty cents an hour in China, compared to $21 an hour in the United States. and $2 an hour in Mexico, low labor costs are also a draw for U.S. suppliers to set up facilities in China, especially for certain labor intensive products. China’s low tooling costs, low energy costs and its currency rate are additional incentives for producing and exporting from there.”
(U.S. – China Automotive Parts Industry Overview)
"What all those disparate groups of workers have in common is they work for companies that once were monopoly powers," said Dana Johnson, chief economist for Comerica Bank Inc.
"That era is gone for those companies. No more monopoly profits and, in many cases, no profits at the moment. Many unions and Michigan workers are operating under a compensation structure based on a market reality that no longer exists. It's the painful new reality."
One aspect of restructuring you’re perhaps not so familiar with:
While it is evident that restructuring is in full swing in the auto industry, we’ve also found equally fundamental restructuring occurring in education – especially at the college level.
Most people are familiar with the encroachment of community colleges into higher education. Compared to years ago, a large portion of students take their first two years at community colleges, before completing their four-year programs. An even more profound change going on is the very rapid growth in online education.
From the US Dept of Education and US Census Bureau…
For the past few years, the increase in total online enrollment has exceeded the increase in all college enrollment – this means that not only is onground (face-to-face) education playing a declining role relative to online education, but its absolute numbers have fallen as well.
Between the 1997-1998 school years and 2000-2001 school years, distance-learning enrollments grew by 1,416,000 students, or 85% (from 1,661,000 to 3,077,000). In contrast, according to US Census Bureau data, from 1997 – 2000 total postsecondary enrollments (both distance and onground) only grew by 811,000 (from 14.502 million to 15.313 million).
1997 – 2000 (Census)
>State University of New York<
In 2003, SUNY had 53,000 students enrolled online, with a total enrollment of 403,000.
By 2005, the online enrollment grew to 86,500, with a total enrollment of 413,500.
>University of Maryland<
(May 6, 2005) Gerald A. Heeger, 62, has been head of the University of Maryland University College since 1999. During his tenure, online enrollment grew from 20,000 students to nearly 125,000.
Online education often is accompanied by extensive discounting of tuition rates; this reflects what has also been the case in the auto industry –competition has driven down the price of these goods/services to the consumer.
As we spelled out in a previous issue of this newsletter and referenced in the prelude, the recartelization of the American oil industry and environmental resistance have kept the energy industry being able to develop and expand to meet the needs of consumers. American businesses and households have been trapped in a virtual killing field of high-energy costs; with little hope of any relief in the near term. While critics lump the U.S. and China together as the primary polluters of the global environment, France has been noted as the poster child for all that is right in terms of energy conservation. The truth is that France has chosen to rely on nuclear energy for much of its electrical production. http://byrned.faculty.udmercy.edu/2004%20Volume,%20Issue%203/Newsletter%20Volume%202004%20Issue%203.htm
RISING MORTGAGE INTEREST RATES
In addition to the rising energy costs and insecurity in the labor markets, households are now facing an additional burden of rising interest rates, affecting their mortgages. As short-term rates are driven up by the Federal Reserve actions in the Federal Funds rates, it influences other short-term interest rates to rise as well.
In the area of variable rate mortgages (ARMs), the Fed’s actions are gradually triggering the adjustment clauses in these mortgages. This increases the monthly payments, reducing further the disposable income available to purchase other goods and services and also reduces the cushion protecting homeowners from defaulting on mortgages.
The second area of concern is the rise in fixed rate mortgages, both for new homebuyers and those attempting to refinance from variable to fixed rates. The real question is are these short-term rates of interest, and some longer term rates of interest like 15 and 30 year fixed rates, higher because of real supply and demand factors in the market, or because of the Fed’s actions.
Yield curve data…
Déjà vu with the Fed policy of tightening (wrong then; wrong now)
Recall that the Fed, once before in 1998 and 1999, became obsessed with the fear of serious inflation reasserting itself. This policy of restraint by the Fed added to the heavily depressing weight of the rise in the federal surplus and the rise in the trade deficit. As discussed in previous articles and supported by data from the U.S. Bureau of Economic Analysis, these actions caused a collapse in the economy in 2000, where the growth rate fell from 7.3% in the fourth quarter of 1999 to a -0.5% in the third quarter of 2000 (not 2001).
The preceding chart illustrates that the core rate of inflation has been relatively flat (tame) for the past several years. The volatility has shown up primarily in energy and food – to a lesser extent.
What’s the difference now?
In a negative sense, much higher energy costs and mortgage interest costs are clobbering households, with no immediate end in sight. The household financial health is being further damaged by the acceleration of job losses and compensation cuts in the auto industry. The trade deficit is still large, if not higher than what is was in 1999. Yet, the growth in real GDP and jobs continues to show great strength…why? Instead of huge and growing federal budget surplus, a significantly large deficit exists in that budget as a result of significant tax cuts a few years back. Remember that taxes depress, government spending stimulates…a federal government deficit means stimulation of the economy in all schools of thought. So despite the call for tax increases to reduce the deficit and Congress’s unpopular attempts to cut back on government spending, if it were not for that significant federal budget deficit, the economy would have experienced another collapse, similar to what occurred in 2000.
…the last weak link in our discussion
Again, as pointed out previously in this newsletter, a large trade deficit has both good and bad sides to it. On the good side, since we are importing more than exporting, we can consume and accumulate capital at a rate beyond what our domestic production possibilities would otherwise allow. On the flipside, since imports depress and exports stimulate, a trade deficit depresses the economy. Of course, this means that it is anti-inflationary in its impact. A second problem is that we have to finance the trade deficit, primarily by borrowing from the rest of the world; hence, our international debtor status is increasing in order to finance this large trade deficit. This international financing of our deficit reflects itself in the increasing amount of debt and equity claims of our economy owned by foreign interests – both private and public.
Who owns U.S. securities…???
Report on Foreign Portfolio Holdings of U.S. Securities as of June 30, 2004
U.S. Department of Treasury, Federal Reserve Bank of New York and the Board of Governors of the Federal Reserve System (June 2005)
It’s not just U.S. government securities that are owned, but foreign interests own a substantial portion of equity interests in American firms. Of much recent interest, is our continued trade deficit with China. As pointed out in previous articles, much of this is due to the Chinese decision to peg their currency (yuan) at a rate of $0.125 per yuan, instead of the near equilibrium of $0.50 per yuan. This means that Wal-Mart, for example, now pays $125 for a large, flat-screen plasma TV that using the near equilibrium exchange rate from a few years ago would have cost $500. It also means that the cost of the U.S. dollar to the Chinese has risen from 2 yuan per dollar to 8 yuan per dollar. Thus a U.S. made tractor costing $20,000 would have cost the Chinese 40,000 yuan a few years back, now costs them 160,000 yuan.
Does this clear up any confusion on why we have a trade deficit with China?
A more general cause of the trade deficit with the rest of the world has been due by an upward trend, over the past several years, in value of the dollar in the foreign exchange markets…this is due to the fact that foreign capital flows in to the U.S., demanding dollars at a greater rate than capital flowing out of the U.S. that supplies dollars. This shortage of dollars causes the foreign exchange price of the dollar to rise, which is equivalent to saying that the dollar price of foreign exchange is falling. This leads to pressure for the dollar to appreciate or in the vernacular of the press – to strengthen against foreign currencies. This in turn, results in foreign goods becoming cheaper to us and our goods becoming more expensive to the rest of the world. This is all reflected in the rise of our trade deficit to the rest of the world over the past several years.
There is a basic issue in question here…has the Fed policy of maintaining relatively high short-term rates in the U.S., in order to combat what they see as the potential and significant rise in inflation, triggered the net increase in capital flows into the U.S. If this were in fact the case, then it would be the culprit in causing our persistent and large trade deficit. Note, that even though the Fed’s efforts are mostly manifested in the short-term end of the market (and intermediate and long-term interest rates do not always reflect the Fed’s policies), the trade deficit nevertheless does have a depressing effect on the economy, and is anti-inflationary in nature.
In terms of purchasing power parity, the U.S. dollar should have depreciated against the yen since June 2004 (and well before).
Reflected in their policy of maintaining a “cheaper” yen, the Japanese central bank has had to acquire U.S. securities and so doing, the dollar has appreciated; this in turn, makes it difficult for the U.S. to export to Japan.
While this is a much less formal type of intervention by the Japanese, it achieves the same as the Chinese pegging of the yuan – their currency depreciates.
In the last analysis, the Federal Reserve monetary policy of pressuring federal funds rate upward in an attempt to slow the economy (fear of inflation), is promoting and prolonging the massive trade deficit – again, a trade deficit depresses the economy.
The U.S. dollar relationship with to the Canadian dollar is more reflective of what one might be expected in a free market. However, remember to keep in mind that the U.S. imports a good deal of energy products from Canada (petroleum and electricity).
The recent appreciation of the U.S. dollar versus the British pound is one of the results of the Federal Reserve’s restrictive policy of driving up interest rates relative to the United Kingdom.
The recent depreciation of the U.S. dollar in relation to the South Korean won is to be expected as a result of the Korean monetary authority pursuing a less restrictive monetary policy (the central bank lowering their controlled interest rate).
Reluctance on the part of the European Union to raise interest rates until very recently helps to account for the appreciation of the U.S. dollar compared to Europe’s Euro.
And now we can answer the questions….
Who is benefiting from the Fed’s policy?
o Other nations, desirous of running trade surpluses
o Foreign interests that own both public and private U.S. short-term securities
o Financial services industry involved in residential mortgage financing: Rising short-term rates and longer-term fixed mortgages rising without justification in relation to long term government bond rates
Who is hurt by the Fed’s policy?
o Households, hurt by higher interest rates in mortgages
o American businesses that are unable to export because of the strong dollar
o Labor, by job losses due to inability to export (overwhelmed by the rising tide of cheaper imports)
In short, government policies do make winners and losers.
For some of the above issues we have covered in past newsletters we touched briefly on the theoretical framework for the analysis. The heart of understanding these issues is to understand microeconomic theory. To many, this is the boring part of economics, especially the theory of income distribution. We would like to give you some additional facts that may startle you, but we hope will whet your appetite for an initial introduction and more elaborate discussion of the topic of income distribution in the next issue.
For example, the only way to understand the massive restructuring going on throughout several industries, such as the auto industry is to understand the difference in total compensation between a typical worker at GM and that of a retail worker at Wal-Mart, for example. The difference is what economists call economic rent, or surplus reward. The common portion of the compensation package is what the worker must be paid to bid them away from their next best competitive alternative – that is the opportunity cost. In terms of opportunity cost, these two workers would receive fairly similar compensation. The difference, or the large economic rent (surplus reward) received by the autoworker is due to the past market power of the original Big Three firms…it was an oligopoly, dominated by General Motors. Labor costs could be passed on to the car buyers in the form of higher prices with some degree of ease. Those days are gone my friends. The American auto industry has been and will continue to be in a tumultuous struggle for market share with foreign transplants having a huge competitive edge. On the other hand, your typical retail worker from Wal-mart, for example, has labored in an industry that has always been extremely competitive.
As competition increases in markets, the income of resources will shrink toward the resource’s opportunity cost, thus eliminating the surplus reward called economic rent. The autoworker located in Mississippi or Kentucky receives around half of the compensation package of their counterparts in the Midwest. The latter portion of the auto industry is being gradually being downsized by the inability of their employers to compete in the marketplace. It is problems like this that we hope to shed some light on as the American economy undergoes restructuring. Our journey in this newsletter is not an easy one, but it will be well worth it.
More to follow on income distribution in the next issue
Did you know…?
Breakdown on employee compensation (from BLS)
1983 = 20.1% of workers
2004 = 12.5% of workers
From the U.S. Bureau of Labor Statistics
UNION MEMBERS IN 2004
In 2004, 12.5 percent of wage and salary workers were union members, down from 12.9 percent in 2003, the U.S. Department of Labor's Bureau of Labor Statistics reported today. The union membership rate has steadily declined from a high of 20.1 percent in 1983, the first year for which comparable union data are available. Some highlights from the 2004 data are:
--About 36 percent of government workers were union members in 2004, compared with about 8 percent of workers in private-sector industries.
--Two occupational groups--education, training, and library occupations and protective service occupations--had the highest unionization rates in 2004, at about 37 percent each. Protective service occupations include fire fighters and police officers.
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