patrick.net

Real = Nominal - Observed Inflation

Fischer stated it as:

Nominal = Real + Observed Inflation

which allows you to substitute ex ante and ex post rates yielding:

Nominal = real + Expected Inflation

This is the equation everyone relies upon when talking about how the money supply and nominal rates (as set by the Fed) will affect the economy.

TampaRentor:

What do you think would happen to the dollar if Benny B dropped interest rates to 1% again? Secondly, with the debt overhang combined with stagnant wages, wouldn't he be "Pushing on a string"? If you were Joe McDebtor, how would a return to the record low rates of the recent past cause you to borrow/consume more? I mean, it's not like CapitalOne is charging the fed funds rate to people? It's not like housing prices are going to take off again with home prices already at record highs. Who is left to buy that hasn't already bought? I mean maybe a few on the margin will jump in, but a "New" boom is not in the future, reagrdless of how low Benny drops the FF rate. When manias ends, they are over.

I don't mean to get all "Japan in the '90s" on you, but I think that this whole thing has to play out based on the laws of gravity and demographics. Irrational exuberance is what caused prices to get out of hand. Interest rates were just a trigger. As reality becomes more evenly distributed amongst the Sheeople, no amount of stimulus is going to overcome sheeople's new found fear of "losing their ass". More significantly, baby boomers near retirement our going to become more conservative, and be even more afraid of "Losing their ass".

There was a comment on Ben's blog suggesting that until the baby boomer bulge finally works its way through the system, housing prices will continue to slide. The posters over there were predicting 2020-2023 for the end of the best. I second that. Even the baby boomers are going to wake up and realize that they can't all sell and move to a low-tax, low-cost state all at the same time. I just don't see stimulus changing the facts.

--Deo V

What do you think would happen to the dollar if Benny B dropped interest rates to 1% again?

Rates dropping to that level may not stimulate consumption as much as last time around (although I will need to be convinced of this emperically). However, it will spur business investment; probably both in R&D as well as M&A. When credit is cheap, businesses tend to build capital stock, especially in the US. Japan had unique problems which slowed or prevented this effect, not the least of which was a terribly corrupt banking system.

Japan had unique problems which slowed or prevented this effect, not the least of which was a terribly corrupt banking system.

So long as moral hazards are present, a banking system will remain corrupted. I do not think is is much better here.

"However, it will spur business investment; probably both in R&D as well as M&A. When credit is cheap, businesses tend to build capital stock"

US businesses have not been investing in capital stock domestically over the last few years, despite the low rates. They have been investing in China. They have been accumulating cash on their balance sheets and de-leveraging. Stephen Roach talked about the theory that capital investment is going to pick up the slack for broke ass consumers post housing bust. His point was that it isn't so clear--why would a business invest in production capacity just after the end user disappears? There has been plenty of M&A, but the only winners in that game tend to be the investment bankers and lawyers. No, they are going to be busy firing people. A 1% FF rate would only happen in the context of a recession.

R&D? Isn't that charged off against current earnings?

"The United states had unique problems which slowed or prevented this effect, not the least of which was a terribly corrupt and unregulated consumer credit industry, structured finance industry, and mortgage industry."

--Deo Vindice

I think dividend tax is partly to be blamed. Since companies do not pay dividends in the name of investor tax efficiency, the only way to increase shareholder value is to increase stock price. As a result, we have all kinds of creative accounting and outright fraud.

We should abolish dividend tax. A business is ABSOLUTELY WORTHLESS if it does not pay its owner money.

In additional to eliminating dividend tax, we should require companies to pay a large percentage of profits as dividends. This way there will be no more creative accounting.

How about growth? Companies can always

1) sell bonds
2) issue new shares

Nominal is just a number denomination. One dollar in 1970 was worth a lot more than a dollar today, because of inflation. Going foward, we can count on the Fed pumping money into the circulation to counter the aftermath when bubble pops, therefore, further reducing the true buying power of USD. Who knows what 2,200 USD can buy in the next 5 years? Certainly not as much as it can today. China's ability to subsidize our lifestyle is limited, they will soon subsidize to an extent of facing internal turmoil because there is not enough resources going around for their own people.

As I said before, I don't buy into any conspiracy theory of gold manipulation. For me it is rather simple, I don't trust the Bush government, I don't trust the Fed/BB, and I don't like to pay inflation tax if I can help it. An ounce of gold would buy you a nice Toga in Roman times, and it buys you a decent suit today, that sounds like a much better preservation of the buying powr of my hard-earned networth than USD.

What do you think would happen if the US substituted a VAT or other consumption tax for dividend and income taxes? Would our savings rate increase?

I hope so. I am all for consumption-based taxation and fee-based government services.

Or have we as a country become accostomed to having what we want when we want it regardless of if we can actually afford it?

It is fine. We will just have the spenders subsidize governmental expenses. :)

Canada has such a corporate structure that allows companies to pay no tax at the corporate level--they're called trusts. Also known as Canadian Royalty Trusts, or CanRoys. The Kommunists in Ottawa threatened to do away with it because it became too popular. They also don't like the fact that so many Americans are buying them.

Fortunately, the Canadian people have wisely come to their senses and tossed the bums out in favor of the conservatives, so it is protected for now. The energy trusts that I am always rambling on about are CanRoys. By keeping them in my IRA, I'm getting 12% without paying tax at all. With any luck, I won't have to pay on withdrawal either, since I'm hoping that the baby boomers will scream until IRA withdrawals become tax free.

--Deo V

Out of SF,

somehow I am wondering if RE will go down much due to different Fed attitudes. Back Paul Volcker pushed up the interst rate noth of 18%, do you think this Fed will be able to do so? Do you think given the indebtedness of the US, we can afford to do so? Frankly I see interest rate heading back down in a year or so.

Of course RE value will come down a bit, I just don't think it will come down that much. Therefore, those who have CASH today should find a way to preserve the buying power of their cash, or else it will just get inflated away while the government bails out millions of speculators and recent homeowners through liquidity injection.

When the mass is comprised mainly of idiots, the idiots win. The government won't tolerate massive bank/REIT/stock market failure. The easiest fix for US' problem is a devaluation of USD, we pay back debt easier, everyone gets saved, and US cost structure will become competitive again.

Canada has such a corporate structure that allows companies to pay no tax at the corporate level–they’re called trusts.

In the US, I think a trust is exempt from double taxation if it passes through over 90% of its income to shareholders. Correct me if I am wrong.

By keeping them in my IRA, I’m getting 12% without paying tax at all.

Yes, it is best to keep them in a tax-deferred account because I think cash distributions are taxed as ordinary income. Again, correct me if I am wrong.

NOT ADVICE OF ANY KIND.

In a political situation, you have to look at what is the composition of the population? Then you target the mainstream profile to win votes.

You think most Americans today have cash, little debt, enough financial resources to fund their medicare and retirement? You think most Americans today are not under the menace of outsourcing or job loss because they are soooo highly educated that they can command whatever salary vs. cheap labor in India and China?

If most Americans are heavily indebted, not particularly skilled, don't have enough money to retire, are under the fear of job loss, then whatever policy that appeals to these people will be popular and eventually get implemented. That policy is called, strategic devaluation of USD and inflation.

"That policy is called, strategic devaluation of USD and inflation."

Somehow, I just don't believe that our creditors have not figured this out. For example, Japan has worse demographics/pension problems than we do. Can they really afford to lose a couple hundred billion dollars from their foreign reserve holdings? The Chinese are willing to do the same? They aren't stupid people. Given that the incentive to debase the currency is obvious to us, doesn't it have to be obvious to them?

--Deo V

Peter P: I believe the REITs are also a vehicle for avoiding corporate tax, not sure how it applies to other industries?

Didn't the bush tax lower the burden on dividends? I believe congress is set to extend the cut.

--DEo V

If most Americans are heavily indebted, not particularly skilled, don’t have enough money to retire, are under the fear of job loss, then whatever policy that appeals to these people will be popular and eventually get implemented. That policy is called, strategic devaluation of USD and inflation.

Actually, I think whatever policy that looks and sounds appealing to the mass but is actually beneficial to the ruling class will get implemented.

Inflation does not meet the requirements because:

1) it sounds awful to the mass - what? It is going to cost more?
2) it is detrimental to the rich because their wealth will be eroded.

Peter P: I believe the REITs are also a vehicle for avoiding corporate tax, not sure how it applies to other industries?

Not sure. I used to own SFF, which is an oil-field trust.

Didn’t the bush tax lower the burden on dividends? I believe congress is set to extend the cut.

I think he wanted to eliminate it, but the opposition was too great.

Both China and Japan know they are the bagholders, but the question is how to head out with least casualty. Don't consider Japanese and Chinese dump, they just got hijacked in a very unhealthy relationship. I have read extensively what the Chinese and Japanese think, on their own media in their own languages, they dicuss often how to do "graceful retreat", hence you see the Chinese going around the world shopping for resources with USD. Japan started overseas investment way earlier than Chinese, they learned from their high-profile mistakes in the US, so they are doing the same, just more quietly.

In 2005, both countries have stopped adding. It is obvious that they can't just start selling, because that will cause panic and eventually detrimental to their own holdings. And a sudden collapse of USD is no good to anyone. However, an orderly devaluation of USD is in the best interest of all parties involved, because no matter how desperate Asians are to American consumer market, there is a limit. Everything has a limit.

I don't know how this will unfold, maybe eventually we all reach a breaking point and one little accident becomes the last straw on the camel's back triggering a sudden collapse, maybe USD devaluation will resume its slow pace. But Bush admin cannot take such an unhealthy imbalance to stay on forever. It won't. The matter is completely out of anyone's control, it is the market momentum at work.

So I am heading out first before the crowd starts. I don't which one will appreciate against USD, so I spread. But putting all my cash in USD will make me lose sleep at night.

The rich are not dump, they have long diversified their money around the world. Bill Gates and Warren Buffet even publicly aknowledged that they are getting part of their portfolio out of USD. Warren Buffet also hoards 1/6 of the world's total silver supply.

The poor don't mind inflation as long as they have jobs. As long as US cost structure becomes more competitive, jobs will start to come back. BB is very clear that he thinks that deflation is nothing but evil, so don't count on us being lenient when deflation pokes its head.

Deo V,

It is not true that capital investment has been asbsent the past few years. Quite the opposite.

It is not true that the only winners in M&A are the investment bankers, although this is a popular cynical view. IBs do get far too much, but the real winner is productivity restructuring and creative destruction.

It is not true that R&D is all charged off to current earnings. US-GAAP on this is quite complicated, and much must be capitalized. Regardless, we were talking about economic effects, not accounting effects. When I say Capital Stock, I mean economic capital stock according to national income accounting, which drives GDP. GAAP earnings numbers are a different universe.

Oops, dumb not dump, I guess I am dumb.

CHINA'S MONEY SUPPLY EXPLODES

Devotees of gold and inflation should take note of the chineese M2 explosion. It makes our M3 look tame.

February 15 – XFN: “China has bought nearly 40% of new U.S. Treasury issuance in recent years… ‘Without fund inflows from China, it would be impossible for the US to keep its interest rates at such a low level with its surging budget deficit,’ Yi said…

February 14 – Bloomberg (Lee Spears): “China’s money supply expanded at the fastest pace in two years in January, exceeding the central bank’s official target for an eighth straight month. M2…grew 19.2 percent from a year earlier to 30.4 trillion yuan ($3.8 trillion) after expanding 17.6 percent in December, the People’s Bank of China said…”

"So I am heading out first before the crowd starts. I don’t which one will appreciate against USD, so I spread. But putting all my cash in USD will make me lose sleep at night."

Amen.

".....a sudden collapse of USD is no good to anyone. However, an orderly devaluation of USD is in the best interest of all parties involved........"

As I have stated (verbosely) in the past, I think that this is exactly how all parties see it. I believe that this very concept is a major topic in closed central bank and diplomatic meetings between the various parties. It would certainly be in our creditors' best interest to agree to a negotiated target for a debasement of the dollar. For one, it would prevent the very catastrophic collapse that would harm everyone. secondly, as you also stated, it gives Japan and China time to move their dollar reserves into something else, i.e. commodities. I think that you are right on! I also think that you are correct that just because all parties have an incentive to work together, it does not mean that an undesireable outcome is not right around the corner. Diplomacy and economics are both tough businesses.

--Deo V

Oops, forgot to add the US presepctive. We are a nation that does not like to delay gratification, not now, not in the past. We can't repay our debts and keep the promises made to baby boomers by telling people to tighten their belts and sacrifice. Just not politically possible. A slow, stealth inflation is the tax that allows us to create the appearance that we are living up to those debts and promises. Slight of hand is the American way.

--Deo V

Randy H:

The Economist had and article over the summer about how companies were not borrowing over the last few years, despite low rates. I work for a commercial bank. This view is consistent with what I see. It's been a bitch.

Yes, I am cynical on megers. "Read Barbarians at the Gate." Cycnicism is not such a bad thing. Not that I'm not down with Schumpeter; it's just that M&A has had a spotty record.

Regarding accounting and R&D, my point is that CEOs get paid for making the quarter. When low rates come, it's during a recession. Everything gets cut. Those options will be long since cashed by the time any beneifts accrue from R&D. Again more cynicism, but I've seen it.

--Deo V

re_2_au:

Great post. One thing though. If you really want to keep your mind from running wild, hide that gold somewhere. The Feds sealed safety deposit boxes during the depression and confiscated gold from anyone who tried to remove it. I also think that bottles of whiskey will be useful just in case the doomsday actually arrives. Now that's some currency with some value if everything really goes to hell!

--Deo Vindice

The Economist had and article over the summer about how companies were not borrowing over the last few years, despite low rates.

I read the Economist as a sacred text. If you'll recall from that issue, the point was not that businesses actually needed to borrow credit when rates are low, but that the discount rates applied to NPV project decisions comes down, thus making the "hurdle rates" lower for new investment decisions. Indeed, there has been a net increase in business investment activity in the past 5 years, not the opposite as you implied.

M&A is still beneficial even assuming zero synergy. It is an essential force behind corporate restructuring. Many jobs are lost, but that is a good thing in the US/Anglo capitialistic model, no matter how much it hurts those directly affected.

My point on R&D cost is that it is not automatically a P&L impact, as you stated. Therefore, the earnings argument is not clear. From an accounting perspective, neither capitalized or expensed R&D are categorized as investment activites. From an economic perspective, both are investment activities. You cannot discuss both in the same argument: apples and oranges.

Frankly I have been seeing a lot of companies using cash, or borrowing money to buy back stocks while the management exercise options and dump stocks like there is no tomorrow. What they are doing, is to use the corporate resources to support the stock price while the management collectively retreat "in style".

I'm wondering if there is any legal ground that such selfish behavior can be held responsible. TOL in particular is on the forefront of such practice.

I’m wondering if there is any legal ground that such selfish behavior can be held responsible. TOL in particular is on the forefront of such practice.

Most likely someone will be found guilty somehow.

Mortgage Companies considering offering 50-year mortgage
(I guess 40-year won't cut it huh?)

"NEW YORK -- The Treasury Department's resumption of 30-year bond sales could have an interesting impact on the home mortgage market, with lenders offering more 40-year loans and maybe even 50-year mortgages for the first time to help some consumers qualify for loans."

I guess the Japanese must be laughing their butt off watching us from across the ocean right now. Well, well, what goes around comes around. I am eagerly looking forward to 100-year mortgage in Bay Area soon.

I am eagerly looking forward to 100-year mortgage in Bay Area soon.

How is a 100-year loan cheaper than an interest-only loan?

When the market crashes credit will tighten up by itself.

Quick fact: I was pre-qualified for a 40-year loan just for the fun of it. The loan officer asked me how much I wanted to get approved for! That was nearly 9 months ago though.

Honestly, I doubt a 50-year loan can save much over a 30-year loan. Perhaps SoCal at anotherfuckedborrower will have more insight.

"Perhaps SoCal at anotherfuckedborrower will have more insight. "
Yes, he ran the #'s in a post a while back:
I think the conclusion was that the bottom of the barrel's been harvested already with the IO/ARM/neg-am, etc., which are cheaper monthlies compared to long-term fixed mortgages.

anotherfuckedborrower.blogspot.com/2005/12/40yr-mortgageis-it-for-you.html

That just about says it all, sports fans. The old statistics the gloom and doomsayers harp about are a poor reflection of the real state of the new economy.

This economy is growing. Innovation is all around. Money is being made. January just saw the highest number of new home starts in 32 years. It’s a great time to be an American.--ScottC

a) Economists have been using adjusted statistics for quite some time; well before the dot-com bust.

b) New Housing Starts are an "old economy" indicator, so they prove nothing if you buy the "new economy" argument.

c) If you really want to gain insight into how economic measures work, might I suggest reading something a bit more informed than BusinessWeek.

Thursday's Financial Times had a few articles regarding how financial markets have already largely priced a real-estate correction in.

Most mortgages are refinanced after only a few years. People tend to take some cash out when they refinance. Accordingly, their prior payments to principal end up back in their pockets, with no debt reduction accomplished. Given these common practices it is almost irrelevant whether people borrow with 30 year, 50 year or interest only loans.

Of course, the negative amortization loans (such as payment option loans) are another story entirely.

DinOr,

One should seek to own a home debt-free by retirement. Debt is a good financial tool if used properly. If the funds borrowed from your home equity are invested with a responsible plan it is better to have more debt and more investment opportunity. When one has more sophisticated financial strategies (and a higher risk tolerance), being debt-free is actually not good financial management. However, most people are unable to resist the temptation to spend the money rather than invest it - so becoming debt-free is the better strategy for the typical household.

I was once debt-free on my home after many years of paying extra toward principal. However, beginning in 1998, I began borrowing against my home and rentals to buy more rental properties. In early March of 2003, with the Dow at about 7300, I borrowed to the max against my home equity to buy stock (I was not in the stock market during the decline of the preceding few years). The markets have moved very favorably for my positions. My higher risk strategy that has played out very nicely... so far.

The economy has performed much better than most people realize. The record housing starts are evidence of this performance. However, housing starts lag the economy. When the slowdown arrives the record levels of building will create a large glut of new houses. Builder margins are high so they can easily lower prices to dump their inventory. We are already seeing incentives in some places. Inventory is already growing rapidly, but generally is not yet above normal balanced market levels.

A favorable wind has been at our back for a long time. But now the wind is coming from an approaching storm. That storm will likely overtake us by the end of this year.

I see half a year of good times (and fast sailing) including rising stock prices before the turning point is reached. Then I expect things will slow as the year ends, and a recession is likely in 2007.

Real estate has already slowed, and will slow further once the economy loses its momentum. The slowing real estate markets will add to the economic slowdown, leading to a typical recession. The recession will cause further pain. I expect a strong recovery in the economy by 2008. I expect the residential real estate markets to bottom by 2009, and recover thereafter.

Randy H: You noted that "Thursday’s Financial Times had a few articles regarding how financial markets have already largely priced a real-estate correction in."

The financial markets had also largely priced in a real estate correction back in 2002 as well. They were VERY wrong then. I believe the correction is real this time - but I was a still a bullish real estate buyer in 2002 and 2003.

When it comes to predicting market turns, the majority is usually wrong.

Zephyr,

I wasn't intending to imply that markets accurately forecast future events. Only that professional investors, hedge funds, et al don't share ScottC's Business Week inspired prognosticating.