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A note on energy prices and the holiday spending season (taken from my Late-October issue of ClearView on the Economy):

As the holiday season approaches, there is considerable concern about the consumer’s ability to enjoy a “merry Christmas.”  Energy is going to simply cost more.  A simple-minded model says that consumers will spend less on other things.  But this has NOT been a good description of how the economy has behaved.  Since mid-2003, the price of oil has steady risen from about $30/barrel to now $60/barrel.  In spite of this doubling, there has been only one quarter when inflation-adjusted consumer spending growth how fallen significantly short of 3% growth (annualized)!

Some economists can be SO one-dimensional.  The economy is complex, with many moving pieces.  LOTS of things can happen at the same time.  Spending behavior has much inertia.  To some extent, consumers can lower their saving rates instead of lowering their spending.  (They have.)  Payrolls have expanded by 4 ½ million over this period, producing new income to support new spending.  And wages growth has picked up some, too, further enabling spending.  Increased home and stock prices have lifted the net worth of the household sector $4 trillion over the last 4 quarters.  Has everyone forgotten the “wealth effect?”

Perhaps the biggest miss of many economists is ignoring the circular flow of energy income.  By producing maybe 1/3 of all of our oil, most of our natural gas, doing most of the refining, and nearly all of the transportation plus distribution, MUCH OF THE VALUE ADDED ASSOCIATED WITH THE CONSUMPTION OF ENERGY STAYS IN THIS COUNTRY!  Therefore, it can be tapped to support spending or investment.

A simple example: from 2003:Q2 to 2005:Q2 consumer spending on energy consumables and utilities increased about $120B per year.  Over roughly the same period, the market capitalization of the 3 largest energy stock has increased roughly $240B.  (I know this compares a spending flow against a wealth stock.)  But you get the point: the rise in value of just these three stocks has “paid” for the incremental increase in energy costs.  This increased wealth is undoubtedly enabling increased spending.  (This is why I recommend a strategy of creating a “natural hedge” of owning energy stocks to insulate families from the possibility of higher energy costs.  The strategy has allowed me to buy a gas-guzzling SUV!)  The government had just better not try to “windfall profits tax” these profits away!
Approx. Rise in Market Capitalization,
6/30/03 to 10/13/05
Exxon Mobil: +$141 Billion
Chevron Texaco: +$49 Billion
Conoco Phillips: +$48 Billion
Memo, Rise in spending on energy consumables and utilities: +$120 Billion (to $489B/yr.)

I’m NOT saying the rise of energy prices has exerted zero drag on the economy.  It has.  And will.  But to be honest, you DO need to come up with good reasons why the extraordinary rise of energy costs has had only a muted adverse impact on economic growth.  With buoyant current housing demands likely to produce downstream spending for furnishings, and with government assistance payments and other disaster relief replacing lost jobs from hurricane-affected areas, my guess is that holiday spending will come in somewhat better than expected. 


RE Hurricanes Katrina and Rita:
As Yogi Berra once remarked, this is like déjà vu all over again.  One year ago, in the email cover-note to the Late-September, 2004 issue of “ClearView …” I went over some of the macro-economics of hurricanes.  Recall that Florida was hit by four hurricanes of modest-moderate proportions, including Charley, which devastated Punta Gorda (SW Florida).  (I’ve personally seen the snapped trees, bent utility poles, and the mobile home village there.)  Hurricane Katrina, and its impact on New Orleans and Gulfport/Biloxi, Mississippi took this to a whole new level.

The scale of human suffering—loss of life and property—is obviously immense.  But my job is to understand and communicate the macroeconomic effects.  Begin with the insured losses.  You MUST understand that $50B of such losses for wind damage (rough estimate; nobody has tallied a reliable final number) EQUALS $50B of new construction.  The insured flood losses ($40B?--but the wind-flood split will be disputed) are the obligations of the U.S. government.  That’s more re-construction.  And then there is the $62B of Congressional appropriations already legislated.  And for uninsured losses, some folks and businesses will necessarily draw down savings. 

These are HUGE sums!  To put it in perspective (hey, what is $62B these days?), the annual budget for the whole State of Louisiana for FY06 is $19B.  (Of course, some of the $62B will be going to Mississippi, Alabama, Texas, and perhaps a few other places.)  The macroeconomics for understanding this comes right out of the “fiscal policy” chapter of my Econ101 Samuelson textbook.  The government spends, or another wrinkle, the public lowers its “marginal propensity to save,” and the economy gets a lift.

And this spending has “multiplier effects.”  My spending becomes your income, and your income becomes your spending and then someone else’s income, and so on.  So $100B of fresh spending ultimately lifts the economy by $200B or $250B.

PLEASE UNDERSTAND that I an NOT saying that hurricane destruction is “good” for the economy.  Re-construction is only restoring lost wealth.  (Wealth is the result of all past production.)  But GDP, industrial production, retail sales, etc. are all current activities measures.  It is these activity measures that we refer to as the “economy” that will be positively affected in upcoming months.  

Here is another BIG mistake that other economists make: they focus on “partial equilibrium” results (i.e., focus only on the specific event or problem).  Sure, employment in the New Orleans metro area has gone from 640k to nearly zero.  Sure, New Orleans has lost a ton of “business” of all types.  These are “measurable” quantities even at a U.S. scale.  But what you don’t directly observe are pick-ups in activities in myriad places throughout the U.S.  I’ll give you a simple example.  One trade association I work with was to have its annual meeting in New Orleans in late-October.  That’s out—a loss for the Big Easy.  But they moved the meeting to Las Vegas—its gain.   As bad as it is for New Orleans, for the U.S. economy, it’s mostly a wash.  Not understanding the “general equilibrium” effects of a situation, reflecting all the subtle and complex interactions of the U.S. economy, is a major failing for economists, and thus a major source of forecasting error.  (I could tell you stories here—one of the best calls I’ve made—versus the masses--in my forecasting life...)

Let me suggest what you should expect.  Hurricane Katrina hit the States late in August.  Some of the data for August has already shown hints of hurricane disruptions.  But more business disruptions spilled over to September.  This is simply a matter of arithmetic—when you are shut down, you are not producing or selling anything.  Now layer on the impacts of Hurricane Rita: more shutdowns and destruction and insured damages.  The economic numbers for September (released mostly in October) will look AWFUL.  Employment down.  Industrial production off.  Retail sales in retreat.  DO NOT BE DISHEARTENED, AND DO NOT EXTRAPOLATE THESE RESULTS!!!  Business WILL come back on line—it was already happening in the Post-Katrina environment before Rita came along.  This will show as sizable gains in October activity levels (assuming no more hurricanes!).  And then layer in the reconstruction spending.  My guess is that the activity figures will show a strong finish to 2005!  And this should spill over into 2006, as well.

We are seeing this drama play out in the weekly initial claims for unemployment compensation figures.  I LOVE this data, because every Thursday morning I get a fresh read on the economy.  It is a reliable, cyclical economic indicator, rarely leading you astray.  Prior to Hurricane Katrina, the weekly claims came in around 325k (a very favorable reading for the economy and the labor markets).  But the last two weeks were 424k and 432k (ordinarily well into the economic “danger” territory).  Remember, those 640k New Orleaners are mostly unemployed.  So the initial claims have risen to reflect their filings; the simple arithmetic says it has more to go.  But once they have filed, the numbers WILL retreat to mirror the other U.S. fundamentals, which were and are basically sound.  So cut this indicator some slack for a few more weeks

Finally, I hate to be hard-hearted at a distressing time, but somebody has to say it.  Disaster relief (rescue, delivering emergency food/water/ fuel, and restoration of order and basic services) is one thing—quite appropriate for “government.”  But if the federal government takes on the tasks of rebuilding and restoring the hurricane-flattened areas, this creates a MAJOR problem.  In the insurance business (and economics profession), it is called “moral hazard.”  To state it simply, if the “government” is going to cover my losses and pay for my rebuilding, why should I buy insurance (which at least has some actuarial basis)?  But insurance premiums on beach front property are extremely costly.  Duh?!  And flood insurance in cities 12 feet below sea level is expense?  Duh?!  And levees built by the “low cost bidder?”  Duh?!  (For goodness sakes, without any redundancies, a la Holland?)  If people want to live in these higher risk places, fine.  But they have to bear the true costs of living there.  I do not see why I, living in the Frost Belt city of Pepper Pike (with all its high taxes) has to subsidize such risky living behavior.  If a “beneficent and compassionate” government absorbs much of the rebuilding/restoration costs, THEN IT ONLY GUARANTEES FUTURE DISASTERS AND UNIMAGINABLE FUTURE GOVERNMENT SPENDING OBLIGATIONS.

I am frequently asked to comment on the U.S. trade deficit and the foreign exchange valus of the U.S. dollar.  The material that follows puts many of the associated issues in a context.

"...I wanted to lay out a little background on Int’l Trade & Finance 101. This might save us some time and create a better understanding for the readers.

(This was one of my fields “specializations” in graduate school econ.)

Let me pose some simple Q&As.

 1. Why do we have a “trade deficit?”  There are several components to the answer to this question.  First, we have an “open” economy (more open than many) where foreign producers/sellers have relatively easy access to the largest, and among the industrial countries, fastest growing market in the world.  Second, as consumers, we have little bias against imports.  In many cases, we relish them for their quality and seek them out (for example, BMWs and Sonys).  In other instances, we have a brand of capitalism that encourages domestic sellers to offer the highest quality (or multiple levels of quality) for the lowest prices, regardless of production origin.  Our system rewards those that does this well.  (For example, Wal-Mart; it is no accident that they are the largest single importer from China.)  Third, our economy has expanded faster than most of our major trading partners.  Our imports grow in proportion to our growth.  Our exports grow in proportion to foreign, growth.  So if our economy expands faster than do foreign economies do, then our imports will tend to grow faster than our imports.  This is exacerbated by America’s tendency to LOVE imports!  Imports here just don’t grow proportionally (one for one) with our overall growth, but MORE than proportionally (maybe 1.3 to 1.0).  This is pretty rare in international trade and country tendencies, and again reflects the openness of our economy and the absence of a bias (mostly) against foreign-produced goods.

 2. How big is America’s trade deficit?  Year-to-date 2004 (September), the merchandise trade deficit is running just under a $600 billion deficit.  The single largest bilateral trade deficit is with China, running at a $152 billion rate; the latest monthly figures annualize to a $180 billion deficit.

 3. Is “equilibrium” defined as a “balance” of trade (zero deficit/surplus)?  No!  Countries with very high savings rates tend to run persistent trade surpluses (example: Japan).  Countries with low savings rates tend to run persistent deficits (example: America).  So “equilibrium” for Japan is to run surpluses and for the U.S. to run deficits.  We actual compliment each other.  These tendencies will probably not last forever, as the state/stage of economic development and demographics change over long periods of time.  

 4. What is an “excessive” trade deficit?  A difficult question to answer with a definitive quantitative answer!  One answer: a deficit that foreigners are unwilling to fund!  Another approach: it is probably a bad idea for the deficit—which is the incremental increase in indebtedness to foreigners (strictly speaking, if we are talking about the current account deficit)—as a share of GDP to exceed the growth rate of nominal GDP for any length of time.  IF this is the case, then international debt as a SHARE of GDP is expanding.  Note that you can have lasting trade deficits, but if this condition does NOT hold, then international debt as a share of nominal GDP will get smaller and smaller over time.  

5. The previous question makes a connection between a trade deficit and international debt; expand on that.  THIS IS FUNDAMENTAL!  If you do not pay for all your country’s imports with your country’s exports, then foreigners MUST be offering you credit.  This is often termed a foreign capital inflow.  By the way, this is not an economic hypothesis or theory; it is an economic LAW, or tautology.

 6.  OK, how does the dollar (the foreign exchange rate) fit into this?  To an extent, you can think of the U.S. dollar (or any other currency) as a commodity, where there is a supply of it and a demand for it.  Remember Econ101?  “Price” is determined where supply = demand (the “market clears”).  When foreigners buy U.S. exports, that creates a demand for dollars.  When foreign sellers sell imports they get dollars, creating a supply of dollars.  So when the U.S. does not “pay” for all its imports with sales of exports, that creates a foreign supply of dollars.  But that is NOT the end of the story!  There is also a demand for dollars (and a supply of dollars) caused by investment desires of foreigners to invest in the U.S. (and a supply of dollars generated by U.S. investors seeking to invest abroad).  These investment demands/supplies of dollars must be netted against the trade deficit-generated supply of dollars.  This can go any way!  The foreign investment demand for dollars can EXCEED the trade deficit-produced supply of dollars.  That would tend to LIFT the price of the dollar.  And this was the case in the roaring late-1990s, when America saw an ever-widening trade deficit AND an appreciating dollar!

 7. So why is the U.S. dollar now falling?  Things change.  First, the trade deficit is bigger (a record high).  This means in the context of the material above that there is a big excess supply of dollars created by the trade deficit.  Second, foreign investors may be getting “dollared up” in terms of their dollar-denominated investment exposure (remember: the deficit creates incremental new debt that must be absorbed).  It is NOT so much as “foreigners getting out of dollars” (in the aggregate), but not wanting to take on so many new dollar investments.  This is dollar-deficit indigestion.  The U.S. remains a real good, safe place for foreigners to invest, but there are now other very good (in terms of risk-reward) places to invest, such as Asia outside Japan and South America.  Capital (savings) is a scarce commodity, and it is allocated and rationed! 

 8. And the role of foreign central banks?  This is the third factor that can create a demand or supply of dollars.  Foreign central banks will hold dollars because it is a reserve currency, and used to effect, facilitate, and settle transactions.  Some central banks will demand and hold dollars to affect exchange rates.  For instance, the central bank of Japan has been known to intervene in the foreign exchange rates to BUY dollars (creating a demand) in order to support the dollar and keep if from falling, which is to say, the yen RISING.  Why? They fear a rising yen—which would tend to raise the price of Japanese-produced goods for sale in America, and make them less competitive relative to U.S.-produced goods for sale in Japan and other country markets--might stifle export growth, hurting overall economic growth.  There was a recent story that the central bank of China might be diversifying out (selling) dollar-denominated investments?  Why?  IF they suddenly unglued their yuan peg to the dollar, and the yuan rose, all those dollar-denominated investments would suddenly be worth less—an investment loss.  (A 10% $ devaluation loss on 550 billion DOLLARS of holdings is a $55 billion loss!!!)

 9. Anything else important?  Yes! Confidence.  Confidence is a very important aspect of any investment decision.  If foreigners lose confidence in any aspect of the U.S. economy, they would probably want to lighten up on U.S. investments (or actually take on less new investments); this creates a supply of dollars, pushing down its price.  Foreigners might lose confidence if they see America not coming to grips with its fiscal deficit.  If Alan Greenspan resigned and I (Dr. Ken Mayland) was appointed Fed Chairman, that would surely result in a loss of confidence and dollar selling!  (Too bad foreigners don’t know me better!)

 10. Any catches for foreigners?  Yes! IF foreigners are unwilling to fund (by capital inflows) deficits this large, then they MUST be willing to either buy more FROM us (exports) or accept lower exports TO the U.S.  Many of these foreign economies are not doing well, and they hardly can afford getting weaker by selling fewer exports to the U.S.  So the deal with the devil they make is for their central banks to keep taking on U.S. debt to fund the bigger trade deficits.  (Charles DeGaulle made this observation in the 1960s!)

 11. What is the BEST way for this situation to resolve itself?  From America’s standpoint, the best solutions would be for the major economies of the world to: one, stimulate their poorly performing economies so that they would naturally demand more U.S. exports (lowering the trade deficit); two, eliminate trade barriers to their economies for U.S. goods, thereby increasing access and ultimately more U.S. exports (lowering the trade deficit); three, allow as time passes for U.S. imports to fall as a result of current and past (since early 2002) dollar depreciation (lowering the trade deficit). 

 12.  What is the WORST solution?  In principle, we could lower the trade deficit by purposely slowing our economy down (or creating a recession), which would lower our imports.  While the International Monetary Fund (IMF) has imposed this condition on some countries in need of assistance (“conditionality”), it is VERY UNLIKELY our policymakers would choose to impose this solution on us.  Just think of the political implications and fallout. 

 13. The dollar has been falling for some time.  Why isn’t the trade deficit going down?  First, empirical research shows that it takes up to three years for exchange rate changes to FULLY affect trade flows.  By my calculations, using a back-of-the-envelope version of the Federal Reserve’s economic model, in 2003 the economy was still feeling the negative economic impact of the RISING dollar through 2001.  And the dollar exchange rate is a “price” influence; it can be offset by “demand” influences, i.e., the relative economic growth rate influence discussed in point #1, above.  And then there is the technical “J-Curve” effect.  When foreign exchange rates change, prices change immediately while trade flows adjust slowly over time.  So suddenly, those imports are coming into the country at higher prices, so the costs (QxP) of those imports rises!  This makes the trade deficit worse, at least temporarily (until imported quantities adjust lower).

 14. More dollar declines?  Probably.  Combine naggingly large trade deficits, dollar debt indigestion, and $2 trillion daily trading in the f/x markets (much of it jump-on-the-bandwagon speculation) and you have a good case for further dollar depreciation.  BUT NOTHING IS CERTAIN (BUYER BEWARE)!  

 15. Want some perspective?  The trade-weighted (average of several currencies) dollar is down just under 30% from its ealy-2002 peak.  Between 1985 and 1988, the dollar fell 39% on the same basis.  The dollar right now is just a few percentage points below that 1988 level.

 16. What’s the worse that could happen?  Panic and illiquidity in trading the dollar.  “Disorderly markets” with other currencies and countries (for example, Russia and Argentina) have lead to plummeting currency values, big increases in domestic interest rates, plunging stock market prices, and recessions.  The U.S. and its dollar is a special case.  Our debt is in dollars.  We can print up plenty if needed!

 17. Finally, how bad is it to have a lot of international debt outstanding?  Not necessarily bad.  On one level, people go into debt to buy homes, and companies take on debt to buy equipment and build factories.  These are generally recognized as good uses of credit.  Surely some of our international debt is put to productive use. At another level, I personally don’t owe any foreigners a red cent; do you?  So why should I care?  (Well, I do care in that there are broader macro implications that WILL ultimately affect me.)

 18. You said that there are effects on the domestic economy?  You bet!  In your gut you know that a cheaper dollar suggests that imports will go up in price and we will import fewer of them, and with our exports cheaper, we will export more.  Here are the simulated effects coming from the Fed’ model: for every 10% trade-weighted devaluation of the U.S. dollar, the inflation-adjusted GDP will rise a total of 2.5% (beyond what it otherwise would have grown, after 3 years), the unemployment rate will fall one percentage point, and inflation and short-term interest rates will rise by 0.4 percentage points.  Of course, these are approximations, and assumes “all else is held constant” (which never happens).  Many persons and companies, however, would readily sign on for this “trade-off” (more growth and jobs for higher inflation)..."


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