Thursday morning radio: the economy on WREL

Mike Smitka

Well, I've gone through another week without a post on the auto industry, but Thursday has come and my WREL Lexington (VA) radio segment with it. Here's my latest.

First, our host Jim Bresnahan asks about the gyrations of global stock markets. China? – attributing a reason to what happens in the stock market is hard. As an economist I don't pay attention to the stock market, because how it does has no link to the economy in the short run, and little or no impact on the economy. Most trading now is computer to computer, operating faster than the blink of an eye, and opaque in details. So why things move in a particular direction, and how much, no one can explain. Now the reporter on CNN has to give a report every hour, and we as humans like things to have causes, and they'll attribute the up or down to something. So in the short run the market is random, and betting on it is a crap shoot, one where the house – Wall Street – wins. You have to pay a fee, and the computers can see your trade before it gets executed and (legally – there's no regulation) bet against you. As to the US, we're seen a strong rise in the market the past few years have seen; the US economy has after all been growing, and corporate profits are up. Stock prices ought to reflect that, but the link is loose so things will go up and down. Don't panic, invest for that long-run link and don't let yourself try to beat the house in the short run.

Now as to China as a cause of the gyrations, what's been happening in China is not news. Of course I'm better informed than average. I've been teaching a course on the Chinese economy since I came to Washington and Lee almost 30 years ago, and first studied China when I was a freshman in college, over 40 years ago. I can read Chinese, albeit slowly and speak a bit. There are a couple historians in town, and literature and language specialists, and I can't begin to compare to them. But in this area I really am the go-to person. So here's what I see.

That the economy there is slowing, well, it began slowing a couple years ago. Over time an economy can grow only as it has new inputs, capital, labor, technology. China's population is no longer growing – and in a few years will begin falling – and the working age population is already in decline. That's been offset by migration, people moving from farm to city, but that is coming to an end. Much of the countryside has emptied out, and in particular there are very few young people working as farmers. That's the labor side, clearly slowing.

Then there's capital. China is the size of the continental US, and has completed its expressway system, which is more extensive and of course in better shape than our interstate system. That created a lot of jobs, and as in the US, that sort of construction also generated a lot of corruption. (We've forgotten how bad things used to be here, as over time we developed systems to monitor public works, while politicians have developed alternative, and more reliable, sources of funding.) Anyway, lots of other infrastructure is now also in place, and while cities are still growing, even there housing is often ahead of demand. For other sorts of capital China has also built up their economy. There are three times more cell phone users in China than in the US, and so the market is no longer growing, and most of the phones are made inside China as well. A lot of computers are in place. So capital accumulation is naturally slowing.

Then there's technology, one measure of which is total factor productivity. China has learned how to assemble cars, and while most of the engineering took place in Detroit and Wolfsburg – General Motors and Volkswagen control the top brands – the factory end is now pretty sophisticated. Cell phones are assembled in China, and more and more of the chips are made there. The world's largest PC company, Lenovo, is Chinese, and their universities graduate a lot of electrical engineers. While Lenovo started out by buying IBM's PC business, they now have enough experience to continue pushing the business themselves. So while China will keep improving, they're well along the catch-up process and the easy gains have already been made.

Hence China's headline growth has fallen from 10% to 7% and henceforth they'll slow to 4%-5%. That's still much faster than the 2% growth of the US. But as to the stock market, this slowdown was known to be happening, indeed was written about 20 years ago. The details of timing weren't know then, but the general outlines were clear. So what's happening in China isn't news and shouldn't have much effect.

Now there is the collapse in stock prices and some sectors of real estate. Chinese investors are not experienced, and many are naïve. In addition, for a variety of reasons Chinese bank accounts pay nothing. So as incomes have risen, money has flowed into stocks and real estate, and they've not been thinking carefully about long-run values. So there are a lot of empty apartments and people who have bought stock on the basis of rumors. While corporate accounting is much better, it's still weak – not that we don't have our scandals – so it's not always clear what you're buying. In any case, prices had no basis in reality and are now coming back to earth. Unfortunately it's very hard to work with that. Diagnosing a bubble is hard, and the tools that might pop it are also likely to trash the wider economy. So fighting a bubble can do more harm that good. But it's not clear why Wall Street should react strongly, since (unlike between Europe and Japan and the US) direct links between the financial system of China and those of other countries are weak.

Separately, there's a bit of news on the US end. Over the last 3 months housing prices have on average fallen a bit. Construction is back to growing on the pre-crash pace – but not at pre-crash levels. We're still down about a third – 31.6% to be precise – but there's no sign we're moving back towards prior levels. That's not good news. So while it's a backward-looking number, it will be interesting to see what we learn from today's release of GDP data.

Now we're about out of time today, but next week I want to talk about changes in the labor market at its two extremes, teens and older workers. During the Great Recession teen employment fell by one-third, but had been declining even before then. Are teens no longer interested in afterschool jobs? Or is there a lot of slack still, lots of people looking for jobs, and employers prefer to hire anyone but teens?

Then there's the older end. In 1981 only about 400,000 people aged 75 and above were working; today over 1.5 million older Americans are working. Some of that is simply that there are a lot more older Americans; our population is aging. But the share of older Americans working has also risen. So what's going on there?

More next week!

Low oil prices: not a Saudi conspiracy

Mike Smitka

Saudi Arabia is not what it used to be. Their petroleum and other liquids production in 2014, at 11.6 million barrels per day [mbd], is only about 1 mbd above what it was in 1981 (and is just shy of the peak over the period 1980-2013). But their market share is distinctly lower, falling from 17% (of global output of 60.6 mbd) to under 13% (of 93.0 mbd). That limits their pricing power.

Elasticities tell the story. The short-term price elasticity of demand is about -0.2, the medium-term one of course is more elastic at -0.5 or greater. [In most energy markets the income elasticity of demand is roughly 1, though recent work finds it is less in the OECD.] So if the Saudis cut output by 10%, global output falls about 1%. That means prices rise 5%. But with the quantity they sell down 10% and prices up only 5%, that means their income falls by 5%. With a population burgeoning in numbers and expectations, and as the ideological seat of the Wahhabi sect that fuels radical Islam – but so far has not seen cause to bite the Saudi hand that feeds them – well, the kingdom can't afford a large income hit. Oh, and they're consuming what to me is a surprising amount of oil.

One other bit of economic logic reinforces this argument: when interest rates are low and prices are low, it makes sense to leave oil in the ground rather than to pump and sell it. Selling turns oil into bank deposits, and those earn nothing. Leaving oil in the ground also provides the option to benefit from future price rises [though the option loses its value if prices fall further]. So do you want to store your oil in the ground, or store your oil in the bank? (Those with finance acumen can do the corresponding net present value calculation, and maybe even put a valuation on the option.) For the Saudis, pumping oil makes sense only if their focus is cash flow rather than maximizing national income.

Now if OPEC (or at least the Middle East subset) was a true cartel, the Saudis could count on others cutting back as well. That changes the arithmetic in favor of cutting output. But Iraq needs to pump every barrel they can, and Libya and Iran as well. Such lack of discipline is reflected in the history of OPEC: in the past, whenever prices were low, attempts by the Saudis to drive up prices were offset by rampant cheating by other OPEC members. There's no reason to think today would be different. But in the past the Saudis were big enough to go it alone; today they're not.

Now the other part of the accusation is that the Saudis are after market share, not revenue, and that by keeping prices low they'll drive new entrants out of the market (which means production in the US! - they're our friends?). Of course [to an economist!] in general the predation story does not make sense, because would-be predators incur up front costs that typically far offset any putative longer-term gains. But in this case the story is worse.

Yes, many firms in the oil patches of North Dakota, Oklahoma, Texas and Ohio/Pennsylvania are bleeding badly or in bankruptcy; rig counts this year are down by 50%. But Chapter 11 bankruptcy is a wonderful thing, however horrible the overhead can be in delay and legal fees. Debt disappears, businesses do not. For those businesses that are not viable there's Chapter 7 bankruptcy. The businesses vanish, but the assets get sold – they don't disappear. Yes, skilled workers will scatter, but theirs is a geographically mobile existence and they can be enticed to show up again. (The on-again off-again nature of such work is one reason wages are so high.) Oh, and 50% remain, and those 50% are drilling in the best spots and/or have the lowest costs. So the moment the Saudis think they've won and ease up on the pump, well, the US industry will be back in business. What then would the Saudis gain? – a period in which they get less money for what they pump, but no ability to enjoy years of high prices! The Saudis understand this very well.

In sum, the claim that the Saudis are pumping a lot of oil to try to drive new producers (particularly US frackers) out of business is ludicrous. To reiterate, low prices may curtail additional drilling today, but that's scant help to Saudis in keeping prices high tomorrow and the day after.

Data: Energy Information Agency, Monthly Energy Review. Using "Total Petroleum and Other Liquids instead of "Crude Oil Production" does not change the percentages more than a tad but production volumes are higher. The historic series for the latter longer, so I created a second chart. For rig counts and other current data, see WTRG Economics.

Further reading:

Butler, Nick. "Oil Prices – The Saudi Dilemma." FT Blogs | Nick Butler, August 16, 2015.

This is a puzzling presentation of the predation line by an experienced and generally thoughtful energy analyst. What Butler is saying is that the new King Salman bin Abdulaziz al-Saud and his young (age 30) economics deputy Crown Prince Muhammad bin Salman don't understand what they're doing. (On re-reading he doesn't mince words, stating the King, age 79, and oil minister, age 80, are "out of touch.") I'm a sceptic, and believe it really is in the leadership's interest to pump a lot of oil – but history is full of potentates in their dotage who aren't well advised, or (in this case, with the King a newcomer) who in the interest of cementing their hold on power ignore experienced advisors whose tenure goes back to their predecessors.

Gately, Dermot, Nourah Al-Yousef, and Hamad M. H. Al-Sheikh. 2013. “The Rapid Growth of OPEC’s Domestic Oil Consumption.” Energy Policy 62 (November): 844–59.

It's not just China that's increased petroleum consumption. I was surprised by the magnitude of OPEC's thirst, I obviously need to work against my presumption that populations in the Gulf region are too small for their consumption to matter.

Hamilton, James D. 2008. “Understanding Crude Oil Prices.” Working Paper 14492. National Bureau of Economic Research. http://www.nber.org/papers/w14492.

This is a good overview of issues. Warning: Hamilton is among other things a very good econometrician, and the overview assumes a familiarity with the technical jargon of economics, e.g. "random walk without drift". He blogs (with Menzie Chinn) at Econbrowser.

Hochman, Gal, and David Zilberman. 2015. “The Political Economy of OPEC.” Energy Economics 48 (C): 203–16.

They provide more (and more current) detail than Hamilton on the behavior of OPEC. It is as the name plainly says an "organization." It is (empirically) not a cartel, whatever pronouncements individual oil ministers may make from time to time. Remember, to an economist deeds speak louder than words.

Thursday Update (albeit posting late)

Mike Smitka

I do a weekly radio segment on the economy on WREL, the local Lexington Virgina AM radio station. Here are my notes from the Aug 20th show. These are not necessarily the order in which I presented them, and I avoid numbers when I can - radio is not the medium for conveying data – but I like to have them in front of me.

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Employment: I won't talk details, but job growth continued to trend somewhat above population growth, with no sign of acceleration. Projecting out, as I've mentioned periodically for the past two years, we won't return to normal levels of employment until 2017 and more likely 2018. I'll return to that topic later in the fall.

New Residential Construction: The latest data were out Tuesday [Aug 18]. The showed slow improvement, especially for multifamily units, the latter something we've seen all this year. For all the feel-good headlines, residential construction is still only level of January 1992 when the population was 20% smaller [321 mil today vs 255 mil then]. Corrected for population growth, the adjusted rate is still below any point of the last 60 years – we're at about the 1990 trough, but still below the level of the early 1980s housing bust. [If numbers are bad on radio, graphs are worse, but I can include here!] The recent peak was in January 2006. Today we're at half that level [49%] in per capita terms. Times are good only if you don't remember what things were like a decade ago, before the Greenspan-Bush bubble burst: relative to April 2009, well, housing starts are 2.4x that level! The bottom line is that housing continues to be a big drag on the economy.

CPI:  headline CPI for July was 0.2%, and for January - July [compounding the geometric average of 0.09%] it averaged an annual rate of 1.0%. Now there's the drop in gas prices, while food prices are falling despite the California drought. Those pull down the headline number; inflation less food & energy is higher at 2.3%, though for past 3 months that number has trended down. [A query for my students come September: how volatile are the data? – do 3 months a trend make?]

The standout: services excluding energy-related rose at 2.8% and shelter at 3.5%. But "medical care commodities" rose only 1.9% and "medical care services" only 2.2%, both below overall the "core" rate of inflation and both below the level for recent years, perhaps reflecting cost controls of Medicare.

Too many numbers to discuss but: 16% trimmed-mean CPI and median CPI are down a bit to 2%, sticky price CPI at 2.1% is up a bit. As noted, overall headline rate 0.2% from year ago, but headline inflation less food and energy was at 1.8%. All combined, the data don't indicate a trend, up or down.

Energy: I was in California recently, and saw gas prices well over $4. Returning to Virgina, I was surprised to see prices approaching $2. Lower oil prices have had a huge impact – though CA has more taxes and due to smog issues a more expensive type of basic gasoline, so their prices won't get as low.

Separately, the drill rig count is down 50% so far this year. Of course the half still drilling are doing so in the most productive geologies. Well output drops quickly in places such as North Dakota and Oklahoma (falling by half over two years – my recollection is the rate is faster). So total output won't keep rising, but with continued drilling neither will production collapse. Meanwhile the weak global economy means demand isn't strong.

Is this collapse due to a Saudi conspiracy, to preserve their market share? That misses the arithmetic of what output changes do: the Saudis are today a smaller part of global market and their behavior has less impact. If they cut output 10% or about 1 mb/d, it could – would! – drive up prices. However, my back-of-the envelope calculations suggest prices would rise by perhaps 5%, not by enough to increase their revenue. So this [-10%+5%] implies their income would drop 5%. With a burgeoning population (and an ever-bigger royal family!) that has high expectations, the Saudis need money to buy off their people. It's made worse by the royal family's dependence on the Wahhabi movement, which provides the religious foundation of (Sunni) Islamic fundamentalism. The Wahhabis helped the Ibn Saud gain power, and the House of Saud supports them today, bankrolling Wahhabi schools around the world. There's plenty of irony that our "good friends" the Saudis support the movement behind the ideology of terrorism. In contrast Iran's Sunni fundamentalism is more nationalist than terrorist – indeed they are quite effective in fighting ISIS and el Qaida. Why are they our enemies? That's a topic for Mark Rush (W&L politics) and Pat Mayerchak (retired VMI Intl Studies) on their WREL radio segments, as both are are knowledgeable about and have lived in and visited the region.

ACA: In California I attended a nursing conference along with my wife, and as part of a presentation on the Affordable Care Act. There I saw a video put together by a reporter who asked people on the street about ACA and Obamacare. What the reporter found was that most hated "socialist" Obamacare, but loved the Affordable Care Act. Of course they are one in the same thing. If the people on the street base what they say on their personal experience with ACA, they seem to understand that it does what the name suggests, the policy has been a success. But the average person is unable to connect that with what they hear on Fox news. Even media not dominated by preconceptions contributes to such confusion, as they hear "balanced" reporting that gives air to "the other side" – even when the facts show there is no other side!! Of course these healthcare professionals have to deal with patients who through the internet and advertising and talking heads "know" what ails them and which medications they need. It was (hopefully!) a sobering lesson for the healthcare professionals who comprised the audience, though the clip was shown because of survey data suggesting healthcare professional have very little understanding of the ACA.

This should serve as a caution as the Republican primary heats up. Most of what I've heard doesn't make sense, and some of what is coherent is either wrong or would be bad policy, not producing the results the candidates presume. The primary is about putting together sound bites, not putting together policy. As we approach next year we'll have platforms and position papers and issue speeches, but for the moment most of what is said on the hustings leaves me as an economist speechless, that is, I have nothing to analyze.

Interest Rates: the Fed has already been acting. The taper is over, and long-term assets are falling, from $2.09 trillion to $1.94 trillion or -9%. Most of the other special lending has been nil for 5 years. While 30-year rates not as low as early this year, they have been falling since June and are under 3%. As I claimed at the time, the taper in fact didn't lead to rising rates. Now the Fed is indicating it will likely boost short-term rates by the end of the year, which will surprise no one, most of all financial markets. Remember, too, that rates are 0% and thus "boosting" will be to raise short-term rates to 0.5% at most, which is still low! Anyway, in expectation of this increase 1-year rates have gradually risen to 0.4% and 3-year rates to 1%. Those rates are still extraordinarily low, and the implication of a fairly flat yield curve is that a 1-year bond in 2018 will yield only 2.5%.

The bottom line: markets expect interest rates and inflation to remain very low for years to come.

China: there's lots of talk of depreciation, but it's really a dollar appreciation. Indeed, once we recognize that China trades with the whole world – Europe is more important to them than North America – the RMB (the currency's official name, it's the yuan in common parlance) is in fact stronger than a year ago. Why? – because the dollar is stronger relative to the currencies of Europe, Japan, Korea and Southeast Asia as well as Canada and Mexico. The flip side is that it's a great time to be an American tourist abroad. Japan is cheap – my wife and I stayed in a home through Airbnb at $50 a night – and Paris was reasonable. London is still expensive, but they're not on the Euro. Anyway, to date the change is fairly small at 4%, well within the range of volatility of major currencies, and much less than the dollar has strenghthened against the bulk of China's trading partners. [See the previous post on this blog.]

The bottom line is that still leaves them with a stronger yuan relative to a year ago, and certainly relative to 3 years ago. If their intent was to boost their economy, they needed to push the yuan down a lot more!

Furthermore, China is doing what we're asking, liberalizing their markets. Chinese savers (which includes lots of companies that can no longer find investments equal to their cash flow) don't have diversified portfolios. All their assets are domestic, and they are heavy on stocks and real estate and bank deposits that pay 0%. So foreign assets appear very, very attractive, particularly as their stock market crashes. And we're poised to raise rates, while longer-maturity Chinese rates are falling (not that the average saver can tap longer-term markets). So if you were Chinese where would you park your savings? at home in yuan? No, overseas in dollars!! So with everyone wanting to buy dollars, of course the price of the dollar rises and that of the yuan falls. (Given the lack of experience of players in China's markets, that also gives rise to a trend of a falling yuan that gives all the more encouragement for trend-driven Chinese investors to buy dollars while the getting is good.)

For my Econ 398 students: Rudi Dornbush explored this in one of the early rational expectations macro models, though we'd have to devote a couple class days to and likely won't spend much time on open economy issues.

China: yuan depreciation or dollar appreciation?

by Mike Smitka, Economics, Washington and Lee University

The coverage I've read focuses, implicitly or explicitly, on the RMB [yuan 元] / US$ rate, that is, the bilateral context. (An exception is the graph in the latest Economist article, The Devaluation of the Yuan: The Battle of Midpoint, 15 Aug 2015, 63). Their focus is however capital flows, which as I've blogged about before in "China's Pending Depreciation" [on this blog] and "Foreign Exchange Controls" [on my Econ 274 "China's Economy" class blog] will lead to a fall in the value of the yuan – exactly what's happened.

Ho, hum: the 3% change still leaves the yuan stronger than in September 2008

China however trades with the world, not just with the US. Indeed, in 2008-10 [BIS weightings for their trade index, which includes 68 countries] Korea and Japan accounted for 23.8% of China's trade, the Euro area 19.4% and the US 19.0%. More detailed data for 2013 [essentially all countries] show that Japan plus Korea accounted for 14.1% of China's overall trade [imports + exports], the Euro zone at 10.4% [and Europe as a whole at 17.6%], the US at 12.5% [and NAFTA at NAFTA 13.8%], and ASEAN at 10.7%. So while trade with the US matters, Europe as a whole is more important than North America, but it is Asia that really matters.

Let's look at the data. First, the Bank for International Settlements calculates a trade-weighted exchange rate index for 68 countries, and also calculates an inflation-adjusted "real" exchange rate index. (China has had higher inflation that the US, for example, which over time works to appreciate China's currency relative to the nominal dollar rate.) Since the onset of the financial crisis in September 2008 the yuan has risen by 27% in nominal terms, and [the blue line] 32% adjusting for inflation. That has made life significantly more difficult for would-be Chinese exporters, who in labor-intensive sectors such as shoes and garments have not been able to increase productivity. The result is a hollowing out of manufacturing in those areas, with jobs moving to Vietnam and Bangladesh.

Then there are the incendiary headlines, such as Jared Bernstein's "Q&A’s on China’s big currency devaluation" at the Washington Post. I'm sorry, going from 元6.2/US$ to 元6.4/US$ is only a 3% change, not a big devaluation. It's not unusual for the Euro or the Japanese Yen to move that much in the span of a day or two. Furthermore, it still leaves the yuan stronger than it was in September 2008. Ho, hum.

In contrast, over the last 12 months, relative to the US$ the Japanese yen has depreciated by 21.2%, the Euro by 20.6%, the Korean won by 16.3% and the Thai baht by 11.6%. Against that the Chinese yuan has only fallen by 4.3%. Relative to its major trading partners, the Chinese currency hasn't fallen, it's gotten stronger – and that includes the US if we go back before August 2011.

Instead, we should really be viewing this as a dollar appreciation. Our short-term interest rates are poised to rise above zero; those elsewhere remain at or near zero. That makes US assets look attractive, and (tech stocks aside) our stock market also looks sensibly priced relative to (say) China. Thank goodness for China "fixing" its rate, despite $250 billion worth of outflows of "hot" money. Absent such "unfair" behavior, the yuan would surely have depreciated by far more!

Click on graphs to enlarge.