Thursday, October 1, 2015

Teacher Pensions are Well Earned

An article with this title, written by Michael Hiltzik, recently appeared in the Los Angeles Times. In LA Times fashion the article, more an editorial than newsworthy, nonetheless appeared on the front page of the Sunday Business Times. The article caught our attention, not just because of an interest in public pensions, but also for the indispensable work of public school teachers.

In the piece, the writer singles out a teacher with 30 years' experience in the Los Alamitos School District, a small district outside of Los Angeles. The teacher is mentioned by name in the article (presumably to lend credibility) which we won't do here. Our argument is not with the retirement pension of this teacher, or of any teacher in particular. This educator spent 30 years in front of a classroom, made payroll contributions to her retirement plan and is entitled to rely upon that pension income in her retirement.

This case, however, illustrates a point about public employee pensions and those calling for reform. The reform effort, proposed in California for the 2016 electoral ballot, along with local measures passed several years ago in the cities of San Jose and San Diego, do nothing to touch existing retiree or current employee pensions. Rather, the reforms, are effective only for prospective employees, yet to be hired. This simple fact, is what makes the anti-reform efforts of the public unions and editorials like this one in the Los Angeles Times, so peculiar.

But let's go to the core of Mr. Hiltzik's argument. The teacher in question, now 61, will soon enjoy a lifetime annual pension "in the range of $100,000", representing approximately 90% of her highest year annual salary. Mr. Hiltzik goes on to characterize that pension as "decent". Now, if a pension of 90% of salary is considered "decent" in the world of state and local government, then literally millions of private sector workers are living indecently. Saving an account balance through an IRA or 401k that will generate lifetime retirement income of 90% of highest year salary is virtually unheard of in the private sector. 

Mr. Hiltzik, however, continues to justify this level of retirement income by pointing out that the teacher "funded much of her pension from her own paycheck, a contribution that comes to 9.2% of her pay this year". This now reaches to the point of this post. While no one would like to see this teacher's retirement income, so well earned, so well funded and, well so decent, to now be changed. But what we must also consider, is that this lifetime pension of $100,000 per year (adjusted for cost of living increases) must actually be paid by someone, in this case, the school district and the CalSTRS public employee pension system.

But then again, if Mr. Hiltzick's representation that the teacher has funded much of her pension is true, then what's the concern?  Now, this is where we need to drag some math into the conversation. If the teacher's pension is $100,000 and it represents 90% of her highest year salary, then her salary, by simple mathematics would have been roughly $111,000. That would mean her payroll contribution in her highest year, at 9.5%, was $10,555. This would be her contribution, though, for just her highest (presumably last) year of employment. Her average salary over her total employment, we can assume was approximately $60,000. That would imply total pension contributions over 30 years were on the order of $170,000. Investment earnings, to a varying degree, would have been earned on those contributions, so for arguments sake let's say the current value of this teacher's contributions, plus interest are approximately $350,000.

Let's now consider the value of the pension to the teacher and, most importantly for this discussion, the cost of the pension to the public agencies that must provide it. Investment professionals use a rule of thumb for spending in retirement from a 401k or IRA of 4%. Using this metric, a portfolio that produces $100,000 in annual income, would need to be precisely $2,500,000 in size. So, in effect, our teacher is indifferent to an annual lifetime pension of $100,000 or to having been given a lump sum of $2.5 million, from which she can draw 4% per year.

But let's also consider the impact of this one pension on the public agencies that are required to provide it. These public agencies are holding roughly $350,000 from our teacher's lifelong payroll contributions, plus investment income. With a pension liability for the agencies that amounts to $2.5 million, our teacher's pension is underfunded by $2,150,000. Magnify this case, by literally millions of public employee pensions and you can begin to appreciate the enormity of the public employee pension crisis and its impact on local governments and their taxpayers.

Wednesday, September 23, 2015

Chicago Hikes Taxes to Pay Public Employee Pensions

Mayor Rahm Emanuel at City Council Meeting on 2016 Budget
Chicago Tribune
News broke this week of a proposal by Chicago Mayor Rahm Emanuel to hike property taxes for city residents by $588 million over the next four years. Tax increases are certainly not uncommon, but what caught median attention was the direct link between the need to raise taxes and the fact that the tax revenue would be directed to shore up underfunded public employee pensions. Community residents suddenly find themselves faced with the stark reality that their ability to fund their own retirement savings will be compromised by the city's need to fund the retirement of its employees.

The news followed recent downgrades of the City of Chicago in May 2015 to junk bond ratings. In lowering the city’s rating, Moody’s Investors Services cited “the city’s highly elevated unfunded pension liabilities” continuing, “we believe that the city’s options for curbing growth in its own unfunded pension liabilities have narrowed considerably.”  This thus points to the most troubling concern about public employee pension liabilities: that even well-intentioned efforts at pension reform may take years to slow the growth of unfunded liabilities.

For taxpayers of the City of Chicago, the pension deficits of the city are additive to those of the State of Illinois.  In a working paper of the Harvard Kennedy School of Government in 2012, the authors estimated that the household public employee pension burden of taxpayers in the City of Chicago – that is, each individual family’s share of unfunded public employee pension liability - totaled $81,118, comprised of $41,966 for their share of City of Chicago liabilities and an additional $46,152 for the share of State of Illinois underfunding.  If you happen to live in the City of Chicago, you might want to start planning for how you will pay this obligation.  Failing an economic miracle or a Federal bailout, the taxpayer is the only resource for paying this deficit.

Pension liabilities have now been cited as the reason for credit downgrades in Connecticut, New Jersey, Pennsylvania and Puerto Rico, as well as for the cities of Cincinnati, Philadelphia, Detroit, Chicago, Evanston, Omaha, Jacksonville, Des Moines and Minneapolis, among others.  These credit downgrades stand apart from the local governments that have suddenly and dramatically been plunged into bankruptcy like the cities of Stockton, Detroit, San Bernardino, Vallejo, Harrisburg and Central Falls.

For states, like the State of Illinois, the problem is even more complex. While cities, individuals and private businesses can reorganize their liabilities in bankruptcy, no such provision exists for the states, at lease under current law. Without the legal ability to restructure their pension obligations in bankruptcy court, states faced with pension deficits similar to those of Illinois must opt for one of two unenviable choices. They can raise taxes, where possible to fund the replenishment of their pension fund, or they can reduce general services to residents to provide budget relief for funding the shortfall.  But in many instance the tax route isn’t just unpopular, it’s simply not practical. According to Moody’s, to fully fund the City of Chicago’s annual required pension contribution would necessitate raising its property taxes by 95%.

A recent report of Alliance Bernstein quantified the annual pension costs, debt service and fixed charges of the City of Chicago at 40% of its general fund budget. That would mean paying just these items, would require that all the other vital services of the city, including police, fire, sanitation, public works, etc., must all get crammed into an ever shrinking portion of the pie, now just 60% of the total budget.

So just what happened to turn these pension funds so horribly upside down?  First, in the case of the Chicago Police Benefit Fund, average salaries grew by 55% over the past fifteen years, or roughly 4% per annum – not unreasonable.  Average pension benefits, however, grew by 79% over this same period, while the number of former employees receiving retirement benefits increased by 45%.

Modest annual salary increases, coupled with rising benefits and an accelerated population of retirees, spelled soaring benefit payouts for the fund, with total retirement benefits growing by 160% over the same period. Plan contributions simply failed to keep pace. The solution, it now appears, falls squarely on the shoulders of its taxpayers.

You can read more about the US state and local government pension crisis in my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon, iTunes and Barnes and Noble bookstores. 

Wednesday, September 16, 2015

Election Year Spin on Social Security

Bernie Sanders' campaign for the White House has triggered a firestorm of rants, tweets and accusations about Social Security, thrusting the now seventy year old program to center stage in a forum of election year theatre. Sanders' charges, often wrapped in outright inaccuracies, are carefully aimed at a demographic the candidate knows to be voter-ific: aging Baby Boomers. Most, or at least half, of this generation are wholly unprepared for the expenses of retirement, while the other half is, well, just modestly underfunded. Both will be dependent on Social Security in varying degrees, a program that is suffering a mid-life crisis of its own.

The purpose of this post is not to offer my opinions on Social Security, but rather to simply state the facts, as more officially presented to Congress by the Trustees of the Social Security Administration in their 2015 Annual Summary on the Social Security and Medicare Programs. Both the summary and the full report of the Trustees can be easily accessed on the internet or through the link provided in this post.

Sanders' claim of the "myth of Social Security insolvency" is quickly followed by accusations that Republicans plan to "cut benefits" to retirees. Boy, I tell you, it's enough to get a retirees' blood to boil. Then again, maybe that's the point. But in Sanders' attempts to sway public opinion for his electoral purposes, the blatant misstatement of the facts surrounding Social Security actually does far more harm than good for the program and to the millions that depend upon it. 

In an article from earlier this year in the Des Moines Register, entitled "Social Security; Expand it don’t Cut it", the Senator was quoted, 

"Republicans are trying to convince voters that Social Security is in crisis. Let's not kid ourselves: We do have an urgent problem on our hands, but it's not Social Security. Millions of middle-class Americans are facing a retirement crisis as a result of inadequate income and growing wealth inequality. Social Security isn't the problem. It's an essential part of the solution."

While the Senator is correct about the latter part of his comments, he's dead wrong about the former. Social Security is most definitely in crisis, at least according to the Trustees of the Social Security Administration. Perhaps before moving on, we should spend a moment and define who the Trustees actually are and what their role is in all of this. 

By law, there are six Trustees of the Social Security Administration or Trust Fund. These are, the Secretaries of the Treasury, Departments of Labor, Health and Human Services and the Commissioner of Social Security. The two remaining Trustees are public representatives who, along with the aforementioned cabinet members and Commissioner, are all appointed by the President, or in this instance, specifically by President Obama, a Democrat. That being said, it's really not rational to dismiss the comments in the report, or at least not to 
discount them as a Republican ploy.

Here, then, are direct quotes from the 2015 Trustee report to Congress. Decide for yourself if Social Security insolvency is a myth, as Senator Sanders argues:

“Social Security and Medicare together accounted for 42% of total Federal program expenditures in 2014”

“Both Social Security and Medicare will experience cost growth substantially in excess of GDP through the mid-2030s”

“Social Security’s Disability Insurance Trust Fund now faces an urgent threat of reserve depletion by 2016”

“Beyond DI, Social Security as a whole as well as Medicare cannot sustain projected long-run program costs under currently scheduled financing”

“The Trustees project that the Medicare Trust Fund will be depleted in 2030”

“After 2019, Treasury will redeem trust fund asset reserves until depletion of Social Security Trust Fund reserves in 2034”

Seems fairly straightforward to me that there's an urgent problem with not just Social Security, but Disability Insurance and Medicare. Now why would Bernie Sanders be arguing something altogether different?

For more detail on Social Security and the broader retirement crisis in America, please see my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon, iTunes and Barnes and Noble bookstores. 

Thursday, September 10, 2015

Are Stocks Headed Lower?

This is, of course, the question foremost on investors' minds. After all, it's been several years since we've seen a correction to the major averages that stocks have experienced since mid-July. True to form, market swoons of this sort seem to come out of nowhere. Yet as one market sage was quoted, "no one rings a bell at the top". But did we see the market top on July 20, or are we poised to consolidate and move higher?

Visit any financial news website and there are plenty of commentators quick to provide an expert opinion. But of course, no one really knows where markets are headed. We simply try, as best we can, to make informed judgements (or as some have called them, "bets"). 

If you look closely, though, the data have been quietly sending indications of direction. The plunge in oil prices earlier this year seemed to have caught investors (and oil company executives) completely off guard. Oil prices that had hovered in the range of $80-100 per barrel for five years, began a move in the latter part of 2014 that can only be described as a plunge. Now settling in the low 40s, equity investors are considering the implications of these new levels for global industrial demand and GDP.

But there were warning signs of oil's imminent decline that now appear more clearly in hindsight. A robust and vibrant US oil sector, with highflying fracking stocks like Pioneer Natural Resources, EOG and Oasis began to wobble in 2014, but only after their drilling and exploration counterparts that lead production, like Halliburton and Schlumberger, faltered. Prior to this, warning shots were fired by HiCrush and US Silica that make the key raw materials integral to the fracking process. But the real leading indicators we now see were in specialty energy companies like Geospace Technologies that make seismic data analysis tools and provide critical research for drillers and oil exploration companies. Their stock began crashing in late 2013 and should have signaled the "canary in the coal mine" for anyone interested in the direction of oil demand, supply and price.

Oil aside, however, the abysmal levels of a broad range of commodity prices, from copper to steel, has investors questioning global industrial demand. With prices for many of those commodities now believed to have been artificially inflated by China government investment (i.e., building empty cities and bridges to nowhere) everyone is a bit concerned about the veracity of sustainable global demand. Commodity dependent economies like Brazil, South Africa and Australia are unquestionably suffering ill effects, as a result of the reduced demand. These effects are echoing throughout the emerging markets. They are also being felt in the US high yield bond market, where many small energy companies financed their growth and development and now struggle to meet debt service.

With the US and EU economies piddling along, all eyes for now will remain on China. As government mal-investment there subsides, investors are questioning whether there is really internal demand to support consumption or growing global demand to boost exports? The answer, from the most recent data, appears to be a resounding no.

Thursday, September 3, 2015

Will China Selling put Upward Pressure on US Treasury Yields?

There's been more than a little attention devoted to this question lately. The concern follows reports that China has been selling portions of its massive US Treasury holdings to support a destabilized Yuan. 

Marketwatch had a nice piece this morning that should dispel much of investors' concerns. This chart from Marketwatch shows net flows of foreign private and official sector purchases of Treasuries. Despite recent selling pressure, private sector purchases appear to be more than offsetting the selling of foreign governments.

Here are some other factors to consider that should equally support US Treasury prices, if not exert downward pressure on bond yields. First, as reported elsewhere, China cannot dump its holdings of UST for fear of price instability and also the question of where to go to reinvest some $1.2 trillion of proceeds. Second, if the world is really trending towards deflation, as is being reported, US Treasury bonds will climb in value. As inflation erodes the value of fixed income securities, deflation produces just the opposite effect. Third, lower US budget deficits (for however long that lasts) will decrease UST new issuance. Fourth, US pension funds are increasingly talking about "de-risking" their investment portfolios, by selling equities and corporate bonds to move into US Treasuries and other safer investments. 

Given these considerations, don't be surprised if near-term the 10-year heads back towards its January 2015 low of 1.68%, particularly if there's a flight to safety trade following a stock decline.

Friday, August 21, 2015

Means Testing Social Security

Chris Christie's recent comments about means testing Social Security benefits set off a torrid of accusations of Republican cuts to Social Security. Leaving aside the obvious fact that Governor Christie is only one of more than a dozen candidates running for the Republican nomination, critics nonetheless seized the opportunity to indict the entire party for mistreating senior citizens. Social Security reform has been called the third-rail of American politics, and Christie received quite a jolt.

But what is means testing about and can it help restore the solvency of the Social Security Trust? As discussed in previous blog posts, the 2015 report of the Trustees of the Social Security Administration clearly spells out the trouble ahead for Social Security. By their estimates, Social Security will be insolvent by 2034, with the Disability Insurance component becoming insolvent next year. The Trustees point to the present value deficit of the Trust Fund, now running $10.7 trillion. Argue all you will about what to do, but clearly something must be done, unless our intent is to bury our heads in the sand and simply leave the mess to future generations.

With a deficit that large, there are only two possible avenues to cure the problem: increase payroll taxes to boost the income side of the equation, or reduce outflows. Those leaning left advocate the former, those leaning right, the latter. We've pointed out in other blog posts, though, the limitations and consideration with raising the payroll tax rate. So let's spend a few moments examining other options.

Means testing, as discussed by Governor Christie is an attempt to gradually reduce outflows of Social Security by reducing benefits for those who need them least: the wealthy. The idea is test the means of financial support of retirees, before providing scarce resources from an impoverished and soon insolvent Social Security Trust Fund. Left leaning opponents of this plan are quick to characterize means testing as a Republican attempt to cut benefits, when in reality, it is simply attempt to limit benefits to the wealthy. 

Paul Krugman blogged about this earlier this week from his platform as acting-editor of the New York Times in a sensational piece entitled, "Republicans Against Retirement". Catchy, no?  In bolstering his argument that means testing is impractical, he and other Democrats with political aspirations, point to just one study on the topic, a sloppy bit of economic research by Dean Baker of the Center for Economic and Policy Research. That study based upon 2009 data, concluded that means testing would save very little, as "more than 75% of Social Security benefits go to individuals with non-Social Security incomes of less than $50,000 per year". Sounds reasonable.

But let's stop and think about this. First, this is 2009 data, that comes at the depth of the greatest recession since the Great Depression. Second, Baker is not referring to those individuals with pre-retirement annual incomes of less than $50,000, but rather those in retirement claiming income for tax purposes of less than $50,000. So he is measuring retirement income from a combination of pension income, private investment income and capital gains, and taxable distributions from 401(k) and IRA accounts.

As you might imagine, retirees, like everyone else in America, are doing their best to manage their tax liability. Thus, retirees are only reporting investment income to the extent they must, often choosing tax-exempt investments like municipal bonds, and avoiding capital gains on stock investments. Thus, someone who has $10 million invested in tax-exempt bonds, and earned $500,000 in annual investment income, would record non-Social Security income of $0.00 (assuming they had no pension or other income). Similarly someone with an IRA of this same amount may choose to take distributions of $50,000, as a prudent way of managing income and tax liability.

But let's leave these obvious considerations aside (as does Mr. Baker in his analysis). Let's also ignore the fact that we're working with income data that is six years old. The point is, Baker's study still reports that 3.4% of Social Security benefits are provided to retirees with greater than $80,000 per year in non-Social Security income. With total benefit outflows of Social Security last year of just over $706 billion, were these benefits means tested and reduced, the annual savings to Social Security would thus be in the range of $24 billion per year. It may not fix the entire problem, but that ain't chump change to a system with a $10.7 trillion deficit. 

Wednesday, August 12, 2015

What's the Real Level of US Debt to GDP?

One of the most widely used metrics for analyzing the level of debt of a country or sovereign government is Debt to GDP. The idea is that in comparing the overall government debt of Japan to China, for instance, the absolute amount of government obligations needs to be viewed in the context of the size of the economy, as measured by Gross Domestic Product. Countries with larger economies, like the US and China, can sustain higher levels of debt, because the tax base available to them for servicing the debt is so much bigger than, say France or Portugal.

The World Bank publishes Debt:GDP ratios for all major industrialized nations as well as developing economies. Alarms began to sound in 2010 over excessively high levels of debt to GDP in Greece. By 2012, the last year of World Bank published data, the debt to GDP ratio for Greece had climbed to 167%. More economically stable economies like that of Denmark, Finland, Germany, Australia and Canada, have ratios in the range of 50%. 

While debt to GDP ratios in the West have been rising now for several years, developing economies like Bulgaria, the Czech Republic, Guatemala, Latvia, Nigeria, Peru and Uganda tend to evidence ratios that are far lower, generally below 30%. Of increasing concern, though, are industrialized nations of Europe like France, Italy, Ireland and Portugal, who along with Greece, each now report ratios of greater than 100%, a benchmark that signals distress.  

Of great concern are the debt levels of Japan, now roughly 200% of GDP, a level from which most economists believe it will not be possible for Japan to safely manage its debt, without risk of great financial calamity. Harvard Economics Professor Kenneth Rogoff and Carmen Reinhardt in their highly acclaimed work, "This Time It's Different" show that debt to GDP levels of higher than 90% lead to sharply lower rates of growth for economies, going forward.

Amidst these "problem" economies, the US shows a ratio of 96% as recently as 2013 in the World Bank analysis. This figure reports what is known to as "gross debt", a number that is also often reported on a net basis. The difference between net and gross is the treatment of debt the US government owes to "itself" or specifically Medicare and Social Security. This topic is discussed at length in other blogs on this site.

But here's the catch. While US debt to GDP is considered borderline and not as excessive as the troubled economies of Greece and Japan, the US debt, even on a gross basis is understated on a global comparative basis. This is because few countries of the world have sizable levels of governmental debt undertaken at the state and local level. But in the US, the combined debt of state and local governments now totals approximately $3.1 trillion. When added to the US Treasury gross debt of $18.1 trillion this brings total US governmental debt to $21.2 trillion. Based on US GDP of $17.8 trillion for the 2nd quarter of 2015, this would place the US debt to GDP ratio at 119% (on a comparable global basis) higher than any other World Bank monitored country, save Japan, Lithuania and Greece.

Add in other liabilities of the US government, like the $10.7 trillion present value deficit of Social Security or the estimated $14.4 trillion present value deficit of Medicare, and the ratio becomes a downright alarming 260%.

Tuesday, August 4, 2015

Will Raising Payroll Taxes Save Social Security?

The dire findings of the 2015 report of the Trustees of the Social Security Administration has stirred public debate about whether a hike in the payroll tax rate can save Social Security. The Trustees' report once again alerts Congress to the looming insolvency of Social Security, now estimated by 2034, and of the Disability Insurance program, projected to become insolvent next year. The most expedient solution, if not the most practical, is to simply raise the payroll tax rate. Indeed, many have advocated just this. 

Proponents of a tax hike claim that by raising the rate by 2.3%, we could insure the solvency of Social Security for another 75 years. But part of understanding the status of Social Security is recognizing the many assumptions and forecasts that are embodied in the Trustees' report. For instance, the Trustees' report projects that OASDI costs will rise to just 6.2% of GDP by 2089. Really, 2089? The Federal Reserve can't even predict GDP next quarter and the Trustees are projecting what GDP will look like 74 years from now? Let's get a grip, people.

When Social Security was originally imposed, payroll taxes were just 2% of the first $3,000 of wages and salary, or a maximum of just $60 per year (roughly $1,050 in current dollars). By 1960, however, the tax rate had already tripled, on its way to today's current level of 12.5% (with these amounts equally split between employer an employee). That puts the maximum worker contribution in 2015 at just under $7,500 (with an equal contribution by employers) or seven times greater than what the maximum worker contribution was when Social Security was first enacted (adjusted for inflation). In fact, payroll taxes have grown so dramatically it's now estimated that 82% of American households pay more in FICA payroll taxes than they do in federal income taxes. Yet despite this growth in payroll taxes, the 2015 Trustees report estimates that the OASDI, the Trust Fund for Social Security and Disability Insurance is underfunded on a present value basis, by $10.7 trillion

In planning to raise the tax rate, we must also consider that in 2010, President Obama championed the idea of temporarily cutting the payroll tax rate, as a measure of economic stimulus for a then struggling US economy. Indeed we did, and the IRS gleefully provided the following statement to taxpayers:

"Millions of workers will see their take-home pay rise during 2011 because the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 provides a two percentage point payroll tax cut for employees, reducing their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid. This reduced Social Security withholding will have no effect on the employee’s future Social Security benefits." - IRS release, IR-2010-124, Dec. 17, 2010.

The New York Times ran a story that proclaimed,

"The biggest Christmas present that many people will get this year comes form the Federal Government, thanks to the tax bill that President Obama signed a week ago" - New York Times, December 24, 2010.

In 2011, pushing back on Republican opposition in Congress to extending the tax cut into 2012, President Obama challenged members of the GOP to "fight as hard for working class families as you do for those who are more fortunate". Who could resist?

So if a cut in the payroll tax rate provides economic stimulus by putting more dollars in Americans' pockets, particularly the pockets of working class families, wouldn't a tax hike do precisely the opposite, take money from workers paychecks and provide drag on the economy? Well, of course, it would. Americans like quick fixes, but I'm afraid solving Social Security will require a more elaborate plan than simply raising the tax rate.

Thursday, July 30, 2015

Why for Many this Might Still Feel Like a Recession

The first preliminary read of second quarter GDP was just released, showing an annualized rate of growth of 2.3%. This follows a revised Q1 post of 0.6%. All in, the US economy in the first half appears to have expanded at something like a 1.5% rate of growth. But the GDP report that we read online or in the newspapers will actually tell us very little about how we're doing personally or why for so many people this might still feel like a recession.

The official measure of GDP is compiled quarterly by the Bureau of Economic Research of the Commerce Department of the US government. It's intended to measure the production of all goods and services in the economy. The measure is then adjusted for inflation, compared to the prior quarter, and annualized. The result is what is referred to as the "real" rate of growth in the economy during the quarter, or simply GDP.

But the Commerce Department has no way of actually tracking inflation adjusted sales. If your bill at the grocery store is $200, the grocer doesn't report those sales to the government adjusted for inflation. Rather, sales data for your grocer and throughout the economy are reported on a nominal (or real dollar) basis as they occur. 

So how does Commerce get to the "real" inflation adjusted rate of GDP that we all read? Very simply, they start with total sales from all sectors, consumer, business, government, investment and adjust for the net value of exports (i.e., exports-imports). This total, or nominal GDP, is then reduced by Commerce's estimate of inflation. Different than the CPI that most of us are familiar with, Commerce uses a GDP price inflator, as its preferred measure of inflation. If inflation (or the GDP deflator) in a quarter were zero, for instance, then nominal and real GDP would be the exact same number. But it seldom is. So inflation is subtracted from the current dollar number to arrive at reported GDP.

Now, this being the case, we must also bear in mind that it's in the government's interest to report as high a quarterly GDP as possible. After all, politicians can point to (real) GDP as a measure of growth and the vitality of the economy. Negative GDP changes indicate recessions. Severe GDP declines, depressions. This is not to say that Commerce is cheating or cooking the books, but here's the point. GDP growth as we are all accustomed to seeing it, is a calculated number. It depends heavily on what GDP delator is subtracted from nominal GDP in order to produce the real GDP that we all read about. Again, not to suggest foul play, but by understating inflation, the government could (were they so inclined) artificially overstate the headline rate of growth in the economy. 

More to the point of this article, though, is understanding that whatever rate of inflation the government calculates, the number is only meaningful to us to the extent that the rate of inflation of the things that each of us actually buys, precisely reflects the "basket" of items used to comprise the GDP deflator. Now here's where this gets interesting.

Let's take 2015 Q1 numbers as a point of reference. For Q1, the rate of GDP (after revisions) was revised to show an increase of  0.6%.  In the Commerce report, they indicate that the growth of nominal production of goods and services, was 0.8%, indicating that the GDP price deflator (or the government's official measure of inflation) for the first quarter was 0.2%, or close to zero. None of you felt any inflation in the first quarter, did you?

And that's the point. The GDP deflator reflects changes in prices for a government calculated, theoretical basket of goods and services. Because it is a collection of items, however, each individual item will have its own rate of price inflation. Some prices may be rising, some falling but when you roll it all together and assign weightings, Commerce can compute an average price change, or GDP deflator.

Here's why this is so important.  Let's say that in Q1, when the GDP deflator was 0.2%, food costs rose by 3% and rents rose by 5%.  But these gains were offset by falling prices in electronics, computers and washing machines. The result was 0.2% overall, or virtually no change in inflation for the quarter. But let's also assume that you, personally, didn't buy a new washing machine or computer, but you did buy groceries and pay rent. Then for you, personally, the rate of inflation was (on an annualized basis) something closer to 4%. When this rate is subtracted from nominal GDP of 0.8%, then GDP to you felt like -3.2% - a deep recession.

This illustration points to the problem with the GDP statistic. As with much economic data, it is often reported on the basis of broad aggregates in the economy, in this case a broad measure of assumed inflation. By using aggregates to arrive at economic data for the economy as a whole, we may be losing sight of what the average consumer may actually be experiencing.

Friday, July 24, 2015

A Generation Empowered

A Generation Empowered's Analysis of the 2015 Social Security Administration's Annual Report and what it means to the Millennial Generation.