21st Century Economics

In the 60’s and 70’s, as the baby boomers moved into the marketplace, the flood of labor drove labor prices down and created intense competition for jobs. The early boomers - born in the late 40’s and early 50’s - moved into and up the corporate ladder fairly easily but they were still there when the late boomers - born in the late 50’s and early 60’s - arrived. This slowed expansion and limited movement up the corporate ladder.

This and other aspects of the massive movement of the baby boomers into the labor force have had far reaching effects on our economy and on the world economy. Many of these effects are not immediately obvious.

Let’s examine some:

As the competition for jobs increased, businesses found that they did not have to pay premium rates for labor to get a good labor force. Conversely, they discovered that they could grow in size of the labor force while keeping their percentage of investment in labor about the same. This allowed many companies to grow every large at relatively modest increases in labor costs.

For awhile, the large labor market and large company sizes worked well but when normal cost of living and inflation caused labor prices to rise, the companies found they had a glut of labor that they did not need and that productivity was inefficient. This set up the stage for massive layoffs in the late 80’s and early 90’s that eliminated entire layers of management and consolidated tasks into fewer workers.

The lower labor cost prompted many companies to NOT invest in labor saving devices such as robotics in the automobile industry. Meanwhile Japan did invest in robotics and other forms of automation and labor saving devices.

When the slowly rising labor costs did push US companies to re-examine their labor situation, they found themselves no longer competitive with foreign manufacturers and labor markets. This setup the massive movement to move labor off-shore and into cheaper third-world labor markets. The loss of revenue from the labor and taxes of the lost jobs created recessions in 1975, 1980, 1982 and 1990. The median household income dropped to a 14 year low in 1982 and dipped again to 1971 levels in 1994. During that same period, personal savings as a percentage of disposable personal income dropped to record lows in the late 80’s and has continued lower every since. It hit 3.8% in 1997, the lowest level in 58 years.

Because it took time to adjust the labor market and the productivity efficiencies to the global market changes, the business inventories versus sales ratio rose to a record high in 1991 of 1.80 before falling to a low of 1.35 in 1999. This 1991 figure meant that we had more supply than demand and prices, at that time, were not competitive. This put even greater pressure to lower prices to clear out existing inventories and to control production.

For reasons not entirely clear, there has been a remarkable correlation between the percentage of the labor force that is aged 16 to 34 and inflation. As the boomers moved through this age group in the late 70’s and early 80’s we saw double digit inflation. One theory is that the politics of the economy followed the mood of the voters - at that time, being more liberal than conservative. As he boomers move into their late 40’s and 50’s, we should be able to expect a more conservative economic policy being demanded by the voters.

As the work force ages, there will be changes in how the labor is performed. For instance, one grocery chain found that its employee turnover rate dropped from 400% per year to just 80% per year when they began to hire more older workers.

The middle boom years, 1964 to 1977 when birth rates were down, will create a relative scarcity of workers that will have the reverse effect that the boomers had. Labor wages will climb as companies compete for the fewer workers available. In fact, labor costs have risen by 45% over the past 10 years. There will also be a renewed interest in capital investment in labor saving equipment such as robotics and computer automation. This has created a large rise in investments in plant and equipment since the mid 1990s. It is therefore not a surprise that in 1997, the business investment in plant and equipment as a share of total economic activity rose to a record level of 16% in 1997 (not counting WWII years).

All in all, the demographic economy of the boomer labor force has been one of intense competition in a buyers (employers) market, over supply and lowered wages. In the later retirement years of the boomers, that trend will reverse and there will be an intense competition in a sellers (employees) market, a significantly reduced market and higher wages.

It should be noted that the present economic bull years when the boomers are investing heavily in business and industry, there have been significant expansions of those businesses. This is reflected in the lowest unemployment figures in decades. Unfortunately, when the bulge of the boomer’s prime employment years pass, the period from 1964 to 1977 produced a greatly reduced birth rate. This expanded demand plus the reduced supply will drive wage prices up, unemployment will remain low and there will be a major growth in incentives and benefits to attract and keep workers.

The market demand from the buyers controls the market supply from the sellers. In other words, the seller sells what the buyer is buying. If the demand increases, the supply will expand to meet that demand. There is often a small delay between rapid rises in demand before the supply catches up but this is not of particular importance to large slow swings of market demand as a result of demographic changes. (It can be a factor in fad or impulse marketing, however.)

It is an established fact that people in certain ages of life and career will, on average, buy certain things that are often in common with others in that same age of life or career. For instance, we know that, on average, people buy their first homes between the ages of 25 and 34. Most of this is common sense - you don’t market hearing aids to teenagers or toy dolls to senior citizens. In fact, nearly the entire market of a capitalist economy is based on this concept.

Having established this short list of facts that most of us will agree are intuitively obvious, let’s now look at some additional facts. These are FACTS that can be verified from a number of sources but perhaps the best is the US Census Bureau.

There are 71 million households (76 million people) that can be called part of the Baby Boomers - those born between 1946 and 1964.
An Echo Boom of 64 million people (currently making up 41 million households and growing) are the children of the Baby Boomers - are those born from 1977 to 1993.

Between 1964 and 1977, there was a relatively slow birth rate of 41 million babies.

In the next 50 years (1999 to 2050), the share of the US population age 65 or older will go from 12.5% today to 21% - a 68% rise.
The number of people 85 and older will grow to 19 million from just over 3 million today - a 533% rise.

In 1940, 7% of those 65 are expected to survive to age 90. Today, the figure is 25%. By 2050, 42% of the 65 year olds will survive to age 90. (Believed to be a conservative estimate)

These and other similar statistics make up what we call the demographic economics of the boomers and their effects on our economy. Because so many of us are actually a part of this group, we have not visualized it as an historical or unique event but simply the way life is. If you can step back and see this in perspective to what has happened to world economies in the past and how it will affects us in the future, you begin to see this a much more powerful and predicable series of events. And as you know by now, If you can predict an event, you can profit from it!

Imagine if you had been aware of this situation in the 1950’s - what would have been a good investment? How about everything related to schools? As the bulge in boomers moved from kindergartens, to elementary to high school, the demand for books, clothes, food and schoolteachers expanded to historic highs. Gerber foods, for example, doubled its sales in just two years from 1948 to 1950.

In the 70’s and 80’s, the real estate boom was entirely predicable. You had 76 million people competing for the existing housing and the demand exceed the supply for a long time.

If you had invested in industries that supplied this massive but evolving demand, you could have made a fortune - as many did.

In retrospect, you can see lots of missed opportunities but the nice thing about demographics of this kind is that the opportunities are not over yet. The boomers and echo boomers are still there and still affecting the economy in a very big way.

The massive bull market we have been experiencing is no accident and it surely is not the results of actions by our President or Congress - despite the fact that they try repeatedly to take credit for it. It is because 76 million baby boomers (roughly 27% of the entire US population) have moved into their peak earning and their peak spending years.

Sales of new accounts in mutual funds exceeded $1 billion in a 30 day period in January 1998 for the first time in history. In 1960, there was a total of $640 billion in all mutual funds. Now there is more than $7 trillion. Almost all of that was invested by the boomers during their peak earning years. The early boomers are already moving into the age of retirement. This is why there is now more money in mutual funds and other investments than ever before in history.

But it’s not a totally rosy picture. The boomers will move on to the next stage in life starting in 2007 when the oldest ones begin to reach retirement age. The related changes in their buying and saving habits will have a marked and profound affect on our economy and the world. In fact, it is predicted to be the worse economic period in our history and perhaps for the entire world will follow the boomers into retirement.

21st Century Economics will show you the what’s, why’s and how’s to survive this megatrend and how to profit from it. In fact, if you don’t profit from it, you will be caught in it and suffer significant financial losses and personal hardships. This is not a prediction, it is simply a fact that has not yet happened.

We will be updating this service on a regular basis with new information of what the latest active trends are so that you can get in on the earliest part of the upward turn or get out on the earliest downward turn of a number of specific markets.

Background:

Robotics can be defined as any mechanical device that reduces manual labor by humans. This is obviously a simplistic perspective but it suits the purposes of this discussion. You either have cheap labor or you have expensive labor. If you have cheap labor, you have little incentive to seek out and invest in labor saving devices.

If you have expensive labor, you will seek ways to reduce the costs of the labor. That works fine until all your competitors are do the same thing to reduce labor costs.

You might also find that competition has found a way to reduce its labor costs while maintaining a very high degree of productivity, efficiency and quality. Japan did that in the early 80’s.

In the late 70’s and early 80’s, Japan was faced with a labor shortage, increased competition but a potentially large demand for its cars. To reduce costs, it invested heavily in the development of robotics for many of its auto plants. There are now plants that turn out auto parts hours a day and the entire plant employs 15 or 20 people - to watch the robots.

Japan did the same in the electronics industry. Their products dominate the markets in electronics and have challenged the American auto manufacturers in their own country by keeping quality high and costs low.

When Japan was experiencing their high labor costs, America was in the peak years of the baby boomers moving through their most productive labor years - 16 to 34 years old. All 76 million of them reached that age in the same time. This flood of the labor market held down prices for more than two decades with the effects only just now beginning to subside.

While the labor was cheap in this county, there was no incentive to seek labor saving devices. Even after Japan reduced its labor costs, the US industries did not respond until they began to lose large amounts of market share to Japanese products. Then they sought ways to reduce costs. One of those ways was to begin to move their assembly plants to other locations where labor was very cheap. The thinking was that this was cheaper than what Japan did and it avoided the problems of pollution controls and labor unions.

Unfortunately, a robot that can work 20 hours a day, 7 days a week for little more than a can of oil for pay will never be able to compete with a human worker. US auto makers underestimated the degree of efficiency and quality that a robotic force could apply to the complex assembly of cars and electronics. Despite moving 1000’s of jobs to other countries to reduce labor costs, the US businesses have never been able to compete with the quality and productivity of the Japanese robotic assembly plants.

New Motivator Coming:

American business, on average, has never been particularly smart when it comes to long range strategic planning. They are more driven by the quarterly stockholders reports and the annual fiscal balance sheets to worry about three to ten years away. As a result they almost never invest in the long term strategic development of their industry unless and until motivated by loss of profits.

Despite the massive bull market and the long running market expansion that has been flooding billions of dollars into US business, we are about to head into a much different market that will increase the pressure on many American manufacturers to invest in robotics.

Following the baby boom years of 1946 to 1964, when 76 million babies were born, there was about 13 years of reduced birth rates. In this 13 years, 41 million births occurred or about 45% of the baby boom years.

This baby lull period is now coming into the labor force as the boomers leave. In 1999, they are 22 to 35 years old while the boomers are 35 to 53 years old and beginning to move out of the labor force. By 2007, the boomers had started retiring. The net effect is that the labor force is decreasing by more than 30 million people.

There has also been a shift in attitudes and work ethics of these post-boomer babies. Many of them grew up in schools with computers and many more of them went to college than the boomers did. This effectively reduces the blue collar labor force even more. As with any limited supply, and constant or increasing demand, the cost goes up. Labor rates, as a share of real business costs have risen 45% in the last decade and will continue to rise sharply for the next 7 to 10 years - until the echo boomers (the children of the boomers) enter they work force.

The response to this gradual rise over the past decade has been a gradual rise in capital investment in plants and equipment resulting in a 1997 record high post-WWII investment of 16% of their total economic activity. That percentage will be seen as low by comparison in the next few years.

Robotics to the Rescue

Predictions of what will happen in the future is understandably an inexact science and must be based on a number of inputs from leading industry analyst, current trends and the activities of similar industries and leading edge industry competitors. There are, in fact, often some very predictable results from such studies and an image of the future environment can take on a reasonable form. However, this analysis must be seen as an on-going task since what the industry will become is evolving constantly.

Michael Dertouzos, Director of the Computer Laboratory at the Massachusetts Institute of Technology (MIT), Cambridge offer the following observations as to his expectations of where the IT industry is going in the next twenty to twenty-five years. The statements in italics reflect comments that 21st Century Economics has added based on more recent studies and our own perspective of the world. Our comments have an emphasis on energy and electricity markets because of the importance they play in the overall economy.

Technoprophecy

* Manufacturing will be reborn, as customization replaces the assembly line and local high-tech workshops supplant centralized factories. In fact, “Mass Customization” is a term recently coined to describe the way that manufacturing is doing this now. The centralized factories will survive but with significant computer automation to control the customization processes.

* Business alliances will proliferate, creating hundreds of virtual corporations that may be spread all over the globe. ExtraNets (virtual networks) connecting suppliers to producers and then directly to their customers will evolve in nearly every industry. This will support the growing Internet economy

* Office productivity will increase 200%, yet people will work longer hours with less job security. This prediction is likely now but may prove to be less true after the bulge of the baby boomers mover out of their prime working years. Every job, regardless of the activity, will require computer literacy as a core competency.

* Electronic commerce will greatly reduce the need for any cash transactions. Smart cards, EDI and other on-line transactions will almost eliminate coins and paper currency and make it easier for the government to tax you.

* Your health-care costs will plummet and your health will improve, as computers monitor your vital signs and doctors bid online to care for you. Corporate health care costs will go down while worker health will go up. Preventive care will become a hallmark of both business and the health care industry. Unfortunately, the aging population will probably drive costs to the government to the breaking point and the large excess will be passed to the population as reduced coverage and higher co-payments and premiums.

* Virtual Reality will become the new primary form of entertainment and edutainment. Virtual Reality will also invade routine business communications and advertisements. Look for it to make its first market debut in video games, then in the military and then in marketing. Entertainment will be last because of the changes needed in standards and the costs of the equipment.

“Today we do our office work with just about the same inefficiencies [as] when we dug our streets with our hands. Looming ahead of us in the next century is an incredible opportunity to improve office work, not by 10%, but by a factor of 60 in many instances. Productivity will rise in the Information Age as it did in the Industrial Age and for the same reasons it did before: the application of new tools to relieve human work — more results from less work.”

But he warns of more missteps along the way where ill-advised IT innovations and poor implementations will under-deliver or have a negative effect on productivity. The man-machine interface is on his list as a fundamental challenge that affects the overall impact that IT will have.

The net effect will be that software developers must be much more in tune with the needs of the eventual users. This means that more than just the processing formulas have to be built into the software designs. Usability in the form of intuitive man-machine interfaces, easy to understand instructions and a true customer-oriented approach to the entire development concept must be adopted by every developer - both internal and external to the organization.

Among the effects of these design requirements is that internal IT or IS support departments must add skilled staff that are familiar with requirements analysis, user interface design and creating help or tutorial screens of complex ideas in easy to understand forms.

This report was originally created in July 1999 but is as relevant today as it was then. In fact, most of what it predicted has happened and the opportunities for profits (or not taking large losses) have increased.

What happens to our air is critical to our economy.
If it changes, even slightly, we will feel the financial, health and food effects of it. As a global megatrend, it has far reaching implications on the financial well being of every nation on earth but especially the US. For that reason, it is important to understand the forces at work here.

Life as we know it is possible on Earth because of a natural greenhouse effect that keeps our planet about 60o F warmer than it otherwise would be. Water vapor, carbon dioxide (CO2 ), and other trace gases, such as methane and nitrous oxide, trap solar heat and slow its loss by re-radiation back to space. With industrialization and population growth, greenhouse gas emissions from human activities have consistently increased. These steady additions have begun to tip a delicate balance, significantly increasing the amount of greenhouse gases in the atmosphere, and enhancing their insulating effect.

A wide variety of activities contribute to greenhouse gas emissions.
Burning of coal, oil, and natural gas releases about 6 billion tons of carbon into the atmosphere each year worldwide. Burning and logging of forests contributes another 1-2 billion tons annually by reducing the storage of carbon by trees. The result is that the atmospheric level of CO2, the most important human-derived greenhouse gas, has increased 30 percent, fro m 280 to 360 parts per million (ppm) since 1860. Over the same time period, agricultural and industrial practices have also substantially increased the levels of other potent greenhouse gases — methane concentrations have doubled and nitrous oxide levels have risen by about 15 percent. These gases have atmospheric lifetimes ranging from decades to centuries; today’s emissions will be affecting the climate well into the 21st century.

The overall emissions of greenhouse gases are growing at about 1 percent per year. For millennia, there has been a clear correlation between CO2 levels and the global temperature record. Fluctuations of CO2 and temperature have roughly mirrored each other over the last 160,000 years. The current level of CO2 is already far higher than it has been at any point during this period. If current emissions trends continue over the next century, concentrations will rise to levels not seen on the planet for 50 million years.

Which countries account for the largest proportions of CO2 emissions?
In 1995, 73 percent of the total CO2 emissions from human activities came from the developed countries. The United States is the largest single source, accounting for 22 percent of the total, with carbon emissions per person now exceeding 5 tons per year. Over the next few decades, 90 percent of the world’s population growth will take place in the developing countries, some of which are also undergoing rapid economic development. Per capita energy use in the developing countries, which is currently only 1/10 to 1/20 of the U.S. level, will also increase. If current trends continue, the developing countries will account for more than half of total global CO2 emissions by 2035. China, which is currently the second largest source, is expected to have displaced the United States as the largest emitter by 2015.

Opportunities for Profit

These reports on the megatrend of global warming and ocean rise are not so much meant to present immediate investment opportunities as to alert you to an inevitable trend that will eventually affect all of us. This is not speculation but scientific fact. Unfortunately, it is not in our nature to react ro respond to events that unfold very slowly. Our government and that of many other nations will never put global warming above more immediate issues related to current economic growth and prosperity. For that reason, there will be virtually no preventive measures and no preparation for the eventual effects.

Because there are a few scientists that do understand the coming event and can foresee the impact it will have on society and our economy, they must be silenced so as to not upset the rest of us in our ignorant bliss. To that end, the government will frequently offer up studies that contradict those of established scientists so that the public will remain confused and non-responsive to the warnings. This also allows the government to push off any response until it actually begins to affect our economy - i.e., take money out of the pockets of corporate America - THEN we will address the issues and begin to prepare. Unfortunately, that will be very late in the process and little will be able to be done without major upheavals and deep changes that affect many people.

If a stock is being bought and sold in a thin market the volatility will be large. A thin market is when there are few bids to buy and few offers to sell. This can exist if there is a high demand for the stock but a limited supply of shares. The few trades that do occur in a thin market can affect prices significantly. Institutional investors tend to avoid thin markets because when they buy and sell large blocks of stock, they can significantly affect the stock’s price. They may also find it difficult to get into and out of a position.

If you were to plot beta of a stock over time, you might see changes as the volume of shares in a typical trade fluctuates.

A change from a low beta to a high beta can mean that a thin market has developed for this investment. If the company is buying back its stock or there is a developing takeover in which a buyer is trying to buy up all the shares, the market for this stock will become “thin” and the volatility will increase.

Depending on why this is happening, it can trigger a buy signal for a wise investor.

A change from a high beta to a low beta can indicate that the stock is not seen as being very popular or that is has resolved a major internal problem that has reduced its susceptibility to outside influences. For instance, if an airline is buying fuel on the commodity market, its costs and market position can fluctuate with the price of oil and be influenced by competition with other fuel users - trucks, utilities, heating, manufacturing, etc. This could result in a high beta.

It turns out that, like many computed factors of an investment, particularly stocks, there can be a lot of useful information in examining the volatility of a stock. The most obvious is that it is often taken as the direct corollary to RISK. If a stock can rise fast and fall fast, you are at risk for catching the falls and not the rises. If it falls a lot and you have bought on margin, you can owe a lot of money in a short time that you did not expect to.

A direct measure of the volatility of a stock is a computed value called the “beta coefficient”. It is the covariance of the stock in relation to the rest of the market. By definition, the S&P 500 has a beta of one (1). Any stock with a higher beta is more volatile than the market as represented by the S&P 500 index. A stock that is expected to rise and fall more slowly than the market will have a beta lower than one.

A Beta does not necessarily mean that it will not rise or fall as much as he S&P 500, it just means that it may not move as fast as the index. Beta is based on past performance.

Another related factor is called “alpha”. It indicates the volatility of the investment itself rather than the rest of the market. If a stock is not expected to change in price in the coming year as a result of its inherent values such as growth of earnings per share, then it has an alpha of one (1). If it is expected to grow by 25% in the next year, regardless of the performance of the market as a whole, then it has an alpha of 1.25. Alpha is based on expected or projected future performance.

Putting them together, you can get some interesting insights into the expectations of the investment. (A high is a factor larger than 1, a low is a factor lower than 1).

A low beta and a high alpha would be an ideal investment. It would mean that there is low risk and a projected high return over the next year. This situation is rare in typical investments.

A high beta and a low alpha may be a poor investment since it indicates that the stock is a potentially high risk with lower growth than the rest of the market.

Notice what I have said here. It is NOT inflation itself that has had the impact on the economy but our reaction to it. Granted, inflation does change the economic balance and does create its own effects but then we amplify that effect by over-reacting to it. It is for this reason that any investor needs to understand exactly what it is and how it works - how it really works, not how you think it works and how to respond to it.

Real Inflation

Inflation, has for many years, simply referred to a continuing increase in prices. This is distinguished from price increases as a result of changes in value. Many now believe that price increases that continue are almost always associated with changes in the supply of money.

By today’s standard, the M1 (the government’s measure of the highly liquid money supply) would be a close indicator of inflation under the old definition. It was often discussed that an increase in the money supply might “stimulate” inflation.

Under that definition, we spoke of the “value” of the dollar changing in relation to the value of a dollar. In other words, it was the goods that retained a relatively constant “value” and its “price” changed with the relative value of the currency. A simple supply and demand concept applied to the currency.

Unfortunately, in recent years, inflation has undergone a change of identity. Most now think of inflation as referring to the prices themselves. We even use the CPI as the corollary to inflation indicating that the prices of that hypothetical market basket is the same as inflation. It is not.
Real Inflation is a reflection of the money supply relative to the value of goods. Let’s see this from one more perspective. If there is only $100 in the economy and I can buy 10 identical items - call them widgets - with that $100, then the widgets are priced at $10. If we arbitrarily set this as a standard, then we can also say that the widgets have a “value” of $10 each. That was today. Tomorrow, I print another $100. There is now $200 in circulation. The “value” that I placed on my 10 widgets has not changed from yesterday. I have not made any more widgets so their “value” is still $10 but now each dollar is worth half of what it was yesterday. It now takes $20 to buy each widget.

It was the change in the money supply that caused the change in the price of the widgets. Inflation is the result of that change in the money supply that altered the price (not the value) of goods not the change in the price of the goods.

The Real CPI

To understand CPI, first we have to return to the point made above - that changes in prices are not inflation. This is not something you have to take on faith - it is fact.

The CPI as we know it and as it is defined by the government is not inflation, it is an index of prices for a select group of times. If it changes, it is in response to, not the cause of inflation. If, however, it responds to inflation is a consistent and directly related manner, than it can be used as an indicator or inflation. That is exactly how it is viewed by many. Unfortunately, as you will see, it is neither consistent nor directly related.
Using the CPI to gage inflation is sort of like measuring the overflow of a river to determine if too much rain is flowing into the pool - First off, the rain may have already stopped by the time the overflow occurs. Second, you can never be really sure that the overflow was really from just the rain or was there some other causes also - like other creeks or snow melt or ?.

Finally, you might actually have not change in water volume at all - maybe it is just that someone has opened and shut some flood gates upstream. These are analogous to similar problems that CPI experiences.
As noted in the widgets example above, the reference of value is not the dollar but the goods in the CPI basket. The items in the basket have the almost same intrinsic value from day to day but their price changes because the value of a dollar changes.

This is contrary to what most people think about when they view inflation and money. We normally think of the dollar as having a fixed value and it is the intrinsic value of the CPI basket of goods that have changed because of changes in labor costs, transportation, energy or some other contributory cause. That is a false concept but one that the government makes no attempt to change. In fact, changes to the labor, transportation and energy costs and others all may be simply responses to changes in the money supply.

Given the method of measure (fixed basket of goods) of the CPI and the lack of response to technology and expenditures in stocks and taxes, the CPI tends to be more positive than actual inflation really is. In other words, CPI is going to always be lower than the real inflation. By how much is the big question. When we look at historical data, we see that its accuracy varies but it is more incorrect at times when the economy is about to take a downturn - meaning that it softens its predictive value just as it is needed most. The reason for this is that consumers begin to alter their buying habits as money tightens and employment changes - all precursors to a economic downturn but the way that CPI is determined does not take these changes in consumer behavior into account.

CPI is not the figure to use to measure inflation but because it may be a metric that responds to inflation, you might think that it can still be useful to be used as a comparative index of how the supply of money has changed the prices of goods- in other words, it may be seen as a measured response to the money supply - or is it?

Historical Views and Theories

Profit 2000 takes the position proposed by Don Paarlberg in his book, “An Analysis and History of Inflation” (Praeger Publishers). In it, he studied 15 different economies from Ancient Rome to modern day Brazil and concluded that a moderate degree of inflation is usually accompanied by increased economic activity. This has certainly been borne out by recent US history.

It turns out that economic thought is divided into two theories: Keynesianism which believes that an increased money supply can lead to increased employment and output; and Monetarists (like Paarlgerg) that believe that an increased money supply ultimately affects only prices, leading to inflation and that output is not increased.

Monetarists support their position with some fancy math called the quantity theory of money and the equation of exchange. These are formulas that equate spending and buying to money movement from buyer to seller on a total economic scale.

The result of the math is to show that inflation is equal to the growth rate of the money supply minus the growth rate of real output. The growth rate of the money supply is controlled by the Fed. The growth rate of real output is determined by resources and technology and has historically been about 3% per year. Therefore, if the Fed allows growth rate of the money supply to exceed 3%, we have inflation.

Alan Greenspan has announced that the current Fed’s goals for M2 growth is 5% per year. He is allowing that if the Keynesianists are correct, then there is a goal of 2% inflation to increase employment and output. If however, the Monetarists are correct, then he is figuring that 2% is a controllable amount of inflation that can be easily managed with interest rate hikes and other Fed controls.

Like many theories of modern times, there are smart people on both sides and there is sufficient evidence to argue both sides with vigor. It often depends on what data you look at. Paarlberg chose to look at historical economies as well as modern ones to validate his perspective.

In keeping with his monetarists perspective, Paarlberg also proposes that inflation is not caused by production or prices but by the supply of money controlled by governments. A careful examination of what the US Treasury, M1 money supply and other currency exchanges were doing in each of the 11 inflationary periods over the last 50 years proves that Paarlgerg is right.

The M1 supply adjusted for CPI plus stocks and government taxes (collectively referred to as the MCCPIG) has flattened or declined prior to every single one of the 11 economic downturns since WWII - with no misses or false alarms.

By contrast, the quoted government figure for the M1 supply rose 3.7% between May 97 and May 99 - remarkably close to the average government figure for average CPI of that period which was 3.6%. There is no other economic indicator with as good a record for predicting economic activity, but as we will see, both the CPI and the M1 may not be consistently accurate.

Now let’s examine why.

The Real Money Supply

First some Facts: As of March 1999, the M1 has risen 1.5% over the past year, the M2 has risen 8.6% over the past year and the M3 has risen 10.6% over the past year. I should note also that M2 has been showing rates above 8% since Feb 1995 indicating a positive economic outlook.
Studies show that Personal consumption expenditures are equal to 92% of disposable personal income - meaning that an indicator such as M2 which is close to a measure of what people have available to spend is 92% of what they DO spend. If we know that M2 has change upward, we can forecast that consumption expenditures will rise by a proportional amount and vice versa. Therefore, these “M” supply numbers tend to be good indicators of future economic activity.

Let’s try another analogy. I have a large tub of water with a hose in it. The hose puts water in and takes water out of the tub. I can definately say that if I can see water coming OUT of the hose, then the water in the tub is going down. Depending on the size of the tub and the hose, there may be a very small response in the tub to the water moving in the hose. The M2 is the tub of water. The hose is money flowing into the economy from the treasury or out of the economy by putting it in less liquid forms - long term CD’s, purchase of goods, etc.

To understand all this we have to first understand what the M1 really is. It is defined as the money that can be spent immediately. It includes cash, checking accounts and NOW accounts. The M2 is the M1 plus assets invested in short term money-equivalents such as money market funds. In other words, it is the liquidity of the money that determines if it is counted in the M1 and M2 supply numbers.

At issue is just exactly what does that really include. Upon more careful examination, the government defines this in such a way that it counts money that are otherwise committed to be used as taxes and that are locked up in the stock market.

The M1 and M2 have risen steadily since about 1930 but since 1995, the M1 has turned down while the M2 has turned up. The difference between M1 and the M2 is investments in money equivalents such as money market funds and bank deposits but M2 contains M1 so how can one go down and one goes up? This was an indicator to look further at where all the money was actually going.

The other place that has collected a lot of money is the stock market. The M2 supply reflects the $600 billion that investors have put into the money market funds but it does not reflect the $3 trillion in equities - that is an 1100% increase since 1980. That’s a lot of money that is not reflected in the M1 or the CPI.

The Anomaly

There is more money flowing into the economy than can be accounted for by the CPI with respect to prices. Under the basic supply and demand concept, which we will assume is an inviolate law of economics, there should be more price rise than is indicated by the CPI as a result of the increases in the money supply.

So what does this mean? What we have are some indicators that do not accurately indicate what we think they do.

They show rate of money being created by the Treasury. If we do not use the M1 and M2 absolute values but only the changes over time, we see that M1 and M2 have constantly risen since 1930 but if we include the money invested in the stock market and the money paid in taxes, we will see that M1 and M2 should be much higher than they are being reported that they are now.

The M1 supply adjusted for CPI plus stocks and government taxes (collectively referred to as the MCCPIG) has flattened or declined prior to every single one of the 11 economic downturns since WWII - with no misses or false alarms;

By comparing the CPI index level at two different times, you can make a statement about how prices have changed between he events. For instance, In December 1988 the CPI was 120.7 but December of 1998 it had gone up to 163.9. Doing the division of 163.9/120.7 =1.358, now subtract 1 and multiply by 100 to get a 35.8% rise in the CPI in the 10 years from 1988 to 1998 or about 3.6% per year rise.

The contents of the ” fixed basket of goods and services” is determined by the Bureau of Labor Statistics (BLS) after conducting a survey of consumer expenditures about every 10 years. The items being purchased rarely change but the BLS can adjust the weights of each of the 364 items in the basket. Some major changes were made in 1998 to the CPI.

The number of categories that the ” fixed basket of goods and services” is divided into went form 7 to 200 and the item structure and weights were changed. A more important change is that the CPI will not be calculated using a geometric mean estimator for about 60% of the expenditure categories that comprise the hypothetical market basket. The effect is subtle but important. It means that the quantities of goods in a particular category can change in response to the relative price changes. The new method of CPI calculations lowers the CPI value by about .2% over the old method.

In the past, the quantity was fixed and as prices of the items increased the CPI rose. The problem was that this did not reflect consumer spending. For example, if the cost of one vegetable rises, consumers will migrate away from that by buying a different one that has not risen as much. If the CPI reflected only the one that rose in cost, it would distort the picture of consumer inflation.

CPI’s value is that it is taken to be regarded as THE measure of inflation but because it is subject to consumer responses and handles the introduction of technology poorly, it sometimes results in a number that is larger than actual inflation by .5 to 1%. It also does not reflect stocks or government taxes which can have a major impact on the economy. Still, it remains one of the best indicators of inflation.

As noted above, the value of the CPI has risen by an average of 3.6% for the past 10 years but this does not reflect the month-to-month volatility of the usual method of reporting CPI which is to report the percentage change from the previous month or to report the CPI on a monthly basis.

For instance, the monthly percentage change CPI in April 99 was .7% but in March 99, it was .2%. You might interpret this to be a 350% rise in CPI from March to April when, in fact, the actual rise was from 165.0 in March 99 to 166.199 in April 99 - a rise of about 1.2 index points our of 165. A very small amount. Even if this were seen as the inflation rate for that month and you projected that for 12 full months, it would equate to an annual inflation rate of 8.7%. This gives a totally incorrect view of the economy and would be drastically out of line with the trend for the past 10 years of 3.6%. In fact, the entire year to date (January 99 thru May of 99) has a total rise in the CPI of .97% (less than 1% overall or an average of about .19% per month giving an annual rate of just 2.3%) or about 25% of the 8.7% figure). This is how the Wall Street wingnuts and economic pundits manipulate figures to scare people into buying or selling their advice and products.

What is important is how the market reacts to the CPI. If the CPI changes, in general the market goes in the opposite direction. Bonds (fixed income) and equities go down when the CPI goes up and vice versa. It is seen as less volatile than the PPI and so it is used as a better indicator of long term inflation trends.

Like most economic indicators, CPI does not provide proof positive of any particular trend but in combination, it can provide some insights into where the “trends” and “pressure” is pushing the economy.

Right now, the total picture, including the CPI, indicates that the although inflation is being constrained by heroic efforts by the Fed, we are seeing a weakening US Dollar, rising unemployment and very high energy prices that are adding to building pressures to push inflation higher. Employment compensation is rising rapidly, housing and vehicle markets are taking a dive, raw materials have risen and the Fed has lowered the rates several times with a high likelihood of a second lowering later in the year.

21s Century Economics takes the position proposed by Don Paarlberg in his book, “An Analysis and History of Inflation” (Praeger Publishers). In it, he studied 15 different economies from Ancient Rome to modern day Brazil and concluded that a moderate degree of inflation is usually accompanied by increased economic activity.

This has certainly been borne out by recent US history. He also proposes that inflation is not caused by production or prices but by the supply of money controlled by governments. A careful examination of what the US Treasury, M1 money supply and other currency exchanges were doing in each of the inflationary periods over the last 50 years proves that Paarlgerg is right.

The M1 supply adjusted for CPI plus stocks and government taxes (collectively referred to as the MCCPIG) has flattened or declined prior to every single one of the 11 economic downturns since WWII - with no misses or false alarms. The M1 supply rose 3.7% between May 97 and May 99 - remarkably close to the average CPI of that period.

A chart of M1 (deflated by the MCCPIG) since 1994 shows a percipitous drop from an index value of just under 170 in 1994 to under 100 in 2000. Given the Paarlgerg theory, the adjusted M1 (deflated by the MCCPIG) indicated that we were headed for a monster recession of epic proportions. At that time, Alan Greenspan said, “..storm clouds are massing over the western Pacific and heading our way”. Buy an umbrella! He and the MCCPIG were right on. In March, the bottom dropped out of the tech market and we entered a protracted bear market.

Personal income represents the compensation that individuals receive from all sources - wages, dividends, interest payments, proprietor’s income, transfer income (social security, welfare, unemployment) and other labor income. If we see this rise, expenditures often rise soon after. If Personal Income rises but expenditures don’t, then more people are putting money into savings. The nominal Personal Income and the Real Income (adjusted for inflation) are considered very good indicators of the current strength of the economy.

Increases in the PCE causes = The Stock Market to Rise
The Bond Market to Decrease
The Value of the Dollar to Rise

Decreases in the PCE causes = The Stock Market to Decrease
The Bond Market to Rise
The Value of the Dollar to Decrease

Bear Market Implications
People will spend money for three reasons:
(1) Because they have earned more
(2) Because they are buying something important
(3) Because they think that the value of money will soon decrease drastically

In both (1), you would see a rise in Income precede a rise in Expenditures. In (2) you would see a rise in Expenditures without a rise in Income. Often this would be matched by an increase in Durable Goods Orders. (See Guide on the Economic Indicator: Durable Goods Orders).
The same rise in Expenditures would happen in (3) with no rise in Income and often with a lesser rise in Durable Goods Orders. This is because when people are trying to expend money that they think will soon lose much of their buying value, they tend to buy consumables - food, gasoline, heating fuel, clothes, ammunition, etc.

If there are more people out there that think an impending Bear Market is real and will result in a major market setback, then you will see a large increase in Expenditures in the prior time period with no corresponding rise in either Income or Durable Goods Orders.

If on the other hand, there are more people that think that the economy will survive intact with little or no effects from Iran, Iraq, the new president or any other economic downtown, then the Expenditures will rise normal for the near term, and no rise at all for a seasonally adjusted Expenditure indicator.

If you see the Expenditures indicator abnormally rising, you can bet that people are stocking up on all the Bear Market kinds of supplies that all the doomsayers are saying will be needed after a major stock market setback - like moving funds out of equities and into gold or other cash equivalents. If that is the case, then you should be invested in stocks, bonds or commodities that reflect that potential.

If you see this rise, you can also expect that the value of the dollar will rise. If you see that, then buy gold as soon as you see a pattern of rise.

This rise in Expenditures may precede the actual rise in the value of the dollar and of monetary equivalents. The Expenditures rise should peak in just prior to an expected crisis (the indicator comes out between the 22nd and the 31st of the month) .

As soon as you see it, if it has risen by 10% or less over the previous money, then sell your gold. This is a cautious approach since you do not want to have to try to time your sell on a day-by-day basis by watching the paper or computer as the price of gold fluctuates.