Monday, December 18, 2017

Washington's Collusion with Russia

According to a recent press release from the Kremlin, we find the following:


Given that it's starting to look like the second edition of the McCarthy Era in Washington, it is interesting to see that, behind the scenes, there are hopeful signs that at least two of the three world superpowers/superpowers-in-waiting are co-operating when it comes to preventing yet another terrorist attack and loss of innocent life.

In case you were wondering, the Kazan Cathedral in St. Petersburg is an amazing piece of architecture as shown here:



It is also a magnet for both worshippers and tourists and, most certainly, a terrorist bomb would have resulted in very significant casualties and potentially serious damage to an important Russian icon.  In 2014, we spent few days in St. Petersburg.  On one of our visits to the cathedral while a service was taking place, we were ushered through metal detectors whereas, other times we were able to enter the premises unhindered.  Apparently, the Russian's have long suspected that the Kazan Cathedral is a potential target for terrorists. Despite Washington's ongoing anti-Russia rhetoric, some behind the scenes collusion may have saved some lives.

Thursday, December 14, 2017

Interest Rate Reversals - A Warning from History

There is no doubt that we live in "interesting times" when it comes to global interest rates.  For most of us, the post-Great Recession period of near zero interest rates has been unprecedented and the recent experiments with negative interest rates are a new reality for investors.  While all of this may appear to be a brand new phenomenon, in fact, things are even more interesting when one looks at real interest rates, rates that are corrected for inflation as shown here:

  
A recent posting by Paul Schmelzing on the Bank of England's "Bankunderground" blog looks at the really long term trends in real interest rates and how, by putting the current interest rate environment into a long-term context, we can better understand the relationship between the current low real interest rate environment and the prospect for a return to "normal" interest rates.  To assist with this relationship, the author has looked at seven centuries of data for real risk free interest rates and has produced this graphic:


For your illumination, the source of the risk-free asset data is as follows:

1.) 14th and 15th centuries - sovereign rates in the Italian city states

2.) long-term rates in Spain

3.) long-term rates in the Province of Holland

4.) long-term rates in the United Kingdom after 1703

5.) long-term rates in Germany

6.) long-term rates in the United States

From this data, the all-time real average risk-free rate stands at 4.78 percent and the 200 year average stands at 2.6 percent.  As you can see from the red line on the previous graph, the current rate environment is significantly depressed.

For those of us that have been paying attention to nominal interest rates over recent decades, we've noticed a significant downward trend as shown on this graph showing the yield on ten-year Treasuries:


The author's calculations show a similar trend in real rates over the very long-run as shown on the red line here:


On a constant time trend, the red line shows an average fall in interest rates of about 1.6 basis points per year.

If we take a further look at the multi-century trends, we find that real rates have been depressed below long term averages several times in what are termed "real rate depression cycles".  Here is a graphic showing the nine historical periods of real rate depression plotted by size of interest rate depression versus the duration of that depression:


As you can see here, while the current period of real rate depression is relatively small when measured using the amount of interest rate decline, it is the second longest period of real rate depression over the 700 years in the study.

Lastly, let's look at how these real interest rate depressions reverse themselves:


As you can see, real rates rise very rapidly after they reach their trough, climbing an average of 3.15 percentage points within the first 2 years after the interest rate trough is reached.

A long look back at historical data suggests that the current depressed real interest rate environment is not unique.  While no one can predict the timing, history also shows that real interest rates are  likely to reverse themselves very quickly.  This reversal will have a significant impact on investors, particularly bond investors, who will see the value of their fixed income portfolios "readjust" in what could be a very negative way. 

Let's close with this quote from Alan Greenspan:

"By any measure, real long-term interest rates are much too low and therefore unsustainable...When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.

Caveat emptor.


Tuesday, December 12, 2017

Does Spending on War Increase Employment?

Donald Trump's cryptic comment about "the calm before the storm" while in the presence of top-ranking military officials and his ongoing Twitter feed reminding North Korea and Iran of their place in the global village have made a paper by economist Heidi Garrett-Peltier more pertinent, given the importance of military spending to the U.S. economy.  

Let's start by looking at a summary of U.S. military spending by year (in billions of dollars) since fiscal 2003:


Here is a graph showing U.S. annual military spending as a percentage of GDP going back to 1960:


With that background, let's look at Dr.. Garrett-Peltier's paper entitled "Job Opportunity Cost of War".    She opens by observing that the recent request by the Trump Administration to increase military spending by 10 percent must come at the cost to cuts to domestic programs like education and healthcare as well as reduced foreign aid or at the cost of increasing the federal debt which will result in increased interest payments on the debt in the future.  Given that the defense industry in the United States is scattered throughout many states, increased military spending is seen as a way to create jobs.    As such, here are two figures which show the importance of defense spending by state in both billions of dollars and as a percentage of state GDP:


While there is no doubt that some states see great benefit from increased federal military spending, Dr. Garrett-Peltier's analysis questions whether the spending of trillions of dollars on wars in Afghanistan, Iraq, Pakistan, Libya and Syria have actually meant the loss of opportunity to create even more jobs in the domestic economy by improving health, education, infrastructure and environmental outcomes (i.e. does spending in areas other than the military actually result in the creation of even more jobs?)

First, the author estimates the employment multipliers for defense spending as well as other types of federal spending to provide an accurate comparison; this provides us with an assessment of the direct, indirect and total jobs created by spending on defense in comparison to other non-defense alternatives.  Here is a graphic showing the employment multipliers expressed as jobs created per $1 million in spending in several key economic sectors:

Each million dollars in spending creates the following direct and indirect jobs:

1.) Defense - 6.9 jobs

2.) Clean Energy - 9.8 jobs

3.) Elementary and Secondary Education - 19.2 jobs

4.) Higher Education - 11.2 jobs

5.) Infrastructure - 9.8 jobs

6.) Healthcare - 14.3 jobs

As you can see, federal spending on defense actually creates fewer direct and indirect jobs than any of the other 9 subsectors measured in the study.

Based on an estimated cost of the War on Terror over the period from 2001 to 2016 of $3.69 trillion, the average cost per year for strictly war-related spending (above the Pentagon's peace-time base budget) works out to $230 billion per year.  This annual spending supported about 1.552 million defence-related jobs.  According to the author's calculations, this level of spending would have supported an additional:

1.) 2.829 million jobs in elementary and secondary education

2.) 1.702 million jobs in healthcare

3.)  989,000 jobs in higher education

4.) 667,000 jobs in infrastructure

5. ) 661,250 in clean energy

...above and beyond the 1.5 million jobs that would have been created by the defense spending. 

Here is a table showing total job creation in just four sectors of the economy from $230 billion spending per year:


The analysis by Dr. Garrett-Peltier shows that the cost of war to the U.S. economy is substantial.  The spending of nearly $3.7 trillion on war has meant that the United States has lost the opportunity to create millions of jobs in sectors that are critical to American voters, particularly in health care, education, America's aging and decaying infrastructure and clean energy.  Apparently, outside of men and women willing to serve in the U.S. military, Washington should not be counting on war to create jobs for Americans.