Economic Freedom of the World

The Cato Institute, my favorite think tank, has just published their annual Economic Freedom of the World report. It starts with a terrific summary of the importance of economic freedom:

The foundations of economic freedom are personal choice, voluntary exchange, and open markets. As Adam Smith, Milton Friedman, and Friedrich Hayek have stressed, freedom of exchange and market coordination provide the fuel for economic progress. Without exchange and entrepreneurial activity coordinated through markets, modern living standards would be impossible. 

Potentially advantageous exchanges do not always occur. Their realization is dependent on the presence of sound money, rule of law, and security of property rights, among other factors. Economic Freedom of the World seeks to measure the consistency of the institutions and policies of various countries with voluntary exchange and the other dimensions of economic freedom.

Here's one sobering excerpt:

The United States, once considered a bastion of economic freedom, now ranks 12th in the world, tied with the United Kingdom at 7.81. Due to a weakening rule of law, increasing regulation, and the ramifications of wars on terrorism and drugs, the United States has seen its economic freedom score plummet in recent years, compared to 2000 when it ranked second globally.

Here's why economic freedom is so important: it brings greater prosperity and higher living standards:

Nations in the top quartile of economic freedom had an average per capita GDP of US$39,899 in 2012, compared to US$6,253 for bottom quartile nations. Moreover, the average income of the poorest 10 per cent in the most economically free countries in 2012, US$11,610, was almost double the overall average income in the least free countries. Life expectancy is 79.9 years in the top quartile compared to 63.2 years in the bottom quartile, and political and civil liberties are considerably higher in economically free nations than in unfree nations.

Below is a graphic showing the rankings (click to enlarge). Sadly, I note that Argentina, my wife's native country, ranks #149 out of 152 countries. The bane of Argentina is Peronism, which eschews the rule of law, relies heavily on income redistribution, thrives on crony capitalism, and professes to be all about helping the poor. I've remarked in several posts over the years about the disturbing parallels between the policies of the Obama administration and those of Argentina's President Kirschner.

Putting commodity prices and the dollar into perspective

Falling prices for many commodities, including gold and oil, combined with a rising dollar, have sparked lots of concern of late about whether the Fed is too tight and whether the risk of deflation is once again rising. I think those concerns are way overblown and quite premature. As I see it, most commodity prices aren't weak, they are merely less strong than before. Moreover, the dollar today is not strong, it's merely less weak than before. From my perspective, the strength of the dollar reflects an improved outlook for the U.S. economy, and lower commodity prices reinforce that outlook since they lift a burden from U.S. producers and consumers.

The chart above shows the real, inflation-adjusted value of the dollar against a large basket of other currencies and against a basket of major currencies over the past 40+ years. In the past three years the dollar has risen from all-time weak levels to a level that is still below its long-term average. Three years ago the dollar was extremely weak, whereas today it is merely somewhat weak. This should bring a sign of relief to everyone who conducts their affairs in dollars. For a more detailed look at the dollar's valuation against other major currencies, see my post "The Return of King Dollar" from last month.

The chart above shows the nominal value of the dollar against a basket of major currencies (Euro, Sterling, Yen, Canadian, Swedish Kroner, and Swiss Franc) over the past 8 years. It's jumped up this year, but it's been at this level several times in the recent past. What's happened of late is nothing new or extraordinary.

The chart above compares the value of the dollar (against the same basket of currencies in the prior chart) to an index of spot, non-energy commodity prices. Here we see that there is a decent tendency for the dollar and commodity prices to move in opposite directions (note that the left y-axis shows the inverted value of the dollar): today's stronger dollar is accompanying a decline in commodity prices, and it probably implies further weakness in commodity prices. But nothing in this chart suggests a plunge in commodity prices is necessary or imminent. Commodity prices are still very high compared to where they were in late 2001, and the dollar is still relatively weak.

The chart above compares the price of gold to the price of a basket of industrial commodity prices (excluding energy). The two tend to move together over time, but gold prices are far more volatile (note that the scale of the left y-axis is more than twice the scale of right y-axis). Gold is meaningfully off it's 2011 high, but still far above its 2001 low. Commodities are only moderately off their all-time high. When gold and commodity prices were extremely depressed, back in the late 1990s and early 2000s, the dollar was extremely strong and Alan Greenspan was worried (correctly) about the risk of deflation. That is manifestly not the case today. If anything, weaker commodity prices and a modestly stronger dollar work to reduce the risk of a big increase in inflation.

As for oil prices, the chart above shows that the inflation-adjusted price of oil is still extremely high relative to what it was just two decades ago. Falling oil prices of late have only brought modest relief, so far, to consumers.

But that relief should increase in the near future. The first of the above two charts shows the average price of regular gasoline at the pump. The second chart compares pump prices (the orange line) to the price of gasoline futures (white line), which tend to lead pump prices. Today's gasoline futures prices suggest that pump prices for regular gas should fall to $3.00 or lower within the next week or two. That is good news for everyone who depends on gasoline.

The chart above shows the Journal of Commerce Commodity Index, along with its major subcomponents. Each is indexed to 100 as of the date in late 2001 that commodity prices reached a multi-decade low. Oil and metals prices have both risen by about the same amount, whereas miscellaneous commodities (e.g., hides, rubber, tallow, plywood, red oak) have risen only modestly, and textiles have hardly risen at all. In aggregate, the commodity complex is still trading at relatively high levels compared to just over a decade ago.

The cure for higher commodity prices is higher commodity prices, as they say. Commodity prices became extremely expensive a few years ago, and that sparked a wave of new exploration and production. Increased production combined with weaker economies in China and Europe have halted and reversed that rising price trend, with the result that commodity prices are receding from their extreme levels.

The dollar was crushed three years ago, and now it has managed to recover some of its strength. That undoubtedly reflects the fact that the U.S. economy is doing better than most other major economies (though no one is seeing glory days), and that means that the Fed is likely to raise rates sooner than other central banks will. There's nothing unusual at all about that, and in fact it's another reason to cheer. Things could be an awful lot worse, and they have been.

Moral of the story: markets worry way too much about rising interest rates and deflation these days.

Households have finished deleveraging

I've been following this issue for more than two years because I think it has very important implications for the future of Fed policy. One of the defining characteristics of the current recovery has been a widespread risk aversion, which in turn has led to a significant amount of deleveraging and a simultaneous increase in money demand on the part of U.S. households. The Federal Reserve's Quantitative Easing operations were essentially designed to accommodate this, since the net result of QE was to transmogrify notes and bonds into risk-free, short-term assets which, in turn, satisfied the risk-averse public's increased demand for money and money-like balances.

One important consequence of risk aversion is the desire/need to deleverage and otherwise reduce debt burdens. (Jargon note: reducing debt and debt burdens is equivalent to an increasing demand for money; having debt is like being short money—reducing debt is equivalent to going long money.) There are many ways to do this: paying down debts, canceling debts, refinancing debts at a lower interest rate, saving more money, and accumulating more assets. The massive increase in risk aversion in the wake of the financial crisis of 2008 manifested itself in an equally massive increase in the demand for money, money equivalents (e.g., bank savings deposits), and safe assets (e.g., short-term TIPS, gold). The Fed accommodated that risk aversion by buying notes and bonds and creating bank reserves. Banks have invested essentially all of their $3.5 trillion increase in bank savings deposit inflows since late 2008 in excess bank reserves which they still, apparently, are content to hold.

As the chart above shows, as of June 2014, households' financial burdens (debt and related payments relative to disposable income) had fallen significantly from their pre-recession high, but they have been unchanged for more than a year. Households responded to too much indebtedness by going bankrupt, writing down debt, paying down debt, getting new jobs, earning more income, refinancing debt at lower interest rates, and by saving more. But it is becoming increasingly apparent that households'  desire to delever has all but evaporated. That implies that the next chapter in this story, whenever it begins, will involve increasing indebtedness and a decline in the demand for money and safe assets. There are already signs that this is happening, most notably the increased growth rate of C&I Loans that we have seen year to date, the weakness in gold prices, and the decline in the real yield on 5-yr TIPS.

The chart above shows that, as of June 2014, households' leverage (total debt as a % of total assets) had declined by more than 25% from its recession-era high. As with debt burdens, leverage has declined thanks to a variety of factors: less debt, lower interest rates, more savings, and rising equity and housing prices. Household leverage is now back to the levels of the mid- to late-1990s, a period that saw low inflation and strong economic growth. The "bubble" that was created in the runup to the 2008 financial crisis has completely popped. Households have adjusted to new realities, so perhaps we'll see more normal, less risk-averse behavior going forward.

Even the federal government's borrowing binge has faded. The FY 2014 federal budget deficit was a mere 2.8% of GDP, down from a high of over 10% in late 2009. In dollar terms, the federal deficit declined by an impressive two thirds in just over the past four years. The federal government hasn't yet actually deleveraged (federal debt outstanding is now at a post-war high of about 72% of GDP, as shown in the chart above), but it is no longer leveraging up by leaps and bounds.

An important part of the big decline in debt burdens and the big deleveraging of household's balance sheets has been an increase in holdings of "money" and money equivalents. The M2 measure of the money supply is arguably one of the best measures of money, and the chart above shows the current composition of M2. Savings deposits are by far the largest component, and they have grown by $3.5 trillion since the onset of the 2008 financial crisis. But the growth rate of savings deposits has been declining in the past year or so, from a high of 18% in 2010 to just 5% in the past 6 months. This is consistent with a decline in risk aversion and a decline in the demand for money on the margin.

The big increase in money demand shows up clearly in the chart above. It plots the ratio of M2 to nominal GDP. Since the onset of the 2008 financial crisis, the public has increased its holdings of "money" relative to nominal income by more than 20%. That's equivalent to the typical household deciding that they need to increase their holdings of cash by an amount equal to one-fourth of a year's income. That's a lot of money that has been "stockpiled" on the sidelines—upwards of $2.2 trillion. If the demand for that money should ever decline—because, say, risk-taking becomes the vogue—it would be like opening the floodgates: a wave of extra liquidity would wash through the economy, boosting nominal GDP and likely raising prices. Unless, of course, the Fed tightens monetary policy by enough to offset the decline in money demand. It would probably take much higher interest rates to convince households to continue to hold their sizable savings deposits in a world with much less risk aversion.

So this is where we stand today. The great era of risk aversion and deleveraging is fading into the past. It is gradually being replaced by a new era of more confidence and a desire to embrace risk and shun safe assets that yield almost nothing. This bodes well for equities and the economy, but it also creates a serious risk of inflation, should the Fed fail to accommodate the declining demand for money in a timely fashion.