MONDAY, JUNE 4, 2018
JIM: Our next guest has many distinctions and probably the most noteworthy is the unique distinction of having been the only Chief Economist in the Federal Reserve System’s history. As the former Chief Economist and Senior Vice President of the Federal Reserve Bank of Dallas, he served 25 years advising the President on monetary and economic policies. He is widely published in the nation’s leading business press including the likes of the Wall Street Journal, New York Times, USA Today, as well as being a much sought after media expert for national radio, television, and internet programs including CNN, Fox News, National Public Radio, just to name a few. Today, he’s going to give a little insight on a talk that he’s spoken around the country on, how to make good money in a bad economy. It’s with great pleasure I welcome Dr. Michael Cox. Welcome, Dr. Cox.
DR. MICHAEL COX: Thank you, Jim. It’s nice to be here.
JIM: Hey, it’s great having you on. I know I heard you a couple months ago and it’s good to have some optimistic output, especially when you watch the news today, everything seems so negative and I know one of the negative issues you talked about, you also talked about opportunities and that was we’re in a bad economy. What do you mean by bad economy?
DR. MICHAEL COX: Well, you’re right that I’m optimistic long-term but I’m a little bit pessimistic short-term relative to say the last quarter-century boom we had. If you look at certain signals on the economy like the unemployment rate, which supposedly is officially 6.1%. If you look at say the stock market, you’re going to come to a conclusion perhaps that this is a good economy but if you dig a little bit deeper, you’ll find out that the reason the unemployment rate is falling is because people are dropping out of the labor force and by the miracles of the way the Bureau of Labor Statistics calculates unemployment, if you’re no longer looking for a job, even if you don’t have one, you’re not counted as unemployed. Putting them back in, then the unemployment rate really is closer to 11% than 6%. GDP is growing but it’s growing about half the rate it did in the 25-year boom we had from 1982 to 2007. The inflation rate is low but there’s a whole lot of money in the pipeline, which could make inflation just skyrocket so digging a little bit deeper, what you find is that these are peripheral signs of a good economy but it’s not good underneath the surface.
JIM: Now you mentioned the stock market’s going gangbusters – those are my words, not yours – but we have seen a nice run in the stock market. What’s going on with that?
DR. MICHAEL COX: Right, the stock market hit a high just what a week or two ago over 1700 on the Dow. Sold off some since then but if you look at that peak, actually the Dow is only up about 20% from where it was in October 2007. That’s six and a half years of running the Dow, we’ve been able to get up about 20% going back to that peak. Now if you annualize that and put it up to a 25-year basis, right, so six and a half, compound it 25 years, it turns out the Dow would be up. If it continued to go up at the rate it has been going for the first six and a half years for the completion of this quarter century, we’d be up about 94%. Now let’s compare that to what it did the quarter century from 1982 to 2007. The Dow was up 1750% so this really isn’t even a bull market. Even if you take it to its highs, we haven’t really gone that far but that still prompts the question, well, why is the Dow even up? You want to talk about that, what’s pumping the Dow up to where it is?
DR. MICHAEL COX: Well, that I’ve done some really serious research on. I’ve gone back and taken the Dow, which I think the Dow started third quarter of 1896. It was either the second or third quarter of 1896. I’ve used 118 years of data to figure out what drives the Dow and I have identified four variables that can explain about 98% of the movement in the Dow. One of them is just simply GDP because when you produce GDP, you produce earnings and the earnings go in the top line of present discounted value with expected future after-tax earnings, which is supposedly what a rational market would price the stock at. Another thing that the Dow depends on is the tax rate. When you take the earnings away that companies earn and government takes them rather than people, that drives the Dow down, also the price level. These are monetary earnings and so if the price of their goods that firms sell goes up, then the earnings should go up and the price of their stock should go up but also the interest rate. What we find in this analysis is that all of those variables are highly statistically significant when you do what graduate students in econometrics and economics call hypothesis testing econometrics. What we find is that by far the most significant variable is the interest rate and we find that for each 100 basis point movement inside the 10-year T note rate and that’s a one percentage point movement or 100 basis points up in the interest rate, the Dow has historically fallen by 10.5% so the Fed’s policies of driving interest rates to unprecedented lows has been the primary variable driving the market to unprecedented highs. Said another way, the Fed is creating a bubble.
JIM: Let’s talk about interest rates. What do you feel about rising interest rates? You haven’t talked about the bond market and the impact on that. What would rising interest rates do overall for investors?
DR. MICHAEL COX: Well, we think we saw what it would do according to this 118 years of data. It was a one percentage point increase in the interest rate would drive the market down 10.5%. If we’re going to go back up to say 4.7% average long-term T note rates, which is the long-term average, you’re talking about the market having to sell off in the broad indexes over 20% as an estimate. What’s not so important really is the exact decline. What is important is understanding if you’re going to continue to participate in thinking the market was going to go up by buying, buying, buying, going long in market indexes at a time when we’re poised for interest rate increases, you’re truly gambling. You’re not being scientific about it anymore. The market says that that doesn’t happen historically very much at all and usually interest rate increases drive the market down. Now you asked about the interest rate increases. We saw I think what could happen to the market if interest rates increase. We saw that back at the first part of this year as the baton changed from Bernanke to Janet Yellen. Everybody thought she was going to come in and do what Bernanke had not done. He was bubble boy, creating interest rates down, down, down his whole tenure. People thought well, we painted ourselves into a corner. We’ve got to reverse this now. She’ll do it so just the thoughts of her raising interest rates caused the market to tumble. It looked like the party was over but then she came in and said you know, I’ll be happy Janet. I’ll be easy Janet, the dove that she’s always known for being. I’ll be that after all. It’s not my nature to be tight. I’m not a Paul Volcker. I’m more like a G. William Miller. Then the rates started to come back down again from their peak on December 31 of last year and as they did, the market went back up again and so we’ve seen the relationship between interest rates and the market is still there. It’s still strong and I think that’s what we’re seeing right now with the market selloff. We’re seeing the expectations that the Fed is going to pass tapering and they’re going to start to raise the fed funds rate and we’re going to be in an increasing interest rate environment going forward.
JIM: I’ve talked to some mortgage bankers in the recent weeks and months and they all thought interest rates were going up and they’re surprised that we’re still in this low interest rate environment. I’ve heard some cynics say the biggest spire of debt is the U.S. Government and they have no interest in raising the interest rates and maybe we’ll just stay at low interest rates. Do you see that as a possibility?
DR. MICHAEL COX: Absolutely. In fact, this was something that came up on Fox. I was on Fox earlier last week and Liz Claman there brought this up. She said what are the views of the Fed right now? I said look, there are two views. One view is the Keynesian view, the view that the Fed is doing this on purpose, driving interest rates down in order to stimulate demand, drive up the stock prices. That creates wealth people spend. You lower interest rates for firms. They can refinance and spend the lower interest rates for mortgage borrowers and so people buy a house but then that’s one view of the Fed. Maybe there’s another view which we should entertain as being correct because this is a view which really you could ascribe to Japan and that’s the view that the Central Bank has been pretty much coopted by government and other political players to help them and not the private sector, not help business but help government and their political friends. If you think about it, low interest rates help the Treasury. With $17.7 trillion worth of debt outstanding, which requires interest servicing, low interest rates help them. That’s one branch of government, one agency, the Fed helping another formal branch of government, the Treasury. Also, low interest rates help Fannie and Freddie, another semi-government agency. Fannie and Freddie need to issue their mortgage-backed securities and it’s easier for them to do them when people want to buy them in a low interest rate environment than a high interest rate environment. In fact, that’s what the Fed has been buying. If you look at the Fed’s balance sheet, they’ve been mainly buying mortgage-backed securities recently so that looks a little crony-ish. Plus the low interest rates help the big banks. Big banks now the most recent data shows are loaning in their credit card market at about 15.1% but on the cost of funds side, they’re borrowing in CDs of 26 basis points so that big spread because of low interest rates enable them to be very profitable as well and there’s been some feeling that the big banks in New York have kind of coopted the New York Fed and maybe even some other banks. Where does this lead? We should talk about where this leads if we keep on this low interest rate policy forever.
JIM: Why don’t we do that?
DR. MICHAEL COX: Well, if you look at Japan, when the Nikkei plunged in the early 1990s, Japan had been on a tear, right, the Japanese economy running off, doing great for three or four decades. Then the economy started to get soft. Now it got soft because of China and because the world of infra goods was shifting from the relatively high cost Japan to the relatively low cost China but Japan Central Bank didn’t really understand that or thought they could correct it anyway with their interest rate policy. The Nikkei crashed from about 40,000 to under 20,000 in the early 1990s. The Central Bank of Japan said let’s follow this Keynesian monetary policy we’ve heard about. Let’s cut interest rates so they did some actions in the fed funds and everything, the T bill rate in Japan from about 5.5% down to near zero, less than 0.5%. Well, it didn’t stimulate the economy and they kept thinking well, it’s going to. We’ve just got to do it some more so they kept on cutting it and keeping it down there. It’s going to. It’s going to work. Now it’s been almost 20 years of low interest rates, more than 20 years of low interest rates, and still the Japanese economy is not performing. They’re at the third lost decade of jobs. GDP is not growing. Manufacturing is not growing and if you ask why the Japanese Central Bank is doing that and you look at well, how about the fact that Japanese debt relative to GDP is 260%, already a third of their budget is spent just on interest on the debt. Imagine what would happen to their budget if the interest rate went back up so essentially there the Central Bank now has been bought by the Treasury and that’s the same direction America’s headed but it’s not good for the economy. A central bank whose efforts are directed toward helping the government is not a central bank which is going to help the economy.
JIM: Let’s take a short break. When we get back, let’s talk about taxes.
JIM: Welcome back as we continue to visit with Dr. Michael Cox, a global economist, as we’re discussing some of the challenges that face investors going forward. Before the break, we talked about we really don’t have that great of an economy. The stock market is kind of teetering and has been growing based on these low interest rates and then all the effect that a change in these interest rates or staying the same can have. Let’s talk about taxes. I’ve heard it said that right now America has the highest corporate tax rate. I know our personal tax rates, the Supreme Court said that ObamaCare is part of our taxes so we’ve seen tax rates increase on a personal level both with the last budget bill and the passage of ObamaCare. What impact is all of that going to have?
DR. MICHAEL COX: The Wall Street Journal ran an article today where they surveyed adults to see whether they felt that their kids were going to have a better life than them and a record nearly 70% of the adults felt like their kids would not have as good a life as them. They felt like America is on the wrong path and I completely agree with that. I think America is right now with this big left turn we’ve made, with so many people seeking to live at the expense of others, we’re on the road to serfdom. Friedrich Hayek’s book The Road to Serfdom is the road we’re on. There seem to be two views of the American Dream right now, the one which I adhere to and grew up with and yesterday’s immigrants came here for and that’s the dream of opportunity, coming here and I’ll respond to the incentives around me to start a business, work hard, get educated, be personally responsible. I like the economic freedom. Give me a meritocracy. I’ll pull myself up by my own bootstraps or my own bookmarks and I will make a better life for myself and I’m strong and self-reliant and self-independent. I can do it. That path leads to progress and wealth naturally and all your clients will understand that. It’s good personal responsibility, good choice making that leads to success in a person and in an economy but increasingly you find another kind of an American Dream out there and that’s the dream to live at the expense of others. People seek a government and they sometimes move to states for this, which will redistribute income from the rich to the poor. What they see is an unfair economy of the haves and the have-nots. They’re willing to be our dependents as long as they get what we produce and they’ll vote for a big government who will redistribute the income and that leads, of course, that path has always led to decline and to poverty and that’s what I call the road to serfdom. I was particularly surprised at the last election, frankly the reelection of President Obama, that Americans voted to stay on this path. That to me tells me that this is a chronic problem. You can’t blame it on a particular person like our so-called political leaders. We have to look at who is America now. I think America is at war inside our country with ourselves, one group fighting another, and it’s happening because of the increased inequality that has been going up since the early 1970s. That, by the way, is coming from a failure of our educational system. That’s another article in today’s Wall Street Journal, failure of a high school degree to be worth something on the job market; 70% of Americans don’t get beyond high school and if they’re going to be in the middle class, then a high school education has to have substantial intellectual capital. It doesn’t and as a result we have a wide income distribution and the clamoring for income redistribution is not going to stop. I was very surprised to see that Thomas Piketty’s book, Capital in the Twenty-First Century, has become so popular, a bestseller on the New York Times list. This tells me that the mood of America today is the majority of Americans today are ready to vote to take money from others. That means taxes will continue to go up and I think that’s going to happen for a long time. I know that was a lot but I wanted to say all that just to form the basis for why I believe as a client of a money manager group, I need to understand that it’s very important today to do everything I can to protect myself from taxes, not evade but definitely avoid taxes.
JIM: Well, Dr. Cox, I really appreciate you joining us today. A lot of wisdom in your words. For myself personally, I look at some issues and I can’t imagine a better time for opportunity. When you look at, for example, what’s happening in North Dakota with the oil boom and the opportunities that might be there, and then on the other hand, you see a government that spends more money than they take in and nobody wants to face the issues, it’s really easy to be bipolar in your outlook today but I really appreciate you sharing today and hopefully, we can have you back in the future.
DR. MICHAEL COX: I would love to, Jim. Thank you for having me on.
JIM: Thanks for joining us this week and tune in again next week as we explore another phase of the Real Wealth process and remember, if anything you heard in today’s show you’d like to get more information about, contact us. Also, if you feel that any of this information would be helpful to a friend or family member, just Forward the link.
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