Declining GDP Can Be Good

The following is an open letter to John Mauldin in response to Thoughts from the Frontline Weekly Newsletter, Six Impossible Things. It ties in with another story at telegraph.co.uk about the rapid decline in money supply.

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Good essay, as usual, Mr. Mauldin. Hey, ask a trusted scientist about dimensional analysis. Your delta force equation is slightly incorrect; it should be multiplicative, not additive. Conceptually it's right, but the formula is formed wrong and the implications may be very different when you use the correct dimensions and mathematical operations. You might characterize this with the label "Busy Boys ... Better Boys", from the 3-cent stamp I discuss at the end, where I reveal another time in American history that produced sustainable healthy economic output. In short, declining GDP might not be bad if we think about it a little deeper than our illustrious leaders who seem to be acting out of habit, not knowledge.

First Fixing the Formula
For your delta force equation the definition of productivity has to be "dollars per person", since "population" is clearly "sum of persons". Therefore, the plus sign is wrong; it must be "multiplied by". Think about it this way in dimensional analysis: if you get 10 miles per gallon and have 20 gallons of gas, how many miles can you travel? The formula is "M traveled = 20G x 10 MPG". Take away the numbers and just use dimensions: M = G x MPG.

The "per" in math means"divided by", and so the Gs cancel each other out:
G x (M / G) [in our case, 20G x 10M / G)]

Canceling out the Gs...
20 x 10M = 200M

You can't do that with addition: 20G + 10MPG = M is an invalid formula.

So look again at your delta formula. What you're saying is correct, but addition is the wrong operation and the implications are different when you properly put them into the correct mathematical dimension.

In dimensions, your delta force would be "Dollars" = "People" x "dollars per person" [D = P x D/P]. But there is still something missing. Some dollars per person are zero. My 5 year old productivity is zero because he isn't working. Likewise for the unemployed. Those have to be clarified as "working people" x "average dollar per working person".

Implications
It is not enough to "grow one's population", one must grow the population of people "that contribute to monetary productive efforts". If population grows, but the output of the new people are smaller than existing labor, it may not produce a rising GDP. To the extent new population produces less per person than existing population, GDP may decline if workers leaving the work force were more productive.

The corporation I work for is making this mistake. In the latest economic downturn, they got rid of highly-skilled labor because their wages and benefits were high, resting on imported immigrants with lower wages. The consequence now is that what they produce requires much higher labor input, because the inexperienced immigrants repeat many of the old mistakes the experienced laborers learned how to avoid. I'm not against immigrant labor, I'm just pointing out that low-wage immigrant labor may do more harm than good, even though low wage costs can increase productivity metrics. Wage-based productivity metrics can't tell you how much output was sacrificed.

There is a component of output, momentum, that doesn't manifest itself instantly with the replacement of high wages with low wages. Decay exists in everything. Poorly maintained plant and equipment break down more often. Poorly engineered products don't last as long. Poor quality of service and product diminishes customer willingness to return for more or refer others when needs arise.

If our economic stimulus programs don't produce another artificial credit-induced wave of consumer spending to make up for the diminishing sales of the old customers, the diminished momentum from displaced experienced labor is going to become evident when the consequences of the inexperienced low wage worker is reflected in declining output, increasing costs, or declining sales.

Busy Boys ... Better Boys
I think this single-minded focus on dollar metrics by economists, business managers, and policy planners is insufficient for solving the real problems facing the global economy. I have a 3-cent US postage stamp I found in my Mom's estate. It has no date on it, but others appear to be from the 1950s. This little 3-cent stamp speaks volumes about the decline in American culture, and it's impact on GDP when we consider the abstractions evident in the Delta Force equation.

It's a picture of newspaper boy on the left walking through a neighborhood. A bag rests over his shoulder with the motto, "Busy Boys ... Better Boys". On the right is a hand holding a torch with the motto, "Free Enterprise". Between them is a statement, "In recognition of the important service rendered their communities and their nation by America's newspaper boys."

We used to call that "work ethic"; it used to be a virtue. I don't recall seeing any government program honoring and extolling the virtues of work ethic like that 1950s postage stamp. Instead the focus is on entitlement, equality, and rights. It's evident, too, when you shop for products and services. Finding anyone with a work ethic that values one's contribution to others is rare, especially in the young. The predominant theme is one's right to income, or making a sale (getting one's money) at the cost of integrity and future product loyalty.

It isn't enough to just get more people earning wages, or keeping wages high to prop up tax revenues. The culture needs to re-discover the value of contributing to the success of others, which is the essence of the old work ethic. The idea that one's existence earns them a fair wage without consideration of their contribution is the essence of the decline in American industry and economic health.

Bad Can Be Good
Declining GDP or contraction of money supply are not problems in and of themselves. They are symptoms of something more fundamental. Whether they are good or bad depends on the essence of the underlying fundamental. A family that lives within it's means is a financially healthy family. If that family had a growing GDP (lots of economic activity based on new debt) they would be creating new money (increasing money supply) as they take on new debt and buy more products and services.

If they change their wayward ways, stop incurring new debt, reduce spending to conform to current income, they will flatten their contribution to GDP and contribute to a reduction in money supply. This is good for the family and the community, because there comes a point when economic activity shifts from debt service payment to new product and service output, but at sustainable levels. This was what characterized the decades following the great depression, an age where people understood the good things of life come from hard work, not easy credit.

If the old GDP reflected this old over-spending habit of the community at large (an addiction to "more stuff" now!), a declining GDP may be indicative of a more sustainable and healthy future. Furthermore, to the extent business learns to evaluate their output based on making product more desirable to the consumer, not only on price, it means a higher satisfaction (standard of living) and a more sustainable business model for business.

PIIGS - Propped Up By Hope

Maybe Governor Daniel K. Tarullo's testimony to Congress helped the stock market sell off yesterday. There's nothing better than a federal official making an official proclamation that "Europe is still in trouble, and it can mess up the U.S.,too. We don't expect another U.S. bank crisis, but ya never know!" That, of course, was a paraphrase. Actually, the direct quote was

...holding out hope that further financial disruptions can be averted

There ya go, Europe is propped up by hope!

Too bad the fed can't just get involved in more swap markets. Their excess profits are returned back to the US Treasury, and the last crisis not only earned $5.8 billion in interest on forex swaps alone, but cut the cost of federal funding from the flight to dollars.

It's good business being a central bank.

Over the life of the previous temporary swap program (from December 2007 to February 2010), all swaps were repaid in full, and the Federal Reserve earned $5.8 billion in interest. Finally, the Federal Reserve bears no market pricing risk in these drawings.

Analyzing Non-Borrowed Reserve Trends

Now this is interesting.

(click for full size)

Latest Observations from the chart. (full data series available from The Fed):
2009-12 968.670
2010-01 966.727
2010-02 1113.265
2010-03 1094.656
2010-04 1036.615

We see a drop from Dec. to Jan., but then a spike from Jan to Feb. It might not be coincidental the stock market was dropping after Jan. Money that flees equity risk may have been parked into the safety of bank deposits for a period of time, faster than banks were making loans. But Feb. to Mar. to Apr. we see either money has been flowing out of banks, or banks are lending more reserves into new loans.

It will be interesting to see in June what happens in May as this early May market turmoil reveals itself in the national metrics of bank balances. If the previous paragraph correctly identified cash flows, we would expect May's non-borrowed reserves to be up, based on the theory that retail investors sweep their proceeds into bank accounts and professionals sweep their proceeds into Treasuries.

Program Trading In A Falling Market

Look at SPY on March 3rd & 4th, 2010

The high on the 3rd was 112.80
The low on the 4th was 113.10.

That gap wasn’t filled before today.

Look at today’s one-minute intraday chart gradual falling off up until 14:21 EST.

The low was around 112.97 at which point it tried to bounce up but couldn’t hold. The steep sell off got really bad just about the time that false rally crossed back below 112.97 and took out the gap.

It appears there just happened to be a lot of mathematical models around that price point, whether because of the gap or something else. Volume started picking up at 14:00 EST, and then at 14:35 when the support was broken volume really took off in a free fall to the day’s bottom.

There’s no particular spike in volume, just this surge of selling and then buying over the last two hours of the trading day. A lot of stop losses were filled today which probably precipitated the free fall.

Forget the silly rumors of an order error. It's just someone making a joke that a bunch of simple minds believe and repeat until everyone believes it. Today's market action was driven by algorithmic trading and people with day jobs having their risk management strategies triggered by the machines.