America First: Federal Debt

Mike Smitka / Dec 23, 2017
Edited from a post on his Econ 102 course web site

Food for thought. The new tax bill will add $1 trillion in additional debt over the next decade – I emphasize that because the US already is adding debt faster than the economy is growing. The same is true of Japan. (Europe varies, but the OECD provides data that should allow an estimate of the growth rate of aggregate Euro Zone debt. I've not looked at their web site.)

As I will discuss in class during the Winter 2018 term, debt can't grow faster than the economy forever. The analysis is straightforward, though I won't do the arithmetic here. The stock of debt affects dynamics: the higher the level of debt, the more that higher interest rates make matters worse. So we've been helped since 2010 by exceptionally low interest rates. That is changing, with the Fed likely to bump short-term rates from 1.25% to 2.25% or higher in 2018. I expect rates to continue moving higher in 2019, once the new tax cuts phase in. For better or (in this case) worse, the Republicans in Congress are not conservatives, they're radicals who give only lip service to fiscal responsibility. At some point taxes must increase – again, debt can't grow faster than the economy indefinitely, and the deficit dwarfs the actual budget so even draconian cuts won't do the trick. (See the bottom graph, which uses Congressional Budget Office "cyclically adjusted" deficit estimates.)

Who on the political horizon is equal to the unpopular but necessary task of raising taxes? Japan's case does not make me optimistic. The issue is worse there, because debt is much higher, and thanks to demographics the economy is growing more slowly. Fiscal conservatives at the Ministry of Finance and elsewhere began talking about this issue in earnest in the early 1980s. Over time the need to cut deficits became sufficiently accepted across the political spectrum to be turned into legislation. The resulting shohizei (消費税, national consumption tax) took effect in 1989 with a modest 3% rate, as part of a broader tax reform that lowered other rates. The first big boost, to 5%, took effect April 1, 1997. The magnitude and timing of the increase was ill-judged, and the hike's initial impact was amplified by "buy now" campaigns for big-ticket items. Car sales boomed through late March 1997. Sales then fell off the cliff – I was living in Japan and visited a car dealership towards the end of the March. It was empty, because the registration process meant any sale wouldn't be recorded until after April 1. The consequent recession was such that, while the ruling Liberal Democratic Party continued to talk of further rate increases, it took 17 years to implement the next hike. There was always a good reason – the 9/11 US terrorist attack of 2001, the Lehman Shock of 2008, the 3/11 Tohoku earthquake in 2011, and pending elections all seemed to conspire to overcome good intentions. Meanwhile, and as expected due the to the rise of expenditures to cope with the aging of the population and various short-term stimulus and reconstruction projects, deficits remained stubbornly high. And that's in a country where the political consensus has remained one that taxes are too low, not that they are too high.

Cars are a long-term payment scheme

“The bottom line is that most people do not buy a home but rather commit to a long-term payment scheme.”

Izabella Kaminska, FTAlphaville, November 7, 2017

And the good phrasing doesn't stop there: her line refers to a Convexity Maven (Harley Bassman) note "House of Cards."

The above lede on the Financial Time's Alphaville blog caught my eye. It applies equally to the auto industry. Over 70% of new car purchasers use some sort of finance, and trade those wheels in before the loan matures for another financed "ride". At a 7.6% interest rate (the base rate from a major OEM's web site), and with a 7-year loan, a "purchaser" will still owe half the face value of the loan at the 4 year point. With 17% depreciation per year, their trade-in will just equal their loan value in the 52nd month.

Even I took out a loan – a 0.9% financing deal was too good to refuse. However, I didn't do a long loan, only 4 years, and I put 50% down so that I'd never be upside down. As it turns out, though, interest rates have stayed really low, and my short-term savings hasn't been earning at best 0.1%. So I might just as well have dipped into savings and paid cash for the whole thing. In any case, the four year consolation prize of being free of car payments will soon be here.

The point at which someone trapped in a long-term car payment scheme breaks even will vary with the depreciation rate, interest rate and length of the loan. Here are sample calculations. Note that a shorter-maturity loan pays down much more principle in the first year, and so purchasers aren't underwater for long. The cost, of course, is a higher monthly payment. Here I assume (unrealistically) that the loan is for 100% of the car value as reflected in the resale market – no extended service plan rolled in, no downpayment. The number of permutations with the latter is unwieldy. So if the car is valued at $60,000, then with a $10,000 downpayment (or tradein plus incentives), an 84-month, 7.6% loan remains rightside-up throughout but provides $5000 equity only in the first year, before that $60K has depreciated much, and then again from the 55th month.

---

Car payment calculations, $50,000 loan
Maturity (months)	Interest rate	Monthly Payment	Depreciation rate	Upside down until:
84	7.6%	$769	17%	52
84	6%	$730	17%	50
84	3.9%	$681	17%	46
84	7.6%	$769	16%	48
84	6%	$730	16%	45
84	3.9%	$681	16%	40
72	7.6%	$867	17%	33
72	3.9%	$780	17%	26
60	7.6%	$1,004	17%	12
60	3.9%	$919	17%	4
60	0.9%	$852	17%	1
48	0.9%	$1061	17%	0

Graph(s) of the Day: Govt Transfer Programs

Mike Smitka

Ten days since the last graph ... time to add another. Here are the largest transfer programs in the US as a "stacked graph." These include those not only of the Federal government but also much smaller state and local programs. I've not included private transfers. Those aren't large, or more precisely are no longer large, in an era when few companies provide employer-funded defined-benefit pensions.

Here are these data normalized to GDP - the vertical axis should be "per cent" but I can't relabel so you have to note .14 is 14%. As expected, the increase looks much less dramatic, and you can see the sharp falloff of unemployment insurance as the labor market improved post-2011.

First, you can see the magnitude of government transfer programs. In our $20 trillion economy, they come to $2,700 billion or about 14% of GDP. (Remember, transfers don't show up directly in GDP, they are personal income and enter the economy only when someone spends the money.) However, the graph is not particularly helpful, because this is nominal GDP, which reflects not just "real" growth but also inflation. To better convey the magnitude, you should divide each of these series by nominal GDP. Rather than ask you to do that – it is straightforward task in FRED – here's the graph for the total divided by nominal GDP. You can see that there was a big increase with the Great Recession, but that the amount is slowly decreasing. I expect that is muted because of the retirement of the Baby Boomers, and not just by the still partial recovery during which 2% of prime-aged workers have yet to re-enter the labor force. But admit that I have not dug in deeper.

We can also look at the composition. In the early 1950s there were few retirees as a share of the population, and many of those retired did not qualify for social security. That changed as more and more workers were "vested" in the program (which was enacted only in 1937). As a share unemployment was much higher, but that's as part of a very small total. The catch-all other category looms large as a share of transfers, but small as a share of GDP. Neither Medicare nor Medicaid existed until 1966. Today retirement programs predominate: social security and medicare together are $1.6 trillion. State-level healthcare programs (Medicare) adds another $560 billion. The remainder includes miscellaneous small items such as veteran's benefits ($90 billion), food stamps (or formally SNAP, at $65 billion), and tax rebates, such as the $7,500 that a well-heeled American gets back from the purchase of a Tesla Model S but also the much more substantial earned income credits that help a low-income individual offset various taxes. In other words, what we would commonly refer to as "welfare" is too small relative to our $20 trillion economy for FRED to break them out as separate line items. [For much, much more detail see Table 3.12 Government Social Benefits in the National Income and Product Accounts.]

All of this provides an anchor to the economy: these flows continue even if we enter into a recession. That's important, because when someone loses a job, the impact spills over to local retailers and others, and leads to additional job losses, the "multiplier" of Economics 102. Now as you can see from the data, unemployment benefits are generally trivial, and they are also time-limited (24 weeks or roughly 6 months). But they increase sharply during a recession, and act as another component of our "automatic stabilizer," allowing people to cut consumption less and thereby partially offseting the spillover effects from the loss of a job. It's important not to overstate the cushion this provides, as it's hard to find a job during a recession. Benefits aren't very generous, either, averaging only about $300 per week – for many workers the replacement rate is only about 50%. Given the severity of the Great Recession, Congress did recognize the importance of even partially stemming the cascading effects of job losses; the ARRA temporarily increased the duration of unemployment insurance for up to 99 weeks. If you'd been earning $36,000 per year, however, and just barely making car and house payments, you couldn't make ends meet on $1,200 per month in unemployment checks. Goodbye house, but keep the car or you'd be unable to work even if a job became available.

Sticky Prices and Macroeconomics

Mike Smitka

We're now starting on AD/AS analysis in my intro macro class. It involves a lot of handwaving, given the simplifications imposed by using blackboard models – do we want our y-axis to be "the" price level or the rate of inflation π or (later in the term) the rate at which π is changing? At the same time the x-axis is a broad aggregate, (real) GDP, that we conceptualize as a physical aggregate. So why do they behave as supply and demand curves ought to, sloping up and down, respectively? One answer is that prices are sticky. If you want the argument, go to a textbook.

The more general issue is one that plagued the classical economists: if prices adjust freely, then why should there ever be unemployment, or other unsold goods? Why should productive capacity in an economy ever sit idle? Here the key is that prices are sticky. My wage, for example, is set but once a year, and that in accord with a salary pool based on expected tuition and other revenue sources, which likewise are updated only once a year. So if a shock hits the economy – prices rise unexpectedly (or inflation, the rate of price rises, rises unexpectedly) I will see my pay fall behind, and even if the university does set out to adjust things, it may take a couple years to get back in synch. Since labor accounts for a bit over half of all costs for producers of goods and services in the US, most attention focuses on that behavior.

Now I've never seen a breakdown of the frequency of wage changes across the economy, though I've never looked and I'm not a labor economist. But the Federal Reserve Bank of Atlanta Inflation Project does recompile the data that underly the Consumer Price Index into goods and services that are "sticky" and those that are "flexible". Over time they average out to be about the same, inflation truly is general, but in the time frame of a few years they can and often do move in opposite directions.

Their web site details which goods are sticky and which are flexible, with the weights each have in the CPI basket of goods and services. On the flexible end are things such as gasoline, electricity prices, food purchased in a supermarket, women's clothing and (yes!) new car prices – think of all those rebates and subvented [jargon for manufacturer-subidized] loans and leases that appear when sales are slow. On the sticky side are personal care services (how many years since my barber upped his price? – the sign's yellow!), fast food prices, school fees and beer prices.

For building a supply model we'd want to look at components of business costs besides labor, things like the billing rates for lawyers and accountants or xerox paper. No one to my knowledge has put together a comparable flexible/sticky producer price index. But for building theory, all we need to know is that in the real world prices are sticky.

Dealer Musings (II): Ruggles on Gap Insurance

David Ruggles

Gap insurance is a by-product of the extension of car loans to longer maturities. Once only 3-4 years, loans now extend out to 7 years (and sometimes more). At current interest rates of 7.6% (quoted on a Chevy dealer website), at the end of 3 years the purchaser will have only paid $18,200 on a $50,000 loan. However, the resale value may only be $25,000 or 50%. So the purchaser will be “upside-down” on their loan by $7,000. Now there’s generally some sort of downpayment, but purchasers can add on extras that aren’t figured into the insurance value of the car but might be built into the loan. So if they total their car and are paid only the replacement cost (less deductible!), they’re in trouble. Or in this case, their truck in Texas was underwater, and their auto loan is, too.

Now consumers can be quite naive about this risk. That's not true of banks. If the borrower defaults and the bank repossesses the car, they’ll be out the “gap” between the balance of their loan and the wholesale value of the car (plus the out-of-pocket costs of hiring a “repo” specialist, and cleaning up and transporting the vehicle to auction). Hence “gap” insurance. (Of course the same issue faces anyone involved in vehicle finance.)

...don’t be surprised if some GAP insurers become insolvent...

Friday class, Friday graph of the day: Trade

Mike Smitka

Krugman (co-author of Krugman & Wells, our Economics 102 textbook) won his Nobel Prize for work in international trade, but his "open economy" chapter remains at the end of the book. That textbook structure dates back to the first true "principles" text in 1947, written by Paul Samuelson (another Nobel laureate, and a co-founder with Heckscher and Ohlin of modern trade theory). Since then all successful new texts chose to market themselves as potential replacements, which is realistic only if they are close to what econ profs were already using. We do not see product differentiation! But that's a topic for Econ 243 (Economics of Strategy / Industrial Organization) and not Econ 102.

Dealer Musings (I): Ruggles on Recalls

David Ruggles

I wish I had something pleasant to say about things affecting dealerships. I'll try to come up with something before the end of this series. But if a person long on the sales side of the industry can't think up an optimistic story, maybe there isn't one. After all, how many perennially downbeat sales people have you met?I start though with safety recalls, and follow with gap insurance and then the latest twist in branding that pits the Factory against dealers.

Graph of the Day: Wed 18 Oct

Mike Smitka

Today saw the latest release on residential construction. The default graph on FRED is the total number, of course with multiple series for new starts versus permits versus under construction, and by region. But between 1960 and today the US population rose 80%, from 180 million to an estimated 325 million. Everything else being equal – and it's not, we know that the baby boomers are retiring and downsizing – we would expect the desired amount of housing to reflect the size of our population. So my graph makes that adjustment, dividing by population. As you can see, the current level of housing under construction has doubled since its December 2012 trough, but remains significantly lower than at any time prior to the Great Recession.

Graph of the Day: Mon 16 Oct

October 11, 2017

Among the "headline" inflation numbers, experienced observers look not at the overall monthly, seasonally-adjusted CPI but at the CPI less food and energy. You all know what's happened to energy, but you also know that it's temporary, until the effects of Harvey wear off. Food has such effects when a droughts or floods will hit a major crop area one year but not the next. So look at the graphs – not a formal statistical test, but a start! – and look for co-movements of these three indices. Don't see any? Maybe that's why the focus is on "core" inflation!

...inflation remains below 2%...

Graph of the Day

Mike Smitka

This graph shows:

1. the nominal interest rate, here on 3-month Treasury bills (which are short-maturity US government bonds and typically have the lowest interest rate among similar maturity instruments),
2. the corresponding 3-month rate of inflation for the economy as a whole, in the form of the quarterly GDP implicit price deflator [which is thus much broader than the CPI measure of inflation, as befits an economy-wide interest rate, and which carries an odd name tied to the technical use that motivated developing the measure], and
3. the difference of the two, the "real" interest rate.

The Price of Oil

Mike Smitka, Professor of Economics
Washington and Lee University in Lexington VA
from WashU in St. Louis MO, where I'm participating in a conference

Both governments and automotive companies are placing large bets on alternative vehicle drivetrains, above all electric vehicles. In this context Roberto F. Aguilera and Marian Radetzki's The Price of Oil, which Gavin Roberts reviews for Eh.net, appears to be a "must read." I have yet to look at it, and would certainly like to see whether more recent evidence backs up their core claims. Their bottom line is that both new technologies and new politics will keep the price of petroleum low for the next decade. In contrast, I believe both high technical and intractable political hurdles impede the commercialization of battery electric vehicles. Low oil prices amplify these challenges. Really cheap oil makes EVs unlikely to eliminate the gas engine by 2040.

...really cheap oil makes EVs unlikely to eliminate the gas engine...

Autos can't live without China

mike smitka

I take part in an online discussion forum on Japan that occasionally strays into economics and business topics. One ongoing thread is the potential impact of erecting a "bamboo curtain" around China. A couple posts assert that realigning global production following the elimination of trade with China would not be a big deal. They seem to forget the havoc caused by 3/11 (the Japanese tsunami/earthquake), where damage to a mere two plants impeded global automotive production. One produced a dye essential for certain black/red paints. Red isn't all that popular in most markets, but surely the firms that used it for black lost sales to rival manufacturers who had a different pigment mix. [You don't substitute a different pigment without lots of testing – it's finicky, and the pigment layer may be only 19 microns deep. A different particle size or stickiness and you get paint that looks bad or worse, doesn't adhere. BMW owners won't tolerate peeling paint!] Then there was the Renasas plant in Sendai, which was already in the process of shutting down. Work on their new plant in Southeast Asia was accelerated, and round-the-clock teams worked as well to restart production in Japan. Fortunately there were pretty big inventories and the processor involved was used in more than one function. It did mean certain option packages weren't available, but by so China however would not be just two plants.

...without a global market, it would make much less sense for European, Japanese and Chinese suppliers to set up shop in Detroit...

Sugar tariffs

Mike Smitka
reposted from my Econ 102 Macro Principles blog

First, here are data to help you remember that import prices are not everything. Prices effectively triple between the wholesale price sugar farmers such as the Fanjul brothers receive, and the price you pay in a store. A big baker will pay something much closer to the wholesale than the retail price - if you buy by the train car (not the truckload!), delivery costs per pound are very low. The price gap between Brazilian and US sugar is about 40%. So even if the tariff was eliminated, the price would only fall by about 6¢ wholesale, and by about the same retail. How eager would consumers be to fight over 6¢ per pound? Even though I do some baking, it takes me over 1 year to use a 5 lb bag!

Prices	1980's Average	2013
Brazil Raw Sugar Price	-	14 cents
U.S. Raw Sugar Price	22.16 cents	20.46 cents
US Wholesale Refined Sugar Price	27.06 cents	27.22 cents
Grocery Store Refined Sugar Price	33.59 cents	64.32 cents

Automotive Employment Decomposed: New vs Used Car Dealers

Mike Smitka

...employments is centered in new car dealers and parts manufacturers...

Scott Wood of Carvana asked me about the increase in employment in automotive retail. With a bit of poking, I found that the Current Employment Survey (CES) run by the BLS provides fairly detailed breakdowns. Now I very strongly suspect that in the survey responses, employees at a new car dealer are not subdivided into those who work in service vs finance vs new sales vs used sales. All are likely classed by the main  business category of new car sales. Still, this provides a starting point. As it happens, while used car dealership employees have risen faster, the bulk of the increase in employment stems from the rise in new car dealership employees. While I'm at it, I also am posting (i) car vs parts/accessories/tires and (ii) assembly vs parts manufacturing. As expected – well, at least by me! – people who work in parts plants vastly outnumber those at "the" car companies. The latter get the political attention, but they're not the ones who "make" cars, they just put together the pieces.

Quick Update: US Labor Force Graphs, including autos

Mike Smitka

Here is an overview of (i) unemployment across the Great Recession and the subsequent recovery, highlighting U-6 "total pain" versus U-3 "headline unemployment." U-6 peaked at 17% of the labor force. It doesn't reflect those who dropped out but weren't "discouraged" or "marginally attached" by the BLS – currently, as per the graph below, that's still about 2% of prime-age workers, and 4% for age 20-24 workers. See the graph on the right for details.

I also calculated a "normal" level of total employment, using the relatively constant age-specific rates in the period prior to 2007, but adjusting the total for demographic changes, particularly "boomer" retirement. That's the graph immediately below. By that measure we're still a year away from "full" employment, assuming no slowdown. We have however added 12.2 million jobs, relative to population growth, since the trough of the Great Recession.

Finally there's the auto industry. On the retail side employment is at a historic high. However on the manufacturing side, despite robust domestic production, the industry employs about 130,000 fewer workers than at the onset of the Great Recession, or about 12% fewer. That is, one in eight jobs vanished. Why? – productivity. This reflects a long-term trend, it simply takes fewer people to turn out a vehicle today than in 2006, primarily due to more efficient parts production, because that's the sector where nearly 3 out of 4 workers in vehicle manufacturing are located.

Harvey to clear the industry's excess inventory

Mike Smitka

...the Thu 31 Aug Automotive News morning 'cast gives 300K-500K vehicles, but unfortunately the storm lingers...I hope I am wrong on the 1 million figure...

Harvey will cost insurers billions. Part of that will go towards the purchase of replacement vehicles. Macabre, yes, but that's a timely bump for an industry that has been grappling with excess inventory. Houston proper has 2 million people, and extend out to Harris County and you have almost 4.6 million. Immediately adjacent counties add 1.2 million more. At present the cars of a significant slice of that population are underwater, and will remain so for another day or more. That means they're totaled. Across Texas as a whole that certainly means 1.0 million vehicles, and perhaps more. A week ago the industry was awash with excess industry. Now it's not.

...for the auto industry Harvey is not a disaster but a turn of good fortune...

As sales fell over the past 9 months, the US industry built up inventory. A healthy level is around 60 days of sales. But by June 2017 dealers had 74 days worth of cars and light trucks on their lots, and pared that level only modestly to [Ward's] 69 days in July, or 4.2 million units. Of course this hides significant variation, with GM holding 104 days (0.98 million units) and Ford 76, while Subaru had only 40. Now much of the excess is in sedans, as demand shifted towards light trucks – the latter sold at a 10.8 million unit rate in June, while sedans sold at only a 5.8 million rate. The industry is responding: over the past year, NAFTA light truck production was [Ward's] up 4%, sedan production down 11%. That won't be reversed in the short run – suppliers can't spew out extra parts overnight – so sedan inventories were already set to keep falling.

Now Texas is truck country, as CNN's videos of Houston neighborhoods indicate. So Harvey won't be as big a boon for sedan sales, though Texans who find they're underwater on their loans may be forced to downsize to a mere car. The impact remains: 1.0 million units represents 16 days sales, and will help the industry draw down inventories to closer to 50 days. For the auto industry Harvey is thus not a disaster, but a turn of good fortune.

The US Bureau of the Census tracks the dollar value of automotive retail inventories. The most recent data – $68 billion in June 2017 – do not separate detail new versus used vehicles, or parts and tires versus vehicles. In contrast, the biggest purely retail sector, drugs and druggist sundries, comes to only $60 billion.

Auto Inventory Cycle Adjustment: More Pain Ahead

Mike Smitka
Washington and Lee University

During the extended housing boom of the early 2000s, consumers used home equity lines to go on a consumption binge. Light vehicle sales remained strong, while the model mix richened. Then the housing bubble reached its peak (and gas prices rose). The good times were over, and at the February 2009 trough sales fell to that of the trough of the 1981 recession. In relative terms the situation was far worse, because in the interim the US population grew by almost 80 million. Relative to employment, sales were a full 15% below the previous post-1976 (before which consistent data are unavailable).

Cars are durable goods, and even though the average vehicle now lasts 12 years, they eventually need to be replaced. Meanwhile the US population continues to increase and incomes have recovered (though for most Americans, not risen). From an excess of vehicles per household going into the recession, the number fell below what households wanted, and has now recovered. In February 2007 SAAR was 16.7 million units; that level wasn't hit again until March 2014. Fueled by low interest rates, longer loan maturities, and high used vehicle prices, sales crept back up. Indeed, Paul Traub of the Federal Reserve Bank of Chicago argues that they have been higher than sustainable.

...it's payback time...

It's payback time. Over the past several months the Light Vehicle SAAR (seasonally adjusted annual rate of sales) fell 7.5% from its December 2016 peak of 18.051 million units. This represents a drop of over 1 million units. Now  inventories rise and fall as a normal response to short-term swings in sales. With a steady fall, though, they mushroom, and mushroom they have. (Thanks to Paul and his May 2017 presentation to my W&L auto seminar for the graph on the left.) Now that the drop appears to be more than a transitory blip, it's time to bring inventories under control and pare production.

The supply chain is like a snake....

The supply chain is like a snake. If it's to eat bigger prey, it has to bulk up, and that takes time as suppliers rehire and otherwise add capacity. (This is on top of the normal investment to replace tooling for old models with that for new. Given the hit balance sheets took from the Great Recession, they also had to repair balance sheets to add capacity.) Going into the recession, production peaked in June 2007. It took over 6 years, until November 2013, to reach the previous peak.

....that's consumed too big a meal.

Now it’s like a snake that’s just consumed too big a meal: it's sluggish, because it takes time to get it out of its system. The Production Index hit 131 in October 2016, and bounced around that level through April 2017. It’s since fallen 7.6%. But that at best brings production in line with sales. It doesn’t pare inventories. That will require either an uptick in sales (fueled by assorted incentives) or a further cut in output. GM for example has chosen the latter, with extended summer vacations – not that they aren’t discounting, after all they can’t totally ignore price cuts by competitors. Output will surely fall more; it’s better to overshoot a bit, given uncertainly about whether sales will fall further. And today labor is no longer a fixed cost. As per Econ 101, the flip side of higher marginal costs makes it relatively more profitable to cut production than prices.

That leaves two questions. One: what is the stable level of output? I’ll save that for another post; too many graphs already! The second is employment. Here the bottom line is clear: productivity continues to rise, a trend visible as far back as data are available. Industry employment is certain to fall, and on a permanent basis. As a dismal scientist, I close with that graph, and with that of auto industry manufacturing employment.

I leave out many pieces. One is that while manufacturing productivity increased, that's much less true of automotive retail: employment there is at a historic peak. Then there are the finance, household formation, population data, household formation, depreciation and other pieces of the peak sales story that Paul Traub sets forth. I have not tried to put together the last couple months of inventory data, or compiled the various media reports of reduced production at GM factories, eg Lake Orion where the slow-selling compact Sonic (and the Chevy Bolt EV) are produced. Finally, while I can't provide any details, I do participate when my schedule permits in the monthly sales analysis roundtable that BWG hosts for their clients. My reading of these various sources is that at a more detailed level, some manufacturers are slower in responding than others, while the impact of the sales slowdown is uneven across manufacturers/brands, with for example the shift towards light trucks amplifying the impact on producers that are sedan-heavy, such as some of the Asian brands.

Real Yield Curve

Mike Smitka

I look at data of various sorts, often out of mere curiosity. One ongoing puzzle is the evolution of interest rates. I've posted graphs of nominal rates, and implied future rates. Below are similar graphs for real rates, as calculated by Treasury using inflation-adjusted bond (TIPS) yields. The first are the real rates at various maturities. (That's the graph on the left – click to expand.) I then use the difference between yields at different maturities to calculate the implied future interest rate. (Duh, that's the graph on the right.)

At one level these look sensible. We see that longer maturities have higher yields. We see craziness in fall 2008. But real rates remain low, around 1% into the far future. They look sensible, but they don't make sense.

...[they] look sensible, but they don't make sense...

One explanation might be global excess savings, what Ben Bernanke termed in 2005 as a global savings glut, driven by countries where individuals and firms are building up financial assets as their populations grow but where they've run out of sensible domestic investment possibilities. That requires financial outflows (and for that to happen, a trade surplus). And on the US end we do indeed see the flip side of trade deficits and net financial inflows. (Again, you can't have one without the other.)

After all, conceptually the return on investment ought to be higher in labor-abundant, poor economies. But I find it hard to believe that story, when we find it going on year after year. OK, many economies have unstable politics, which might make would-be investors cautious. So savings could pile up. But we don't see sharp breaks that might be consistent with that story, that is, with the ebb and flow of politics. Indeed, if that sort of uncertainty is key, we ought to see a huge Trump bump, because politics in the US now looks zany. Policy change is precluded by political infighting and the failure to appoint staff across the Federal government. We have no ability to address a crisis, much less attend to long-run challenges such as putting in place a true healthcare system, improving eduction or setting our fiscal house in order. The bottom line is that I don't see any such effect in the data.

The other story is secular stagnation: that despite the hype and self-promotion of Silicon Valley and the venture capital vultures who circle in search of easy feeds, there just isn't much happening. Cheaper taxi services – Uber, for example – just aren't working out. And from an economy-wide perspective it's hard to see an economic revolution in that, or better dating apps, or in receiving streams of 140 characters. In the $20 trillion dollar US economy, there's room for a lot of successful new $50 million businesses, but again, from a $20 trillion dollar perspective they are chump change. Robots? – I've been visiting factories for decades, automation is already widespread. The low-hanging fruit has been picked, and "hard" goods are only a 20% slice of our consumption. Artificial intelligence? The Executive Director of our small local United Way of Rockbridge worked in the earliest AI initiative at Stanford in the 1970s. Algorithms aren't new, and the cost of computing has long been near zero. Again, the low-hanging fruit has already been picked.

...the other story is secular stagnation...

My preferred explanation then is that (to borrow the title of Marc Levinson's most recent book), the transport, information and energy revolutions that exploded after 1800 represented An Extraordinary Time. That era has now come to a close, and henceforth we will no longer see the productivity growth that underlay the rise of the US. To borrow again, this time from Robert Gordon, this represents the Rise and Fall of American Growth.

However it's not just an American story, something emphasized more by Levinson than by Gordon. It's the story throughout the OECD economies, Europe and Japan and now even China. We can pray that in the next 3 decades South Asia and Africa converge on the developed economies through their own growth miracles. But for now they're too small, and too isolated financially, to offer a solution to the secular stagnation that we see in the US.

Disclosure: I'm using Levinson's book this fall in my 2 sections of Econ 102, Principles of Macroeconomics. I listened to the Audible recorded book version this spring, and am now reading the hard copy one. Gordon is also available as a recorded book, but given his prolific use of data, I can't imagine consuming it without his graphs in front of me – and I do my listening while driving.
For completeness, Bernanke reviewed his original savings glut story 10 years later, in a 2015 Brookings post. Here too is The Demise of U.S. Economic Growth, a modest-length paper that covers the stagnation themes that appear in the latter 100 or so pages of Gordon's 750+ page book.

Auto margins and disruption

Just a quick cross-reference in line with the previous post a great quote:

“TSLA, for all Musk's gift-wrapping abilities, is primarily a manufacturer, and history has shown us that the economics of the automotive industry are crap. ”

Graham Osborn, Contributor 10 Aug 2017, 09:51 AM

found in the comments to "Some Thoughts About Tesla's Latest Bond Offering" posted by Montana Skeptic at Seeking Alpha on August 10th.

No margins, no disruption: the New Mobility Challenge

Mike Smitka
Washington and Lee University

If you want to disrupt an industry, you need to pick one with fat margins. That's the real challenge for the entire family of "new mobility" models, and more generally for "disruptive" technologies in the automotive footprint. It's one thing to be able to arbitrage regulated monopolies, which is what most incumbent cab companies are. But that only works if your strategy provides you with entry barriers, and the monopolies you break into earn piles of money. Local cab companies are however perfectly capable of developing their own cell phone apps, benefitting from the high ratio of "locals" in the customer base. That's true up and down the automotive value chain: all operate with thin margins. They are thus NOT ripe for "disruption."

...why would anyone want to try to disrupt a market with thin margins?...

At base, motor vehicle manufacturing, distribution, repair, and the final market of transportation services have few monopolies. Yes, if you want to develop the next-generation diesel engine there are only two players who are capable of the underlying material science and have the ability to manufacture with the requisite quality in the requisite volumes. (These two are Federal Mogul and Mahle.) There are however multiple firms capable of "mature" piston production. The same is true for every other component that I can think of: there are often a small handful of "leading" firms but there are also commodity producers of older technologies. The only way to preserve margins is to keep innovating.

Furthermore, it's a complex chain. Assembling vehicles, as Tesla is learning, is the easiest part – and they don't yet have their Model 3 assembly line up and running, despite having more employees than the normal volume assembly plant. But that's the tip of the iceberg: they have yet to solve the national distribution challenge in a cost-effective manner. Assuring that component supply lines can meet your production plan, and that you can take tradeins, provide financing and repair vehicles quickly, all that takes a lot of people and a lot of physical assets. Experience helps, too. If you're to grow rapidly, those have to be in place beforehand. Some resources can be borrowed, including the financing, as happens in the "traditional" franchised dealership system (though Tesla has decided not to do so).

It took over a decade from their establishment of a solid footprint for Honda, Toyota and VW to succeed – and as VW has demonstrated, laurels can be lost. After all, in the early 1960s and again around 1968 VW was THE import market in the US. They're now barely a player. The VW vertically integrated, single model mass production strategy worked for a while, as did Henry Ford's monomaniacal focus on the Model T and nothing but the Model T. Neither VW nor Ford were ever able to lower costs sufficiently to develop a sustainable advantage against the evolving products of rivals. In contrast, Tesla is a high-cost producer with a high-cost distribution system. High costs aren't an insuperable barrier if you aim to break into the premium car segment, but even then you have to keep renewing your product. High costs don't work if you aim for the high volume, middle-segment of the market.

Ditto Uber on the downstream transportation service end: taking over the taxi business would be great, but only if the underlying business was unusually profitable. But it's not. There's little room for cost reduction – materials, labor, overhead. It's not as though existing taxis are new and drivers well-paid. There not much room to cut economic costs, even if in the short run costs can be shifted to unsuspecting parties (Uber's owner/driver contractors). The only way Uber can provide reliably better service than incumbent Yellow Cabs is to have higher peak load capacity, with the requisite assets of vehicles and drivers. Superior service at a comparable price lets them grab market share, but they've not expanded the market. And without a bigger market they can't sustain their high-cost strategy. A cell phone app doesn't lower the cost of a car, or lower the minimum wage paid by alternate jobs. To reiterate: creating a big taxi company does not provide a route to healthy long-run margins.

...creating a big taxi company does not provide a route to healthy long-run margins...

So don't be fooled by the apparent ease of entry by disruptors. Yes, Tesla can draw upon the base of automotive suppliers to launch a car, something that would not have been possible in the more vertically integrated world of the 1960s. Numerous Chinese domestic players have done the same, and one or two may even survive if not thrive, the Geely's and Great Walls. But Tesla can't rapidly expand in the mature markets of NAFTA and the EU, absent a revolution in battery costs that decades of leading-edge chemistry research has yet to deliver. They can't compete in costs against the still-improving technology of the internal combustion engine. They can't compete by eroding the fat margins of incumbents, because margins aren't fat.

Autonomy is much the same. The suite of sensors need to be integrated into a vehicle, software integrated into the actuation of steering, braking and so on. Everything then needs to be tested. Car companies are good at that – that's why they're called assemblers. Many of the pieces are already in place, but consumer acceptance is still uncertain, and the only way average transaction price can rise is if sales fall: the average new car purchaser can only finance so much, given stagnant incomes amidst a driving population that is virtually flat. In other words, implementing a costly technology won't help margins. Indeed, it's already gotten the CEO of Ford fired.

...govt policy can disrupt the (auto) market, but not Tesla, not Uber, not Waymo...

There is one exception: government policy can disrupt the market, by enacting direct and indirect subsidies (such as California ZEV credits or safety mandates). But not Tesla, not Uber, and not Waymo. What is amazing is that, given automotive margins, they purport to have "disruption" as their strategy. It may work on the stock market, at least for a while. It won't work in the automotive market.

Germany will be first in EVs – but don't invest in VW!

Mike Smitka

The first big market for EVs will be the EU, not China and certainly not the US. This is not common wisdom: after all, isn't Beijing pushing EV technology, including forcing firms to buy batteries from "domestic" players? And then there's Tesla in the US. Of course in terms of hype no one can beat Elon Musk (and in semiconductors, NVDIA). But against global production of 90+ million units Tesla's puny 80,000 units in 2016 is on the order of the reporting errors in global sales data. They aren't disrupting anything. Instead the disruptor will be VW, adding to the presence of Renault and Nissan.

This was one of my key takeaways from the 25th GERPISA conference in Paris in June, garnered across 4 days of R&D center visits, presentations and conversations. [For fellow researchers, next year's GERPISA will meet in June in Sao Paulo Brasil.]

On the regulatory side, EU fuel efficiency rules cinch tighter in 2020-21, and thanks in part to VW the test cycle standards – currently the New European Driving Cycle – will be tightened to better reflect actual EU driving patterns. (Currently, for example, back seats can be removed and the alternator disconnected, while accelerations are unrealistically slow and idles too frequent.) That will make it extremely difficult to meet CO2 mandates. Reconfiguring diesel systems that passed due to "cheats" will lower their efficiency and raise their costs. Keeping to a diesel-centric strategy won't work. This will be a particular challenge for VW. At the same time, France was already moving to limit the presence of diesels in urban areas.

Hence BEVs (battery electric vehicles). VW just announced they've frozen the design of their first model, to be launched in 2020, and will thereafter start turning over their fleet to BEV models. For now they are basing their model on the underlying architecture of the Gulf. However, they are working on new architectures that will facilitate flat battery packs – we at GERPISA visited Renault's vehicle competitive teardown facility, and that's one of the things they look for in their analysis of new platforms.

Then there are batteries. VW will not make their own cells, reflecting both a lack of internal capabilities and to maintain the flexibility to shift their sourcing as cell technology advances. But they will make their own modules and packs, to better control weight and safety. Those are also heavy and bulky, so doing this in their assembly plants makes sense. Ditto Daimler.

Now VW is not alone, even if their diesel-heavy strategy and legal issues places them in an awkward position. Renault continues to update the Clio (and Nissan the Leaf), and both are poised to launch additional vehicles in line with demand. Meanwhile, the various EU members are building out base infrastructure. France already has charging capabilities along major highways; Norway (a small market!) is already 30+% electric. The government role is central, because infrastructure is expensive, and needs to be pervasive. Private efforts suffer from chicken-and-egg issues. For-profit charging ventures inevitably focus on dense areas. But for consumers to make a BEV their sole vehicle, national availability helps: there's always that trip to the beach, or a quick weekend getaway to the countryside. Such locations wouldn't generate enough business to make it pay to set up charging, at least early in the rollout of BEVs. But their presence facilitates market expansion.

After hearing pieces of this story from multiple people, I'm now convinced that BEVs will happen sooner than I expected in Europe. Key is that they will now provide a better value proposition relative to diesels, which intrinsically sip rather than gulp fuel. But batteries remain expensive, so that's not good news for VW. To meet efficiency standards they'll need to sell a lot of EVs. To do so on a competitive basis against the standard gasoline vehicles from other manufacturers means VW will lose money on each one it sells, to the tune of billions of euros as volumes rise. So VW has solved the subsidy dilemma: economies of scale and competitive costs can't be achieved without somehow getting BEV volumes up. EU incentives aren't enough; paying for a test fleet is one thing, doing it for millions of cars is another. VW incentives may well make the difference – indeed, Volkswagen is betting the company that that will be the case. In the interim, though, VW will not be particularly profitable. That interim will extent until 2027, at which point costs will fall, or VW will. Don't invest in VW!

...for the next 10 years, don't invest in VW...

For the US, the current administration is hostile to environmental issues, and is promising to roll back fuel efficiency standards (which will benefit luxury car makers, primarily German, and hence is not particularly helpful to domestic manufacturing). At the same time, the current Congress seems unable to pass any legislation, much less focus on such long-run issues as energy policy. That may change over the next couple elections, but for the time being there will be no national infrastructure policy in the US, and without that BEVs will remain a niche product. Yes, the fines VW is paying will be used to build charging infrastructure, particularly in California. But there's no national vision behind it, only an attempt of VW to get some modest indirect benefit out of their fraud settlement.

Then there's China. For the same budgetary reasons as elsewhere, Beijing will rein in central government subsidies by 2020. Yes, they want electric vehicles, they want to have a presence in new technologies. No, they don't want to pay for it. Economic nationalism fails as a policy when it requires spending serious money. Meanwhile Panasonic and others are building plants there, suggesting that a "Chinese companies first" stance will work no better there than it has in the passenger car market, where VW and GM are #1 and #2. In fact, China has already relaxed its stated limitations on foreign firms setting up new joint ventures: new ones are fine if they're for EVs.

...China may be the largest single BEV market, but it lives on subsidies and those are fading...

One presentation at GERPISA made that clear, using insurance data (not registration data, known to be misleading due to false registrations by various corrupt "car companies" that let them pocket government EV subsidies without actually making vehicles). As everywhere, BEVs are a small share of the market. Once the data were disaggregated geographically, it turns out that in many regions there are essentially no sales. In contrast, in some metropolitan areas BEVs appeared quite popular.

Ah, but the details! Tomasso Pardi of ENS-Paris Saclav, the Director of GERPISA, together with Deng Xiaoxiang presented those. In such cities BEVs qualified for a license plate at no cost and with no wait, while buying a plate for an ICE (internal combustion engine) car requires entering a lottery with average wait times of 2 years, and paying up to $12,000 in fees. The BEV exemption thus provides a huge implicit subsidy – but the BEV quota is finite. In one major city the quota of 50,000 was quickly filled. Total BEV sales: 50,800. Absent subsidies, there's as yet no market for BEVs in China, and these subsidies are not set to expand. At the national level they are already shrinking, and there's no systematic rollout of charging infrastructure. Instead, we have owners dropping wires from the window of 5th floor apartments to let them charge their cars. [There were a couple news stories last year on this, if I can find the links I'll edit them into this post.] So while China may be the largest single BEV market, that's due to a confluence of idiosyncratic and transient subsidies, not to effective policy or consumer demand.

So in the end the EU will be first. What is not yet know is whether battery prices will fall sufficiently to become competitive with ICEs. After all, ICE costs are also falling – a decade ago, did anyone foresee "real" cars running on 3-cylinder engines? Lower component count aside, those save weight in a manner that batteries don't, and so allow downsizing in suspensions, frames – everywhere! – with attendant cost reductions. No current commercial battery technology can offer those indirect savings. Even if things go well, it will still be well into the 2030s before EVs will comprise half of sales in development markets. By that time biofuels will also have advanced. My own belief is that in 2030 we'll see a variety of drivetrains coexisting in the global market, with variations in dominant power sources from country to country.

Airlib', and Uber All is Over: ridehailing & carsharing aren't viable businesses

Mike Smitka from Brunate, Italy

Sorry for the sorry attempt at a pun, but I had my normal 4-week Spring auto seminar that included a week with students in Detroit and daily classes. The closing week included two two-hour Skype sessions with co-blogger David Ruggles, fit in between his guitar lessons while he remained home in Las Vegas. Then came the Industry Studies Association conference (where I presented a paper on why there will be no disruption in the auto industry in terms of new entry, but already has been in OEM profits). Then it was off to the GERPISA global auto industry conference in Paris, where I gave two presentations in two sessions, moderated a third session and took part in a meeting of the organization's steering committee, 4.5 days of work. My wife accompanied me to toot around, and then we headed to Germany (my brother was finishing a month in Freiburg), are now high above Lake Como at the top of the funicolare above the city, and leave this morning for the southern end of Lake Lucerne for a day en route to the Zurich airport and home. OK, enough with excuses that I'm sure elicit tears of sympathy.

On to higher topics: Uber. The firm's death spiral should now be visible for all to see. I'm not thinking of the firing of the founder by the board, but of the string of a dozen-plus executive departures, many voluntary (example: the CFO). People are fleeing the Titanic, the big players with Golden Parachutes (lifeboats would be demeaning), while tough times their plebeian drivers face are getting tougher (including loss of market share to various and sundry rivals). Investors (crocodile tears) in our latest dot.com fad are set to go down with the ship, as any hope of an IPO have surely vanished.

I've mentioned from time to time Airlib', a Paris "new mobility" provider. While they target a different segment from Uber, their experiment suggests wider problems with the hailing/sharing segment. Their cars are visible in residential areas of the Paris, where they have charging stations and the parking spots to go with them. (Which is more valuable, I wonder?) My wife and I watched their all-electric fleet of by-the-hour rentals come and go; they had a row of vehicles on the sidestreet of our hotel, plus we ate outside at an adjacent restaurant. On the surface they have plenty of business, families swiping their pass at a window to open a car up, and after unplugging the charger it was off on a quick shopping trip, things of that sort. There were also a lot of Airlib' staff, apparently repositioning cars to places with too few while freeing spots where users might want to drop vehicles off, and cleaning cars. But Autolib' cars are not clean, they're old and dingy, custom-made Pininfarina cars amidst a sprinkling of new Renault ZOEs.

Apparently the company is not doing well (conversations with Paris-based researchers, not my own research). First, that we saw a lot of Airlib' vests was not unrepresentative: their personnel costs are high. People don't treat shared cars as their own, so they need constant cleaning. That requires a car to take drivers to Airlib' parking locations, who then take them to a cleaning facility. Of course a car then needs to be sent to pick up drivers once they've returned a car to a slot. The bottom line is that the process requires two people and a car that is then unavailable for rent. The above photo is representative of what soon happens: a hub cap missing, body panels that have been repaired, an overall dirty exterior, and an interior that has seen better years (not days). One side aspect of the constant cleaning, though, is that it facilitates repositioning cars.

Second, cars remain in the fleet: custom, bare-bones electric econocars have no resale value, so need to be driven until they die – they soon look like taxis everywhere. I didn't have the keypass to get inside one, and didn't want to interrupt a family unloading groceries, but apparently the insides are worse than the outsides. Third, the rentals are short-term, too few hours to generate the expected level of revenue. Finally, from a public policy standpoint, survey data (researchers at the GERPISA conference) suggest that users would otherwise use public transport: they are not giving up cars. Airlib' does not lessen urban vehicular congestion, it makes it worse.

I also wonder about the parking spaces they occupy: do they add to urban congestion by leaving fewer free, resulting in more circling of the block in search of a spot? There's a US parallel: friends down from New Jersey report that they don't drive into the city very often, midtown is occupied by Uber vehicles. Since unlike a regular taxi they can't be hailed, they obtain no benefit from cruising the streets. Instead they park, or more properly "stand" with their drivers inside, taking up a visible share of the already sparse Manhattan parking spots. My friends are patient people, they're in to visit their architect daughter Stephanie Goto, but it's insufficient for the Uber hurdle.

One parallel business is Zipcar. They've been acquired by Avis; I've not tried to see if that segment is broken out. Is the short-term rental business profitable? I have my doubts, but at least Zipcar is now owned by an experienced fleet management company, with "ordinary" cars that can presumably be remarketed (sold at auction) and replaced by new vehicles on a regular basis to keep them fresh in user's eyes.

Anyway, I have a wealth of topics coming off of the past two months, including my own preliminary presentation at GERPISA on the geography of the Chinese industry. Are producers locking themselves into high-cost production locations, driven to the provinces by industry policy – I mean, there's a car plant on the province-island of Hainan! Is Shanghai becoming a new Detroit, a center of global R&D, with most global suppliers having engineering centers there? More on those issues later: I've summer research money to compile data from a 900+ page company directory. There's also notes from the GERPISA visit to Renault's R&D center, including their competitive analysis "teardown" hall (a room doesn't have enough room).

Now really, to be profitable, new ventures should focus on high-margin businesses, not low-margin ones. What do you get by disrupting the latter with an app? Low margins. Unfortunately the auto industry as a whole is a low margin business. That's why over the past 50 years there's been scant new entry: it's not for lack of imagination, it's for lack of profits to be had.

Chinese assembly flow

I'm back from a week in Detroit with students [schedule here] that included factory tours at the Ford Rouge plant in Dearborn, Giffin in Auburn Hills and Continental Structural Plastics in Carey, OH. Both Giffen and CSP were 2017 PACE Award winners. Even though what they saw is a small sample of the range of processes in automotive parts manufacturing and final assembly, they now have a sense of what goes on.

So here is a really nice video that follows a vehicle through the assembly process. During our trip we didn't see welding robots but we did see a paint shop and robots inserting/removing material from a SMC stamping press. Because those were not metal parts we didn't see e-coat in the paint shop of Continental Structural Plastics in Carey, OH. We did however see the stamping of body panels, which is not shown in this video. We did see the roof liner being inserted in the Ford Rouge plant (though given the large number of things being done, students likely don't recall that one particular step). In any case much of this video should now be familiar to my students. Oh, and China is not much different from the U.S. Production in China is driven first and foremost by quality and speed considerations, not by labor costs, so robots do the welding and the heavy lifting.

NYTimes video

LF Participation: Improvement Continues

Mike Smitka, Economics
Washington and Lee University

...how many older workers can be enticed back into the labor market?...

Rather than headline unemployment rate I follow participation rates because so many would-be workers dropped out of the labor market during the Great Recession. In a couple age brackets we've now returned to normal as judged by the pre-recession average, which was roughly flat over the period 2000-2006. The black line is a moving average, which means that it lags as participation increases. The raw average is now at 99%, but bounces around a lot from month to month. I'm thus conservative in how I approach the data. While I do not correct for this (I don't have age-specific data) the share of the labor force working involuntary short hours is down to 3.3% from a Great Recession peak of 6.0%. Some of this improvement thus includes a transition from part-time to full-time work. It's taken 7 years, which means a lot of personal pain and sidetracked careers. But most of the slack in labor markets has now disappeared.

Of course these data are national averages, so there will be a lot of local variation. One caution: participation by older workers at near historic highs. The aging of the baby boomers means there are many people wanting jobs who a generation ago would have been fully retired. How many of them can be enticed back into the labor market? We'll find out over the next couple years. In the meantime, if labor markets really are tightening, then we should start to find employers offering higher wages to attract and retain workers, first on a regional level, then nationally. I however don't follow those data. I need to start reading the Federal Reserve Beige Book, which provides the qualitative impressions of Fed staff in each of its 12 districts.

Data Point: Real Yield Curve

Periodically I've posted graphs showing the future bond yields implied by the difference between (say) the yield on a 5 year bond and a 7 year bond. The Treasury also issues TIPS, bonds whose post-inflation yield is guaranteed. Doing so gives suggests after-inflation returns – the yield on a 2-year bond – of 0.65% in 2022. Over the past 10 years, as per the previous post, real bond yields lay below the real growth rate by about 0.65%. So will the ceiling on real growth over the next 5 years be 1.5%?? This of course is consistent with the argument of Robert Gordon that the US is seeing and will continue to see lower growth than experienced in the first four post-WWII decades. (For reference I also include one measure of inflation, the rate of increase in personal consumption expenditures after lopping off items with the highest and lowest price changes. This continues to trend just under 2%.)

US Deficits and Sustainable Debt

As Congress and the Trump Administration begin to work on their fiscal program, with the potential for tax cuts and expenditure increases, it's important to think about whether our current deficit is sustainable. Now Japan is fast approaching a point where debt issues will overwhelm their financial system. (My senior capstone read a paper by Hoshi & Ito^Note that lays forth that case, arguing that the breakdown point will occur by 2027.) The US is not Japan: we have a growing population, less debt, and smaller deficits. Nevertheless at some point we too will need to put our fiscal house in order.

...we don't need to run a surplus, but the current deficit isn't sustainable...

What follows uses a simple (but standard) arithmetic framework to clarify what matters. As long as debt to GDP is stable, we should be OK, because the demand for financial assets grows with the economy. In general institutional investors such as pension funds hold government bonds for good reasons, and that a particular bond has matured doesn't change that. So they want to buy new bonds to replace the old. In other words, at today's level of debt, the Treasury can "roll over" debt, issuing new bonds to replace old. There's not only no need to repay our debt, financial markets would be hard-pressed to find alternative assets if we did so. Indeed, 20 years ago, under the impact of the Clinton administration's budget surpluses, Federal debt was declining rapidly and there was hand-wringing about how financial markets could function if all the debt was repaid. Some of that public worrying was partisan, used by those who wanted to argue that large tax cuts were OK.

Our economy is also growing. So even if the absolute amount of debt continues to rise, potentially debt to GDP will not. Indeed, that's what happened following WWII. By the end of the war debt surpassed GDP, but fell to just over 20% by 1974. This didn't happen because we ran budget surpluses. Quite the contrary, on average we ran small deficits after 1948. But we did grow, enough to outgrow our debt. But today we're running significant deficits and not growing.

Interest rates matter. In the 1950s and 1960s they were relatively low, so the interest the Treasury paid on our debt didn't offset growth. Today we again have low interest rates, but we also have low growth. So we need to ask whether that changes the situation.

Again, what we want to look at is whether debt is stable relative to GDP. That is, if B is the stock of bonds and Y is GDP, is B/Y growing? On its own – assuming bonds are rolled over – the stock grows with accumulated interest: _t+1 = B_t(1 + i), where B_t is the stock of bonds at time t and i is the nominal interest rate. Similarly, GDP grows at Y_t+1 = Y_t(1 + g) where Y is nominal GDP and g is the nominal growth rate. Hence debt to GDP will grow at:

B(1+i)
Y(1+g)

To put this to use, we need three pieces of information: what is the level of debt, B/Y; what is the growth rate g;, and what is interest rate i. That will give us an indication of whether debt is sustainable, and if not, what level of surplus is needed to keep it within bounds.

The first is easy: Federal debt is approximately 100% of GDP, that is, debt to GDP ratio is 1.0 – convenient for arithmetic, as multiplying by 1 is easy. We then need to know the ratio (1 + i)/(1 + g). When i and g are single digits in percentage terms, as in the US, that ratio is approximately 1 + i - g. In other words, with our debt ratio of 1, B/Y will shrink as long as (1 + i - g) is less than 1. The critical issue then is the value of (i - g). If i > g then our debt level will rise, unless we run surpluses. If i < g then we can run (small) deficits indefinitely, as happened during 1949-1974, yet not see our debt level rise.

Now while it might seem that we ought to be able to earn better than the growth rate, this is fundamentally an empirical question. Thanks to the Great Inflation of the 1970s and 1980s nominal interest rates and nominal growth varied wildly. But real growth and real interest rates stay within fairly narrow bounds, except at the depths of our recent Great Recession. The graph below sets forth those data. Excluding the peak around 2009 we find that the average level of (i - g) is about -0.6%. If we include the peak, the average is roughly 0. Now as the graph below indicates, real long term bond yields fell over the past 15 years and are now on the order of 0.8%. Investors, rightly or wrongly, have not built strong growth into bond prices. So to date there's no evidence that the Fed's ongoing normalization of interest rates will raise real interest rates relative to growth. If so, we can run deficits of 0.6% of GDP forever.

To reiterate, we don't need to run a surplus. However, we do need to bring the budget close to balance. Unfortunately, our current deficit is about 3% of GDP. Now that's a vast improvement over the -10% of GDP level at the trough of the Great Recession. Employment growth and profit growth led to stronger income tax receipts, while the improved employment situation led to a drop in "safety net" expenditures. That combination lowered the deficit by a full 7% of GDP. Unfortunately we can't expect further gains, as profits are now high and (un)employment low. There is however downside potential. So we ought to count on the deficit averaging out at -3.5% of GDP, not -3.0%.

...that means we need to "enhance revenue" by 4% of GDP, not cut taxes...

That does not factor in the aging of the baby boomers, who haven't fully retired and whose healthcare expenses will continue to rise until offset by rising boomer mortality. Such retirement-related expenses will likely come to at least 1% of GDP. Hence we need a fiscal adjustment on the order of 4.0%-4.5% of GDP. Congress needs to "enhance revenue," not cut taxes.

Note: Hoshi, Takeo, and Takatoshi Ito. 2014. “Defying Gravity: Can Japanese Sovereign Debt Continue to Increase without a Crisis?” Economic Policy 29(77): 5–44.

Tesla: First the Cash, Then the Crash

Tesla recently (briefly) surpassed both Ford and General Motors in market capitalization. My own prognosis for Tesla's longer-run prospects aside, once the Model 3 launches cash flow will improve markedly. Financial markets may interpret that as validation of the high price they've put on Tesla shares. That however is a predictable result of the nature of cash for an automotive assembler, and will have nothing to do with Tesla itself. But it does mean that you shouldn't short Tesla yet.

...you shouldn't short Tesla yet...

Why do I believe this will happen? As our alumnus Bill Cosgrove emphasized in him many visits to Econ 244, in up cycles car companies spin off stupendous amounts of cash. In down cycles they're cash incinerators. Let's examine one source of that (there are others).

Historically dealerships financed the biggest asset in the auto industry, the inventory that sits on their lots. In particular, they pay for cars as they roll off the assembly line. (To be precise, dealerships' banks pay for them via the financing of "floor plan".) Suppliers contributed, too, because they are paid 90 days in arrears. In the early years of the industry they were the biggest cost of production. From the 1920s that role diminished, as Ford and General Motors integrated vertically into making their own engines and frames and bodies. But over the last 25 years car companies systematically spun off their internal parts into standalone operations, Delphi in the case of GM and Visteon in the case of Ford. So paying suppliers in arrears is again qualitatively important. Now when sales increase, for example up 2% in the month, car companies then take in 2% more cash, but pay out nothing more. It's only after 3 months do the payments to suppliers start to rise. That process continues as long as sales rise, irrespective of underlying profitability. A rising tide raises all ... wait, that's not the right image.

Or maybe it is. Because at some point the tide goes out, and with it goes the cash flow. The process reverses. Now car companies are taking in less money, but they're paying out the same amount or – if sales were rising and not just flat – amounts that will continue to increase for 3 months. Worse, it often takes a while to react, as a car company you don't want to slow production because of one odd month. And so the factory pushes metal onto dealership lots. As sales continue to fall, inventory piles up, and at some point the dealers push back, and stop ordering cars. In other words, inventory adjustment amplifies the pace of the downturn. Cars companies burn through cash. They turn from printing presses of profits into incinerators of money.

So when the Model 3 launches, Tesla will report a significant improvement in cash flow. Tesla investors will get good news for a few quarters, as the first 100,000 cars roll off the line and make their way into the garages of the more well-heeled of the enthusiasts who laid down their $1,000 advance deposit. This shift in finances will appear to validate the case for Tesla's high stock price.

But sales can't keep rising forever, particularly as Tesla will only have this one new model, and in a market where consumers are shunning sedans. At that point Tesla will begin hemorrhaging cash. They will have to pay suppliers more and more even as revenue stagnates and then falls. Worse, because they don't have independent dealerships, their debt will also explode as inventories build up. They won't be able to cut output fast enough, because they will have to keep paying suppliers for the higher level of orders prevalent 3 months earlier. They won't be able to cut sales staff, either, if they want to stay in business. Unlike traditional dealerships, their stores won't have service revenue, because most Tesla's will be new. That will be made worse by the nature of their product, as there won't be the oil changes that help service operations generate profits for dealerships even when car sales tank.

...don't short Tesla – yet...

So don't short Tesla – yet. But that time will come, because of the nature of the auto business.

NPR Marketplace: When it comes to NAFTA and autos, the parts are well traveled

Mike Smitka
Washington and Lee University

On the Friday 24 March NPR Marketplace did an extensive story on automotive parts and NAFTA. For the show, go to When it comes to NAFTA and autos, the parts are well traveled on the Marketplace website.

Scott Tong put together the story, with travel to Ann Arbor. The story that aired featured extended pieces of interview with Dave Andrea of CAR (the Center for Automotive Research) and with Michael Smitka of Washington and Lee University. Scott did a very good job addressing a complex topic.

This is part of a longer Marketplace series NAFTA explained.

For the interview with me Scott was actually sitting in the back seat of the Honda CRV that he discussed with David. Scott skyped me on my computer, I recorded it on my iPhone and then sent the audio files to him. That process worked well, though I had on headphones to lessen feedback which in retrospect probably didn't improve the sound that much, but did make it harder for Scott to piece together the specific questions he was asking as there was no recording of that.