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In this issue of The Institutional Risk Analyst, we speak with Ed Kane, an old friend and fellow alumnus of St. Johns College High School in Washington, D.C., about the state of US economy and economic data used to track it. Professor Edward J. Kane teaches at Boston College and has published extensively in the economics and bank regulatory literature. Professor Kane was a founding member of the Shadow Financial Regulatory Committee. He served on this committee from 1985 to 1995 and again from 2005 to 2015. He also served for twelve years as a Trustee and member of the Finance Committee of Teachers Insurance and for about five years as a Senior Fellow in the FDIC's Center for Financial Research. Currently, he consults from time to time for the World Bank.
The IRA: Ed, thank you for making time to speak with us. Your comments to us earlier about inflation and the state of prices in the economy since the outbreak of COVID are quite provocative. The dual mandate of full employment and price stability assumes we can accurately measure inflation. Talk about the changes you observe in behavior since the start of the pandemic.
Kane: Once people and organizations learn that they don’t have to work physically every day in an employer-owned building, enormous changes in lifestyle become feasible. Many people have found out that they could work effectively from a home office if they can make one. This will allow them to reduce the frequency of costly and inconvenient home-to-business commuting Also with tony restaurants, stores, and theaters shut down, going back and forth to the central city every day does not make a lot of sense. Among other things, this will reduce air pollution in our major cities.
The IRA: Always good to look on the bright side. We were located in Midtown Manhattan all of last year, but made the decision to move to Westchester in February. Midtown is basically empty. The office buildings are vacant and many of the retail businesses are just barely hanging on, even after doubling or trebling prices for food and necessities. The cost of operating a grocery or pharmacy or a restaurant in Manhattan is prohibitive when volumes are so greatly reduced. COVID forced people to change their behavior. Because of technology, we and millions of others were able to make that change.
Kane: Inertia leads us to go along doing things in the ways in which we have always done them until we experience a major disruption, Then we have to rethink whether and how we might do basic tasks differently. In 1989, for example, I was invited to visit Arizona State University. At the time, I was finishing up a book on the S&L mess. I realized that I could keep my secretary in Ohio busy by making extensive back-and-forth use of a fax machine. That was an early example of working remotely.
The IRA: Your comments about inflation caught our eye. We have long believed that inflation in the US is greatly understated and that this has led to the terrible economic and political problem of income inequality. But you have suggested something even more, namely that the response to COVID has scrambled all of the equations and relationships used to measure aggregate prices. How do the Fed and other agencies even begin to calculate aggregate inflation?
Kane: This is a really bad time to be focused on macroeconomic data. The example of the forest and the trees is instructive. We can see the forest via macro data, but we miss the individual trees and, in particular, the amount of mortality and replacement of trees that is occurring. Macro data hide the individual changes in different segments of the population. Some of these distributional changes can be quite important. The forest can seem healthy when all of the trees are doing well, but the same conclusion is possible when many species are dying out and being replaced by the expansion of new or more robust species. The blossoming species are better adapted to the environmental changes that are occurring or will occur, but merely counting trees (i.e., looking only at macro data) would fail to surface the extent of this transition.
The IRA: We wrote about the land rush caused by COVID and the low-interest rate environment in many markets ("The Great Correction of 2025"). Rents and home prices in Manhattan are falling, but prices in Brooklyn are rising. How does the FOMC parse this divergent price performance?
Kane: In the face of the massive disruption of COVID, we need to ask a basic question: why is inflation apparently so low? The answer is that it is clear that individual prices are far from steady. Prices are stable in some cases but unstable in others. For example, rents in central cities and suburban areas are moving in different directions. The average change in real estate prices across the larger area might be small. But anyone can see that housing prices across metropolitan areas are not stable. Rents in central cities are falling, but they are rising in the suburbs. Hence, employment in construction is booming to repurpose both spaces.
The IRA: Residential home prices nationally rose more than 10% in 2020. In some particularly hot markets, home prices have gone up twice that rate. When Treasury Secretary Janet Yellen was Fed Chair years ago, she expressed surprise that more young people were not buying a home. Of interest, that Yellen comment is the single most remarked upon post we’ve ever shared on Twitter.
Kane: When the Fed says that inflation is stable, they are missing the point of what stabilization should mean in practical, human terms. Innovative forces have unleashed a lot of growth, but they have also unleashed in the Schumpeterian sense a lot of creative destruction. Things will not go back to the “same old, same old” after this pandemic subsides.
The IRA: What do investors and the FOMC do about the basic instability in economic data? Is it possible to get economists to stop focusing on the erroneous macro data and start looking at the trees instead of assuming a homogenous forest?
Kane: It is really a question of refocusing the questions we ask. Macroeconomics has for many years been painted as the central story economists have to tell. This seems so because, for a long time, we did not see substantial and sudden variation in prices for goods and services that can each perform more or less the same function. Now we are starting to understand that the news about the behavior of prices should be reported differently. The media have to report the good news and the bad news. Not just the average news. The average economic news does not tell you much today and is certainly not the whole story.
The IRA: It’s funny you say that Ed. As you know very well, in the world of financial analysis, the first question you ask about a subject is where it stands vs the peers. You segment the population into quartiles and deciles. When we built our earliest bank model in the 2000s at Institutional Risk Analytics, my colleague Dennis Santiago immediately sliced and diced the FDIC data and generated standard deviations and other measures for bank metrics. We conducted a census of banks. But somehow the macro community just “assumes” the average is meaningful.
Kane: Average inflation rates, index measures of the rising stock market and suburban building activity, and the GDP growth rate during this business-cycle recovery phase are not the main story. They are part of the story, but the rest of the narrative is about what is going on inside that inflation rate or inside the stock market. What is the standard deviation of prices within the CPI or GDP deflator? This is seldom in the news. Price weights in standard indexes are not reflecting the changes in what and how the Covid plague is re-optimizing the composition of what macroeconomic principles courses call C+I+G. This re-optimization entails reallocating household, corporate, and government revenues and spending plans. More-detailed indexes report prices and equity returns in individual industries. Consider falling prices in airlines, hotels, casinos, restaurants, retail stores and malls. Quantities sold in or by these venues are down even though retail sales were booming last month. Economists have to go inside macroeconomic numbers and ask questions about the weights that deserve to be assigned to individual prices of products and services that are becoming more and less relevant. I believe that the real story is about the lasting shift to more remote working and shopping and the large commercial and office spaces that these phenomena will require society to repurpose.
The IRA: Well, we just ordered $10k worth of bathroom hardware and fixtures and never walked into the store. But we had to make an appointment to assemble the order by phone because the vendors are overwhelmed with demand for home improvement. Remember when we talked about everyone moving into the cities and “walkability”? Now they are in the suburbs fighting for the last Kohler toilet in stock at the Home Depot.
Kane: Exactly, change is the story. To not stress what is happening to the job mix, work patterns and consumer demand, no matter how good or bad the averages seem, is a major mistake. A lot of people have not accepted the bad news in terms of the asset and human capital revaluation entailed by massive changes in work patterns and workplaces used by the urban workforce. Many seem to be hoping that things will go back to the way things were, back to “normal.” But I am always reminded of the concept of “hysteresis” which basically says we may travel up one path in response to outside forces, but when these outside pressures subside, we should not expect that we will return to the same ways of doing things. We have to recognize that hysteresis is a general phenomenon. Investors, in particular, must ask what kind of paths will unfold if and when we establish herd immunity, and accept that the good old days cannot completely return.
The IRA: So how do we get policy makers to stop relying upon macro data and start to consider the particular of micro economics in their deliberations?
Kane: I have been working on a book on this which, because of the disruption we are talking about, I may not have time to bring to a finish. The distribution effects of the contra-cyclical policies the Fed has followed over its lifetime have been great for the banking industry and the rich in general, but not so good for ordinary folks. And Fed leaders have just begun to give lip service to softening its adverse impact on the lower and middle classes. The very wealthiest Americans have been positioned politically to influence Fed policies in their favor. This helped business leaders to experience great leaps in their well-being since WWII. However, since about 1970, while members of the upper 10 percent of the income distribution have prospered mightily, ordinary households have not done nearly so well. Fed spokespersons love to claim that “a rising [macroeconomic] tide lifts all boats,” but many families feel themselves firmly stuck in the mud both when the tide comes in and when it goes out. The desire to get a better deal for lower-income households is fueling protest movements and waves of social disruption the likes of which the US has not seen since the 1930s.
The IRA: You recall the political compromise that led to Humphrey-Hawkins in 1978. Democrats wanted a guaranteed job for every American, but instead Congress created the dual mandate of full employment and price stability. The FOMC targeted federal funds as the default policy tool and pushed interest rates ever lower, but all the while the purchasing power of the dollar eroded. Is this the source of income inequality today?
Kane: During the post World War II era, households that were able to save some of their income and thoughtfully put some of their savings into the stock market have done very well. For example, in reading your newsletter about 10 months ago, I learned about a firm Square (NYSE:SQ) that had positioned itself to take over a lot of the banking industry’s traditional funds clearing and settlement business. After gathering more detailed information about the firm, I bought 500 shares at $28 and it traded at 10x that price this morning.
The IRA: The equity bull market over the past half century was essentially fueled by low interest rates, was it not? Essentially, the Fed followed the greatest ever generation through the life cycle and is now enabling them to liquidate their equity holdings.
Kane: Interest rates are an important half of the story. Traditionally, we price corporations in equity markets by discounting projected future earnings. What interest rate you pick for that calculation is a critical part of this valuation problem. But as with macroeconomic data, particular firms perform very differently from market-wide averages and indices. The GameStop fiasco with Reddit and Robin Hood is a case in point. But such examples aside, the disruptions brought on by COVID have radically affected valuations, up and down, in many industries. Here, too, we have been forced to experiment and to overcome inertia in order to deal with changes forced on us by COVID.
The IRA: In the 1930s, the problem was deflation. The government had no debt, but levered up its balance sheet and bought assets and time. For example, Fannie Mae was created in 1938 to liquefy the secondary mortgage market. Today, we have mountains of debt and scores of assets like commercial real estate that seem moribund. Yet prices for residential housing are soaring. Is the problem inflation or deflation or both?
Kane: The problem is disruption. Disruption forces adaptations for managers of everything, and economists and policy makers must recognize this. More than any other time in my professional career, the data upon which decision makers must rely is displaying enormous instability and dispersion. Economic forecasts are diminished by this instability. We know there are important changes underway, but we don’t have much of a handle on the nature of the change. Landlords in Manhattan, for example, must accept that the old habitation patterns are unlikely to ever return. Disruption is the over-riding challenge: to admit what we don’t know and can’t know, but also to accept the fact of change. A friend of mine had a picture of a river strategically located in his bathroom. The caption underneath the picture quoted a Greek philosopher who said “We never pass the same stream twice.” We do know that many industries associated with the travel, leisure, hospitality, the performing arts and retail sectors will never be the same in our collective lifetimes. Families, business, and governments have to face facts. That is the key to investing today in my view. Recalling the concept of hysteresis, we simply cannot expect to go back the way we came.
The IRA: Thanks Ed. Be well.
