Wednesday, May 25, 2005


When talking heads are upside down, how can the public not be confused? Today, I have listened to a number of market commentators and I have read a number of blogs. One good discussion included Ed Yardeni as a bull and Bill Gross as a bear. Barry Ritholtz tried to explain the "conundrum" of a 4% 10 year bond in the middle of a strong but slowing economy on Kudlow and Company.

The reason that neither the bulls nor the bears can put this economic puzzle together is because they either do not focus on an important piece of the puzzle or they do not see the size of the hole that it would plug.

Productivity in China has grown at a compounded rate of better than 6.6% for a decade or more. Six point six percent productivity is a huge number. During this unusually strong run, the work of two people has been replaced by the work of one person!

If a business is able to be more productive than competitors, the business makes more profit. Therefore businesses have incentive to increase productivity. When competitors catch-up, consumers are the winners. Both businesses make and their products more cheaply and consumers buy at lower prices.

Politicians have bashed China for political reasons, but the truth is that Americans are buying goods at incredibly low prices. By opening our markets to free trade, America has been challenged to increase our own productivity. The progress made in the past 10 years is unprecedented. America was already an industrialized economy so it was not possible for us to experience the same productivity rate as China. However, our rates have been incredibly high. For 10 years, our productivity growth averaged better than 4%.

Again, the consumer is the winner when all businesses reduce the cost to manufacture products. Inflation has been on the run for quite a number of years. The costs of many goods and services have declined. Many times the savings realized are not obvious to consumers. When a consumer buys a book from Amazon, the nominal price might be 25% below the price of the same book at Barnes and Noble. The savings are not equal to 25%. Most likely the book was delivered by Amazon free. The consumer that took an hour to drive to Barnes and Noble spent extra money on gas other transportation costs and he "lost" an hour of time. The total savings to the consumer may have been more than the total nominal price of the book.

Every single day, billions of transactions happen that cost less now than they would have a few years ago. After several years of strong economic growth, it is natural for market watchers to expect inflation to rear its ugly head; but, it has not!

The bears see the 4% yield on the 10 year treasury bond and assume the bond market is forecasting very slow economic growth and perhaps a recession. The bulls see a 4% yield versus stocks at 16 times earnings and say stocks are so cheap that the economy has to strengthen. The bulls avoid bonds because a 4% yield does not seem to be compatible with strong economic growth. Ironically, the bears and the bulls have been making money. Bonds have appreciated in value as have stocks. Only those who are hiding in money market accounts are getting creamed.

Again, productivity may start out as a benefit to a business and indeed business profits continue to be stronger than all expectations. However, productivity generally becomes a benefit to the consumer. A productivity growth rate of 4% shows up eventually as almost a 4% disinflation rate for that particular product. The other beneficiary is the wage earner. If productivity is up 4% and wages up only 3%, the 4% is against the total product cost whereas the 3% is only against the wage portion of the product costs. Productivity gains can be shared at least temporarily three ways--increased company profits, increased wages and lower prices to consumers.
I submit that the 10 year rate of 4% is not forecasting a supper slow economy (although the economy is slowing) as it is forecasting a super low inflation rate. The FOMC preferred measure of inflation, the PCED, shows a rate of 1.6%--before the recent declines in oil and commodities.
Oddly enough, the ten year rate is also being held down by the fear of the housing bubble. The number of boomers who are ready to buy second homes is being pushed down because of all the hype about the real estate bubble. The demand for second homes at these low rates would indeed be much higher if buyers were not being bombarded by "news" of the real estate bubble.
A bubble in real estate will exist when most market watchers capitulate to the idea that Americans on average can now afford two homes, that there are millions of Americans at prime buying age, and that the housing boom will continue for years to come. The current fear of a bubble has definitely slowed housing sales.
We are living in an era like non before this one. Even the industrial revolution did not change the world as quickly as our world has been changed in recent years. The increase in the average standard of living has been remarkable. Investors have already forgotten that birth control pills have dramatically changed our world. Families today with two children have little understanding of the difference in their standard of living between their family and a family with 4 children of just a few years ago.
One of the prime reasons the crime rate in America has gone down sharply is because the birth control pill has reduced the number of unwanted children (In "Freakonomics", Steven D. Levitt gives a lot of the credit to Roe vs. Wade). Grand children are currently participating in the largest inter-generational shift in wealth in history. The wealth of grand parents is being split in pieces that are larger than ever before.
The point is that there are many powerful disinflation forces and wealth creation forces at work today that were not present a few years ago. Free trade, lower birth rates and technologies from cell phones to internet services are powerful forces. We are living in a golden age. It is time to stop fretting about low interest rates and to realize that low interest rates are a blessing.