Sunday, October 14, 2018

How Many Households Qualify as Middle Class?

By the standards of previous generations, the middle class has been stripmined of income, assets and purchasing power.
What does it take to be middle class nowadays? Defining the middle class is a parlor game, with most of the punditry referring to income brackets as the defining factor.
People tend to self-report that they belong to the middle class based on income, but income is not the key metric: 12 other factors are more telling measures of middle class membership than income.
In Why the Middle Class Is Doomed (April 17, 2012) I listed five minimum threshold characteristics of membership in the middle class:
1. Meaningful healthcare insurance (i.e. not phantom insurance with $5,000 deductibles, etc.) and life insurance.
2. Significant equity (25%-50%) in a home or equivalent real estate
3. Income/expenses that enable the household to save at least 6% of its income
4. Significant retirement funds: 401Ks, IRAs, etc.
5. The ability to service all debt and expenses over the medium-term if one of the primary household wage-earners lose their job
I then added a taken-for-granted sixth:
6. Reliable vehicles for each wage-earner
Author Chris Sullins suggested adding these additional thresholds:
7. If a household requires government assistance to maintain the family lifestyle, their Middle Class status is in doubt.
8. A percentage of non-paper, non-family home hard assets such as family heirlooms, precious metals, tools, etc. that can be transferred to the next generation, i.e. generational wealth.
9. Ability to invest in offspring (education, extracurricular clubs/training, etc.).
10. Leisure time devoted to the maintenance of physical/spiritual/mental fitness.
Correspondent Mark G. recently suggested two more:
11. Continual accumulation of human and social capital (new skills, networks of collaborators, markets for one's services, etc.)
And the money shot:
12. Family ownership of income-producing assets such as rental properties, bonds, etc.
The key point of these thresholds is that propping up a precarious illusion of consumption and status signifiers does not qualify as middle class. To qualify as middle class (that is, what was considered middle class a generation or two ago), the household must actually own/control wealth that won't vanish if the investment bubble du jour pops, and won't be wiped out by a medical emergency.
In Chris's phrase, "They should be focusing resources on the next generation and passing on Generational Wealth" as opposed to "keeping up appearances" via aspirational consumption financed with debt.
What does it take in the real world to qualify as middle class?
Here are my calculations based on our own expenses and those of our friends in urban America. We can quibble about details endlessly, so these are mid-range estimates. These reflect urban costs; rural towns/cities will naturally have significantly lower cost structures. Please make adjustments as suits your area or experience, but please recall that tens of millions of people live in high-cost left and right-coast cities, and millions more have high heating/cooling/commuting costs.
The wages of those employed by Corporate America or the government do not reflect the total cost of benefits such as healthcare insurance. Self-employed people like myself pay the full costs of benefits, so we have to realize there is no ideal average of household expenses. Some households pay very little of their actual healthcare expenses, other pay for part of these costs and still others pay most or all of their healthcare insurance and co-pays.
1. Healthcare. Let's budget $15,000 annually for healthcare insurance. Yes, if you're 23 years old and single, you will pay less, so this is an average. If you're older (I'm 64), $15,000 a year only buys you and your spouse stripped down coverage: no eyewear, medication or dental coverage--and that's if your existing plan is grandfathered in. (If you want non-phantom ObamaCare coverage, the cost zooms up to $2,000/month or $24,000 annually.)
Add in co-pays and out-of-pocket expenses, and the realistic annual total is between $15,000 and $20,000 annually: Your family's health care costs: $19,393 (this was before ACA).
Let's say $15,000 annually is about as low as you can reasonably expect to maintain middle class healthcare.
2. Home equity. Building home equity requires paying meaningful principal. Let's say a household has a 15-year mortgage so the principal payments are actually meaningfully adding to equity, unlike a 30-year mortgage. Let's say $5-$10,000 of $25,000 in annual mortgage payments is interest (deductible) and $15-$20,000 goes to principal reduction.
3. Savings. Anything less than $5,000 in annual savings is not very meaningful if college costs, co-pays for medical emergencies, etc. are being anticipated, and $10,000 is a more realistic number given the need to stockpile cash in the event of job loss or reduced hours/pay. So let's go with a minimum of $5,000 in cash savings annually.
4. Retirement. Let's assume $6,000 per wage earner per year, or $12,000 per household. That won't buy much of a retirement unless you start at age 25, and even then the return at current rates is so abysmal the nestegg won't grow faster than inflation unless you take horrendous risks (and win).
5. Vehicles. The AAA pegs the cost of each compact car at $7,000 annually, so $14K per year assumes two compacts each driven 15,000 miles. The cost declines for two paid-for, well-maintained clunkers and increases for sedans and trucks. Let's assume a scrimp-and-save household who manages to operate and insure two vehicles for $10,000 annually.
6. Social Security and Medicare Taxes. Self-employed people pay full freight Social Security and Medicare taxes: 15.3% of all net income, starting with dollar one and going up to $127,200 for SSA. But let's take a household of two employed wage-earners and put in $8,000.
Property taxes: These are low in many parts of the country, but let's assume a level between New Jersey/New York/California level of property tax and very low property tax rates: $10,000 annually.
Income tax: There are too many complexities, so let's assume $2,000 in state and local taxes and $5,000 in federal taxes for a total of $7,000.
7. Living expenses: Some people spend hundreds of dollars on food each week, others considerably less. Let's assume a two-adult household will need at least $12,000 annually for food, utilities, phone service, Internet, home maintenance, clothing, furnishings, books, films, etc., while those who like to dine out often, take week-ends away for skiing or equivalent will need more like $20,000.
8. Donations, church tithes, community organizations, adult education, hobbies, etc.: Let's say $2,000 annually at a minimum.
Note that this does not include the cost of maintaining boats, RVs, pools, etc., or the cost of an annual vacation.
Here's the annual summary:
Healthcare: $15,000
Mortgage: $25,000
Savings: $5,000
Retirement: $12,000
Vehicles: $10,000
Property taxes: $10,000
Income and Social Security/Medicare taxes: $15,000
Living expenses: $12,000
Other: $2,000
Minimum Total: $106,000
Vacations, travel, unexpected expenses, etc: $5,000.
Realistic Total: $111,000
That's almost double the median household income of $59,000. Note that this $111,000 household income has no budget for lavish vacations, luxury vehicles, large pickup trucks, boats, second homes, college expenses, etc. There is no budget for private schooling. Most of the family income goes to the mortgage, taxes and healthcare. Savings are modest, along with living expenses and retirement contributions. This is a barebones budget.
$111,000 household income is right about the cut-off point for the top 20% of household income. How close are you to the top 1%?
Toss in a jumbo mortgage, college tuition paid in cash, an aging parent to care for or any of a dozen other major expenses and the minimum quickly rises to $155,000, which puts the household in the top 10% of household income.
How can we even talk about a "middle class" when the minimum thresholds put the household in the top 20%? And we haven't even considered the ultimate  minimum threshold of middle class membership: family ownership of income-producing assets such as businesses, rental properties, bonds, etc.
The key takeaway of this chart is the concentration of the household wealth of the bottom 90% in the family home. The wealthy and upper-middle class own income-producing assets, while the bottom 90% own some life insurance, cash and pensions, but their largest asset by far is the family home. (They also "own" a tremendous amount of debt.)
The problem is life insurance, cash and pensions don't generate much income, and neither does the family home. Households counting on the equity in bubble-priced housing are not factoring in the unwelcome reality that all bubbles pop, even housing bubbles that can't possibly pop.
To have the equivalent security and generational wealth enjoyed by the middle class two generations ago, households have to check off all 12 minimum thresholds. I'm not sure there is a "middle class" any more; if we use these 12 minimum thresholds, the U.S. now has a super-wealthy class (top .01%), a very wealthy class (top .5%), an upper class (top 9.5% below the wealthy) and the rest (bottom 90%), with varying levels of security and assets but at levels far below what median-income households enjoyed in bygone eras.
By the standards of previous generations, the middle class has been stripmined of income, assets and purchasing power.


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Friday, October 12, 2018

Here's Why the Next Recession Will Spiral Into a Depression

Here's the difference between a recession and a depression: you can't get blood from a stone, or make an insolvent entity solvent with more debt.
There are two basic differences between a recession and a depression:
1. Duration: a recession typically lasts between 6 and 18 months, while a depression drags on for years or even decades, often masked by official propaganda as "slow growth" or "stagnation."
2. The basic dynamic: recessions are business / credit cycle events that wring out the excesses of credit expansion (i.e. lending to unqualified borrowers who subsequently default) and mal-investment in low-yield, high-risk speculations and projects that only made financial sense in the euphoria of bubble psychology (i.e. animal spirits acting as if bubbles never pop).
Recessions are brief because the basic dynamic is to write down defaults, tighten up credit and absorb the losses from failed speculations. As consumers and enterprises cut back borrowing, they trim spending, leading to lay-offs, reduced tax revenues, contraction of credit and all the other consequences of wringing excesses out of the economy.
But once the losses have been absorbed and insolvent households and enterprises have worked through bankruptcy, then the decks are cleared for a renewed credit / business cycle expansion.
Depressions, on the other hand, are generated by self-reinforcing feedback loops: insolvencies beget more insolvencies, reduced prices for assets beget lower prices for assets, and so on.
There are two critical differences between the two dynamics: high fixed costs and dependence on credit / asset bubbles for "growth." Recessions clear excesses in otherwise healthy economies with low fixed costs, rising productivity, broadly distributed gains in earned income, safe yields on capital set aside for savings and retirement and high returns on productive investments. Growth is the result of rising productivity of labor and capital.
Depressions are the result of the opposite set of dynamics: growth is the result of a vast expansion of credit that drives mal-investment and risk-laden speculation. Productivity stagnates as capital flows to speculative gambles ("sure things" in a bubble euphoria) and expansions of capacity that far outstrip demand.
In these credit / speculative driven economies, capital is forced to "chase yield," i.e. seek a return in risk assets rather than in low-risk secure investments. Soon, everyone is dependent on credit / asset bubbles for their paychecks, increases in wealth, pensions, sales, tax revenues, etc.
Economies prone to depressions have high debt levels and high fixed costs.Both generate self-reinforcing feedback loops: as loans issued to uncreditworthy borrowers default, liquidity dries up and marginal borrowers are pushed into default. As credit dries up, sales decline, profits drop, employees are laid off to cut operational costs and previously sound borrowers slide into default.
As defaults beget more defaults, lenders are pushed into insolvency, sparking a banking crisis. Borrowers sell assets at fire-sale prices to raise cash, pushing assets prices lower, putting borrowers underwater. As this insolvency is liquidated in bankruptcy / defaults, lenders must sell assets, driving prices ever lower in a self-reinforcing feedback loop.
The key here is to understand the difference between fixed costs and operational costs. Fixed costs are, well, fixed: they don't decline even if income, sales or tax revenues decline. Fixed costs include: rent, mortgage payments, debt service, mandated healthcare insurance premiums, etc.
Operational costs decline rapidly in recessions; fixed costs don't. Operational costs include wages paid to recent hires, fuel for the company trucks, etc. As business slows, some employees are laid off, reducing costs, and company vehicles log fewer miles, reducing fuel costs, and so on.
Fixed costs remain the same even as sales, profits, income and tax revenues plummet. Economies burdened with high fixed costs have very little wiggle-room (i.e. buffers) before reductions in sales, profits, income and tax revenues trigger losses, i.e. expenses are no longer covered by income.
Here are some examples of fixed costs:
For state and local governments, pensions and benefits due retirees are fixed:they don't go down in recessions. Rather, what drops in recessions are the tax revenues needed to fund the pensions.
California pension funding:
New York City pension funding:
Insulin is another fixed cost. Those needing insulin don't stop needing it in recessions. Notice the enormous increase in the cost of insulin, i.e. inflation.
Notice how all the big-ticket essentials (i.e. fixed costs) are rising in price: the only items with declining prices are those that are generally optional-- TVs, clothing, etc.
Everywhere we look in the U.S. economy, we see sky-high fixed costs. Investors who overpaid for commercial real estate will default once their business tenants close down, homeowners who overpaid will default once one of the household's primary jobholders loses his/her job, state and local governments that have feasted on a decade of rising tax revenues will suddenly face staggering deficits as tax revenues crater--the list of those with high fixed costs and no wiggle room other than bankruptcy is essentially endless in America.
Here's the difference between a recession and a depression: you can't get blood from a stone, or make an insolvent entity solvent with more debt. Losses will have to taken, and nose-bleed fixed-costs will have to be slashed; reality will eventually have to be dealt with.
But everyone will resist this process because high fixed costs are the gravy train everyone depends on. Slashing fixed costs destroys the income needed to support asset valuations which are the collateral for the stupendous mountains of debt that define the U.S. economy. Once that debt is written down, the entire financial system collapses.


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Tuesday, October 09, 2018

The Distortions of Doom Part 2: The Fatal Flaws of Reserve Currencies

The way forward is to replace the entire system of reserve currencies with a transparent free-for-all of all kinds of currencies.
Over the years, I've endeavored to illuminate the arcane dynamics of global currencies by discussing Triffin's Paradox, which explains the conflicting dual roles of national currencies that also act as global reserve currencies, i.e. currencies that other nations use for global payments, loans and foreign exchange reserves.
The four currencies that are considered global are the US dollar (USD), the euro, the Japanese yen and China's RMB (yuan). The percentage of use in each of the three categories of demand for the reserve currencies--payments, loans and foreign exchange reserves--are displayed below.
Many observers don't seem to grasp that demand for reserve currencies extend beyond payments. Many of those heralding the demise of the USD as a reserve currency note the rise of alternative payment platforms as evidence of the USD's impending collapse.
But it's not so simple. Currencies are also in demand because loans were denominated in that currency, so interest and principal payments must also be paid in that currency. There is also demand for the currency to be held as foreign exchange reserves--the equivalent of cash to settle trade imbalances and back the domestic currency.
Notice the minor role played by the yen and yuan, despite the size of the economies of Japan and China. There's a reason for this that's at the core of Triffin's Paradox: any nation seeking to issue a reserve currency must export its currency in size by running large, permanent trade deficits (or an equivalent mechanism for exporting currency in size).
The reason why the yen and yuan are minor players is neither nation runs much of a trade deficit, and neither exports its currency in size via loans or other currency emittance mechanisms.
Triffin's Paradox is the tension between a currency's domestic role and its global role. The nation's issuing central bank prioritizes domestic concerns--bolstering employment, tamping down (or generating) inflation, supporting the private banking system, etc.--but the rate of interest, etc. set by the issuing central bank has enormous impacts on nations using the currency for payments, loans and reserves.
No currency can serve two masters at the same time. If the issuing central bank raises interest rates for domestic reasons, the increase in rates may be ruinous to offshore borrowers who must convert weakening home currencies into the strengthening reserve currency to make interest payments.
Higher yields strengthen reserve currencies and weaken emerging market currencies. This increases the costs of servicing loans denominated in reserve currencies.
The question for any wannabe reserve currency is: how do you export enough currency into the global system to support the demand for payments, loans and reserves? If the issuing nation runs a trade surplus or modest deficit, trade doesn't export enough currency into the global financial system to meet the demands placed on a reserve currency.
The alternative mechanism is debt. If the issuing central bank issues lines of credit to banks, then institutions can make loans denominated in the reserve currency to offshore borrowers.
The EU banks have issued loans in euros, and the fatal consequence of this is now becoming clear. Emerging market borrowers will be forced to default as their currencies weaken against the euro and the USD, driving the costs of servicing their debt denominated in euros and USD higher.
Loans denominated in USD and euros will bring the periphery crisis home to the core's banking sectors as these loans default. It was all fun and games when the USD was weakening thanks to the Fed'a ZIRP (zero interest rate policy), because it became progressively cheaper to service loans in USD as USD weakened and emerging market currencies strengthened.
Now that dynamic has reversed: every click higher in U.S. yields vis a vis other currencies will only push the USD higher.
The system of reserve currencies is dysfunctional for everyone, creating and incentivizing fatal imbalances in trade, yields and debt. Some look to a basket of currencies (SDRs) as the solution, but all this does is tighten the coherence of a system that's already dangerously hyper-coherent, i.e. highly susceptible to contagion.
There is no perfect reserve currency. Even gold has its limitations. As a result, the best available solution is a world of multiple currencies, some of which are not borrowed into existence, i.e. gold and bitcoin. Given a transparent range of options, nations, borrowers and lenders could choose whatever mix of currencies best suited them.
Some years ago I proposed using bitcoin as a reserve currency: Could Bitcoin (or equivalent) Become a Global Reserve Currency? (November 7, 2013)
The way forward isn't to replace the USD with another dysfunctional reserve currency-- the way forward is to replace the entire system of reserve currencies with a transparent free-for-all of all kinds of currencies.


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Sunday, October 07, 2018

The Global Distortions of Doom Part 1: Hyper-Indebted Zombie Corporations

The defaults and currency crises in the periphery will then move into the core.
It's funny how unintended consequences so rarely turn out to be good. The intended consequences of central banks' unprecedented tsunami of stimulus (quantitative easing, super-low interest rates and easy credit / abundant liquidity) over the past decade were:
1. Save the banks by giving them credit-money at near-zero interest that they could loan out at higher rates. Savers were thrown under the bus by super-low rates (hope you like your $1 in interest on $1,000...) but hey, bankers contribute millions to politicos and savers don't matter.
2. Bring demand forward by encouraging consumers to buy on credit now. Nothing like 0% financing to incentivize consumers to buy now rather than later. Since a mass-consumption economy depends on "growth," consumers must be "nudged" to buy more now and do so with credit, since that sluices money to the banks.
3. Goose assets based on interest rates by lowering rates to near-zero. Bonds, stocks and real estate all respond positively to declining interest rates. Corporations that can borrow money very cheaply can buy back their shares, making insiders and owners wealthier. Housing valuations go up because buyers can afford larger mortgages as rates drop, and bonds go up in value with every notch down in yield.
This vast expansion of risk-assets valuations was intended to generate a wealth effect that made households feel wealthier and thus more willing to binge-borrow and spend.
All those intended consequences came to pass: the global economy gorged on cheap credit, inflating asset bubbles from Shanghai to New York to Sydney to London. Credit growth exploded higher as everyone borrowed trillions: nation-states, local governments, corporations and households.
While much of the hot money flooded into assets, some trickled down to the real economy, enabling enough "growth" for everyone to declare victory.
But the unintended consequences also came to pass: all that free-flowing credit enabled the monumental expansion of production capacity in virtually everything: the world is awash in productive capacity (over-capacity), which means producers (other than Apple) have very little pricing power.
Meanwhile, all the cheap debt that was spent on buying back shares boosted share prices but it didn't generate any gains in productivity or any new products: it just enriched the owners of shares.
In other words, the majority of that corporate debt binge was mal-invested: it boosted capacity beyond global demand and it was squandered on share buybacks. Now the debt service must be paid, but thanks to near-zero pricing power, corporations aren't making enough profit to even service debt.
In response, companies are cutting the quantity and quality of their goods and services to scrape up enough cash flow to roll over existing debt and borrow more money to maintain the appearance of solvency.
Central bank policies completely distorted production capacity and global supply chains, crippling corporations with staggering debt loads and zero pricing power. Once global demand declines-- which is the inevitable result of bringing demand forward for a decade-- hyper-indebted corporations won't be able to service their debt. They will default, burdening banks with stupendous losses.
In effect, these corporations are zombies-- not among the living (solvent) but not yet dead (bankrupt). As interest rates rise, these zombies will find it increasingly difficult to roll over their immense debts and add additional debt to keep afloat.
There's one more unintended consequence: massive currency disruptions.When the Federal Reserve dropped Treasury bond yields to near-zero, they crushed the value of the U.S. dollar USD on global markets, effectively encouraging non-U.S. companies to take loans denominated in cheap dollars. As their domestic currencies rose against the USD, it became progressively cheaper to service their dollar-denominated debt.
But now that the Fed has raised interest rates, bond yields have soared, pushing the USD higher. Now the benefits of borrowing loans denominated in USD and paying the interest in other currencies have reversed: the strengthening USD has crushed emerging-market currencies, making it much more costly for companies to make their interest payments.
Zombie corporations in emerging markets using currencies that are in free-fall to service USD-denominated debt are doomed. If the loans were denominated in local currencies and issued by domestic emerging-market banks, nobody in the developed world would care.
But many of the USD-denominated loans were issued by European banks, which means they will suffer catastrophic losses as the emerging-market zombies default on their USD-denominated loans.
The defaults and currency crises in the periphery will then move into the core.Globally, the dominoes are starting to fall as the unintended consequences manifest in cascading debt and currency crises.
Gordon Long and I explore these interconnected crises in a new video program A Distorted Global Supply Chain (31 minutes)
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