Real vs Nominal (Interest rates and GDP)

This post is for all those lucky public school teachers out there who make $28,000 a year. Have you ever wished that you could use those dollars in, for example, 1914. I'm sure you've considered it. Just think! If I had only been able to take $100 of my money and put it into Coca-Cola. I'd be rich!

I know you all realize this is just wishful fancy. However, I must burst your bubble further. Just as you cannot go back in time, you also cannot assume $28,000 of currency in 2008 translates into the same thing in 1914. We have to take into account that word that homeowners love (because it makes them wealthier), and teachers hate (because they live on fixed income) Inflation!

This is the difference between real and nominal variables in economics, real variables have been adjusted for inflation. For example, say as a teacher you make $28,000 a year. However, you do not receive pay raises and every year inflation causes the price level to increase by 5% generally. You might think you income is staying the same. But it turns out, to your dismay, that you are effectively receiving a 5% paycut every year!

In the same line of thinking. Let's say our GDP grew a nominal rate of 8% from 2007-2008. However, inflation was 6%. Adjusted for inflation, our GDP would have grown by a real rate of 2%.

It also works the same way for interest rates. Let's say you put money into a savings account at 2% interest. However, inflation is usually around 3% even in a healthy economy. You are in fact losing 1% of the value of your money by putting it into a savings account!

Therefore, you have to be wary of inflation when you are considering your financial future. You may think you are gaining something or only losing a little, when it fact it is more than you bargained for! Yet, inflation can be a good thing for some people. As I previously stated for someone who owns a home. If the rate of inflation is higher than the real interest rate, your home gains value by just sitting there!

The bottom line here is. Be Real!

Debt vs Equity: or Bonds vs Stock

Given the current collapse of Bear Stearns, and the buyout by JP Morgan at just $2 a share, I thought today might be a good time to talk about Debt and Equity in a company. So, here are your basics:

A company's debt is often held in the form of bonds. These bonds are generally issued at an interest rate i, and can either be paid in full at a maturity date or over a period of time. Bonds are normally a sound investment with lower risk than their counterpart stock. Therefore, bonds are issued at lower interest rates. This is due to the fact that in the event of a collapse, such as Bear Stearns, the bond holders are paid first. Stock holders are compensated only with that remains, if anything remains at all!

Equity is usually equated with common stock. This is the value of share in the company that you often seen sliding across Bloomberg TV. Stock is generally more risky for the aforementioned reasons, and so you can expect to earn a higher rate of return on stocks. In the late 20th and early 21st century, companies have been finding stock to be quite cumbersome for the same reasons mentioned. Having to pay a higher interest rate to a bunch of unconnected shareholders can be fruistrating, and thus in the spirit of creative response, companies found a way around the issuing of stock or bonds.

Commerical Paper: is the creative response to the problem of common stock. Commerical paper is essentially the company using its good standing with a known bank to obtain loans. This cuts out the stockholders. This process, however, can also be risky. Banks that make these loans generally do so on good faith, so if a corporation does not make good on the faith, the banks can be left holding the bill. Enron was a case and point of this occurrence.

So there you have it! Debt vs Equity. It is, as always, a small and incomplete explanation of how the process functions. But I hope you have left informed!

The Core of Macroeconomics
Y=C + I + G + (X-M)

I hope that everyone is doing well this fine evening. We've seen a lot of volatility in the Market today, as well as a spike in the price of Gold. That's to be expected in times like these. As the status of the dollar becomes more uncertain and volatility increases, people are convinced that fleeing to the old trusty gold standard will save them from the windfall. That's all for the news, because today I would like to be more informative and focus upon a fundamental identity in macroeconomics. Perhaps it will help some of you understand what is going on in our economy!

Y = C + I + G + (X-M) in other words National Income = Consumption + Investment + Government spending + (Exports -Imports).

What does this mean?

Well, national income is basically the GDP of a country. What is the GDP you might ask? GDP is essentially the value, in dollars for we Americans, of all the final goods and services produced in our economy. Tractors, bikes, steaks etc. etc.

Consumption is, as it sounds, the amount of goods we as citizens have consumed. For example, how many steaks have we eaten.

Investment and this is key for economics. It's basically things you've purchased that you plan to gain income from. Such as houses, machinery for a business etc.

Government spending is the total amount the government has spent in a period. Be it debt spending or not!

(Exports-Imports) is also pretty self explanatory. It is the amount of stuff we've sent to other countries minus the amount we have purchased from other countries.
How is this relevant to today's economy?

Well, you might notice my rant about the Fed cutting the interest rate and allowing banks to keep money longer. This is because, as many of you know, we are currently experiencing a large government deficit and a large trade deficit. Both of these put pressure on our $ to devalue, because economies like to be in equilibrium. If the dollar weakens, it becomes cheaper for the US to export, shrinking our trade balance. Not only does it hurt people more than it has to, but it is also a matter of pride. The dollar should be a symbol of stability, in my opinion.
However, the act by the fed of putting more money into the system has made the decline in the dollar stronger than it should have been. This, coupled with stagnated wages in the face of inflation (also caused by the interest rate cuts) is sure punishment for the average person. If somebody asks you what the trouble is with our current economy, now you know!

The Fed's Plan 3/11/08

The Market is currently on a 200 point rally today. Shame on me for posting such a depressing analysis yesterday? I would have to disagree.

This article gives a synposis of the fed's plan.

Basically, everyone is happy because the FED is going to allow troubled banks to keep their loans longer, and they're injecting MORE money into the system. Of course we would expect a short market rally, because that is what the market wants the FED to do. All these people who made bad mortgage investments are crying for a bailout, and this chairman is not going to let the politicians down in an election year!

I believe it was our own Mr. Benjamin Franklin (who is also feeling the crunch of the declining dollar) who said that insanity was doing the same thing over and over again and expecting different results. The FED is just adding more liquidity to the market coupled with lowering interest rates. This is usually sound policy, but now the other variables have come into play.

Our trade deficit, our budget deficit, and inflation are more problematic than they have been in the recent past. This move by the FED will devalue our currency more, boosting gas prices higher, and making the dollar weaker. Wall Street will rally, but everyone else is going to feel the pinch of inflation, which will make its way back to Wall Street. The politicians are just hoping this happens after November 6.

Analysis of Today's Economy

Today on 3/10/08 the DOW fell 1.29%, to 11,740. Oil Prices hit a record high above $108 a barrel. A majority of American think we are in or heading for a recession. The dollar continues to weaken, and credit has dried up around the world. It is truly a wonderful day to start this blog! Information on today can be found my looking at the links to your right or checking out this article.

I thought I might take a moment to give my own personal historical account on how we came into this mess. I will try to be as brief as possible...

It all began when the dot-com bubble burst in 2001. On January 4, 2001 the prime interest rate was 9%. As the bubble burst and the economy went into a downward spiral, the FED acted as expected by cutting interest rates. This expanded the money supply and this theoretically a shot in the arm to a struggling economy. However, with the events of 9/11 and the wars in the middle east, the economy continued its downward spiral. So, the FED cut rates more and more until finally in June of 2003 the interest rate bottomed out at 4%. This was a low unheard of in recent history, and its effects in a globalized economy were difficult to predict.

This is where the sub-prime mortgage loans came into play. With interest rates this low, and with housing prices going through the roof, everybody decided it was time to buy a home! They got adjustable rate mortgages (ARM's) because they were cheaper as long as interest rates remained low. The real estate market bubbled in response to these cuts because people got the idea that you couldn't lose money on real estate. This is the first tell-tale sign of a bubble and you will certainly lose if you get caught up in this madness.

Long story short...

The economy began to "recover" and the FED allowed the rates to rise. All those profit seekers with ARM's decided to cash out and the market was flooded. Housing prices dropped, interest rates increased, and people began to default. All those people who thought they couldn't lose began to lose big time! The FED rushed into help by cutting interest rates again. But oh here's where the other variables come into play!

1. Gas prices had been rising due to growing economies in places such as China and uncertainty in the middle east.

2. Our long growing trade deficit was finally putting stress on the dollar to depreciate, as the laws of financial gravity state it must in order to bring the balance back into equilibrium.

Thus, by cutting interest rates, the FED hurt the dollar more because it had become more sensitive. The depreciation caused by increasing the money supply with interest rate cuts drove the dollar down further, making gas even more expensive. High gas prices impose higher transactions costs on everything, the demon of inflation is unavoidable!

We and the FED appear to be stuck between a rock and a hard place? What shall we do, I might have to save that for the next post!

Mission Statement: This Blog will seek to provide the reader with the author's understanding of the myriad of forces at work in the world of investment and economics in general. After providing this understanding, it will seek to demonstrate the utility of firm-foundation theory and its use in fundamental analysis. Finally, this blog will seek to demonstrate the utility of this theory as applied to the author's own portfolio.