Recently on CNBC, economist Larry Kudlow debated John Kerry’s economic adviser, Roger Altman, on the meaning of the recent improvement in payroll jobs numbers and the decline in unemployment. Obviously, these favorable reports — 144,000 new payroll jobs created in August with upward revisions to the reports for June and July — improved George W. Bush’s chances of getting reelected. However, Altman opted to interpret these employment reports negatively. Specifically, he challenged Kudlow to answer the question: Why has family income declined?
Kudlow correctly brought up the fact that there are numerous indicators of improving standards of living outside one measurement called “family income.” In fact, the “family income” measurement itself doesn’t even count all the ways a family can improve their spendable income within a year. Interest rates help illustrate this.
Many economists and politicians accept that monetary policy — i.e., control over interest rates — has a critical effect on the economy. Ostensibly, the Federal Reserve will raise interest rates to increase the cost of doing business, which in turn should slow the economy. Conversely, when the economy is in trouble, Fed policy is to lower interest rates, thereby encouraging businesses and consumers to borrow and effectively stimulating economic growth. The problem with this analysis is that changes in interest rates affect more than borrowers — they also affect savers and investors.
Fed chairman Alan Greenspan engineered a dramatic decline in interest rates from the end of 2000 to the end of 2003. The federal funds rate declined from 6.57 percent to 0.96 percent during this period. This reduction in interest rates had a direct effect on short-term interest rates as measured by the yield on 3-month Treasury bills. This decline in rates was great for borrowers. The cost of major investments in homes and automobiles fell dramatically as interest rates fell. Many of us refinanced our homes during this time, increasing our spendable income without increasing our earned income by one dime.
In addition, lower interest rates have tended to boost the value of existing homes, allowing homeowners to increase their income by taking second mortgages after they have refinanced their first mortgages. This ultimately keeps a homeowner’s monthly payment the same. And the exemption of up to $500,000 in capital gains on the sale of a personal residence can produce a tax-free increment to those entrepreneurs who buy and sell homes as a source of income. These changes in the tax code benefit consumer income but don’t appear in the equation that calculates family income.
The point is that lower interest rates appear to have substantially increased the standards of living of those in the middle class without any increase in earned income. So, why then is family income not rising?
One reason is that for every borrower there is a saver. The same fall in interest rates that helped the middle class is systematically undermining the income of fixed-income investors. The decline in short-term interest rates dramatically lowered income from short-term investments.
For example, let’s say there is a wealthy investor who wants an absolutely safe investment. In late 2000, he invests in Treasury bills, the safest investment, and receives annual income from that investment of about $60,000. Assume also that this income is sufficient to maintain this individual’s lifestyle. By late 2003, however, the imputed income from this investment has fallen to less than $10,000, a dramatic decline in family income! So much for safe investments.
The story is not limited to short-term interest rates. Every day, investors who purchased bonds ten or twenty years ago are finding a dramatic reduction in their income when they have to buy new securities to replace old securities. Using the AAA bond yield as a proxy for long-term interest rates, an investor who purchased long-term bonds in late 1981 is finding that his income will be reduced by two-thirds when he has to reinvest the proceeds of his maturing bonds. Each week more and more of these 20- and 30-year bonds are maturing with a devastating effect on “family income.”
Roger Altman’s reliance on one statistic to illustrate the economic conditions of the middle class reflects either his basic misunderstanding of how the economy works or the fact that politics is clouding his economic judgment.
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc.