Protectionist Threat Increases

When I was in Brussells at the European Enterprise Institute in October to present my report on globalization, another participant at the seminar, André Sapir, argued that concerns about increased protectionism presented in my report were overblown, and that not much had really happened in that respect.

In response, I conceded that things could have been worse and that protectionist policies haven't been as far-reaching as in the 1930s, but pointed to several examples of it happening and also argued to pre-empt the emergence of more examples of protectionist policies we need to remind ourselves why such policies are bad.

Now we are seeing the U.S. deciding on higher tariffs on steel pipes and steel grating, further highlighting the very real threat of protectionist policies.

New Commodity Price Highs

Oil- and other commodity prices were at or very near new annual highs today in terms of U.S. dollars (and currencies pegged to the USD) The 4 commodity price indexes followed at Bloomberg are now up between 30 and 60% during 2009. That certainly suggests that inflationary pressures remains significant.

The gains in commodity prices are more moderate in terms of most other currencies (the exception being the yen) during the latest year, yet during the latest month commodity prices have increased even more in terms of other currencies.

The Value Of Fundamental Stock Analysis

Via Mish I see this article by John Hussman about the stock market. After arguing that the [U.S.] stock market is overvalued ,a conclusion I agree with as all long time readers know, he cautions that this doesn't mean that stocks will necessarily fall.

"From current valuations, durable market returns appear very unlikely. As I noted last week, whatever merit there might be in stocks is decidedly speculative. That doesn't mean that the returns must be (or even over the very short term, are likely to be) negative. What it does mean is that whatever returns emerge are unlikely to be durably positive."

Or in other words, what high current valuations means is that future long term return will be low. People who buy stocks and hold them for a long period of time will experience low, non-existent or even negative returns. That however, doesn't necessarily mean that short term return will be low. It could in fact be very high, but that high short term return only means that later return will be even worse.

Fundamental analysis can say that expected return is only 2% (in reality, such precise estimates about the future is not possible, the precision only exists to illustrate the point) per year during the following 10 years or so, but it can't say what return the following year will be. However, if return the following year is
-10%, then expected return will rise above 3% per year. If it on the other hand is over 20% then expected return will fall to approximately zero. If return is over 30% then expected return will be negative.

One example of this was the Japanese stock market in 1988. Any valid fundamental analysis made then would have revealed that the Japanese stock market was very overvalued in 1988, yet return for investors was very high in the year that followed. But that only meant that it became even more overvalued, contributing to the negative returns that stock investors have experienced in the Japanese stock market during the latest two decades.

While fundamental analysis can't say anything certain about future short- to medium-term return, it can help establish probabilities. And the higher expected long term return suggested by fundamental analysis, the higher is the probability of rallys and the lower the probability of sell-offs, and vice versa.

The Failure Of The Left To Understand Double Counting

Say that you received a certain sum like $1000 from some older relative for the specific purpose of buying a new computer. But at the same time you really want to go away on a trip. Common sense would tell you that you can't use that $1000 for both a computer and a trip (assuming that both cost exactly $1000 each).

But the Democrats in America has invented a new form of accounting that would enable you to do so. The trick is to establish two separate accounts. First you have a computer account which you put the $1000 in, so that you can meet the payment a year or so from now. Then you have a "unified" account which also receives that $1000 and which immediately spends it.

Most of you would recognice that the $1000 has been double counted to pay for both bills even though it can only pay for one of them.

But the Democrats would then respond that the unified account abides by cash payment accounting, and so it can spend that money now, and this has nothing to do with the fact that the money is really reserved for the computer account. But in reality you can't use the same money for two purposes, so even though one can say that the unified account now borrows from the future account, this only means that the unified account will have to borrow from others to pay back to the computer account later, and that the trip will create a need to borrow in the future from others, something which according to proper accounting principles should be attributed to the present time since this is when the cost occurs.

Substitute "Medicare" for "computer" and you have the fallacy of the Democrat's fraudulent double accounting in their health care bill clarified. Yes there are savings in Medicare and tax increases, but those savings and tax increases can't be used both to cover projected Medicare deficits between 2017 and 2026 and to pay for health insurance subsidies now. That Dean Baker and the New York Times fails to understand this is just embarrasing to them.

Does Sustainable Growth Depend On A Low Savings Rate?

Marketwatch published a really strange column by Jeffrey Korzenik. He claims that a sustainable recovery depends on a relatively high level of female participation in the work force. Not because the labor supply is needed (which perhaps would be a more valid argument), but because it lowers savings and because lower savings is supposed to be essential for a sustainable recovery.

The argument is that given a certain level of labor supply, a more even distribution of work outside the home between the sexes will lower savings. The reason for this is that in one income households, the probability is higher that the income will go lost because of unemployment than in two income households. This means that one income households will have stronger reasons to save for "rainy days" than two income households.

This argument is more or less true, though the effect is probably not as big as he thinks because two income families have a higher probability of losing half of their paychecks. Other factors, mainly Fed monetary policy play a greater role in lowering the savings rate.

His second argument is however completely false. A sustainable recovery does not depend on lower savings. Quite to the contrary, a sustainable recovery requires higher savings. Higher savings would enable higher investments (or a lower trade deficit), something which would help expand productive capacity and increase long term growth.

If lower savings had really been beneficial, we would have seen weak growth in China and a big increase in U.S. growth from the 1960s to the 2000s. In reality, China's economy is booming while growth slowed sharply in the U.S. from the 1960s to the 2000s.

Fourth Israeli Rate Hike

Bank of Israel raised short term rates for the fourth time, making it the biggest interest rate increaser since the beginning of the financial crisis.

More hikes are likely since inflation is above target while economic growth is relatively high and since interest rates are still relatively low (1.25%).

Lost Decade For Stocks & The U.S. Economy

Jim Hamilton points out that the latest decade was a lost decade for stocks. Nominal stock prices are actually lower than a decade ago. And although that was partly compensated for by dividends, inflation took away even more.

One reason for this dismal performance was weak earnings-the other that valuations have gone down. The relative role of the two factor depends on whether you look at 1 year earnings or 10-year earnings. With 1 year earnings the key factor was falling earnings. If you instead use 10-year earnings the keý factor was falling valuations.

However, that certainly doesn't mean stocks are cheap as the 10-year P/E ratio is significantly above the historical average. Instead this reflects the extreme overvaluation we saw at the peak of the tech stock bubble.

The 00's was a lost decade not just for stocks but also for the overall economy. GDP growth was for example the weakest since the 1930s.

Here are terms of trade adjusted growth for different decades (Q4 to Q4, 2.8% annualized growth assumed for Q4 2009, compared to Q3 2009)
1950s 4.2%
1960s 4.4%
1970s 2.9%
1980s 3.1%
1990s 3.3%
2000s 1.6%

The 00's thus had far lower growth than the 70s, 80s and 90s, not to mention the 50s and 60s. Terms of trade adjustment made little difference, except for the 1970s, where it reduced growth by 0.3%: points.

If you take into account that population grew by about 1% per year, this means that real income growth was very weak.

Because employment rose only 3% even as the population grew by more than 10%, the employment to population fell from 64.4% to 58.5%, reflecting both a drop in the participation rate and an increase in the unemployment rate from about 4% to about 10%.

Lower economic growth means that the potential for earnings growth will be limited as profits cannot in the long run grow faster than the overall economy. The lower rate of growth would imply that the P/E ratio should in fact be even lower than in the past, making stocks look even more overvalued. On the other hand, lower interest rates justifies higher valuations. These two factors should more or less cancel each other out, so the historical average is a good gauge of whether or not stocks are overvalued, and right now that indicator suggests that stocks are overvalued.

U.K. Price Inflation To Increase Above 3%

U.K. inflation has for the last few years been significantly above the euro area average. In the last two years between November 2007 and November 2009 consumer prices rose a cumulative 6.1% in the U.K. (4.1% in 2008, 1.9% in 2009), versus 2.6% (2.1% in 2008, 0.5% in 2009) in the euro area.

The main reason for this is the weak pound of course. On the other hand, the temporary VAT cut enacted this year helped reduce the gap. Not by as much as 2.1% (2.5/117.5), because first of all this rate doesn't apply to food and many other goods and services and secondly because some producers, wholesalers and retailers used part of the cut to boost their margins rather than to cut prices. Even so, it probably lowered inflation by perhaps 0.5% to 1%.

Now that the VAT cut is reversed, this will help increase the inflation rate by a similar amount. Together with rising commodity prices, this could increase the inflation rate from the current 1.9% to above 3%. At that point, Mervyn King will be forced to write a letter of explanation to Alistair Darling, the Chancellor of the Exchequor. No doubt that explanation will mention the VAT factor and rising commodity prices, but that leaves the question of why inflation didn't fall more in early 2009 despite the fact that the VAT and commodity price factors had the opposite effect then.

The reversal of the cuts will also weaken economic growth. To the extent prices are increased this will of course reduce purchasing power and it will also reduce real output to the extent margins are again reduced as lower margins will make it less profitable to expand operations and hire workers and more profitable to cut back on operations. In some weak businesses, it will cause the entire company to fail.

The effects of the reversal of the VAT cut will thus be stagflationary. For economic growth however, other trends will counteract the negative effect, whereas for inflation other factors will enhance it.

The Misleading Numbers Of U.S. Health Care Reform

The U.S. Senate passed its version of health care reform today as reluctant centrist Democrats were either bought of (Senators Nelson and Landrieu) or were able to get some aspects they didn't like removed (such as Senator Lieberman with the public option). The problem is that the House, where bills can pass with a simple majority instead of the 60% supermajority required in the Senate, passed a bill with a public option and without the payoffs to Nelson and Landrieu. The most likely outcome is that House Democrats will reluctantly agree to these changes.

Supporters of the reform argues that it will really not cost that much. Yet these numbers are misleading for two reasons:

First, as Ann Coulter and Jay Cost points out, the 10-year number is misleading because taxes will be collected during 10 years while benefits will be paid out only during the latest 6 years. But during later decades taxes and benefits will both be collected all years, meaning that the costs will be much greater.

And secondly, Democrats double-count some tax hikes and budget cuts, causing the negative effect on the deficit to be underestimated, as James Pethokoukis points out.

Will Cash Soon Be Regarded As A Barbarous Relic?

Edmund Conway argues for the abolition of physical cash-notes and coins.

Doing so would indeed have its advantages-including making traditional robberies for money impossible, and it would save us the cost of making physical cash.

Yet for those of us skeptical of unlimited government power there are reasons to oppose the abolition of cash.

First of all, it would further increase the ability of the central bank to manipulate the economy as the zero bound barrier would disappear and central banks could impose negative real interest rates. Conway the Keynesian of course thinks this is an advantage and the use of quantitative easing is reducing the advantage or disadvantage associated with it, but it remains a factor and if you realize the role of central banks in creating the problems they claim to fight, this is a reason to oppose it.

Secondly, it would further increase the dependence on banks, which in turn will increase the demand for government support and regulation of. Conway argues that we are already well advanced on that path, which is true but from that it doesn't follow that we should go furter.

Thirdly, it would remove the possibility of protecting the privacy of your transactions, and move us further towards an "1984"-style control society. Conway mentions this objection, but claims that cryptographic techniques can be invented to make protect people's privacy. I'm not an expert on this field and so it may be possible, but I doubt it.

Conway contradicts himself by saying that this would stop "black market" activities and so prevent people from evading taxes. But if these great cryptographic techniques exists how can "black market" activities be prevented?

And the elimination of "black market" activities might not be a good thing even for tax payers, as the elimination of the treat that tax increases could increase "black market" activities could encourage politicians to raise taxes even more. At the same time, many useful activities which can't be performed in the official economy because of high tax rates won't be done at all if they can't be performed in the "black market".

Cash, in short, fills the same function as gold once did in limiting government power (though not nowhere near as well as gold did). But for government officials and supporters of more government power, that is likely just another reason to abolish cash, which is why more and more of them are likely to argue for it in the future. Just like gold is will therefore soon be dismissed as a "barbarous relic" by statists.