Saturday, November 26, 2005

Hong Kong-The Unknown Ideal

Virtually unnoticed not only by the Swedish media but by all the mayor international news sites too was the news that Hong Kong's economy grew at an annual rate of more than 11% in the third quarter of this year, taking year over year growth up to 8.2%. Moreover, second quarter year over year growth was revised up to 7.3% from the previous estimate of 6.8%.

This is in part driven by strong productivity growth but is also reflected in very strong job growth, with employment increasing 2.7% and full-time employment increasing 3.4%.

Aother positive factor is that this strong growth happened "despite" the fact that government consumption was reduced by 3.3%. Hong Kong had a very low level of government consumption (Does not include welfare and other government transfer payments, but this is much less extensive in Hong Kong than in the west too) to begin with at less than 10% of GDP versus nearly 20% in the United States and nearly 30% in Sweden, yet they still manage to reduce it, not just relative to GDP but in absolute terms too. Even so, the leader of the Moderate Party (Who is supposed to be the "anti-statist" party) in Sweden , Fredrik Reinfeldt, still claims that somehow government services need to have sharply increased funding even though they already costed more than 3 times than in Hong Kong. And as have been discussed here before, a similar story can be seen with the Republicans in the United States. Government consumption was only 8.5% of GDP during the third quarter, yet Hong Kong does seem to have a fully functioning infrastruture and health care and its students have top scores in international comparisons. So how can it be maintained that it is necessary to spend 30%?

This means that the Hong Kong boom have a sound basis and that Hong Kong can eliminate its budget deficit while keeping its by western standards extremely low tax rates.

Hong Kong's economic success illustrates the benefits of free market economics. When the economic success of countries like Latvia and Estonia this is sometimes dismissed as being merely a "catch-up" effect as they with their low initial income level can benefit from existing technology and markets in rich countries. But Hong Kong cannot be as easily dismissed as they already were the richest country in Asia, having a higher per capita income than countries like Japan, Sweden and Hong Kong's former colonial power, the United Kingdom.

Yet they still manage to maintain extremely high growth. The reason for this is of course that Hong Kong is the economy in the world that comes closest to the laissez faire ideal, with its very low levels of government spending and taxation, its low regulatory burden, its consistent free trade policies and its lack of a independent monetary policy.

Friday, November 25, 2005

About Japanese Price Deflation

BBC Business News curiously reported that price deflation in Japan ended in October. Yet if you look deeper into the story you see that this refered to the Japanese version of "core inflation", which excludes only fresh food, but not non-fresh food or energy. Looking at the all-items index, price deflation in fact accelerated to -0.7%. While the deflation scare mongers thinks this is very bad, for the Japanese this means that their purchasing power is increasing as this is driven by increased supply of goods and not monetary deflation.

Interestingly, despite the fact that the inflation rate is exactly 5%:points lower in Japan than in the U.S. (which has 4.3% inflation), the yen have fallen dramatically (more than 15% ) against the U.S. dollar. This is clearly driven by the higher nominal interest rates in the U.S. But this capital flow is clearly irrational since real interest rates is higher in Japan. The real yield on 10-year bonds is 2% in Japan and nearly zero in the U.S. Combined with the accumulated fall in the yen's real exchange rate which makes the yen look highly undervalued, this means that Japanese bonds actually look more attractive than its U.S. counterparts, despite the lower nominal yields.

Thursday, November 24, 2005

Too Little, Too Late

During the latest week, ECB chief Jean-Claude Trichet have clearly indicated that interest rates will at last be raised to counter the increasing inflationary tendencies. As was to be expected, the politicians and pundits which previously argued for a rate cut are horrified by this. However, most likely the hike will only be a quarter point, to 2.25%. That means that it will still be lower than the 2.5% it was before the June 2003 rate cut and it means that interest rates will still be negative in real terms.

Given how extremely loose today's 2% is, with real rates being negative and money supply growth at 8.5%, a quarter point hike will clearly be too little too late to rein in the inflationary excesses consisting of not only too high consumer price inflation, but more importantly the housing bubbles created in most European countries and the increase in debt levels that have followed.

The politicans that now object to the small rate hike argue that growth isn't strong enough. Yet the fact is that today's 1.5-2% is aroung the 10-year average, so this weakness is not cyclical. Instead it is related to the excessive tax and regulatory burden as well as the aging population. If the politicians wants higher growth, they should do something about these structural problems, not aggravate the current inflationary excesses which might boost growth in the short-term but is likely to damage the economy in the long term (Not that we should expect politicians to consider the long term).

Thursday, November 17, 2005

Uselessness of Competitiveness Report Confirmed

When the ranking of competiveness from the World Economic Forum was issued in late September, I dismissed the report as useless based on the observation that despite the fact it defines competitiveness as growth it ranks rapidly growing economies like China, India and Latvia very low while ranking slow-growing economies like Sweden and Germany very high.

Now a more systematic look at this issue published on Johnny Munkhammar's blog confirms this and shows that there is zero correlation between "competitiveness ranking" and growth. In my original post, wrote that a dart-throwing monkey probably would do better. Well, that was perhaps a bit too hard. It seems that the "World Economic Forum" is merely equally bad as the dart-throwing monkey....

Wednesday, November 16, 2005

"Equivalent Rent" Distortion Finally Noticed In Media

Finally, a mayor news outlet noticed the way in which the government calculates "home owner's equivalent rent" underestimates inflation.

From CBS Marketwatch:

"Housing prices - and the core CPI -- would have risen even more, except for a statistical fluke stemming from the way the government calculates homeownership costs by using rents of comparable houses.

Because many houses are rented with utilities included, the rental portion of the monthly bill is deemed to fall when utility prices rise."

It should be added that overall CPI is underestimated too because of this factor, although slightly less so than core CPI.

I made the same point months ago in my essay on "core inflation":

"This effect is enhanced in the statistical numbers by the fact that when fuel prices rise while rents have in the short-term not been adjusted upwards then the "home owners equivalent rent" will be decreased as it is calculated based on rents minus fuel costs. Meaning that any increase in fuel costs for home owners will be exactly matched by an equivalent decrease in "home owners equivalent rent" which in turn means that higher energy prices will at least in the short term have the effect of lowering the core inflation numbers."

Saturday, November 12, 2005

Both Good and Bad in Germany's New Budget

As I've discussed before, the latest German elections ended with neither of the two main parties, the Christian Democrats and the Social Democrats failed to achieve majority even with their prefered coalition partners, the Liberals and the Greens respectively. The Social Democrats could have held on to power with the help of the post-communist Left Party, but as they have ruled this option, a "grand coalition" with the Christian Democrats is now the only remaining option.

Today, the details of the economic policies of the new "grand coalition" was revealed. And it contained both good and bad policies.

Starting with the good parts, they seem to realize how important it is to reduce Germany's budget deficit especially with its aging population. With regards to the last, they also wisely choose to cut back on pensions both by freezing benefits (which means reducing them in real terms) and raising the retirement age.

Another positive is a slightly less rigid labor regulations and a small cut in the payroll tax.

The bad news is that the small payroll tax cut will be more than offset by much larger tax increase, both in the form of a value added tax (consumption tax) increase from 16% to 19% and a increase in the top income tax from 42% to 45%. Another negative is that government "investment" spending is set to increase.

Given the already too high level of German taxes, further tax increases are particularly damaging and will further reduce the incentives for wealth creation. And contrary to the belief of the Christian Democrats, the value added tax is as damaging as the payroll tax as both act as "tariffs" on economic exchanges and thus reduce economic activity. Instead the budget deficit reduction should have been focused on spending cuts, particularly in the welfare and entitlement systems.

As the package contained both good and bad news, it will probably have almost no net effect either way on the performance of the German economy. But given how weak the German economy is, not doing any further damage is not good enough.

China's Irrational Currency Policy

As you probably know, because of the increasing U.S. trade deficit and the increasing Chinese trade surpluses there is strong pressure on Cina to revalue its currency.

I have somewhat mixed feelings on this subject. On the one hand, I don't think that a fixed exchange rate policy like China's is more of a "manipulation" than floating exchange rates. If anything, it is in fact less manipulation since under a free market monetary system -a gold standard- there would be no exchange rate fluctuations as there would be no exchange rates. And you can hardly accuse the Chinese of having set the current exchange rate for mercantilist purposes since they also refused to devalue in 1997-98 even though they then faced intense pressure to do so.

However, despite the above, I still think the Chinese leaders should revalue the yuan substantially. The reason for that is that it is nearly inevitable given the current size of the bilateral U.S.-Chinese trade imbalance that China will be blamed for U.S. economic woes during the coming U.S. recessions. This means in turn that if China holds on to its current peg it is nearly inevitable for the 27.5% across the board tariff that New York Senator Charles Schumer(D) and South Carolina Senator Lindsey Graham(R) have proposed will pass along with more quotas and other formal protectionist measures.

And with some 14% of China's GDP being constituted by goods exports to the U.S., this would have a devastating effect on China's economy.

While a revaluation would hurt the Chinese economy too, it would do much less damage since the lost export revenues would be partially compensated by a cheaper import bill. And by revaluing the yuan substantially, the risk of tariffs and quotas being slapped on Chinese exports would decrease greatly. And even if it didn't stop tariffs and quotas the damage done to China would be lower since the yuan value of Chinese exports and accordingly the U.S. exports to GDP ratio would be reduced.

China's leaders are probably aware of this, and it was because of this that they had the marginal 2.1% revaluation in July and it is because of this that they now imply that they will continue to gradually increase the value of its currency.

Yet keeping a pegged currency while saying it will not stay that way is one of the worst possible options. Not only will this mean that one of the benefits with a fixed exchange rates, namely reduced exchange rate uncertainty, will be lost. But even worse this will mean that the inflow of speculative capital betting on a stronger yuan into China will increase further. Such a strategy is certainly rational for the speculators since China have made it clear that a gradual appreciation will happen. But it is not good for China since this forces the Chinese to continue the massive build-up of foreign exchange reserves to compensate for the inflow of speculative capital. That in turn is bad for China as they will lose a lot of money on the falling yuan value of their growing reserves and it is also bad for the world economy since it increases the inflow of Chinese capital into western bonds and thus artifically keeps down bond yields.

China should get this revaluation business over with and either float the currency or revalue it to at least 7 or perhaps even 6 to the dollar. The Chinese leaders argue that it would be too disruptive, but in the end it is inevitable to avoid even more U.S. protectionism and delaying it will only cause more disruptions.

Friday, November 11, 2005

Is the Trend of Reduced Government in Japan Reversing?

Today's first estimate of Japan's GDP during the third quarter was at first glance better than analysts had expected with growth being 1.7% at an annual rate compared to the previous quarter, compared to the expected 1.2%. At a terms of trade adjusted basis, growth was only 1.1% however. On the other hand, the fast growth in the investment income surplus from offshore means that national income grew 1.9% on a terms of trade adjusted basis. And since Japan have zero population growth, this means that all of these growth numbers are equivalent to more than a percentage point higher growth in the U.S.

One worrisome item is the fact that growth in government demand this quarter seemed to be the main driving force behind economic growth . In recent years, Japanese politicians have tried to reduce the sky high budget deficit through cutting the wasteful government "investments" that previous governments have tried to prop up the economy with in a Keynesian manner. But this quarter government spending rose relative both GDP and national income. Let's hope for Japan's sake that this is merely a abberation and not the reversal of the trend of reduced burden of government. Because of its extremely large (6% of GDP) budget deficit, Japan certainly cannot afford to increase it further. And tax increases would discourage productive behavior.

Prime Minister Koizumi promised during the latest election campaign that he would reduce the burden of government, so probably this was indeed merely a abberation. However, we cannot be sure as politicians can never be trusted to keep their election promises. Remember, Franklin D. Roosevelt promised in the 1932 presidential election campaign to cut government spending......

Thursday, November 10, 2005

Record U.S. Trade Deficits

After having failed for six months to reach above the record $60.4 billion mark reached in February, the U.S. trade deficit reached the new record level of $66.1 billion in September.

This reflected largely temporary factors, like Katrina (who while reducing oil imports increased fuel and natural gas imports even more) and a strike at Boeing, so the deficit is likely to fall back in October, particularly if Boeing can compensate the lost September shipments with higher October shipments.

And it will probably not have much of a effect on third quarter GDP, because while the rise in the trade gap was nore than the advance GDP numbers assumed and while the August deficit was also revised up, this will probably be mostly cancelled out by higher than expected wholesale inventory levels.

However, while the deficit in October is likely to fall from the $66.1 billion level, it will still likely stay above $60 billion. Not all of the increase was due to the temporary Katrina and Boeing effects as the increase in the deficit with China illustrate. And while oil prices have fallen back from their peaks they are still slightly above the average $57 paid by importers in September.

Tuesday, November 08, 2005

How the U.S. Can Still Run a Investment Income Surplus

One of the more surprising economic facts is that the United States still run a investment income surplus. That is, Americans receive more in interest, dividends and profits from abroad than non-Americans receive from America. After having run hugh current account deficits for more than two decades now and having therefore obtained a multitrillion dollar net foreign liability one would have expected America to run a large deficit in investment income.
Since non-Americans have so much more assets in America than America have abroad then clearly America "should" run a large investment income deficit.

Equally surprising is that the investment income surplus have barely fallen in recent decades. While relative to GDP, the investment income surplus have fallen from the more than 1% of GDP it was at in the early 1980s when the U.S. started regularly running large current account deficits, it was in 2003 in nominal terms actually twice the 1980 level. And while the surplus fell somewhat in 2004 and continued to fall during the first falf of 2005 it eas even during the second quarter of 2005 at a higher level in nominal terms than in 1980 or 1998.

How can this seeming mystery be explained? The explanation is that Americans invest much smarter. At year-end 2004 , American assets abroad were $10 trillion versus foreign assets in the U.S. of $12.5 trillion. Yet as the average yield on for American investors were 4.2% versus 2.9% for foreign investments in the U.S., Americans received $415 billion in investment income from abroad versus the mere $362 billion for foreign investors in the U.S.

In what way are Americans smarter investors, then? Well, by to a much higher extent investing in stocks and direct investments than the non-Americans who invest in the U.S. Of the $10 trillion of U.S. foreign assets some 58% are either direct investments or stocks. By contrast, of the $12.5 trillion in assets that non-Americans have in the U.S. , only 37% are direct investments or stocks . The result is that with regards to ownership of business, America have more assets abroad than foreigners have in the U.S., $5.8 trillion versus $4.6 trillion.

And as a rule, ownership of business yield a lot more than bonds and other interest yielding holdings. Bonds are simply a much worse investment than equities. The total implicit yield (including retained earnings) in equities tends to be something like 7% at today's P/E ratios, much higher than bond yields. And direct investments often produce even higher yields than equities.

Indeed, the irrational foreign apetite for fixed income securities is so great that not only does this cover the U.S. current account deficit, it also enables Americans to "recycle" money they get by issuing bonds for foreigners and invest them in businesses in the home countries of the foreigners, creating large gains for Americans who pay 4% in interest yet receives 7% or more in yields from business ownership.

Why are foreigners allowing themselves to get screwed this way through their irrational preference for bonds? To some extent it might just be a case of greater timidity and risk-aversion.

Another explanation may be fear of provocing a protectionist backlash in the U.S. Americans don't mind if foreigners subsidize their consumption by buying low-yielding bonds, but they get upset if foreigners buy American companies. Case in point were the hysterical reactions to the Japanese purchases of Columbia Pictures and Rockefeller Center around 1990 and the anger over the bid for U.S. oil company Unocal from Chinese oil company CNOOC. As the Asians reckon that export income is more important for their economy than higher investment returns, they abstain from buying American companies.

Similarly, Asian central banks have been pouring in money into U.S. government bonds to keep their currencies cheap. Of the $2.5 trillion in U.S. foreign net liabaility, $2 trillion represents foreign central bank holdings of U.S. government bonds and other interest yielding assets (By contrast, U.S. government assets abroad were "only" $190 billion).

As long as Asians continue to fear stronger currencies or outright protectionist measures, they will continue to squander some of the money they make from exports to America and allow Americans to make arbitrage profits by "recycling" the money into higher yielding foreign investments.

In the short term, the U.S. investment income surplus should fall now after actually having risen between 1998 and 2003. Both as a result of continued U.S. current account deficits and as aresult of higher U.S. interest rates. The longer-term outlook is more uncertain. The large current account deficit "should" mean that the surplus should soon be turned into a deficit. Remember, with a mere 4% interest rate on the annual current account deficit of $800 billion, this means that the 2004 surplus of $53 billion "should" be eradicated by 2006. But this might take a lot longer if Americans on a aggregate level continue their smart strategy of "recycling" the money that foreigners put into low-yielding U.S. bonds.

Monday, November 07, 2005

The Gas Tax of the Riksbank

The high oil prices have created worldwide anger over high prices of gasoline. Americans were shocked when in the wake of Katrina, gas prices reached $3 per gallon ( 1 gallon is 3.785 liters so this means the gas price was $0.80 per liter). Now it have fallen back somewhat from that peak and is usually closer to $2.50, but even that is shocking to Americans.

But that is of course nothing compared to the gas prices that exist in most Western European countries where the gas price is often double or more the $3 per gallon peak that Americans were so chocked about.

Sweden is one of those countries that have a extremely high gas price, with prices being usually around 12 kronor per liter or $1.50 per liter or $5.70 per gallon. Of those 12 kronor,around 7 are various forms of sales taxes.

Anger over this is increasing and there is a organized (non-violent) rebellion against high gas taxes called Bensinskatteupproret meaning "The Gas Tax Rebellion". It have so far collected nearly 670,000 signatures (And that is a lot for a country with 9 million people)for its call to reduce gas taxes.

Tax rebellions are of course always encouraging (Just too bad Swedes aren't as upset over other taxes). However, there is one aspect of all of this that seem to have gone lost. As usual no one blames the central bank for these price increases even though they are definetly part guilty too.

Gas is made by a internationally traded and into Sweden imported commodity and so prices depends on exchange rates. And the Swedish krona have fallen dramatically this year, being 20% more expensive versus the dollar and nearly 7% more expensive versus the euro. This is certainly something which should be blamed on the interest rate cut by the Swedish Riksbank this June from 2% to 1.5%.

Exchange rates are namely increasingly controlled by interest rates, and never have this been so clear as during the recent year. We have seen how the Swedish krona and the Japanese yen have fallen dramatically, as Swedish interest rates have come down dramatically and Japanese interest rates have stayed at their extremely low (at least in nominal terms) levels. The US dollar have on the other hand risen sharply versus the euro reflecting Fed rate hikes while Euro zones interest rates have stayed unchanged. The Brazilian real have been the big winner rising sharply versus the dollar (and by extension even more sharply versus other currencies), something which reflects Brazils extremely high interest rates in both real and nominal terms (To a lesser extent it also reflects Brazil's terms of trade gains from rising commodity prices).

If we make the quite reasonable assumption that the entire 7% decline in the Swedish krona versus the euro is a result of the interest rate cut and since 5 out of the 12 kronor gas price is either imported material or value added tax on it (something which automatically increase if the commodity price increases), this means that the gas price have been increased by 0.35 kronor from the Riksbanks rate cut. Any Swede upset about high gas prices shouldn't just be upset at the gas taxes, they should also be upset at the Riksbank.

Saturday, November 05, 2005

"Greedy Oil Companies" Revisited

Alan Reynolds have a great column about the issue of "Greedy Oil Companies". Here he points out that oil prices are driven by supply and demand, not by oil executives and points out what would happen if oil companies responded to the populist calls of Bill O' Reilly and others:

"Exxon-Mobil's recent profit margin was up to nearly 9 percent of sales. Suppose they tried to cut that to a nickel out of every dollar by offering to sell crude oil for $3 a barrel less than the going price on the Chicago mercantile exchange. Refiners around the world would instantly commit to buying every drop. By the next day, the world price of crude would be same as before.

Suppose the Big Five oil companies got together and agreed to cut retail gasoline prices at their company-owned stations by 20 cents a gallon. Motorists would soon drain those stations dry, leaving the much larger number of independent gas stations in a position to charge even more. Meanwhile, independent station owners would file a complaint with the antitrust division of the Department of Justice accusing the majors of collusive predatory pricing to drive them out of business."

How Low Interest Rates Partially Mask the Bush Spending Spree

Last night, the Congressional Budget office came with its monthly budget review, with preliminary numbers for October 2005 and definite numbers for the 2005 fiscal year (October 2004-September 2005). Aside from minor adjustments, the numbers for fiscal year 2005 were already known. They showed the first decline in the budget deficit since fiscal year 2000, but not because of lower spending. Spending continued its 5-year trend of rising relative GDP. The explanation was instead a surge in tax revenues, casused by three factor: rising asset prices (boosting capital gains tax revenues), rising corporate profits and the expiration of depreciation incentives . Because of this government revenues reversed the trend of declining relative to GDP and rose from 16.3% to 17.5%. And as spending "only" rose from 19.9% to 20.1% of GDP, the deficit fell from 3.6% to 2.6%.

One spending item that deserves more attention then it have been given in most recent analysis of the U.S. Federal budget is net interest on the public debt. This is because it is only partially controlled by the President and the Congress. It is perhaps even more controlled by the Federal Reserve. Net interest expenditure is a function of two variables: the level of the public debt and the rate of interest. The former is basically controlled by the President and Congress while the latter is basically controlled by the Federal Reserve. While both (Just like any revenue and spending item) are also influenced by external factors of course, it is still fair to
say that the President/Congress and the Federal Reserve respectively controls them as they could if they wanted to cancel out the effects of the influence of those external factors through discretionary measures.

What we can see when taking interest expenditure into account is that Bush have in fact increased spending far more than the increase from 18.5% of GDP in 2001 (Clinton's last budget) to 20.1% in 2005 would suggest. In 2001 federal net interest payments was 2.1% of GDP but in 2005 it was only 1.6% of GDP. This decline was of course most definetly not the result of a debt reduction from Bush. Indeed,the federal debt increased from less than 33% of GDP in the second quarter of 2001 to 37% in the second quarter of 2005. Instead it was the result of a Fed-engineered decline in average interest rates from 6.4% to 4.3%. The savings that the Federal government have made from the Federal Reserve's easy money policy have thus served to partially mask the trend in non-interest spending.

If average interest rates on the federal debt had been unchanged, then interest expenditures would have been 2.4% now instead of 1.6% and federal spending would have been 20.9% instead of 20.1% and the deficit 3.4% instead of 2.6%.

The implication of this is that the much talked about spending spree from Bush and the Republican congress have in fact been underestimated when one only look at total federal spending (or even worse total non-military federal spending). If we only look at non-interest spending, it have increased from 16.4% in 2001 to 18.5% in 2005, the by far biggest increase during any president since at least FDR. And again, it gets even worse if we factor in the interest expenditures that the deficits during Bush have created.

Looking forward, interest expenditures looks likely to increase both because of the continued increased of the federal debt caused by the deficits and because interest rates have started to recover as a result of the Federal Reserve again starting to tighten monetary policy.

The preliminary results for October 2005 indicates very rapid spending growth and slowing but still strong revenue growth. Revenues increased 9%, which is slower than in fiscal year 2005, but still higher than nominal GDP growth. Spending increased at first glance only 2.5% (lower than inflation), but taking calendar effects into accout it too increased 9%, meaning that the underlying budget deficit also increased 9%. It is unclear to what extent these numbers are affected by Katrina.

Friday, November 04, 2005

Michael Darda vs. the Truth

One of the most laughable claims this year came in today's NRO-column by Michael Darda who claimed that:

"the ratio of average home prices to personal incomes is not out of whack with historical norms. In fact, despite rising off the lows of the 1990s, the ratio remains below historical averages."

Huh? In the last Flow of Funds report for the second quarter the ratio of housing values to disposable income was a record 204% ($18433.1 billion/$9017.8 billion) , compared to the 1980-1999 average of 143%.

Needless to say, his column contains numerous other errors too.

Like when he tries to claim that personal income growth was 6.3%. This is true if you refer to nominal gross personal income, but a more relevant measure is real disposable personal income. And because of the surge in tax revenues that NRO is so happy about, nominal disposable income rose only 5.3% and because of the 3.8% increase in the PCE deflator (For the sake of the argument it is accepted as a accurate price gauge), real disposable income rose only 1.5%. That he "forgets" to adjust income growth for inflation is pretty remarkable given the fact that just two paragraphs later he himself emphasize the need to adjust for inflation.

He then tries to reassure us by saying that household financial assets have risen too. But financial asset prices are just as prone (if not more) to decline as real estate prices, as the decline in financial asset values between 2000 and 2002 illustrated very clearly, so this is hardly reassuring.

He then tries to tell us that gross private savings have risen slightly since 2000. Which is true but this reflects collapsing government finances. The total national savings (whether gross or net) rate have for the last few years been at their lowest level since the Great Depression (In fact because of Katrina, net national savings was negative during the third quarter )

Finally, he claims that "total outstanding credit-market debt is off the 1990 peak with respect to total assets". Assuming he refers to the "Credit market instruments" line in the Household balance sheet in the Flow of Funds report, this is simply not true. In 1990the ratio of "Credit market instruments" to Total Assets was 15.0% (3593/23940). In the second quarter of 2005, this ratio was 17.5% (10694.3/60976.3).

Thursday, November 03, 2005

Formal Inflation-Targeting is Useless

Many people think that government institutions will somehow behave better if the discretionary powers of government officials are limited by formal rules. But as it is government officials who will enforce these rules they are often ignored. We see that in how the U.S. Supreme Court repeatedly ignore the Constitution they are supposed to enforce either by ignoring the written rules it contain or by enforcing rules which is nowhere to be found in the Constitution depending on the arbitrary political whims of the Supreme Court justices.

Another example is how central banks with so-called inflation targets ignore those targets at will. The European Central Bank (the ECB) for example is supposed to according to its own rules hold money supply growth at around 4.5% and hold consumer price inflation below 2%. Yet even though money supply growth is now 8.5% and consumer price inflation is 2.6% , the ECB refused again to do what their own rules would require them to do- to raise interest rates.

The ECB is obviously trying to appease and bail out the politicians of countries with deep structural problems like Germany and Italy even though they are not supposed to do that and even though that will in the long run create a lot more problems than it solves.

The lesson of this is that government officials can't be restrained by formal rules as long as they are able to interpret these rules themselves. We should therefore also not expect any real change if Ben Bernanke succeeds in making the Fed adopt such a rule.

Wednesday, November 02, 2005

European Inflation Idiocy

New blog postat the Mises blog.

Tuesday, November 01, 2005

Problematic Aspects of the U.S. GDP Reports

Most commentators were euphoric over the seemingly strong third quarter GDP growth number of 3.8%. If we look at the details however, we can see that there are many troubling aspects which surprisingly few commentators (Indeed as far as I know, none besides me) have noticed.

First of all, because of a sharp deterioration of terms-of-trade (related mostly to the energy price increases), the purchasing power of U.S. production increased far less than the headline 3.8%-number. If we deflate the nominal increase of 7.0% with the 4% increase in the price index for domestic purchases rather than the 3.1% increase in the price index for GDP, we find that real production growth was more like 2.9% than 3.8%.

Another negative aspect is the high extent to which growth was driven by government spending. While the misleading volume measures indicates that the burden of government purchases (not including government transfer and interest payments) fell as it rose 3.2% versus 3.8% for the economy. But the price index for government spending rose a full 6.3% versus the 3.1% GDP price index, meaning that the private sector suffered what one might call a deterioration in its terms-of-trade versus government. As a result nominal government spending rose at an annual rate of 9.8% versus the overall 7% increase. Because of this government purchases rose from 18.89% in the second quarter to 19.01% in the third quarter, meaning that private sector growth was in fact even weaker than the above mentioned 2.9%.

A third troubling fact was the fact that because of the high capital consumption caused by Katrina, Net Domestic Product fell in fact during the third quarter, by 4.4% at an annual rate in nominal terms and by 8.2% in real terms. This means that Americans in fact saw their net income fall sharply during the third quarter. On the other hand as the sharp increase in capital consumption was largely driven by temporary factors like Katrina this means that Net Domestic Product is likely to increase even faster than Gross Production during the fourth quarter But it is still important to notice that America became poorer not richer during the third quarter.

A fourth troubling fact related to the previous one is that both the household savings rate and the net national savings rate fell sharply and became negative during the fourth quarter as American consumption (both government and private) rose despite falling real income. The household savings rate fell from 0% to -1.1% while the net national savings rate from -0.2% to -5.5%. This of course reflects to a high extent Katrina-related damages and so we can expect a great improvement in the fourth quarter. But this still means that real American wealth (as opposed to asset price inflated paper worth) fell and even excluding Katrina, the absolute level of savings is far too low.

What does this mean for the future outlook? Clearly with a negative savings rate, there is no room for further increases in private consumption spending and because of the declines in real spending in August and September the fourth quarter number for private consumption will likely only show a very small increase at best.

On the other hand there will of course be a continued sharp increase in government purchases related to Katrina-related reconstruction. This will likely keep the headline GDP number well into positive territory for the fourth quarter , but such growth is hardly sound. Beyond that, the conflicting forces of weak household finances on the one hand and on the other hand high corporate profits and a continued government spending produces a uncertain outlook.