You Should Have Seen It Coming, Larry

Larry Kudlow rightly blasts the wasteful spending related to the rebuilding of New Orleans after it was devastated by hurricance Katrina two years ago.

The problem is that back in 2005, Larry Kudlow attacked the people that criticized the New Orleans spending spree with completely nonsensical arguments. Let's hope Larry and others learn from this that government projects as a rule tend to be very wasteful, with higher costs and less results than private sector projects.

Mark Thoma vs. The Economist

Today, Mark Thoma, who usually don't have much original commentary on his blog but instead publishes the commentaries of others, unusually enough comments and criticizes an article at length. The article in question is the article from The Economist about the benefits of a recession that I told you about recently. Thoma is a leftist Keynesian, so it is hardly surprising that he dislikes the semi-Austrian message of the article. Here is his arguments and my replies.

1. I disagree that we need recessions to have a dynamic economy. Equilibrium means (in simple terms) "no tendency for change" and there is nothing inconsistent with having a constant flow of entering and exiting firms at equilibrium.

When profits are high - as in the traditional price signaling story - there is a rush to enter industries, but the trick is to get there first and take some of the profits before others beat you to it, innovation and technological change are not so important. There are lots of profits to be had by entering with existing technology so, while it does allow the installation of the best and latest technology, there's no strong pressure to innovate. In fact waiting until there is an innovation could be costly.

It's when conditions are tight, i.e. when everyone is making close to zero economic profit, that new cost saving or demand enhancing technological change will pay off. If you have a better product or lower costs than rivals, then you will gain an edge and realize profits. The only way to get ahead is to build a better mousetrap. Sure, conditions will be tight in recessions - that's the traditional creative destruction story - but things are tight in a competitive equilibrium too and the pressure to innovate does not disappear just because the economy is operating at full employment...

...I am not an Austrian economist and I don't play one on the internet, so I won't claim to be able to recite what Schumpeter (or anyone else in the Austrian camp) said about this on a particular page of one of his books, so maybe someone who is an adherent to this "we need business cycles" approach can explain why we cannot wipe out the inefficient while remaining at or very near full-employment.

First, while Schumpeter is an Austrian by nationality, he is not usually considered to be part of the Austrian school of economics, as are for example Carl Menger, Ludwig von Mises, Friedrich Hayek, Murray Rothbard and George Reisman (the latter two aren't even Austrian by nationality). So I won't try to defend Schumpeter's arguments. But in the Misesian version of the argument, a lot of inefficient companies are being artificially sustained through monetary expansion. In order for factors of production to move on to more efficient companies, these inefficient companies have to be destroyed. This requires tighter monetary conditions, which together with the usual time lags in reallocation in resources will produce a short-term decline in production (aka a recession).

2. Overproducing houses is not like overproducing goods that cannot be stored, i.e. perishables. When too much popcorn is produced relative to demand, it goes to waste. Resources that could be used elsewhere are wasted forever since the excess can't be frozen or stored for the future (or at least assume so for the purposes of illustration, there is that stuff in movie theaters). With houses, there is an intertemporal shift in resource use, but since houses don't spoil in a short period of time, and because people will continue to demand them in the future, overproduction today will result in underproduction tomorrow. The houses were built too soon, and that's an efficiency loss because we gave something up, but when we produce less houses later we can recover (some of) the goods that were lost (too many houses and too few cars in year one, but in year two it's the opposite, too few houses and too many cars relative to the no distortion outcome). In the case of popcorn, since it couldn't be stored, lack of storage means we didn't have the opportunity to produce less later, so there is no way to make up for it, even in part, later on.

That is to say, I hope we don't "creatively destroy" the houses that were (over)built. Sure, some can be creatively transformed into restaurants, business offices, etc., to attenuate the misallocation in the short-run, but there's no need to tear them down and replace them. With time, population and demand will grow, and the houses will be filled. Hula hoop factories needed to be creatively destroyed, they needed to be torn down and replaced - it's unlikely demand will return in the future so having those factories around would be a waste, they would never be re-opened - but houses are not hula hoops. With houses, there is no need to "purge the excesses of the previous boom," just wait for population to catch up (and would it be so bad to have low cost housing available in the interim?).

No, the houses need not be destroyed, particularly not in areas where there are positive population growth. In those areas, demand should indeed catch up-at least in that famous long run where Keynesians say we are all dead. There could however be alternative uses for the land which produces a higher value.

And more to the point, what needs to be destroyed are again not necessarily the houses per se, but the companies, building projects and jobs which built the houses. While the houses perhaps need not be destroyed, as the past building of them are sunk costs, what should be eliminated is any further waste of resources by building more of them. In a world without any adjustment costs, that wouldn't cause any recession. But in a world with adjustment costs (such as the one we're living in), it will.

3. I don't understand the reasoning that says the Fed should not stabilize the economy because it will "create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession."

The reasoning is that if we stabilize the economy, people will then believe recessions are impossible (or underestimate their likelihood) and make bad decisions, so we shouldn't stabilize at all.

People who believe the Fed can prevent all economic fluctuations will be, so to speak, "creatively destructed" the first time there is a recession. But to refuse to stabilize the economy to the best of our ability because we are afraid people might misperceive the degree of stability that is attained seems misguided to me. I would have thought an Austrian response would be to do what's best for the economy and let those who misperceive be weeded out by the market process (or better yet, that they become informed about the true risks - this is a market failure from lack of information and while I'm pleased to see The Economist acknowledge markets can fail, the solution is to provide the information, not to refuse to stabilize).

The only thing right in this part is that first statement about not understanding the argument. So let me explain it to Thoma and others who don't understand. If the Fed through lower interest rates and the implicit or explicit promise of a bail out encourages asset price bubbles and the excess debt and wasteful over-investments, this creates a situation where such behavior is profitable for the investor-but damaging to the overall economy. This is no different from how say massive subsidies of certain farm products makes it profitable to farmers to over-produce but damaging to the overall economy.

This is certainly not a case of "market failure", as the government in the form of the Fed has knocked out the market's weeding out mechanism.

Finally, I note that Thoma fails to comment at all on one of the most important arguments from The Economist: namely, the need to reduce imbalances such as a too low savings rate and excess borrowing.

EMU Money Supply Growth Accelerates

There have been speculations that the ECB might cancel its previously signaled September rate increase due to the credit market turmoil. It remains to be seen whether they actually will cancel it, but this news of a further acceleration in Euro area money supply growth clearly says that they should go ahead with the rate increase.

U.S. House Price Decline Accelerates

And this was in June, before the recent acceleration of credit anxiety.

Who's Next?

With the bursted housing bubble being already an established fact, and a recession coming soon (if not already present, only not yet revealed in the by necessity lagging statistical releases) in America, the question soon arises about who is next. After all, in many countries house prices have increased as much or more than in America. While there may perhaps be special factors in some of these countries justifying the house price increases in a way no fundamental factors could justify America's house price bubble, certainly some markets are significantly overvalued.

The reason why America came first was that it was home made to a much higher extent than in other cases. Alan Greenspan made interest rates go through a roller coaster ride, being first pushed down from 6.5% to 1% and then raised back to 5.25%. During the period of super low interest rates many subprime borrowers were hooked by Greenspan's teaser rate, only to see their personal finances in disarray when interest rates were raised back to more sustainable levels. Also, many near prime and prime borrowers were able to use their homes as ATM's when interest rates were low and house prices rising, something which they are unable to do so now.

In no country has interest rates been reduced and raised in such a dramatic way as in America, which is why it has been hit first. Still, there are other markets where house markets look highly overvalued.

One example of this is certainly Australia, where house prices have increased again after a brief slowdown in 2005. As I've stated before, Australia would likely have fallen into a recession in 2005 if it hadn't been for the commodity price boom. If America's likely recession directly and indirectly causes a significant slowdown in growth in China, this will end the commodity price boom. And with imbalances in Australia being if anything worse than in 2005, then an end to the commodity price boom will certainly mean an end to the housing bubble in Australia. And an end to both the commodity price boom and housing bubble in Australia will certainly mean an Australian recession.

Also, a number of European countries have housing markets look overvalued. This includes among others Britain, Ireland, Spain, Sweden, Denmark and the Baltic states.

Of particular interest is perhaps Britain. Two factors which have driven the housing boom there now look like they are disappearing. First, global financial turmoil will likely reduce or even end the bonuses in London's all-important financial City-district. That will take a heavy toll on the high end housing market in the greater London area. Second, the net inflow of immigrants from Eastern Europe are already starting to decline and will likely continue to decline more dramatically soon, perhaps even ending or even reversing, as economic growth in Eastern Europe is a lot higher than in Britain and as the decline in births in the early 1990s in Eastern Europe will soon translate into declines in the working age population.

Spain's housing market is already showing signs of cooling and could halt even further if there are more ECB rate hikes. This factor could also damage other overheated housing markets whose interest rates are determined by the ECB -either because they are part of the euro are or have pegged their currencies to the euro-, such as Ireland, Denmark and the Baltic states.

Sweden's housing bubble will on the other hand probably get worse next year as a result of the housing tax reform, so I don't expect any downturn in the Swedish house market until 2009 at earliest.

Have Globalization Increased or Decreased Inflation

In light of the increase in commodity prices in recent years as a result of increased demand from China, India and other emerging economies many people have doubted the argument from me and others that globalization has kept down price inflation. The argument, endorsed by Ben Bernanke and others, is that the increase in commodity prices will cancel out the effect of the entry of cheap finished goods from China and others.

Yet there are at least two good reasons to believe that the net effect from globalization is to keep down prices, even though higher commodity prices will somewhat limit the effect. First of all, globalization means that competition is a lot tougher than it would have been under national self-sufficiency. Secondly, globalization also means increased efficency as production for a global market increases the possibility of economies of scale, which will allow companies to lower prices. Thirdly, so far particularly China buys a lot less than it sells, as is reflected in its huge trade surplus. That means that China is increasing global supply of goods and services a lot more than it increases global demand. And if supply increases more than demand, this implies a downward pressure on prices.

Note however that argument three only applies in today's world. If China's politicians were to realize that a much stronger yuan is in their national self-interest, then this means that the price cutting effect of cheap finished products from China would be greatly reduced, while on the other hand commodity demand from China would increase as commodities are cheaper in yuan terms, putting an upward pressure on commodity prices in dollar and euro terms. It would also reduce factor one, as the competitive pressure from China would be reduced. If U.S. politicians were to have their way and the yuan is significantly revalued, this would greatly increase price inflation in the U.S., reducing the room for the Fed to cut interest rates and thus likely destroy a lot more jobs than reduced import competition would save.

Why America Should Have a Recession

While today's reports on durable goods orders and new home sales were relatively bullish, most other reports still indicate a weakening U.S. economy. And the credit crunch this month likely implies that reports for August and September will be a lot weaker. Which is why I still think it is likely that America will fall into a recession this year.

But beyond the descriptive issue of whether America will have a recession or not is another, perhaps even more interesting, discussion. Namely the normative discussion of: should it have a recession?

What kind of question is that, you might ask. Recessions means that production falls and unemployment rises which makes people worse off, so of course recessions are bad.

Well, all of that is true, but it misses the point. While it is not good that the need for a recession has been created, it may just be the case that under the circumstances, a recession is a lesser evil compared to not having a recession.

The Economist, who for long has been my favorite among established magazines, not least because it very often implicitly or explicitly argues for Austrian economic theories, argues this case in its latest issue.

It points out that recessions are processes which weed out inefficient firms and forces a reduction in imbalances. Case in point is the massive counter-cyclicary
policies of Japan in the 1990s which while being successful in avoiding a steep recession/depression, created a nearly permanent stagnation. Another example is in fact America, who despite the positive supply boost from Bush's tax cuts and the housing bubble actually had relatively moderate growth during the recent business expansion, and who will now likely suffer the hang over from the housing bubble.

As the article points out, sometimes downturns get out of hand and get more severe than they need to be. This was certainly the case in America in the 1930s when massive bank failures created a significant monetary contraction. But as long as the recession is the result of the end of monetary inflation, rather than outright monetary deflation, then recessions are a necessary evil to purge out the wasteful excesses of previous inflationary booms.

Not Just Subprime ( Again )

When the financial press discuss the severe (but now perhaps abating) credit crunch, they act as if the temporary panic and the subprime mortgage problem was the only problem for the U.S. economy. But as I told you recently, it's more than that. It is fundamentally a general housing bubble and excess debt problem.

Here is another piece of evidence for this: the market for luxury homes are also weakening dramatically.

And things should get worse for the luxury housing markets, particularly in New York, where financial workers do much of the buying. This is indicated by rapidly increasing financial sector job cuts. So far this year, financial sector job cuts are 75% higher than all of 2006. One quarter of those job cuts was announced during the first three weeks of August, and today Accredited Home Lenders announced another 1,600 job cuts and Lehman 1,200 job cuts. And those numbers do not include the recent First Magnum Financial bankruptcy, which means the loss of an additional 6,000 financial jobs.

Meanwhile, Wall Street bonuses are likely to get cut for the first time in five years.

Statistics No Substitute For Intuition

Ssome investors have come to believe that old-fashioned intuition and rational motive-based economic analysis is obsolete. Instead, what works are advanced mathematical models based on historical patterns. Well, that may work sometimes. But as many of them have come to experience recently, it doesn't always work that way. As the Washington Post notes, these so-called Quant Funds have lost really big money recently, as their "scientific" models failed to predict movements that was 25 standard deviations from the normal.

They Figured That Out Now?

Fed vice chairman Donald Kohn has finally figured out that rising house prices will increase debt levels and suppress savings. The rest of us figured that out years or decades, but better late than never, I guess.

Now on to the next step. What was responsible for the previous rise in housing prices that created the problems of high debt and low savings responsible for the current economic problems in the U.S.? So that we won't have to wait another few years before Mr. bright Fed official figures that out, I'll give him a helping hand and spell it out right now: FED POLICY, or to be more precise, the policy from Federal Reserve of artificially suppressing interest rates.

Hong Kong Growth Accelerating

Economic growth in Hong Kong accelerated to a 6.9% rate in the second quarter, up from a upwardly revised 5.7% in the first quarter, according to the volume measure of GDP. In terms of trade adjusted terms, growth was even more impressive, at 7.7% (Calculated by me using numbers available here)
, up from a upwardly revised 6.4% in the first quarter.

Both private consumption (+6.6% ) and investments increased faster(+11.1%), while trade surplus was flat. Government consumption increased in absolute terms, but continued to decline relative to the overall economy.

Hong Kong's economy benefit both from its strong microeconomic fundamentals -being the freest, most laissez faire oriented economy in the world- and from the boom in its dominant trading partner, mainland China.

The latter however constitute the greatest threat to Hong Kong's growth. While China's economy enjoys an enormous structural strength with its massive supply of cheap labor and savings, its quasipeg to the U.S. dollar is creating great distortions, including malinvestments, rising consumer price inflation and an excessive current account surplus. The latter makes China highly vulnerable to a U.S. recession, especially if that would make U.S. lawmakers pass anti-Chinese trade legislation.

And if China's economy would weaken, so would Hong Kong's.

Carry Trade Meltdown

With most of the focus being directed at stock-and bond markets, few have noted the dramatic currency movements. To the extent currency movements have been noticed, it is usually with regards to euro/dollar and dollar/yen movements. Perhaps somewhat surprisingly, the dollar have risen against most currencies in response to the subprime meltdown-despite the fact that this is an American problem. Howerver, the dollar have fallen sharply against one currency-the yen. So, in essence, the previous currency trends where the dollar have fallen against most currencies but risen against the yen, have gone into reverse the last few weeks.

Indeed, the currencies that rose the most in previous months, such as the dollars of Australia and New Zealand, and the Brazilian real, have also been the ones that have fallen the most. The Aussie and Kiwi dollars have fallen roughly 10% and the Brazilian real roughly 13% against the U.S. dollar in a mere month.

But it gets even uglier if you look at the movement of the yen versus the Aussie and Kiwi dollars and the Brazilian real. The yen has risen 22% against the real in a month and 20% against the Aussie and Kiwi dollars.

Take a look at this chart, where we see the New Zealand dollar rise 25% against the yen in four months-only to fall 20% in less than a month. Can anyone seriously in light of that defend the Friedmanite assertion that floating exchange rates will move in relation to economic fundamentals?

But apart from its economic theoretical implications, these movements will further endanger financial stability in the world. With the massive carry trade, investors who borrow in yen and lend in Aussie and Kiwi dollars and real, there's got to be a lot of people who have lost a lot of money on this in the latest month. To some extent that will only mean Japanese households. But it could also mean more hedge funds.

A Time To Look For Bargains

Just as I predicted, U.S. stock prices have been extremely volatile and erratic although generally volatile downwards. From Monday to Wednesday they simply declined in line with my trend estimate. They then continued to decline during most of today's (Thursday) session, only to suddenly during just a few minutes of trade erase the losses of the day in line with my volatility prediction.

Today featured unequivocally bearish economic news with rising jobless claims, falling housing starts and a stagnant Philly Fed which is what together with increasing general anxiety is what triggered the decline that lasted through most of today's session. Then for no real reason the losses were suddenly erased at a record time. Again, this sort of extreme erratic volatility up and down is what one could expect in a bear market so bad that people actually consider the utterly useless U.S. government bonds to be a safe haven!

Expect more of that irrationality and erratic volatility in the near future. However, since the fundamentals support the bearish case, the trend will continue to point downwards for U.S. stocks.

Interestingly enough, many European markets have actually declined even more than U.S. stock markets in a bear market triggered by problems specific to the U.S. economy. To be sure, globalization has decreased the link between local economies and local stock markets, which is why some extent of global correlation between stock markets is actually justified. But it is certainly not justified for European stock markets to fall more than U.S. stock markets who still after all remain a lot more exposed to the U.S. economy.

This means that the indiscriminate declines in almost all stock markets have created bargains for investors. They probably exist on all stock markets -including the American ones- but they likely exist particularly on European stock markets where many stocks with limited exposure to America have taken a heavy beating from America-specific problems.

Nice Euphemism

Mark Thornton notes today's funny euphemism. In describing what he sees the need for a weaker dollar, Martin Feldstein of NBER, uses the euphemism "a more competitive dollar" to describe dollar depreciation.

Blame EU For Rising Milk Prices

The increased prosperity of China have led to a sharp increase in Chinese consumption of dairy foods. And while local production is soaring, so is imports. China's increased imports of dairy products have now led to sharply increasing milk prices in Germany, a large exporter of dairy products. This in turn have of course led to angry consumers in Germany. But these consumers shouldn't be angry at China. They should be angry at the EU and its farm policy.

The natural response to this increased demand would of course be for German farmers to raise more cattle and so increase milk production. But as is pointed out in this story, the EU and its quota system forbids farmers from increasing production by more than 0.5% per year until 2015, when the quota system will finally be ended. This proves for the umpteenth time the insanity and evil of farm subsidies which not only cost tax payers a lot of money, makes consumers pay more and even hurts most farmers.

About The Market Turmoil

It is difficult to know where to start when commenting on the extreme market turmoil of the last few days. A good place would perhaps be to read George Reisman's excellent summary of the background of the crisis. We should never forget to emphasize how this is all Alan Greenspan's fault.



After you've finished reading Dr. Reisman's piece, a few additional points should be noted.

1) Markets are more erratic than ever. I have followed financial markets on a virtually daily basis for more than 10 years and so I have experienced large up and downs in all markets. Yet I cannot remember the markets ever being quite as erratic as this week. This means not only that the short-term mood swings, the sudden swings between extremely bullish and bearish sentiment, are larger than ever. But most importantly that the swings are more detatched from news and rationality than ever.

Two movements were especially noteworthy in this context. On Tuesday, after the FOMC decided to keep a relatively hawkish stance, the stock market first fell on the news as expected. But then after just half an hour or so, it suddenly reversed cause and rallied sharply, a rally which continued on Wednesday. What gives? Well, supposedly Bernanke indicated that he wasn't worried about the subprime crisis and that was supposedly a reason to buy. As if Bernanke's comments had any relevance with regards to the underlying fundamentals.

Similarly, on Wednesday, oil prices first rose after a report showing declining crude oil and gasoline inventories. But then they turned down and finished lower than they started.

Not to mention of course, the swings between the sharp sell-offs late last week, the sharp rally Monday to Wednesday and the sharp sell-off on particularly Thursday.

With the markets behaving so irrationally it is dangerous to engage in short-term speculative movements. The erratic nature of the markets ultimately of course reflects nervousness about the housing bust and its repercussions.

2)The black helicopters did arrive. And not just the Federal Reserve helicopters but helicopters from the ECB and half a dozen or so other central banks and they all flooded the markets with newly created money to force down the interest rate on overnight loans to their target rates.

Note however that this does not represent a loosening in monetary conditions per se, only that the central banks prevented the markets from tightening them on their own.

The markets are now pricing in a Fed rate cut at the next meeting at latest, and perhaps even at an emergency extra meeting next week. I think the latter is unlikely unless we see a further dramatic deterioration in financial conditions, but the former now appears likely.

I have previously not believed in rate cuts anytime soon, but now it appears a lot more likely. I don't think they should cut as inflationary pressures are too strong, and I have a feeling that most FOMC board members too are more skeptical than the markets about the benefits of rate cuts. However, can they really withstand the pressure from the markets and pundits to lower rates? I increasingly doubt it. Not that rate cuts are going to save the day. A recession will likely appear anyway and by not rooting out inflationary pressures now, we are simply likely to see a prolonged recession and a weaker recovery later.

3) As previously noted, the markets are so erratic right now that short-term speculation is dangerous. However, since the underlying fundamentals are so weak we are first of all likely to see these erratic swings continue and any trend movements are more likely to be sloped downward rather than upwards.

Not Just Sub-Prime

A common argument among those with a more bullish view of the U.S. economy -i.e. there wont be any recession- is that while the subprime sector may be a mess, it isn't big enough to drag down the whole economy. Subprime credit losses are perhaps only $100 billion. A big number to be sure, but considering the $13.7 trillion size of the U.S. economy, not big enough to cause a recession.

But even setting aside the fact that subprime credit losses may be even bigger than that, it misses the point entirely. The point is that the problem of the bursted housing bubble is not just a subprime problem. Subprime borrowers and lenders are of course hit hardest as their finances were almost by definition most fragile from the start. In any financial crisis, those with the most fragile finances are hit the hardest.

But the bursted housing bubble is causing ripple effect that damages others too.The decline in house prices causes residential investments to continue to decline. The decline in house prices (and increaseingly stock prices too) also creates a negative wealth effect that will make all home owners -not just those with subprime mortgages- cut back on consumer spending.

Meanwhile, weak demand, falling profits, falling stock prices and higher risk premiums on corporate bonds will make corporations less willing to invest.

All of which adds up to a recession.

Obvious Empty Threat

China threatens to sell off U.S. bonds if the U.S. Congress imposes tariffs on Chinese goods.

Now really, that is a quite laughable threat, one which most anti-Chinese U.S. politicians are likely to answer with: "Go ahead, make my day".

The reason for this is that the reason why China bought these bonds in the first place was to prevent the yuan from rising in value, and it is this policy which is the background for the threat of tariffs. In other words, China is threatened with tariffs because they prop up the value of the dollar. And so now the Chinese say that if tariffs are imposed on them, they will stop the policy these tariffs are designed to end! Not much of a threat! Moreover, the reason that the Chinese have had to hold down the value of the yuan is to boost exports. Does anyone then believe that they would be willing to aggravate the negative effects on exports by dumping the dollar?

While Chinese currency policy have long been irrational, this threat is not only irrational but pathetic too.

Jim Cramer On Rate Cuts

While the formal outcome of today's FOMC meeting is more or less a foregone conclusion (Fed will leave rates unchanged), the short-term direction of the stock- and bond markets will be decided by the wording of the accompaning statement. The Fed is an institution so powerful that a single word in a statement could destroy or create hundreds of billions of dollars in financial wealth. The key is whether or not they will open for rate cuts in the near future. If they do, stocks and bonds will rally. If they don't and instead continue to emphasize inflation as a greater threat than weak growth there will be a sell-off in the bond market and probably even more in the stock market.

Most statements from Fed officials indicate they will basically leave statements, but it cannot be ruled out that the increased anxiety over the subprime mess and the risk of a recession have caused them to change their minds.

Someone who's mental health will be in great jeopardy if they leave the statement unchanged is Jim Cramer, host of CNBC show "Hard Money". His buddies at some of the subprime banks are losing money and that is making him very upset and makes him lose anything resembling objectivity and rationality. The female host looks rather shocked and embarrased by his performance. Watch it for yourself here:

Financial Journalist Analysis In Action

For weeks, stock- and bond markets have been jittery due to the subprime mess and the likelyhood that it will spread to the overall U.S. economy. So, the likelyhood of a significant weakening of the U.S. economy isn't news. Nothing new happened today to support that scenario, and indeed if anything the stock market rally today would contradict it.

Yet when oil prices fell sharply today (after weeks and months of rising prices), clueless financial journalists attribute it to.... worries about the subprime mess. While I am certainly not a believer in efficient market hypothesis, even fund managers aren't that slow in catching on. The real reason for the sell-off was that some fund managers became worried that oil was over-bought and then after some started to sell, mass psychology prompted other fund managers to go with them. The price decline was only about a dollar early in the day, but more than $3 by the end of the day after bearish sentiment spread. We saw a similar, but opposite movement in the stock market, with the market rising at first only moderately, but as the Dow and S&P 500 broke through the +1% barrier for the day, mass psychology caused bullish sentiment to spread and the S&P 500 ended up 2.4%.

This again illustrates why the analysis of financial journalists are unreliable (with a few exceptions). Just study the raw data they provide and then ignore their analysis which are all too often clueless.

Does "Core" Inflation Predict All-Items Inflation?

I've criticized the concept of "core" inflation and the habit of completely focusing on that and only that before, a criticism which has spread to an increasing number of people. Now some people try to defend the concept by asserting that core inflation supposedly predict future all-items inflation. Yet after having studied the historical data available here I found many troubles with this view. I here use the PCE deflator rather than the CPI, not because I somehow think this index is best (I don't), but because that is what the Fed thinks is best so for the sake of the argument I use it.

First of all, particularly in recent years all-items inflation (I use the word "all-items" instead of "headline" as "core" inflation now is what typically dominates the headlines) have typically been higher than core inflation, so core inflation systematically under-predicts all-items inflation. During the latest 7-year period, all-items PCE deflator has increased at an average annual rate of 2.35% while core PCE deflator increased 1.93%.

As Peter Schiff commented on Ben Bernanke's assertion that energy prices would soon moderate:

"Finally, Bernanke dismissed concerns about the wisdom of favoring core inflation over headline by asserting that oil prices will soon moderate. Considering that oil prices rose another 2% during his two-day testimony, and that he and his predecessor have consistently underestimated oil prices for years, what now makes his crystal ball any clearer?"

Another and even more serious problem is that there is in fact no tendency at all for movements in core inflation to somehow predict future movements in all-items inflation. During 2001 for example, core inflation accelerated from 1.5% to 2.2% (with most of the increase coming during the first half of the year), yet all-items inflation fell during 2002. During 2002 and 2003 core inflation decelerated sharply, yet all-items inflation accelerated during 2004. Between 2004 and the first half of 2006 core and all-items inflation both reached and stayed at above average levels. In mid-2006 (the second and third quarters) "core inflation" reached post-1999 highs, yet all-items inflation fell back sharply during the fourth quarter of 2006 and first quarter of 2007. Only in the second quarter of 2007 did all-items inflation again accelerate, but only after core inflation had started to moderate significantly. So to the extent there is any correlation between current core inflation and future all-items inflation, this correlation is negative.

By contrast, there does seem to be some positive correlation between current movements in all-items inflation and future core inflation. The acceleration in all-items inflation in early 2000 was followed by acceleration in core inflation in 2001. The deceleration of all-items inflation during particularly the first half of 2002 was followed by a sharp deceleration of core inflation during 2002 and 2003. During 2004, we as previously mentioned saw all-items and core inflation accelerate significantly at about the same time, but this significant acceleration was preceded by a smaller acceleration all-items inflation while core inflation remained low. Then during the second half of 2006 we saw a significant deceleration of all-items inflation followed by a significant deceleration in core inflation during the first half of 2007.

Anyone who understands sound economic theory shouldn't be surprised by these results. After all, if you have a central bank which inflates the money supply, which prices would you expect to increase first? Relatively flexible prices such as food and energy whose commodities are traded on financial markets, or relatively sticky prices such as most items in the "core" index? Well, you don't have a genius to realize it is going to be the flexible prices which will be increased first and that the sticky prices will be affected only later. Which means that the movements of the flexible prices should have a relatively good predictive power for the movements of the sticky prices. On the other hand, there is no reasons to expect the movements of the sticky prices to predict the movements of the flexible prices. Indeed, to the extent inflation comes in waves, you should expect the sticky prices to at least sometimes start to rise just before the flexible prices starts to fall.

There are two noteworthy implications of this: first of all, again it has been shown that there are no legitime reasons for the Fed to focus on "core inflation". And the only reason for the rest of us to focus on it is because the Fed focuses on it and because of this core inflation provides a hint of their interest rate decisions.

Secondly, if historical patterns persist, we should see core inflation accelerating soon reflecting the sharp acceleration in all-items inflation during the first half of 2007. That will make it difficult for the Fed to lower interest rates to counter the recessionary effects of the subprime mess.

Zimbabwe Mess Gets Even Worse

Whenever I hear a new story about Zimbabwe my immediate thought is "surely now things can't get worse". But time after time Mugabe manages to prove that thought wrong. Just as one could have expected, his attempt to stop hyperinflation not by stop the printing of money but by draconian price controls enforced in a brutal manner by his thugs, have made things even worse there as the shelves of stores are empty and production is halted everywhere as the prices Mugabe's thugs try to enforce imply massive losses for producers.

They Said "Vigilance"!

Ever since Jean-Claude Trichet took over as ECB President from Wim Duisenberg, the ECB has had a somewhat ridiculous way of signaling future rate increases. Whenever they're planning to raise interest rates at the next meeting, they use the word "vigilance". When they're not planning to, they don't use it. And today Trichet actually said "vigilance", meaning that they will raise interest rates in September.

Some people had speculated that they would hold given the strength of the euro and stock market turmoil, but thew were proved wrong. My guess is that Sarkozy's attacks on the ECB if anything actually made Trichet more determined to raise interest rates to prove his independence from politicians in general and politicians from his country of origin (Trichet is French too) in particular. Trichet did in fact clash with Jacques Chirac when he was Bank of France president and the euro had yet to be introduced.

Still, the ECB is nevertheless too timid in his rate increases, as their far too gradual approach have been unable to stop money supply- and credit growth from rising above 10%, a clearly unsustainable rate. And euro area consumer price inflation should pick up significantly later this year for much the same reason as America's consumer price inflation will pick up.

1028 Economists

1028 economists sign a petition against protectionist sentiment in general and in particular with regards to China. Most are people I've never heard of , but many familiar names such as George Reisman, Walter Block, Bryan Caplan, Lawrence White, Walter Williams, Greg Mankiw (Who tipped me about the list), Edward Prescott and Larry Kudlow also appear.

The reason it was only 1028 wasn't because they couldn't find more, but because they wanted the same number as the number of economists who in 1930 signed a petition pleading with president Herbert Hoover and Congress not to implement protectionist legislation. A petition that was ignored with destructive effects.

My main problem with the petition is the implicit Economic History theory in it that it was the protectionist legislation that caused the Great Depression. While it certainly was negative and aggravated the downturn somewhat, the main cause for the downturn was monetary factors, with an inflationary over-investment boom and stock market bubble followed by sudden shift to sharp monetary deflation.