Saturday, September 29, 2007

The Poverty Definition & The Birth Crisis

I have discussed before the fact that the reason why Israel has such an apparent high level of inequality and poverty is due to the fact that its Muslim and ultra-Orthodox Jewish minorities in effect chooses this status by having many children. Certainly nothing wrong with this if they finance it themselves, but the problem is that Muslim and ultra-Orthodox Jewish advocates use this self-chosen status as poor to argue for more subsidies from Israel secular Jewish majority.

Unlike most other rich countries, Israel has no problem with low birth rates. Most rich countries have birth rates well below the 2 children per woman needed to sustain the population in the long run, while 5 countries (the United States, New Zealand, France, Iceland and Ireland) have birth rates at roughly 2 children per woman. Israel stands out by having a fertility rate well above that level, with a fertility rate as high as 2.84 women per children.

So, although most Israeli politicians probably want high birth rates in order not to be demographically overrun by the Palestinians and neighboring countries, the main reason cited for subsidizing families with children is not really to increase the birth rate but to reduce poverty.

Yet the question is, what is poverty really? Most countries define it by either relative or absolute income, adjusted for family size. I see now an interesting Jerusalem Post article questioning this view. The author Asher Meir points out that if we have two households with the same income, wherein one decides to use their income on getting a really large garden whereas the other decides to spend it on having a really large family. Both use their income to attain what they desire and both thus improves their well-being, but in official poverty statistics, the household with the large family would be classified as poor while the household with the large garden would not be classified as poor. Official statistics thus presume that children should be seen as a burden, while large gardens or flat screen televisions or other inanimate material objects should be seen as economic well-being.

But since both constitute well-being that is an invalid classification. This means that a lot of people classified as poor shouldn't be seen as poor and that the poverty justification for these subsidies is invalid.

Ironically, the underlying mentality of this poverty statistics assumption is in fact arguably the root cause of the low birth rates in most rich countries which are then used as an argument for subsidizes to families with children in these countries. As children are discussed as an economic burden which prevents people who have children from living a good life and as this view becomes part of the cultural value system, this leads people to abstain from having children. If instead children were considered a form of high standard of living just as much or more as SUV:s or flat screen televisions are, then most people would choose to have 2 or more children without government subsidies. Changing that cultural deficiency in most rich countries would be far more effective in raising birth rates than any subsidy program.

Cowboy Keynesianism + New Key Dollar Lows

Professor Jeff Frank makes point similar to mine in a letter to Financial Times. Both with regards to how U.S. consumer price inflation will soon accelerate sharply, and how higher "core" inflation will follow higher all-items inflation. However, he has a new funny way of characterizing the Fed's inflationary policies:"Cowboy Keynesianism".

Incidentally, the dollar fell to new lows against many currencies today, including the euro, the Australian and Canadian dollars and the Swedish and Norwegan krona. Perhaps most importantly, it broke through key psychological levels like $750 per ounce of gold and 7.50 versus the yuan.

Friday, September 28, 2007

Hong Kong's U.S. Dollar Peg Fuels Inflation

Interesting article about how Hong Kong's peg of its currency to the U.S. dollar creates increasing problems now that Helicopter Ben decided to inflate even more than before.

Already before the decision, Hong Kong's economy was booming with 7% GDP growth, a booming stock market and booming house prices. While Hong Kong's fundamentals are mostly very strong with its low tax and government spending and laissez faire principles, some of the boom was related to extremely fast money supply growth. As late as 2005, money supply growth was just 5%, but the latest figures show it accelerating to more than 25%.

With this in mind, Helicopter Ben's rate cut couldn't have come at a worse time. In order to maintain the peg, Hong Kong was forced to implement its own rate cut, which is going to make inflation a lot worse in Hong Kong. At first, the effect has mainly been to raise stock prices, which was already boosted by the Chinese governments decision to allow mainland citizens to invest in the Hong Kong stock market. Ultimately though, this will spread to consumer prices. The Financial Times notes the redistributive effects of this:

"Even so, the financial secretary now says “the spectre of inflation” is one of his greatest concerns, and in particular its impact on the poor.....

...the poor bear the brunt of any cost-of-living increases while those better-off enjoy returns from soaring values of property and financial assets."

The only sensible thing would of course be to end the peg. There is no logic for Hong Kong to peg its currency to the U.S. dollar. If its main priority is to hold back inflation, they would peg it to gold. If their main priority was to increase trade, they would peg it to the yuan (and ultimately once the yuan become fully convertible, abolish the Hong Kong dollar and have a monetary union with China), as Hong Kong's trade with China is 5 times larger than its trade with the United States-a multiple that is rapidly increasing.

As long as it stays, significant asset price inflation is likely especially if Helicopter Ben continues to cut interest rates. That from an investment point of view means that the Hong Kong stock market will continue to provide good returns, especially with the likely continued large inflow of Chinese investment capital.

Thursday, September 27, 2007

German Inflation Increases Rapidly

Today's numbers from the Euro area clearly illustrate why the ECB's decision to cancel its rate hike was highly irresponsible. While money supply growth fell back slightly, from 11.7% to 11.6%, that was still the second highest rate of increase since the creation of the euro, and far above anything consistent in the long run with price stability or financial market stability.

Meanwhile, preliminary German consumer price inflation figures for September show a much larger increase in price inflation than expected. From 1.9% in August to 2.5% in September. The increase in the EU-harmonized measure is even bigger, from 2.0% to 2.7%.

Of course, as I wrote in the recent post "The Inflation Time Bomb", a significant increase was to be expected, yet this was an even bigger increase than I had thought for September alone-remember, some of the effect I talked about won't show up until October and November-. The increase may perhaps be smaller in other parts of the euro area -that remains to be seen- but this clearly raises the risk that November euro area inflation will actually be closer to 3% than 2.5%.

According to all of the official rules the ECB is supposed to follow, they should raise interest rates-and raise them significantly. Yet they don't, because ECB chief Jean-Claude Trichet is a pathetic coward who aren't man enough to stand up to Europe's most prominent economic crank, Nicholas Sarkozy, even though Sarkozy actually lacks the power to harm Trichet.

Wednesday, September 26, 2007

The Money Supply Definition Issue Revisited

I recently explained why Frank Shostak's narrow definition of money is false and why his arguments for it are of really poor quality. I won't repeat this now so in case you forgotten about it or didn't read it, follow the link.

Two famous Austrian-leaning economists who have fallen for Shostak's nonsense are Mike Shedlock and Gary North. Mike Shedlock basically repeated Shostak's false claim that some forms of money should be viewed as credit transactions rather tha money plus arguing that it better predicted recessions. In the linked post, I explained why that argument was false too.

Gary North today on LRC linked to a paper written by himself where he argued M1 -the official money supply measure most similar to Shostak's- is better than broader measures like M2,MZM and M3.

His argument is actually worse than Shostak's. He rejects on account of being the money supply measure increasing in the long run most similar to the CPI. This is so unbelievably nonsensical. Even setting aside the usual Austrian objections to this Friedmanite approach, there is no reason theoretically to expect the money supply to follow the CPI even in the long run and even assuming the CPI correctly measure true consumer price inflation. This is first of all because shifts in asset values relative to GDP can mean that money supply can increase faster or slower than the value of production. And secondly and even more importantly, money prices of goods and services do not just -I can't believe I have to explain this to someone considering himself an economist- depend on the money supply but also the supply of goods and services. If the supply of goods and services increase, then the CPI will of course even in the long run increase a lot slower than the money supply.

The most relevant number to compare the money supply would actually be nominal GDP. And the money supply measure most closely tracking that would be M2 or M3. Nominal GDP between 1985 and 2005 -fourth quarters for GDP, December for money supply, the reason why 2005 is the last year is because that was the last year M3 was published- increased by a factor of 2.95, whereas M2 increased by a factor of 2.7 and M3 by a factor of 3.15. M1 strongly undershot it by increasing by a factor of just 2.2. MZM on the other hand strongly overshot it by increasing a full 4.1.

However, to the extent we should expect some under- or overshooting of nominal GDP, that would be overshooting it. The reason is that asset values have increased far faster than nominal GDP, with both stock- and house markets being far, far higher valued relative to GDP in 2005 than 1985. This means that either M3 or MZM should be considered the money supply measure most closely tracking economic activity. And since M3 has been "discontinued" by the Fed, this means MZM in practice for us.M2 is less useful, while M1 -as well as Shostak's closely related measure- should be considered completely useless.

The Inflation Time Bomb

I have a few times recently predicted that year over year consumer price inflation in the U.S. would rise to more than 4% by November or maybe even October. Given the fact that official inflation was just 2% in August, you might wonder why such a dramatic increase will occur in a mere 2 to 3 months. The reason is that the year over year rate is held down by the dramatic decline in energy prices between August and November last year. The result is that overall CPI was actually 1% lower in November 2006 than August 2006. So, the CPI in August 2007 was 3% higher than in November 2006, an annualized increase of 4%. So, all it takes for the CPI to increase 4% over the previous year, is for the CPI to increase 1% in the coming 3 months, or 0.3% to 0.4% per month-which it will easily do given the surge in commodity prices and the falling dollar.

Moreover, the effect will grow progressively larger as time goes. As you probably know from daily experience, retail goods prices are usually fairly stable compared to the highly volatile prices of things traded on financial markets, such as stocks, bonds, currencies and commodities. Most producers and retailers are reluctant to raise prices for their customers on account of what might be just temporary fluctuations in their input costs, and so the initial effect on consumer prices are much smaller than the long term effect if input costs stay high.

It is for example well documented that import prices usually don't rise initially as much as one would expect after the domestic currency falls. This is because exporters in other countries fear that they might loose market share if they raise prices immediately to compensate for exchange rate movements. And they fear that if the currency movements revert they might have trouble regaining that market share even if they again cut prices. So they prefer to absorb the falling exchange rate of the country they export too by reducing their margins-if it is only a temporary movement. This absorption might be permanent too even if the exchange rate movement proves to be permanent, but usually companies will find it more profitable in the long run to restore their margins. This means that there will be a lagged effect on import prices some time after the currency movements. This in this case means that there will be a lagged effect in 2008 on import price inflation from today’s dollar decline.

A similar logic also goes for commodity prices. There is likely to be a lagged effect on inflation from the commodity price rally. The effect will be strongest and appear first in higher energy prices and food prices. However, after some time, so-called core prices usually rise too, as I documented in my post "Does "core" inflation predict all-items inflation?".

Note that the surge in commodity prices and the elimination of last year's energy price decline from the base will push up consumer price inflation in most other countries as well. The euro area inflation rate will for example easily rise to 2.5% or so -from just 1.7% in August- later this year. However, the effect in most countries will be much smaller because they have much stronger currencies. This means first of all that the increase in commodity prices in their currencies are much smaller and also that they don't have the same general upward pressure on import prices -and export prices, which helps bid up domestic prices- as America do.

Monday, September 24, 2007

Trichet vs. Sarkozy

Since Nicholas Sarkozy became the president of France, he has relentlessly attacked the ECB for allegedly pursuing too tight monetary policies. Which is of course complete nonsense considering how money supply growth have risen above 10% in the euro area, so what the ECB should be criticized for is the exact opposite-namely of pursuing too inflationary policies. Their cancellation of the signaled September 6 interest rate increase completely eroded their already weak credibility as inflation hawks or as independent of politics. That was in effect an appeasement of the monetary crank Sarkozy. And after the ECB announced the cancellation of the rate hike, Sarkozy of course publicly gloated and took credit for it. While the August credit scare probably had a bigger role, Sarkozy is certainly right that it was a PR victory for him and that the ECB dishonored itself.

Now ECB chief Jean-Claude Trichet tries to shift the attention away from him by attacking Sarkozy for spending too much and running a too large budget deficit. He is certainly right about that as France now has the by far highest government spending to GDP in Europe -and the entire world, except for maybe North Korea and Cuba- and the highest budget deficit of Western Europe. That is of course the real reason for France's weak growth, not the non-existent tightness of ECB policy. But while Sarkozy is an economic crank, at least he is a crank with honor. Trichet by contrast is dishonored and humiliated by his cowardice appeasement of Sarkozy.

Saturday, September 22, 2007

Peter Schiff On Fed Rate Cuts

Peter Schiff is right on in his analysis of the Fed rate cut in his latest weekly column. A few excerpts:

"Coming at a time when rate increases were needed to combat the sinking dollar and surging gold, oil and other commodity prices, Ben Bernanke’s 50 basis point cuts in the Fed funds and discount rates this week may go down as the most irresponsible move in Fed history....

....Wall Street bulls have heaped praise on the Fed, at times calling the rate cuts courageous and brilliant. From their response, you would have thought that Bernanke’s solution was akin to Einstein’s breakthroughs on relativity. In the first place, what is so brilliant about cutting rates? My five year old could do it and would gladly accept payment for his service in popsicles.

Furthermore, a fifty basis point cut was not an act of bravery but one of cowardice. The brave thing to do would have been to raise rates and allow market forces to purge the economy of the imbalances built up during the Greenspan bubbles. It would have taken some real courage to level with the American public and let them know that our profligacy has consequences, rather than pretending it can ride to the rescue with a wave of its magic wand and a crank of the printing press....

..Bernanke’s attempt to circumvent the free market forces that are bringing on a long overdo recession (which is necessary to purge our economy of unsustainable imbalances) will lead to an even greater disaster. Make no mistake about it; had the Fed done nothing, or raised rates as I would have preferred, the economy would have clearly tipped toward a severe recession. However, by “coming to the rescue” with rate cuts, the Fed assures us that we will experience something far worse.

Again, the coming recession is not the problem but the solution. Painful as it will be, a recession is the only way to cure our sick economy and we will need to grin and bear it. When it ends, our nation will be a lot poorer, but at least we will be clawing our way out of this gigantic hole. Cutting rates now only assures that we will dig ourselves into an even deeper hole. In the end, it will be that much harder for us to get out, and we will be that much worse off when we finally do.

Although they may slow the process down for a few quarters, the rate cuts will neither prevent the recession nor keep house prices from collapsing. But they will cost us dearly. The dollar’s fall, which had been held somewhat in check by the possibility of a hawkish Fed, has accelerated in earnest now that the curtain has been pulled back.

Unlike previous bouts of Fed easing, this time any additional liquidity will not artificially pump up the economy or the housing market, but merely accelerate the rise in consumer prices and eventually push up long-term interest rates as well.Bernanke’s attempt to circumvent the free market forces that are bringing on a long overdo recession (which is necessary to purge our economy of unsustainable imbalances) will lead to an even greater disaster. Make no mistake about it; had the Fed done nothing, or raised rates as I would have preferred, the economy would have clearly tipped toward a severe recession. However, by “coming to the rescue” with rate cuts, the Fed assures us that we will experience something far worse."

New Toy Action Figure

Via Don Luskin, one of the few hard money supply-siders.

Friday, September 21, 2007

Gold Better Safe Haven Than Other Currencies

After Ben Bernanke in effect decided to lease just about every helicopter in America to flood the country with money -with a disproportione number of helicopters concentrated around Wall Street, of course-, an increasing number of people have finally started to realize that the U.S. dollar and interest bearing assets demoninated in the U.S. dollars sucks bad as investments. So they've decided to take their money into other currencies and interest bearing assets denominated in thoe currencies.

There is however a problem with that. Because public debate and central bankers in other countries are mercantilist in their nature, they will not react gladly to their currencies making new highs against the dollar. See for example here the complaints from exporters in the Euro area. And of course, Asian central banks are infamous for intervening to hold down their currencies.

The sharp increase in the euro makes more ECB rate hikes increasingly unlikely, as they know that further rate hikes would create further upward pressure on the euro. This means that inflation will get worse in the Euro area too. Similarly, the upward pressure on Asian currencies will likely increase their level of foreign exchange reserve accumulation which in turn will expand their balance sheets and so increase their money supply.

Thus, the more inflationary Fed policies will pressure other central banks pursue more inflationary policies to limit the increase in the exchange rate of their currencies. For that reason, it is unwise to rely on other central banks currencies as havens from Helicopter Bernanke's inflationary policies.

The only real haven is in real assets, including commodities such as gold. Stocks are in principle havens from inflation as the nominal value of their profits and fixed assets increase with inflation. However, if you believe as I do in stagflation, then most stocks will still suffer because of the cyclical downturn. The same thing goes with many industrial metals. Gold and some other noncyclical commodities are havens from both elements of stagflation-both inflation and recession. Stocks of producers of these commodities are also likely winners.

Thursday, September 20, 2007

Saudi Arabia To Drop Dollar Peg?

The parity between the U.S. and Canadian dollars happened even faster than I expected, as the Canadian dollar briefly traded above its U.S. counterpart today, with the U.S. dollar continuing to collapse against most other mayor currencies as well, not to mention gold and other commodities.

Behind the U.S. dollar meltdown is not only the direct effects of the rate cut, but also a rumour that Saudi Arabia and the other Gulf States might drop their dollar pegs.

Even before the rate cut, the peg created very strong inflationary pressures in Saudi Arabia and the other Gulf states for much the same reason as why China's semi-peg to the U.S. dollar is creating strong inflationary pressures in China. Namely, the central banks were forced to expand their balance sheets so they can accumulate enough foreign exchange reserves to prevent their currencies from rising. The Fed rate cut will aggravate the problem greatly and make the pegs even more irrational and unsustainable than in the past. Now speculations are growing that they will drop the peg, or at least make it less strict like Kuwait has already done. If it happens, the dollar's decline would quickly accelerate.

Given the extreme inflationary pressures in Saudi Arabia, dropping the peg to the U.S. dollar and allowing their currency to rise against it would clearly be in their economic self-interest. Not doing so risks causing them serious problems. The only thing holding them back is likely the fear that the U.S. government will consider it a hostile move.

Dollar Breaks 1.40 Level Against Euro

As a result of the Fed's rate cut, the dollar fell to a new record low against the euro, so that a euro now costs more than $1.40 for the first time ever. It also fell to 6.57 Swedish kronor, the lowest level against the Swedish krona since the 1992 devaluation of the krona.

Another key psychological barrier likely to be broken soon is the 1:1 parity level against the Canadian dollar. The Canadian dollar at US$0.9913, the highest in more than 30 years, and it seems likely that soon the Canadian dollar will have the same or slightly higher value than its U.S. counterpart. As late as in early April, a Canadian dollar cost only 87 U.S. cents, but have risen 14% in less than 6 months. Given the fact that the United States is still Canada's dominant trading partner this is going to be disliked by many Canadian exporters -and import-competing domestic firms- and these dramatic fluctuations is of course what leads some Canadians to call for a North American Monetary Union.

However, despite the damage to exports that these sharp currency movements create, Canadians might still benefit from having their own currency to the extent it allows them to pursue less inflationary monetary policies than the Fed would have imposed on them.

The U.S. dollar also fell below the key 40 barrier against the Indian rupee today. It will probably fall below 7.50 against the Chinese yuan soon. That seems in a way even more certain than the continued decline against other currencies although the timing is less certain as Chinese authorities have increased the irregularity of the yuan's appreciation against the U.S. dollar.

Meanwhile, the one honest currency of the world, gold, continues to soar to new post-1980 highs against the U.S. dollar.

Tuesday, September 18, 2007

About Fed Rate Cut

While a rational analysis would have argued against any cut, and while a 25 basis point cut seemed slightly more likely, a 50 basis point cut wasn't exactly shocking to me. I considered it to be almost as likely as a 25 basis point cut. Just as with the ECB announcement nearly two weeks ago the central bank again disappointed on the downside.

The results on financial markets were all too predictable with both stock and commodity prices surging and the dollar falling. The dollar now seem fall below the key 1.40 dollars per euro level to the euro really soon while oil and gold and other commodities will continue to rise in value. While official commodity trading had ended before the Fed announcement, electronic trading shows gold breaking through the $730 per ounce level and oil breaking through the $82 per barrel level.

Tomorrow's CPI report for August will probably show flat or falling numbers compared to July, but ultimately the surge in commodity prices that we've already seen and that will be further encouraged by today's move will set into motion sharply rising consumer price inflation later this year and in 2008. For that reason, the Fed will regret today's appeasement of the Jim Cramer's of the world.

Swedish Economic Growth Reach New Record

Swedish economic growth according to the volume measure rose from 3.0% to 3.5%. It rose somewhat less according to the terms of trade adjusted measure, from 4.1% to 4.4%, but that still means a new high in terms of trade adjusted growth since at least the 1960s.

While there is a strong cyclical element in the current Swedish boom, the reason for this acceleration is the free market reforms implemented by the centre right government elected a year ago. The burden of government spending has continued the decline that we saw during the previous Social Democratic government, while the incentives for work has improved significantly with a combination of lower income taxes and reduced unemployment benefits. The benefits of these supply boosting policies on the labor market is evident in the record high growth in the previous weak spot of the Swedish economy-employment. Employment increased a full 4% with private sector employment increasing 4.9%-the highest private sector employment growth ever recorded in Swedish statistics.

The improvement should continue next year as the government has promised further income tax cuts, while also cutting back on sick leave benefits. Moreover, the housing tax reform should strengthen the cyclical element in the boom.

Problems could however arise later -2009 at earliest, probably 2010 or 2011- as the government makes enlistment into the unemployment benefit system mandatory, something which will reduce incentives for those who have now chosen to opt out of the system (except to the extent they're forced to pay the 70% of the system financed through taxation) both by raising their taxes when they work and by giving them more benefits if they don't work. Then there is of course the question of the inevitable hangover from the housing bubble created by the Riksbank's inflationary policies and by the housing tax reform.

Why The Fed Shouldn't Cut Interest Rates

Via Greg Mankiw I see this interesting article from Allan Metzer of the American Enterprise Institute.

While it seems nearly certain that the Fed will cut interest rates later this evening, Metzer points out that it risks creating a return to the stagflation of the 1970s. I agree. As I've pointed out repeatedly, the sky-rocketing commodity prices and falling dollar will contribute to an increase in the U.S. inflation rate to 4% by October or November. If the Fed decides to push through agressive rate cuts like they did in 2001, that level could be made permanent or even go even higher than that.

Greenspan: The Liar, The Fraud

Alan Greenspan is in the news a lot currently because of the release of his new book. I haven't read the book. Nor will I read it if it means that I have to buy it or if reading it means that Alan Greenspan in any other way will financially benefit from it. Enriching a hypocritical fraud like Greenspan goes against my principles.

To see why he is hypocritical fraud, just see his denial of his guilt in creating first the tech stock bubble and then the housing bubble.

First he claims that he tried to prevent the tech stock bubble by raising interest rates, but failed to do so. The truth is that the late 1990s stock rally started in 1995 after the Fed signaled that the wave of rate increases in 1994 was over and might be partially reversed. And partially reverse it did, cutting it from 6% in June 1995 to 5.25% in January 1996. While they did raise to 5.5% in April 1997, they then in the autumn of 1998 started a series of rate cuts, from 5.5% to 4.75%.

And more importantly, the Fed's role in fueling stock bubbles doesn't necessarily come through direct rate cuts, but in its direct and indirect role in preventing the increase in interest rates that a free money market would automatically push through in the case of any increase in relative preference for stocks. The double digit growth rates of the MZM and M3 measures of money supply during the late 1990s indicates a strong role of the Fed sponsored monetary system in suppressing interest rates.

He similarly denies his role in the housing bubble by pointing to how long term interest rates did not rise after the rate increases in 2004-2005. This is dishonest for more than one reason. First of all, the housing bubble started already in 2001, when he pushed through rate cuts of an unprecedented magnitude, from 6.5% to 1.75% in a mere year. Secondly, because of the increased popularity of adjustable rate mortgages, short-term interest rates were just as important as long-term interest rates. Thirdly, movements in market interest rates always tend to precede movements in the fed funds rate as market interest rates is really the future average fed funds rate during the duration of the bond.

If really long-term interest rates were determined only by global liquidity, then how come long-term interest rates are only about 1.5% in Japan and 6% in Australia? This is all the more telling given the fact that Japan has a very high budget deficit and a huge public debt, while Australia has a budget surplus and a very small public debt. Clearly, the interest rate differential between Australia and Japan is a result of different expected future central bank interest rates.

And long-term interest rates did in fact rise from 3.3% in June 2003, when the deflation scare made everyone believe interest rates would stay low for long, to 4.7% in June 2004 when the Fed had already signaled the start of a series of rate increases. That long-term interest rates didn't rise further after that merely reflected that the series of rate increases after that was priced in by the markets.

Why doesn't any journalist confront Greenspan with these facts? Are they really all that clueless? And why doesn't anyone confront Greenspan with what he himself wrote about the origin of asset price bubbles back in 1966? Quote from Greenspan's "Gold and Economic Freedom":

"When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve's attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain's gold loss and avoid the political embarrassment of having to raise interest rates. The "Fed" succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom."

[Cross-posted at the Mises blog]

Saturday, September 15, 2007

How Should The Money Supply Be Defined?

Mike Shedlock argues against the view that there is strong inflationary pressures in the U.S. economy. Since I am one of those who have argued for that view, I feel I must reply. Ultimately, the disagreement is a disagreement of how the money supply should be defined. The broader definitions that I favor show a lot faster growth than the narrower definition that he favor.

Mike Shedlock is generally a good economic analyst, but he suffers from one fatal flaw: he believes in Frank Shostak's definition of the money supply. The problem with that is that Shostak have a far too narrow definition. Exactly which items are included in that definition is not clear, as he in his article about the money supply only argues against including certain items, rather than specifying exactly what is included. But it seems fairly similar to M1.

Shostak for example excludes Money Market Mutual Funds despite the fact that you can use your holdings in them as a means of payment by for example writing a check on the ground that when you write a check you instruct the fund to sell assets and then the money is transferred to the holder of the check and so money is only transferred, not created. But this is just another case of Shostak being completely clueless. Advocates of including MMMF:s in the money supply have never argued that money is created when people reduce their MMMF holdings by for example writing a check. Quite to the contrary, here the money supply is being reduced as MMMF holdings fall while the amount of cash is held constant and transferred from the buyer to the seller. The money creation instead occurs when people deposit money in MMMF as the seller of the assets receives cash while the depositor simultaneously also has money in the form of MMMF assets, while before the transaction only the future depositor had money in the form of cash.

Shostak also argues against including saving deposits because banks formally have the right to insist on a 30 day waiting period. But to this Murray Rothbard pointed out:

"The objection fails to focus on the subjective estimates of the situation on part of the depositors. In reality, the power to enforce a thirty day notice on saving depositors is never enforced; hence, the depositor invariably thinks of the savings account as redeemable in cash on demand. Indeed, when in the 1929 depression, banks tried to enforce this forgotten provision in their savings deposits, bank runs promptly ensued"

Thus, since money deposited in savings deposits can be used as a means of payments they should be included in the money supply. That should be the general principle in determining what is and what isn't money: can it be used as a means of payment. That would indeed include both savings deposits and MMMF:s.

Shedlock also tries to put up an empirical defense of Shostak’s definition. He claims that it accurately predicted 6 out the latest 6 recessions, although he concedes it gave two false signals, in 1985 and 1995. However, looking at his chart, it did not in fact predict the most severe of all recessions, the one in 1981-82, where it fluctuated between 5 and slightly above 10% during and before the recession, but did not show a downward trend.

What's worse, the measure failed to predict the late 1990s tech stock bubble, as money supply growth remained moderate during the entire era. By contrast, measures like M3 and MZM did rise in reflection of the tech stock bubble.

Also, recessions need not be associated with falling money supply growth if there is stagflation. Money supply growth has been extremely high and rising in
Zimbabwe recently, yet Zimbabwe has suffered a sharp drop in economic activity. It all depends on who the early receivers of money are and how they use it. Sometimes it can cause tech stock bubbles, sometimes it can cause housing bubbles and sometimes it can simply cause consumer price inflation. Theoretically it can also have no effect at all on any prices if the early receivers decide not to use it. The latest acceleration in monetary growth is most likely to cause an acceleration in consumer price inflation, which I expect to rise above 4% later this year.

Friday, September 14, 2007

China Raises Rates Again

China tries traditional means to tighten monetary policies for the umpteenth time by raising interest rates again, having recently raised reserve requirements.

But as I've pointed out repeatedly on this blog, that will only have limited success in adressing the problem of too high monetary growth and to the extent it works it will aggrevate the excessive current account surplus.

The only real effective solution to both problems would be to significantly revalue the yuan. And while in recent weeks, the rate of yuan appreciation has again accelerated, with the yuan rising 1% in three weeks, this follows more than seven weeks where it was basically unchanged against the dollar. It must rise a lot faster than 1% in ten weeks against the dollar to have any meaningful effect, especially considering how the dollar is falling against most other currencies.

End of British Housing Boom?

I recently pointed to Britain as being next in line in suffering a housing bust. Here is signs that it might be happening now.

Wednesday, September 12, 2007

Oil Hits $80 Per Barrel

Yet another all-time high for the CRB Futures index today, as it rises another 0.8% to 428.83, now putting it more comfortably above the July 19 peak.

Leading the way is the arguably single most important commodity, oil, which briefly rose above the $80 level, while closing up 2.2% at a new all time high for closing prices, at $79.91.

Just like in 2006, oil prices reached a peak at $78 per barrel during early August. The big difference is that high oil prices have proven a lot more sustainable this time around, something I predicted. That forecast was made because the reasons for the bull market in oil wer much more sustainable late July/early August this time than in 2006. In 2006 it was based on fear of supply disruptions due to a Katrina-like hurricane in the Mexican gulf, or a U.S.-Iranian war in the Persian gulf. This time sharp increases in demand from particularly China and India has pushed up prices. Also helping to push up the dollar price of oil is the weak dollar, which hit a new all-time low against the euro today, and a 13-year low against the yuan. A weaker dollar means that the incentives to increase production or reduce consumption are a lot weaker than the dollar price of oil would suggest.

Responsible for the most recent surge in oil is in part the recent acceleration in monetary growth, which as one could expect, first and foremost bids up commodity prices.

And of course, the Energy Information Administration's statistics today showing a sharp drop in oil inventories also helped a great deal. Oil inventories are now below last year's level after having exceeded year ago levels for most of 2007. And more importantly, the inventories of two of the products produced by oil-gasoline and heating oil are far below last year's levels. Gasoline inventories are down 8% from last year's level and are now at an all-time low -or at least for as long as statistics has been compiled- relative to demand.

So oil should remain high, and probably go even higher, if the Fed inflates as much as it seems likely to do. A downside risk would be a unusually mild winter, which would depress heating oil demand. An upside risk would on the other hand be an unusually cold winter. Not to mention of course the possibility of other supply disruptions, like Middle East wars.

CRB Futures Index Reach New High

Further illustrating my point about the strong inflationary pressures, the CRB Futures index of commodity prices reached a new all-time high, surpassing -albeit only very slightly- its previous peak from July 19. In mid-August, it had fallen by about 6% from the peak, but has now reached a new high.

Oil was one of the commodities reaching an all-time high, while gold is nearing a 27-year high.

Saturday, September 08, 2007

Stagflation Ahead

One interesting aspect of the economic turmoil is that as a matter of fact, monetary conditions aren't really tight. As I recently reported, euro area monetary growth in July reached an all-time high during the existence of the euro, yet the ECB cancelled the previously signaled rate hike. Meanwhile, the most recent numbers on bank lending and money supply growth in America surprisingly indicate that not only did they decline in August, they accelerated somewhat. M2 and commercial bank lending have increased 1.5% (annual rate of 20%), and MZM by 3% (annual rate of 40%) during the latest four weeks.Despite this, the Fed is likely to cut interest rates by 25 or perhaps even 50 basis points on September 18th.

It remains doubtful given the loss of confidence whether this can actually prevent -or more accurately postpone- the coming U.S. recession. But one thing is for certain, there is not going to be a deflationary recession like some believe. It will be a case of stagflation. This in turn is going to limit the Fed's rate cuts.

Already responding to this inflationary environment is gold, which reached new highs on friday. Gold -and gold producer's stocks- is a particularly attractive investment during stagflation. Like other commodities it is a inflation hedge. But unlike most others, particularly industrial metals, it is also relatively insensitive to cyclical

Friday, September 07, 2007

U.S. Employment Report Even Weaker Than You Probably Think

Stock prices and the dollar fell, while bond prices rose on the news that payroll employment fell for the first time in four years -albeit only with 4,000-, as opposed to market expectations for a rise of 120,000.

Actually, though, the numbers were much weaker than the headline would suggest. First of all, previous months were revised down by a cumulative 81,000, meaning that the actual number was 85,000 lower than the previously reported number. Secondly, this number assumed that 120,000 more jobs was created in new businesses than was destroyed in disappearing companies-an implausibly high number given the stage of the business cycle. Thirdly, household survey employment showed a full 316,000 fewer jobs, also suggesting that the real decline was much larger than the payroll number. The unemployment rate only held steady because the labor force participation rate fell by 0.2%:points. Had the labor force participation rate been unchanged, unemployment would have risen from 4.6% to 4.9%.

The ISM numbers for both the manufacturing and non-manufacturing sectors for August came in stronger than expected, declining only slightly or being unchanged. It remains to be seen whether the ISM or employment reports provided a truer picture of economic activity in August. I personally think that the employment report provides a more accurate picture in this case.

This is likely to make a Fed rate cut at the next meeting on September 18 a foregone conclusion. The only question is whether it is going to be a 25 or 50 basis point cut. A 25 basis point cut looks more likely, but only slightly so. Ultimately it will be determined by the incoming data between now and September 18.

Tuesday, September 04, 2007


Robert Mugabe -that's right, the Robert Mugabe, the Zimbabwean dictator who as dictator has destroyed the Zimbabwean economy- has a masters degree in economics from the University of London. While some of the theories of neoclassical economists are unrealistic, even they don't teach theories as absurd as stealing the land of its most productive citizens and giving it to incompetent thugs, hyperinflation and price controls. Either Mugabe forgot just about everything they learn, or the University of London didn't examine him properly. At any rate, the status of a University of London masters degree in economics is certainly significantly devalued by this news.

Sunday, September 02, 2007

Only Inconsistent With Neoclassical Economics

Robert Schiller is at it again, claiming that bubbles are inconsistent with economic theory, and therefore tries to go outside the realm of economics.

"Economists, in particular those at the Federal Reserve, are loathe to believe asset markets have become bubbles because bubbles seem inconsistent with rational investor and consumer behavior, the bedrock of economic analysis. “The notion of a speculative bubble is inherently sociological or social-psychological, and does not lend itself to study with the essential toolbag of economists,”"

He may be right that they are inconsistent with neoclassical economic theory, but he need not leave the field of economics to explain them. All he need to do is study Austrian economics, or more specifically the Austrian business cycle theory.

And besides, going into sociology or socio-psychology doesn't really solve the problem if you intend to remain comitted to neoclassical assumptions. The neoclassical theory has a implicit sociological/socio-psychological theory about the hyper-rational investor, which cannot be changed unless you're gonna change neoclassical theories. Particularly if you're also going to remain committed to neoclassical theories about the neutrality of money and the impossibility that central bank actions will create situations where it could be economically rational for investors to create bubbles, but economically irrational for society as a whole, as the central bank subsidize interest rates for the investor and pledges to limit their damage if they get out of the bursted bubble market too late.