Real U.S. GDP Continues To Contract

The latest U.S. GDP report has almost a déjà vu feeling over it, being in many aspects nearly identical to the one released three months earlier about the previous quarter. Then as now, the headline number that the financial press focus on was slightly positive (exactly 0.6% by an amazing coincidence) and then as now was the real terms of trade adjusted slightly negative (-0.3% this time as compared to -0.7%). The reason for this divergence was that the fast increase in import prices made the GDP price index increase much slower than the price index for gross domestic purchases.

And then as now did government spending continue to increase, meaning that the real decline in private sector activity was even bigger. Government purchases (including both government consumption and investments, but not including transfer payments) rose to 19.9% of GDP, the highest since the third quarter of 1992, and way up from a (post-World War II) low of 17.2% in the first quarter of 1998.

The main difference is that the other details look even worse. Not only did residential investments continue to fall, but business investments turned down, a expected development considering the decline in domestic profits. As domestic profits continue to decline so will business investments. The trade deficit meanwhile continued to rise, from $708.9 billion at an annual rate to $737.3 billion, although due to the perverse methodology of the headline volume measure, that still counted as a positive contribution from trade as the rise was caused by rising import prices. Inventories were roughly unchanged, but as they fell the previous quarter, that still meant they gave a positive contribution to GDP.

Consumer spending rose slightly, at a 1% rate. What was seemingly positive was that real disposable income rose slightly faster than that and so the savings rate rose. But the savings rate was still zero, and that is far too low, especially in a situation with falling asset values. Moreover, this increase do not reflect household's share in sharply declining retained earnings (dividend payments continue to rise despite falling profits)-and a rising budget deficit. Speaking of which, the so-called tax rebates that are now paid out will no doubt boost real disposable income this quarter, which in turn will likely boost both consumer spending and the formal savings rate for the second quarter. But that will be anything but a sound or sustainable upswing.

Peak Oil? It's Peak Politics

Interesting article from Irwin Stelzer in the Weekly Standard about how it is political factors that are holding back global oil production, rather than lack of petroleum on this planet.

Examples of this include Iraq and Nigeria, where terrorist attacks and political incompetence is holding back oil production way below capacity. Regulations against foreign investments are similarly preventing potential oil fields from getting started in Russia, Venezuela and Mexico. And in the United States, Democrats along with some Republicans, including John McCain, have stopped oil drilling in Alaska and other parts of America for environmentalist reasons.

In addition to these factors holding back oil production, there is another political factor contributing to making oil extra expensive, at least in the short- to medium term: central bank inflation. Because oil is a commodity traded on global markets, its price is fully flexible and therefore react immediately to central bank inflation. By contrast most other consumer prices are more or less sticky in the short- to medium term and so central bank inflation will cause the relative price of oil to rise.

Why McCain Will Likely Win

Obama's shall we say controversial reverend Jeremiah Wright is in the news again. The main loser from this is clearly Obama. However, the main beneficiary won't be Hillary Clinton. The reason for this is that Obama's core supporters, blacks and left-wing intellectual whites, either share Wright's beliefs or at the very least finds them excusable because they believe that blacks are so oppressed that somehow this excuses any seemingly bad behavior. Indeed, some even find the criticism against Wright to be racist. Because of that and because most primaries are already over, Hillary won't benefit much from this, and because she is so much behind it is unlikely to enable her to win.

By contrast, in a general election, where blacks and left-wing intellectual whites are only a small proportion of the voters, this factor, together with similar controversies such as Obama's "bitter"-remarks, will drive much of the key swing-voters of working class whites into voting for McCain instead of Obama.

The Democrats, by foolishly choosing a candidate whose background was largely unknown and who had no experience in handling the kind of attacks that any Presidential candidate will face, will therefore like do what I never thought they could do: lose to the Republicans despite the unpopular Iraq war and despite the rapidly deteriorating economy. If the Democratic superdelegates had any sense, they would choose Hillary over Obama. But they seem unlikely to do so. That is however probably good for reasons
that I explained before.

The Problem With Monetary Central Planning

Danish economics blogger Claus Vistesen, who despite being a non-Austrian and so for that reason often being wrong on some issues is a quite talented analyst (and for that reason has been added to my blogroll), calls me "The econsphere's in house Austrian economics analyst". Considering that there are many Austrian economics bloggers on the web aside from me, that should be interpreted as a compliment.

That reference to me was made in the context of a discussion of ECB monetary policy where he noted my observation that current ECB interest rates aren't high enough to meet the ECB's consumer price inflation target, much less its money supply target. Something he comments with:

"Of course, at this point we also really ought to put the hawks' argument to the test. How far and long should the ECB raise rates in order to bring down inflation to the target (2%) not to speak of bringing the M3 growth within range of its 3-4% growth target?"

Now we are finally getting closer to the point of it all. The answer to that question is that we don't know how high they should be to reach these goals, or at least not the consumer price inflation goal because the effect there is lagged (by contrast money supply is easier to change because the effect is more immediate) . And as we can't really know for certain how high inflation will be otherwise a year or so (the fact that the time lag is not fixed in time further complicates the issue) later, this means that central bank policy can just as well push inflation further away from its goal than closer to it. As central banking is a form of central planning, it faces similar problems as other forms of central planning, including the knowledge problem.

The Oil/Gold Divergence

Recently we've seen a great divergence in commodity prices. While oil and most other commodities have continued to rise sharply make new all time high, gold along with silver is trading significantly -more than 10%- below their all time highs reached earlier this year.

As a result, the gold/oil ratio is down to 7.5, down from 10 in mid-March. What, then, is the cause of this? Will this trend continue?

The cause for this divergence is that oil price movements, apart from non-monetary factors, reflect actual inflation while gold price movements mainly reflect movements in inflationary expectations among investors, or to be more precise their demand for gold as an inflation hedge. Actual inflationary pressures remain strong which is the primary reason for why oil has risen so much in price. Meanwhile, gold and silver has taken a beating as demand for them as an inflation hedge has cooled. Instead, many investors have moved their money back into stocks, which can also potentially be an inflation hedge, as inflation also mean that the nominal earnings of companies are inflated.

Will this persist? Well, oil will continue to rise, albeit perhaps briefly interrupted by corrections. Gold weakness will perhaps continue for a while because of the current bearish sentiment, but in a few months or so, it will recover. The reason is that while stocks are an inflation hedge, they are not recession hedges. In recessions their earnings decline. Which is what we've seen despite positive currency effects. And once investors again are reminded about that, they will again move their money out of stocks. And at that point, many will choose the investment object that is a hedge against both recessions and inflation, namely gold.

Luskin At It Again

Don Luskin again proves his status as the clown, or con artist, of economic commentary.

This time he argues "$119 Oil Won't Stop Economic Growth". In one sense that is correct, since first of all there is no economic growth to stop since America is in a recession. And secondly, the high oil price is largely a result of monetary inflation, so the higher price is simply stopping the monetary expansion from boosting real output. However, Luskin is of course a recession- and inflation denier, so he is still wrong even about that.

Just to illustrate that he is a con artist deliberately trying to deceive his readers, one can see his reference to how economic growth was supposedly "almost 33%" between 2002 and 2007. By that he is referring to nominal growth, which was 32.2%. Normally you round 0.2 down, not up, but that is only a minor error. A far bigger error is characterizing nominal growth as economic growth. Nominal growth is a result of both economic growth and inflation, and characterizing it all as growth means defining inflation as growth. Of course, by that standard, Zimbabwe is the by far fastest growing economy in the world.

He also again confuses the issue of a U.S. downturn and a global downturn when he says that economic growth drives the oil price and not the other way around. It is indeed true that global economic growth, particularly growth in Asia, is driving up the oil price. But that does not mean that the higher oil price reflect economic growth in the U.S.-or that it won't other things being equal deepen the recession.

Clarification

Since I know some readers of this blog also read Johnny Munkhammar's blog and since I know that at least one person have already been confused by this, I should clarify that the Stefan Karlsson who wrote for him is not me. It is a different person with the same name as me. I have not had several formal positions in international financial business. Karlsson is the third most popular last name in Sweden, after Johansson and Andersson, and Stefan is a fairly popular first name too, so there are quite a lot of people whose name is Stefan Karlsson.

It was because there are so many with my name that I in the past used to spell my name as Stefan M.I. Karlsson, with M.I. standing for my middle names Mikael Ingemar, to distinguish myself from the others with the name Stefan Karlsson. In time I started to prefer not to spell out M.I., but that can still be noted in the URL of this blog.

The Real Problem With Non-Austrian Economics

Thorsten Polleit argues in case of Misesian apriorism (praxeology) within economics at the Mises Institute web site. The article has many good points and should for that reason be read, but I have two problems with it.

First of all, it bases the case for praxeology on Kantian epistemology. A better case can be made using Aristotelian/Objectivist epistemology, like Murray Rothbard did, and like I did in my University essay in Theoretical philosophy(not online).

Secondly, in my experience, neoclassical micro economic theory or New Classical or New Keynesian macro economic theory is not particularly empirical. They are at least as aprioristic as praxeology, and in one sense they are in fact even more aprioristic.

While Kantian and Aristotelian/Objectivist Austrians will argue over whether the origin of the praxeological axioms can be viewed as empirical or not, they are certainly empirical in the sense that we do meet them in applied form in our daily experience. I for example act daily, face a scarcity of time and other resources, and face a uncertain future, and thus face opportunity costs in every action I take, but ultimately choose one action based on my assessment of what will be most beneficial for me, and so on.

By contrast, neoclassical micro economic theory is to a large extent completely disconnected from the empirical reality that real people face. Instead, it ludicrously asserts that economic action can be described as functions of differential equations and various other advanced mathematical functions such as Lagrange multipliers and matrix algebra.

These advanced mathematical functions have absolutely nothing to do with the actual economic reality we see, and so will at best once they've been translated again into English (or other verbal languages, such as Swedish) simply come to the same conclusions that we already knew before we performed these equations. Often however, these mathematical equations are worse than useless in enhancing economic understanding, they in fact necessitate the adoption of a false description of reality. One example of this is the focus on equilibrium (a focus necessitated by the fact that the first order condition of a Lagrange multiplier is that the partial derivative is zero, which in this context translated into English means that no further economic gains can be made, or in other words that equilibrium is reached), which in turn means that there are no room for one of the key elements of economic reality, namely entrepreneurship.

Thus, while the praxeology of Austrian economics means a aprioristic understanding of actual economic laws, the mathematics of neoclassical economics means a aprioristic understanding of....well, advanced mathematics. But it does not in any way help you gain a deeper understanding of the subject matter economics is supposed to be about, namely the causal relations of real world economic life.

More or less the same thing is true for New Classical macro economics (including Real Business Cycle models) and to a only somewhat lesser extent also New Keynesian macro models.

It is true that non-Austrian economists usually, apart from having substituted real economic theories for mathematics, also do empirical research, in the form of econometric regression analysis. While I completely reject the usefulness of things like Lagrange multipliers in understanding economic reality, I am actually contrary to many other Austrians, open to a limited degree of usefulness of econometrics. The reason is that while praxeology helps us understand the causal connections of real life economic experience, it does not say anything about how applicable different applied phenomena's are in today's economic reality. And as the purpose of economics is to help us understand the economic reality we actually face, not just the economic reality we could conceivably face, one must analyze the actual data to see how applicable various causal connections. And econometrics can have a limited degree of usefulness in that task, as long as one is aware of the limitations of econometrics. Namely that first of all, an econometric study is just a local study of a particular data series, not necessarily applicable to other data. For example, during one period of time changes in interest rates may have had a very large impact on investment activity, but during another period of time it will only have a very small impact. Similarly, while a certain causal factor may be very important in one country, it may be of lesser importance in another country. And secondly, one have to take even this local result with a grain of salt, as it is impossible in practice to statistically control for all other conceivable causal factors. Understanding these limitations, econometrics can have a limited usefulness in understanding the relative importance of different causal factors. However, if one does not understand these limitations and try to apply econometric results in radically different contexts then the ones where they were derived, then it could reduce, and not enhance, our understanding of the economic reality we face.

But the point here is that in the distinction of aprioristic versus empirical, Austrian and non-Austrians do not differ in any radical way. Both rely on both aprioristic theory while also performing empirical analysis of actual economic events. The main problem with non-Austrian economics, is that they have substituted actual economic causal relations for mathematical functions, a problem which is greatest in the aprioristic version of non-Austrian economics.

End Of Deflation Hurts Japan

Japan saw consumer price inflation rise in March to its highest level in more than a decade. At 1.2% it is still very low compared to the rest of the world, but it nevertheless a big increase from the previous negative numbers.

While non-Austrian economists have generally described the previous price deflation, as a problem, many now realize that rising prices may not be so good. Economic and Fiscal Policy Minister noted that "isn't at all a good thing because it's being driven by higher energy prices rather than demand". Or in other words, it is supply-driven.

The flip side of this is that just as higher prices caused by supply factors are bad for the economy, so are lower prices caused by supply factors good for the economy. Or in other words, price deflation is not a bad thing as long as it is not caused by monetary deflation.

Cheap Food-Good Or Bad For Third World Countries?

There are many good arguments for abolishing any and all farm subsidies. Farm subsidies cost tax payers money even as they raise the price for consumers. Normally you would have expected subsidies to lower prices for consumers. But not so, at least not for consumers in the country with the subsidy, making it the worst deal possible.

However, just because farm subsidies is clearly a bad thing, and should be abolished ASAP, doesn't mean that all arguments against it are sound. I have often seen certain prominent Swedish libertarians argue against farm subsidies on the basis of how it supposedly impoverishes the Third World by destroying their ability to focus on their alleged comparative advantage in farming, with Africa being depicted as the big loser, and so constitutes "the White Man's Shame", to quote the phrase that one of them used in his best-selling book.

There are however two big problems with this argument. One problem is in terms of political impact. If we accept the argument that somehow African poverty is the fault of "our" government's policies, then this will be used by the foreign aid lobby to argue for higher foreign aid to compensate for that alleged negative impact. Moreover, if these imports are so bad, why don't the African countries stop them by slapping tariffs on them? Thus, by emphasizing this argument these libertarians might decrease, not increase, freedom.

The second, and much bigger, problem with this argument is that it isn't true. While exporting subsidized food to the third world, we may hurt their farmers, but we will help non-farmers in those countries. And it is simply not the case that just because a country is poor, its comparative advantage is in farming. Some of the biggest farm exporters outside the U.S. and EU is in fact food exporting middle income countries like Brazil, Argentina and Russia. They, and not the very poor African countries, are the losers from U.S. and EU farm subsidies. By contrast, most, if not all, African countries are in fact net food importers, and thus benefit if they receive cheap food imports. This is all the more true if you exclude crops like coffee, cocoa and bananas that aren't grown in either the U.S. and the EU and thus are unaffected by farm subsidies.

"But", I can already imagine someone objects, if U.S. and EU farm subsidies are abolished wouldn't this increase the incentive for Africans to farm and wouldn't it thus perhaps change the current status of Africa as a net food importer? Well, yes it would increase the incentive for Africans to farm and yes this would reduce their net imports, hypothetically but not likely, to the point where they would no longer be net importers. But that does not mean the African countries would be better off. The reason is that to the extent these imports are cheaper than the cost of producing them, they are according to the principle of comparative advantage, something which is not economically beneficial to produce. That this comparative disadvantage might to some extent be the result of subsidies is irrelevant for the African countries.

This is only relevant from the perspective of the global economy and the subsidizing countries. The subsidies reduce overall global output, but the loss for the subsidizing countries and alternative food exporters like Brazil and Argentina is bigger than the overall global loss, meaning that the African countries gain.

If someone still doubts this, imagine that somehow food started to rain down from the sky, like in the Bible. Would the libertarians promoting the "farm subsidies hurt African countries" argument at that point curse the skies, and tell Africans to still use their alleged comparative advantage to farm even though the food that would produce is already available? That would make put them in the same position as the candle makers in Bastiat's famous petition who similarly argued that natural riches are bad because they damaged some producers.

That cheap food isn't bad for poor countries are now illustrated by the riots and possible famine caused by the sharp increases in food prices. If the above discussed argument was correct, then they should be really happy about this because this mimics the effect of abolishing subsidized exports. But given the problems it has created, it should be obvious that it isn't a good thing.

To summarize, abolishing farm subsidies is certainly something we should do and something we should do ASAP. But this is not because it hurts African countries, which it doesn't, but because it hurts us. The argument that it hurts African countries by providing them with cheap food is not only false, but obviously false given the obvious problems created by higher food prices, and risks promoting more government interventions.

Which Presidential Candidate Is The Lesser Evil For The U.S. Economy?

After Ron Paul lost to John McCain in the Republican primary and subsequently ruled out running as a third party candidate, there are no voices for economic sanity left (except for the generally unknown candidates of the Libertarian Party and Constitution Party) in the U.S. presidential race. And as Hillary Clinton defeated Barack Obama in the Pennsylvania primary, this means that the Democratic nomination remains undecided (although Obama remains the most likely winner), which in turn means that there are three viable candidates left: John McCain, Barack Obama and Hillary Clinton. None of them is even close to being a good alternative, but one is in fact a lesser evil.

Although I know some libertarians are rooting for Obama while holding McCain to be the greatest evil, that is something I don't agree with. In fact, I think that given the likely circumstances, McCain is in fact the lesser evil.

One reason is that McCain seems to be the by far best on domestic policy, promising tax cuts instead of tax increases, and at least in general unspecified terms propose spending cuts instead of promising large number of new government programs, as Hillary and Obama do. Moreover, while Hillary and Obama argue about which of them is the greatest protectionist, McCain argues for free trade. On the other hand, McCain supports a neoconservative foreign policy, which at the very least means a continuation of the current American presence in Iraq, while both Hillary and Obama promises if not a complete, then at least nearly complete withdrawal.

But the most powerful argument for why McCain is the fact the lesser evil under the current circumstances is that the Democrats are likely to hold onto and indeed increase their congressional majority, particularly in the Senate. Remember, the president is not all-powerful. In order to implement his policies he (or she, if Hillary against all odds manages to defeat both Obama and McCain) needs congressional support.

When there is united government, that is when the same party controls the White House and both chambers of Congress, and then things tend to get out of hand, as that party's statist projects get approved out of party loyalty. This is something we've historically seen under both Democratic and Republican hegemony. When, by contrast, there have been divided government, then the White House and Congress have blocked each other's statist projects because of partisan rivalry. This is something we for example saw during the last 6 years of Bill Clinton's administration, and this is what has been seen in the most recent Congress.

During the first 6 years of the Bush administration, Bush only vetoed one spending bill and that was for the wrong reason. Now, by contrast, Bush have vetoed several Democratic spending bills.

And so, with McCain as president, he is likely to block the Congressional Democrat's quest for more domestic socialism. While the Democratic Congress will block his neoconservative foreign policy initiatives. By contrast, a Hillary or Obama administration is likely to get their vast expansion of domestic socialism easily approved by their fellow Democrats in the Congress.

Markets Are Right To Ignore G7 Statement

Canadian finance minister Jim Flaherty, along with his colleagues from Luxembourg and France, complains that the currency markets have been ignoring the G7 statement calling for a stronger dollar.

They're right about that in the sense that apart from a small and short-lived bounce immediately after the meeting, the markets have indeed ignored the G7 statement. But as I pointed out then, the markets should ignore that statement. There are no reason to act on the mere words of anyone, unless they either contain persuasive arguments about the fundamentals or threats of concrete action to change the fundamentals, which in this case would mean eithr interest rate cuts outside America, interest rate increases in America or direct foreign exchange interventions. But as the statement neither contained persuasive arguments or the hints of action, it deserved to be ignored.

U.S. Dollar Falls To Record Low Against Oil, Euro

The destruction of the value of the U.S. dollar continues as a euro for the first time traded above the $1.60 level, while oil is rapidly approaching $120 per barrel. This again indicates very strong inflationary pressures in America.

Interview With Peter Schiff

If you haven't already read it, read this interview with Peter Schiff, one of the most accurate and intelligent investor and economic analyst around.

Don Luskin's Pathetic Recession Denial

The only thing more pathetic than economist's who failed to predict the current U.S. recessions are those who still deny it. And who else to deny it than the man commonly known as the Stupidest Man Alive, Donald Luskin. Or more likely, the most Dishonest Man Alive, considering that his arguments although extremely misleading are clever attempts of deception. At any rate though, he is systematically wrong about almost everything.

Let's just look at his latest column where he denies the existence of a recession and still says the economy is recovering. To back that up he produces one lie or misleading statement after another. They are in fact so many, that it would make this post far too long if I refuted them all, so I'll just

First he claims that General Electric's earnings were just bad in its financial division, and so it provides no evidence of general state of the economy. There are two falsehoods present in that statement. First of all, financial operations are part of the economy, so excluding that is in this context misleading. Secondly, if you read the actual financial statement from General Electric, you can see that even most of its non-financial units seeing earnings decline, with infrastructure being the only one with noteworthy gains, and with total earnings from continuing operations falling even excluding the financial units. Moreover, GE notes explicitly that while they saw booming revenues outside the U.S., their U.S. operations experienced hard times.

This brings us to Luskin's next "evidence" against recession. He notes that some other companies did better than GE, and that this proves there is no worldwide downturn. That is again misleading for two reasons. First of all, I don't think anyone has claimed that there is a worldwide downturn yet. Although there are some who believe it will happen in the future (I don't), that is a forecast of the future, not a statement about the present. And it is highly dishonest to mix the issue of a global downturn in a discussion about a U.S. downturn. Secondly, because of exchange rate effects, the earnings of multi-national companies will rise significantly in dollar terms even if their earnings in terms of say euros or yens are flat.

Then there is his discussion of macroeconomic data. Although he acknowledge the Philly Fed indicator came in weak, he uses the Empire manufacturing index, as well as the recent industrial production report as evidence of strength. Yet that is a highly misleading presentation-again for two reasons. First of all, that industrial production does not, even if it stays unrevised, show what he claims it shows. While it showed an increase of 0.3% compared to February, he conveniently forgets to mention that the February reports showed a 0.7% decline. Also, the increase was almost entirely a case of mining and utilities, with manufacturing showing a mere 0.1% increase.

Moreover, he conveniently left out a large number of other reports showing weakness. Including a report showing falling real retail sales, falling business sales even in nominal terms, a sharp decline in housing starts, rising jobless claims -both initial and continuing-, the Beige book showing broad deterioration of business conditions and falling coincident indicators. Indeed, as the decline in coincident indicators more or less meets the definition of a recession, it proves that the recession has started.

He further claims that the New York Fed claims that the total value of mortgage defaults are just $116 billion, and that this supposedly makes the total writedowns of $250 billion unrealistically high. I don't know where he got that $116 billion number from, as I can't find it on the New York Fed web site or find it referenced by anyone else. But even if that number exists, there is certainly no reason to believe it will be all. Default means only loans currently in default, and not those near default, such as delinquent loans. And with the total value of mortgage debt being more than $10 trillion and with the delinquent and foreclosure rate being 7.3%, and with many more delinquencies likely to come, it is simply laughable to think that total losses will stay at $250 billion, much less just $116 billion.

Don Luskin with his denial of a recession is in short, really as pathetic as Baghdad-Bob when he denied Iraqi war losses even as American troops were already in Bagdad. Luskin deserves to be similarly dismissed as a fraud.

The Non-Mystery Of The Commodity Price Boom

Paul Krugman seems puzzled as to why for example oil reached a new all time high of $117 per barrel yesterday, and why commodity prices in general is soaring.

However, there is no puzzle. As I explained here, what is driving the commodity price boom is a combination of both monetary and non-monetary factors.

Coincident Indicators Indicate U.S. Recession Began In November 2007

While the financial media focuses almost exclusively on the leading economic indicators published by the Conference Board, I find the coincident economic indicators to be at least, or even more, interesting than the leading indicators. One reason for that is that the coincident indicators are the one the NBER use to determine when a recession has started. The coincident index has four components: nonfarm payroll employment, real disposable income excluding transfer payments, industrial production and real business sales. And the current numbers certainly shows the U.S. is in a recession, and that this recession started November last year.

While they now claim that the coincident index rose in March, I first of all think this number will be revised down. Previous months numbers have systematically been revised down (Two months ago, they claimed that the coincident index in January 2008 were 0.2% higher in January 2008 compared to October 2007. Now they say the index fell 0.2% in that three month period) and considering the fact that two of the components, real disposable income and real business sales, are a mere imputation due to lack of actual data and considering that the industrial production number looks unrealistically high. And secondly, even if it isn't downwardly revised, the level will still be 0.2% below the peak reached in October 2007. The numbers thus clearly indicates a recession, and that this recession began in November 2007, although it is still a relatively mild one, particularly if I am wrong in my prediction of downward revisions.

Of Course They're Not High Enough

ECB hawk Axel Weber again hints that he would really like to see interest rate increases, after Euro area inflation hits new all time high of 3.6%, and even the so-called core rate (excluding energy, food, alcohol and tobacco) hitting a new high of 2.0%.

It seems clear to me that Weber really wants to raise interest rates and that the ECB would have already done that if it had been up to him alone, but that he is outvoted in the ECB board by more dovish members who wants to keep interest rates on hold or even cut them. Anyway Weber says

"We will have to continuously monitor closely all incoming data and evaluate whether the current level of interest rates in fact ensures price stability."

Actually though, there's no question in my mind, and probably not Weber's either, that it doesn't. The ECB made a big mistake in canceling its planned rate hike last September, and because of that and previous feet-dragging when it comes to raising interest rates, inflationary pressures are strengthening. The ECB and the rest of Europe are now witnessing the fact that if you try to avoid an economic downturn by adding more inflation, you will end up with both.

Chinese Growth Remains Strong

As expected, China's economic growth rate slowed during the first quarter of 2008 to "just" 10.6%, down from 11.2% in Q4 2007. These are year over year growth rates. The change from the previous quarter was probably less than 10% at an annual rate.

Even so, this report is very bullish for the Chinese economy. The reason is that this slowdown was the result of a temporary factor, namely the harsh and cold winter weather with large quantities of snow, which caused massive supply disruptions. This however won't be a factor during this quarter so growth will bounce back.

What is particularly bullish is the fact that growth in domestic demand seems to be accelerating, which will enable China to keep strong growth even as higher oil prices and the U.S. recession cause its trade surplus to fall. Interestingly, the trade surplus fell even in dollar terms compared to a year earlier. In yuan terms the decline was even bigger, and relative to GDP the decline was much bigger. Although some of this decline could be attributed to the aforementioned supply disruptions, it should be clear that domestic demand is now growing faster than production.

This not only means that China is decoupling, it also means that the Chinese is to an increasing extent themselves enjoying the fruits of their hard labor, instead of sacrificing themselves for American consumers.

Berlusconi To Revive Italian Economy?

So Berlusconi won the Italian election and will now for the third time become Italian prime minister. What does that mean for the weak Italian economy?

Since he was unable to revive it during his two previous terms, I am somewhat skeptical to the idea that he will achieve any significant improvement this time. His ideas does however look good, focusing on on tax and spending cuts. If he really implements these ideas then the Italian economy will likely become stronger. However, since the main problem of the Italian economy is over-regulation rather than over-spending and since he hasn't mentioned anything about regulation -at least not in the foreign press stories I've read. My Italian readers are welcome to correct me if that is a misleading impression- it seems unlikely that we will see any dramatic improvement. Still, a modest improvement is better than no improvement at all, and a stronger Italian economy would not only be good for Italy but for the entire European economy.

Swedish, U.K. Inflation Rise

Both Swedish and U.K. inflation reports indicated rising inflationary pressures, just like previous reports from the Euro area and the U.S.

In the case of Sweden, the rise was much higher than most analysts (though not me) had expected. There are several different consumer price measures around, but the one the Riksbank targets rose to a 5 year high of 2.3% (and remember, that number is suppressed by technical factors). That implies that the fantasy of a rate cut later this year that most bank economists have been putting forward will remain just a fantasy. Although the most likely scenario is for the Riksbank to remain on hold, a rate hike looks more likely than a rate cut.

In the case of the U.K., the report was about producer prices which rose at their highest rate since 1991. This in turn suggests that consumer price inflation could pick up again in the U.K., something which will be further aided by the weak pound.
Given the fact that the Bank of England has a formal inflation target, and not the broad and fuzzy "full employment and stable prices" mandate of the Fed, this will greatly limit their ability to implement significant rate cuts to prevent the U.K. economy from falling into a recession.

Investor's Business Daily:Greenspan Inflated Too Little

Just to illustrate that the worst money cranks are often the supply-siders, Investor's Business Daily editorial page asserts that Greenspan should be criticized not for inflating too much, but for inflating too little.

As can be expected of an assertion that absurd, its arguments are out of touch with the facts and self-contradictory. It for example first says that in 1999, "deflation was the concern". Where they get the idea of risk of deflation from is unclear, as not only were stock prices soaring to absurd heights, house prices and consumer prices were also rising, and in the first half that year the previously depressed commodity prices started to rise again.

Then they tell us that the housing bubble started already during the second half of the 1990s. They further claim that because the second half of the 1990s were a rate increasing cycle, this somehow proves rate cuts couldn't have caused the housing bubble. There are three problems with this argument.

First of all, inflationary monetary policy does not necessarily imply nominal rate cuts compared to the past. All it implies is that it lowers interest rates compared to how high they otherwise would have been. As interest rates in the absence of higher money supply could have risen due to higher inflation expectations and/or higher time preferences, this means that inflationary monetary policy is potentially consistent with unchanged or even rising nominal interest rates.

Secondly, interest rates were in fact lowered, from 6% in February 1995 to 4.75% in late 1998 and the first half of 1999.

And thirdly, the housing boom were quite modest and hardly of a bubble character before 2001. In the 6 years between December 1994 and December 2000, aggregate mortgage debt rose just 51.6%. By contrast, in the following 6 years between December 2000 and December 2006, mortgage debt rose 104.5%.

And even while saying monetary policy supposedly can't cause prices to increase, they apparently believe it can lower them, as evidenced by their complaint of how the allegedly sound IT stocks collapsed in value in 2000, and how it have now caused house prices to fall.

The IBD editorial finally claims that it isn't a bubble until it bursts, and that if Greenspan hadn't started to reverse his rate cuts starting during the second half of 2004, it wouldn't have bursted. Well, I guess that it is true that had interest rates been kept at 1% indefinitely then it would have bursted later. And prices might not have fallen at all in nominal terms. Instead we could have gotten the correction in the form of super high consumer price inflation which would have lowered the real price of houses. But in real terms it would have still bursted, and the problems would have been even bigger than now.

G7 Statement. Why Care?

So the G7 decided to issue a statement against "sharp fluctuations in major currencies".

This will probably lead to a stronger dollar on Monday. However, unless those words are backed up by action in the form of lowering the negative interest rate differential or direct currency market interventions, there is no rational reason for caring about this.

I think it is basically out of the question that America would participate in such a intervention. Interventions by the Europeans and Japanese are by contrast possible-but at this point not likely. And while the ECB and Bank of Japan is likely to keep interest rates on hold, the Fed will likely cut them further. That means that the likely dollar bounce on Monday will be short-lived.

Et Tu, General Electric?

You know things are bad when even General Electric, the epitome of a stable and safe company, reports falling profits. Although this decline has occurred mainly in its financial unit, it is noteworthy that even its non-financial units are doing surprisingly bad. This is particularly true as more than half of General Electric's profits come from operations outside the United States, profits that is boosted by currency effects. For example, as the euro is up 16% compared to year ago levels, the dollar profits of General Electric's European operations will be up 16% even if the profits in terms of euros are unchanged. With that in mind, the weakness of General Electric's profits is ominous.

This bearish report comes after several other similar reports, from for example Alcoa and AMD. This indicates in turn that coming profit reports during the rest of the reporting could come in weak too, which of course would be bearish for stocks.

U.S. Trade Reports Show Strong Inflationary Pressures

The last two days we've been getting some statistics related to U.S. foreign trade. And they all indicate continued inflationary pressures in America.

Import prices rose a full 2.8% from the previous month and 14.8% compared to 12 months earlier. Much of this is related to soaring prices of oil and natural gas, but even excluding energy, import prices rose 0.9% and 5.0% compared to a year earlier. Still, while that is higher than in the past, the price of non-fuel imports is rising a lot less than one would expect given the decline in the dollar. That can be explained by two factors, neither of which are really sustainable and both of which indicate future lagged effects of current dollar weakness.

One is that some contracts are made on the basis of futures contracts which were written months ago, meaning that they are still trading on the basis of the exchange rates prevalent several months ago. However, when futures contracts are written today for the purpose of trade that will be made months from now, this will of course be made on the basis of current exchange rates, meaning that prices will rise months from now because of the current decline of the dollar.

The other explanation is the tendency of many export companies to absorb short-term exchange rate fluctuations in their profit margins rather than passing them on as price increases. The idea behind this strategy is that market shares are more easily lost than gained, and so if the dollar recovers it makes sense to temporarily accept lower profit margins rather than permanently losing market share. However, if the exchange rate movements turn out to be permanent, it would make more sense for these companies to sell their products in other markets where profit margins are higher, meaning they will raise export prices to countries with permanently weak currencies. As the dollar stays weak, more and more companies will interpret the weakness as permanent and pass on the price increase (Or hypothetically if the dollar recovers they will abstain from lowering prices. But in any case they will raise prices relative to the exchange rate movement).

All of this means that import prices will continue to rise significantly in coming months, even if the dollar stabilizes.

Meanwhile, export prices are also rising fast, up 1.5% from the previous month and 7.9% from 12 months earlier. The story here is roughly similar to the import price story, with the commodity price boom being the primary mover but with other prices rising fast too. Here however, it is the agricultural commodity prices rather than energy prices, as America is a large net importer of energy products while being a large net exporter of farm products.

Also, here too other prices are rising more slowly than the dollar value of other currencies for much the same reasons as in the case of non-energy imports. Note that it is not only higher import prices which will contribute to higher domestic price inflation in America. The rising export prices will have a similar effect. The reason is that as it becomes more profitable for American companies to export, they will feel much less pressure to lower prices for Americans, and more room to raise prices for Americans.

The trade report indicates that the U.S. trade deficit is in fact rising despite the weak dollar. Although this month surprisingly showed a decline from the previous month in the petroleum deficit and a rise in the non-petroleum deficit, the underlying trend is for the petroleum deficit to rise because of the rise in oil prices while the non-petroleum deficit to fall because of the increase in agricultural prices as well as the weak dollar and weak domestic demand. However, this cannot simply be explained by the commodity price movements. Even if oil prices rise and the demand for oil is relatively inelastic, this need not imply a higher trade deficit as Americans then if they were determined to increase their savings would cut back more drastically on the purchases of imported goods. However, it seems that the Fed's dramatic rate cuts have reduced the willingness to save so much that it for now overwhelms the substitution effect from the falling dollar. That may perhaps change in the future, but for now it seems that the demand-boosting effect from lower interest rates overwhelms the substitution effect of a weaker dollar. That in turn implies that domestic inflationary pressures remain in place.

U.S. Dollar, Pound Reach Record Lows Against Yuan, Euro

The yuan and the euro each reached symbolic thresholds against the U.S. dollar and the pound, respectively. The yuan rose so that a U.S. dollar now for the first time sine the early 1990s cost less than 7 yuan. More specifically it rose to 6.9907 yuan per dollar.

Meanwhile, the U.S. dollar is not the only currency falling. The pound reached a new all time low against the euro, so that a pound is now worth less than €1.25. Which alternatively formulated means that the euro for the first time ever cost more than 80 pence. Back in December, when I first started to warn that the pound would fall, it was worth €1.38.

These currency trends are likely to continue. In the case of the yuan it is in fact a certainty as it has different dynamics than other currencies and is directly controlled by the central bank that is committed to a gradual but basically uninterrupted appreciation against the dollar. The pound will likely continue to fall as the U.K. economy will continue to slow and probably fall into a recession. Still, the downside potential does not look as great as in the case of the U.S. dollar, as the Bank of England has not -at least not yet- been as aggressive as the Fed in its inflationist response to the downturn.

Very Professionally?

Greenspan, like David Lereah and Jerry Bowyer, is unintentionally becoming a really good comedian. In Reuters, he says:

"I have no regrets on any of the Federal Reserve policies that we initiated back then because I think they were very professionally done"

Note that Greenspan creating the biggest housing bubble in American history and thus creating the massive problems America now faces is not just professional, but very professional. Personally, I have trouble seeing how a dart-throwing chimp or even a drunken lemur would have caused less problems than Greenspan.

Greenspan of course again denies his guilt in creating the problems by using the same old BS about global market forces pushing down long term interest rates that he has used in the past. As I've already refuted that nonsense, I won't bother doing it again, so those who haven't read it or forgotten what I wrote may read it here.

About IMF Gold Sales

So the IMF has decided to sell of 403 tonnes out of the 3217 tonnes it has in gold reserves. 403 tonnes is equivalent to 14.2 million ounces, which at current market prices is worth roughly $13 billion.

The reason given for this move is that it will generate new income. That really doesn't make much sense. If they by income mean return, then selling gold is a bad idea since gold is likely continue to rise, and rise at a lot faster pace than at current interest rates. If they by income mean liquidity, then it is slightly more understandable, but it would really because of the aforementioned factor be more rational for them to borrow using the gold as collateral. But then again, since I am not a friend of the IMF, I don't mind if they make bad investment choices.

What effect will this have on the gold market? Will it lower the gold price? Certainly, at least in the short term. Will it end the gold bull market? No, it won't. The fundamentals supporting the gold bull market, primarily the habit of central banks in general and the Fed in particular to debase their paper currencies will continue to support gold in terms of these paper currencies, both because of the direct effect of lowering the value of the paper currencies, but more importantly because it supports the demand for gold as an inflation hedge. Also, the preference for gold in many emerging economies, particularly India, as jewelry, implies that demand for gold as jewelry will continue to increase as these economies continue to grow.

It is unclear exactly during which period of time that IMF will sell the gold, as the IMF only says they will sell it in a "non-disruptive" manner. Presumably, this means that they will sell it gradually during an extended period, perhaps one or two years. This will depress gold during that period somewhat and limit the gains, but not by enough to stop gold from continuing to climb and within a relatively near future, regain the $1000 per ounce level.

U.K. House Price Decline Accelerate

U.K. house prices fell 2.5% in March, from February. This is the largest decline since 1992, and could, not coincidentally, trigger the first U.K. recession since 1992. The fluctuations is the U.K. economy has moderated significantly during the latest decade because of the declining role of the more volatile manufacturing sector and globalization and because previous slowdowns have been immediately met with accelerated monetary expansion. Now however two factors are dragging down the U.K. economy. First of all, the expanding financial sector has started to bust because of the global financial unrest. And secondly, the fact that previous slowdowns were met with monetary expansions means that increasing imbalances have been built up, with overvalued house prices, large external deficits and record debt levels, imbalances not too dissimilar to the one we've seen in America. This means that the problems are much deeper than in the past, increasing the odds for a U.K. recession sometime during 2008 or 2009.

Assets & Liabilities & Myths About Write-downs

When the issue of bank losses is discussed, I frequently read statements which indicate ignorance about basic principles of corporate accounting. Such as the assertion that write-downs of bad debt will reduce the money supply or that write-downs is the explanation for the low level of bank reserves rather than the explanation I mentioned the other day. Both of these assertions are false, for reasons I will explain. But in order to explain it I must explain some of the most basic principles of corporate accounting, or more specifically the balance sheet of corporations.

A corporate balance sheet consists of two sides: assets and liabilities. The liabilities side includes owner's equity, which can be viewed as a liability towards the shareholders. Assets and liabilities must in accordance with the principle of double entry book-keeping always be equally large. This is essentially true by definition as owner's equity is defined as the residual left after subtracting external liabilities (debts) from assets. Any increase or decrease in the value of assets must be matched by a equally large increase in the value of the liability side of the balance sheet, whether through external liabilities or owner's equity or a combination of them.

So, returning to the issue of write-downs, if there is a write-down in the value of certain bank assets, such as mortgages, this means that there must be a similarly large decrease in the liabilities side of the balance sheet. Which liabilities will be written down then? Since people depositing money in banks or in other ways lending to the bank have usually not assumed the credit risks for the loans banks makes, this must mean that owner's equity is what will take the hit. This has relevance for the issue of the effect from write-downs on the money supply. Owner's equity is not part of the money supply. The only bank liabilities that are part of the money supply is customer deposits. But as long as the banks do not collapse, the value of customer deposits is unaffected. And bank collapses are not something which the Fed is going to accept. This means that although write-downs will lower the value of bank credit, it will have no direct effect whatsoever on the money supply (It might have indirect effect though, if it makes banks more cautious to issue new loans).

What about the effect on bank reserves? There will be no effect on bank reserves either. The reason is that bank reserves just like bank credit are a form of asset. Bank reserves consist of physical cash held in bank offices and ATMs as well as bank deposits at the central bank, i.e. Fed in the United States. If the value of bank loans is written down this will only affect the liability side of the bank balance sheet, i.e. owner's equity as previously stated. It will however have no effect on either the value of the physical cash the bank have or the value of its deposits at the Fed. And for that reason, it won't have any effect on the level of bank reserves.

Blog Recommendation

I usually don't recommend blogs in separate posts, and instead simply add them to my blogroll. I will however make an exception for What Is Not Seen. It is run by a good personal friend of mine, Daniel Halvarsson, who works as fund manager at Independent Investment Group in Umeå. He blogs about issues related to macroeconomic developments and investments from a mainly Austrian perspective, while also highlighting technical analysis, and is therefore a valuable complement to my blog that I recommend. His title What is not seen is taken directly from my favorite Frenchman, Frederic Bastiat. His blog has of course presumably been one of those things not seen so far by most here, so do see it now by following this link.

Myths About The Monetary Base And Bank Reserves

One of the hottest (if not the hottest) intra-Austrian debates today is between what is sometimes referred to as deflationists and inflationists/stagflationists. This is not a policy debate of course, as all Austrians is anti-inflation, but rather a debate about whether the current recession will be associated with deflation or inflation. Examples of deflationists are Frank Shostak, Mike Shedlock and Gary North while examples of stagflationists include me, Antony Mueller and Peter Schiff. The dispute is largely originated in a dispute over the definition of the money supply. I have already dealt with that issue extensively (see for example here, here and here ) so I will not repeat this here. Instead, I will focus on the appeal made by the deflationists to the development of the monetary base, which have been largely stagnant for the latest year.

The implicit or explicit argument from the deflationists appear to be that 1)The Fed controls the monetary base, so it is a good reflection of how tight its policy is 2) The monetary base determines the money supply, so the stagnant monetary base implies a stagnant money supply. Yet both of these assertions are simply wrong, at least given the current financial structure.

I have actually once answered the monetary base argument before. At that time I pointed out that more than 90% of the monetary base is made up by what in monetary statistics is called currency in circulation, which is to say paper notes and metal coins held by the public. And I also pointed out that the amount of currency in circulation is determined by public preference for making payments using notes and coins versus making electronic transactions. In the U.S. this is also determined by demand in high inflation third world countries for using dollars as means of payments instead of local currencies. Most likely the stagnant amount of currency in circulation reflects the trend towards a cashless society as well as growing repatriation of previously exported dollar notes and coins due to the distrust of the dollar that the decline in its purchasing power has caused.

I also illustrated that point by pointing out that during the inflationary boom of the 1920s, the monetary base was stagnant. By contrast, the monetary base soared during the deflationary depression of the 1930s, as bank collapses caused people to prefer to hold money in the form of cash instead of deposit money.

However, I now realize that this response was unsatisfactory in one aspect. Namely, because my focus on the currency in circulation part of the monetary base seemed to imply that the other part of the monetary base, bank reserves, do in fact have the characteristics that the deflationists claim. That's not what I meant, although now I realize that the post was written in a way which could reasonably be interpreted that way. And as I see Robert Murphy write a whole article focusing on bank reserves as a proxy for monetary conditions it is clear that the issue must be addressed. So I will now clarify: bank reserves are in today's system basically irrelevant too, both as a proxy of Fed policy and of monetary conditions.

The reason is that there really isn’t any demand for bank reserves. To the contrary, banks do everything they can to minimize it because reserves inflict opportunity costs for them in the form of foregone interest income. In the past, banks still felt compelled to keep large reserves because of the risk of bank runs. But with the Fed providing unlimited quantities of liquidity in the case of unexpected increases in withdrawals, this is not an issue anymore. Today, the only thing preventing banks from reducing reserves to zero is formal reserve requirements and the need to have cash available for withdrawals from bank offices and ATMs. But with the banks moving away from deposits with reserve requirements such as demand deposits and instead finance its operations in for example Money Market Mutual Fund accounts (And using so called sweep operations the banks ensure that the level of demand deposits are always minimized even if customers deposit money there) that don't have any reserve requirements the level of required reserves is declining in importance. And with the increasing use of electronic transactions, cash for customer withdrawals is also becoming less important and is at an absolute level very low. Because of this, bank reserves are increasingly disconnected from the level of money supply.

Indeed, if Robert Murphy had looked more closely at figure 1, he would have seen this point. Bank reserves in early 1990 were $60 billion as compared to $42 billion now. If bank reserves really had been a good proxy for the money supply, then that would have implied a cumulative monetary deflation of 30% during the latest 18 years. The Fed under Greenspan would, if bank reserves were really a good proxy of monetary conditions, have been the ultimate hard money institution, providing more deflationary conditions than a gold standard. Nor do the trends show any correlations with the housing bubble, as it started already in 2001 while the monetary base was flat until 2003. And after a brief upswing in 2003-04 it was basically flat after that. In other words, bank reserves have in today's system nearly no correlation with monetary conditions.

But if the Fed performs open market operations, won't that expand bank reserves? Well, no. While it may result in brief spikes, these spikes won't last as the banks will lend out or invest the money the open market operations produce, either as bank loans or investments in securities. The reason why they are unlikely to keep the money more than a few days is the above mentioned fact that reserves represent opportunity costs and that it is more profitable for the banks to lend/invest. Contrary to what Murphy claimed, it is not the Fed that has moved away reserves from the systems, it is the banks themselves. If you doubt that, just check out the statistics for bank credit, which have soared in recent months.

Because the banks have the opportunity to lend/invest the money they get from the Fed and the incentive to do so, the Fed has almost no control over bank reserves. If they started to impose reserve requirements on all deposits, they could have controlled it, but as it is they don't. Nor is it a reflection of credit conditions or monetary conditions as bank credit grows at double digit rates.

To summarize, the stagnant monetary base and bank reserves have absolutely nothing to do with interest rate policy, and is instead a reflection of the trend in the payment system to move away from currency in circulation and deposits with formal reserve requirements to deposits without reserve requirements, combined with the Fed's promise to help all banks with unlimited quantities of liquidity if they need it. The deflationist claim that the Fed is not inflating is not only serious because it implies misleading investment advice, such as staying away from gold and buying treasuries. It is also damaging because it implies that Bernanke is actually mimicking market conditions (something which Murphy actually explicitly wrote in his article), thus effectively destroying all opposition to Bernanke's inflationary policies. Unwittingly, the deflationists are thus helping Bernanke.

Comedy Evening

Some books are so funny that you don't even have to read them to laugh-all you need to do is to read the titles. These two books, published 2006 and 2003 respectively, are so unbelievable laughable that the mere display of their titles is enough to crack me up.

U.S. Employment Contraction Accelerates

Today's U.S. employment report is in many ways eerily similar to last months, with continued decline in nonfarm payrolls despite continued government job growth and despite the fact that many jobs are simply assumed through the faulty birth/death model (astonishingly, they actually increased the number of assumed jobs, from 53,000 per month last month to 64,000 per month this month). Also, like last month, job growth in previous months was downwardly revised. Excluding the phantom jobs assumed by the birth death model, private sector job growth is now negative on a year over basis and is shrinking at a rate of 150,000 to 200,000 per month, considering that published private sector employment growth was a negative 100,000 (roughly) both of the previous months and considering the 64,000 phantom jobs assumed. This estimate is also confirmed by the household survey which shows negative job growth on a year over year basis, including government jobs. Excluding government employment, the decline is of course even bigger. For a more detailed reasoning around these issues, see the analysis I did after the previous month's release.

The main difference between these two releases was that the unemployment rate rose sharply in Mars, after declining slightly in February. But that is of lesser importance as employment fell during both months, with the difference in the change of the unemployment rate being caused by a falling participation rate in February and a rising one in Mars.

The overall conclusion is that the employment numbers confirm a U.S. recession, particularly in manufacturing and construction, while the government sector seems to be the only one that is growing.

UPDATE: Menzie Chinn at Econbrowser has a good illustration of the effects of the revisions on employment levels and changes.

Ron Paul vs. Ben Bernanke Again

Although Ron Paul won't become president, he will be re-elected as Congressman. That is something we already know because he won the Republican primary for his Congressional seat and because there aren't any Democratic candidate there. That means that for at least nearly 3 more years, Ben Bernanke will have to endure getting confronted by the only politician that understands economics and so understands that the root cause of the current economic problems are the activities of Bernanke and his predecessor Alan Greenspan. Here is the latest example of Ron Paul confronting Bernanke.

Eastern Europe-Not A Homogenous Region

Often you hear the economies of Eastern Europe being referred to as more or less a homogenous region. In reality though nothing could be further from the truth. In few other regions do the economies differ so much among each other as Eastern Europe. Indeed, there are so many different types that describing them all would require too much time and energy from my part. There is really only one thing which they have in common, and that is their ominous demographics, due to a collapse in birth rates in the early 1990s. So I will limit myself to Russia, the Baltic States and the largest of the new EU member states.

Russia differs from the others in two important respects. First of all, it is much bigger than the other countries, both in terms of the size of the population, the economy and the geographic size. Secondly, and perhaps most important in this aspect it is a large net exporter of oil and other commodities. Related to this fact is the fact that Russia in contrast to the others has a large current account surplus. The windfall gains from the commodity price boom have been so large that the Russian government has been unable to find ways to spend them.

Russia's dependence on commodity exports is in the short to medium term actually a good thing for them, as I expect the commodity price boom to continue this year and probably a few more years. But of course, it won't last forever. And at that point, the weaknesses in the rest of the economy could start to appear.

The Baltic States have similarly to America a good microeconomic structure with low tax rates and limited government spending, but terrible macroeconomics. The Baltic States and particularly Latvia have extremely large current account deficits combined with high (double digits) inflation. Particularly Estonia has seen a dramatic slowdown in growth. This has been associated with a small downturn in the external deficit. However, that deficit remains large, and price inflation have actually accelerated. In order to clean out the excesses, a painful recession seems necessary and inevitable. However, in the long run that is a lesser evil compared to trying to postpone the ultimately inevitable.

But the situation is arguably even worse in Hungary. Hungary have, in sharp contrast to the Baltics not enjoyed any previous boom. Hungary has for years had much lower growth then in the other Eastern European countries, and now even has lower growth than in most Western European countries as well. Hungary is really the worst of two worlds. Not only does it have serious macroeconomic imbalances with very high inflation and very high budget and current account deficit, but it also has highly inhibiting levels of taxation and regulations. A combination of the worst parts of the American and French economies, in short.

And there seems to be little political will to deal with the problems in Hungary. A referendum recently rejected with a 80% majority the proposal to reduce government spending and the budget deficit by imposing low user fees in health care and higher education. It is therefore difficult to be anything but bearish about Hungary.

Poland and the Czech Republics seem much sounder both in macroeconomics and microeconomics. While both have current account deficit they seem to be moderate and mostly reflect capital inflows to sound investments. Monetary and price inflation is much lower than in either the Baltic states or Hungary. Meanwhile, the burden of spending is gradually falling, and in Poland there are plans to introduce a flat tax.

The shining star of Eastern Europe is however Slovakia. Slovakia had a growth rate of 14.3% in the fourth quarter of 2007. Even if this perhaps to some extent reflects some statistical distortion, it seems clear that real growth is well above 10%. Meanwhile, despite this rapid growth and despite the fact that Slovakia has pegged its currency to the euro, money supply growth is only slightly higher than in the euro area. Indeed, at 11.2% for M2 money supply growth doesn't appear to be higher than the real growth rate. While that is not low in absolute terms, it is remarkably low considering the extremely rapid real growth rate and the euro peg. How it is possible with such a relatively low monetary growth rate under these circumstances is not clear, and something I'll have to do more research about, but it clearly means that Slovakia's boom is on a sound basis, unlike the previous Baltic boom. It is also something which will likely enable Slovakia to join the euro area already next year, and become the 16th state to join the euro. Ultimately the basis for that boom is the low flat tax system and the fact that these cuts were accompanied by sharp spending cuts, particularly in welfare payments.

Financial Journalist's April Fool's Joke

Financial journalists pulled a real April fool's joke on the markets today when they claimed that the ISM Manufacturing index indicated a stronger U.S. manufacturing sector. However, first of all, even the headline index remained at 48.6 below the 50 threshold between contraction and expansion, and the rise from 48.3 wasn't exactly impressive.

Secondly, and even more importantly, if you look at the details, they show a stagflationary and not expansionary tendencies in the U.S. economy. The key new orders and production sub-indexes both fell significantly and both indicate contraction. One thing that however rose significantly, and indicates very rapid increases was the prices paid subindex. It rose from 75.5 to 83.5, which is the highest since October 2005. This again confirms rising inflationary tendencies in the U.S. economy even as real output contracts.