GDP Data Much Worse Than The Financial Press Tells You

So the official GDP number came in at 1.9%-close enough to my 2% forecast for me to be able to say "See, I told you so" (especially since I added "give or take a few tenths of a percentage points"). Brian Wesbury on the other was wide off the mark with his 3% forecast.

The review of previous data also came in as I expected, with inflation being revised up even as nominal growth was revised down producing an even bigger decline in real growth. However, I have to admit that I expected a bigger downward revision (because previous downward revisions were greater).

Looking at specific quarters, Q4 2007 official growth was revised down to -0.2% from +0.6% and Q1 2008 from 1.0% to 0.9%. However, the real numbers are in fact even worse than these numbers suggest, for two reasons.

First, there is the factor that I've mentioned several times before, namely the terms of trade factor. This was actually most dramatic during Q2 2008. That alleged 1.9% growth depended on the ludicrous assumption that inflation was just 1.1% at an annual rate. If you instead deflate the nominal GDP growth of 3% with the 4.3% increase in the gross domestic purchases deflator, then growth was -1.2%.

Second, income data suggest far weaker growth. National income should in theory be equal to GDP plus/minus net factor income from abroad minus capital consumption. Yet because they originate from different data sources they usually aren't equal, something which is accounted for by a post called "statistical discrepancy". National income for Q2 2008 is not yet available, but between Q1 2007 and Q2 2008, the statistical discrepancy rose from -$188.4 billion to $43.6 billion, meaning that national income rose $232 billion less than GDP. I calculated real GDP and real national income by dividing the change in the nominal number with the change in the price index for domestic purchases. Here is the result, with the headline volume number besides them.

GDP Volume GDP Real NI Real
Q2 2007 +4.8% +3.4% +1.6%
Q3 2007 +4.8% +4.0% +1.2%
Q4 2007 -0.2% -1.3% -0.9%
Q1 2008 +0.9% 0.0% -2.0%
Q2 2008 +1.9% -1.2%

(Sorry about the unaesthetic format, but blogger for some reason refuses to accept my attempt to create margins between the numbers. If anyone knows how to fix the problem, they're more than welcome to tell me)

The reason that no real national income number exist for Q2 2008 is because as I mentioned before, the number for national income is not yet available. As you can see ,real GDP was weaker than volume GDP for all quarters, with the difference being greatest for the latest quarter. Real national income was weaker than real GDP for all quarters except Q4 2007 when an increase in net factor income boosted national income. Still, real national income remained weaker than volume GDP.

Given the widespread economic discontent among Americans, it should be obvious to anyone outside the group of pro-Republican supply-siders that real national income better reflect the economy than volume GDP.

Finally, it should be noted that government demand (this includes all government purchases, both those considered consumption and investments, but does not include transfer payments like welfare and social security) reached 20.1% of GDP, the highest since Q2 1992. During Clinton's last year in office, this number was below 18%, and as late as Q1 2007 it was 19.2%. This increase is primarily driven by higher military spending, but non-military government purchases also increased. This means that the decline in the private sector is even greater than the above numbers suggest.

Oil, The Dollar & ECB Monetary Policy

A fallacy regarding monetary policy and oil have been spread among surprisingly many economics bloggers-including even some whose writings are normally good (meaning Barry Ritholtz and Claus Vistesen).

The idea is that the ECB by raising interest rates will in fact increase price inflation by raising the oil price (This idea, had it been true would by the way have been applicable on all other central banks except the Fed). The chain of reasoning behind this surprising conclusion goes something like this:

- Higher ECB interest rates will make the euro stronger, all other things being equal.
- A stronger euro will raise the oil price, all other things being equal.
- Therefore, it follows that higher ECB interest rates will raise oil prices.

A pretty straightforward syllogism: A (higher interest rates) causes B (stronger euro), B causes C (higher oil price), and therefore A causes C. But the problem is that if one of the premises in a syllogism is false, then the conclusion does not follow. And the second premise contains no less than two errors.

First of all, it is only partially true that a stronger euro will raise the oil price all other things being equal. It will raise the oil price in terms of U.S. dollars and other currencies that the euro rises against. But it will not raise the oil price in terms of euros. To the contrary, it will lower the oil price in euro terms. In fact, the reason why the U.S. dollar price of oil rises because of a stronger euro is because the euro price of oil is lowered.

The reason for this is that as the euro rise against the dollar, this will automatically (by definition) lower the euro price of oil if the dollar price is unchanged. That would mean that the average global price would fall as the Europeans get cheaper oil, while the cost of oil for Americans is unchanged. But that would create a disequilibrium as it would increase the demand for oil in Europe while not reducing American demand (an effect which would be even greater if you also consider the effect on supply). And so, in order to get back to the old equilibrium global average price, the dollar price of oil must rise, both to make oil more expensive for Americans and to limit the price reduction. The end result of a stronger euro will thus be to raise the dollar price of oil, but by a smaller amount than the increase in the euro's exchange rate versus the dollar so as to make oil cheaper for Europeans. What this means is that the increase in the dollar price of oil presuppose (is dependent upon) that the euro price of oil falls, and that thus in euro terms, the second premise is completely false.

Moreover, it is not the case that "all other things are equal" if the stronger euro is caused by higher interest rates. The "all other things being equal" condition only holds for "autonomous" exchange rate movements. If interest rates are increased, then this will decrease European demand for oil and thus lower the global average price, and therefore also the price in both euro and dollar terms.

From all of this it follows that the effect of ECB interest rate increases is ambiguous for the dollar price of oil (as the total demand effect counteract the exchange rate effect) while the effect on the euro price of oil is unambiguously to lower the price (as the two effects reinforce each other).

Are They Serious?

Bloomberg News reports that even as profits at S&P 500 companies looks set to plunge 24% compared to a year before, profits for 2008 as a whole are forecasted by so-called analysts to rise by 1.6%, because profits will supposedly soar during the fourth quarter.

This alleged Q4 boom will supposedly be the result of a base effect from the large write-downs during Q4 2007. But while this base effect will likely mean the end of the large year over year declines we've seen so far, the forecast that profits will boom rests on the assumption that somehow the problems for the financial sector will be over by then and no more write-downs will be made. A forecast which is so out of touch with reality that it's absolutely breathtaking.

This illustrates why Wall Street is in such a mess, and would have collapsed by now if Helicopter Ben hadn't flooded them with money. Remember, we're talking about the same analysts that a year ago forecasted profit growth of over 10% during Q2 2008 this year. And whose colleagues at other parts of the company a few years earlier came up with the idea of investing in the U.S. housing market.

The Never Ending Foreign Sucker Express

One of the seemingly mysterious facts is that America can continue have a net surplus on international investment income flows. I mean, as protectionists always points out, haven't America had a constant trade- and current account deficit for more than 25 years, with the deficit being as large as 5 to 7% of GDP during the latest decade, meaning that America particularly during the latest decade has been a massive net borrower from abroad. And yet, despite being a massive net borrower, America continues to have a large net surplus in investment income from abroad. So in order words, foreigners are in effect paying America large amounts to borrow, and not the other way around (usually it is the borrower who is paying the lender).

How is that possible? The most blunt and honest answer is that the foreigners who invest in America are suckers who allow themselves to get screwed by the Americans.
To illustrate this point, let's look at their track record. First, their preferred choice of investment was U.S. government bonds. Government bonds have the advantage of at least not losing in value in nominal dollar terms, but because the U.S. dollar is constantly debased in the form of inflation and depreciation they are still losing in value in real terms. As I found when doing research for the paper I told you about a while ago, U.S. government bonds had the by far worst return of any government bonds in advanced countries during the latest 25-year period.

Then they started accumulating Mortgage backed securities in the hope of getting a higher return than from government securities. And well, I think we are all aware of how well that went. And now they are accumulating financial stocks, as we see in the case of Singapore's latest purchase of Merrill Lynch-stocks. Singapore had already bought a large stake in Merrill Lynch in December when the stock was worth more than twice their current value, meaning that the Singaporeans have lost more than half of what they invested then. Presumably, they hope things will turn out better this time.
But unless Merrill Lynch has gotten completely out of the housing market (I haven't studied their balance sheet in detail so correct me if I'm wrong, but I find that unlikely) then things are just going to get worse.

As I pointed out recently, house prices will fall a lot more before this is over. That in turn means that the value of any securities or loans backed by houses will also fall further, meaning that Merrill Lynch will continue to make big losses, losses that will have to be absorbed by the shareholders, including the Singaporeans.

This Is Seriously Messed Up.....

I saw this via both Mark Thoma and Jeff Tucker. Tucker's main problem with the article appears to be its policy views, but my main problem is actually with this part (although I agree that the policy part had flaws too):

"Though economics as a discipline arose in Great Britain and France at the end of the eighteenth century, it has taken two centuries to reach the threshold of scientific rationality. Previously, intuition, opinion, and conviction enjoyed equal status in economic thought; theories were vague, often unverifiable. Not so long ago, one could teach economics at prestigious universities without using equations and certainly without the complex algorithms, precise (though not infallible) mathematical models, and computers integral to the field today.

No wonder bad economic policies ravaged entire nations during the twentieth century, producing more victims than any epidemic did."

I've commented mathematical formalism in economics before (see here and here).
I will here aside from linking to these posts only add that mathematical formalism does not prevent bad ideas. You can express any theory, including communist ones, as a bunch of Greek letters and then differentiate them and pretend that this operation have somehow made it scientific. Far from stopping bad theories, mathematical formalism will help advance them because they will distract from the actual issue at hand by instead focusing on series of differentiated Greek letters.

Not Just Q2 GDP On Thursday

The by far most important statistics day this week will be Thursday July 31, when the BEA will release Q2 GDP for the U.S. Speculation have been growing over what the Q2 U.S. GDP number will land at. After the relatively strong durables goods report last week I expect it to land at roughly 2%, give or take a few tenths of a percentage points, although as I pointed out before, basically all of this will be a statistical illusion.

Perhaps even more interesting will however be the simultaneously published annual review of the previously published "final" numbers who will turn out to be not so "final" after all. I cannot of course today say what the exact numbers will be, but based on previous annual reviews (se my comments in 2005, 2006 and 2007) we can get a good hint of what the general pattern of revisions will be.

Real growth for most quarters will be revised down, and so will average growth. This will take the form both in higher assumed inflation and lower nominal growth. The quarters that will be of particular interest will be Q4 2007 and Q1 2008. While it is not certain that they will be revised down (as I said, most quarters are revised down, but not all), it is likely. That in turn means that not just the real terms of trade adjusted number that I focus on could be negative for those quarters, but also even the official volume number. It should further be noted that even if the official number isn't revised below zero this time, that may still happen during the 2009 or 2010 (and even 2011 for Q1 2008) annual revisions.

Given how negative other indicators are, it is clear that official real growth should be negative for these quarters.

Cato Split On Inflation

There seems to be great disagreement over at the Cato Institute whether or not inflation is a problem. One day, we can see Alan Reynolds declare that inflation is not a problem. A few days later, Steve Hanke declares that inflation is a problem.

This is in some ways similar to the debate within the Mises Institute whether inflation is a problem, where I and some others, including Antony Mueller and (sometimes) Bob Murphy, do believe that inflation is a problem, while Frank Shostak and his follower (as well as Gary North) believes that deflation is the problem.

Swedish, Euro Area Monetary Inflation Decelerates

Euro area money supply growth fell again in June, with M2 growth falling to 9.4%, the lowest since May 2007. However, 9.4% is still far too high.

Swedish money supply growth decelerated far more dramatically, with M2 growth falling to 7.4%, the lowest since June 2005. During the period between late 2005 and early 2008, M2 growth fluctuated between 10% and 15%. Seasonally adjusted monthly values aren't available so meaningful 3 or 6 month growth rates can't be calculated, but it seems safe to say that had such numbers been available, they would have been even lower than 7.4% at an annualized rate.

The fact that monetary growth decelerates weakens the case for further interest rate increases if the trend continues, particularly in Sweden. However, given the high money supply growth rates experienced so far and given the usual time lags, price inflation will continue to remain high for a while. On the other hand, the combination of decelerating nominal money supply growth and rising price inflation implies an even sharper deceleration of real money supply growth, which in turn implies an increased risk of a recession in Europe.

Stock Buy-Backs Not The Cause Of Bank Problems

I found Eric Englund's LRC article about stock buy-backs to be quite misleading. It points to how American banks have made significant stock buy-backs through the years and how they are now in a crisis and so uses this as proof that stock buy-backs do not increase a company's value.

The problem with this argument, first of all, is that no one has really claimed that stock buy-backs will increase a company's value, at least not after the buy-backs are made. However, the key fallacy here is that maximizing a company's value is not (or shouldn't be) a self-end. No company exist for its own sake, it exist for the sake of its shareholders. Hence, what should be maximized is not a company's value (except when that maximizes shareholder value), but shareholder value. That means performing share buy-backs (and paying out dividends) whenever the marginal return of equity is lower for investments performed by the company then when investments are performed by the shareholders independently. When the return on the other hand is higher within the company no share buy-backs should be performed and dividends should be limited, while possibly even new shares should be issued.

Thus, it is an open question whether or not share buy-backs are good or not. It depends on where the money can be put into the best use. Turning now to the second flaw in Englund's argument, the specific case of American banks, how could Englund possibly claim that it would have been better if the evidently incompetent management and analysts at American banks would have had even more money at their disposal to invest in the inflated American housing market? Given how incompetent the staff (the ones responsible for investment decisions) of American banks has been, there can be no doubt that the less money they have at their disposal, the better. And that means that stock buy-backs helped limit the malinvestments created during the housing bubble and that had by contrast Englund's anti-stock buy back views been prevalent, even greater malinvestments would have been made and even more value would have been lost.

Haggle To Fight Inflation

Venezuela's government has started to call on people to haggle more in order to bring down inflation (Hat tip Greg Mankiw), which has risen in Venezuela to 32.2%. Of course, this is better (as it at least do not create much more problems) than the Chavez regime's other method of legal price controls, but ultimately it won't solve the problem. To solve the problem, Chavez would have to reduce money creation, but it seems unlikely that they would want do that, as that would imply reduced government revenue.

Haggling was by the way explained in this scene from history's funniest movie, Monthy Python's Life of Brian.

Statistics In Disconnect With Reality

John McCain economic advisor Phil Gramm was generally mocked and condemned when he recently stated that there is no real recession in America and that Americans are simply experiencing a "mental recession", and then further added that Americans are "a nation of whiners".

Yet if you look at the official GDP numbers, Gramm does not seem to be off the mark, at least not with that "mental recession" part. John Berry on Bloomberg News predicts that the Q2 U.S. GDP number will show 2.5% growth. And while I think it will come in lower than that, it will likely be closer to 2.5% than 0%.

But exactly where do you see that growth? I mean, with employment, real wages and profits falling, that GDP number seems to be out of touch not just with the public's perception of their economic situation, but also with all other available information of the economy.

There are several explanations for this, but the most important one is the factor I discussed in detail here. John Berry notes that rising net exports will be the most important factor behind the predicted growth. But here we notice something very fishy. Trade data for June is not yet available, but the average trade deficit for April and May was $60.1 billion. By contrast, during January to March, the average trade deficit was $58.3 billion. Unless we assume a real dramatic decline in the trade deficit in June (which is highly unlikely), then we will thus see a significant increase in the trade deficit between the first and the second quarter. But rising net exports is by definition supposed to imply a lower trade deficit, and certainly not a higher trade deficit.

However, in the flawed way the Bureau of Economic Analysis calculate GDP, the actual trade deficit is irrelevant. Instead they assume that sharp increases in import prices do not lower purchasing power and calculate exports and imports by volume. And according to that methodology, the average trade deficit for April and May was just $45.1 billion, down from $49.5 billion during January to March. That means that trade could add as much as 2 percentage points to GDP, even tough the actual trade deficit will be increasing!

This will again illustrate how flawed the current GDP methodology is, and it also explains the disconnect between GDP numbers and the economists who take them at face value, such as Phil Gramm, and the dismal economic reality that most Americans experience.

Krugman Gets It All Wrong

Paul Krugman accuses libertarians who fail to see the alleged advantages of health care socialism of being like robots in science fiction movies who when faced with information incompatible with the assumptions of their programming simply says "does not compute".

I've dealt with the issue of health care systems extensively in the post "Myths & Facts About The American Health Care System", where I indirectly deal with Krugman's arguments. I will this time apart from linking to that post, comment on Krugman's obsession with the relative cost of health care in America to European systems.

As Bryan Caplan notes (See also Mark Perry on this issue), Singapore's health care system is arguably even more free market oriented than America's, yet health care costs are only about a quarter of America's- And it is less than half of any European system's. The same thing goes for Hong Kong's system. Neither Hong Kong's or Singapore's systems are pure free market, but neither are America's and their systems are at least and arguably more free market than America's. How does then the fact that their health care systems cost less than half of the European systems compute with Krugman's assertion "The basic facts on health care are clear: government-run insurance is more efficient than private insurance"?

As safely as California's cyborg governor can be trusted to say "I'll be back", Krugman's supporters can be trusted to simply think and say "that does not compute" when confronted with these facts....

Paul Krugman Gets It Almost Right

Paul Krugman has a blog post whose message is in many ways very similar to my post "short- and long-term price elasticity", except he illustrates the message with a supply- and demand diagram.

The one thing I would object to in his post is the fact that he only draws a distinction between short- and long-term effect on demand, while assuming a completely inelastic supply, or in other words a vertical supply curve. While that may be if not completely true, then at least approximately true in the short run, it is simply not true at all in the long term. Although Krugman's favorite politicians in the Democratic Party greatly limit through environmentalist regulations the possible domestic supply increase, the supply response in less environmentalist countries like Brazil is a lot stronger.

Moreover, the non-vertical nature of the long-term supply curve actually does not depend on whether we've reached "peak oil" or not. Even if that was actually true, and it would be impossible to increase supply compared to current levels, it would nevertheless be the case that higher oil prices would raise supply compared to what it would have been at lower prices. This is to say, if prices were lower then supply would have fallen faster, instead of being unchanged or falling slower. Which in terms of Krugman's diagram would have implied a upward sloping long-term supply curve, with a "P3" price below and to the right (implying a higher quantity) of P2.

How Much Further Does House Prices Have To Fall?

A question many people ask at this point is how much further does U.S. housing bust have to go before it bottoms? If we look at residential investment spending, it has already fallen from its historical peak of 6.3% of GDP during the second half of 2005 to 3.8% during Q1 2008, a number which will surely fall further during the second quarter. This also means that it is already below its 1980-2000 average of 4.3% of GDP. However, during previous recessions in 1982 and 1991, residential investments fell as low as 3.2% and 3.4%, and with the greater inventory overhand, it is likely to fall below that level this time.

Perhaps even more interesting than how much further the residential construction sector has to fall is how much further house prices have to fall. Further significant decline in house prices could threaten not just the 3-4% of GDP constituted by residential construction, but also threaten consumer spending, not to mention bank stability.

There are of course different ways to assess just how much house prices have risen, and therefore implicitly how much they might have to fall to once again make them reasonable and sustainable. Since there are two competing price indexes, OFHEO and Case-Schiller and since they diverge significantly, one has to first decide which one of them to use. As I've written before, OFHEO probably understated both the increase during the boom and the decline during the bust while on the other hand Case-Schiller likely overstated the increase during the boom and the decline during the bust. Because however I think the OFHEO index is probably somewhat closer to the truth and because the net worth statistics issued by the Fed is based on it, I will use OFHEO.

One is to look at nominal house prices, but I would argue that this is misleading because of the significant general price inflation and the significant increase in nominal income levels.

My favourite indicator is instead house values to disposable income, which I used in the mises.org article from November 2004 when I predicted the current bust. I then pointed out that historically, housing values have tended to fluctuate between 135% and 150% of disposable income, but that the value during Q2 2004 (the latest number available during that writing) had risen to 184%. I now see that the values have been retroactively upwardly revised somewhat, but it still wasn't higher than roughly 188% with the current data, with the historical range being more like 138 to 153%. It was 183% in Q4 2003 and 192% in Q4 2004. It reached a historical peak of 206% during 2006. Starting late 2006, and continuing at an accelerating rate during 2007 and 2008, this number has now started to dive. Even so, during the latest available quarter (Q1 2008), it was still as high as 188%, which is to say it have fallen back to the level of Q2 2004.

In order to get back within the historical range, house prices will have to fall at least 19% relative disposable income. And were house prices to fall to the lower end of the historical range, then they would fall some 27% relative to disposable income. Compare this with the mere 9% relative decline from the peak we have seen so far. Or saw until Q1 2008. Using the likely Q2 2008 numbers, more of the needed decline will have been done away with (even excluding the temporary boost to disposable income from the tax rebates). But even so, it is clear that house prices will have to fall a lot more in relative terms to get reasonable and that most of the decline is ahead of us.

It might be argued that because interest rates are so low now, prices won't have to fall as much. Well, that will probably prevent a decline to the lower end of the range, but given the loss of confidence in housing, a return to at least the higher end of the range seems likely. That will not mean a 19% nominal decline if nominal income continues to grow, but the decline in relative value will still imply a decline in what should matter for saving decisions, real wealth.

This picture would probably not be very different even using Case-Schiller. The reason for this is that while the decline so far have been greater using the Case-Schiller index, the initial boom was also greater, meaning that a much greater decline now would be motivated if Case-Schiller would have been used.

4 Different Austrian Money Supply Definitions

I have during several occassions (see for example here, here,here, here and here) discussed the issue of the definition of the money supply. This issue may seem technical and uninteresting to some, but because money supply play such a key role in Austrian economic analysis it is nevertheless important. The purpose of this post is however not to discuss that issue again (those interested are recommended to re-read the linked posts) but rather to highlight that there aren't just two different money supply definitions, there are actually at least four different money supply definitions used by Austrians.

The previous posts discussed the issue as basically being MZM versus Frank Shostak's definition, yet it should be noted that two other definitions are used. Gary North appears to still favor M1, and recently the Mises Institute has started to post a definition they call TMS ("True" Money Supply). Regarding TMS some confusion has appeared, both because of the presentation on the Mises Institute web page and Frank Shostak's use of TMS to refer to his own definition. In the presentation, Shostak's article about the money supply is referenced and because of that and because of Shostak's use of the word TMS, one can get the impression that TMS is identical to Shostak's definition. However, as was noted in this comment thread on this blog and as Shostak follower Mike Shedlock also has noted, the TMS published by the Mises Institute is not identical to Shostak's definition, as TMS includes saving deposits while Shostak argued against including them, a view that he still appears to hold judging by his numbers.

Britain's Fragile Economy

Matthew Lynn has a very interesting column about why Britain's economic fundamentals are very weak and why the economy faces a significant downturn. He names four factors: The tax increases implemented by the Labour government has eroded British competitiveness, the high budget deficit which will disable it from cutting taxes, the too low level of savings and too high level of debt and the policy of increasing the dependency on financial services and reducing the dependency on oil production (the latter might have been good during other time periods, but with the financial downturn and skyhigh oil prices, it is not good now).

And with inflation being significantly above the 2% target, the Bank of England has no room to reduce interest rates further.

U.S. Consumer Price Inflation Rise To 5%

Sometimes, strange things happen. It seems that I was actually too bullish on inflation. I wrote yesterday that I didn't think that U.S. consumer price inflation would rise above 5% until July. But it actually rose to, or actually marginally above, 5% (5.02% to be more precise) already during June.

According to Bloomberg News, this was the highest yearly increase since 1991. Actually, though, inflation is probably worse now than it was then because that was before the Boskin commission recommended and got implemented various manipulations of the CPI in order to make the increases smaller than the raw numbers suggest. While this new methodology is applied on current data, it has not been used to retroactively adjust old numbers, meaning that comparisons of 1991 data and 2008 data is a case of comparing apples and oranges. Note that this fact does not rest on the view that the Boskin changes were illegitimate. If you think they weren't legitimate then current inflation is really higher than the numbers suggest. If you on the other hand think they were legitimate then inflation in 1991 was really lower than the inflation numbers suggested. Regardless of what you think on this matter, however, current inflation is in a relative sense underestimated compared to 1991 inflation. This in turn means that inflation now is probably higher than at any time in 1990 or 1991, and that you would have to back to the early 1980s or the 1970s for worse levels of price inflation.

Yearly inflation will likely continue to rise during July and August. What happens then is less certain, but even if it falls back from the high in August, it is likely to stay above 5% for the rest of the year.

GM Was Paying Dividends?

GM today announced that they will fire a lot more workers while selling assets and suspending dividends to improve its cash flow. Well, that clearly seems like the right things to do given its dire financial situation.

What amazes me is that GM was actually paying out dividends in the first place. GM has been in a crisis and making losses for several years now, so paying out dividends until now were highly irresponsible. I know there is a case for keeping dividends stable and not cutting them directly when profits fall or disappear temporarily, but given how long GM have been making losses, this decision to suspend dividends should have come a lot sooner. GM management appears to have had until now the same curious definition of "temporary" as the ECB board.

PPI Rise Most Since 1981

The Producer Price Index for finished goods in America rose another 1.8% in June, after rising 1.4% in May. As a result, the year over year increase rose to 9.2%, the highest since June 1981.

Meanwhile, the price indexes for intermediate and crude goods rose 14.5% and 45.5% respectively, indicating more inflation in "the pipeline".

This follows Friday's report that import prices are up 20.5% and export prices up 8.6%. Tomorrow's CPI are likely to show much lower rate of increases for three reasons: 1) The CPI is even more adjusted (hedonics etc.) in various ways to lower its increase 2) The CPI consists to a large extent of services whose price increases likely have accelerated less 3) Many retailers are likely reducing their margins to attract customers in today's weak economy. Even so, the CPI will likely also accelerate its increase, and although the rate of increase will likely stay below 5% in June, it will rise above 5% by August at latest and probably as soon as July.

About Freddie-Fannie Bailout

As most of my readers have probably already heard, the U.S. government has offered a bailout of mortgage agencies Freddie Mac and Fannie Mae.

I always believed that the U.S. federal government would do anything to stop them from collapsing, and this is of course exactly what they're doing. Seemingly surprisingly was the offer from the Treasury department to buy their shares. That would seemingly contradict my view that shareholder's equity will be wiped out (or reduced to some symbolic sum like in the Bear Stearns bailout.) in such a deal. While there is a small chance that this will be the end of it, and that this intervention will save the day for the shareholders, that is similar to the small chance that a lottery ticket you buy will give you a large sum of money.

The reason for this, as most stock investors seemed to realize given today's decline in Freddie's and Fannie's stocks, this bailout will require a lot more taxpayer cash in order to be successful. And it will likely be politically impossible to bail out the shareholders of Fannie and Freddie. Bailing out bond investors will appear controversial enough.

Go Bush, Go!

I am not a Bush-supporter in general, and some libertarians might object to this move on procedural terms (worrying about a what they believe is a "power grab" by the executive branch of government), but still, I must applaud the decision by President Bush to sign an excutive order lifting the ban on offshore drilling. I am not an expert on U.S. law, so I am not sure what possibilities the Democratic Congress have to reimpose the ban, but I hope they won't succeed. While this won't be enough to bring down fuel costs to a more reasonable level, it will certainly help.

I should also mention that John McCain, who I've previously criticized for siding with the Democrats on this issue, have actually flip-flopped (flip-flopps aren't always bad as this case illustrates) on this issue to the right side and now supports offshore drilling. While I still have serious reservations about McCain and certainly don't like him per se, that is another reason for believing he is a lesser evil than Obama, who denounced the decision to allow offshore drilling.

UPDATE: Having looked into it, it seems that this executive order only repeals the previous executive order imposed by his father in 1990. A Congressional decision will still be needed for it to become law, and that unfortunately looks very unlikely given the current Democratic majority.

This means that the ban will remain effectively in place, which in turn means that fuel prices will remain hig.

U.S. Stocks To Recover?

Greg Mankiw notes that newsletter pessimism have reached the highest level since June 1994 and also notes that June 1994 was a very good time to buy (The great tech stock bubble started in 1995). Confirming this, my good friend Daniel Halvarsson's favorite indicator, bullish percent, also shows that stocks are oversold right now, with the bullish percent falling to 27, below the 30 threshold for oversold.

Thus, a short-term recovery in stocks after the 14% decline since May 19 seems likely soon. With the worries created by Fannie Mae's & Freddie Mac's problems and the collapse of IndyMac, stocks may fall on Monday and perhaps a few days more, but a temporary bottom and following rally nevertheless seem near. However, because stocks are still fundamentally overvalued and because the underlying economic fundamentals are deteriorating, this rally will likely be another sucker rally. And with money supply growth showing signs of decelerating and with virtually all of it going into bidding up commodity and other goods prices, this sucker rally will likely be weaker and shorter than the one that started in Mid-March.

Bob Murphy On My Speculator Article

I now see that Bob Murphy commented my LRC article on speculators and oil on the "Crash Landing blog".

There seems to be two problems he had with my article. The first was his assert was with my argument that speculators can lower as well as raise futures prices depending on whether they have a net short or long position. He then presents a long argument involving speculation that Iranian president Abema-dinobots [?!?] meeting with an "accident" in June 2009, something which raise the futures price from $145 to $350. Then he says that some speculators who believe the "accident" with Abema-dinobots will only raise it to $300 will at that point take short positions, and that this proves speculators can move prices in one direction even if some take positions in the opposite direction.

But this mixes up the categories. Sure there can be speculators who want to short at such a position even as speculators move it up. But what this will do is not to eliminate the net long position of speculators but to expand the number of contracts. But the increase in the number of contracts will not change the fact that speculators have net long positions while traditional hedgers have net short positions.

In the end he writes:
"
One final thing: In his defense, maybe Karlsson had the following in mind. Suppose we are at an initial equilibrium, where a futures price is determined only by traditional hedgers, such as oil companies and airlines. Now a bunch of speculators come on the scene. If their activity leads to a higher futures price, then that will cause the original hedgers (the fundamental traders) to become net short, as they "export" some of their contracts to the Nation of Speculators. But that means the Nation of Speculators must be net long.

And vice versa is true: If the Nation of Speculators ends up causing a financial-world (i.e. market) futures price to be lower than it would be without trade with the speculators, then the Nation of Hedgers will import futures contracts from them at their cheaper price, and become net long. That means the Nation of Speculators is net short.

OK I guess I will give Karlsson the benefit of the doubt, and assume this is what he had in mind."

Yeah, that's exactly what I had in mind, and I don't think I wrote anything different, so I don't see what the fuss is about.

As for his other point, that futures prices can move spot prices, let's say in the aforementioned scenario with Abema-dinobots' "accident" that the accident won't occur. Well, then at a price of $300 or $350, the price will be far too high. A massive surplus will then occur, and unless speculators are willing to accumulate massive inventories, they will lose big as they will be forced to sell at the goods market equilibrium of $145, the same it would have been without the Abema-dinobot speculation. If on the other hand Abema-dinobot really meets with the "accident" and this "accident" really does result in massive supply disruptions, then the goods market equilibrium will move to $300-$350, and the speculators will be vindicated. But this movement would have occurred even if the speculation hadn't taken place, and so again speculators won't raise the price.

The only way in which this could have effect on the price would be if either speculators start to accumulate physical inventories or if it makes producers, wholesalers or retailers start to accumulate inventories (or in the case of producers, cut back production temporarily) in anticipation of such an event. Then it would raise current prices while lowering the price in June 2009. However, this would only imply a temporal shift in price and not a permanent increase and it doesn't change the fact that only speculation in physical inventories can affect the spot price, not pure futures price speculation.

The Failure Of (Non-Austrian) Economics

Via Anthony Mueller's Continental Economics Blog I see the following interesting column by Simon Jenkins, where he like John McCain indicts [the majority of] economists for their failure to predict the current problems.

"When I studied economics we were told we would be masters of the universe. Ours was not a dismal but a noble science. It had harnessed the verities of maths to those of human behaviour and would go on to conquer politics. Rampant recession would go the way of hyperinflation. Like leprosy and cholera, they were epidemics that modern medicine had rid from our shores."

And then he goes one to describe to how economists have failed in this, whereupon he concludes that economics is not a science and that ultimately political considerations should determine economic policy.

I agree with some of this. Certainly neoclassical economists have failed miserably in trying to predict the economy, "despite" their allegedly "scientific" approach of expressing economic theories in the forms of Greek letters analyzed through Lagrange multipliers. And certainly, human behavior and therefore economic aggregates doesn't
really function that way and so attempts to do it will fail.

And I also agree that there is more to political decision making than economics. Economics can only describe what outcomes will follow if you follow certain policies. It doesn't say anything whether those outcomes are desirable or not.

However, I would disagree in his view that economics should be entirely dismissed from economic decision making. Because he believes, based on the failure of neoclassical economics, that economics can't describe the consequences of various policies. Yet even neoclassical economics can sometimes do that, even if they for ridiculous reasons express it in terms of Greek letters. And Austrian economists can usually describe the consequences of various policies.

In short: the current crisis does indeed expose the shortcomings of neoclassical economics. But that shouldn't be taken as a pretext to reject all economics, considering that there has been one school of economics who have predicted the current mess.

Fannie Mae, Freddie Mac's Pains-Jim Rogers' Gains

Led by Alcoa, U.S. stock indexes, recovered somewhat today. Two stocks that didn't recover where those of the quasi-governmental mortgage agencies Freddie Mac and Fannie Mae, who are down 88% and 80% respectively from their 52 week highs. The probability that these half-state/half-private hybrids will go bankrupt seems to be increasing. Of course, the government will never allow them to completely collapse. However, there is a risk that any bailout will mean that shareholder's equity will be wiped out, which is why it is rational for investors to stay away from the stocks.

One who is making big money from this is libertarian investment super star Jim Rogers. I told you last year how he was making big money from selling short Fannie Mae, which had fallen from roughly $60 per share to $30. Now Fannie Mae is trading at $13 per share. I don't know how big amounts he was selling short, but it seems likely he made sizeable profits from his, just as he did with his bets on rising commodity prices.

Here is an interesting interview where he discusses among other things, his emigration to Singapore, the future of Asia and America and the oil market. He also reveals a great gain in the personal area in the form of him and his wife having a second daughter. He also predicts the end of the Federal Reserve, an area where I am not as optimistic. Just because it causes disasters won't make it disappear. The Fed didn't disappear after the Depression, just as the Zimbabwean central bank hasn't disappeared. In order for that to happen, there must be widespread awareness of the role of the central bank in creating the problem, something which is not present now.

I also note that he is still waiting for the dollar sucker's rally that he has been waiting for since late last year for the purpose of getting rid of the rest of his U.S. dollar assets, a time during which the dollar has dropped significantly against most currencies. So even if there is another sucker's rally he is likely to lose from waiting. But that just illustrates his old self-admitted characteristic of being a terrible short-term trader (at one time he even said he was "the worst trader in the world"), even as his extraordinary skills in analyzing the fundamentals that create long-term trends make him one of the best investors in the world.

It's Official: S&P 500 In Bear Market

The key S&P 500 index tonight closed at 1244.69. That's down 20.5% from its October 9, 2007 closing peak of 1565.15. This in turn means that it meets the official definition of a bear market, which is to say that it has to be down 20% or more from its peak. One can of course question why the figure 20% was chosen and why they're measuring in nominal rather real dollars (with the CPI being 4% higher than in October 2007, the real decline is even greater, closer to 23.5%), but even so it is certainly noteworthy that the decline is so great that this generally used definition is met.

Slovakia Euro Entry Might Make ECB More Hawkish

Slovakia was recently formally invited to become the 16th member of the euro area in 2009. Slovakia is thus the fourth of the countries that joined the EU in 2004 to join the euro area (Slovenia joined in 2007, Malta and Cyprus in 2008).

One effect of this might be to make the ECB more hawkish. This is for two reasons. One is that if Slovakia is included then average growth and and therefore also inflation (because of the Balassa-Samuelsson effect) will increase, which means that the ECB will have to push interest rates higher to reach the inflation target, while feeling less pressure to ignore it for short-term growth considerations. The second reason is highlighted today by the Wall Street Journal, namely that the Slovakian central bank governor Ivan Sramko, who will join the ECB governing council, is considered to have relatively hawkish views on monetary policy.

Alcoa Report Shows Strong Inflationary Pressures

Wall Street seems pleased by Alcoa's report, because while it showed declining profits(-24%) , the decline was lower than expected. Yet as this article notes, one thing that shouldn't please them is that the report showed strong inflationary pressures. Alcoa reported that higher input prices took a big bite out of its profits, but that this was largely compensated by the fact that they were able to raise the prices they charge from their customers. That is price inflation in action.

The G8 Political Nonsense

Again we see a case where you wonder whether politicians are really stupid or whether they're just liars and con-artists. I personally think it may be a little bit of both.

First the G8 say that they're worried about rising prices for energy and food commodities. Completely ignoring of course how it is their governments' policies which have created these problems in the first place, by massive central bank inflation, by preventing drilling (See Joseph Farah's column on this) and subsidizing ethanol.

Then they say that global carbon dioxide emissions should be reduced by 50% until 2050. Making this kind of pledge for 2050, a year when none of these leaders are going to be in office and most are in fact likely to be dead, is very easy of course. It is also nonsensical since they won't personally be in anyway accountable for it. They might as well have pledged to cut it by 99% by the year 2550.

And more importantly, there is simply no way this goal can actually be reached, unless 1) Some new really revolutionary technology suddenly appears 2) We see a massive increase in global poverty 3) Billions of people are eliminated.

While alternative number 1 is by all means desirable, it seems highly unlikely, which leaves with alternative number 2 and 3, both of which I find highly undesirable. And not only should it be seen as highly undesirable for any sane person, it also contradicts their first point. Why complain if higher food prices lead to starvation? Fewer people mean less carbon dioxide emissions! And why complain if higher transportation costs leads to an economic downturn? An economic downturn reduces carbon dioxide emissions!

The whole reason why the high prices of energy and food is a problem is the same reason as to why the goal of reduced carbon dioxide emissions (given the absence of some implausible technological breakthrough) is not sound: it will lead to less human well being.

Short- And Long Term Price Elasticity

One issue related to the issue of the high price of oil is how sensitive, or elastic to use economese, the supply and demand is to price changes. One argument against the "inventory argument" against speculation as the source of higher oil prices is that if both supply and demand is completely inelastic, then higher prices due to speculation will not create higher inventories. Well, yeah if it is completely inelastic then that would be true. But notice the very big emphasis on if. And particularly with regard to demand that is highly unrealistic. If gasoline is $4 per gallon (one gallon is slightly less than 4 liter, so this is equivalent to $1 per liter), then a lot of trips that would have been made with gasoline at $1 per gallon will be cancelled. Meanwhile, as car makers are now noticing, the high price of gasoline is causing a sharp decline in car sales in general and the sale of SUVs in particular. Also, this is likely to encourage the ethanol boom further. So there is certainly every reason to believe that although the short term price elasticity may not be high, it is definitely not completely inelastic. This in turn means that if speculation were a factor, then inventories would have been rising, which they haven't.

It should however be noted that there is every reason to believe that long term price elasticity is higher than short term price elasticity. Although people will respond to a dramatic price hike by canceling leisure related trips or other discretionary trips, they may find it difficult to switch their SUV to a more fuel efficient car overnight, particularly as the value of that SUV is falling on the secondary market. Moreover, although some will switch to public transportation to work, others will find that more difficult. But as time goes by, SUVs are going to get increasingly rare as the new car market will increasingly consist of fuel efficient cars. Moreover, the higher fuel price will increase demand for public transportation and so create new routes and enable more commuters to stop driving their car for work. And also, the higher price of fuel is likely to encourage more people to find jobs closer to their homes.

For all of these reasons, the long term effect on demand is likely to be much higher than the short term effect. It is not just monetary policy that works with time lags, commodity markets also have time lags. This difference in elasticity in the short term and long term is likely to be even higher on the supply side of the market. If oil prices suddenly surge, producers can only respond with higher supply if spare capacity exist. To the extent there is no spare capacity, then supply is in fact inelastic in the short term. However, things are different with regard to the long term. The higher price of oil will encourage producers to explore more, and will also encourage them to drill for known resources. It will take years before these factors will bring out oil to the world market, but eventually it will happen. This means that long term price elasticity for supply could be quite high, even if it is very low in the short term.

This is essentially the explanation for why commodity markets tend to move in cycles.
First you have a boom cycle where there is shortage, which due to the low (but not nonexistent) short term price elasticity will create significant price booms, booms that will last for several years. But then once people switched to more fuel efficient alternatives while at the same time all the new fields get operational, then suddenly there will be excess capacity and prices will fall back significantly. That will however once again encourage people to use more fuel and discourage new exploration and drilling, which eventually after a few more years could create yet another cycle characterized by shortages. And so on and so forth.

Riksbank, ECB Raise Interest Rates

Yesterday both the Swedish Riksbank and the ECB raised interest rates by 25 basis points, to 4.5% and 4.25%, respectively.

However, they differed in the tone of the statements accompanying the hikes. Although the ECB's statement wasn't as dovish as many financial journalists tried to make us believe, they certainly did not commit themselves to further hikes. As this hike is really too little, too late to prevent inflation from getting worse in the near future, they might still feel compelled to do it again. However, that is far from certain as the ECB have a track record of ignoring its inflation target, always blaming this on "temporary" (normally you don't call things that happens every year "temporary") factors and falsely predicting that inflation will soon fall below the target.

By contrast, the Riksbank was quite hawkish, signaling not just one but two more hikes later this year. This is not likely to be enough either, but clearly it indicates that it takes its inflation target more seriously than the ECB. Not that this is necessarily a good thing. As I described in my recent Timbro report, the root cause of today's problems in the Swedish economy is that the Riksbank took its target far too seriously back in 2005, when it reduced interest rates to as low as 1.5%, in order to push up inflation. The problems with high debt levels and high inflation is what we are seeing now, and it seems unlikely that the Riksbank will be able to push back the inflation created by its previous policy to its target anytime soon without pushing the Swedish economy into a recession.

Natural Limit To Inflation

In one of his interviews recently, investment superstar Jim Rogers, said something which I thought was quite funny. When explaining why he thought everyone should aviod U.S. dollar-denominated assets, he said it was because Bernanke is a crazed inflationist and that "he's gonna print money until he runs out of trees".

Again, I thought that was quite funny and figuratively speaking that is largely true, although it is not likely true in a literal sense. Shortage of trees is unlikely to be an obstacle for Bernanke because first of all most money in America is deposit money rather than paper money, secondly because there are quite a lot of trees available in the world and thirdly because he could always add more zeroes on the notes in the unlikely event such a shortage would occur.

Now, it seems that Zimbabwe's hyperinflation (currently at least 165,000%, with some arguing that it could be as high as a million %) could possibly be contained by a shortage of physical paper. The German company which has so far supplied the Mugabe regime with the paper they need for the money they print, now says it will stop these shipments. So unless the Mugabe regime quickly finds some other supplier, shortage of paper could actually be what stops Zimbabwe's hyperinflation. While Bernanke won't be stopped by shortage of trees and paper, another even more extreme inflationist could be stopped by that.

Sucker Rally Wiped Out

Yesterday, the S&P 500 index closed at 1261.52. Not only does this imply a decline of more than 10% since I called for a decline in the index on May 20, as this is a new record low close for the year, this means that the entire sucker rally that we've seen since March 17 (when it closed at 1276.6) has been wiped out.

Part of the reason for this sell-off is the continued increase in the price of oil, which reached yet another all time high this morning as a higher oil price hurts most companies. And at the same time the potential gains fro the companies that do benefit from a higher price, namely the oil companies, are limited by the fact that their likely record earnings are going to provoke a new windfall profits tax if and when Barack Obama is elected president, while the Democrats increase their Congressional majority.

It should further be noted that this stock market decline happens at the same time as commodity price indexes reach new all-time highs, confirming the stagflationist scenario.

ISM Price Index Highest Since 1979

Although the markets interpreted the latest ISM Manufacturing report as bullish news because the headline index rose above the key 50 level, the details were more bearish. Both production and new orders were basically flat and employment turned more negative. And even more importantly, the prices paid index rose to a full 91.5, the highest since July 1979. Yeah, that's right, this price indicator signals the worst inflationary pressures since before Paul Volcker broke the back of the great inflation of the 1970s. While one should take the exact levels of these kind of survey based numbers with a grain of salt, this is consistent with the sharp increase in market price numbers we've seen and so clearly indicates very strong inflationary pressures.

Frank Shostak's Confused Analysis

Frank Shostak today had an article on mises.org that was confused even by his standards. I don't have the time or will to correct all of his errors, but I'll discuss the two most important.

He for example asserts that "It is not possible for increases in the price of oil to set in motion a general increase in the prices of goods and services without corresponding support from the money supply."

But this overlooks the question as to just how this oil price increase happened in the first place if it wasn't caused by a higher money supply. Presumably, such an autonomous increase in the price of oil would be caused by falling supply for the home market (either in the form of falling total oil production or increase in foreign demand, which in the latter case means that the available global oil supply is diverted to foreign bidders). And since that falling supply of oil isn't cancelled out by any increase in the supply of other goods and services, this means the total supply of goods and services will fall. Lower supply of goods and services will given a certain money supply always raise the average price level.

Shostak's insistence on ignoring non-monetary factors is all the more puzzling since his money supply definition asserts that money supply have been stagnant since late 2004. While monetary factors usually tend to work with a time lag, the time lag is growing implausible long for Shostak to be able to explain the doubling of the oil price and general acceleration of price inflation with monetary inflation. This in turn implies that either his money supply definition is wrong or his analysis of the connection between money supply and prices is wrong. Or as a more likely third alternative, both of his theories are wrong.

Ukraine Use Currency Appreciation To Curb Price Inflation

I recently told you about the alarming increase in price inflation in Ukraine, which risked sending the country into a hyperinflationary spiral.

It now seems that the National Bank of Ukraine have started to notice and deal with the threat. Interest rates have been raised and money supply growth slowed. However, real interest rates are still very much negative and money supply growth at 50% year over year (down from 54% in January) is still way too high. The most important tool instead appears that it has finally allowed the Ukrainian currency, the hryvnia, to appreciate. If you look at this graph, you can see that the hryvnia was basically flat against the U.S. dollar until just a few months ago at roughly 5 hryvnia per U.S. dollar. But since April, the hryvnia is up about 10% so that a U.S. dollar now only cost about 4.5 hryvnia to buy a U.S. dollar.



The problem is of course that this appreciation combined with the high inflation rate means a massive real appreciation of the hryvnia, which in turn will further aggravate another problem, namely Ukraine's massive current account deficit of over 10% of GDP. That is why the central bank should focus on other measures to restrain money supply growth. Still, intervening to suppress the exchange rate would have of course have fueled monetary expansion, so permitting the currency to appreciate is still a good thing in itself. Especially since the prevention of a hyperinflationary spiral is of greater importance than containing the current account deficit.