The Cause Of The Weak 2001-07 Recovery

Via Barry Ritholtz I see this NYT article about how the 2001 to 2007 expansion was the weakest expansion on record, at least in terms of average annual growth. If you consider its length it was greater than some previous expansions (such as the very short-lived expansions from July 1980 to July 1981 and from April 1958 to April 1960), but still one of the weaker.

What was the cause of this? The NYT journalist, Floyd Norris mentions one of the explanations, namely that the 2001 recession was so short and mild and that the weak recovery was in part a pay-back for this. However, he argues that this can only explain some of it since the expansion even including the previous recession was slower than previous ones. However, what he fails to consider was that the 2001 recession really should have been a relatively severe one, since it came after a massive tech stock bubble had been deflated and large imbalances had been accumulated. Normally, when you see bubbles like that you have sharp downturns afterwards. But because Greenspan quickly inflated a housing bubble by cutting interest rates from 6.5% to 1.75% in less than a year the recession was shallow.

The payback for this came in two forms. Both in the relatively slow boom between 2001 and 2007 and in the new recession that most likely started in November 2007 (I see that like me, Norris dates the end of the peak of the boom to October 2007)

Foreign Central Bank Dollar Purchases Continue To Accelerate

I recently reported that foreign central bank purchases of dollar assets, which as we shall see mean Treasuries more specifically, have accelerated recently. This trend continues according to the latest numbers.

In the week ending June 26, the year over year increase in dollar assets held by the Fed on behalf of foreign central banks was $347 billion. As I reported the last time, that increase had accelerated to $389 billion by the week ending August 6. Yesterday it was reported that this increase had accelerated to $426 billion in the week ending August 27. Add to this the original increase of nearly $30 billion per month, and foreign central banks are now financing the entire U.S. trade deficit and more. While this is not the only reason for the dollar rally, it is certainly one of the more important ones.

It is interesting to note that the entire acceleration in dollar asset is in Treasuries. In the week ending June 26, the increase in Agency debt (meaning Government Sponsored Enterprises like Freddie and Fannie) was $225 billion, a number that in the week ending August 27 had fallen to $197 billion. By contrast, the increase in holdings of Treasuries had accelerated from $122 billion to $229 billion. This is something that would explain the widening yield gap between Treasuries and Agency debt.

Foreign central banks sure seem to like Treasuries. With that kind of demand from other governments, the U.S. government is having no problem in financing its deficit. As long as this demand continues, the dollar will also likely remain strong. When that demand wanes, however, the dollar will likely fall again.

The Hawk Still Flies

Axel Weber, ECB's most prominent hawk recently said that interest rate cuts is out of the question, and that as soon as economic data becomes stronger, interest rates will in fact be raised.

The likely reason why he made these comments is that there seems again be increasing speculation in financial markets that the ECB will soon cut interest rates. Markets believed the same thing in the beginning of the year, but instead of a cutting rates, the ECB raised them. Again, the markets are likely to be proven wrong.

As it happens, these speculations are self-defeating. The recent decline in the euro's exchange rate and oil will likely have little effect on price inflation (with the weaker euro counteracting the effect of oil) while providing support for growth (with the weaker euro strengthening the effect of oil).

Weber's position is also the only one consistent with the ECB's mission. ECB has no mandate to try to provide short-term stimulus to the business cycle and is instead obliged to keep money supply growth below 4.5% and price inflation below 2%. With both money supply growth and price inflation being much higher than that, there is simply no room for interest rate cuts.

U.S. GDP Allegedly Up - National Income Down

Predictably, markets cheered the seemingly strong GDP report.

Nominal GDP growth was upwardly revised from 3.0% to 4.6%. At the same time, as the domestic product deflator was upwardly revised from 1.1% to 1.3% and the domestic purchases deflator was upwardly revised from 4.3% to 4.4%, this means that unadjusted growth was upwardly revised from 1.9% to 3.3%, and adjusted growth from -1.3% to 0.2%.

Yet what seemed to be ignored was that the report also said that corporate profits fell again-and this despite the fact that the BEA definition of profits is unaffected by write-downs. Overall corporate profits fell in nominal terms by an annual rate of 9.2% compared to the previous quarter and by 7% compared to Q2 2007. If you adjust for inflation, then we're talking about double digit declines in corporate profits.

And moreover, this number would have been even more dismal if it hadn't been for the rising profits from the foreign subsidiaries of American companies compared to the profits of the subsidiaries of foreign companies in America. The profits of domestic non-financial companies fell in nominal terms as much as 21.8% at an annual rate compared to the previous quarter and by 17,4% compared to Q2 2007. Adjusted for inflation, these declines are even larger.

The point about that is first of all is that it will likely cause companies to reduce their investments in the future. And the second point about that is that if there really was such a strong boom as the headline GDP figure claims and if profits fell so dramatically, then who is reaping the benefits of this alleged boom? Workers? No. While they at least enjoyed rising nominal income (+3.1%), real compensation of workers fell by 1.2%. Government? No. The budget deficit soared during the second quarter and increased even excluding the effect of the so-called tax rebates.

So, if all sectors -corporations, workers, government- of the American economy suffers from falling real income, then how could real GDP boom by more than 3%? There's something seriously wrong with that picture.

However, this discrepancy is not a mystery. In my post on the previous GDP report, I explained this mystery. First, there is the terms of trade effect, which accounts for almost the entire alleged GDP growth. Secondly, there is the statistical discrepancy effect. National income rose only 2.1% in nominal terms, compared to 4.6% for nominal GDP, despite the fact that factor income from abroad fell this quarter compared to the previous one. This was the fifth quarter in a row that national income increased less (decreased more) than nominal GNP. With inflation during the quarter running at 4.3%, real national income fell by more than 2%.

Some would perhaps argue that I am biased by assuming that the national income measure is more reliable than GDP. After all, this discrepancy could reflect an underestimation of national income as well as an overestimation of GDP. This is true, but given the other indicators available, both in other government reports, in private sector reports and reports of increasing economic discontent, it seems clear that the national income number better reflect economic reality.

Savings & Capital Gains

As a follow-up on yesterday's post on David Malpass idea that capital gains should count as savings, I will now explain exactly why the idea is mostly wrong.

You may have noticed that I wrote "mostly" wrong, and not simply wrong. There is a valid point in including shareholder's stake in retained corporate earnings. This is a factor which increases the fundamental value of the stocks that people hold (and thus would enable them to sell some of their shares and still own stocks with the same total value as before) and could thus perhaps just as much as dividends count as income. However, if we do this then we will no longer be talking about household savings as distinct from corporate savings. Instead, that number would measure the level of private sector savings.

A more consistent measure of household's savings as distinct from corporate savings would BTW subtract the money that people invest in newly issued shares from companies. Given the logic that retained earnings shouldn't count as household savings because the money stays within companies, then savings transferred from households to companies shouldn't count as household savings either.

What however should not count as household savings are capital gains that reflect pure asset price inflation. Which is to say, asset price increases not matched by increase in the fundamental value of the asset. Such price increases may benefit sellers, but they only do so at the expense of buyers. From the point of view of the overall economy, it could at best be described as a zero-sum game (it is a zero-sum game in a formal accounting sense. Taking the negative dynamic effects of asset price bubbles into effect it is however worse than that.

The implications of not making such a distinction are absurd if you think about it. If asset price inflation is a form of income and savings, then why not agree to simply double all asset prices each year? With total asset values in the tens of trillions of dollars, Americans could quit working and still enjoy a multifold increase in their current national income of roughly $12 trillion. Who needs hard work and thrift when all you need to do is to send a piece of paper between each other and claim that for each transaction its value has increased! It sounds absurd, and it is indeed absurd, but note that the "logic" in this hypothetical scheme is really no different from the logic of claiming (like for example David Malpass did) that increases in the price of internet stocks or houses unmatched by changes in the fundamental value of these assets constitute income and thus savings. The absurdity in my hypothetical scheme thus reflects the absurdity of claiming that asset price inflation adds to national income and savings.

Malpass Didn't Just Wreck Bear Stearns

Paul Krugman correctly points out that the illusion by many American households that capital gains should be treated as equivalent to savings wasn't as he puts it,"a delusion of the great unwashed", it was a doctrine promoted by the pro-Republican supply-side cheerleaders of the housing bubble. Most notable among these were David Malpass, known as chief economist at Bear Stearns, who repeatedly argued (see for example here)the case for treating capital gains as savings. The conclusions from this theory, and the rest of his analysis, were that there was nothing wrong with the housing boom or the American economy.

It was probably not coincidental that he was chief economist at Bear Stearns, a company whose fate is all too well known. The conclusions of his analysis, that there was nothing wrong with the housing boom, of course prepared the way for the decisions of Bear Stearns management and investment strategies to invest heavily in the U.S. housing market. This later led to the collapse of that company.

Moreover, as Malpass went out of his way to spread this message in interviews and op-ed columns and as this in turn led other pundits to spread that message, and as some probably acted on that analysis, this also contributed to lowering actual savings (although to be fair, his role in that respect was far more modest than his role in wrecking Bear Stearns).

Swedish Employment Growth Remains Strong

When reporting on the latest Swedish GDP number recently, I expressed doubts that growth was really as weak as the report claimed, and that it would likely be revised up later. The reason for that is that the number is inconsistent with many other indicators of economic activity. There are many other economists who share that view, including Sven-Arne Svensson, chief economist at Erik Penser Fondkommission.

One of the indicators which are inconsistent with the 0.2% adjusted growth number is employment. The number of employed persons rose 2% in the second quarter, with private sector employment growing 3.9%. Hours worked rose even more dramatically, although that is likely to a large extent a calendar effect.

Now, we could on the other hand expect productivity to fall for much the same reason as why employment rose. The Swedish centre-right government's policy of reducing income taxes for low and middle income workers combined with cuts in unemployment- and sick leave benefits have boosted labor supply among low and middle income workers. Combined with various targeted cuts in payroll taxes, this have significantly boosted labor supply and therefore also employment among low productivity workers. But the flip side of particularly strong employment growth among people with low productivity is to lower statistical productivity. For that reason, it seems likely that GDP is growing slower than employment.

Still, I find it implausible that the decline in productivity has been as large as the current numbers suggest. And while it is also possible that employment growth is overestimated, the most likely explanation (considering the other anomalies, including those mentioned by Sven-Arne Svensson) is that the preliminary GDP growth number was too low.

The Swedish economy is likely facing a downturn, but it seems unlikely that it started as soon as the second quarter this year.

How Russia Differs From The Other BRIC

Johan Schück writes (in Swedish) about how Russia differs from the other three BRIC, Brazil, India and China. While all four of these countries have experienced a significant upswing during the latest decade, their demographic future differs significantly. While
India is expected to see a 36% increase between 2005 and 2025 in its working age population, Brazil is expected to see a 20% increase and China is expected too see a roughly constant working age population, Russia is expected to see a 20% decline in its working age population.

This will mean that it will be far more difficult for Russia to regain its status as a significant economic power. With its large nuclear arsenal it will always be a military superpower, but it will be not become an economic superpower. Combine the demographic implosion with the fact that the commodity price boom is unlikely to last forever, this means that Russia's relative importance could actually decline, in contrast to the likely increased importance of the other BRIC.

Note that this does not just apply to Russia. Just about every Eastern European country experienced a collapse in birth rates in the early 1990s, due to the temporary hardship created by the mismanaged transformation of communist economies to market economies. The decline in birth rates in the early 1990s translates into a collapse in the number of people in their late teens and early twenties in the coming years, meaning that there will in coming years be a significant decline in the working age population in coming years.

And there is really nothing that could be done (except immigration from even poorer parts of the world, but that is not likely to be popular) to prevent this decline. Not for the reason Schück advances, namely the alleged impossibility of raising birth rates. Indeed, in recent years Russia has seen a significant upswing in its birth rate, a "baby boom" if you will, with many other Eastern European countries also seeing similar upswings as general economic conditions have improved and many countries offering great increases in economic incentives for people to have babies. Instead, the reason why this won't help in the coming years is that a higher number of new babies now won't translate into a higher working age population until about 18 to 20 years from now. So while this will help after 2025, it won't help before that.

The Effect Of Chinese Currency Appreciation On Inflation

In the Financial Times, Adam Posen and Arvind Subramanian argues that China should end its mercantilist exchange rate policy and allow the yuan to rise faster to contain inflation. I agree that such a move would indeed lower inflation in China. However, it won't work in what they call a global fight against (price) inflation.

Indeed, a stronger yuan is likely to raise, not reduce, inflation outside China. The first reason for this is that it will raise Chinese export prices, and the second reason is that it will make commodities cheaper in yuan terms and so raise their price.
The beneficial effect on the global economy of a stronger yuan thus doesn't lie in that it would lower inflation generally, but in that it would reduce the excess current account surplus in China and by extension also reduce the excess deficits of some other countries.

Financial Markets Explained Again

Back in January, I posted a youtube video of two British comedians, John Bird and John Fortune, who explained the subprime crisis in a (of course, being comedians...) humorous, but also surprisingly accurate way. While not giving the full story (in particular, not fully revealing the role of central banks, even though it was hinted in the end) about the current problems, it did accurately reflect some of the causes.

I just found another youtube video from the same comedians about finance. This one isn't fully as good as the first one in terms of either humor or accuracy, but it is still certainly good enough in both aspects to be worthy a post here. In this one, the problems of moral hazard, government deceit and incompetent (and therefore overpaid) bankers and many other issues are discussed. (I could only find a version which was texted in some Eastern European language, probably Czech (If I am mistaken about that, Czech readers are welcome to point it out. Anyway though, it shouldn't really matter)

Today's Quote

From Conference Board economist Ken Goldstein Regarding the sharp decline in Leading Economic Indicators in July:

"If there's a second-half recovery, it'll be the second half of 2009,"

My additional comment: Indeed. Or it might be the second half of 2010......

Housing Hardship Illustrated

Interesting story about the hardship created for some by the housing bubble that has recently bursted in Britain. Similar stories will likely be found in other countries with bursted housing bubbles.

Analyst Earnings Forecasts More Misleading Than Ever

Anyone who follows the corporate earnings forecasts by so-called professional analysts know that they are systematically too optimistic about the future, constantly forecasting at least 15% or so annual earnings growth. From a time to time that actually happens, but since anything near that is unsustainable in the long run, they usually end up being lower. Now Bloomberg reports that their forecasts have been more wrong than ever:

"The CHART OF THE DAY shows analysts correctly predicted results for 6.7 percent of the companies in the Standard & Poor's 500 Index that released second-quarter earnings, the fewest since Bloomberg began tracking the data in 1992...

....At the start of the year, profits at banks, brokers and insurance companies were projected to rise 22 percent in 2008, according to the average estimate of analysts surveyed by Bloomberg. They're now expected to decline 48 percent. Analysts forecast an 11 percent gain in retailer earnings when 2008 began, compared with an 11 percent drop now, according to data compiled by Bloomberg."

It should be again noted that although the divergence was unusually large this year, we've seen similar misses most quarters and years. The big question is, why does anyone trust these guys? Who hires them? It would be a lot cheaper for the banks to simply have a computer program that randomly chose earnings growth forecasts between 10 and 20% for selected industries. That would likely give about the same forecasts that we receive today.

China's Domestic Boom

Even while growth in Europe and Japan has stalled, there are some mayor global economies which haven't stalled-namely the so-called BRIC, which is to say Brazil, Russia, India and China. Of particular interest is China, not only because its economy is much larger than the others, but because particularly Brazil and Russia depend on China. Brazil and Russia are both large commodity exporters and as the commodity price boom ultimately depends on Chinese demand, this means that their prospects depend on China.

And so far, there is no evidence of any significant slowdown in the Chinese economy. While industrial production numbers for July, and likely even more so August, will be depressed by factory closings related to the Olympic Games, growth has hold up very well despite the downturn in America and slowdown in the EU and Japan. Indeed, as is illustrated in the figure below from The Economist, growth in domestic demand (particularly retail sales) have in fact accelerated significantly even while export growth has plummeted.

Not only has export growth decelerated sharply in yuan terms, but the trade surplus is declining in yuan terms even as nominal GDP growth has been roughly 20%, causing net exports to plummet as a percentage of GDP. But because of the higher growth in domestic demand, real GDP growth has fallen only slightly.

This shift in the focus of Chinese producers from exports to domestic demand is exactly what not only the Chinese economy, but the world economy as a whole need, and there are good reasons to believe it could continue.

Notw however how I wrote "could continue" and not "will continue". The reason for this is that there are some worrisome signs that Chinese officials do not understand the need for China to focus on boosting domestic demand, as the yuan's appreciation versus the U.S. dollar have stalled during the latest month, and as export tax rebates have increased for some exporters. While the stall in appreciation versus the U.S. dollar is not necessarily as worrisome as it seems in light of the dollar's rally (the yuan's overall trade weighted value has in fact because of this increased faster than earlier in the year) and while it is certainly understandable that Chinese officials are worried about job losses in export related industries, these moves are still not a good thing. It would be much better if they for example reduced taxes on domestic economic activities in order to create jobs there.

Despite this policy mistake, China still has a good chance of decoupling and making it with only a milder slowdown. Something which would also be positive for commodities and therefore also Brazil and Russia.

Gross & Net Flows

As I stated in the previous post, one reason why U.S. interest rates are low while the dollar recently has risen, is the fact that various mercantilist central banks and sovereign wealth funds have more money than ever and are stepping up their purchases of U.S. dollar assets to preserve their currency pegs versus the U.S. dollar.

There is evidence of this in the available data over how much securities the Fed holds on behalf of foreign central banks. In the year to June 25, these foreign central bank holdings increased $347 billion to $2,322 billion. $347 billion over a year means approximately $29 billion per month, which means that roughly half of the U.S. trade deficit was financed by these central bank purchases.

By August 6, foreign central bank holdings had increased to $2,396 billion, and the annual increase had increased to $389 billion. If you add translate that 6 week acceleration of $42 billion in monthly terms, $30 billion, and add this to the original $29 billion monthly accumulation, this means that foreign central banks went from covering half of the U.S. trade deficit to covering all of it.

While this wasn't the only factor behind the dollar rally, it was clearly a important reason. Steve Saville, according to Mike Shedlock, however disagrees, using arguments that indicate failure to understand currency markets.

"It should also be noted that the weekly volume on the foreign exchange market exceeds 10 TRILLION dollars, so it really makes no sense to assert that a $28B purchase could affect this market's trend so dramatically."

But what matters for exchange rate movements is not gross flows, but net flows. If banks both sell and buy $1 trillion, that will have no effect at all on exchange rates because the effects of the sales and purchases cancel each other out. If by contrast, you buy, and don't sell, $60 billion a month that will have a big impact on exchange rates because then prices will have to rise enough to convince net holders of $60 billion to "permanently" get rid of their USD assets. Whether that net number simply involves $60 billion of sellers, 0r $1.06 trillion of sellers and $1 trillion of buyers doesn't really matter. Exactly how big that price increase need to be vary somewhat depending on what the prevalent market psychology is, but given the tendency of some to be more eager to buy something when it rises in price, that could in some circumstances be big.

The empirical correlation is likely to be even weaker considering that there are always other important factors involved sometimes counteracting and sometimes reinforcing the effects of the interventions, but it should be clear that the ceteris paribus (other things being equal) net effect can sometimes be big. While, again, these accelerated central bank purchases of U.S. assets isn't the only factor explaining the market moves, it is clear that they are one of the factors involved.

Why Interest Rates Are So Low

Robert Higgs at the Independent Institute blog asks why interest rates are so low. This is a particularly interesting question with regard to Treasury bills which yield less than 2%.

The most straightforward and simplistic answer is that interest rates are low because the Fed says that they should be low. But this leaves out how they achieve this. Ultimately, if markets want higher interest rate then this requires an increased money supply.

There isn't one, but several explanations for this. During the Fed's initial rate cutting cycle between August 2007 and March 2008, the explanation for this was mainly increased money supply growth. In recent months, money supply growth has slowed, but interest rates remain low for Treasury bills and similar safe securities.

The reason why money supply growth has slowed is because the Fed doesn't target it. It targets interest rates. And if other factors put a downward pressure on interest rates, this means that money supply growth automatically slows.

Several factors have contributed to keeping interest rates low, despite falling money supply growth (or to be more technically correct for reasons described above, these factors have caused money supply growth to fall given the interest rates set by the Fed). One is increased risk aversion. This is evident in rising corporate bond yields, with Baa corporate bonds now yielding less than before the Fed's interest rate cuts started, implying sharply increasing risk spreads. Increased risk aversion, it should be noted, will at the same time contribute to higher interest rates on assets that are considered risky and to lower interest rates on assets that are considered safe (Because investors increase their demand for them), such as Treasury bills.

Falling asset values have also made many households and companies less willing to borrow and spend, also putting downward pressure on interest rates. On the other hand, the sharp increase in the budget deficit caused by the weak economy, the tax rebates, the bailout of banks and increased military spending have had the opposite effect.

Furthermore, the high oil prices have caused the size of Sovereign Wealth Funds to increase, which means increased demand for various forms of investments, including U.S. government bonds. This is particularly true for the Arab Gulf States who have a fixed exchange rate vs. the U.S. dollar and so must buy dollar assets to maintain this. The high growth of the foreign assets of the Chinese central bank has had similar effect.

Finally, it seems likely that inflationary expectations have fallen among investors, while an increasing number are also bullish on the dollar. Whether or not these expectations of future inflation and exchange rate movements will turn out to be true is irrelevant. What matters for demand for U.S. government securities are expectations. Lower inflationary expectations can be seen in the falling spread between nominal government securities and TIPS (Treasury Inflation Protected Securities), as TIPS yields have risen while nominal yields have been flat. There are reasons to take this indicator with a grain of salt, but it is also confirmed by the decline in the price of gold, the traditional inflation hedge.

Today's Joke

Q: Why is obesity a growing problem in Britain?
A: Because the Bank of England constantly increases the number of pounds people have!
:-)

Recommended Reading

Very interesting article in The New York Times about Nouriel Roubini. I don't agree with him on everything of course, particularly not his Keynesian leanings, but he is still one of the best economic analysts around, and his (and mine) bearishness has been vindicated by the latest year's events. Interesting aspect of the article is how it highlights the complete failure of the mathematical models used by most academic economists these days, and how these models was what prevented them from seeing what would happen.

Peter Schiff has written a really good article about how the recent dollar strength is very damaging to the world economy and prevents necessary adjustments. As you know, I doubt that this rally will last more than at most a few months, but the fact that it has started in the first place will cause significant damage.

Some excerpts:
"America does indeed pose a global threat, but not for the reasons these economists suppose. Foreign economies are suffering not because Americans have slowed their voracious spending, but because they are defaulting on hundreds of billions of dollars of existing loans underwritten by lenders around the world.

The conventional wisdom is that foreign economies depend on Americans to buy their exports. This is false. The global expansion of the past decade has created new demand everywhere, and people and businesses in all corners of the world are spending. However, in America, spending has largely been achieved through a massive vendor financing scheme. Foreign supplied credit has allowed Americans to continue buying, even while American income and savings have dropped. As this credit goes bad, the losses are landing on the bottom lines of foreign financial firms. In other words, the global pain is not resulting from American contraction but from having financed our preceding expansion. This is a critical distinction few have been able to make, and it is vital to appreciating the decoupling that has already occurred beneath the surface.

The current losses that banks in Europe and Asia are now suffering are real, but future losses can be avoided by suspending future lending to Americans. Shutting off this credit will of course torpedo the dollar, but that is precisely what must occur. By allowing the dollar to drop to its natural, unsupported level, not only will the American caboose be decoupled from the global gravy train, but the rest of the cars will move along the tracks much faster....

...Some foolishly believe that many of the world’s problems result from dollar weakness, and that pushing the dollar back up would be good for all. For example, since the weak dollar is contributing to the rise in oil prices, a stronger dollar should help bring prices down. However, if foreign governments weaken their own currencies to push the dollar up, they will simply succeed in bringing oil prices down for Americans. Oil prices will go up for their own citizens. This can’t be an attractive bargain for any European or Asian political leader."

The Effect Of Recent Market Movements On Monetary Policy

One rarely discussed aspect of recent market movements is how they will affect monetary policy makers. And even when they are discussed, the discussion is usually misleading. This is a real shame, because this aspect is important. Economic events are often connected to each other, and will frequently either be self-reinforcing or self-preventing.

The recent market movements that I am referring to means primarily the drop in the price of oil and other commodities and the dollar rally against the euro in particular. The effects that I will focus on are the effect on real growth and price inflation.

For the U.S., the effect will clearly be to lower inflation. This is primarily the effect of the lower commodity prices, but this effect will be reinforced by the stronger dollar which will also lower other import prices compared to where they would have been without the recent decline. Note however that this will in most cases not mean actual price declines. Instead it will mean that price hikes that otherwise would have been implemented will be cancelled. While non-fuel import prices have risen sharply, they have in fact risen a lot less than you would have expected them to given the magnitude of the previous dollar decline. Despite the fact that domestic inflation has often been quite high, export prices in China and many other countries have in fact fallen in terms of yuans and the respective domestic currency in other countries. So despite facing rising costs of both labor and commodities, exporters have in fact accepted to receive lower prices in terms of their domestic currencies.

The reason why they accepted this massive margin squeeze is likely that they expected the dollar to recover eventually and didn't in the meantime want to lose market share that could be difficult to recover. In the long run these low (in many cases negative) margins would have been unsustainable, and would force them to raise prices eventually, but now that the dollar is recovering they can maintain their current prices. So, while it stops further price increases, it won't mean price cuts in most cases.

Anyway though, the point is that this will clearly lower U.S. inflation compared to how it would have been otherwise. The effect on U.S. growth is more ambiguous. On the one hand, the lower price of imports and particularly oil imports will boost domestic purchasing power and therefore boost growth (at least properly measured growth). But on the other hand, the stronger dollar will likely hurt exports and also increase import competition and so put a stop to the reduction in the non-petroleum trade deficit. As the theoretical net effect is ambiguous, it is unclear whether the actual net effect of these counteracting forces will prove to be positive or negative. But at any rate, whatever net effect arise in either way it is likely to be very small, and can given the uncertainty of the direction be treated as nonexistent.

So for the U.S., the effect will be to lower inflation, while having no effect on growth. It should be clear that as the Fed tries to strike a balance between inflation and growth, the inflation-lowering effect will make the Fed more dovish, i.e. less eager to raise interest rates.

Turning to the euro area, the effects will be somewhat different. On the one hand, the recent market movements have a somewhat ambiguous effect on inflation. On the one hand, the decline in the price of oil and other commodities (which have been less dramatic in euro terms than dollar terms, but nevertheless significant) will lower inflation. On the other hand, the weak euro will lift non-commodity import prices relative to how they otherwise would have been (although for similar, but reversed reasons as the ones related in the American case, that may not mean actual price increases but cancelled price cuts). As the theoretical effect on price inflation is ambiguous, this also means that the actual empirical net effect will likely be little, which means that we can for practical purposes treat it as non-existent.

The effect on growth is however very much unambiguously to raise economic growth. Because the euro area, like the U.S. is a net importer of oil, it will see its purchasing power rise from lower oil prices. Meanwhile, the weaker euro will reinforce this effect by also increasing nonfuel net exports.

With little or no effect on inflation and a clearly positive effect on growth, the recent market movements will clearly make the ECB more hawkish, and so ease the pressure on them to cut interest rates, and perhaps even enable them to raise them further.

With the Fed becoming more dovish and the ECB becoming more hawkish as a result of these market movements, the recent trends will eventually become self-preventing. It will likely take some time before the markets figure this out, so don't expect this fact (or the many other facts that argues against the sustainability of recent trends that I've discussed recently) during the coming days and probably not even the coming weeks. But eventually, markets will be forced to face these facts.

Oil Price Decline Bubble?

There seems to be two popular explanations of the recent oil price decline among pundits. One is that this proves that the old price level represented speculation all along. The second is that this represents a shift in fundamentals.

Explanation number one is simply dead wrong. There could be some truth in explanation number two, but it is probably not the entire story. As I've tirelessly tried to explain, a speculative bubble is certainly a possible scenario, but it requires symptoms in the form of rising inventory levels. Because unless demand (and supply) is completely inelastic (which is an unrealistic assumption), any price not representing fundamentals can only be sustained by increasing inventory levels. And there was simply no evidence of rising inventories at any time. It is possible, especially given the limited degree of truth in explanation number two, that had oil stayed at the peak of $147, then inventories would have started to rise. But that is only a possibility, and even if it were true, it doesn't mean that prices like $130 or $140 would be justified.

Explanation number two could have some truth in it, as we see weakening economies in Europe and Japan, something which clearly would hurt demand. Also, the strengthening dollar represents a form of shift in fundamentals for the dollar price of oil (although it represents a negative shift in fundamentals for the price of oil in other currencies), but there are reasons to believe that this rally could be related to the third explanation discussed below.

The third explanation is that the recent decline could be a bubble, triggered by recent short-selling rules. As Merrill Lynch consultant David Bowers explain, the decision by U.S. authorities to enforce a ban on short-selling on 17 banks and financial institutions has set in motion a massive short-squeeze forcing hedge funds to unwind their short positions in these stocks. And since these short positions were used as funding for long positions in oil and other commodities, the unwinding of these short positions in banks also meant unwinding the long positions in oil. The unwinding of these short positions in financial stocks also at the same time forced these hedge funds to buy dollars (as financial stocks are bought back with dollars), which contributed to the dollar rally, a rally which further depressed the oil price.

Combined with the factors I discussed in my recent post about financial market behavioral patterns, this is the explanation for the recent decline in oil. But if the old price wasn't significantly inflated by speculation, and if most of the recent declines reflect speculation, then it follows that the current price could be significantly depressed by speculation. Probably not entirely, but to a very large extent.

The first tentative indication that this could be true came from the significant drops in inventories of petroleum products last week (the week ending August 8). While crude oil inventories only fell 0.4 million barrels, distillates (diesel and heating oil) fell 1.7 million barrel and gasoline fell 6.4 million barrels. Given that these numbers fluctuate a bit from week to week, one week's decline is not conclusive evidence that prices are too low. We'll have to wait and see what happens in the coming weeks. But if inventories continues to fall, then we'll have to conclude that the current price is too low, and that the only speculative "bubble" is the latest decline.

Obama's Damaging Tax Plan

Greg Mankiw on his blog showed a chart (see below) on how marginal tax rates at different tax levels will be affected by Barack Obama's tax plan. This just covers low- and middle income workers, the tax rates will be raised for high income earners as well.

"Economists for Obama" (via Economist's view) reacted negatively on this, accusing Mankiw and those who originally produced the chart (Alex Brill and Alan Viard) of being dishonest. The reason is that these increases in marginal tax rates will not occur because of increased tax payments from the middle class, but from reduced tax payments. But how could marginal tax rates increase as a result of a plan that will reduce tax payments? Simply because Obama advocates higher tax credits, tax credits which will be phased out at higher incomes.

Actually though, at least Brill and Viard (Mankiw's chart too is open about referring to marginal tax rates) are very clear that they are referring to marginal tax rates and not total tax payments. And while the introduction tax credits which are phased out is definitely likely to be more popular than outright tax rate increases which raise tax bills, such tax credits are in fact likely to be even more damaging to the economy. The reason for this is that this will not only create a negative substitution effect which reduces labor supply, this effect will be reinforced by the income effect from lower tax bills. Furthermore, the increase in the budget deficit that this creates will have a crowding out effect on private investments.

While tax increases meant to reduce the budget deficit have a theoretically ambiguous effect on growth (the substitution effect will reduce it, the income and crowding out effect will increase it), Obama's plan of phased out tax credits has a ambiguous negative effect as the substitution effect not only is not counteracted by the income and crowding out effects, it is in fact reinforced by them.

This kind of economic irrationality is also mirrored by Obama's plan to raise taxes on oil companies and use the revenues for additional so-called tax rebates for the middle class. Hmmm...increased taxation of oil production combined with consumption stimulus, implying lower supply and higher demand, what kind of effect can that have on the oil price?

The American economy already faces great problems because of the destructive policies of Greenspan and Bernanke. Tax plans of this kind will only make these problems worse.

Official Statistics Questioned

Via Wille Faler, I see this interesting video explaining how government statistics is distorted. I don't agree with all of it (more specifically, his critique of imputations is misguided, and I also find it implausible that real inflation is as high as he claims) but it is still worth watching as he also makes a lot of good points, by for example pointing out how "hedonics" is assumed to be a one way affair, even though real life quality changes aren't.

What Recent Market Movements Teach Us About Financial Markets

The recent dramatic market movements with a rising U.S. dollar and falling commodity prices teaches us quite a bit about how financial markets function, some of which I hinted in my recent analysis of these movements.

One is the seemingly odd fact that in financial markets, lower prices can actually increase supply and decrease demand, and so further lower prices in a price-lowering spiral. The reason is that first of all, this decline could make people believe that the particular asset is in a downward trend. Whether this downward trend is because of a perceived shift in fundamentals or a change in market psychology makes little difference. At any rate, it will cause people to sell (or abstain from buying).

Similarly on the upside, rising prices can attract new buyers and discourage people from selling if these price increases convince people of the existence of a new upward trend, a bull market in that particular asset class.

Further contributing to this phenomenon is the existence of "stop-loss" investment rules for fund managers and other investors. These rules compel investors who follow them to sell a particular asset if it falls to a pre-determined level. While these rules may perhaps from a risk-minimizing point of view for fund managers have some justification, it creates the seemingly perverse effect that lower prices will cause people to sell.

Of course, anyone who after all have decided to sell or buy will at any point prefer to sell to the highest currently available bidder and buy from the seller who offers the lowest price, so the normal market clearing mechanism still exists. Instead, the implication of this is that market prices will swing more than what will be justified based on information of fundamental factors, which in turn implies that under- and overvaluations will appear.

The second lesson relates to the existence of quant traders, as well as others, that trade on the basis of various historical relationships. Case in point is the relationship between the dollar and oil. On a fundamental basis, for reasons explained here, an "autonomous" increase in the dollar should lower the dollar oil price, but by less than the increase in the dollar. However, I've noticed that quite often, oil prices increase or decrease more than the change in the value of the dollar in response to sudden swings in the dollar's value. Case in point was the 4% drop in oil last Friday (August 8) when oil fell 4% in just one day. As there was no other market affecting news that day (There was of course the start of the war between Russia and Georgia, but to the extent that would affect the price it would be to increase, not decrease, it) it would seem that the entire decline can be attributed to the dollar rally. Thus, the opinion I criticized here is likely in fact true in a short-term technical perspective. The reason for this is most likely that many traders react to exchange rate movements by buying (if the dollar falls) or selling (if the dollar rise), something which is done to such a large extent that oil change by a factor of more than one, even though it should rise by a factor of less than one.

As was explained here, such mispricing will not hold unless by chance the fundamentals change in a way which justifies the price change. The result of a too high or too low oil price will be increases or declines in inventory levels, which is ultimately unsustainable and result in a return to price levels motivated by fundamentals, including the effect on fundamentals caused by exchange rate movements (which again is a change in the dollar price of oil in the opposite direction of the dollar's value, but by a factor of less than one).

The implication of this is also to create temporary under- and overvaluations because of technical factors.

What we are seeing here are examples of why markets aren't efficient. That in turn implies both a role for technical analysis to analyze these behavioral patterns (which methods of technical analysis is a separate issue) and fundamental analysis to identify which asset values are temporarily depressed (or inflated) because of these behavioral patterns and are therefore likely to eventually soar (or plummet) in value.

EU Politics In Action

Via Sebastian Weil I see this great short German documentary (with English text) revealing corruption among EU Parliamentarians at the expense of European tax payers. As Weil puts it, the documentary really speaks for itself.

Zimbabweans Turning Away From Government Money?

Given that inflation in Zimbabwe is running at something like several million per cent, one has to wonder why people there accept money. If I had been a Zimbabwean, my first choice would have been to get the out of that hell hole. But if for some reason that would not be possible, I would either require foreign money in transactions (even though that is reportedly prohibited by the Mugabe regime) or return to barter. Even barter is preferable to a joke of a currency like the Zimbabwean dollar.

Via David Theroux at the Independent Institute blog I now see that many are starting to think like that in Zimbabwe now. Gasoline, in the form of gasoline coupons, is increasingly used as currency with many openly pricing their goods in terms of liters of gasoline. Although the article says that this is equivalent to barter, it is more accurate to say that if gasoline were to become de facto currency, this would mean that Zimbabwe would have a commodity based monetary system, quite similar to the gold standard. I suspect however that the Mugabe regime, seeing its revenue source vanishing, will use violence to crack down on this practice.

Technically, You're Not Crooks, Just Optimists

This (see also the preceding cartoon where Dogbert is hired to cook the books) creates so many real-life associations in the form of for example politicians, real estate agents during the housing bubble and Wall Street corporate earnings forecasters.....

Alan Reynolds & Inflation

In a post on the Cato Institute blog, "Cato @ Liberty", Alan Reynolds refers to my post on the apparent disagreement between him and his fellow Cato fellow Steve Hanke on the issue of inflation. He apparently thinks I mischaracterized his views as he comments my formulation that he doesn't think inflation is a problem with "huh?".

(BTW, Alan, my last name is spelled with just 2 "s". Not that I don't find it interesting to see this error as people who misspell it usually make the opposite mistake and insert only one "s")

I'll again link to the original article and let readers decide what the reasonable interpretation of it is. Personally I have some difficulty seeing how an article entitled "Why Not to Panic on Inflation" with matching text should not be interpreted as saying that inflation isn't really a problem, or at least not a significant one. And the point of that post was simply to note his views and contrast those with Hanke's, not really to discuss the accuracy of those views.

But now that we're on that subject, let me note first of all that he is somewhat unclear in his text as to whether he thinks that all-items inflation shouldn't be seen as a form of inflation or whether he simply thinks it lacks predictive power over future inflation. And similarly, whether ex-energy inflation should be seen as the true form of inflation or whether it should be seen as a leading indicator for inflation. And that is not the same thing. Yet while he mostly discusses the issue in terms of what the best leading indicator is, he also writes "The price of oil fell this February, for instance, and that month’s CPI was unchanged - zero. Did that mean inflation was zero? Of course not." which clearly means that all-items CPI isn't inflation.

As for the leading indicator issue, we all know that energy prices are volatile and it should therefore not be surprising that they often fall back after periods of dramatic increases (which . However, as I noted in this post, since 2000 significant movements in all-items inflation have tended to precede movements in "core" inflation (ex food and energy) while on the other hand movements in "core" inflation have if anything a negative relationship with all-items inflation.

And when it comes to comparisons with past periods of inflation, that is to a large extent a comparison of apples and oranges as today's CPI isn't calculated using the same methodology as before, as a number of methodological changes designed to lower the reported rate of inflation have been introduced all of which lowers currently reported inflation. However, these changes did not result in any revision of previous numbers, making it misleading to compare the numbers. Using the old methodology, inflation, especially ex-energy inflation, would be a lot higher. Or alternatively, using the new methodology inflation in the 1970s would have been a lot lower. That means that regardless to what extent you think these changes were justified, the numbers are to a large extent incomparable.

The Irish-Spanish Divergence

According to the preliminary estimate, euro area inflation rose another 0.1%:point in July to 4.1%. It is for that reason that the ECB is unlikely to cut interest rates anytime soon despite many recent signs of weakening real economic growth (Although strong German export data today did contradict that general negative trend).

The first country-specific reports seem to confirm that inflation rose further. In Spain inflation rose 0.2%:points to 5.2% and in Holland, who for long have had the by far lowest rate in the euro area, it rose a full 0.7%:points to 3.0%.

However, in one country, Ireland, inflation fell from 3.9% to 3.6% (using the EU harmonized index). If the preliminary estimate for the euro area holds, this means that Irish inflation will be 0.5% below the average, while in June 2007 Irish inflation was 0.9% above the average.

The fact that Irish inflation falls relative to the rest of Europe when they experience a cyclical downturn is a good illustration of the Balassa-Samuelsson theory at work, whose conclusion is that the relative real exchange rate should correlate positively with economic growth. With fluctuating exchange rates, this would mean a falling nominal exchange rate, but for countries with fixed exchange rates and within monetary unions this would mean lower price inflation. As the relative real interest rate at the same time rises, this will provide a stimulus to increased savings in Ireland and thus help reduce its imbalances.

More puzzling then is why we haven't seen the same thing happening in Spain, at least not so far. Both Ireland and Spain had a housing bubble driven by low interest rates and large-scale immigration that have now turned into a bust, yet the Irish economy seem to cool in a more unambiguous way. One possible explanation lies in the composition of their immigrant populations. In Ireland most immigrants were (apart from returning Irish expatriates) Eastern Europeans, mostly Poles. In Spain by contrast, most immigrants were from North Africa and Latin America (although the number of Romanians in Spain rose sharply in 2007 following Romania's EU entry). High economic growth and a rapidly appreciating currency in Poland means that many Poles have found it worthwhile to return to Poland and many others yet to abstain from leaving the country in the first place, meaning that net emigration from Poland most likely (No recent actual statistics exist yet) have plummeted dramatically, or even stopped completely.

A comparable improvement in economic conditions in North Africa and Latin America haven't occurred, and the economic gap was much more dramatic to begin with, so there net emigration has probably continued. That means that population growth in Spain have probably held up far better than in Ireland, which in turn limits the decline in total economic growth. No figure for recent months exist yet, but in the year to January, population growth was 1.9% in Spain, far higher than in other parts of the EU.

As higher population growth means greater demand for housing, this will also limit the severity of the housing bust. On the other hand, the higher relative inflation this implies will make it more difficult to improve net exports in Spain.

GDP & The Terms Of Trade Issue

After I posted a comment under a post by James Hamilton, it seems that the issue over terms of trade and what should be considered real GDP has finally started. James Hamilton has commented the issue here, , anonymous blogger "knzn" commented the issue here and Brian Wesbury commented the issue here. Hamilton's fellow econbrowser blogger Menzie Chinn commented the issue here, but he really doesn't argue for or against it and instead simply explained the difference between the production deflator and the purchases deflator.

I start with James Hamilton. He use a "Crusoe"-island approach, which I kind of like.

"In 2007, Islandia produced 500 coconuts, which residents sold to themselves for $1 each, and imported 1 barrel of oil, which cost $100. The oil was paid for by borrowing from foreigners.

Ready to calculate GDP? We want the dollar value of domestically produced final goods and services, to wit, the dollar value of the 500 coconuts. Got the answer? Very good. Nominal GDP in Islandia for 2007 was $500. If you wanted to describe that in real terms, you'd call it 500 coconuts. You don't count the oil in either nominal or real GDP because Islandia didn't produce any oil.

Here are the numbers for 2008. We grew 510 coconuts, sold them for $1.01 each, and still imported 1 barrel of oil, paying $125 for it. So nominal GDP was $515.10 (a 3% increase) and real GDP was 510 coconuts (a 2% increase). The change in the implicit GDP deflator would be the change in the ratio of nominal GDP to real GDP, namely, +1%.

But wait a minute, Islandia's pundits decry. How can your crummy accounting claim that inflation was only 1%? Last year we bought 500 coconuts and 1 barrel of oil for $600, but this year if we tried to buy the same thing it would cost us $630. The inflation rate, they tell you, is obviously 5%, not 1%. You must have intentionally cooked the books, they charge, just to make the economy appear better than it is!"

However, as much as I like the approach, his conclusion is wrong. As he wrote, what we want is the value of domestic production. But what value? Value is not intrinsic in the things we produce, value is value in terms of the things we want. The value of a worker's earnings does not lie in how many things he produce, but in how much he can buy for it. Saying that terms of trade is irrelevant for the value of domestic production is like saying that the relation between wage and consumer price levels is irrelevant for real weekly earnings of workers.

The logic behind the GDP deflator approach would thus imply that if a company executive tells workers that they're going to have to accept a 90% wage cut even as their cost of living is unchanged, they shouldn't mind because the workers will continue to work as hard and produce as many goods as before for the company and since their personal GDP deflator falls 90%, the value of their wages are unchanged (even though their nominal wage is down 90% and their cost of living unchanged)! Similarly, a company executive could tell shareholders not to worry about the 50% decline in revenues since that decline was entirely the result of reduced prices on the goods they sell, and since the company's GDP deflator is down 50%, revenues aren't really down at all!

Or similarly, supermarkets could raise prices by 50% and tell customers that they shouldn't mind paying more because their wages (their personal GDP deflator) haven't been raised! And suppliers to a company could similarly tell the company that they shouldn't object to paying more to them as long as they abstain from raising the price they charge their customers! Or in the case of Islandia, those foreign oil producers could tell them that even though the world price is $125, they shouldn't mind paying them $200 since that won't affect the GDP deflator and thus not reduce real GDP!

As for knzn, he takes a different approach and says that he does not care about the value of production. Well, he is free to care or not to care about whatever he wants, but
the vast majority of people do care about the value of their income and that is why people laugh at Phil Gramm's "mental recession"-remarks (See here for a clip of how people spontaneously laugh when Obama tells them about those remarks) that contradict their daily experience even as the official GDP statistics support Gramm. Economists who want people to think that GDP isn't something laughable better care.

He continues by saying "Personally, I care a lot more about the people that don’t have jobs, or potentially won’t have jobs in the future." But first of all, why then look at GDP numbers in the first place? Why not only look at employment numbers? And secondly, the employment numbers are far more consistent with the terms of trade adjusted GDP number as employment has been falling (and would have fallen a lot more if not for the flawed "Birth/Death" model).

He then says that he cares more about productivity (which he defines in unadjusted terms) because that is supposedly more stable then terms of trade movements. But even setting aside the fact that GDP is supposed to measure the value of production regardless of how stable or not certain aspects are, it is not true that productivity is particularly stable. If you go to the Bureau of Labor statistics web site, you see that their measure of productivity (non-farm business output per hour) moves up and down in a quite erratic way. In 2003 for example, productivity at an annualized rate rose by 5.6% in the second quarter and 10.3% in the third quarter only to fall by 0.4% in the fourth quarter.

As for Brian Wesbury, who delivered the by far worst GDP forecast of all economists(3%, even as he assumed a 3% increase in the GDP deflator!), he agrees that 1.1% is a far too low inflation figure and notes like I did that if you deflate the nominal GDP increase with the domestic purchases deflator, real GDP declined. However, he says that would be misleading and says that if you include import prices to calculate real GDP you must add imports to GDP, a sum he says increased more than 5%. But that does not follow. What the domestic purchases price index include is first of all usually not directly import prices, but the prices of various forms of domestic demand, like private consumption, government consumption and business investments, and that is usually not the same even for imported goods, as the retail price of for example a sweater made in China includes the margins of the American retailer (and often also wholesaler). That means that including imports would double-count it. However, as discussed above, the value of domestic production is determined (partly) by how much imported goods that domestic production can buy.

Greenspan Professes Innocence

I see that Greenspan has produced yet another article where he tries to make us forget how he not only failed to identify , but more importantly caused the housing bubble. For examples of his dismal forecasting record see Krugman on this, for a refutation of his denial of guilt see my previous writings on this.

Greenspan is not all wrong in this new article. He is right that it would be wrong to try to solve the problems with protectionism (that will only make things worse)and he is right that in any economic system, there will exist poor judgements and excessive optimism and excessive pessimism. With regard to that latter issue however, he ignores of course that if the central bank subsidize overinvestments during periods of optimism and bails out failed investors during the bust (whish is to say, if central banks do what Greenspan did as Fed chairman), then this will create much bigger bubbles and much greater levels of overinvestments (malinvestments) than otherwise.

Soccer Explained

As you may have noticed by the fact that I write about "gasoline" and "labor", instead of "petrol" and "labour", I try to use American English, rather than British. The reason for that is that there are a lot more Americans than Britons, both in the world and more importantly among my readers. However, in one case I personally have something with the American word and prefer the British, namely with regard to what Americans call "soccer" and Britons call "football".

I like the British word much better, not just or even primarily because it is more similar to the Swedish word (fotboll), but because you in that game actually strictly use the foot (except for rare occasions when the ball bounces on the head), whereas in what Americans call football, they seem to mostly use the hands to move the ball. American "football" is thus more like a version of rugby than anything properly called football given the normal meaning of "foot" and "ball".

Anyway, despite this, I write "football"/"soccer" just for clarity so I won't be misunderstood on the rare occasions I write about the sport. One thing that long puzzled me was why Americans call it soccer. If I had put my mind to it, I would have easily been able to find out, but I never did as I didn't think much about it and to the extent I did maybe thought that there was no particular reason for it, and that someone perhaps simply made it up.

Today, however, I found out why Americans call football soccer. It is explained in the below video by a really hot 27-year old Russian woman by the name of Marina Orlova, who apart from nice curves also has two degrees in philology and has made a career by launching youtube-videos explaining the origin of words by the motto "intelligence is sexy". Her videos has 92 million youtube-views and counting. If you want to see more of her videos got to her website or click on the embedded video, which will take you to the youtubeurl where it is shown and where there are links to other videos explaining the origin of other words (including why the popular Russian invention known as the AK-47 is called the AK-47).

Australia Running Out Of Luck?

There are increasing signs that the Australian housing market has started to turn down. The Australian bureau of statistics today said that house prices fell during the second quarter, albeit only slightly. Meanwhile, money supply and credit growth seems to be decelerating significantly.

If this trend continues, then it is clearly a good thing, as the level of household debt has risen to alarming levels. The Reserve Bank of Australia (RBA) may not need to raise interest rates further, but it shouldn't start cutting anytime soon either (as some predict), as this might slow down the correction of these imbalances. Otherwise, they risk a repeat of the 2005 developments (more on that below).

I have repeatedly in the past said that as long as the price of the commodities that Australia exports keeps rising, there won't be a downturn in the Australian economy. And there is no sign of that. I reported recently how Australian iron ore exporters received an 85% increase in prices from their Chinese customers (They've pushed through similar increases from the Japanese and other customers). And other reports suggest that revenues from commodity exports will increase by some 40% in 2008-09 to $212 billion, something which is already resulting in a significant decrease in Australia's trade deficit.

For this reason,, Australia is not heading for a immediate downturn (at least not in terms of trade adjusted terms). The situation is in fact eerily similar to the one in 2005 when the housing market experienced a short-lived dip but the economy kept growing because of the commodity price boom. The housing market then soon recovered as money and credit growth remained strong. This meant that while Australia escaped a recession, they also missed the opportunity to reduce their imbalances. Now they have another opportunity to do that without significant pain. If the RBA starts to inflate more again, then this opportunity will also go lost. That means that the imbalances could remain until the commodity price boom turns into a bust. And the combination of a housing bust and a commodity bust would be very ominous for Australia. For this reason, the RBA should not loose its cool and start to cut interest rates at this point.

Spanish Stagflation

I have long argued that the real threat to the European economy lies not in the U.S. downturn, but rather in home made booms that are turning to bust. This problem is apparent in many countries, including Ireland, the U.K., Sweden and the Baltic states. And, most significantly for the euro area, Spain.

That it is Spain and Ireland who faces particular problems is evident in the latest unemployment report from eurostat. While the unemployment rate for the euro area as a whole is still slightly down from a year ago as Germany, France, Belgium and Finland experiencing significant declines in unemployment, Spain and Ireland have experienced significant increases in unemployment. The Irish unemployment rate rose from 4.5% to 5.7% and the Spanish unemployment rate rose from 8.1% to 10.7%. As a result of the latter, Spain has surpassed both Slovakia and Poland in unemployment, and has the highest unemployment rate within not just the euro area but the entire 27 nation EU as well.

If you go the Spanish statistical office own report on unemployment, you can see that things aren't quite as bad as the dramatic increase in unemployment suggest. Employment is actually still up slightly compared to last year, as the number of immigrants continues to grow fast and as the female participation rate continues to grow. Still, this is hardly ground for complacency as a country with a growing population and increased willingness of women to work outside the home clearly should experience rapid employment growth given the rapid growth in labor supply this implies.

You can also see the effect of the housing bust in the fact that employment in the construction sector has begun to contract, and contracts quite dramatically (8% in the latest year). Almost the entire decline in the employment rate can be attributed to this bust.

The main difference between Spain and Ireland is that the relative inflation rate compared to the rest of the euro area hasn't declined in Spain. In the euro area as a whole, the inflation rate rose from 1.9% in June 2007 to 4.0% in June 2008, or 2.1%:points. In Ireland, the increase in inflation was just half that (1.1%:points) and at 3.9%, Ireland now has slightly lower inflation than the euro area average. By contrast, Spain has seen its inflation gap differentiate as inflation rose from 2.5% to 5.1%, or 2.6%:points. And according to preliminary estimates Spanish inflation may have risen to 5.3% in July, which given the preliminary euro area average of 4.1% would widen the gap further. While the economic situation has become more stagflationary in the rest of the euro area as well, nowhere are the stagflationary conditions as bad as in Spain.

The higher inflation rate Spain could perhaps limit the nominal decline in house prices compared to Ireland, but on the other hand it also means that Spanish competitiveness will continue to be eroded, making it more difficult to compensate for the housing bust through rising net exports. Also, even if the nominal decline is smaller, the real decline will be as great, and the lower real interest rates will also make it more difficult to achieve the necessary increase in household savings.
For these reasons, Spain's monetary situation is arguably worse than Ireland's. On the other hand, Ireland is far more dependent than Spain and the rest of the euro area on trade with the U.S. and the U.K. and will therefore be hit harder by the slumps in those two countries.

U.S. Employment Report Even Weaker Than It Seems

The U.S. employment report yesterday was regarded by the markets as a bullish one, because the decrease in payroll employment was somewhat smaller than expected. However, considering how the Bureau of Labor Statistics continue to insist not only on continuing to impute jobs from the "Birth/Death" model, but in fact imputes more and more of them, even as any honest observer would expect fewer and fewer (in fact at this point none at all, or even negative) jobs created in new businesses relative to the number destroyed in business failures, it should be clear that job destruction is accelerating.


In February, the assumed seasonally adjusted monthly addition from the Birth/Death model (The raw monthly number is seasonally unadjusted. I've calculated the adjusted number by taking the total number added during the latest 12 months and dividing it by 12) was 53,000, in July it was 71,000. This means that the payroll number is in fact getting more and more distorted by this flawed model.

If you add the 71,000 imaginary jobs added by the model to the 76,000 private sector jobs lost according to the official number, then we're talking about at least 147,000 fewer private sector jobs.

This weakness was also confirmed by the rise in the unemployment rate from 5.5% to 5.7% and the decline in aggregate hours worked of a full 0.4%, a decline confirmed by the even sharper increase in the household survey of part-time unemployment. All of this suggests the opposite interpretation of the report compared to the one the financial markets decided for: namely that it indicates an accelerating and not decelerating downturn.

Swedish Economic Growth Decelerates Dramatically

Preliminary numbers indicate that Swedish economic growth fell to just 0.7% in the second quarter. Using my terms of trade adjusted approach, growth was even slower at just 0.2%.

Unlike the American numbers, which were stronger than other indicators indicate, the Swedish numbers were weaker than one would expect given other indirect indicators. That Sweden will head into a recession is likely, but it seems implausible that so much of the slowdown had happened already by the second quarter. Most likely, this is the result of a too big calendar adjustment. I therefore find it likely that there will be future upward revisions, though probably not so much already by the next release of these same numbers in September.

At any rate though, regardless of how much of the slowdown had occurred duing the second quarter, it seems clear that Sweden will fall into a recession. The political blame game is all too predictable with the Social Democrats continuing with their confused attacks on a supposedly too expansive fiscal policy, only to propose more fiscal expansion themselves, in the form of increased government investments. Logical consistency ,or learning from Japan's failure to boost its economy with government investments in the 1990s, appear to be overrated virtues according to the Social Democrats. Most right-wing pundits on their hand either completely ignore the numbers or simply urge people not to "panic" while not explaining why the downturn has started.

Had they read and spread the conclusions of my Timbro report they would have had a good explanation for the problems. But now that they don't, the nonsensical Social Democratic theory risks becoming the explanation accepted by most Swedes. A bad theory always beats no theory.