Heaven Forfend!

Anonymous blogger "Pro Growth Liberal(PGL)" attacks John McCain's economic policies and defend Obama's because Obama's are more Keynesian. What particularly offends PGL is McCain's pledge to reduce government spending:

"The notion that reducing government spending is a cure for a recession must have Lord Keynes rolling over in his grave"

Oh, heaven forfend,we sure don't want that! No, no, what we want is for Lord Keynes' rotting corpse to do somersaults in his grave by reading him the Misesian way of dealing with recession, as was described for example by Murray Rothbard here.

Larry Sechrest RIP

I actually didn't know about Larry Sechrest until less than two weeks ago when Per-Olof Samuelsson told me about two of his essays, one about Alan Greenspan and one about Richard Salsman's attacks on the Austrian business cycle theory and its application on the Great Depression. I rold you about the latter in a post here. Now I see that he has died at the relatively low age of 62. That's sad as I liked the essays, particularly the one about Salsman, and as he could have contributed with more good writings if he hadn't died. But at least we can enjoy what he already has written, so if you haven't read the essays, I recommend you ro do so now.

U.S. GDP Report Show Significant Private Sector Contraction

Just as I expected, the third quarter GDP showed a contraction. The contraction of 0.3% was however somewhat smaller then I expected.

However, the reason for this smaller contraction is not really a sound one: government spending soared. While I had expected government spending to rise, it rose a lot more than usual. Government purchases rose from 20.1% of GDP to 20.4%-the highest since Q3 1991, and up from just 17.6% in Clinton's last quarter (During the Clinton era, government purchases decreased significantly as military spending fell). As before, military spending increased particularly much, but non-military federal spending and state & local government spending increased its share of GDP too. Excluding government purchases, the contraction would have been closer to 2%.

Although business investments fell somewhat, the main factor behind the decline in private sector activity were a continued sharp drop in residential investments and in consumer spending. The decline in residential investments is basically sound as it will reduce housing inventory. The decline in consumer spending is arguably sound too as savings is too low. It will need to fall more as it remains near a post-Depression high.

Moreover, there is also the old issue of terms of trade. Despite the sharp drop in import prices in August and September, the increases in May to June were enough to cause import prices to rise more than export prices. So despite the fact that the actual trade deficit fell (were assumed to fall, we don't have the September numbers yet) only slightly, net exports supposedly added a full 1.1 percentage points to GDP. Measured properly, it would have added just 0.5 percentage points. If you then deflate the nominal increase of GDP by the 4.7% increase in the domestic purchases index instead of the 4.1% increase in the domestic price index, the decline would have been 0.9% instead of 0.3%. Private sector activity would have declined 2.5%.

In the fourth quarter, the terms of trade factor should finally reverse, and then the volume number will actually exaggerate the decline. This combined with the deterioration in real economic activity will mean that we will see a really big fourth quarter headline decline even if government spending continues to increase.

The numbers concerning another issue discussed here, the discrepancy between the production numbers and the income numbers (national income has consistently for several quarter been a lot weaker than GDP), are not yet available. The damage created by the hurricanes has however boosted capital consumption, meaning that national income will probably continue to be even weaker than GDP.

The bottom line is that although the headline decline of 0.3% may appear mild, the numbers are far worse if you look at the details. And the fourth quarter numbers are likely to show a much greater contraction (particularly for the headline number).

Depositors Flee Swedbank

Swedish media report that confidence in Swedbank among regular Swedish bank customers is disappearing. Net withdrawals were SEK 9.5 billion, or 4.1% of total deposits at Swedbank. SEB, another bank with high exposure to the Baltic countries is also losing customers. The bank with the strongest reputation for being prudent in its lending standards, Handelsbanken, is by contrast gaining customers, and so is Nordea. However, the losses for Swedbank and SEB were far bigger than the gains for Handelsbanken and Nordea, and so total deposits fell by 0.6%. This will create more problems for Swedbank (to some extent well-deserved given its role in creating the Baltic boom which has now turned into a bust), and will at the same time have a deflationary effect on the Swedish economy.

Interesting Interest Rate Facts

Today the Fed is expected to announce another formal interest rate cut of at least 50 basis points, down to 1%, you know the level Greenspan decided back in 2003 would create so much benefits through the boost it would provide to the housing market. Yet if you look at the effective Fed funds rate (the one that really matters) it has in fact been close to or below 1% since October 10, meaning that today's announcement will in effect simply be to officially announce what they've already done. Regular readers will remember that this is not the first time the Fed effectively cuts interest rates before formally announcing it. On October 7, I pointed out that the Fed had already cut interest rates, something which the Fed formally confirmed the next day.

Now that we're on the subject of interesting interest rate facts, I should point out that the bond market is now (at least seemingly) pricing in price deflation during the coming 5-year period. The yield for the 5-year regular U.S. government bond was 2.67% this monday. Yet the yield of the 5-year Treasury Inflation Protected Securitys (TIPS) was 3.74%. Meaning that unless the consumer price index fall by an average of more than 1% per year during the coming 5-year period, TIPS will provide better returns than regular bonds. While the current deflationary monetary trends make it basically certain that consumer price inflation will decelerate dramatically in the coming months from its current level of over 5%, consumer price deflation looks less likely. Of course if these deflationary monetary trends continued for a longer period, then consumer price deflation will inevitably follow. But given the determination of the Fed to use all available means to prevent deflation, it seems unlikely that monetary conditions will really be deflationary for sufficiently long time to achieve sustained consumer price deflation of more than 1% for the coming next 5 years.

As TIPS returns have consistently outperformed the return of regular government bonds for a long time, it seems that either bond traders are systematicaly underestimating future inflation and/or that the lower level of liquidity of TIPS relative to regular bonds are creating a liquidity premium for them.

New Theory Of Recessions

Whatever your opinion is of the music of Judas Priest, it was of course completely ridiculous to blame them with the suicide of 2 teenagers, based on the alleged subliminal message of "do it" if you played the record backwards (!?). I mean, if you really start playing records backwards to find messages and find a message of suicide convincing you got to be pretty messed up to begin with. Not to mention the fact that it would be pretty stupid for Judas Priest to try to have their fans killed (As Judas Priest pointed out, if they had the will and ability to put some kind of subliminal message on it, would have rather been "buy more records" so they could make more money) or the fact that "do it" can mean just about everything, from painting your house, to taking out the garbage, to having sex with your spouse, to buy Judas Priest records, to visit this blog or literally whatever (I could add hundreds or thousands of additional examples, But I think the ones I've already mentioned are more than enough to illustrate the point). In short, this law suit against Judas Priest qualified for the title of one of the most ridiculous law suits ever.

This ridiculous trial comes to mind when I see this (presumably not seriously meant) article blaming AC/DC for the economic crisis in the U.S. (thanks Chris for the link). Every time AC/DC has been successful, the British economy has gone on a highway to hell , so to speak. I haven't calculated the econometric correlation value, but the theory that "AC/DC cause U.K. recessions" will probably pass the test of statistical significance....

But seriously speaking, what it really illustrates is of course that correlation is not causation.

Icelandic Stagflation

In a bid to stabilize its currency, which is down 70% this year, Iceland raised its interest rate from 12% to 18%, after having cut it from 15.5% just a few weeks earlier. To the extent it succeeds, it might actually strengthen the economy, as the excessive weakness of the krona is the key problem facing the Icelandic economy. Not only does it contribute to a sharp increase in inflation, but by increasing the domestic currency value of its foreign debt, it makes the problem of too much debt even worse. However, in these times of extreme risk aversion from investors, it can be questioned just how effective it will be. Moreover, given the extremely high level of inflation in Iceland, 18% isn't exactly high.

To get a perspective on how bad things are in Iceland, the forecasts in this Bloomberg report are useful.

"The central bank is raising rates as Iceland, the first western nation to seek financial help from the IMF since the U.K. in 1976, faces an economic contraction, coupled with possible hyperinflation and rising joblessness. The economy will shrink as much as 10 percent next year, the IMF forecasts. Iceland will receive about $2.1 billion from the Washington-based fund, according to a deal struck on Oct. 24....

....The increase in the key rate comes after the central bank on Oct. 15 cut it by 3.5 percentage points from 15.5 percent. That move indicated policy makers were focusing on growth and abandoning their target of stabilizing inflation, which may soar as high as 75 percent in coming months, according to Lars Christensen, chief analyst at Danske Bank A/S in Copenhagen."

And I personally think that a 10% contraction is probably on the optimistic side.

MZM In Europe

I have discovered after having researched the issue more thoroughly, that I have been mistaken on which money supply definition in Europe best approximates the proper money supply definition, MZM. While it has been obvious to me for quite a while that at least in Europe, M3 is too broad money supply definition, as it includes government securities of a maturity of up to 2 years, I mistakenly thought that M2, while perhaps containing a few deposits that could properly be characterized as time deposits, mainly contained savings deposits in addition to the demand deposits included in M1. But after having discussed the issue today with a person who works in the division of the Swedish statistics bureau responsible for these statistics, I now realize that what in America is referred to as savings deposits is in fact included in M1 in Europe. The deposits which in the European money supply definition is part of M2, but not in M1, are only deposits which are properly characterized as time deposits. In America, the non-M1 part of M2 includes in addition to small time deposits also savings deposits, so I assumed this was the case in European money supply statistics too.

But as it turns out, this was not the case. This underlies another of my points in my post "MZM outside America", that you cannot trust the M1, M2 and M3 definitions to be the same in different countries (except within the EU). And so, if you want to compare monetary growth in different countries you have to make sure the definitions of the seemingly similar monetary aggregates really are the same.

Embarrassingly, in my Timbro report on Swedish monetary policy, I wrote that M2 was the best money supply definition in Sweden, but now it turns out that it is M1. However, as the trend movements and even quantity of M1 was fairly similar to the period that the report focused on, it actually doesn't make any significant difference in that respect. The main difference is in the monetary trends of recent months, where M1 growth has been much lower than M2 growth. This means that the outlook for the Swedish ( and Euro area) economy is less inflationary then I previously thought it was.

Roubini Is Primarily A Keynesian

I have sometimes received the question of whether Nouriel Roubini should be regarded as an Austrian. I have generally answered to that he is primarily a Keynesian, even though he has some Austrian leanings. And I certainly stand by that assessment. Don't get me wrong here. I find Roubini and his RGE Monitor to be interesting to read, and while he remains more Keynesian than Austrian, he does display Austrian characteristics both in his approach (he skips much of the idiotic mathematical formalism prevalent in non-Austrian economics) and in part of his analysis ( he recognice that Fed monetary policy was too loose during the housing bubble and that this was a key factor behind the bubble). But while he has some Austrian leanings (and is therefore more accurate in his analysis than most economists), he remain mainly Keynesian. Kevin Duffy explain why here.

Supply-Siders: Inflation Is Growth

Steve Forbes had a column whose basic message was that although government intervention had created some problems now, free markets had over a longer period created great wealth and that if the politicians don't overreact then the economy will recover. I basically agree on that, although I think he underestimates greatly just how much damage the interventions already undertaken will cause, and therefore think he is too optimistic about the prospects for an immediate recovery even if the politicians restrain themselves. What I however thought was most interesting and misleading was this part:

"Even in recent years the much-maligned U.S. did well. Between year-end 2002 and year-end 2007 U.S. growth exceeded the entire size of China's economy. Obviously China's growth rates were higher, but China was coming off a much smaller base."

China's GDP in 2007 was 24.67 trillion yuan, which with the exchange rate on December 31 of 7.2946 is roughly $3.4 trillion (with today's exchange rate it is more like $3.6 trillion). Q4 2007 U.S. GDP was $14.03 trillion, and cumulative real growth between Q4 2002 and Q4 2007 was 15%, meaning that cumulative real growth with Q4 2007 dollars were $1.83 trillion, only slightly more than half of China's GDP. The only way in which Forbes can be right (sort of) is if we look at nominal growth, as nominal GDP rose from $10.59 trillion in Q4 2002 to $14.03 in Q4 2007, an increase of $3.44 trillion. But using nominal numbers in such comparisons are highly misleading as that treats inflation as growth. In case it is not immediately obvious why that is wrong, remember that if we use nominal growth numbers to represent economic growth, that would make Zimbabwe the fastest growing economy in the world.

Nor is this the first time this has happened. Larry Kudlow back in 2006 also used a similar comparison with the Chinese economy by comparing it to nominal growth.

Even while claiming to be anti-inflation, supply-siders are in practice usually pro-inflation (with some exceptions). Their use of nominal growth numbers to represent economic growth could therefore perhaps be interpreted as a form of Freudian slip revealing their inflationary bias.

More On Ayn Rand & Alan Greenspan

Yaron Brook, executive director of the Ayn Rand Center for Individual Rights (a division of the Ayn Rand Institute) has commented on Alan Greenspan's assertion that he has found a flaw in his free market philosophy, pointing out that Greenspan hasn't had anything resembling a free market philosophy for several decades.

Meanwhile, Dean Baker presents a very distorted and misleading interpretation of Ayn Rand's philosophy in light of the actions and comments by former follower Alan Greenspan.

"First, insofar as Greenspan acted (or didn't act) out of ignorance of the true situation, it was because he was ignoring Ayn Rand, not because he was following her...

...What would Ayn Rand expect to happen? On the one hand we have the hot shot executives, on the other hand the schmucks who own stock in these banks. Would Ayn Rand expect that the executives would put aside their ambition, their lust for success, their greed, in order to benefit shareholders who are too dumb to even know what a credit default swap is?

Not for a second; Ayn Rand would watch the Wall Street big boys run roughshod over their shareholders' interests and be applauding them every step of the way. That is how the game is played. If Greenspan didn't think the Wall Street crew would rip off their shareholders for every last penny, then he was not a worthy disciple of Ayn Rand."

Apparently, Baker only knows that Rand argued for egoism, while ignoring that part about how her version of egoism, which she called rational egoism, precludes deceit and reliance on government subsidies. He also appears to have missed that Rand argued for free markets, as he later correctly notes that today's financial industry is not anything remotely resembling a free market, and that the Wall Street executives he claimed Rand would celebrate does not want free markets, because under a free market they wouldn't have been able to get away with this kind of rip-off.

Rand's reputation is clearly damaged today by her former association with Greenspan, something which is partly deserved, partly undeserved. On the one hand, she certainly did err in ignoring the warning signs that were apparent already in the 1970s (With Greenspan supporting some of Gerald Ford's stupid ideas, including the "Whip Inflation Now"-buttons(he now claims to have considered the buttons stupid, but at the time he endorsed them, meaning he was either lying then or now)) about Greenspan's flawed character and non-commitment to her principles. On the other hand, Greenspan got much worse after her death, and had she been alive today, even she would have almost certainly given up on him and rejected him just as much as Yaron Brook has done.

More On The Effects Of The Surging Monetary Base

Recently, the U.S. monetary base has increased in a unprecedented way. As is illustrated by the chart below, the monetary base has increased more in the last few weeks, than in the preceding 5 years.

As I've noted before, the monetary base in itself has no impact on economic activity. It can however have an indirect impact if it causes money supply to increase. The question then is to what extent money supply will increase because of this. I discussed that issue a few weeks before, and that discussion still largely holds.

However, the point could be made that although MZM rose the latest week, it is still down over the last few weeks and months, so that so far the deflationary effects of the financial distress have been greater than the inflationary effects of the surge in the monetary base. However, that may not necessarily hold, so we should watch the coming releases to see if the latest week's up tick was just a temporary aberation or the beginning of a new trend. If it is the latter, then the combined stock- and commodity bear market may come to an end.

A second point that could be added is that while the increase in the monetary base may perhaps prove to be inflationary, there is actually a good reason to believe that the bank reserve part of the monetary base will be permanently higher relative to deposits (meaning that the monetary base will be permanently higher relative to the money supply). The reason for that is that the Fed since October 1 has started to pay interest on the deposits that banks have at the Fed (bank reserves consists of the cash in vaults and ATM's that banks have plus their deposits at the Fed). Before this change, banks had a strong incentive to minimize reserves because reserves represented a opportunity cost in lost interest income compared to the alternative of lending them out or investing in money markets. Now that the Fed is paying interest, that incentive is far weaker. And given the fact that a deposit at the Fed represents almost the ultimate safe haven, banks in these times of high risk aversion increasingly view that as a attractive option compared to money markets or lending. The result is that the increase in bank reserves (and therefore also the monetary base, which consists of bank reserves plus currency in circulation) will not increase money supply to the same extent as usual.

U.K. Enters A Recession

After falling to zero in the second quarter, U.K. economic growth turned negative in the third quarter. As it seems highly likely that the economy will shrink in the fourth quarter as well, the U.K. now meets the popular definition of a recession. If they had measured recession on a monthly basis using other indicators (as in the U.S.), the recession would most likely have been determined to have started already during the second quarter as the zero growth in that quarter probably reflected how the beginning of a monthly contraction in the second quarter was masked by the effect of positive growth in the first quarter spilled over into the second (If March output is say 0.3% higher than the Q1 average, then monthly output will have to decline during the coming months to prevent the second quarter growth from being positive).

More specifically, the U.K. economy contracted by 0.5% compared to the second quarter (if expressed in annualized terms as growth numbers in America, that would be a 2% contraction). Most analysts had expected negative growth, but not that negative (consensus was for -0.2%), and so the pound fell sharply after the news. The pound is now at an all time low against the euro, at a 5-year low against the U.S. dollar and at a 13-year low against the yen.

Given how bad the imbalances in the U.K. economy have been and given the general global downturn, there is no reason to expect the fourth quarter contraction to be smaller. Indeed, it will probably be greater.

Danish Peg Under Attack

While the currencies of Sweden and Norway (not to mention Iceland) has fallen against the euro in response to the financial turmoil, which have led global investors to flee small currency zones, the Danish krone has been very stable at 7.45 versus the euro. The reason why it has remained so much more stable than the other Scandinavian currencies is very simple: Denmark pursues a fixed exchange rate policy to the euro, which is why it tends to be unchanged against the euro and why it therefore always move up and down by the same percentage as the euro against other currencies.

But even as the Swedish central bank, the Riksbank, cut interest rates yesterday by 50 basis points, the Danish central bank, Nationalbanken, felt compelled today to raise its interest rate by 50 basis points. The reason is that the Danish krone has been under speculative attacks and that the Danish central bank feels that it needs to reinforce its direct interventions on behalf of the krone with higher interest rates.

Especially given that the macroeconomic conditions of Denmark are fairly sound, with a (until now at least, it will probably fall because of the economic downturn) large budget surplus and a somewhat smaller current account surplus, it seems unlikely that the speculators will succeed in bringing down the peg. However, this might require a further increase in the interest rate differential to the euro area, something which will make the deflationary monetary conditions in Denmark even worse, and cause a significant cyclical downturn.

That in turn will likely strengthen those in Denmark that wants it to abolish the krone and replace it with the euro. By having a peg, Denmark has anyway given up its monetary independence. The only differences that keeping the krone makes is maintaining transaction costs and reduce transparency, plus of course as these news illustrate, an added risk premium for Danish securities, a risk premium which rise during times when it is worst for the Danish economy.

That is not likely to sway the more hardcore opponents of euro entry: the leftists who are convinced that the euro is a "neo-liberal" plot to bring down the welfare state and who doesn't seem to quite grasp what I just pointed out above about monetary independence under a peg, and the supporters of the nationalist anti-immigration party, the Danish People's Party, who wants to keep the krone for sentimentalist nationalist reasons. But for the likely swing voters in a possible future referendum this could be a decisive factor for achieving a victory for the pro-euro camp.

Prime minister Anders Fogh Rasmussen, who is in favor of the euro, was going to launch a referendum, but postponed it after the European Court issued a ruling that modified the very restrictive Danish immigration laws. As these restrictive immigration laws enjoy an overwhelming popular support, Fogh Rasmussen feared that the ruling would create enough anti-EU sentiment to make a victory for euro supporters impossible. But as the Danish centre-right government made a deal with the Danish People's Party to add new restrictions to immigration laws that would compensate for those deemed illegal by the European court, this issue has to some extent faded away. And with the price of keeping the krone for sentimental reasons become increasingly obvious and steep with these developments, popular sentiment is likely to become increasingly pro-euro, something which will likely make Fogh Rasmussen more anxious to have a referendum as soon as possible.

Greenspan Finds A Flaw In His Thinking

Alan Greenspan now says that he has found a flaw in the "free market ideology" that has guided him.

Just when you think that Greenspan can't sink any lower, he makes sure to prove you wrong. After having spent the last few years defending himself and argued that there was nothing wrong with the government interventions which he was responsible for, he now tries to prove his humility by arguing that his one error was that he didn't believe strongly enough in government interventions.

As Butler Shaffer puts it, he seems to have his own version of an old slogan of his former mentor Ayn Rand: "Big government-America's most persecuted minority"

Swedbank, Other Swedish Banks Present Relatively Stable Earnings

Compared to banks in for example America, which have suffered enormous losses, Swedish banks have so far been islands of relative stability. One bank, Handelsbanken, in fact presented rising earnings yesterday. The other big three Swedish banks, SEB, Nordea and Swedbank all saw their profits fall, but not that dramatically.

If you look at Swedbank, the bank around which most rumors have circulated and also the bank which my Baltic readers appears to be most interested of, their profits fell by about a third from year ago levels in Q3. This decline was mainly attributable to falling commission revenue as well as portfolio losses and increased loan losses. The portfolio losses were mainly related to Lehman's collapse and the increase loan losses was mainly a result of rising loan losses in the Baltic countries. Loan losses in Sweden increased dramatically too, but from a much lower level.

In their comments, the Swedbank management concedes that things aren't going so great right now, but they argue as they have done before that it is only temporary and nowhere near as bad as the rumors suggest. However, in this interview in Svenska Dagbladet, Swedbank CEO Jan Lidén concedes that they have been to optimistic about their Baltic division and that they will probably have to revise up their forecasted loan losses.
As the Baltic hard landing has only barely begun, and as Sweden too enters a cyclical downturn, that upward revision will probably be quite large.

Today's Currency Bloodbath

This is the effect that increased worries over a weaker economy in the country that uses the USD as currency can have on exchange rates (In addition to the similar movements in recent months).....

Euro, Swedish Krona-Down 4% against the Yen and 2% against the USD
Canadian Dollar-Down 4.5% against the Yen and 2.5% against the USD
Mexican Peso, Australian Dollar, New Zealand Dollar-Down 5% against the Yen and 3% Against the USD
Norwegian Krone-Down 5.5% against the Yen and 3.5% against the USD
U.K. Pound-Down 6% against the Yen and 4% against the USD
South African Rand-Down 8% against the Yen and 6% against the USD
Brazilian Real-Down 9% against the Yen and 7% against the USD.
South Korean Won-Down 9.5% against the Yen and 7.5% against the USD.

Source (I've rounded to half a percentage points)

Tyler Cowen Is Wrong On Austrian Theory & Interest Rates

As many of you have already seen, Tyler Cowen has again criticized the Austrian view that the low Fed funds rate was the main factor behind the housing bubble. His views doesn't differ dramatically from mine as he appears to concede that it was one of the factors behind the bubble, and as I believe that other factors were involved (mainly moral hazard created by previous bailouts, but also things like the Community Reinvestment Act and Wall Street incompetence). The difference thus lies in the relative importance we attribute to these factors. Also, he criticizes the Austrian business cycle theory on some points.

The case for arguing that it was the main factor lies in the fact that the boom started in 2001, with mortgage debt and house price growth being above 10% despite the recession and with construction activity unusually enough increasing during a recession. The reason why it happened during that year was that the Fed in less than a year cut interest rates from 6.5% to 1.75%.

As for his argument about long term interest rates and short term interest rates, that is a restatement of Greenspan's argument for absolving himself of guilt which I rebutted here. In short, first of all, short-term interest did have a direct impact on the market due to the spread of adjustable rate mortgages. And furthermore as I explained there are several reasons to believe long term interest rates will be affected. The reason why they didn't rise further after the Fed started to raise rates again in 2004 was that the market had already priced in the hikes (the 10-year yield had risen from 3.3% to 4.7% between June 2003 and June 2004 in anticipation of the coming rate hikes).

As for his and Paul Krugman's argument that consumption would have to fall during the boom and that there is no reason to expect a boom for that reason, that argument overlooks two things. First of all, consumption does in fact fall in relative terms during booms (at least relative to investments, in these days with trade deficits, it need not fall relative to GDP). The reason there is no absolute reduction is precisely because the boom is financed with the creation of new money (as opposed to voluntary savings), which due to the time lags involved do not immediately reduce consumer purchasing power and therefore consumption.

And in addition to the aforementioned effect of a higher real money supply due to the inevitable time lags involved, there is also another reason why higher relative investments have a more positive effect on output than higher relative consumption. Namely the fact that higher investments cause production capacity to expand and so boost supply in addition to demand, while higher consumption by contrast do not cause production capacity to expand. In fact, during busts the effective production capacity tends to fall as the production capacity specifically designed for the production of investment goods is no longer used.

Run On Several Currencies

The Swedish krona again fell to new lows against the euro and the dollar, with the decline being particularly dramatic against the dollar.

But it could be worse. Although the South Korean won have stabilized somewhat in recent days after the dramatic plunge last week, several other smaller currencies are experiencing dramatic declines. The South African rand has lost more than a quarter of its value against the U.S. dollar in just little more than a month, while the Brazilian Real and the Mexican Peso have both lost roughly a fifth of their value in just about 5 weeks.

To a large extent, these dramatic declines are the result of the fact that these countries are commodity exporters. But given the decline of currencies like the South Korean won (which is a big importer of commodities) and the Swedish krona, it seems that there is also a general flight of capital away from currencies perceived (whether justifiably from a fundamental perspective or not) to be risky.

Taxpayers Finance Excessive Wall Street Bonuses

"Despite" receiving hugh sums of money from taxpayers, Wall Street will continue to pay out tens of billions of dollars in bonuses to the same employees who were responsible for bringing their companies to the point where they would have collapsed if the government hadn't bailed them out, Guardian reports.

In the article we can read that on Wall Street, bonus is something you receive even if you don't do anything good.

"For a normal person the salaries are very high and the bonuses seem even higher. But in this world you get a top bonus for top performance, a medium bonus for mediocre performance and a much smaller bonus if you don't do so well."

The article asks the question of why these companies keep blowing such large sums on bonuses when that money is needed to shore up the capital bases destroyed by the bad investment decisions made by those that receive bonuses. The reason is of course because they know the government will provide them with that money and if they had stopped paying bonuses all they would have done is save money for the taxpayer's.

Jonathan Weil continues on this subject, and points out that a key reason why Wall Street need money from the government is because they blow such enourmous sums on excessive bonuses (The other key reason is of course the dismal job performance of those who receive these bonuses).

In a free market economy, these firms would have been replaced by sounder financial firms. But that won't happen because of the government bailouts.

At the same time, we can see how some of the bonuses go to campaign contributions to Presidential candidates. We should perhaps not be too shocked by the fact that these candidates support the bailouts that finance these bonuses.

Why U.S. Exports Will Fall Sharply

Brad Setser thinks that the U.S. trade deficit will start falling sharply. I too think it will fall during the coming months, though probably not in any dramatic way. And after that it will probably not fall any more.

Setser points to how earlier this year, exports have increased a lot faster than non-oil imports and argues that now that the price of oil has fallen dramatically, the oil import bill will fall and so lower the overall trade deficit.

But what Setser completely overlooks (he doesn't even mention it) is the fact that the conditions that created the decline in the non-oil deficit have been swept away. Since these conditions were also responsible for the high oil price, one would have thought that he would have noticed them, but apparently not. First of all, economic growth in the rest of the world has deteriorated dramatically and secondly, the dollar's exchange rate has strengthened dramatically. These two facts will likely not only end the decline in the non-oil deficit but cause it to start rising again.

On the other hand, the U.S. slump is of course also worsening, thereby limiting the increase in the non-oil deficit. What seems certain though is that exports will start falling significantly in the coming year because of the weaker foreign economies and the overvalued dollar. Also, the decline in the price of food commodities will lower the value of U.S. agriculural exports. The domestic slump in the U.S. will by contrast limit the import boosting effect of the overvalued dollar. That will likely still cause the non-oil deficit to rise, while the lower oil price causes the oil deficit to fall. All of this probably means that although the U.S. trade deficit will probably fall in the coming reports, it will stabilize during 2009 at a level not much lower than today. Indeed, if (with emphasis on if) OPEC manages to stabilize the oil price through output cuts, the deficit will in fact start rising again in 2009 as a significant drop in exports cause the non-oil trade deficit to rise.

Richard Salsman Refuted Again

Do read this interesting critique by Larry Sechrest (Thanks Per-Olof Samuelsson for the link) of Objectivist anti-Austrian Richard Salsman view of the Great Depression and the Austrian Business Cycle Theory. Per-Olof Samuelsson has also written an article criticizing Salsman and I have written two posts criticizing him and other Objectivist anti-Austrians ( see here and here). I haven't heard of him for some time now. While I don't really miss him, it would be interesting to hear how he could explain the current economic crisis.

Chinese Growth Declines

Chinese economic growth fell to 9% in the third quarter, the lowest since 2003. The two main factors behind this is the slowdown in exports growth and the Olympic Games. Some would have perhaps thought that the Olympics would boost growth, but because factories in the Beijing area were closed down, it probably lowered growth. What was most remarkable though was that domestic demand held up very well, with retail sales rising 23.2% in nominal terms in the year to September. That nominal retail sales growth stays that high even as inflation is falling implies that real retail sales growth is in fact rising.

One reason why domestic demand so far has held up better than in other parts of the world is that the Chinese financial system (specifically its credit system) is less integrated with the rest of the world. This means that apart from the decline in the stock market and the slowdown in exports, China is not affected by the financial turmoil. Of course, these aren't insignificant factors and that is why economic growth has in fact fallen. And it might in fact have fallen even more than these numbers suggest as Chinese statistics are even more unreliable than in other countries.

It remains to be seen to what extent the reversal of its previous tightening measures can compensate for the negative effects of the worsening global turmoil.
What is clear though is that a further slowdown in Chinese growth would be bullish for the U.S. dollar as it would make the Chinese central bank boost its dollar purchases and it would be bearish for commodities both because of the stronger dollar and because of the reduction in demand.

The Real Point About "Joe The Plumber"

A hot issue recently in the U.S. Presidential campaign is the case of Joe the Plumber, who confronted Barack Obama during one of his meeting about his tax plans which would hit in the future if he expanded his company. Obama answered him that it was important to "spread the wealth" and McCain seized on this case in the final debate

For having embarrased The One, the left-leaning media started digging into Joe's past and it turned out that Joe was his middle name rather than first name, that he lacked the license and formalities required by him from the government and unions and that he didn't make anything close to the $250,000 that he would have to earn to get hit by Obama's tax hikes.

But really, I don't think it is that important of Joe is his first or middle name. And nor do I care avbout licensing (see Lew Rockwell on this issue). And Joe never claimed to make $250K now. What he said was that if he invested in expanding his business then he will hopefully make that kund of money.

The point here is that the Obama tax hike will make it less profitable to invest and expand your business and so might discourage some from doing so. This means less investments and less wealth-creation. And it should be emphasized, Obama's so-called tax cuts have the same effect as they are phased out as income rise, raising the marginal tax rate (See more on this issue here). And so Joe the Plumber himself is really not that important. What is important about this story is that it illustrates how both Obama's tax hike and his "tax cuts" will contribute to increased marginal tax rates across the board and so discourage wealth creation, leading to less of it. In the current cyclical downturn ,that kind of Herbert Hoover-type policies are the last thing America needs.

For more reading on this case, see Lew Rockwell and Mark Steyn

Confusing Effect With Cause

Mark Thoma links to an article by an historian by the name of James Livingston. He argues that the cause of the current financial crisis as well as that of the 1930s was inequality, or more specifically corporate profits constituting an abnormally high share of national income in both the late 1920s and in the last years of the boom that preceded the current bust. With profits being abnormally high, firms invest in asset markets instead of in real investments causing asset price bubbles.

There are several problems with this theory. For example, real investments did in fact rise during those booms sharply. But the most important problem with the theory is that it provides no credible explanation of why inequality and the relative share of corporate profits had risen so much. Given how weak unions were to begin with, it hardly constitute a credible explanation. And are we really to believe that unions strengthened dramatically during the Depression when profits collapsed and so labor's share of national income rose?

No, the real explanation, as I've explained repeatedly (see for example here) monetary policy. Money supply increases causes for various reasons prices to rise faster than wages, causing the profit share to rise. Furthermore, loose monetary policy cause stock prices to increase even faster than profits both by lowering interest rates (and so increasing the present value of projected future profits) and by creating a positive sentiment. This increase in asset values benefits for obvious reasons those who had assets to begin with, which is primarily the rich, and for that reason it increases inequality.

Increased inequality is in other words not the cause of the asset price bubble. Instead, it is like the asset bubble a related effect of inflationary monetary policies.

Isn't That The Whole Point Of Keynesianism?

Paul Krugman links, seemingly sarcastically to an article (which was published back in July) in the sarcastic news site The Onion which says that "recession plagued Americans demand new bubble to invest in". As someone that the article claims to have interviews put it:

"What America needs right now is not more talk and long-term strategy, but a concrete way to create more imaginary wealth in the very immediate future. We are in a crisis, and that crisis demands an unviable short-term solution."

But what Krugman doen't seem to realize is that this provide a perfect satire of the Keynesian view that we shouldn't worry about long-term effects of policies during times like this. That was their attitude during the time the housing bubble was being inflated. And while some Keynesians express worry about a possible housing bubble during the latter stage of it, they didn't have any problem with the initial creation of it nor did they actually even then advocate policies that would have bursted it. Krugman for example argued against tightening monetary policy and he never objected to his fellow Democrat's promotion of the Community Reinvestment Act or Fannie Mae and Freddie Mac.

Monetary Conditions Turn Deflationary

This evening's statistics on U.S. monetary statistics show that MZM fell sharply in the week to October 6, from $8693.3 billion to $8638.6 billion (My own calculations based on numbers available here. To calculate MZM, you subtract small time deposits from M2 and then add Institutional Money Funds). That's a decline of more than 0.6% in a week. It is now down 1.2% from its peak in July.

Even M1 and M2 fell back last week, though they (particularly M1) are unlike MZM still up significantly compared to late July.

This provides an explanation of the massive combined stock- and commodity price sell-off in recent weeks. As long as this monetary contraction continues, we will likely see a continued bear market in stocks and commodities.

This decline has happened despite the record fast expansion of the monetary base created by the Fed's various schemes to prop up the banking system. It thus seems that at least for now, the inflationary effects of the Fed's various schemes have been overwhelmed by the deflationary effects of the increased risk premiums created by the recent financial distress.

One thing interesting to note is that even as the quantity of deposit money is declining, traditional paper and metal money (aka cash aka currency in circulation) is increasing at a record fast pace, being up nearly $10 billion or 1.25% in 3 weeks. This mirrors the development during the Great Depression when currency in circulation increased rapidly even as overall money supply fell fast, as popular mistrust in banks caused people to withdraw their deposit money and hold them as notes and coins. These numbers indicate a similar development (although so far much less dramatic, but that might change).

Swedish Krona, South Korean Won Tumble

I have long believed that the Swedish krona has been undervalued from a fundamental point of view. But since it is perceived to be more risky, and because I believed that the financial distress would continue I didn't think it would rise anytime soon.

Usually, the Swedish krona only moves very little against the euro, but yesterday it tumbled some 3% against the euro and in late trading, a euro for the first time rose above 10 SEK. Or to put it another (inverted) way, the krona fell below €0.10. As the U.S. dollar rose against the euro, the decline was even more dramatic against the U.S. dollar, but the USD is far from all time highs.

I am not sure about the cause of this dramatic movement as there was no news that would trigger this kind of dramatic movement. But a small part can probably be explained by the stock market sell-off today which as previously noted is bad for the Swedish krona, and Swedish media speculate that attempts by Swedish financial institutions to rebalance their portfolios after the latest turmoil could have contributed. And as usual with financial markets, this triggers automatic selling from fund managers with stop-loss rules which further deepens the decline in a vicious spiral.

That the krona becomes even more undervalued than before is very beneficial for Swedish exporters of course. But it also means that inflation won't fall as much as elsewhere, which will limit the extent of further interest rate cuts by the Riksbank.

Meanwhile, while the currency of its neighbor and closest competitor, Japan, is at record levels, the South Korean won is tumbling against virtually all other currencies (except for the Icelandic krona and Zimbabwe dollar). It fell nearly 10% against the U.S. dollar today and now stands at 1,377 per dollar. As late as mid-2007, it took only slightly more than 900 won to buy a U.S. dollar. The cost of buying a yen has similarly risen from 7.5 won to 13.8 won during that period.

The effect of this is likely to be a lot more negative for South Korea than the effects of the weak Swedish krona on Sweden. This is because first of all, the won has tumbled a lot more than the Swedish krona. And secondly because Korean companies and households have much larger foreign currency denominated debt. As the won tumbles, the won value of these foreign debts soars. Indeed one of the triggers for today's massive decline was concern that trouble would arise over these debts. But as these troubles get worse because of the decline, a vicious spiral is created. This is similar to what happened during the financial crisis in Asia 1997-98 and more recently in Iceland. As South Korea was one of the countries that was hit hardest in the 1997-98 crisis, one would have thought that they would have learned the perils of taking on too large foreign currency denominated debt, but apparently they didn't learn their lesson, so now reality will teach them that lesson again.

Current Slump Likely Worst In 70 Years

Judging by today's mini-crash, it seems that the short-term rally might have been even more of a short-term phenomenon than I thought it would be. Given the heightened anxiety from market participants, short-term swings are more erratic and thus also more unpredictable than ever.

While the direction of the short term fluctuations of this highly erratic stock market is unclear, what is very clear is that the slump in the economy is getting a lot worse, which of course, implies that the medium term direction for stocks will be down. America has been in a recession since November last year, but until recently that recession was fairly mild. The trigger for today's sell-off was a barrage of dire economic news. I didn't find them particularly surprising as economic news for the latest month or so have been consistently very weak and as it should have been apparent that the latest turmoil would make these numbers even worse. But it appears that others was surprised by the negative tone of retail sales, business sales, empire state manufacturing index and the beige book.

Tomorrow's industrial production number will probably show a big decline too, judging by the 1% decline in hours worked in manufacturing in the employment report. And what is even more important is that the numbers in coming months will become worse. Although the decline in the price of oil will provide some relief, the sharp decline in asset values (which will continue over the coming year, as house prices remain at historically high levels and as stock prices remain far above levels seen in previous slumps) will force consumers to again start saving, meaning that consumer spending will have to fall. Meanwhile, the higher risk premium, the slumping profits and increased pessimism will cause business investments to continue to decline. And the highly overvalued dollar and the weaker foreign economies will cause exports to fall.

The combined effect of these factors is that the slump will intensify. This will probably make the current slump the worst since the 1930s, worse than both the 1973-75 and the 1981-82 slumps.

(Austrian) Economics Movie?

This article warning that Paul Krugman could become "massive douchebag" after winning the Nobel economics price is pretty funny (so funny that even though it sort of satirizes Krugman, he links to it on his blog). An excerpt:

""I think it's safe to say that Paul had pretty high self-esteem before the Nobel thing went down," said one of Mr. Krugman's Princeton associates, who spoke on condition of anonymity. "But now he's walking around like he's Jay-Z or something."

The first ominous sign, according to the associate, came at a meeting of the economics department this morning, when Mr. Krugman showed up with a coffee mug reading, "No. 1 Economist."

While his colleagues discussed the current global financial crisis, Mr. Krugman "couldn't be bothered" and spent the meeting texting Matt Damon instead.

At one point, one of his fellow economists asked him a question about credit default swaps, to which Mr. Krugman reportedly snapped, "Credit default swaps can suck my ass -- I'm Paul Fucking Krugman!""

In the end it also contains the idea of turning Krugman's popular text book "International Economics-Theory And Policy" into a movie starring George Clooney.

That would perhaps be good way of spreading sound economics. Making some kind of movie or TV-series or something like that to spread sound economics. As far as I know the ontime this has been tried was with Milton Friedman's Free to Choose.You could for example have "Economics in One Lesson-The Movie" or "Man, Economy and State-The Movie" or "America's Great Depression-The Movie".

Especially if the adaptation were done with the help of comedians or other people with a great sense of humor this could be a hit as is illustrated by the great popularity of comedians John Bird's and John Fortune's role play about financial markets and subprime lending.

One thing that of course has to be avoided at all costs would be using the kind of Greek letters and mathematical equations that typically appears in neoclassical academic texts, as the second commentator to Krugman's post pointed out regarding the suggestion that Krugman's book should be turned into a movie.

The focus should instead be to illustrate Austrian theories with practical examples and humor to as high as extent as is possible without compromising any important theoretical points.

Why Strong U.S. Dollar Will Reduce U.S. Corporate Profits

One thing that will limit the likely temporary stock price recovery from last week's lows is that in the earnings reports of the coming weeks the effect of the dollar rally on the dollar value of the earnings of multinational U.S.-based companies will be apparent. Just how big the effect of that will be in this earnings season depends on to what extent companies have used futures/forwards to lock in the previous high exchange rates and how big the negative effect on earnings will be on stock prices depends on to what extent investors have factored in this effect. I have no idea what the answer to the first question is, and I am not really sure about the answer to the second question either, but considering the very negative effect of PepsiCo's earnings warning today on its stock price, it seems likely that it isn't fully factored in (although it is probably partially factored in). The effect will likely be even bigger in coming quarter as the dollar is even stronger now and as futures contracts expire and have to be renewed.

In previous earnings seasons, the profits of mayor U.S. corporations have been held up by the weak dollar which has boosted the dollar value of foreign earnings. As the euro was earlier this year up 15% year over year against the dollar, this meant that even if the euro value of the European subsidiaries of companies like Coca Cola or McDonald's were unchanged, the dollar value of that would still rise by 15%.

Now with the U.S. dollar being higher than year ago levels against almost all other currencies except the yen and the yuan and the currencies that are pegged to the U.S. dollar (such as the Hong Kong dollar and the Saudi riyal), this effect will not only vanish, but also be turned into its opposite. Now the dollar value of foreign earnings will fall even if they are unchanged or slightly up in local currency terms. The effect will be even larger for exporters whose margins will be squeezed. To some extent however the effect will be counteracted by gains for importers.

Moreover, with most foreign economies weakening, the local currency value of these earnings will probably take a hit in most cases. The combined effect of these two factors means that the dollar value of earnings from foreign subsidiaries will start falling after having previously soaring. And as domestic earnings will continue to fall, this means that overall profits will decline.

Ron Paul & Jim Rogers On The Financial Crisis

Ron Paul and Jim Rogers were interviewed recently on Fox News and CNBC respectively, and as usual they both made very good points. The one thing I would correct Rogers on would be that he doesn't seem to realize that China, Singapore and the other Asian countries do in fact borrow to the U.S. and that it is largely in U.S. government securities and other U.S. assets that they hold the reserves he's talking about, and that they are suffering because of this.

Anyway, that's only a minor point and for the most part he is right on the mark. I especially like his characterization of government officials in the beginning and what he says they should do at this point at 4:20 into the video. The first video is with Paul, the other with Rogers.

More On Iceland

In contrast to other stock markets this week, what's left of the Icelandic stock market plunged 77%(!) today after trading resumed after having been suspended for three days. That mostly reflects the fact that the stocks of the nationalized banks have been become worthless.

Bloomberg also has an interesting story on how the collapse of the Icelandic krona is causing a collapse in the Icelandic economy, both by creating massive inflation and also by causing the krona value of the foreign currency debt to soar. I made those same points in my recent post on Iceland, so that's not really news for regular readers, but the story is still worth reading as it provides more background and specific cases of people hit.

More On Stock Market Valuation

My call last Friday of an imminent stock market rally has as most of you probably know been vindicated.

Another thing in that post which have been confirmed was the view that at the time, the U.S. stock market had reached fair value after having been overvalued from a fundamental point of view for some time. I see in the Wall Street Journal that Robert Schiller, using a slightly different methodology came to the same conclusion.

I compared how the S&P 500 had developed relative to GDP since a point in time where I believed stocks were reasonably valued, namely 1994. In the long run, stocks should increase at the same pace as GDP. The reason for that is that stock market valuation can be rewritten as being equal to the P/E ratio times the profit share of GDP times GDP.

Of these three components the only real sustainable source of increase in stock market valuation is GDP (Globalization complicates this potentially, but any deviation would have to assume that domestic companies keep losing or gaining more in other countries than the other way around(. Because although the profit share of GDP often go up and down (it usually increases during booms, while decreasing during busts), profits can't in the long run keep increase faster than production as workers will not accept constantly losing ground. Similarly, while the P/E ratio can go up and down, if it increase too much stocks will simply become overvalued. While it is possible with one-time permanent shifts in levels, the fact remains that the only sustainable source of rising stock market values is a higher value of production.

Illustrating the point that the profit share remains constant in the long run, is the fact that Robert Shiller also concluded that the value of the stock market were at or slightly below the long term value. He used the so-called Graham P/E. The Graham P/E uses the average annual profits during the latest 10-year periods, and so avoids being distorted by unsustainably high profits during the peak of the booms, or temporarily low profits during the downturn. The historical average for the Graham P/E is 16.3, and during Friday it was 15, yielding almost the same conclusion as my methodology.

The article also makes another point that I made in my post. Although we are now seeing a rally and will continue to see one for a while, interrupted only by temporary profit-taking, this was probably not the end of the bear market, because usually when they end, valuations are below the historical average. At its low in 1982, the Graham P/E was just 6.6, less than half of Friday's level. It will probably not fall that low, but it will certainly fall below 15.

Krugman Did Not Win Because Of His Keynesianism

As many of you have heard now, Paul Krugman won the Nobel price in economics today. The "Information for the public" release from the Riksbank can be read here, the "scientific background" can be read here.

The award made Bill Anderson at the LRC blog furious because it could be seen as an endorsement of Krugman's Keynesianism and left-liberal political views. And he has a point in the sense that Krugman and some of his followers could abuse the award as an endorsement of his macroeconomic and political views. And for that reason this award is indeed bad news.

However, it must be emphasized that he did not win the award on account of his macro economics, much less his politics. As is apparent if you read the information release, what he receives the award for is his contributions to trade theory. And his ideas in that area really aren't that bad.

His main contribution is that he emphasized that contrary to traditional non-Austrian trade theory, trade need not arise because of differences in technology or relative endowment of production factors, but also because of economies of scale. This is really not a departure from the core idea of comparative advantage, but more an extension.

Similarly, his idea that trade arise because of preference for diversity of brands is correct, though not really revolutionary. The same thing goes for pointing out that if international trade is not possible, the bigger of two different countries will be richer. That is simply a result of the bigger country having a bigger intranational trade.

His final theory that he is awarded for is that if initially there are high transportation costs for manufactured products but no transportation costs for agricultural products and if there is free migration between regions for manufacturing workers but not peasants, then this will inhibit urbanization as it will be more profitable to move workers to rural areas to overcome transportation costs. And from this it follows that if these costs fall, those incentives will weaken and so encourage urbanization.

None of these theories are really seriously objectionable and although some of them had already been advocated by Austrians they weren't popular or even known among non-Austrians, so in that sense, Krugman is actually one of the more well-deserving winners in recent years. The only problem is the risk that it will be believed that he is awarded for his other ideas, those that are more well-known to the public.

Foreign Central Bank Intervention Could Prolong Dollar Rally

I have previously argued that I think the U.S. dollar is overvalued and that the dollar rally would therefore last at most until the end of the year.

I still think it is overvalued in the sense that in the absence of central bank interventions, it would drop sharply. But I now think it might stay overvalued for longer than I previously thought.

Essentially, exchange rates like all other prices are determined by supply and demand. For currencies, this supply and demand can be further sub-divided into supply and demand for goods & services and supply and demand for assets. Demand for a certain currency is constituted by foreigner's purchase of domestic goods, services and assets, while supply of a certain currency is constituted by domestic demand for foreign goods, services and assets. If a certain country (or more strictly currency zone) runs a trade deficit, this means that domestic demand for foreign goods & services is greater than foreign demand for domestic goods & services, or in other words that the goods markets create a net demand for the foreign currency. In order for currency markets to remain in equilibrium, this requires a net demand for the domestic currency in the asset markets, or in other words that there is greater foreign demand for domestic assets than domestic demand for foreign assets.

Moving from this abstract general theoretical reasoning to the specific case for the U.S. dollar, it is clear that in the absence of central bank intervention, the dollar should and would fall. The U.S. runs a still large trade- and current account deficit, meaning that there is a large net demand for foreign currencies in the goods markets. At the same time, the U.S. provides worse value for investors than just about any other countries. While U.S. stocks may no longer thanks to the recent sell-off be overvalued in a historical sense, they are still overvalued compared to stocks. Meanwhile , interest rates on government securities are lower than in almost all other countries (particularly after adjusting for inflation) while the so-called sophisticated debt securities (including mortgage backed securities) issued by U.S. investment firms have turned out to be hoaxes backed by dubious collateral, and so should impress no one at this point. There should therefore be no reason why the U.S. should attract foreign capital more than foreign countries should attract U.S. capital. This should create a strong disequilibrium in the sense of shortage of demand for U.S. dollars, and so should drive down the value of the U.S. dollar so as to reduce, if not eliminate, the trade deficit and also make U.S. assets cheaper.

However, the problem with the above analysis is that it only applies to currency markets where central banks or other government institutions don't intervene. In reality they do, as we all know. Central banks have of course been net buyers of U.S. assets for years now, but until recent months these purchases where relatively moderate and more diversified into other mayor currencies such as the euro. Now, in recent months, central banks purchases of dollar assets as shown in Fed statistics have soared. From having financed less than half of the trade deficit, it now finances more than 100% of it. This implies that the required non-central bank capital inflow has gone from nearly $30 billion per month to being negative, causing the dollar to soar.

Returning to the theoretical level, this means that you can't analyze merely in terms of how attractive these assets are with respect to for example interest rates. You also need to take central bank behavior into account.

The real question in this supply & demand analysis is how central banks will behave in the future. If they stop or greatly reduce their dollar purchases, then this will doom the dollar rally. If they keep this up, however, the dollar rally will probably continue, or at the very least it won't be reversed.

Of course, we can't know for sure how they will behave. But there are increasing signs that they won't reduce their dollar purchases anytime soon. Because of the global downturn, many Asian countries that once tried to restrict their dollar purchase to limt the growth of central bank balance sheets and so contain inflation have now indicated that they will step up dollar purchases to hold down the exchange rate of their currencies to subsidize exports. The up tick in dollar purchases and the ensuing dollar rally came very soon after China stopped the gradual yuan appreciation in early July, indicating a great role for China in these events. And as the Chinese leaders seem increasingly worried about growth, and less and less worried about inflation, there is no reason to believe they will scale back dollar purchases.

Another indication was the announcement by Singapore this week that it would end the gradual currency appreciation policy to boost growth. And it seems likely that many other countries in Asia and elsewhere will reason as China and Singapore.

For that reason, it seems likely that central banks will keep up the high pace of dollar purchases as long as growth remains weak, which will probably be until at least next year, prolonging the dollar rally. Meanwhile, the trade deficit boosting effect of the dollar rally will be limited by the decline in the price of oil. The most uncertain factor here is private sector capital flows, which pose the great threat to the dollar rally, given the aforementioned low value provided by U.S. assets. The likely imminent temporary stock market rally could again increase the willingness to invest outside the U.S., and so push down the dollar against other currencies (except the yen, which will probably fall if stock markets rise) during the coming rally. This effect will however be limited by the central bank actions, and once the rally is over, this effect will disappear.

The bottom line is that the increased central bank purchases will probably continue and this will likely prolong the dollar rally until they decide to reduce these purchases, which will probably not be until the economic slowdown/downturn ends.

About This Week's Monetary Statistics

Last week, I told you about how monetary statistics had some really extraordinary features. The same thing is true only to a slightly lower extent of this week's numbers.

If we start with foreign central bank purchases in the week ending October 8, they totaled some $19.5 billion (they purchased $32.5 billion of Treasuries while selling $13.0 billion of Agency bonds.) While that is less than last week, it is still very high (if that rate sustained it would be more than a trillion dollar in a year) and explains the continued strength of the dollar. I'll return to that issue in a separate post later this weekend.

Continuing with base money, we could see that Reserve Bank Credit rose another $103.6 billion to $1494.7 billion in the week to October 8, creating a 4-week gain of 66.3%(!). The monetary base rose a relatively more moderate $74.4 billion in the two weeks to October 8, to $985.9 billion. Even so, this means that the 2 week average monetary base is up 16.8% compared to 4 weeks earlier. Although currency in circulation has increased unusually fast too in recent weeks, what really drives the increase in the monetary base are increases in bank reserves, which are up to $179.9 billion, up from $47.1 billion in the two week period 4 weeks earlier.

Despite the sharp increase in the monetary base, MZM actually fell by 0.28% to $8693.3 billion in the week to September 29. MZM is down 0.42% in the latest 8 week period, indicating that monetary conditions are actually deflationary (undoubtedly one of the factors behind the combined stock- and commodity price rout) despite the Fed's aggressive moves to reignite inflation. So far it seems that the deflationary effects of the financial distress is slightly more powerful than the inflationary effects of the various Fed schemes they have launched. If we look at the various components, we can see that M1 continues to soar, seeing a weekly 2.1% gain to $1510.4 billion with demand & checkable deposits up another $29.1 billion and currency in circulation up another $2.4 billion. However, this was more than cancelled out by a $49.5 billion drop in savings deposits and a $6.9 billion drop in institutional money funds.

Bank credit on its hand, had a very different message from MZM this week. Bank credit soared nearly 3% in the week to October 1 to $9864.4 billion, creating a 4 week gain of 5%. This may seem puzzling. While the financial media may exaggerate the credit crunch, surely there is no massive credit expansion around, particularly not at that very high rate (A gain of 5% in 4 weeks implies an annual rate of nearly 90%!). What is going on here is not a general credit expansion, but a shift in credit transactions from money markets to bank balance sheets. Because at the same time as bank balance sheets expand rapidly, money market mutual funds and commercial paper is contracting. This means that one should not interpret the bank credit numbers as indicating a massive credit expansion. But this also means that one should not as Larry Kudlow did in his most recent column, interpret the sharp decline in commercial paper as indicating a massive credit contraction. Overall credit are probably stagnating or declining slightly, while at the same time increasingly being on rather than off bank balance sheets.

Dow 9000!

The Dow rise above 9000! News dated April 1998

The Dow fall below 9000! News dated October 2008

I'll return later for more on this issue, but for now I think the dates of these two headlines give a pretty good picture of how bad things are.

More On Mark To Market Accounting

Jonathan Weil provides another argument against abandoning "mark to market" accounting. He points out that such a move, which would enable companies to attribute a higher value to assets than current market value, would make the problem of investor distrust of corporate financial statements even worse. He also points out that companies do in fact have more discretion than some people claim to ignore market values in their accounting.

For my own analysis of this subject, see here.

Good News, Bad News From Latvia & Estonia

The good news from the Baltic countries is that inflation is falling in both absolute and relative terms. In Latvia inflation fell to 14.9% in September, down from 15.6% in August and 17.7% in May. In Estonia, inflation fell to 10.5%, down from 11.1% in August and 11.4% in May. By contrast, euro area inflation is down only to 3.6%, from 3.8% in August and 3.7% in May. Both the absolute and relative level of inflation will continue to fall in coming months because of the fixed exchange rate versus the euro and the economic downturn.

And now that we're on the subject of the economic downturn, the bad news is that the downturn appears to be getting worse. In Latvia, industrial production fell a full 11.1% from a year earlier, and in Estonia real retail sales fell 6% from a year earlier. It seems pretty safe to say that the downturn will get worse before it ends, something that is bad news for Swedbank and the other Swedish banks with high exposure to Latvia and Estonia.

In the medium to long term though, to the extent the fixed exchange rate limits the discretionary powers of the government, it will also limit the ability of government to mess things up further and so enable Estonia and Latvia to purge their excesses and thereafter start a new recovery.

Global Coordinated Interest Rate Cut

As most of you have probably already heard, several of the largest central banks today all cut their formal interest rate by 50 basis points (0.5%:points). Among those included were the Fed, the Bank of Canada, the Bank of England, the ECB, the Swedish Riksbank and the Swiss National Bank. In addition, the Chinese central bank reduced its target rate by 0.27%:points (the Chinese like using numbers that can be divided by 0,09). The Bank of Japan didn't participate but issued a statement expressing support for the action, and the Reserve Bank of Australia had of course already implemented a full 100 basis point cut.

At least in the case of the Fed, and probably some of the others too, this move won't have much of an impact as they had already implemented de facto interest rate cuts. The main effect will be psychological, although that might not be meaningless considering how the dramatic market movements recently have been driven by increased fear. It will certainly not even be close to ending the crisis, though.

U.S. Federal Deficit Reach New High

The Congressional Budget Office yesterday released its preliminary budget data for September and therefore also for fiscal year 2008 since that ended in September. The numbers show that the deficit reached a new all time high in dollar terms of $438 billion (although it was well below the highs of the early 1980s as a percentage of GDP), up from $162 billion in fiscal year 2007. The increase in the gross debt was more than twice that because of the increase in debt held by government agencies.

This reflected both falling revenues as a result of the weaker economy and the so-called tax rebates but also soaring spending. Calendar adjusted spending rose 8.3%, far above nominal GDP growth of 4% (and even slower growth of national income). As a result, federal government spending as a percentage of GDP will likely reach 20.8%, the highest level since 1994. And even this really underestimate how high spending has become because first of all GDP might be overestimated and secondly because the cost of interest payment has been held down by falling interest rates. Accounting for that spending may be at an all time high.

For fiscal 2009, it seems almost certain that spending will increase further. Not only is that what typically happens during downturns, but perhaps even more importantly because of the cost of the bailouts and probably also because of some new "stimulus package" enacted by President Obama and the Democratic Congress. The only spending post likely to be contained will be interest payments. While the higher debt would perhaps make some believe that they will rise, this effect will be more than cancelled out by the lower interest rates.

Meanwhile, revenues will continue to decline (and decline even faster than in fiscal 2008) because of the economic slump and perhaps also because of "tax credits" in the likely "stimulus package".

As a result of falling revenues and soaring spending, the deficit will probably rise sharply in the next fiscal year. This will be very convenient for the additional bailout schemes that will likely come, where part of the strategy will likely be to exchange Treasuries for Mortgage backed securities and other assets perceived risky.

I'm Referenced In Sweden's Biggest Business News Paper

Even though it was published earlier in the day, I didn't notice this until just now. It seems that I was quoted by well-known Swedish libertarian Johan Norberg in his column in Sweden's largest business/financial news paper Dagens Industri, where he pointed to the fact that many free market economists ,including me, saw the current problems coming.

"Den liberale ekonomen Stefan Karlsson, som tidigare i år gav ut en insiktsfull Timbrorapport om det österrikiska förperspektivet på konjunkturcykler, hävdade 2004 att USA:s huspriser bara behöver sjunka 20 procent för att en fjärdedel skulle tvingas lämna bostaden. Låga räntor och underskottsfinansiering stökade till: ”Alan Greenspan och George W Bush förhindrade inte att 1990-talets börsbubbla blev en kris. De bara fördröjde den"."

Translated into English this means:

"The [classical] liberal economist Stefan Karlsson who earlier this year published an insigthful Timbro report on the Austrian perspective on business cycles, argued in 2004 that U.S. home prices only had to fall another 20% to force a fourth [of households owning homes] to leave their homes. Low interest rates and deficit financing only messed things up: "Alan Greenspan and George W. Bush didn't prevent the stock market bubble of the 1990s from becoming a crisis." They only postponed it.""

Fed Plans To Buy Commercial Paper

The Fed has launched so many schemes now to reignite inflation since the beginning of the economic downturn and financial crisis last year that I have lost track of how many they have been. Can anyone remember how many schemes they have launched?

Anyway, the latest one, announced today calls for the Fed to buy commercial paper, in order to reduce the widening yield spread between Treasuries and commercial paper.

This is indeed a smart move in the sense that if you want to increase the size of the commercial paper market and lower yields, there is no better way of achieving it then by buying commercial paper directly.

This will likely not be the end of it as the financial distress will likely continue. This in turn means that the Fed will launch even more schemes of this sort and so continue to expand its balance sheet.

The end result of all of this will likely be that the U.S. government directly or through the Fed will end up socializing an increasing share of lending to anything perceived risky, while the private sector (and foreign governments) will increasingly only save in the Treasuries used to finance these schemes. A nearly completely government controlled system in other words, differing from a socialist system mostly in that it provide subsidies for a few private financial institutions.

The Melting Icelandic Economy

The perhaps biggest victim of the global financial turmoil may just turn out to be the tiny nation of Iceland whose population number just slightly above 300,000 (or about 1/1000 of the population of the U.S.). To be sure though, much of its woes are self-inflicted.

Iceland has long had a problem with a much too spendthrift economy, as is evident in its massive current account deficit and its high inflation rate. In recent years, the people of Iceland (or more specifically its banks) have borrowed far too much from abroad, something which they have done mostly in foreign currencies which have had a much lower interest rate than in Iceland. Because of the willingness of Icelandic banks to borrow in foreign currencies, it has been difficult for the Icelandic central bank to contain credit expansion by raising interest rates in terms of Icelandic kronor.

Now the Icelandic krona has fallen some 45% in the latest year against the euro and the U.S. dollar . A year ago a U.S. dollar stood at ISK 61 and a euro stood at ISK 86. Now (October 7, 2008) a dollar costs ISK 107 and a euro costs ISK 147. There are two consequences of this. First, there will be a massive increase in price inflation as Iceland, being a tiny nation, is very dependent on foreign trade and thus also foreign exchange rates. And secondly it will cause a massive collapse in domestic demand and only to a somewhat lesser extent. The reason for the latter is that the value of all those foreign debts accumulated by have now risen some 80% in terms of ISK, bringing many banks and other companies and households to the brink of bankruptcy. The Icelandic government though, is as reluctant as others to allow banks to collapse so it has nationalized the two biggest banks, Landsbanki and Glitnir.

This scenario where a massive currency collapse will cause both a sharp increase in inflation and a sharp economic downturn caused by a massive increase in the foreign debt burden is not to dissimilar to what happened in many East Asian countries in 1997-98.

To avoid a further collapse in the currency, the Icelandic government now says it will peg the ISK to a basket of currencies. Ironically, during the East Asian crisis it was often said that the pegs formerly kept by the crisis hit countries and if they had only kept a floating exchange rate this wouldn't have happened. Now Iceland seems to think that the floating exchange rate policy it kept until today is the root cause of its crisis and that a peg is the solution.

In reality both systems are vulnerable and the only real way to do away with the exchange rate risks is a monetary union (assuming that it is permanent). It remains to be seen just how sustainable this peg will be. What will Iceland do if there are speculative attacks against the peg? Impose draconian capital controls? Raise interest rates to 500% like Sweden did in its futile attempt to defend its peg in 1992? The risk is high that this measure could end up causing even more problems.

In any case though, Iceland will be forced to stop living beyond their means and run as large current account deficits as it has in recent years.

Swedbank Lose Customers, Credit Rating

While Swedbank, as I have previously pointed out, has vehemently denied that it has any significant problems and characterized the rumors of it as lies spread by short sellers, it now seems that the rumors themselves are causing problems for Swedbank.

First of all, they have now admitted that they are now suffering net withdrawals, particularly from really rich customers. It remains to be seen to what extent the increase in the amount guaranteed by the Swedish deposit insurance from SEK 250,000 to SEK 500,000 announced yesterday by the Swedish government might slow these withdrawals.

Secondly, Standard & Poors have now lowered their credit rating. Not that I really trust their credit ratings, but since others do this will hurt Swedbank.

The Fed Has Cut Interest Rates

When people say the Fed has cut (or raised) interest rates they refer to the Fed funds rate. The Fed funds rate however could mean two different things: the target rate and the effective rate. Usually when the media refer to the Fed funds rate they refer to the target rate, yet that rate is in fact of no importance at all except as the guide by which the Fed uses open market operations to control the effective rate at which banks actually exchange funds through the Fed. What really matters is the effective rate. Until mid-September, the effective rate was essentially the same as the target ratem give or take a few basis (0.01%) points. Then something really strange happened.

First it spiked to between 2.5% and 3% for two non-consecutive days, only to settle at first about 1.5%, then about 1%. See it for yourself here (scroll down to the bottom of the page), the effective Fed funds rate has been cut to 1%. This unannounced yet still effective 100 basis point interest rate cut by the Fed is most likely related to the extraordinary monetary statistics I recently told you about. The Fed is determined to drown the banking system with money with any means possible short of helicopters (although that may come later).

On the other hand, most market interest rates (including LIBOR) have risen (some dramatically) during that same period. These divergent interest rate trends illustrate my previous point about the "battle" between the inflationary injections by the Fed and the deflationary effects of the increased risk aversion and financial distress.