Why Greenspan Caused The Financial Crisis

Today I have an article on mises.org explaining why Greenspan caused the current economic problems by answering the arguments of the people that deny this.

Euro-Pound Parity?

Traditionally, the U.K. pound has always been the most valuable currency in the world, apart from briefly the currencies of a few small third world currencies. The odds are however now increasing that the pound might soon be valued less than the euro. It has fallen relentlessly in recent weeks and has traded today at near €1.02/£.

It didn't seem long ago when I noticed how the pound had fallen below €1.25 (which in inverted terms means the euro rose above £0.80), a time when I noticed that the pound had fallen from €1.38 when I first called for its decline. And it wasn't that long ago that the pound was valued as high as €1.5.

While the pound was clearly overvalued at €1.5 and €1.38 and even to a lesser extent €1.25, it is now starting to look undervalued from a fundamental point of view, even factoring in how the more inflationist attitude of the Bank of England relative to the ECB will debase that fundamental value. Which is why while I think it is possible and even likely that the euro will briefly reach a higher value than the pound, we are getting close to the peak of the euro's rally against the pound, at least provided that the Bank of England doesn't opt for some kind of radical inflationist "solution" for U.K. economic problems.

Obama Economic Plan Explained

At the National Review blog The Corner, I found this great explanation of the Obama economic plan, using an Abbott & Costello routine:

Abbott: The economy's a wreck. People have a lot less money now then they did three months ago.

Costello: No problem. The federal government's going to spend $1 trillion to put more money in our pockets.

Abbott: But the government doesn't have any money either. The federal deficit's already around $1 trillion. And the federal debt's around $11 trillion.

Costello: No problem. The government will use tax money.

Abbott: But that's our money in the first place. And we don't have any more money.

Costello: No problem. Then the government will just borrow the money.

Abbott: But the people who usually loan the money don't have any more money either.

Costello: No problem. The government will just print all the money we need.

Abbott: But that will make the money worthless.

Costello: Yeah, but at least people will have money in their pockets.

Abbott: But they won't be able to buy anything with it.

Costello: No problem. We'll just blame it on Bush.

Abbott: Sounds like a plan.

Crisis Is A Failure Of Government Intervention

Caroline Baum has a good column where she points out how the crisis was the result of government fixing the price of short-term loans and bailing out bad financial companies. And that despite all the talk of deregulation, the small army of regulators overseeing banks now has failed to stop the problems.

Krugman, Teetotaller Hangovers & Austrian Theory

Paul Krugman is at it again, denouncing what he calls the hangover theory, which is to say his straw man version of Austrian business cycle theory.

He first claims that Austrian theory can't explain why there isn't increased unemployment during the boom phase or why almost all sectors experience difficulties during the slump, which is not true, as I pointed out in a previous post.

Krugman proceeds to note that in the top ten of states that experienced the biggest housing bubbles along some of the states that experienced the biggest housing bubbles, such as California, Nevada and Florida, are states like Georgia, Alabama and the Carolinas which supposedly didn't have a housing boom, something which he appears to regard as evidence against "the hangover theory". But first of all, it is not really true that there were no housing boom in the states he points too, at least no cyclical one. Because of slower population- and economic growth their structural growth is slower than in for example Nevada, meaning that even if their aggregate housing boom were modest, it could still be a cyclical element in that boom.

But more importantly, it is not inconsistent with Austrian theory to expect other states than the ones with the biggest bubbles, like California, Florida and Nevada to suffer from the bust. It would only be inconsistent if states had been economically isolated from each other with no trade or capital flows across the states. But in reality there is a very high level of economic integration between states. And as many companies in for Georgia were selling goods to for constructors and others in Florida, they will naturally take a hit if their customers stop buying their goods. Their investment in output meant to serve customers profiting from the housing bubble were as much malinvestments as the houses built during the housing boom.

Similar reasoning can be applied to explain the apparent mystery of why not just countries with big housing bubbles, like the U.S., the U.K. and Spain are affected by the current global downturn, but also countries with weak housing markets like Germany and Japan are affected. The Economist referenced the problems of Germany and Japan with Krugman's "hangover theory" term, as "the teetotaller's hangover".

As Germany and Japan borrowed the bubble countries the money they needed for the housing boom and centered their economies on selling goods to bubble countries, they are of course affected when the booms turn into a bust. Germany's decision to raise its value added tax (which taxes imports, but not exports) and at the same time lower its payroll taxes (which taxes exports, but not imports) in an attempt to increase its export dependence don't look that smart now. This is also aggravated by exchange rate effects in the form of the extreme strength of the yen, which are knocking out even many Japanese exporters that might have been able to survive the general slump alone, as well as the extreme weakness of the U.K. pound, which are hurting German exporters in particular.

The Fateful Bailout Of Long Term Capital Management

Tyler Cowen discusses the fateful mistake by Alan Greenspan of bailing out the creditors of Long Term Capital Management (the fund managed by neoclassical financial academics testing their mathematical theories in practice, a test which failed spectularly) that I have discussed before. Although this wasn't the only bailout before this crisis, it was arguably the biggest and most spectacular one, and therefore it was the bailout that created most moral hazard, and so was a minor contributing cause of the current crisis. We are now experiencing the long run during which Keynes claimed we would all be dead. As Cowen points out, while failure of LTCM may have led to deleveraging then, it would have been far better to do so then with much smaller imbalances.

Deflation Boosts U.S. Economy

Because it was released on Christmas Eve, when most people including me were focused on other things, the November personal income- and spending report for the U.S. didn't attract much attention. Yet it contained some interesting news.

Despite the fact that the savings rate rose significantly, real consumer spending rose as much as 0.6% in November, following 5 straight months of declines. This means that the economy probably didn't contract as much as most people have believed, though it will still definitely contract.

But how could real consumer spending increase even as the savings rate rise? Simply because real household income rose sharply, by 1.1%, which is a lot for a single month (at an annual rate it's roughly 14%). And why did it rise so much? Because of deflation, as the price index fell by 1.2%. The deflation during that month thus provided a significant boost to the purchasing power of U.S. consumers and so to the entire economy.

This is not meant to suggest that deflation can't in other circumstances have a contractionary effect. But it clearly illustrates that this is not always the case and that deflation thus can have a positive effect, something which is usually neglected by non-Austrians.

Steve Chapman's Strange Defense Of Inflation

I see via Anthony Gregory that over at Reason magazine, Steve Chapman argues that inflation is the solution to the current downturn.

He has the following arguments for that assertion: first, he argues that inflation is a substitute for increased government spending, and inflation is a lesser evil. Second, it would increase consumer spending by making credit more available and lowering the incentive to postpone purchases. Thirdly, he argues that by redistributing for debtors to creditors, one makes both a favor since the debtors will become more solvent and so reduce defaults, which will benefit creditors. Fourth, he claims that this would actually speed up adjustment of the housing sector by bidding up prices in other sectors more than house prices.

The argument that inflation is a substitute for government spending makes no sense, because first of all under current circumstances inflation is in fact government spending. The way the government achieves inflation is by having its agency the Federal Reserve buy up all kinds of assets in order to expand the monetary base, which in de facto terms is little different from TARP. And the only way it can avoid buying private assets, is for the Treasury to issue more Treasury securities in order to expand government spending. So, government spending is not a substitute for inflation, it is the way inflation is achieved.

As for inflation promoting consumer spending, there is some truth to that, as it usually lowers real interest rates. But insufficient consumer spending is hardly the problem in an America with a all too savings rate.

His argument that inflation is the best way to restore the value of the assets backing mortgage backed securities (houses) is difficult to square with his argument later that inflation would raise other prices more than house prices . Under the current circumstances, I think the argument that house prices would benefit less than other prices is probably correct. But that means that in order to make a really meaningful difference in terms of house prices, you'd have to bring on really serious level of inflation, at least a double digit level of inflation, a level which is really damaging in the long term. And to break that will be anything but painless, as the serious slump Paul Volcker brought on in 1980-82 to break inflation illustrates.

As for the argument that inflation is beneficial for both creditors and debtors, that first of all assumes that inflation will raise nominal income for troubled debtors, and raise it more than their cost of living. If the price of gas increases from $2 per gallon to $4 per gallon, that sure won't make it easier for home owners to spare enough money to make their mortgage payment, it will in fact make it more difficult. Only if their nominal income rises more than their nominal cost of other expenditure will it make it easier for them to pay their mortgages. And it is far from certain that that will actually be the case.

And moreover, even assuming for the sake of the argument that debtors will benefit from inflation, is it really true that creditors will benefit? Only if first of all the value of the repaid mortgages in the case of borrowers who will be able to pay back their loans because of inflation will exceed the value of foreclosed properties in the absence of inflation. But since the value of foreclosed property is ultimately based on the ability to pay of any interested owner, this would require that somehow the income of current owners would be disproportionably boosted in order for the decline in real value of the mortgage to be lower than decline in value for creditors that foreclosure would mean, something which seems implausible in most cases. And moreover, that supposed surplus must exceed the large losses they make in the case of mortgages that would have been paid off anyway, or where no disproportionate income gains for borrowers occur, making it a lot more likely that they will lose a lot.

As for speeding up the relative decline of the housing sector, that may be true, but only in the sense that the housing bubble speeded up the relative decline in business investment after the end of the tech stock bubble. Or in other words, assuming that house prices will be bid up less than other prices, it will not create a new housing bubble, but it could create another bubble. And as the housing bubble created to reduce the pain from the tech stock bubble sure wasn't, nor is another bubble in a new sector a good idea.

Japanese Exports Plunge

In a news story not entirely unrelated to the one I mentioned in the previous post, the Japanese Finance Ministry today reported that Japanese exports plunged a record 26.7%. Not surprisingly, exports to the U.S. fell the most (34%), while exports to Europe fell 31% and exports to China 25%.

Imports fell too, but only 14.4%, and that was mostly a result of collapsing (particularly in yen terms) oil prices. As a result of the much lower decline in imports, Japan again posted a trade deficit. The fact that Japan now appears to have a structural deficit even as it has provides low return for capital again suggests that the yen is no longer undervalued, and is in fact likely overvalued. Renewed sell-offs on global stock markets might push it even higher in the short-term, but once we starts to see a recovery, the yen looks set to fall significantly.

Toyota Starts Losing Money

Toyota has long been the shining example of success within the global car industry, taking market share year after year from primarily the Detroit auto makers. But while Toyota remains in far better shape than the Detroit auto makers, they too are starting to suffering. After being for years one of the most profitable companies, in the world, they now looks set to report an operating loss in the year ending March 2009.

And the trend is in fact even worse than this full year number suggests, as they were profitable at the beginning of the year, the loss is even greater at the end of the year, and suggests an even bigger loss next year, unless the situation suddenly improves.

There are two reasons for this reversal of fortunes. First, the car industry is one of the most cyclical and as Toyota's gain in market share has ended, meaning that its sales particularly in the U.S. is plummeting.

The other reason is the extreme strength of the Japanese yen. While Toyota has moved more and more of its production outside Japan, it is still a large exporter of cars from Japan to the rest of the world. And as the yen is up some 25% against the U.S. dollar this year, and even more against most other currencies. A 1 yen gain against the U.S. dollar will reduce its profit by 40 billion yen ($450 million), meaning that the 23 yen gain against the U.S. dollar this year alone will reduce its profit (increase its losses) by roughly $10 billion. And as Toyota like others use futures and as much of the gain has come lately, we've only seen a small part of the pain for Toyota from this. And add to that the losses from the yen's even greater strength against most other currencies.

Toyota is well capitalized so it will be some time before they face the threat of bankruptcy, like GM and Chrysler. But they are certainly heading for big losses in the coming year(s) unless the global slump ends and/or the yen quickly weaken significantly.

Robert Higgs On The New Deal & World War II

I've frequently recommended Murray Rothbard's great book America's Great Depression. Yet that book's historical section only covers the inflationary boom of the 1920s and the presidency of Herbert Hoover. It doesn't say anything about the New Deal and World War II, leaving the myth that the New Deal helped create a partial recovery and that World War II restored full prosperity untouched.

In this very interesting and lengthy interview at Econtalk , however, Robert Higgs of the Independent Institute does a really good job at setting the record straight on the New Deal and World War II. You can both hear the audio interview, and read the highlights.

Declining Treasury Yields & The Inflation-Deflation Debate

I have recently argued in several posts (for example this one) that the decline in Treasury yields (or in other words the interest rate on U.S. federal government debt securities) indicate increased monetary inflation. But at the same time, Mike Shedlock argues that falling Treasury yields are a sign of deflation. That would at least appear to be contradictory, so who is right?

At this point, you would naturally expect me to write that I am right, and indeed I do believe that I am right about this. Still, while I believe that Mish is wrong, it can't be denied that he could be right theoretically (which is to say under different circumstances, falling bond yields could reflect deflation).

To get to the bottom of this, it must be asked what possible reasons could there be for falling Treasury yields. The answer to that question is that there are broadly 4 possible reasons why Treasury yields may fall:

1) Lower inflation expectations. This reflects more deflationary (less inflationary) conditions and is thus a symptom of deflation. Though it should be cautioned that expectations are a lagging indicator, and when there is a dramatic increase or decrease in inflation, the turnaround in inflation will happen later.

2) An increase in savings/a reduction in the government budget deficit. This is essentially neutral from the inflation/deflation perspective, though in the long term, the higher production capacity this enables will push down prices.

3) An increase in risk aversion/liquidity preference. As government bonds ( at least in the U.S.) are perceived as risk free and are the most liquid asset around, increased risk aversion and/or liquidity preference will lower government bond yields. This is also basically neutral from an inflation/deflation perspective, though it will mean tighter credit conditions for the private sector, which will have a deflationary effect. On the other hand, the lower cost of borrowing combined with weaker private sector activity could encourage government to expand the budget deficit which would negate much of the aforementioned deflationary effect.

4) An increase in the money supply that is used to bid up bond prices. This is the case where inflation pushed down yields.

So, theoretically, a decline in government bond yields could reflect inflation, be irrelevant from an inflation/deflation perspective, or reflect deflation. This implies that falling Treasury yields alone can't be used as conclusive evidence of anything. In order to tell what it implies you have to look at other data as well. This brings us to the issue of what it is a result from.

Is it a result of falling inflation expectations? To some extent, yes, as is suggested in the dramatic decrease in the spread between nominal treasuries and inflation-protected ones (TIPS). However, much of the decline in that spread reflects the much higher liquidity of nominal treasuries and the increasing liquidity premium. And there are also other strange aspects of the TIPS market that makes it less reliable as an inflation indicator. Even so, it seems likely that inflation expectations have declined.

Is it the result of rising savings/a falling budget deficit? Hell no! While private financial savings have increased, the dramatic increase in the budget deficit means that this factor has in ceteris paribus terms acted to raise Treasury yields-and raise it quite significantly. Hadn't it been for the counteracting effect of the other factors, this would have translated into much higher yields.

Is it a result of higher risk aversion/liquidity preference? That is clearly a factor given the sharp increase in the yield spread between Treasuries and various others more risky and less liquid bonds. Though it should be noted that this increase in the yield spread has come in the form of falling Treasury yields, and not higher yields of for example corporate bonds.

Is it the result of a higher money supply? Yes, it definitely is. This evening's weekly money supply release again confirmed the aforementioned upward trend, with M1 rising another 3% in just 1 week, while M2 & MZM rose slightly below 1% each for the week. The cumulative 9 week increase is 8.3% (annual rate of 58.1%) for M1, 3.3% for M2 (annual rate of 20.3%) and 4.3% for MZM (annual rate of 27.5% . The monetary base is up 68.5% in 10 weeks (monetary base numbers are only published for 2 week periods), or 1,408% at an annual rate. This means that the inflationary monetary trends I discussed last week continue and are accelerating.

Thus, while the decline in bond yields may to some extent reflect a reduction in inflationary expectations as a result of the monetary contraction earlier this year, the main reason is the massive flood of liquidity unleashed by the Fed, in interaction with the increased risk aversion/liquidity premium.

Ukrainian Economy Heads For Collapse

The Ukrainian economy is rapidly approaching a sharp downturn. The trigger of the decline is that the price of its main export good, steel, has been cut in half since August. And with Ukraine having a large trade deficit to begin with, and with investor distrust of smaller currencies increasing, this has caused a run of the Ukrainian currency, the hryvnia, something which is aggravating an already dire situation.


After actually strengthening somewhat earlier in the year, the hryvnia have more or less fallen off a cliff in the latest month, losing almost a third of its value. This decline have far more dreadful consequences for Ukraine than the declines in the pound or the Swedish krona has for the U.K. and Sweden, as Ukraine has a lot of foreign currency denominated debt (mostly U.S. dollar and euro), which are rising in value as the hryvnia falls. This creates a vicious circle more similar to the effects of the collapse of the Icelandic krona.

Meanwhile, real economic activity appears to be in a virtual collapse. Industrial production in November fell 15.2% compared to October and 28.6% compared to November 2007.

Fed Has Never Pursued Price Stability

Greg Mankiw argues that the Fed should abandon price stability and instead pursue inflation. He specifically calls for a target of a 30% increase in the CPI over the next 10 year, which he claims would represent a radical shift in policy.

The problem with this reasoning is that the Fed has never pursued price stability in the sense he appears to use the word, which is to say zero inflation. In fact, if you look at the data, you can see that during the last 10 years (November 1998 to November 2008), the CPI rose in fact by 29.5% (the index rose from 164.0 to 212.425), almost exactly as much as Mankiw wants the Fed to target. And if you only look at the latest 5 years (November 2003 to November 2008), the increase was 15.1% (the index rose from 184.5 to 212.425), which would be 32.6% if repeated during the coming 5 years.

In other words, the Fed has already for years pursued the very policy which Mankiw claims would solve the problems. And given the fact that the Fed has created the kind of inflation rates Mankiw wants and given the fact that they have never pledged to pursue any other inflation rate, these inflation rates should already be expected.
To the extent that skepticism about the Fed's ability to create inflation has lowered these expectations, explicit targets shouldn't make any difference.

Fed Formalizes Existing Fact

The Fed went further today than I and most other analysts had expected in their lowering of the official target for the Fed funds rate, lowering it to [for the first time it's a range and not a specific number] 0-0.25%.

This won't make much difference as the Fed had for weeks kept the effective Fed fund rate in that range since December 4. Judging by the rally in stocks, bonds and most commodities (except oil, for some unknown reason), and the sharp sell-off in the dollar, however, it appears to have a short-term psychological effect on traders unaware of the fact that the Fed had already lowered the effective rate to that level.

This effectively means that that the Fed has run out of ammo, in terms of lowering interest rates. But for those of you fear or hope for deflation, there is no need to worry or cheer on account of that. You see, they still have the form of ammunition known as quantitative easing available, which in effect means the ability to buy assets and paying for it through the printing press. And they are already suggesting that they will target the assets whose price are most depressed now.

And if you think Ben Bernanke will hesitate to expand the Fed balance sheet by whatever amount it takes to reignite inflation, think again. Inflation will therefore return.

Dogbert On Modern Financial Theory

Dogbert explains Modern finance theory with regard to diversification:


Arguably, Dilbert creator Scott Adams is slightly unfair here as you're not supposed to invest in things which are almost certain to be worthless, like sick cows, but only slightly so. Clearly there is an over-belief in the value of diversification in terms of reducing risk. While that may usually be the case, it is often not so. For example, risk was not reduced for Swiss banks who decided to diversify away from the calm Swiss real eastate market, and instead invest in American mortgage backed securities. Similarly, someone who owns stock in stable companies like Coca Cola and McDonald's and instead diversified into stocks like Fannie Mae, AIG and GM didn't see risk reduced either.

News In Brief

-The Fed is expected to drop the Fed funds target to 0.5%. Yet with the effective funds rate already at 0.14%, the so-called target rate has lost all meaning. And if they're going to accept an effective rate of 0.14%, why not drop the formal target to 0.15% or at least to 0.25%?

-Meanwhile, I don't have any number for effective rate for Switzerland, but they have already lowered their target rate to 0.5%, and now there is talk of zero interest rate policy for Switzerland, and of quantitative easing once zero is reached. Switzerland is clearly abandoning their old status as a hard money bastion, which is why people should stop consider the Swiss franc as a safe haven (I did that before too, but this change in policy clearly changes things.)

-Somewhat unexpectedly, the U.S. trade deficit rose in October, as an increase in the non-oil deficit and higher oil import volumes overwhelmed the decline in the price of oil. As the increase in oil imports is not sustainable given the decline in demand and as the price was much lower in November than October, the oil deficit should decline dramatically in November, likely leading to an overall decrease despite an increase in the non-oil deficit.

For the quarter as a whole, the deficit will therefore be lower than in the third quarter, though not dramatically so. However, since the entire decrease and more is because of the collapse in the oil price, net exports will subtract substantially from the standard volume GDP. With the volume measure of the trade deficit running at a level $6 billion per month higher than in the third quarter, it could subtract as much as 2 to 2.5 percentage points from growth, which given dramatic declines in consumer spending and investment could mean an overall volume decline of 6 to 7% at an annual rate. Properly measured the decline will be less dramatic, but even in terms of trade adjusted terms, the decline will be relatively dramatic, 3 to 4%.

-The inventory to sales ratio in U.S. businesses reached new multi-year highs in October, something which will likely mean that businesses will have to reduce production more.

-Meanwhile the federal budget deficit rose to $402 billion in the first two months of fiscal 2009, up from $155 billion in the first two months of fiscal 2008. Much of that reflects the TARP, but even excluding that the deficit is soaring. This enormous deficit of course implies that the supply of Treasury securities is soaring too, something which you would normally expect to lower their prices. But in fact, prices have soared, which is reflected in the dramatic decline in yields. This suggests that demand is increasing even faster than supply, something which in turn reflects excess liquidity.

-California's state deficit and debt is also increasing at an ever faster rate, yet because California does not have its own central bank, it can't be as reckless as the federal government. So there is broad agreement that some forms of fiscal tightening measures are needed. Governor Schwarzenegger proposes a combination of tax increases (thus terminating his previous commitment not to raise taxes) and spending cuts, yet because Republicans in the state legislature refuse to agree to tax increases and because the Democrats refuse to agree to spending cuts and because both sides can apparently block a new budget, a stalemate has become reality, increasing the risk that California might default on its debt.

-Money manager Bernard Madoff appears to have run a giant Ponzi-scheme that swindled investors of as much as $50 billion, which is said to be the biggest such swindle ever. Unless you count the Fed-induced housing bubble, of course.

-As the pound reach new record lows against the euro, the U.K. government is planning a bailout of its car industry similar to the ones planned by Sweden and perhaps also the U.S.. Meanwhile, there is an increasing fear that London's leading position in the crisis hit financial sector could be threatened.

The Coming Return Of Inflation

Friday's PPI report for November 2008 again showed a significant price decline, as did Thursday's import- and export price report. Most likely, next week's CPI report will also show a decline in prices (though likely a lot less dramatic). And it also seems likely that when the reports for December are published about a month from now, these price indexes will show another decline.

The most important reason for this was that money supply growth earlier this year had turned first stagnant and then directly negative. That had an immediate impact on the most flexible prices, which is to prices traded in financial markets, including stocks and commodities, although in those cases the global economic downturn had a significant impact as well as it causes corporate earnings and demand for commodities to decline.

Yet we are now likely starting to see the beginning of the end of this brief deflationary period. The reason for this is a reversal of the previous deflationary monetary trends. After reaching a low in the week to October 6, MZM has risen by a full 3.3% in the following 8 weeks, which translates into an annual rate of 23.5%. M2 has risen somewhat less, "only" 2.3%, yet that translates into 16%. And for those who prefer the extremely narrow M1 measure, that is up 5.1%, which translates into an annual rate of 38%. The monetary base is up 49.2% during this 8 week period, which in case you're wondering translates into an annual rate of 1246%. Bernanke hasn't just brought out the helicopters, he has brought out the B-2 bombers too, so to speak.

Because of the extremely high risk aversion, and deteriorating fundamentals for other assets, this massive onslaught of liquidity had at first simply the effect of brining down the effective Fed funds rate (now at just 0.14%, despite the fact that the official target is 1%) and Treasury yields, which at all maturities are trading at all time lows despite the massive increase in the supply of Treasuries due to the dramatic increase in the budget deficit. However, the recovery in stocks and commodities and the decline in the dollar in recent weeks could be a sign that the excess liquidity is spreading from the perceived safe havens to more risky assets, although it must be noted that the weak global economy will probably mean more setbacks for these assets. Still, with Treasury yields so ridiculously low, particularly at the short end (where they as I noted earlier had fallen to zero) certainly creates a climate conducive for alternative assets, despite weak fundamentals. And sooner or later, all the newly created money will spread to other assets and other parts of the economy, and bid up prices of more than just Treasuries.

More From The House Of Rand

The Ayn Rand Institute appears to have a lot better luck in getting attention in the "mainstream" media than the Ludwig von Mises Institute or other more radical free market think tanks. Presumably this is due to Ayn Rand's past association with Greenspan, which has proven to be both good and bad for the official objectivist movement. On the one hand, it appears to be giving them more attention, on the other hand, many think that the disastrous results of the Greenspan era discredits objectivism and laissez faire economics.

Example number of this is this interview with ARI executive director Yaron Brook in newsweek, about Greenspan and the financial crisis. His answers are mostly good, except for the reply to this question, which followed after Brook had stated his opposition to bank bailouts:

"But scholars like Ben Bernanke, current head of the Federal Reserve, says one reason the Great Depression was so severe was that government waited three years before intervening, and let scores of banks fail before then."

To which Brook simply responded by pointing to how unemployment remained very high under Roosevelt. Which is true, but really isn't a response either to the assertion that for the first three years (when Hoover was president), the government pursued laissez-faire policies or that bank failures was a key reason for the depression.

The idea that Hoover pursued laissez faire policies and didn't intervene in the economy is completely false, as Hoover was the most interventionist president America had ever seen (later America has seen even more interventionist ones, including Roosevelt), as Rothbard documented in his book America's Great Depression. I understand that for sectarian reasons Brook will find it hard to officially quote Rothbard, but that shouldn't stop from being able to dispute the "Hoover pursued laissez faire policies"-myth in an interview.

As for the bank failures made the crisis worse-part, it is certainly the case that they do make the crisis deeper in the short-term, especially if wages are inflexible due to other government interventions. But they were hardly the primary cause of the Depression, and that argument do in fact apply to almost all larger companies, including car companies. And if the government bails out all failed companies (or at least all failed large companies) then we will get a Japanese-style zombie economy.

Meanwhile, Alex Epstein, has a blog post in the Telegraph, linking the current crisis to predictions made by Ludwig von Mises and Ayn Rand.

Car Industry Bailout Update

Yesterday, the Swedish government decided to come up with its own bailout package of the Swedish car companies Volvo and Saab, who are owned by Ford and GM respectively. The package consist of SEK 25 billion in subsidized loans and SEK 3 billion in a direct hand-out to research intended to develop more "green" cars. There is no question that it will pass, as for one thing the opposition Social Democrats favor the bailout too, and for another, in Sweden, the members of parliament are expected (and almost always do) to vote as their party leader orders them. And no such thing as "filibuster" exists in the Swedish parliament.

By contrast, U.S. Senators and Representatives often vote independently of what Bush and Obama tells them to. And in the Senate there is a "filibuster" rule which requires 60 out of 100 Senators to get a vote on a certain issue, enabling a minority to block certain proposals.

A majority in the U.S. Senate do favor a bailout of Detroit car companies, but the majority is not big enough to break the "filibuster". Republicans are, sensibly enough, insisting that any loans must be coupled with demands of significant wage cuts to achieve parity with the pay level in Japanese-owned car factories, something the Democrats refuse to agree on.

The Democrats would have loved to wait until next year, after Obama and the new Congress (with a significantly enlarged Democratic majority in the Senate) are inaugurated, but GM and Chrysler are not likely to survive for six more weeks. So what will happen now? I don't know, but there appears to be three possibilities:

1) Senators get so scared by a market sell-off today and in the coming days, that enough of them change their mind to get it passed, similar to what happened to the financial company bailout earlier this year. That would likely be coupled to some concessions from Democrats with regard to reduced labor costs.

2) The White House follows the suggestion of Democrats and lets GM and Chrysler tap funds from the "Troubled Asset Relief Program" (aka the Wall Street bailout funds), something which they have been opposed to until now. This will keep them alive until the enlarged Democratic majority is inaugurated.

3) GM and Chrysler are sent into Chapter 11. That would in my view be the best solution. That would most likely not mean that all their operations would end, but shareholders would lose all their money, and creditors would lose some of what they have lent, while the excessive UAW contracts could be thrown out.

UPDATE: Scenario number 2 now looks most likely to become reality.

Infrastructure Spending Won't Solve Problems

Read interesting column from Amity Shlaes about the utter failure of the Japanese infrastructure spending boom in the 1990s in reviving the Japanese economy. Very relevant considering Obama's plans for a similar infrastructure spending spree.

How Much Do UAW Workers Cost?

Various left-wing commentators have praised an article by David Leonhardt in today's New York Times, denying that workers at Detroit car companies really cost as much as $73 per hour. While he concedes that they are still more costly than workers at Japanese-owned plants, he argues that they aren't as costly as $73 because that number allegedly includes benefits for already retired workers.

But as James Sherk of the Heritage foundation points out, that would be incompatible with established accounting principles. According to established accounting principles set by the Financial Accounting Standard Board, the cost of benefits for retired workers should be taken when they're accrued (when the workers are still working). It is not permitted for companies to promise workers benefits after they've retired without taking it up as a cost now. Leonhardt appears to have derived his figures by only including wages and benefits paid out today to workers, while excluding both the post-retirement costs that are accrued for current workers and the benefits paid out to currently retired workers, which of course is very misleading.

Stabilization Pact Logic Turned On Its Head

As part of the European Monetary Union, there is something called "the stabilization pact" that would prevent members of the euro area from running too big budget deficits, no more than 3% of GDP except during recessions. The argument for this was that when the national exchange rates were abolished, countries with large deficits would no longer have to fear runs on their currencies, similar to the ones that forced Sweden, the U.K. and Italy out of the ERM in the early 1990s, and that the high deficits would destabilize the entire euro area once interest rates were made equal.

Yet this argument was actually flawed in several ways. First of all, while it is true that it will be easier to run a deficit within the EMU than in the old fixed exchange rate ERM system, it is not the case that it is easier to run deficits within the EMU than in a system of floating exchange rate. Indeed, it is arguably easier to run deficits with floating exchange rates as any market distrust would lower the value of its currency, which is generally welcomed by politicians.

And moreover, as the very large yield spread between German and Italian government bonds demonstrate, high deficits are in fact punished with higher interest rates within a monetary unions, as markets fear that countries with large deficits might leave the monetary union or default. The equality of interest rates within a monetary union only applies to the risk free interest rate, but as governments with large deficits like Italy are regarded as more risky because of that, they are disciplined.

Moreover, especially with exchange rates fixed, fiscal expansion in one country could provide a boost to exports in other countries. Thus, there is actually no need for a "stabilization pact" as the harmful effects of deficit financing will more or less entirely hit the country that pursues it.

I now see Keynesians Paul Krugman and Mark Thoma argue the opposite case, namely that relatively anti-Keynesian Germany (with Krugman talking of the "German problem") will be a "free rider", as much of the increase in demand from any Keynesian deficit increasing policy in France or Italy will go to the German export industry while Germany won't need to take on additional debt. This makes Keynesians worried that countries might not increase their deficits enough. Apart from the assumption that Keynesian policies are beneficial, I actually think they might be closer to the truth than the people who were behind the stabilization pact.

Islamic Finance-U.S. Style

The U.S. government today sold 4-week Treasury bills for 0.00%, yeah that's right zero, and afterwards it was actually trading at a negative 0.01%. Why anyone would want to pay to put money in something beyond me, but these are really crazy times of course. Even so, this is likely basically as low as it gets.

This is one explanation for why the interest cost for the U.S. government actually fell during the first two months of fiscal 2009 despite a soaring debt level.

Zero interest rates should mean that financing of the U.S. deficit has now become at least partially sharia-compliant (Islamic Sharia law forbids the taking of interest, in case you didn't know). I don't know if this will really make al-Quaeda and similar groups much less pissed off at the U.S. government, but it is interesting to see how the U.S. government is now introducing a new version of Islamic finance (usually in Islamic finance, interest is de facto charged, only it is formally made to look like rent or profit)

Obama's Keynesian Plans For More Waste

Via Alex Tabarrok I see the following funny paragraph in a New York Times article about Obama's new planned massive spending increases:

"Mr. Obama also responded to criticism of waste and inefficiency in such programs by promising new spending rules, like a requirement that states act quickly to invest in roads and bridges or sacrifice federal money."

That is almost hysterically funny because there is no better way to insure waste and inefficiency than implementing a "use it or lose it" rule for money sent to any state or agency or department.

Someone in Tabarrok's comment section claimed that Obama didn't mean for this rule to be used to prevent waste, but to speed up implementation, and that the comment on waste and efficiency was said in another context. Perhaps that is so (I haven't listened to Obama's speech), but even if it is so it should be noted that this rule nevertheless makes Obama's talk of wanting to counteract waste and inefficiency self-satirical.

It should further be noted that waste is in fact something that Keynesians (which include Obama and his associates and supporters) welcome. After all, waste is a form of spending too, and J.M. Keynes himself made this proposal in his General Theory:

"If the Treasury were to fill old bottles with bank-notes, bury them at suitable depths in disused coal-mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of repercussions, the real income of the community, and its capital wealth, would probably become a good deal greater than it actually is."

Why Irrational Finance Practices Live On

Nassim Nicholas Taleb and Pablo Triana provides an interesting and largely true indictment of irrational financial practices, and more specifically the use of various quantitative models for risk management who are useless or even damaging (as they provide a false sense of security), with the models of Robert Merton and Myron Scholes that were awarded with the Nobel price in economics, but led to disaster when being tested in practice in their fund "Long Term Capital Management".

They express frustration over the fact that these models despite their failure live on, and calls for everyone to confront the quants and point out their uselessness. But what they leave out is why this irrational business practices live on. That they live on in academic circles should perhaps not be too shocking as no market test exist there. What is more interesting is that they live on in financial firms who do face a market test. The explanation for that is very simple though, that because failed financial firms are bailed out by the government, this means in effect that their failed practices are bailed out too and live on.

Data Suggest Wage Gains Could Be Only Statistical

In the last post I noted that average hourly earnings surprisingly increased at an accelerating rate, even as employment fell significantly. As a lower demand for workers will usually result in a lower price (lower wage), that should mean that wage increases should be decelerating instead of accelerating. As I noted, there are two possible explanations for this (or three if you count the combination of the two as a distinct explanation). It could be a statistical illusion, as disproportionate job losses for low paid workers will increase the average wage without anyone actually getting a wage/salary hike. Or it could result from a reduction in effective supply, in the sense that workers demand higher pay. Such demands will result in some not getting any job, but that those that do get a job will be better paid.

Yesterday, I found no signs of the "statistical illusion"-explanation after having studied data sector-wise. However, after having today studied other tables, I did find one that gave some support for it. Namely, the one that sub-divided employment and unemployment according to educational status. While there are many individual exceptions to this rule, it is generally the case that people with a high level of education earn more than people with a low level of education. And so, educational level could be used as a proxy for earnings.

As it happens, employment for high school drop-outs fell dramatically in November, while employment for those with only a high school diploma also fell significantly. Meanwhile employment for those with "some college" (less than a bachelor's degree) rose slightly and employment for those with a bachelor's degree or more was unchanged.

While not completely conclusive, it does give support for the "statistical illusion" hypothesis.

Dramatic Decline In U.S Employment

The U.S. employment data took a turn from bad to worse. The payroll data indicated a loss of 533,000 jobs in November, following upwardly revised losses of 403,000 in September and 320,000 in October. The household survey data showed an even bigger loss of 673,000. The unemployment rate rose "merely" 0.2 percentage points (from 6.5% to 6.7%), but that was only because the participation rate fell from 66.1% to 65.8%. If the participation rate had stayed unchanged, the unemployment rate would have risen above 7%. The participation rate usually fall during slumps as many unemployed workers feel that it is useless to bother applying for jobs after having been rejected many times.

Hours worked in the private sector also showed a really dramatic drop of nearly 1% as not only were many jobs lost, the average work week for those who still have a job fell to a new low. This indicates that more and more people could be part-time unemployed (that means they have a part-time job, but would like a full-time job).

As before, the decline was moreover mitigated by higher government employment (meaning that the decline in private sector employment was even more dramatic) and a continued high number of jobs imputed by the flawed "birth-death" model.

The only thing bullish that I could find in the report was a surprisingly high increase in average hourly earnings of 0.4% compared to the previous month and 3.7% compared to November 2007. Considering the dramatic decline in energy prices, this means that real hourly earnings increased at least that much, and probably more. So those that still have a full-time job are enjoying a rising real income. It seems strange that wage increases are in fact accelerating even as demand for labor is declining fast and unemployment increasing. It could perhaps be that low-productive workers are losing their jobs at a higher rate than others, or it could be that causality is working the other way, that the workers employers are interested in are demanding higher wages, which means that fewer workers are hired but that those that are hired are getting paid better. But that is just speculation. If (with emphasis on if) it continues it would be worth looking into. I see no conclusive evidence for either explanation in the current data though.

Joe The Plumber Even Wiser Than I Thought

Remember Joe the Plumber? The unlicensed plumber that dared to confront "The One" during the presidential campaign with questions about his tax plans. The followers of the Chosen One in the left-liberal media and blogosphere responded by engaging in vicious personal attacks against Joe to distract people from the flaws in the tax plan that their Messiah had proposed. If you didn't read or don't remember my analysis of the story see here.

Now it turns out that Joe the plumber doesn't just understand tax policy, he understands monetary policy as well as he recommends Ludwig von Mises' book "The Theory of Money and Credit"!

This of course makes left-liberal Keynesian Brad DeLong fume with anger, calling it a "Reactionary Goldbug Austrian Plumber-Economist Attack" while offering no factual arguments against Mises' theories. His only argument consists in claiming that Mises misquoted two other authors, but as David Gordon points out in the comment thread, DeLong himself misquoted Mises on that point....

European Central Bankers Follow Bernanke's Path

Today the ECB cut its target rate 75 basis points to 2.5%. This is the biggest cut ever during the ECB's 10 years of existence. Yet as it happens, the ECB was actually a force of moderation, with the Bank of England delivering an even more radical cut, 100 basis points to 2%, and the Swedish Riksbank cutting as much as 175 basis points to 2%.

The moves from the ECB and the Bank of England was expected, but the Riksbank's cut was much more radical than I and virtually all other analysts had expected (most of us had expected 100 or 125). The Riksbank's monetary policy has done a 180 degree turn as they actually raised rates to 4.75% as late as September this year. It appears that the Riksbank board is in a full panic mode about the Swedish recession. As a result, the Swedish krona fell to a new all time low against the euro, so that a euro now costs SEK 10.61. The pound also fell to a all time low against the euro, at roughly €1.15/£ (Or £0.87/€ in inverted terms)

Despite the aggressive character of these cuts, they will likely not make much difference in the short-term, just like Bernanke's aggressive cuts didn't make much difference. The downturn will continue and price inflation will likely undershoot the targets in the short-term (particularly in the euro area). Once oil stabilizes, we will however see an upside risk to inflation, particularly in the U.K. and Sweden. And central banks will likely not dare to be as aggressive in raising rates as they have now been in cutting them.

Why GDP Seemingly Rise During A Recession

On Monday, the NBER officially announced that the current U.S. recession started in December 2007. I personally think that it started even earlier, in October 2007 as the coincident indicator index of the Conference Board -which contains the same indicators as the NBER's recession indicators- peaked in October 2007. The main reason for this discrepancy is the fact that the NBER oddly uses the GDP deflator to deflate business sales instead of the PPI. As the PPI has increased a lot more than the GDP deflator (which was greatly depressed by the terms of trade effect, even as nominal sales rose because of higher import prices, creating a distortion), this causes the NBER to greatly exaggerate the level of real business sales.

Anyway, it is perhaps of lesser importance whether October or December 2007 was the month of the peak. There can be little dooubt that America has been in a recession for about a year now and that this recession has become a lot more severe in recent months. Yet, it is worth noting that the recession so far hasn't met the media definition of a recession, namely two consecutive quarters of contraction. There has been two quarters of contraction, Q4 2007 and Q3 2008, but the two quarters in between seemingly had positive growth. This is something which Michael Mandel of Business Week finds puzzling.

Yet long time readers of this blog should be able to recall that I have already solved this mystery: namely growth was a terms of trade illusion caused by the perverse GDP deflator methodology and that moreover the production numbers likely overstated nominal growth given the fact that growth in national income was much slower.

The One Silver Lining For Detroit Car Makers (Or At Least Ford)

November was another really awful month for Detroit car makers. Sales for GM fell 41% from a year ago, Ford sales fell 31% and Chrysler sales fell 47%. The one positive thing for at least Ford is that the slide in market share seems to abate. The big three Japanese car makers, Toyota, Honda and Nissan also saw their sales fall, by 34%, 32% and 42% respectively. The recent dramatic decline in gas prices have made in particular Toyota's hybrid model Prius a lot less popular, falling 48.3%.

So at least the big 3 in Detroit can comfort themselves with the knowledge that the big three Japanese car makers are starting to suffer too......

That shouldn't be too big of a comfort though considering that first of all GM and Chrysler still lost market share and secondly because while the relative decline is decelerating the absolute decline is accelerating and because thirdly the Japanese are still profitable unlike the Detroit car makers.

Well worth noting is also that the seasonally adjusted annual rate of car sales fell to a 26-year low of 10.18 million. And that's very bad considering how deep the 1982 recession was and considering that the total population has grown by about a third since then.

Krugman On Wage Cuts In A Depression

Paul Krugman has responded to the article by Amity Shlaes that I told you about in my previous post.

More specifically, he focuses his attack on the idea that a lower price of a certain thing will lower excess surpluses of it. Even more specifically, I refer to of course wage cuts as a way to reduce unemployment.

Krugman argues that if there were a general 20% of wages for all workers, then prices would go down by 20% too, which would leave real wages unchanged. There are several fallacies here. First of all, why assume a across the board cut equal for everyone? The point here is that first the Hoover administration and then the Roosevelt administration in various ways tried to prevent wage cuts. But with some sectors suffering greater job losses than others, there is every reason to believe that the needed wage cut was greater in some sectors relative to others, meaning that the interventions to stop that would disproportionably minimize wage cuts in sectors hit hardest by increased unemployment. This means in turn that without the Hoover-Roosevelt interventions, wage cuts would have been greater in some sectors compared to others. Krugman's "equal pay cut for all workers" assumption is completely unrealistic and unwarranted.

Secondly, there is no reason to assume that even a 20% across the board wage cut would leave real wages unchanged. Given the fact that corporate profitability turned negative, there is every reason to believe that businesses would use at least some of their cost reduction to restore the negative margins. Businessman in general really aren't stupid enough to think that "So what if I lose a dollar on every unit I sell-I'll make it up on volumes!" (The few that are will likely soon be bankrupted), so in a situation of negative profit margins lower nominal wages would likely result in ,lower real wages. That in turn means that more businesses could have survived which would have meant that fewer workers would have had to lose their jobs.

While most or at least a significant portion of wage cuts would have been used to restore badly damaged profit margins that we saw in, there is still reason to believe that it also would have resulted in lower prices. Which brings us to Krugman's third fallacy, namely when he first acknowledges that the lower prices will raise the real money supply, but that the usual way in which it will boost demand, through lower interest rates was closed because interest rates had hit zero. But this is not true, as the discount rate at its lowest was 1.5% during the Depression. Moreover, even had the nominal risk free interest rate been zero, a higher real money supply could have still affected the much higher actual lending rates, which due to risk premiums were much higher.

Finally, I should mention one objection that I know many Keynesians will be thinking about, even though Krugman didn't mention it, namely won't lower real wages lower the purchasing power of workers and so reduce demand? That lower real wages will lower worker's purchasing power is true more or less by definition, and it is certainly likely that workers whose only income is their wage/salary will reduce their demand. But since companies and their owners will experience reduced losses/higher profits, their demand will increase. Moreover, in a situation where pay cuts can boost employment, this is not simply a zero sum game, it is something which will boost total production and demand as new workers will get jobs and so will also receive an income.