Monday, March 31, 2008

EMU Inflation Reach New All-Time High

According to the so-called flash estimate from Eurostat, Euro area inflation rose to 3.5% in March, the highest ever since the introduction of the euro in 1999. There are two interesting aspects of this. First of all, this is likely only the first in a series of reports showing rising price inflation in March. When the numbers from for example the U.S., Britain, Sweden are released we are likely to also see pick-ups in inflation there too. The reason for this is the sharp rise in oil prices between February and March as well as the continued impact of the rise in the price of food commodities.

Secondly, the implication of this will certainly< be that ECB interest rate cuts are out of the question in the coming months. Indeed, influential ECB board member Axel Weber recently expressed a preference for raising interest rates. Weber is of course long known to be a hawk, and given the weakness of some parts of the Euro area, that does not appear likely to happen. But it is probably not less likely than a cut at this point.

Saturday, March 29, 2008

Why "Hands-Off" Policy Really Isn't Hands-Off

Bloomberg news reports that more and more within the Fed question the Greenspan-Bernanke policy of "allowing" asset price bubbles to be created and then try to deal with the problems this creates by lowering interest rates and bailing out bankers. This is viewed as asymmetric and is therefore considered to be a damaging policy.

I agree that the Greenspan-Bernanke policy is a damaging policy. My problem is with the presumption that this somehow represents laissez-faire or hands-off during the creation of the bubble. In fact, the bubble is just as much a case of intervention as the Fed's post-bubble actions.

This does not necessarily mean that interest rates are reduced during the bubble compared to before. Sometimes that is in fact the case, as we saw during the first 3 years of the housing bubble, but it is not always the case and it need not be the case. All that is needed is that the central bank holds interest rates lower than they otherwise would have been by increasing the money supply.

Under a free market monetary system, if for some reason people gain irrational exuberance about some asset class, than this would automatically raise interest rates. This would make it a lot more expensive to borrow for such investments, and also make it more profitable to buy bonds rather than that asset class, and so automatically prevent any significant bubbles.

The free market solution to bubbles is of course to abolish central banks and replace them with gold or possibly some other specie based currency that the market chooses. Short of that, however, a policy which more or less automatically raised interest rates whenever there were signs of asset price bubbles would actually be more neutral to the market then a policy which instead allowed money supply growth to accelerate. Such a policy, or a similar policy of targeting very low money supply growth, would imitate the market response and for that reason, constitute less intervention than the Greenspan-Bernanke policy of fueling asset price bubbles with a higher money supply.

Will Europe Decouple?

Now that it is increasingly indisputable that America has in fact slipped into a recession, the debate has shifted to whether or not the rest of the world will decouple from that downturn. In the case of Europe I have for a while argued that it will. I still stand by that view, but I should clarify it.

There is simply no rational reason for believing that an American downturn will cause a European downturn. Exports to the U.S. are in fact only about 2% of Euro area GDP. And even that overstates the dependence as it compares apples to pears. Exports are expressed in gross terms while GDP is expressed in value added terms. This is to say, some of the inputs used to produce that exports is imported. I don't have an exact number for how big distortion this creates, but it is nevertheless clear that an apples to apples comparison would show an even smaller dependence.

So, even a dramatic decline in exports to the U.S., say in the magnitude of 25-30% would only reduce Euro area GDP by a few tenths of a percentage point.

A somewhat stronger argument for believing in recoupling rather than comes from financial markets. As is obvious to anyone who follows the U.S. and European stock markets, there is a strong link between them. Whenever one falls, the other usually follows. This link is to a large extent based on the fallacy of a strong connection in the real economy based on trade that I refuted above, but it might to some extent be a self-fulfilling prophecy. But while it is a real factor, it is implausible to be significant enough that irrational stock market sell-offs is sufficient to push the European economy into a recession, especially as most continental European counties have much lower stock market capitalization to GDP ratios than for example the U.K. or the U.S.

However, while the U.S. downturn will not by itself cause a European downturn, that does not necessarily imply that a European downturn will not happen. It probably will not happen, but it might. If it does, however, it will be the result of home grown factors.

More specifically, some parts of Europe have experienced similar stories of excessive credit growth as the United States, and this will likely cause busts in these countries. We have already seen how Ireland has slipped into a recession, and the Baltic states are showing worrying signs of stagflation with double digit inflation and a sharp deceleration in growth. Both Ireland and the Baltic states are by themselves far too small to cause a European wide downturn. More worrisome is that Spain and Britain show signs of potentially slipping into a recession. Spain and Britain have both experienced similar kinds of housing bubbles as America and Ireland, and while there is no evidence yet that either country has slipped into a recession, there is a real possibility that it might happen. And if it did, it would be very serious for the overall European economy. While the German economy looks quite sound and strong as a result of years of free market reforms and austerity, it could have problems adjusting to a possible significant downturn in Spain and Britain.

At this point, there exists a great amount iof uncertainty over how the Spanish and British economies will develop, as well as how the overall European economy will develop. They may or may not slip into a recession. If they do, this will certainly hurt the German economy significantly. However, the point here is that while Europe may perhaps experience a downturn, this will not be a result of the American downturn. Instead it will if it happens be a result of the negative after effects of local bubbles.

Thursday, March 27, 2008

Austrian Business Cycle Theory And Rational Expectations

After my recent essay in Swedish about the Austrian Business Cycle Theory, I received a comment that linked to Bryan Caplan's objections to it. In essence, Caplan's objections are based on the Rational Expectations-school of macroeconomics, which argues that entrepreneurs are so rational that they won't be fooled by lower interest rates into malinvestments.

Yet there are two fatal flaws in Caplan's argument, each of which by itself is fatal to his argument. The first flaw is that in order for entrepreneurs to correctly anticipate the future downturn created by central bank policy they must be aware of and believe in the Austrian theories. If they don't believe in it, then they will not see that investments based on artificially lowered interest rates will turn out to be malinvestments. And since the Austrian business cycle theory is unfortunately only known and accepted by a small minority, the vast majority is not going to foresee the problems arising in the future.

Secondly, and perhaps even more importantly, even if the Austrian Business Cycle Theory became generally known and accepted among entrepreneurs, it would still make sense for profit maximizing entrepreneurs to act upon lower interest rates. The reason is simple. Because the central bank subsidizes interest rates during the initial boom phase, the economic gains for entrepreneurs during the boom will exceed the economic gains for the overall economy. Moreover, because the central bank generally tends to bail out failed investors during the bust phase of the business cycle, this means that the loss for investors during the bust will be smaller than the losses for the overall economy. A recent concrete example of this is the case of Bear Stearns.

Interestingly, Caplan notes that Austrian economist Roger Garrison has already put forth a version of that counter-argument, but Caplan's reply is simply to note that entrepreneurs will make investments that are profitable to them, while abstaining to make investments that aren't profitable to them. This is of course not an answer at all to the argument that there exists a distinction as to what is profitable for the entrepreneur and what is profitable for the overall economy, and that it might therefore be profitable to create malinvestments.

Finally, given the more realistic assumption that some investors will believe in the Austrian business cycle theory, while most won't and given the fact that investments in the form of both equities and bonds can be sold off, an additional incentive is created for investors aware of the Austrian business cycle theory to create malinvestments during the boom, enjoy the profits of it as long as the boom last, and then sell of the stakes in that investments to more clueless investors during the end of the boom.

UPDATE: I see on Wille Faler's blog a good illustration of how central banks bailout actions make it profitable for investors to create malinvestments.

Bearish U.S. GDP Revisions

The stock market futures rose after a supposedly good GDP report. Yet anyone who says this revision was bullish is one who hasn't really read it at all. At least not at any detailed level. With the exception of the small downward revision of inflation, virtually every revision is bearish. This is particularly true with regard to the semi-new information (By semi-new I mean that preliminary estimates were published in the flow of funds report, but not in the previous GDP report) on national income and corporate profits which both showed significant deterioration.

First of all, the claim that real GDP wasn't downwardly revised is based on the misleading volume methodology, which in effect says that if foreigners pay the people of a country less for an identical volume of exports, then they aren't worse off even though your purchasing power falls. Similarly, this methodology also says that if we have to pay more for an identical volume of imports then we aren't worse off either despite again losing purchasing power. This really makes no sense at all when trying to measure how well-off the people of a country are. So instead of deflating nominal GDP growth with the GDP deflator, one should deflate it with the domestic demand deflator. In this report, nominal GDP growth was downwardly revised from 3.3% to 3.0%, while the domestic demand deflator was downwardly revised from 3.9% to 3.7%, implying a decline in terms of trade adjusted real GDP of 0.7%, instead of 0.6%.

Bulls might on the other hand point to GNP, which rose 4.3% in nominal terms and thus rose 0.6% in real terms. The reason why GNP is rising faster than GDP is because the American factor income surplus is rising as falling interest rates and falling profits for foreigners who have been foolish enough to invest in America is reducing income payments to foreigners. Meanwhile, the falling dollar and strong growth in the rest of the world is increasing the profits of foreign subsidiaries of American companies. In principle, GNP is better than GDP as it better reflects the change in purchasing power for a country.

The problem here is that the other source of data, namely from the income side, is indicating far greater weakness than the GNP number. In theory, national income should be identical to GNP minus capital consumption. But in practice, there is always a small statistical discrepancy. And in the latest year this statistical discrepancy has changed from showing a national income $46.6 billion larger than GNP minus capital consumption to showing a national income that is $139.9 billion smaller than GNP minus capital consumption. In the latest quarter alone, the discrepancy rose from $84.8 billion to $139.9 billion. Because of this, national income was even weaker than GDP, up 2.8% in nominal terms and down 0.9% in real terms. This discrepancy, likely do not reflect lower increases in the factor income surplus than the production side data indicate, but rather more dramatic declines in domestic production.

This interpretation is supported by looking at one of these income data, namely corporate profits. Domestic corporate profits continued to fall dramatically for both financial and non-financial companies even in nominal terms, and much more so then in real terms. And this despite the fact that write-downs aren't included in these numbers as they are treated as "balance sheet items". However, because profits fell so much for foreign companies operating in America and because the profits of foreign subsidiaries of American companies, the overall decline in corporate profits received by American companies was much smaller. It still declined, but by much less than the decline in the profits of domestic operations. This decline in domestic profitability, along with the deteriorating cash-flow situation for American companies certainly indicate that business investments will likely decline significantly during 2008, something which is confirmed by the latest durable goods data.

Another interesting data is that the national savings rate is even worse than suggested by the flow of funds report. Gross savings was 12.5%, the lowest since the Great depression, and net savings was just 0.4%, also the lowest since the Great Depression with the exception of the brief dip into negative territory in Q3 2005 due to the massive capital destruction caused by Hurricane Katrina. The savings rate usually fluctuates in a pro-cyclical way, so we should not be surprised that it falls during the current recession. However, it never really recovered in any significant way during the housing bubble, and now the savings rate could drop to new lows, although it still has a long way to go before it reach the 1932 all time low of 6% gross savings and -7% net savings.

Wednesday, March 26, 2008

The Advantage Of A Stronger Currency

In contrast to Ireland, the German economy appear to be reasonably strong, as was confirmed by the latest Ifo-report of German business confidence, which rose for the third month in a row.

What I found remarkable in the Bloomberg news story about it was this formulation:

"German companies have increased efficiency and reduced labor costs, helping them remain competitive even after the euro gained 17 percent against the dollar in the past year and oil rose above $100 a barrel."

But why should oil for German businesses be calculated in dollars? Wouldn't it be more accurate to calculate in euros? And in euro terms, oil has risen a lot less than in dollar terms. Oil now cost €65 per barrel. While that is too relatively high this increase is a lot lower than the dollar increase. For example, when oil temporarily peaked in August 2006, it was priced at $78 per barrel, or €61.5 per barrel. Since then, the dollar price is up 30% in dollar terms, but only 5.5% in euro terms. Because of the euro strength, the oil shock is quite mild for Europeans. Here is a graph for The Economist's commodity price index which illustrates a similar point. Much of the commodity price boom clearly reflects dollar weakness, meaning that commodities are relatively much cheaper in euros.

Tuesday, March 25, 2008

Ireland Slips Into Recession

I recently wrote about Ireland and how its troubles relate to its membership of the euro area, and how this affects the case for and against monetary unions. In short, the answer was that monetary unions are other things being equal superior to separate currency areas, but if joining such a union implies significantly less sound monetary policies, then a country would have been better off not joining it. And Ireland certainly is a good concrete example of the latter case, as the low interest rate policy of the ECB has caused excessive house price inflation and debt accumulation. Until recently, Ireland has enjoyed the boom part of the boom-bust cycle, but now it is clear it has entered the bust part of the cycle.

Housing prices started to fall last year, and it is now increasingly clear that Ireland has entered a formal recession. Unemployment has reached an 8-year high and the latest GNP figures indicate that Ireland entered a recession during the fourth quarter of 2007.

Note that I use GNP and not GDP figures. Normally GDP is used, but as Ireland's GDP includes a lot of pure accounting fiction, created by multinational companies trying to benefit from the low corporate income tax rate here, GNP is a better indicator of Irish economic activity as it excludes this accounting fiction. However, because corporations can often choose to sometimes formally withdraw more money than usual, so even the GNP number needs to be taken with several grains of salt (all government numbers needs to be taken with a grain of salt, so what I mean is that it is even more unreliable than usual).

What the numbers show is that volume GNP in the fourth quarter of 2007 is up a mere 1.2% compared to the fourth quarter of 2006. What's worse, the quarterly GNP contracted a full 2.2%, i.e. nearly 9% at an annual rate. Quarterly GDP contracted 0.8%, or more than 3% at an annual rate. So there can be little doubt that economic activity in Ireland contracted during the fourth quarter of 2007.

Looking at the details, you can see a dramatic decline in fixed investments in general and residential investments in particular. Private consumption seems to be holding up, but one can question how sustainable that is. What is even more worrisome is the rapid increase in government spending. That is certainly not sound from a long term perspective and this implies that private economic activity is faring even worse than the GDP/GNP numbers suggest.

Ireland's short-term economic outlook thus appears grim and the downturn could possibly in the short term be even worse than in America. However, because the ECB seem determined not to cut interest rates and because Ireland is unlikely to leave the euro area, this means that the problems won't be postponed and aggravated to the same extent as in America. That means that Ireland has a much better chance than America of recovering a sound economy. While for example Thailand and South Korea suffered more severe downturns after the Asian crisis in 1997-98 than Japan did after the bursting of its stock- and real estate bubble in 1990-91, at least they got rid of the excesses and could recover strongly. Japan by contrast kept postponing the problem, preventing any permanent recovery. Ireland is likely to suffer a more severe downturn in the short term, but it will likely soon get rid of the excesses and then return to strong growth, as was the case in Thailand and South Korea. America like Japan, by contrast seem determined to postpone and aggravate the problems, and so make them more permanent.

Kudlow/Luskin Flip-Flop Fast On Fed&Inflation

It sure didn't take long for Larry Kudlow to again flip-flop on the Fed and inflation. After praising Bernanke's shock and awe monetary policies for months, Kudlow earlier this month flip-flopped -without acknowledging that he had changed his mind- and began to criticize the Fed for lowering the value of the dollar. He also explicitly called for Bernanke to be replaced as Fed chairman. Now he flip-flops back into a pro-Bernanke mood, calling Bernanke "my kind of guy" and even "my new best friend", while praising Bernanke's policies.

Why this change of opinion? Well, judging by the length he gives the subject, his main motive appears to be that he personally gains from lower interest rates. He also criticizes the so-called tax rebate because he will probably not gain from it. Well, Larry, I understand you want more money, but your personal financial gains aren't something which is of interest to the rest of us. Indeed, to the extent it results from government redistribution as in these cases, it is more likely an argument for others to oppose that policy.

But what about the inflationary impact he seemed to worry about just three weeks ago? No need to worry, apparently, because Donald Luskin has flip-flopped on that issue. Yeah, that's really convincing. No factual arguments, just an appeal to authority. And we're not even talking about an authority which has proven reliable. After all, Luskin has been proven wrong about basically everything except for inflation.

Now, it is not necessarily wrong to change your assessment of the economy. If the facts change, then so should your assessment. And of course, if Bernanke changed his policy from being a new Arthur Burns to being a new Paul Volcker, then I too would change my outlook on inflation. However, no such change in facts has appeared, so I suspect that this is related to Luskin's betrayal of Ron Paul and joining of the John McCain campaign. As a McCain supporter he is of course expected to fully embrace the standard Republican line of the economy being great in all aspects and the Fed doing right and so on. Luskin has always argued for a bullish view of the U.S. economy, which is why (along with his unfair and hateful personal attacks on fellow Ron Paul adviser Peter Schiff, who unlike Luskin has been consistently right about the U.S. economy, which is likely why Luskin hates him) I was somewhat suspicious of him joining the Paul campaign, but since he at least was an inflation hawk and appeared sincere in his support I was willing to give him the benefit of the doubt. But that was apparently a mistake, and now he has most likely abandoned his hawkish views in order to fit in even more consistently than in the past with the standard Republican economic world view. In line with that, he has also praised the Fed's bailout of failed Wall Street bankers.

But of course, his official reason for flip-flopping on inflation isn't that he has to adjust his views in line with the McCain campaign. His official reason is instead that the Fed chose to cut by only 75 basis points last week instead of the expected 100. This, according to Luskin changes everything. Yeah, that's right, Luskin actually claims that a move to reduce interest rates by 75 basis points represents a kind of hard money policy, never mind the fact that 75 basis point cuts is in a historical perspective unusually big and that it comes on top of a cumulative 225 basis points the previous 6 months, not to mention the fact that this comes at a time when money supply growth is very high. Does he really expect us to take this seriously? Luskin's web site is as you might know called "". What is clear is that either Luskin himself is stupid or he thinks that his readers are stupid. And what is also clear is that anyone who follows Luskin's investment advice will become poor (or at least poorer). So, the only thing right about Luskin these days seem to be how very appropriate the name of his web site is.

Monday, March 24, 2008

South Africa Real-Life Atlas Shrugged

Good story about the South African power crisis, where a combination of artificially suppressed prices and affirmative action policies have caused severe power shortages. South Africa's economy should be thriving considering the high price of gold and other commodities produced in South Africa, but the power crisis and similar problems of similar origin is preventing that. As the reporter notes, this crisis is playing out like a chapter from Atlas Shrugged.

Why We Need Austrian Business Cycle Theory

I've written an article in Swedish web publication Captus Tidning about why free market advocates need the Austrian business cycle theory, meant as an introduction to my upcoming Timbro report on Swedish monetary policy. So those of my readers that understand the Swedish language are recommended to read it.

Saturday, March 22, 2008

Money Illusion In Financial Markets

One disputed issue within macroeconomics is the possible existence of a money illusion. This is mainly discussed with regard to the labor market, where it is discussed whether it is possibly to lower real wages with inflation in situations where this would be impossible with nominal wage cuts.

Yet one interesting question not discussed here is to what extent financial market participants suffer from money illusion? This would perhaps seem implausible. After all, these are the sharp and sophisticated people, the greatest brains in the world, as one observer in this discussion put it. And in a related issue, does the academic finance teachers who taught the financial market participants what they knew perhaps also suffer from it?

The answer actually seems to be a clear "yes" for both groups. Starting with the greatest brains in the world, the evidence seems clear that they do. Why else would government securities be seen as the ultimate safe haven and why would anyone accept the pathetically low yields on U.S. treasury bills, running as low as 0.2%? To quote one of these very sharp and sophisticated people, John Derrick, director of research at U.S. Global Investors:

"You've had a huge flight to quality... people want to own the safest securities at any costs. Yields on very short-term government debt are low but at least you didn't lose money."

Well, people investing in U.S. government securities may not have lost any money, or more correctly any U.S. dollars (although they did lose in terms of most other currencies), but they have lost the only thing relevant for any rational person, namely purchasing power as inflation is running way above short-term yields. The fact that some financial market participants don't seem to care about how they lose purchasing power, but only care about not losing money, is clear evidence that some financial market participants, far from the greatest brains the world, really aren't smart enough to avoid being fooled by such an obvious illusion as the money illusion.

The question is then why they are fooled by the money illusion? Well, the idea that somehow government securities are a safe haven and completely risk free isn't just something which is advanced by people on Wall Street. This fallacy actually has its roots in academic finance theory. For example, in my experience, whenever finance teachers have described the very popular CAPM model for asset pricing, which very simplified says that the return of a stock should be a function of three factors, namely the risk free rate of return, the risk premium for stocks in general and the relative riskiness of a particular stock relative to other stocks, then the return from government securities have always been held up as the real world example of the risk free rate of return. Considering that one of the assumptions of CAPM is that there is no inflation, that example is certainly consistent with CAPM, at least in countries which do not default in the traditional sense.

But while consistent with CAPM, it is not consistent with reality as inflation do exist, and which fluctuates in a way which is not entirely predictable, this means that government securities are not risk free, with the possible exception of the so-called Treasury Inflation Protected Securities. And because finance classes thus teaches the people who later enter financial companies that government securities represent a risk free asset, that is why many of these people now are fooled and see their purchasing power fall.

Friday, March 21, 2008

Commodity Price Rally Not In Danger

I've been right about almost everything in terms of both macroeconomic trends and market movements, with my bearish stance on the U.S. economy, the U.S. dollar, the Canadian dollar and the U.K. pound and my bullish stance on China's economy, commodities, the yuan, the euro, the yen and the Swiss franc. The only area where I've been frequently wrong is in predicting the exact size of central bank movements. I didn't expect the Fed to cut on January 22, just 8 days before a regular meeting, I didn't think the Swedish Riksbank would raise interest rates earlier in the year and I thought the Fed would go for a 100 basis point cut earlier in the week. On the other hand, almost all other analysts made the same mistakes on these occasions. Central bank behavior is particularly hard to predict as they depend on the whims and psychology of central bank board members. While macroeconomic movements and market movements are also related to psychological factors of the general public and market participants, this is mostly relevant in the short term. Medium- to long term trends can be identified by focusing on the relevant data and using correct economic theories to analyze this data.

Returning to the Fed's smaller than expected cut of just 75 rather than 100 basis points, this was taken as an excuse by many traders to sell of gold, oil and other commodities and to a lesser extent also trade up the U.S. dollar against most currencies. This will inevitably cause some to fear or hope (depending on their current position) that this will mark the end of the commodity bull market and the dollar bear market. However, I have no doubt that this is simply a normal correction. There are always temporary rallies during bear markets, as well as temporary sell-offs during bull markets. For example, while oil has risen from $10 per barrel in 1999 to over $100 per barrel now, this rise hasn't come in the form of a straight line. There have been many temporary declines, with some lasting for several months. For example, after peaking at $78 per barrel in August 2006, oil plummeted to as low as $50 per barrel in January 2007. And more recently, after peaking at more than $100 per barrel in early January this year, oil fell to less than $90 in early February. Yet these temporary declines have always been reversed and new all-time highs have been set after that.

The reason why there are always temporary deviations from the trend is that while markets in the medium to long term is driven primarily or almost entirely by fundamentals, it is driven primarily by sentiment in the short term. And sentiment can and do go in either way, sometimes contradicting and sometimes reinforcing the longer term trend.

But few, if any, trends last forever, so how do one determine whether deviations from the previous trend is the end of the trend or simply a temporary deviation? Well, the way to determine that is to check if the fundamental factors driving the trend are still present or whether they have been swept away.

As I argued in my review of Jim Rogers book Hot Commodities, the commodity price rally has been driven by two factors: the nonmonetary structural factors discussed by Rogers in the book, and the inflationary monetary policies by central banks in general and the Federal Reserve in particular. Have any of these two factors been swept away? In short: no.

There have been no signs of a general increase in supply capacity in the recent week or recent months, for that matter. Meanwhile, the structural demand increase from the rise of particularly China is still in place. While I expect China's GDP growth to fall during the first quarter of 2008, this is only a temporary factor related to large supply disruptions caused by the unusually cold and snowy winter (so much for "global warming"). Growth seems likely to pick up again during the second quarter as these supply disruptions will by then be over and as increasing domestic demand will compensate for slower growth in export demand.

And that 75 basis point cut from the Fed certainly didn't represent a shift to anything remotely similar to tight monetary policy. Cutting interest rates by 75 basis points still represent a dramatic easing of monetary policy, at a time when it was already highly inflationary with real interest rates well below zero. Money supply growth remains high and will likely get another shot in the arm after this cut. And as the recession continues and gets deeper, the Fed will nevertheless feel compelled to continue with their interest rate cuts. The exact pace of these cuts is unclear as this again depends on the unpredictable whims of the FOMC members, but there can be little doubt about the direction of interest rates.

In other words, the fundamental factors driving the boom are still in place. And that means that although it is possible that prices can decline a bit more in the short term, prices will soon rise again and hit new all time highs.

Wednesday, March 19, 2008


Wall Street Journal has a long article about how the U.S. housing bust fuel a "blame game". Yet despite being so long, the article conspicuously fails to mention the by far most important reason-namely the Fed's low interest rate policies during that era.

Trying to shift attention to other factors really miss the point that the whole purpose of the low interest rate policy was to encourage increased borrowing. During that era the Fed actively tried to increase credit- and money supply growth as much as they could, and saying that there for example should have been more regulation to prevent "predatory" lending misses the point that this "predatory lending" in fact had the same effect as the low interest rate policies of the Fed and thus was as much of a tool to achieve the goal of the Fed at the time (i.e. to make the recession milder and then to prevent the alleged "threat" of deflation). Had such legislation existed and had it been effective,then the Fed given their goals would have had to keep interest rates even lower for an even longer period of time and that would have meant at least as much damage as what actually happened.

Tuesday, March 18, 2008

MZM Outside America

I have discussed the issue of the definition of the money supply several times (see here, here and here), usually focusing on the American money supply definition and usually with the advocates of Frank Shostak's very narrow definition. Instead, I have argued that the money supply definition known as MZM (Money of Zero Maturity)is the best. In America there is no doubt as to what MZM consist of and it is even published by the St. Louis Fed.

The problem is that in other countries, this definition is not available. And the definition of what constitutes M1, M2 and M3 usually differ between different countries. So instead most people (including until recently me)uses M3 as the best broad money supply definition for all countries. Yet I have recently reconsidered this. When preparing a report for Swedish free market think tank Timbro about Swedish monetary policy which will soon be released (Unfortunately for my non-Swedish readers, it will be in Swedish), I started to actually look at what the different money supply measures included. And it became immediately clear to me that M3 is too broad. M3 included for example interest-bearing securities held by the Swedish public with a maturity of up to two years. A two-year bond could hardly be considered money in my view, as it implies that the holder of it has given up the money invested in it for two years, unless he can find someone else willing to take over that commitment by buying the bond. And the same thing really goes for 1-year bonds and treasury bills. Of the non-M2 M3 items, only money market fund holdings can be considered money. Non-M1 M2 is more unclear since it seems to package together without any subdivision both saving deposits (which should be considered money) and genuine time deposits (which should not be considered money). Still, overall M2 seemed like the best of the three M's. Note that this applies to the euro area too as the Swedish definition is explicitly harmonized with the one used by the ECB.

What this reminds us of is that money supply definitions can be too broad as well as too narrow. And I suspect that M3 is too broad in many other countries as well. In New Zealand for example M3 explicitly includes all funding of New Zealand financial institutions, whereas M2 only includes funding that "can of right be broken without break penalties". Although it is unclear what these penalties consist of, it seems clear that we're here talking about time deposits. Similarly, in Australia M3 also includes CDs and other time deposits. However, no M2 seems to be available on the monetary aggregates page of the Reserve Bank of Australia web site, so the best money supply definition seem to be M3 minus time deposits or alternatively M1 plus "other deposits".

This discussion may seem technical, but as the growth of different money supply definitions often differ significantly (In recent years, broader aggregates seem to grow faster in most countries) it is relevant for determining just how strong inflationary pressures from the monetary system is. In the case of New Zealand, we see M2 shrinking by 1.4% while M3 is up 8.9%. In Australia and Sweden all monetary aggregates show significant growth, although M3 is growing significantly faster than the other aggregates in both countries.

Monday, March 17, 2008

The Federal Reserve Is Using Taxpayer's Money To Buy A Bunch Of Bear Stearns Traders Maseratis

No regular reader of this blog is likely to have failed to notice my deep admiration of Jim Rogers. Not only is he one of the most successful investors of all time, becoming rich first in his partnership with George Soros in the Quantum fund in the 1970s and then correctly calling in late 1998 for the start of the commodity price boom just a few months before it actually started in early 1999. And in the recent year, he has made the really good moves of selling shares of Wall Street investment bankers short while buying commodities in general and food commodities in particular. In short, he has been as right as you could get. The only thing he is bad at in this aspect is by his own insistent admission short-term market timing, but that have certainly not prevented him from becoming one of the most successful investors of all times. And as if that weren't enough, he is one of the sharpest analysts of current events around. And he expresses this correct analysis in a very straight-forward easy to understand way and doesn't bother to modify his wording to be polite or diplomatic. Case in point is his latest Bloomberg News interview, in this case by phone. I especially liked his very, shall we say straight forward way of explaining what the Fed bailout of Bear Stearns means

"The Federal Reserve is using taxpayer's money to buy a bunch of Bear Stearns traders Maseratis"

(Maserati, in case you don't know, is a prestigious Italian luxury car)

He points out that in January, just weeks before its collapse, Bear Stearns paid out billions in bonuses(!), you know to reward them for having made the mistakes that caused their company to ultimately collapse and for causing massive losses for the U.S. economy. But thanks to the Fed bailout, that reward is not in jeopardy, translating in effect to what this quote said. Rogers also notes that he has been waiting for an opportunity to get out of all his U.S. dollar assets during a briefly lived U.S. dollar rally. But now he realizes that he might again be taking losses from his one weakness, short-term market timing, as Bernanke seems determined to ensure this rally will never occur. Anyway, here is interview as a whole.

Fed Bailout Worsens Market Panic

This is proving to be an interesting day. Just two (!) days (Sunday evening, U.S. time) before the next regular meeting, the Fed has decided to cut its discount rate by 25 basis points and provide funding to various Wall Street firms. First and foremost, this extra funding will go to JP Morgan Chase to help it buy Bear Stearns, who would have collapsed the other day hadn't the Fed, using JP Morgan Chase as its middle man, bailed it out.

Interestingly, this does not appear to reduce market panic. Quite to the contrary, as this move clearly indicates panic at the Fed and that there is a risk of a market meltdown, this have caused sharp sell-offs in global stock markets and a sharp drop of the U.S. dollar against primarily gold, the yen and the Swiss franc, and to a lesser extent also the euro.

As a illustration of the current level of market irrationality and panic, the U.S. dollar has however actually gained in value versus a number of currencies, including the Australian and New Zealand dollar, the U.K. pound and the South Korean won. The move is most dramatic in the case of the won, as it fell today by 3.2%, from 997 to the U.S. dollar to 1,029. It has fallen more than 10% against the U.S. dollar in recent months and more than 20% against the Japanese yen. There is simply no rational justification for why news of deepening problems in the U.S. would cause the U.S. dollar to rise against any currency. While the yen and the Swiss franc was unfairly punished by the carry trade in the past, today many smaller or mid-size currencies such as the won is punished by an irrational fear of anything that market participants have arbitrarily deemed to be "risky". In the mid- to long run that creates profit opportunities in these currencies, but as long as this panic goes on, going into them seem unwise.

Considering the panic in today's move by the Fed, it now seems slmost certain that they will go for at least a 100 basis point Fed funds and discount rate cut tomorrow (or perhaps even today! In these crazy times that can't be ruled out, although it is perhaps not likely) as they know that anything less would disappoint the markets.

Sunday, March 16, 2008

EMU And Ireland's Problems

There has recently been an argument in the Swedish blogosphere over Ireland and the European Monetary Union. It started with neocon blogger Dick Erixon approvingly quoting an article in Swedish news paper Dagens Industri (not online) which basically said that because Ireland is part of the euro area, it faces problems because this disables them from lowering interest rates and thus also lowering the value of its currency. To this libertarian (or libertarian-leaning) bloggers Wille Faler and Johan Ingerö criticized Erixon and pointed out that such inflationary policies is not healthy.

Economics has never been Erixon's strong side, and he is certainly dead wrong when he implies that Ireland needs more inflation. However, while Faler and Ingerö are on the right track, I do not find their answers fully satisfactory, so I will therefore go to the bottom of this issue.

There is nothing wrong with monetary unions, per se. Quite to the contrary. It is likely that under a free market monetary system (i.e. a gold standard) we would basically have a single currency in all countries with this free market system. So in this aspect, monetary unions represents a replication of free market conditions even if it is paper based and run by a central bank as in the case of the euro. Because it creates more market like conditions, a monetary union will also be associated with increased trade, and therefore increased specialization and higher structural growth.

However, the issue is more complex than this. Because the euro is paper based and run by a central bank it is not certain that for all countries, it would be preferable (i.e. more similar to free market conditions) to join the euro rather than to have its own monetary policy. That is only the case if an independent monetary policy would be less sound, equally sound or only slightly sounder. If on the other hand an independent monetary policy would be significantly sounder than the policy pursued by the ECB, than it would certainly be preferable to have an independent monetary policy*.

Contra factual speculation always involves a degree of uncertainty, but it seems likely that in the case of Ireland an independent monetary policy would have indeed been significantly sounder. For years, Ireland has had high inflation and a housing price bubble because of the low interest rates set by the ECB. Had Ireland had an independent monetary policy it seems likely they would have had higher interest rates which would have contained these excesses to some extent and thus meant that Ireland would have had less problems now.

The problem here is not the principle of monetary unification, but rather that the ECB have pursued a too inflationary policy. This has hit Ireland disproportionably hard because their economies have boomed for other reasons. These strong economic conditions have made the Irish much more willing to respond to the ECB's low interest rate policy by increasing their debts than in for example Germany and Holland, where people have been reluctant to borrow more. Or to use, more technical economics terminology the price elasticity with regard to interest rates have been much higher in Ireland than in Germany and Holland.

There are thus good reasons to blame Ireland's problems on EMU (given the ECB's inflationary policies), but not because it stops them from inflating more now but because it has compelled them to inflate too much in the past. They thus arguably should not have joined in 1999, but withdrawing at this point is not a good idea. But in order for EMU to work for all members, the ECB must try to replicate the non-inflationary conditions of a gold standard as well.

Saturday, March 15, 2008

Swiss Franc Now Higher Valued Than U.S. Dollar

I didn't see it until now because the Swiss franc isn't quoted on Bloomberg news or any of the other financial news web site that I primarily rely on and because the exchange rates on the Fed overview of exchange rates, reflect quotes from early Friday, but as I went to Yahoo finance exchange rate section, I see that my prediction from Tuesday last week that the Swiss franc would surpass the U.S. dollar in value has already been realized. The quote from late Friday is that a Swiss franc now cost US$1.0022, or alternatively that a U.S. dollar is now worth 0.9978 Swiss francs. Also, my call from this Thursday for the yen to rise above 1 U.S. cent has also been realized as the dollar now only cost 99.01 yen.

Observations About Bear Stearns Near Collapse

Jim Rogers calls for the abolition of the Federal Reserve in the wake of its bailout of Bear Stearns. He adds:

"Listen, investment banks have been going bankrupt since the beginning of time. If people make mistakes -- if you bail out every investment bank that gets in trouble, that's not capitalism, that's socialism for the rich."

With regard to Bear Stearns and its near collapse, Paul Krugman notes a poetic justice in that particular bank getting in trouble, as its chief economist David Malpass was one of the biggest cheerleaders of the phony boom, using nonsensical arguments like "asset price inflation is savings" to deny that there was any problem during the boom and so of course he was not able to forecast the current problems either. And after it became apparent to everyone that there was a problem, he did his best to downplay the problems, a line which does not appear credible considering the problems his bank has gotten into. And finally Malpass has long been bullish on the dollar. In short, Malpass has been as consistently wrong as you could get, something which is probably not unrelated to Bear Stearns problems as they have presumably acted based on his faulty analysis.

Another thing to note was that Bear Stearns was actually mentioned in the hilarious and yet still accurate discussion of the subprime crisis by two British comedians that I posted in January ,with regard to two of their worst funds, "High Grade Structured Credit Strategies" and "High Grade Structured Credit Enhanced Leverage Fund". As was explained in the discussion, these are fancy names for investments in bad debts. This again illustrates the poetic justice in Bear Stearns problems.

Friday, March 14, 2008

Internal Exchange Rates

In finance, there is a concept called internal rate of return. The internal rate of return is the interest rate which
equalizes the present value of the payments received from an investment to the initial investment amount. To use a very simplified example, if you say invest €10 million today and get €11 million back a year later, the internal rate of return would have been 10%. If you would have gotten back €10 million, the internal rate of return would have been zero, if you would have gotten back €10.5 million the internal rate of return would have been 5% and so on. The same principle applies for income received during more than one year, and so if you would have gotten back €5.5 million a year later and €6.05 million, the internal rate of return would have also been 10%.

The higher the internal rate of return, the better is the investment object. And as long as the internal rate of return is higher than the prevailing interest rate plus perhaps a few extra percentage points as a risk premium, the investment is worth making.

Why do I bring up this concept in finance. Not so much for its own sake, but rather because I have come up with a similar concept-internal exchange rates. The internal exchange rate is the exchange rate which equalizes GDP or GDP per capita for different countries or areas. For example, the internal exchange rate with regard to GDP per capita in the US and Sweden was during 2007 was exactly $1.5675 per euro as the US had a GDP per capita of $45,813 as GDP was $13,843.8 billion and the mid-year population was 302.178 million. Sweden on its hand had a GDP of SEK 3073.8 billion and had a mid year population of 9.15 million, giving it a GDP per capita of SEK 335,934. This creates a GDP per capita internal exchange rate of 7.33 SEK/USD and a GDP internal exchange rate of 0.22 SEK/USD. The actual SEK/USD exchange rate is 6.04, implying that at current exchange rates Sweden has a higher GDP/capita than the U.S., but a much smaller GDP. The internal GDP per capita exchange rate is also lower than the estimated PPP calculated by the OECD, implying that after adjusting for price differences Swedish GDP per capita is lower after all. PPP measures are in principle better when comparing standard of living -but not economic influence-, yet they are on the other hand have significant measurement problems as was illustrated by the recent massive revision of Chinese and Indian PPP.

In most countries, the internal GDP exchange rate relative to the U.S. dollar is as in Sweden, much higher than the internal GDP per capita exchange rate because most countries have much smaller populations than the United States. The big exceptions are of course China and India, and to a lesser extent also the euro area.

The perhaps most interesting internal exchange rate is the one equalizing GDP in the United States and the euro area. In the United States, GDP was $14,084.1 billion at an annual rate during the fourth quarter of 2007, while euro area GDP was €8986.4 billion, creating an internal GDP exchange rate of $1.5673/€. Compare this to the exchange rate which I now see at Bloomberg, 1.5637, only 0.24% lower. This implies that at current exchange rate fourth quarter GDP was only 0.24% lower. And there are in fact two good reasons for suspecting that the actual internal exchange rate is even lower during this quarter. First, because this euro area number was based on the then 13 member states, but now Malta and Cyprus is also part of the euro area, which adds 0.2% to euro area GDP. Secondly, because U.S. GDP probably shrank during the first quarter, while euro area GDP probably grew, albeit only slightly. That means that the internal GDP exchange rate for this quarter is likely below $1.56/€, implying in turn that the euro area has probably already overtaken the U.S. as the worlds largest currency area.

It will probably take a while before the financial journalists figure that out, but when they do, remember where you read about it first.

Don't Be Fooled By Seemingly Low Inflation Number

Today's U.S. CPI number came in a lot lower than expected, with both the core and the all-items index being unchanged on a monthly basis. However, people should not from conclude is really low, as there were two special factors temporarily depressing the number. First of all, some of this is reflect problems with seasonal adjustment. The actual all-items and core number both in fact rose 0.3%. Moreover, the repott says that energy prices fell. But this reflects the temporarily depressed oil price in early February, which then stood at around $90 per barrel. Now oil is trading at over $110 per barrel, making this report very out of date. So the seeming lull in inflation will certainly only be temporary.

Thursday, March 13, 2008

Gold, Oil, Euro, Swiss Franc Reach New Records

Gold rise above the key $1,000 per ounce level while the euro rise above $1.55, just as I had predicted (see here and here). In addition, oil rose above $110 per barrel. The next key levels to be broken is for the yen to rise above 1 cent (i.e. for a dollar to cost less than 100 yen, which it actually briefly did earlier today) and for the Swiss franc to reach parity with the dollar and then surpass it in value.

Why Bernanke Is Inflating So Much

Bloomberg columnist Mark Gilbert provides an interesting review of Ben Bernanke's infamous 2002 speech which earned him the nickname "Helicopter Bernanke" because of his "we'll stop at nothing to prevent deflation"-attitude and direct reference to Milton Friedman's "money helicopter".

In it, we see the explanation for Bernanke's behavior. This man is obsessed with the thought of stopping deflation which he views as an imminent threat, despite all the signals of soaring inflation. Indeed, his obsession with this is likely what causes him to ignore the increase in inflation. In it he notes that there are quite a lot of unorthodox policy instruments which would allow the Fed to stop deflation and notes how the 1933 devaluation of the dollar ended deflation in America.

"Deflationists" like Mike Shedlock overlook not only the current inflationary monetary- and price trends because of their incorrect money supply definition, but also overlook the obsession that Bernanke have with literally doing whatever it takes, including monetizing the national debt , to stop deflation if deflationary monetary trends were to appear. The deflation of the great depression and in Japan had its origin in an inability (due to the current gold standard, which although watered down compared to the real thing was still a real policy restraint) and unwillingness to use unorthodox policy measures. Once such was used, as in America 1933 when the gold standard was ended, deflation ended too.

Wednesday, March 12, 2008

Sweden No Longer Highest Taxed Country

Sweden is no longer the country in the world with the highest tax to GDP ratio. In 2007, the Swedish tax ratio was 47.8%, versus 48.4% in Denmark. This means that Denmark is now number one on that non-flattering category.

Both Sweden and Denmark's relative burden of government is somewhat exaggerated by two factors. Namely, the fact that Sweden and Denmark tax transfer payments (Taxing transfer payments instead of simply paying out net money have no real effect for either any individuals or the government, but raises the ratio of both taxation and spending relative to GDP) to a much higher extent than other countries, a factor which is responsible for roughly 3%: points of the relatively higher tax and spending ratios in Sweden and Denmark. Moreover, unlike in most other countries, both Sweden and Denmark have high budget surpluses. If you take these factors into account, France and probably also Belgium have even higher burden of government than Sweden and Denmark.

On the other hand, these tax ratio underestimate the absolute level of taxation in all countries (so this is not a factor in the relative position of Sweden and Denmark, at least not in any significant way) for two reasons. First of all, nowadays the estimated level of black market activities is included in GDP. This is appropriate when measuring the total level of economic activities, but it also means that the tax ratio will underestimate the level of taxation for people working the official economy. Secondly, this tax ratio is estimated relative to GDP, and not net national product or national income. Net national product/national income measures the true level of income as it excludes the cost of capital consumption, and is thus smaller than GDP. That means that the ratio of taxes to national income is much higher. That is the most important reason (the other is that capital income is lower taxed than labor income) why the tax ratio in Sweden for example has long been around 50%, even though the total tax wedge for middle income earners have been around 60%.

Exchanging Bad Debt For Bad Debt

Well, one can accuse the Fed of many things, but not for being inactive. Not only have they reduced interest rates dramatically but they have come up with one scheme after another to reduce the increased risk aversion in some selected credit markets. The latest, as most of you have presumably already heard of, is called Term Securities Lending Facility, in which the Fed will essentially exchange Treasury (government) securities in exchange for mortgage backed securities. The purpose of this seems to be to reduce the yield spread between these two types of securities, which it probably will achieve although only to a limited extent. However, it will certainly not solve the underlying problems of the U.S. housing market and economy with too high levels of housing inventories and mortgage debt and too low savings rate.

In short, it won't have anything near the dramatic effects that Wall Street imagined based on yesterday's massive stock rally (arguably though, that rally may to a large extent simply have been based on the perception that the market was tecnhically oversold and this news was thus simply a false excuse for a rally). Nor is it really likely to have much of the negative effects that some argue. While certainly the mortgage backed securities could be characterised as bad debt, so can the Treasury securities with their pathetic yields, which are negative in real terms. The losses for the Fed from defaults on these securities could thus largely be compensated by the much higher yield on those that don't default. Both mortgage backed securities and Treasury securities should be considered bad debt, as both is likely to inflict losses on anyone who invests in them. In the case of Treasuries in the form of a negative real yield, in the case of mortgage backed securities in the form of defaults on some of them.

And if (big if here) the Fed views this as a substitute for continued dramatic reductions of the Fed funds rate, then this is in fact good, as in being a lesser evil. However, if the Fed views it as a complement rather than substitute, then that will not hold.

Tuesday, March 11, 2008

ECB vs. The Fed

Sebastian Mallaby on the different views of the current situation between the ECB and the Fed:

"The divergence in approaches on either side of the Atlantic is likely to stoke tensions. Americans resent Europeans for not sharing the burden of stimulating the world economy, forcing them into unilateral action. Europeans resent Americans for blundering foolishly ahead, exacerbating inflation. For years there has been an unhealthy imbalance in the world economy, with the United States contributing disproportionately to the growth in demand and doing too little in the way of saving. The response to the current economic mess increases that lopsidedness. Americans are spending heavily to head off the risk of recession while Europeans close their wallets."

To the extent that the exchange rate adjusts, the ECB do not need to worry about inflationary spill-over from Fed policy. And as we know the dollar has indeed fallen significantly against the euro. But has it fallen enough? That seems more dubious as commodity prices have risen a lot more than the dollar has fallen. That can of course to a large extent be blamed on the ECB's more moderate inflationism, but it can also indicate that the dollar hasn't fallen enough.

Mallaby also compared the Fed's action to Bush's action in the Iraq war case, and the split this created with Germany and France. Assuming this analogy is correct, which it probably is, this means that America will face several years of deep problems due to their over-activism, like they have done for the past 5 years in Iraq.

Sunday, March 09, 2008

Sucker Rallies Graphically Depicted

I see (via The Big Picture) an interesting graph depicting how the U.S. stockmarket either in anticipation of predicted Fed interest rate cuts or as a reaction to rate cuts that were unexpected or unuexpectedly large, rallied only to fall back later when market participants reminded themselves of the reason why these rate cuts were implemented. That fits the definition of sucker rallies, namely temporary rallies during a bear market.This pattern was also seen during the 2001 recession.

Saturday, March 08, 2008

The Euro Split

The column in The Economist that is known as Charlemange has an interesting story about how Germany and France are split in the issue of monetary policy. Germany knows from its history that if inflation gets out of control, like it did in 1923, this leads to disaster. They also remember the success of the relatively hard money policy pursued by the Bundesbank in the post-war era. It is therefore hardly surprising that the leading hawk in the ECB board is Axel Weber, a German.

The French by contrast has long traditionally been friendlier to inflation, which is why they now complain that the euro is too strong and call fro ECB interest rate cuts.

Charlemange also note the incoherence of the French attacks on the ECB. While calling for more inflationary policies, Nicolas Sarkozy and other French politicians at the same time express worry about the reduction in domestic purchasing power due to rising inflation. Either these politicians are too stupid to comprehend the link between a higher money supply and higher prices or, which is arguably more likely, the attacks on ECB is simply a way for them to blame France's economic problems on some else.

U.S. Employment Report Confirms Recession

As expected (by me) the employment report showed continued decline in private sector employment who according to these preliminary estimates by an additional 101,000, primarily in manufacturing and construction. In addition, there were significant downward revisions of previous months. The media noted that December employment growth was downwardly revised by 41,000 and January employment growth by an additional 5,000, meaning that the level was 46,000 lower. However, what the media failed to note was that the downward revision of private sector employment was even greater as government employment growth was upwardly revised by 27,000 in December and by 20,000 in January. Add all this up and you get a total downward revision of private sector employment of 93,000, implying in turn that reported private sector employment was 194,000 lower for February than the previously reported level for January.

Private sector employment is down for three months in a row now, clearly indicating a recession. And I in fact suspect that there will be more downward revisions. Although the number of jobs imputed by the flawed so-called "birth-death model" is now lower than in past reports (this is likely one of the reasons for the downward revisions), it still claims that a net 640,000 more jobs was created in new businesses than businesses who failed during the latest year, or roughly 53,000 per month. At this stage of the business cycle, any number over zero likely overestimates this, meaning that the decline in employment is likely even steeper than they now suggest.

This is also confirmed if you look at the household survey. While the payroll survey claims that total employment growth during the latest 12 months 860,000 of which 612,000 was in the private sector, the household survey says that total employment growth during the latest 12 months was just 105,000. If you subtract government employment growth from that you get a decline of 143,000. There can be little doubt thus that private sector employment has fallen since at least December, probably also November, and that it in December-February has fallen a lot more than current numbers suggest.

That, and other indicators, in turn suggests that the U.S. economy clearly fell into a recession during Q4 2007 and that this recession have become more severe during this quarter.

Thursday, March 06, 2008

About Flow Of Funds Report

While everyone is still focused on the employment report due to be released later today, another very important report was released yesterday: the Flow of Funds report.

On the one hand, it showed that household debt growth is finally starting to recede. Household debt increased just 5.7% (The Fed statisticians claim it is 5.6%, but that's because they don't seem to understand the principle of compound growth) at an annual rate, way below the double digit growth levels we saw between 2002 and the first half of 2006. However, while less bad than before, debt still continues to grow faster than income, as disposable income rose just 3.8% at an annual rate (in nominal terms), and so the debt to income ratio reached a new all time high of 133.7.

And unlike in most recent years, this was not compensated for by rising asset values. Because of both falling house prices and stock prices, household assets fell by 1.7% at annual rate to $72,092.5 billion. As a result of falling asset values and rising debt, net worth declined by 3.7% at an annual rate to $57,718 billion. And remember, that's in nominal terms. Adjusted for inflation, the decline would have been nearly 8%.

This decline is likely to be at least as big, and probably even bigger, during this quarter. With this, and the negative savings rate and the falling real disposable income in mind, falling private consumption in coming months looks inevitable.

Business debt on the other hand continued to show very rapid growth, at 12.6% at an annual rate. While corporate profits somewhat surprisingly rose slightly for domestic nonfinancial companies, they are still way below the levels seen for most of 2006 and 2007 even in nominal terms. Dividend payments on the other hand continue to rise fast, and while investment growth has declined it was still positive during Q4 2007. The rapid debt growth is how companies finance this combination of falling profits, rising dividends and rising investments. However, this is hardly sustainable and means that business investments should start falling too.

As a result, the national savings rate fell to a new low, at 12.7% of GDP in gross savings and 0.6% in net savings (Net savings is basically gross savings minus capital consumption). Both are all time lows except for the brief negative net savings that we saw in Q3 2005 after the massive capital destruction caused by Katrina.

So, this report certainly supports the bearish case. And with total private sector debt still rising at an annual rate of 8.5% (causing the private sector debt to GDP ratio to rise from 168.2% to 169.7%), it again confirms that the talk of a "credit crunch" is a myth.

Wednesday, March 05, 2008

Larry, "Shock And Awe" Is The Cause Of Rising Inflation

Larry Kudlow, the CNBC host, who has repeatedly expressed support for the Fed's aggressive interest rate cuts, which he has called "Shock and Awe" monetary policy and who confidently predicted that as a result of these policies the dollar would rise and the price of gold would fall, back when gold stood at $720 per ounce and a euro costed $1.38, as compared to $992 and $1.53 now, is now getting worried about inflation.

You know inflation is bad when even Larry Kudlow expresses worry about it. He also describes one way in which inflation harms the economy, by raising the de facto taxation of capital income as capital income is taxed based on nominal gains. So, even assuming that inflation do not reduce real returns before tax, it will mean that people will have to pay taxes for capital gains which are just inflation.

He finally calls for Bernanke to be replaced by someone who cares more about inflation.

Well, so far so good. Yet Larry fails to mention just how he thinks the Fed should have acted differently and he fails to admit that it is precisely Bernanke's "Shock and Awe" policy that is responsible for the decline of the dollar and the acceleration of inflation. This is to say, he fails to admit that it is the policies he has recommended and praised which are responsible for the inflation he now worries about.

Tuesday, March 04, 2008

Swiss Franc-Next Currency To Surpass U.S. Dollar

Setting aside some currencies of very small or poor countries, there has traditionally been just one mayor currency which has had a higher value than the U.S. dollar. Namely, the U.K. pound (aka sterling). Then after the creation of the euro in 1999, another currency with a higher value than the U.S. dollar appeared. But then the euro fell and the U.S. dollar was higher valued than the euro between early 2000 and mid-2002. After that however the euro regained its status as more valuable than the USD and is now worth more than 1.5 USD. In September last year, after the Fed's first fed funds rate cut in this cycle, the Canadian dollar became the third currency to become more valuable than the U.S. dollar. The Canadian dollar have since fluctuated between a level slightly above and below the U.S. dollar, rising whenever investors focus on commodity prices and falling whenever they focus on the non-commodity part of the Canadian economy. It is currently however slightly higher valued than the USD, with one U.S. dollar costing 0.9867 Canadian dollar.

I now boldly predict that the fourth major currency to surpass the USD will be the Swiss franc. The Swiss franc is already up quite significantly-from 0.82 USD to 0.96 USD (As the USD has fallen from 1.22 Swiss franc to 1.04 Swiss franc), a 17% increase. This is faster than the 15% rise of the euro. The Swiss franc has for long been held down by the so-called carry trade because nominal interest rates is lower than in most other countries. Yet this has been a result of lower inflation rather than lower real interest rates so that has been somewhat unfair. Monetary conditions in Switzerland have actually been fairly tight, with M2 money supply contracting and M3 increasing only slightly (up 1.2%). The result of the combination of tight monetary conditions and a until recently weak currency has been that Switzerland's already huge current account surplus have soared to 85 billion Swiss franc or 17% of GDP.

Today more news bullish for the Swiss franc was released. Switzerland's GDP growth accelerated in the fourth quarter of 2007 to 3.6% compared to Q4 2006. Compared to Q3 2007 real GDP rose 1.0%, which is 4% at an annual rate. This indicate that the Swiss economy is "decoupling" and that together with a rise in price inflation certainly indicate that the Swiss National Bank will be more likely to raise than to cut interest rates. Add to that the likely continued aggressive Fed rate cuts and the Swiss franc's status as a safe haven during stock market turmoil, and the Swiss franc looks nearly certain to rise above the U.S. dollar in value within a not too distant future.

Monday, March 03, 2008

The Confused Female Wage Debate

After IF Metall, the biggest union within the Swedish central union LO, said it would not agree to coordinate wage demand with other LO unions in order to raise female wages relative to male wages, the feminists within LO went ballistic and attacked tacked IF Metall, despite the fact that IF Metall said it was in fact committed to raising relative female wages and that they just didn't think coordination with other LO unions was the right way to do it.

The feminist-dominated media showed their view of "fair and balanced" reporting by also interviewing more feminists to criticize IF Metall. What especially upsetted the feminists seem to be that IF Metall argued that one cause of lower female wages was that many typically female professions was less qualified, to which the feminists replied that they think that they are as qualified as the typically male professions.

Yet what is completely left out of this debate is the fact that wage levels have nothing to do with qualification of the tasks themselves, other than very indirectly, and is instead related to the marginal productivity of labor. Marginal productivity is itself determined by three factors: 1. How high demand is for the products of the company or organization they work for 2. How necessary that task is for producing the products of the organisation 3. How many people that are willing and able to do that job.

Point number one and two should be fairly obvious as an organization clearly can't pay more money than they have available, and as demand for a particular kind of job task is obviously related to how necessary it is and how many workers this requires. Point number three is perhaps not as immediately obvious, but think about it this way. If there are many people trying to get the same kind of jobs, then if a worker quitted, the employer probably wouldn't have to pay any more to get a replacement. If on the other hand there is a shortage of workers for that task then the employer would probably have to pay a lot more to get an equally qualified worker. The marginal productivity of a worker is thus a function of much the employer would have had to pay if that particular worker hadn't worked there.

Why then do women in general have lower marginal productivity? Well, simply because they choose to work in jobs with low marginal productivity, where there is a surplus of workers. Women themselves choose to work in these jobs. No one is preventing them from entering typically male professions. If they stopped applying for these jobs, then the employers would be forced to raise the wages of those jobs. The women who want to work in those jobs presumably apply to it because they like the job tasks or because they don't require much education. And that's a legitimate choice for someone with such preferences, but they should note that it is this preference which causes their lower pay.

And do note that this analysis do not simply apply to a pure market economy. It applies just as well to the typical mixed economy where the government subsidize certain sectors and try to get women to increase their formal labor market participation relative to men, by for example having high taxes on labor in general win order to finance subsidies to day care centers. The only thing this changes is which sectors will demand labor and the relative labor supply by men and women. Ironically, this feminist policy of taxing men and thereby reduce their labor supply and using that income to subsidize formal female labor supply is in fact a contributing cause of the wage gap the feminists are complaining about.

Gold Remains Better Than Any Paper Currency

Many people all too often simply think of currencies in terms of one paper currency relative to others. While one certainly should consider that for several reasons, one shouldn't forget that there are better investment alternatives than paper currencies.

While I have long been (and continues to be) bearish on the U.S. dollar versus most other paper currencies that doesn't mean that I think those other paper currencies are the best investment choice. While the ECB for example pursues sounder policies than the Fed,their policy is onlky sound in a relative sense. The ECB too is inflationary in a absolute sense as they fail to raise interest rates despite the fact that inflation is well above their alleged "ceiling" of 2% and continues to rise. Instead, I have long argued that gold is a better investment alternative now that inflation is accelerating. This is in part due to the direct effect of inflation in terms of depreciating the real value of paper currencies, but even more importantly because of the indirect effect of increasing demand of gold as an inflation hedge.

Anyone who followed that advice would have earned a lot of money as gold is up more than 30% since then, from $750 to $984 per ounce. It will soon break above $1000, probably already this week. Yet that will not be the end of it. Remember during the 1970s, gold rose from $35 to $850, a 24fold increase. At $1000, gold is up only 4 times since the 1999 low. If Bernanke continues his current extremely inflationary policies, gold might very well increase 24fold this time too, which would imply a gold price of $6000 within a few more years.

I now see a story on Bloomberg News entitled "Growing Global Distrust Of Central Bankers" indicating that more and more people realize that with inflation accelerating, government bonds in general and U.S. government bonds in particular suck as investment alternatives and that gold and other commodities is the place to be for investors.The only question is why it took them so long to figure it out.

Saturday, March 01, 2008

Hong Kong's Inflationary Boom

The preliminary numbers for Hong Kong GDP during the fourth quarter of 2007 and for 2007 as a whole was recently released. It contained both good news and bad news for Hong Kong. The good news is that real growth remains high. During the fourth quarter, volume GDP growth was 6.7% and the terms of trade adjusted real growth number was even higher, 7.1%. Both private consumption and fixed investments increased by over 10%, while the trade surplus fell somewhat. Meanwhile, government consumption fell back to a new low of just 8% of GDP.

Thanks to a lower burden of government spending combined with soaring tax revenues, the Hong Kong budget has a record surplus of 116 billion Hong Kong dollars (roughly 15 billion U.S. dollars or slightly less than €10 billion) or more than 7% of GDP, which will now be used for tax cuts as well as some temporary spending projects.

While much of this success is attributable to Hong Kong's laiseez faire policies with low taxes, low government spending and light regulation, it should be cautioned that there is also a darker side of this boom, which are likely to cause future problems.

Hong Kong has pegged its dollar to the U.S. dollar, and this means that Hong Kong is forced to follow Bernanke's extremely inflationary policies. This has caused rapid increases in house prices and it is also evident in soaring consumer- and producer price inflation. As late as 2006, the price index known as the GDP deflator was falling and during the first quarter of 2007, the year over year rate of increase was just 1.2%. In the fourth quarter of 2007 it was 4.7%. Real growth has been in the neighborhood of 6-7% per year since 2005, but the difference is that price inflation and nominal growth is much higher now.

These inflationary excesses could have been avoided or minimized if Hong Kong would have ended its irrational U.S. dollar peg. And they should and could still do it in order to limit the build up of further inflationary problems.

Who Is Taxing Them?

As a follow-up on the last post where I argued that real disposable income and real consumer spending in America would be lowered a surge in inflation, I feel I should comment on this Bloomberg news story about the most recent personal income and spending report.

In it, Drew Matus, senior economist at Lehman Brothers Holdings, makes roughly the same prediction as me and says

"The big issue is the fact that inflation is accelerating, and it's taxing consumer spending. The first half is not going to look all that good."

That's a good characterization of it. Consumers are being taxed by the higher inflation. The only thing missing is the issue of who is taxing them. The answer to that question is of course Ben Bernanke, Donald Kohn and the others at the Federal Reserve. It is their policies which have driven down the value of the dollar and driven up the price of oil and other commodities and so eroded the purchasing power of ordinary Americans. This also means that their inflationary policies wont have the intended "stimulative" effect after all.